atility increase.
C. Continuous high liquidity.
D. Continuous low liquidity.
12. Long straddles create what kind of risk proﬁles?
A. V-shaped  risk  curves  with  unlimited  proﬁt  potential  and  limited
risk.
B. V-shaped  risk  curves  with  limited  proﬁt  potential  and  unlimited
risk.
C. Upside-down V-shaped risk curves with unlimited proﬁt potential
and limited risk.
D. Upside-down  V-shaped  risk  curves  with  limited  proﬁt  potential
and unlimited risk.
13. How is the upside breakeven of a long straddle calculated?
____________________________________________________________
14. How is the downside breakeven of a long straddle calculated?
____________________________________________________________
15. Calculate the values for the following long straddle:
Long 1 November ATM DELL 35 Call @ 2.45
Long 1 November ATM DELL 35 Put @ 2.20
DELL is currently trading at $35.10.
Put cost = __________________________________________________
Call cost = __________________________________________________
Maximum reward = __________________________________________
Maximum risk = _____________________________________________
Upside breakeven = __________________________________________
Downside breakeven = _______________________________________
Range of proﬁtability = _______________________________________
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16. Short straddles create what kind of risk proﬁles?
A. V-shaped  risk  curves  with  unlimited  proﬁt  potential  and  limited
risk.
B. V-shaped  risk  curves  with  limited  proﬁt  potential  and  unlimited
risk.
C. Upside-down V-shaped risk curves with unlimited proﬁt potential
and limited risk.
D. Upside-down  V-shaped  risk  curves  with  limited  proﬁt  potential
and unlimited risk.
17. Calculate the values for the following short straddle:
Short 1 July SMH 37.50 Call @ 1.50
Short 1 July SMH 37.50 Put @ 1.25
SMH is trading at $37.71.
Put credit = _________________________________________________
Call credit = _________________________________________________
Maximum reward = __________________________________________
Maximum risk = _____________________________________________
Upside breakeven = __________________________________________
Downside breakeven = _______________________________________
Range of proﬁtability = _______________________________________
18. Strangles are quite similar to straddles, except ______________.
A. The options have different expiration months.
B. One option is short and the other is long.
C. The options are ITM instead of ATM.
D. The options are OTM instead of ATM.
19. Long  strangles  involve  buying  both  an  OTM  call  and  an  OTM  put
with ______________.
A. Different strike prices and identical expiration months.
B.
C.
Identical strike prices and different expiration months.
Identical strike prices and expiration months.
D. Different strike prices and expiration months.
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20. A long strangle has ______________________________________.
A. Limited proﬁt potential and limited risk.
B. Limited proﬁt potential and unlimited risk.
C. Unlimited proﬁt potential and unlimited risk.
D. Unlimited proﬁt potential and limited risk.
21. Calculate the values for the following long strangle example:
Long 1 November DELL 40 Call @ 0.65
Long 1 November DELL 30 Put @ 0.70
DELL is currently trading at $35.10.
Put cost = __________________________________________________
Call cost = __________________________________________________
Maximum reward = __________________________________________
Maximum risk = _____________________________________________
Upside breakeven = __________________________________________
Downside breakeven = _______________________________________
Range of proﬁtability = _______________________________________
22. True or False: Fixed straddles can be adjusted as the market moves
back and forth.
23. Name two ways of creating a long synthetic straddle using a stock.
1. _________________________________________________________
2. _________________________________________________________
24. Calculate  the  values  for  the  following  long  synthetic  straddle 
example:
Long 100 Shares of DELL @ $35.10
Long 2 November DELL 35 Puts @ 2.20
Stock cost = _________________________________________________
Put cost = ___________________________________________________
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Maximum reward = __________________________________________
Maximum risk = _____________________________________________
Upside breakeven = __________________________________________
Downside breakeven = _______________________________________
Range of proﬁtability = _______________________________________
25. Calculate  the  values  for  the  following  long  synthetic  straddle 
example:
Short 100 Shares of DELL @ $35.10
Long 2 November DELL 35 Calls @ 6.85
Stock cost = _________________________________________________
Call cost = __________________________________________________
Maximum reward = __________________________________________
Maximum risk = _____________________________________________
Upside breakeven = __________________________________________
Downside breakeven = _______________________________________
Range of proﬁtability = _______________________________________
MEDIA ASSIGNMENT
Delta neutral strategies take away the necessity to predict market direc-tion.  However,  we  still  need  to  ﬁnd  stocks  that  are  expected  to  showvolatility and to choose options with low implied volatility. For this mediaassignment, identify several securities that are good candidates for deltaneutral strategies. Before entering the data into the Optionetics Platinumsite, take the time to manually calculate the details of the trade, includingthe  breakeven  points,  maximum  risk  and  proﬁt,  and  the  range  of  prof-itability. After you have calculated this data, plug it into Optionetics Plat-inum  (or  some  other  options  program)  and  see  if  your  calculations  arecorrect. As an added bonus, check out the risk graphs as well. Comparethe risk graphs for various strategies, including straddles, strangles, andlong synthetic straddles.
