A Brief Introduction to Commodity Option Trading
The world of commodity options is diverse and cannot be given justice in a short article such as this. The purpose of this writing is to simply introduce the topic of options on futures. Should you want to learn commodity options trading strategies in more detail, please consider purchasing "Commodity Options" published by FT Press at www.CommodityOptionstheBook.com.
Why Trade Commodity Options?
Just as there are several ways to skin a cat, there are an unlimited number of option trading strategies available in the futures markets. The method that you choose should be based on your personality, risk capital and risk aversion. Plainly, if you don't have an aggressive personality and a high tolerance for pain, you probably shouldn't be employing a futures and options trading strategy that involves elevated risks. Doing so will often results in panic liquidation of trades at inopportune times as well as other unsound emotional decisions.
Commodity options provide a flexible and effective way to trade in the futures markets. Further, options on futures offer investors the ability to capitalize on leverage while still giving them the ability to manage risk. For example, through the combination of long and short call and put options in the commodity markets, an investor can design a trading strategy that fits their needs and expectations; such an arrangement is referred to as an option spread. Keep in mind that the possibilities are endless and will ultimately be determined by a trader's objectives, time horizon, market sentiment, and risk tolerance.
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1. As a futures option seller, it takes money to make money...leave plenty of excess margin in your commodity trading account
Short option traders must be properly funded to be capable of riding out any storm that might materialize. During times of excessive commodity market volatility, many traders turn to the limited risk of option buying. This has a tendency to artificially inflate commodity option prices, due to the increase in demand for the securities. Also, in a more volatile market environment, commodity traders often believe it is more likely that a long option strategy will have an opportunity to pay off. I argue this is a false perception because options on futures buyers must overcome their cost of entry before turning a profit; the higher the price of the option on the way in, the bigger the obstacle to being profitable will be. Nevertheless, in all of the excitement traders often behave emotionally rather than logically; as a result, they exuberantly bid up the prices of low probability options to shocking levels.
Short-Option position sizing
In most options and futures markets, you would want about $10,000 in a trading
account for one, or two, commodity options sold. In some of the higher margined markets such as gold, it would likely be in your best interest to have much more. Another way to determine the appropriate account and position size is excess margin. Generally speaking, it is a good idea to utilize 50% of less of your account when trading short options. Simply put, if your account size is $10,000 you should aim for trades that will require a margin of $3,000 to $5,000. On the flip side, the excess margin listed on the bottom of your statement should be between $7,000 and $5,000.
Some might look at the funds not being used toward margin as a missed opportunity, or a waste of risk capital. However, nothing could be further from the truth. Undercapitalized commodity option sellers will almost undoubtedly get into trouble. Without plenty of excess margin in a commodity trading account, it can be difficult to survive the normal ebb and flow of the futures markets. In addition, a lack of capital dramatically increases the odds of a margin call, which can result in pre-mature liquidation of an option trade. If the situation is dire enough, the liquidation might be at the hand of your commodity broker; which is an unpleasant experience for all parties. With that said, not all commodity option brokers are created equal (see the next talking point).
2. The commodity broker you choose for your option selling account DOES matter!
Unfortunately, many beginning option sellers overlook the impact their choice of commodity broker has on the bottom line of a trading account. Even worse, they assume the only affect their option broker will have on their trading results is the per contract commission charge. As a long-time futures broker I can assure you, there is much more to the relationship between a trader and his commodity brokerage than transaction costs.
Regardless of whether a commodity option trader is placing orders online though a futures trading platform, or by phone or email with a broker, the choice of a brokerage firm will eventually play a big part in the success or failure of a commodity option trading strategy. This is because many futures brokers are averse to allowing their clients sell options on futures; even those brokers that allow it often take other actions to reduce risk exposure to the brokerage such as restricting the commodity option contracts available to trade, increasing short option margin requirements (above and beyond the exchange minimum SPAN margin), and even force liquidating client positions at the first sign of trouble. Futures brokers with heavy handed risk managers can wreak havoc on an option selling account. Imagine your option broker liquidating your trades at a highly inopportune time, before a margin call is triggered, and without notifying you. Such an event can be a costly and frustrating experience; but it can also be avoided by ensuring your commodity option broker is willing and capable of servicing your account type.
My commodity brokerage service, DeCarley Trading, specializes in handling option selling accounts.