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VOCABULARY LIST
Average Directional MovementIndex (ADX)
Delta
Delta neutral trade
Long straddle
Long strangle
SOLUTIONS
Long synthetic straddle
Risk graph
Straddle
Strangle
1. Setting up a delta neutral trade requires selecting a calculated ratioof  short  and  long  positions  to  create  an  overall  position  delta  of______________.Answer: D—Zero.Discussion: The idea with a delta neutral trade is to get the overalldelta as close to zero as possible. Of course, there will be trades thathave  slightly  positive  or  negative  deltas,  but  this  doesn’t  mean  theywon’t have a similar risk graph to a perfectly delta neutral trade.
2. The delta of 100 shares of stock or one futures contract equals plus or
minus ______________.Answer: B—100.Discussion: Unlike  options,  futures  and  stocks  do  not  have  frac-tional deltas. They have deltas equal to 1.00. This allows a trader toset  up  strategies  that  incorporate  options,  stock,  and/or  futures to  create  delta  neutral  strategies.  Obviously,  if  we  buy  100  shares of  stock  and  sell  100  shares  of  the  same  stock,  there  is  no  way to  make  a  proﬁt.  However,  by  creating  synthetic  positions,  we can make a proﬁt using options without needing to predict marketdirection.
3. The delta of an option depends on its ______________.
Answer: C—Strike price.Discussion: One deﬁnition of delta is that it tells the trader the odds ofan option ﬁnishing in-the-money by expiration. Thus, the farther awaythe option strike is from the stock price (in the unproﬁtable direction),
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the lower the delta. In-the-money options have deltas generally above50, while out-of-the-money options have deltas below 50.
4. Name two ways of creating a delta neutral trade with ATM options if
you are buying 100 shares of stock.Answer: Buy two ATM puts or sell two ATM calls.Discussion: One hundred shares of stock equals +100 deltas, so weneed to create a combination of options that equal –100 deltas. Theeasiest  way  to  create  –100  deltas  is  to  sell  two  ATM  calls  or  to  buytwo  ATM  puts.  Though  the  delta  might  not  be  exactly  –100,  usingATM options will make the delta close enough to this ﬁgure.
5. Name two ways of creating a delta neutral trade with ATM options if
you are selling 100 shares of stock.Answer: Buy two ATM calls or sell two ATM puts.Discussion: To offset –100 deltas that comes from selling the stock,you  can  buy  two  ATM  calls  or  sell  two  ATM  puts  to  bring  in  +100delta.  The  idea  is  that  anything  bullish  creates  a  positive  delta  andanything bearish creates a negative delta.
6. By purchasing futures and buying puts, a U-shaped risk graph is cre-
ated that reﬂects ______________.Answer: D—Unlimited proﬁt potential with limited risk.Discussion: This  is  the  optimal  type  of  risk  graph  delta  neutraltraders like to see. Though not all options strategies are created withunlimited reward and limited risk, this is what we strive to achieve.
7. By purchasing stock and selling calls, an upside-down U-shaped risk
graph is created that reﬂects the trade’s ______________.Answer: B—Limited proﬁt potential with unlimited risk.Discussion: An  upside-down  U  is  exactly  the  opposite  of  whatdelta neutral traders want to see, as it shows unlimited risk and lim-ited  proﬁts.  Though  this  type  of  trade  might  be  proﬁtable  most  ofthe time, it takes only one trade that goes wrong to erase an entiretrading account.
8. By  selling  100  XYZ  shares  and  buying  two  ATM  calls,  what  kind  of
risk curve are you creating?Answer: A—U-shaped risk curve with unlimited proﬁt potential andlimited risk.
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Discussion: This  position  is  called  a  long  synthetic  straddle  usingcalls.  The  U  shape  is  created  because  the  trade  proﬁts  on  a  sharpmove lower or a sharp move higher. If the stock stays ﬂat, then a losswould most likely be incurred.
9. By selling 100 XYZ shares and selling two ATM puts, what kind of risk
curve are you creating?Answer: D—Upside-down  U-shaped  risk  curve  with  limited  proﬁtpotential and unlimited risk.Discussion: This  trade  is  a  short  synthetic  straddle  using  puts.  Byselling both the stock and the puts, the maximum proﬁt is the creditreceived from selling the puts and stock. However, if the underlyingmoves sharply in either direction, a large loss can be incurred.