3. Most futures and options traders lose money!
Whether trading futures or options, a common mistake commodity traders make is to blindly follow the lead of random trading books, business news stations, popular financial newspapers, and magazines. The ugly truth is most commodity traders lose money. Knowing this, why in the world would you want to do what "everyone else" is doing? In light of the success rate of the masses, you probably don’t want to join them. Most traders are buying options, and or employing futures trading strategies; a much smaller percentage of traders are selling commodity options. Perhaps option selling is the prime “contrarian” strategy, and should be considered by all market participants for the simple reason that it is unpopular…and historically speaking, unpopular ideas in trading sometimes turn out to be the gems.
4. Sell Commodity Options on the contrary
As opposed to simple premium collection without a purpose, such as carelessly selling calls and hoping nothing happens, I feel like the best odds of success is to patiently wait for market panic or excitement of the masses and to play the other side of the trade. Warren Buffet said it simply, "Be fearful when others are greedy, and greedy when others are fearful"; he wasn’t referring to option trading but the concept can certainly be applied. For instance, some of the best option selling opportunities occur following massive price spikes in a particular direction. When such a price extension occurs most speculators are busy buying options in the direction of the trend at obscenely high prices, when the best trade is often to be a seller of those over-priced options. Of course, this type of approach is equivalent to catching the proverbial “falling knife”. If what you believe to be the exhaustion of a trend, turns out to be the early stages of a much larger move the trade could be in danger of substantial losses.
Selling options as a contrarian isn't easy money, but I do believe it might be advantageous from an odds perspective. After all, times of directional volatility and emotion often involve excessive option premium and this makes it a great time to be an options on futures seller. If you were a store owner, you would prefer to sell hot products at high prices, as opposed to items on the discount rack. Option selling is no different.
Of course, the trick is to be patient enough to improve the probability of your entry being at the peak of volatility; this is easier said than done. However, completely disregarding commodity market volatility when implementing a short option strategy could lead to painfully large losses regardless of whether the futures price ever touches the strike price of the short option.
5. Who are candidates to sell commodity options?
Before choosing to implement an option selling strategy in the futures markets, you must first honestly assess your ability to accept the prospects of unlimited risk and margin calls. Not everyone is capable of managing the emotions that come with these two characteristics of the strategy; and even those who are, will have moments of weakness. As a seasoned commodity option broker, I can attest the markets are capable of making a grown man cry. Failure to keep trading emotions in check could mean letting losers get out of hand, or panicked liquidation at unfortunate prices. Either scenario could be psychologically and financially devastating to an option selling strategy.
Futures Option Volatility Trading with the VIX
The adage buy low and sell high was originally used in reference to price, but can also be applied to the practice of trading volatility. In fact, even as a commodity option trader looking to trade market price as opposed to volatility, ignoring measures of potential explosiveness while entering or exiting a market could mean financial peril. While many commodity traders, whether beginner or pro, understand the concept of buying options during times of low volatility and selling them during times of high volatility, emotions often lead a well-planned strategy astray.
Unlike traders that are looking to profit from a directional move in price, volatility traders are more interested in the pace at which the market is moving than the direction. However, I argue that it is important to chart both price and volatility in a commodity market before speculating in options. Doing so provides trades with a better understanding of the 'big picture'.
In my opinion, the most efficient means of trading equity market volatility isn't through the VIX index, or any other similar measure. High levels of leverage, a lack of options on futures market, and a tendency for the index value to erode over time are major factors working against the viability of doing so. Instead, I believe that traders should look to buy or sell options on S&P 500 futures, or more specifically the e-mini S&P (symbol ES). The S&P 500 is a broad based stock index and its value is sharply impacted by market sentiment and the corresponding volatility. Thus, a trader that is of the opinion that volatility will increase may look to buy volatility through the purchase of options written on S&P 500 futures and those looking for volatility to decrease may look to sell volatility buy going short options on the index. Accordingly, insiders often refer to the practice of buying or selling options as "going long volatility" or "going short volatility".
Trading S&P 500 Volatility through Premium Collection in the Futures Market
As mentioned, one way to speculate on variations in volatility is through the practice of option selling, often referred to as premium collection. It is important to realize that I am referring to trading American style options which allow traders to buy, sell or exercise options at any time prior to expiration. This differs from the European style versions that offer far less flexibility. The increased level of flexibility tends to have a positive impact on the value of the option and thus the amount of premium collected for selling it. In other words, option buyers may get more value using European style options (referred to as end-of-month options in the S&P) due to lower premiums; conversely this concept works in favor of option sellers of American style options.
Why Option Selling?
Option sellers are in the business of collecting premium, much like an insurance company, under the assertion that in the long run the premium collected should outweigh any potential payouts. This theory is based on the assumption that more options than not expire worthless, which has been suggested by several studies including one conducted by the Chicago Mercantile Exchange. Unfortunately, similar to insurance companies who are sometimes forced to honor their policies on excessive claims, commodity option sellers are vulnerable to monster market moves than can be potentially account threatening. Preventing such disasters ultimately come down to timing of entry along with a good understanding of futures market volatility, market sentiment, and market knowledge. Additionally, experience, instinct and, of course, luck will also come into play. Yet, in my judgment option selling is a superior strategy in the long run.
Futures options selling advocates and equity market volatility traders seem to migrate to the S&P 500 futures market (e-mini S&P). There are other stock index futures such as the e-mini Dow Jones Industrial Average and the e-mini NASDAQ, but the e-mini S&P offers the most liquidity as well as a broader based index with smoother price movement.
CBOE's Volatility Index Futures (VIX)
An important measure of volatility when referring to the S&P 500 is the now infamous Chicago Board Options Exchange's Volatility Index, often simply referred to as the VIX. According to the CBOE, the VIX is a "key measure of market expectations of near-term volatility as conveyed by S&P 500 stock index option prices" and has become one of the most prominent measures of market sentiment in the world. In “normal” market conditions, the VIX spends a majority of its time below 20. As chaotic price action in the financial markets heat up, the VIX can see spikes into the 30 or 40 levels. However, in historically extreme circumstances such as the 2008 financial crisis, the VIX can trade into the 70s, or even higher.
The VIX futures contract is the sole futures offering on the CBOE exchange. As a result, not all futures brokers offer access to trade it. Additionally, receiving real-time VIX quotes in a futures trading platform isn’t necessarily a given.
The VIX futures market offers contracts expiring each month. The margin to trade VIX futures fluctuates around $3,000 per contract and the point value is $1,000, making it a very volatile holding in any commodity trading portfolio. For instance, fi the VIX moves from 15.00 to 16.00, the trader would have made or lost $1,000 per contract with a margin deposit of just $3,000. If you’ve followed the VIX, you know that it doesn’t take much time to travel a full point. Thus, most traders are probably better suited trading e-mini S&P options, than dabbling with highly levered VIX futures.
Increased values of VIX are highly correlated with higher option premium in the ES (e-mini S&P) options due to inflated expectations of future volatility built into options on futures prices. Assuming he is willing to accept the risk of participating in such a market, times of inflated expectations of volatility, and therefore over-priced options, are ideal conditions for an experienced option seller.
The Quest for Implied Volatility in Futures Options
Unlike the VIX which is derived from the underlying futures price, among other factors, implied volatility is a component of option price. The implied volatility of a futures option, is the amount of volatility implied by the market value, or price, of the option. In other words, the implied volatility is forward looking in that it incorporates the current market precariousness as well as what market participants are expecting at some point in the future.
You may also find that market emotion and sentiment are a component of futures option implied volatility. As long commodity option traders scramble to “buy” volatility through the purchase of options in an attempt to profit from the latest hype, option premiums can and do explode exponentially. As a sidelined options on futures seller, these types of conditions should be inviting. The premise of this approach is to attempt to sell options to buyers that are simply "late to the party". The key is making sure that as a seller you aren't too early.
Selling Puts can be Lucrative, but the Option Strategy Comes with a Hefty Price Tag
It is often the case that selling puts is more lucrative than calls, but the added reward carries baggage in the form of additional risk. Due to the increased levels of risk, timing becomes crucial. By nature an option selling program in the futures markets tend to leave room for error in the execution. Nonetheless, being short puts in a spiraling market can quickly change that.
The phenomenon of put premium in the stock indices being larger than call premium is often referred to as the volatility smile. The volatility smile is a long observed pattern in which at-the-money options have lower implied volatility than out-of-the-money options along with the idea that there is more value in owning a put relative to an equally distant call. This scenario seemed to be born after the crash of 1987 in the U.S.