10. Buying  a  straddle  involves  buying  both  a  call  and  a  put  with
______________.Answer: C—Identical strike prices and expiration months.Discussion: Composed of both a long ATM call and a long ATM put, astraddle makes money when the underlying asset moves sharply in ei-ther direction. As the stock moves higher, the call increases in valuefaster than the put loses money. The opposite also holds true, with adecline in the stock’s price increasing the value of the put faster thanthe loss incurred in the call.
11. To  place  a  long  straddle,  it  is  optimal  to  locate  a  market  with
______________.Answer: B—Low volatility expecting a volatility increase.Discussion: A long straddle consists of buying two options. Impliedvolatility has a major impact on the price of an option, so we want tobuy options that have historically low IV. This puts the odds of suc-cess higher for a straddle trader. Straddle traders also want to see avolatility increase because this means a larger move in the underly-ing security.
12. Long straddles create what kind of risk proﬁles?
Answer: A—V-shaped risk curves with unlimited proﬁt potential andlimited risk.Discussion: Just like a long synthetic straddle, a straddle has unlim-ited proﬁt potential and limited risk. This is what we are looking forwhen we enter a delta neutral trade.
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13. How is the upside breakeven of a long straddle calculated?Answer: Upside breakeven = strike price + net debit.Discussion: The  upside  breakeven  at  expiration  is  calculated  byadding  the  net  debit  required  to  enter  the  trade  to  the  strike  price.However, this doesn’t mean that a proﬁt can’t be made before expira-tion on a smaller move if volatility increases in magnitude.
14. How is the downside breakeven of a long straddle calculated?Answer: Downside breakeven = strike price – net debit.Discussion: The downside breakeven at expiration is calculated bysubtracting the net debit required to enter the trade from the strikeprice. However, this doesn’t mean that a proﬁt can’t be made beforeexpiration on a smaller move if volatility increases in magnitude. Youwill rarely hold a straddle until expiration, anyway.
15. Calculate the values for the following long straddle:
Long 1 November ATM DELL 35 Call @ 2.45
Long 1 November ATM DELL 35 Put @ 2.20
DELL is currently trading at $35.10.Answer:
Put cost = 2.20 or $220.
Call cost = 2.45 or $245.
Maximum reward = Unlimited to the upside and limited to the down-side (as the underlying can only fall to zero) beyond the breakevens.Maximum risk = (2.45 + 2.20) × 100 = $465 (Total debit).Upside breakeven = (35 + 4.65) = $39.65 (Call strike + net debit).
Downside breakeven = (35 – 4.65) = $30.35 (Put strike – net debit).
Range of proﬁtability = Above $39.65 and below $30.35.Discussion: The  breakeven  points,  maximum  risk  and  reward,  andtotal  costs  are  important  values  to  understand  before  entering  atrade.  These  values  can  be  ﬁgured  manually,  or  you  can  use  a  pro-gram like Optionetics Platinum to calculate these details. Either way,it  is  very  important  to  assess  a  trade’s  risks  before  jumping  in  andputting real money on the line.
16. Short straddles create what kind of risk proﬁles?
Answer: D—Upside-down  V-shaped  risk  curves  with  limited  proﬁtpotential and unlimited risk.
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Discussion: A  short  straddle  or  strangle  creates  an  upside-down V-shaped risk graph. This is not the kind of risk proﬁle that a deltaneutral trader wants to see. Though this type of trade might have ahigh winning percentage in sideways-moving markets, it takes onlyone sharp move to wipe out a trading account.
17. Calculate the values for the following short straddle:
Short 1 July SMH 37.50 Call @ 1.50
Short 1 July SMH 37.50 Put @ 1.25
SMH is trading at $37.71.Answer:
Put credit = 1.25 or $125.
Call credit = 1.50 or $150.Maximum  reward  =  (1.25  +  1.50)  × 100  =  $275  (Limited  to  the  netcredit).
Maximum risk = Unlimited to the upside and limited to the downside(as the underlying can only fall to zero) beyond the breakevens.
Upside breakeven = (37.50 + 2.75) = $40.25 (ATM strike price + netcredit).
Downside breakeven = (37.50 – 2.75) = $34.75 (ATM strike price – netcredit).
Range of proﬁtability = Between $34.75 and $40.25.
18. Strangles are quite similar to straddles, except ______________.
Answer: D—The options are OTM instead of ATM.Discussion: Strangles have a similar risk proﬁle to a straddle, exceptthat the maximum loss area is wider. However, the initial cost to en-ter a strangle is lower. Keep in mind that the underlying asset has tomake a larger move for the trade to become proﬁtable.
19. Long strangles involve buying both an OTM call and an OTM put with
______________Answer: A—Different strike prices and identical expiration months.Discussion: By using OTM options, the trader’s cost to enter a stran-gle is less than the cost to enter a straddle. However, because the op-tions  are  OTM,  the  underlying  security  has  to  see  a  larger  move  togarner a proﬁt.
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20. A long strangle has ______________.
Answer: D—Unlimited proﬁt potential and limited risk.Discussion: Just like a straddle, a strangle has limited risk and un-limited  proﬁt  potential.  The  main  difference  is  that  there  is  a  widerarea  between  the  two  strike  prices  where  the  maximum  loss  is  in-curred. Whether to use a straddle or a strangle is a personal decisionand should be based on the outlook for the stock and the risk graph.
21. Calculate the values for the following long strangle example:
Long 1 November DELL 40 Call @ 0.65
Long 1 November DELL 30 Put @ 0.70
DELL is currently trading at $35.10.Answer:
Put cost = 0.70 or $70.
Call cost = 0.65 or $65.
Maximum  reward  =  Unlimited  to  the  upside  and  downside  beyondthe breakevens.Maximum risk = (.70 + .65) × 100 = $135 (Total debit).Upside breakeven = (40 + 1.35) = $41.35 (Call strike + net debit).
Downside breakeven = (30 – 1.35) = $28.65 (Put strike – net debit).
Range of proﬁtability = Above $41.35 and below $28.65.Discussion: The cost to enter a strangle is lower than the cost of astraddle. However, by comparing the straddle and strangle example,we can see that a strangle takes a much larger move to break evenand make a proﬁt. The maximum risk area is also much larger, fallingbetween the two breakevens. A straddle sees a maximum loss only ifthe underlying closes right on the ATM strike price.
22. True or False: Fixed straddles can be adjusted as the market moves
back and forth.Answer: False.Discussion: Fixed  straddles  cannot  be  adjusted.  If  you  want  to  beable to make adjustments as the trade progresses, then look at usinglong synthetic straddles.
23. Name two ways of creating a long synthetic straddle using a stock.
Answer:
1. Sell 100 shares and buy two ATM calls.
2. Buy 100 shares and buy two ATM puts.
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Discussion: A  long  synthetic  straddle  is  a  delta  neutral  trade  thatconsists  of  shares  of  stock  against  long  options.  A  long  syntheticstraddle with multiple contracts can be adjusted back to delta neutralas  the  trade  progresses.  The  risk  proﬁle  is  similar  to  a  straddle  buthas a U-shaped risk curve instead of a V-shaped one. A trader doesn’tneed to use ATM options, but this is the easiest way to create a longsynthetic straddle.
24. Calculate  the  values  for  the  following  long  synthetic  straddle 
example:
Long 100 Shares of DELL @ $35.10
Long 2 November DELL 35 Puts @ 2.20Answer:
Maximum reward = Unlimited.Maximum risk = [(2 × 2.20) + (35.10 – 35)] × 100 = $450 {Net debit ofoptions  +  [(Price  of  underlying  stock  at  initiation  –  option  strikeprice) × number of shares]}.Upside breakeven = (35.10 + 4.40) = $39.50 (Price of underlying stockat initiation + net debit of options).Downside breakeven = [(2 × 35) – 35.10] – 4.40 = $30.50 {[(2 × optionstrike) – price of underlying stock at initiation] – net debit of options}.
Range of proﬁtability = Above $39.50 and below $30.50.Discussion: The breakeven points take a little more calculating be-cause  the  stock  price  isn’t  exactly  at  $35.  Though  this  calculationcan still be made manually, it is much easier to use a program likeOptionetics Platinum.
25. Calculate  the  values  for  the  following  long  synthetic  straddle 
example:
Short 100 Shares of DELL @ $35.10
Long 2 November DELL 35 Calls @ 6.85Answer:
Maximum reward = Unlimited.Maximum risk = [(2 × 6.85) + (35 – 35.10)] × 100 = $1,360 {[Net debitof options + (option strike – price of underlying at initiation)] × num-ber of shares.Upside breakeven = [(2 × 35) – 35.10] + 13.70) = $48.60 {[(2 × optionstrike)  –  price  of  underlying  stock  at  initiation]  +  net  debit  of options}.
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Downside  breakeven  =  35.10  –  13.70  =  $21.40  (Price  of  underlyingstock at initiation – net debit of options).