While there are no crystal balls to let us know when a futures market will turn around and how low that it might go before it does, being aware of historical patterns in price, volatility and market sentiment may help to avoid a compromising situation. Let's take a look at the relationship between the VIX and the S&P.
VIX and the S&P 500
Looking at the chart below, it is obvious that the S&P 500 has been able to forge recoveries during times of spiked volatility as measured by the VIX. Armed with this knowledge, it may be a viable strategy to look at erratic, and many times irrational, trade as a point of entry for put sellers.
Short Put Option Trading Example
For example, based on this assumption put sellers may have fared well during the lows in 2001, 2003 and 2007, and 2011. That is of course assuming that the option seller wasn't early in his entry. If a short volatility trader enters a market prematurely, there is a strong possibility that the trader will be forced out of the market prematurely due to lack of financing or margin. Let's take a look at one of the most opportune times in history to be a volatility seller (sell puts in the S&P).
Beginning in the middle of 2002 and throughout the beginning of 2003, put sellers with savvy timing may have done very well. However, trading is a game of risk and those selling puts during those times were accepting great amounts of risk in order to reap the reward.
Let's take a look at a continuous S&P 500 futures chart during the 2002/2003 lows. While the VIX is a great indication of volatility and extreme market sentiment, it is also helpful to look at indicators of volatility such as standard deviations. Luckily, the creation of Bollinger Bands allows us to visually determine market volatility through the line plot of two standard deviations from its mean. Times of high volatility are denoted by wider bands, or a larger standard deviation, and times of decreasing volatility result in narrowing bands.
As futures market volatility increases, so will option prices. During such times, commodity option buyers are forced to pay extremely high prices for options that in theory are more likely to expire worthless than not. On the other hand, option sellers are provided top dollar for accepting theoretically unlimited risk.
Higher premiums collected not only increase a futures market trader’s profit potential but it also increases the room for error. The money collected for a short option can be viewed as "cushion" in that it defines the amount in which the trader can be wrong and still make money by shifting the reverse break even further from the market. The RBE of a short put is calculated as follows:
RBE = Put Strike Price - Premium Collected + Commissions and Fees
As you can see, the more money that the option seller collects, the deeper-in-the-money the option can be at expiration without resulting in a loss to the trader.
According to the hypothetical data available to us, in July of 2002 with the September futures e-mini S&P price near 780, it may have been possible to sell the August S&P 500 futures 680 put for $4.3 in premium which is equivalent to $215 before commissions and fees (each point in the e-mini S&P is worth $50). If this was the case, a trader could have collected a little over $200 U.S. dollars for an option that was, at the time, approximately 100 points or nearly 13% out-of-the-money.
$215 per contract before transaction costs might not sound like a lot of money, but considering the margin on the trade (required deposit in a trading account) was under $1,000 most traders could have sold them in reasonable multiples. For instance, selling 5 of the August 680 puts might have brought in a little over $1,000 in premium for a margin requirement of less than $5,000. Those that like to calculate return on margin, it would have been roughly 20% had the option seller held the short futures options to expiration a mere four weeks down the road.
*This chart assumes selling a single option in the full-sized S&P futures, which is equivalent to 5 e-mini S&P options. We recommend using the e-mini version of the options due to liquidity and option market transparency benefits.
At expiration, this trade would yield the maximum profit of $1,075 before commissions and fees if the futures price is above 680. Ignoring transaction costs the reverse break even on the trade is at 675.70. This simply means that this particular trade makes money with the e-mini S&P futures price trade anywhere above 675.70 before commissions and fees. Please note that the amount of commission paid will reduce the premium collected and shift the RBE closer to the market. To look at it in another perspective, the trader can be wrong by 104.3 points after entering the trade still manage to break even. If the trader's goal is to put the odds in their favor, this seems to be a commodity option trading strategy to consider.
Selling Options on Futures with the VIX can be an Attractive Trading Strategy
Without regard to transaction costs, futures and options trading is a zero sum game; for every winner there will be a loser. Thus, putting your odds ahead of those of your competition is a must. In my opinion, selling options during times of high volatility, while exercising patience, and incorporating experience, is doing just that.
With that said, where there is reward there is risk; in efficient markets you cannot have one without the other. A short option strategy in the futures markets should only be attempted by those that have ample risk capital to allow for potential drawdowns as well as the ability to manage fear and greed. Fearful traders are vulnerable to panic liquidation at inopportune times in terms of market volatility and option pricing. Likewise, greedy traders are tempted to sell options closer-to-the-money in hopes of higher payouts but the risk may turn out to be unmanageable. I strongly believe that less is actually more when it comes to premium collection. Trade less, collect less, and hopefully enjoy more success.
An Introduction to Popular Commodity Option Trading Strategies
There have been many books written on options on futures trading, however I sometimes question the usefulness of the information provided. It seems as though much of the literature available leaves the reader in a state of confusion; perhaps a majority of the bewilderment stems from the fact that most option theory is based on stock option trading and the transition to commodities isn't without its hitches. In my opinion, the practice of repackaging stock option trading strategy and theory in an attempt to appeal to and educate commodity traders can be misleading. Additionally, there are large differences between option theory and option trading. Some of what looks good on paper is difficult to execute efficiently in the real world, this is especially true in the world of commodity option trading.
It is a false assumption to believe that an “option is an option”. They may be spelled the same, but they are vastly different due to the nature of the underlying vehicles. As a result options on commodities take on completely different characteristics. After all, everybody agrees that trading stocks is poles apart from trading futures. Why would anybody believe that trading options on stocks is synonymous with trading options on futures?
There are advantages and disadvantages to every commodity trading strategy, but in my opinion, option selling delivers the best overall odds of trading success.
The favorable probabilities are due to the simple fact that options are priced to lose, and time is on the side of the option seller. To illustrate, an option buyer must see the market move in the desired direction, in a minimum magnitude, in a finite time frame, in order to see a profit. Option sellers, however, have far more room for error and can even make money when moderately wrong in regard to futures market direction. With that said, there is no such thing as "easy money" in the commodity markets. Successful commodity option premium collection requires proper risk management, keen instinct, patience and even a little bit of luck.
*There is unlimited risk in commodity option selling!
Introduction to Commodity Option Selling
The premise of commodity option selling is to collect premium through the sale of options on futures in hopes that the time erosion and volatility decay of a particular short option will overcome any increase in option value due to adverse price movement in the underlying futures market. An option selling strategy offers unlimited risk and limited reward, which is opposite of what many might consider rational. Nonetheless, the odds of success on any given short option trade are arguably in favor of the seller over the buyer.
The concept of an option is nearly identical to that of an insurance policy. The buyer purchased the instrument to receive a payout should a substantial event occur. The seller of the instrument, is collecting a payment in hopes of the “policy” expiring worthless. Accordingly, the practice of commodity option selling is similar to the business of selling insurance policies.
Most of the time, premium is collected by the insurance company and kept as a profit, but there will be times in which unexpected circumstances arise and trigger "claims" against the policy, or in the case of option trading a large drawdown at the hands of an increasing option value. In other words, like that of insurance policies, the odds of success on each individual option selling venture is high, but the challenge is to keep the magnitude of the losing option selling positions to a level in which it is possible to be profitable in the long run.
Types of short options on futures
Short Call – Bearish Option Strategy
Call option “writers” receive income (option premium) in return for the liability of honoring the option buyer’s right to buy the futures contract at the strike price. A short call is an eroding asset to the buyer and an eroding liability to the seller.
The buyer has the right, but not the obligation to take delivery of the underlying futures contract at the stated strike price but the seller is obligated to accept the assignment of a short futures contract at the strike if the option is exercised. The seller's risk of being forced to honor the buyer’s rights diminishes with time; all else being equal the value of the option will erode.
In a nutshell, the seller of a call option keeps the premium collect if the trade is held to expiration and the futures price at that time is below the strike price of the call option.
Short Put – Bullish Option Strategy
Put “writers” receive income (option premium) in return for the liability of honoring the option buyer’s right to sell the futures contract at the strike price. If exercised, the option buyer has opted to exercise the right to go short a futures contract at the strike price and the put seller is obligated to buy the futures at the same price. Identical to a short call, a short put is an eroding asset to the buyer and an eroding liability to the seller. Also, the seller's risk of being forced to honor the buyer's rights diminishes with time and volatility.