Range of proﬁtability = Below $21.40 and above $48.60.Discussion: By comparing the risk graphs and different variables, atrader  can  decide  whether  to  short  shares  and  buy  calls  or  to  buyshares  and  buy  puts  to  create  a  long  synthetic  straddle.  Ultimately,we want to enter the trade that provides the best reward-to-risk ratio.
MEDIA ASSIGNMENT
Although there are computer programs that will generate risk graphs andthe details of a particular options strategy, it is very helpful to understandhow  these  details  are  ﬁgured  manually.  In  doing  this  media  assignment,not only should you gain a better understanding of the risks of a trade, butyou’ll appreciate how a computer speeds up the process.
VOCABULARY DEFINITIONS
Average Directional Movement Index (ADX): An indicator developedby J. Welles Wilder to measure market trend intensity. It does not give sig-nals regarding direction, but tells traders whether the stock or index is inthe  midst  of  a  healthy  trend  (either  up  or  down).  The  idea  is  for  direc-tional traders to stay out of choppy or sideways markets (i.e., when thestock or index is not trending), and commit to the markets only when thestock or index is moving within a clear trend.Delta: The amount by which the price of an option changes for everydollar move in the underlying instrument.Delta neutral trade: This is an options/options or options/underlying in-strument  position  constructed  so  that  it  is  relatively  insensitive  to  theprice movement of the underlying instruments. This is arranged by select-ing a calculated ratio of short and long positions with a combined positiondelta of zero.Long straddle: A non-directional option strategy that combines the si-multaneous  purchase  of  the  same  number  of  ATM  puts  and  calls  withidentical  expirations.  The  maximum  loss  is  limited  to  the  net  debit  ofthe  options.  The  upside  breakeven  is  equal  to  the  net  debit  plus  thestrike  price,  and  the  downside  breakeven  is  calculated  by  subtractingthe net debit from the strike price. The maximum proﬁt is unlimited to
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the upside and limited to the downside (as the underlying can only fallto zero) beyond the breakevens.Long  strangle: The  purchase  of  an  OTM  call  and  an  OTM  put  with  thesame  expiration  date.  Look  for  a  stable  market  where  you  anticipate  alarge volatility spike. The maximum risk is limited to the net debit paid.The maximum proﬁt is unlimited to the upside and limited to the down-side (as the underlying can only fall to zero) beyond the breakevens. Theupside breakeven is calculated by adding the call strike to the net debit,and  the  downside  breakeven  is  calculated  by  subtracting  the  net  debitfrom the put strike.Long  synthetic  straddle: A  delta  neutral  trade  in  which  two  long  op-tions are balanced out by 100 shares of stock. Look for a market with lowvolatility where you anticipate a volatility increase resulting in stock pricemovement in either direction beyond the breakevens.Risk graph: A graphical representation of risk and reward on any giventrade.Straddle: A position consisting of a long (or short) call and a long (orshort)  put,  where  both  options  have  the  same  strike  price  and  expira-tion date.Strangle: A position that consists of a long (or short) OTM call and a long(or  short)  OTM  put  where  both  options  have  the  same  underlying  andsame expiration date, but different strike prices.
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CHAPTER 9
AdvancedDelta NeutralStrategies
SUMMARY
Most  successful  options  traders  are  continuously  accessing  risk-rewardprobabilities. Trades that offer limited rewards but high risks are often ill-advised. Instead, experienced strategists tend to focus on situations thatoffer high rewards and limited risks. In order to ﬁnd these more attractivescenarios, traders work to develop more complex strategies and study theprobabilities of success or failure using risk graphs.
In this chapter, the reader is introduced to four advanced delta neu-tral strategies: ratio call spreads, ratio put spreads, call ratio backspreadsand put ratio backspreads. These strategies are a bit more complex andinvolve simultaneously buying and selling either puts or calls in differentquantities.  For  example,  ratio  spreads  involve  either  all  puts  or  all  callsand are established by purchasing a put or call and selling a greater num-ber of puts or calls. Ratio spreads provide a wide proﬁt zone, but comewith unlimited risk. Ratio backspreads, on the other hand, involve sellingone  or  more  options  (puts  or  calls)  and  buying  a  greater  number  of  op-tions  (puts  or  calls).  Ratio  backspreads  are  generally  initiated  as  credittrades and offer limited risk with unlimited reward potential, which is theoptional type of situation for experienced options traders.
QUESTIONS AND EXERCISES
1. A ratio spread is a strategy in which an ______________ number of op-tion contracts of the same underlying instrument are bought and sold.
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