To summarize, if held to expiration, the seller of a put option keeps the entire premium collected if the futures market is trading above the strike price of the put. We’ll go over an example of a short put to give you a clearer picture of how a short option trade works.
Short Strangle – Neutral Option Strategy
Some option sellers practice what is known as a delta neutral strategy in which both call options and put options are sold simultaneously to create a trade without any directional bias. In its simplest form, a short commodity option strangle seller sells a call for every put sold; generally the strike prices are equidistant to the current futures price.
The advantage of selling an options strangle in the futures market, as opposed to selling only one side of the trade (a call or a put), is increased profit potential and more room for error. Obviously, by selling both a call and a put, the trader has automatically doubled the potential gain on the trade. Further, the sale of both calls and puts along with the additional premium collected, provides a bigger buffer to cushion losses should the futures price trade beyond the strike price of either commodity option. Accordingly, many believe this to be a lower risk strategy relative to selling calls or puts outright on a directional basis.
Selling a Commodity Put Example (Crude Oil)
In the example portrayed in the displayed chart, it might have been possible to sell a September $62 crude oil put for 53 cents, or $530, at a time in which crude oil was valued near $80. The same option was worth only 17 cents ($170) just two days earlier prior to a multi-day plunge. Options that have tripled in value, as such, often have a tendency to see sharp premium erosion should the futures market stabilize. Accordingly, these types of spikes in option premium are attractive to option sellers.
On the contrary, those that were already the 62 put prior to the two-day sell-off would be an unpleasant situation. This just goes to show you how important timing and volatility can be, even in a so-called passive strategy such as option selling. Simply put, making money by selling commodity options isn’t as easy as selling calls or puts and hoping for the best. Traders must be patient in order to be in a position to capitalize on an increase in volatility, as opposed to getting run over by it.
The maximum profit of this particular short option trading example, is $530 minus transaction cost. The max payout occurs if the option is held to expiration and the futures price is above the strike price of $64. However, even if the price is a little below $64, all is not lost; this short option position pays off at expiration with the price of crude anywhere above $63.47. This is because the premium collected of 53 cents, or $530, acts as a buffer to the risk of being assigned a futures contract at the strike price of $64.
Should the price of crude be trading below $64 at expiration, the risk is similar to that of being long a futures contract. The option value will fluctuate quickly and the trade faces theoretically unlimited risk.
As you can see from the chart , it is possible for this trader to be profitable whether the market goes up, down, or sideways; the only risk is in a massive price collapse (in this case below $64). If the price of crude is above $64 at expiration ($64 to infinity), the max payout is received by the option seller. In other words, the profit zone is large and likely, while the loss zone is far less likely to be seen.
The Key to Option Selling is Premium Erosion
Similar to buying a car and watching its value drop as you drive it off the lot, (all else being equal) options on futures lose value with every minute that passes. This is because as time passes, the odds of an extreme event diminish. Assuming the futures price doesn’t increase in volatility, and more importantly do so in an adverse direction of the short option, time is money to an option seller. On the other hand, option buyers often suffer slow and painful losses in the absence of a dramatic price change. In fact, some studies have suggested that somewhere between 70% to 90% of all futures options expire worthless.
Because of these characteristics, option selling is the only strategy in which a trader can be wrong and still make money! For example, a trader going short a call option is accepting the risk of the futures price going above the strike price of the short call. However, the futures price can go up, down, or sideways and still produce a profit to the option seller as long as the futures price doesn’t exceed the strike price of the commodity option.
The most common turn-offs to options on futures selling are fears of margin calls, stories of account threatening losses but the truth is trading of any futures or options strategy involves substantial risk. At least commodity option sellers are putting the odds in their favor. On the contrary, option buyers are in essence purchasing lottery tickets in which their risk is limited, but the odds of success are unattractive. In other words, although option buyers face limited price risk, they are more likely to incur a high percentage of losing trades.
The bottom line on option selling strategies
Selling options can be a high probability trading strategy, but it doesn't come without stress and risk. Although option sellers are betting against extreme price moves, it is critical that traders attempt to time their entry in regard to market analysis, sentiment and, most importantly volatility. Failure to do this will increase the odds of panicked premature liquidation, large draw-downs, or worse. Be selective and remember, it is better to miss a trade than to impatiently enter a market only to suffer the consequences of exploding market volatility, and therefore option values.