00 (IWM), NASDAQ 100 (QQQQ), and the iShares Long-Term BondFund (TLT).Earlier in the book, we noted that listed calls and puts on exchangetraded funds have the same contract specifications as those for most equities. For example, one contract normally represents 100 shares of theunderlying instrument. As is the case with equities, these contracts areopen to the possibility of early or American-style exercise by the buyer ofthe contract. Further, options on these index products are physically settled in the same way as stock and are not based on a cash settlement feature. In contrast, most index options settle European-style. In addition,indexes such as the S&P 500 Index and the Dow Jones Industrial Indexsettle for cash. We focus on American-style ETF strategies in this chapter.
ADJUSTING THE TRADEAn adjustment occurs after a position has been opened. It can be a slightadjustment, such as buying more shares or options, or a major overhaul ofthe entire trade. Either way, an adjustment is defined as a modification toan existing options position. It can be used to protect profits, reducelosses, or change the directional bias of the trade. Once an options position is initiated, the trader can choose one of two general paths:1. Maintain a passive position until expiration.2. Be proactive during the life of the position and make adjustments.
There is no absolute right or wrong here. The choice depends on atrader’s risk tolerance and the market circumstances of any given trade;sometimes the path not taken might, in fact, be the better choice. Bothmethods can also incur profits or losses before the trade is exited in full,depending on the type of position a trader initiates and what happens inthe underlying market thereafter.The astute options strategist will always understand the changingrisk-to-reward profile of a particular position, as it relates to the underlying market. Armed with that knowledge, one can make a stronger decision
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about proactive adjustments or whether to sit tight. Before we exploresome of those possibilities on various index proxies, a quick refresher ofsome of the more common limited-risk strategies is in order.
POSITION TYPES RECAPThe category labeling that follows might be a new way of thinking about aparticular options strategy, but the names and characteristics of eachshould be familiar by now. Only key points are outlined here. This is not acomplete list, as more exotic spreads and combinations also exist. However, from this list you will find that these highly popular, limited-riskspreads offer a wide range of ways to profit from various market situations.1. Directional long: Limited-risk directional bets using a purchased
call or put. Maximum position risk is the initial debit.• Bullish directional bias: Call purchase.• Bearish directional bias: Put purchase.2. Delta neutral: Limited-risk position established in anticipation of future movement in either direction. Strategist wants the underlying tomove dramatically and quickly.• Long straddles (natural): Simultaneous purchase of ATM call andput with the same expiration.• Long synthetic straddles: Use of option and shares (2:1 ratio forlong ATM puts). With larger positions in many ETFs, margins canmake this more prohibitive than a natural straddle.• Long strangles: Simultaneous purchase of call and put with OTMstrikes and the same expiration.3. Verticals: Limited-risk and limited-reward directional spreads. Extent of bullishness and bearishness is reflected in strikes and width ofposition.• Bull verticals: Call spread established for debit; put spread established for credit.• Bear verticals: Call spread established for a credit; put spread established for a debit.4. Long calendar: Limited-risk, contract-neutral debit strategy whereinback month is purchased and shorter-term option is sold. Can be established with either calls or puts with the same strike price. Expansion of debit and profit is maximized by collapse of front month short.This occurs when the underlying index is at or near the position strikeprice at the expiration of the near-term, short contract.
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• Nondirectional: Use of ATM options. Strategy looks to collectlarger front month time decay (theta) relative to the purchasedback month.• Directional: Strategist can use same strikes below current price fora slightly bearish play or above for a slightly bullish play.5. Long diagonals: Limited-risk, contract-neutral strategy that purchases back month and sells the near-term contract. Strike prices aredifferent. This strategy takes on the characteristics of both long verticals and calendars, as time, direction, and volatility play a key in profitability and risk of position.6. Long butterfly: Limited-risk, contract-neutral debit strategy that utilizes three strikes (equidistant) on options of the same type (all callsor puts). Middle strike is sold with twice as many contracts as the outside protective strikes. Strategist is seeking spread expansion bystock settling at the inside or short premium strike. Tip: Think of thebutterfly as a bull vertical and a bear vertical combined.The idea behind adjustments is to lock in profits and minimize ourpotential losses, while simultaneously moving our position risk and reward profile in line with any changes that may have occurred due to bothconditions in the underlying and any shifts in our perception that mayhave developed.
WHY ADJUST WITH LIMITED RISK STRATEGIES?Before we get into example trades and show alternative adjustments asthe underlying conditions change, first ask yourself why you might needto make an adjustment after assuming a limited-risk options position.
Directional (Delta) RiskThe delta (or directional risk) of the underlying shares is always fixed at+1 or –1 (often expressed as +100 or –100). For instance, 100 shares ofOIH purchased at 130 will make a profit of $500 if sold at 135, or stand tolose $500 with an adverse move lower five points to 125. Options, on theother hand, have variable or shifting deltas that can move from near zerofor OTMs, to an almost rock-hard and near identical delta of the underlyingfor deep ITMs, which are +100 deltas on standardized contracts.When a trader assumes delta risk, a higher total count (number ofcontracts times delta) means the position is exposed to more directionalrisk, like that of a pure stock trader. In this situation, it stands to reason
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that as the underlying moves, the options trader with delta risk will, at aminimum, consider an adjustment to his existing position. Offsetting theincreased directional exposure lets the trader get paid, so to speak, andthis can only be done by taking some kind of deliberate action or adjustment to the position.
Gamma/Delta RiskWhy do some purchased options contracts just seem to never move, eventhough the stock looks to be moving favorably in the anticipated direction? Then suddenly, as if somebody flipped on a light switch, those verysame options start to explode in price and react with similar gains to thatstill being seen in the underlying? This phenomenon is a function of an option’s gamma and is a very important concept for delta neutral traders.As a refresher, gamma is the rate of change in an option’s delta as theunderlying moves up or down one point. At-the-money options nearing expiration have the highest gamma rate. This makes sense when you realizethat with the clock ticking down, price changes in the underlying are magnified and have the ability to put that option into the category of eitherITM or OTM permanently.An option with a large gamma factor (such as ATM near or on expiration) needs only fractional price movement in the underlying and throughthe strike price to shift the option from being worthless to having realvalue only pennies from the striking price. A call option in this situationquickly piles on value and would essentially mimic the stock as the highgamma value shifts the delta rapidly toward +100 for every call contract.At the same time, of course, once the delta approaches the hard delta(+100 or -100) of acting like stock, the gamma component drops precipitously if the stock maintains that direction (see Figure 13.1).On the other end of the spectrum, very deep ITM options will retaintheir hard stock-like delta, until the underlying moves aggressively closerto the strike price. At that point the gamma factor will begin to increaseand affect the delta with a reduction in its directional value, so that it begins to act less like stock. OTM options work in the same capacity, exceptfrom the other side of the gamut, where they don’t react (or barely) withthe underlying stock movement until a severe move occurs and/or there isa substantial pickup in the implied volatility.When a trader assumes gamma risk, which for our purposes is typically associated with being long a straddle, market movement equatesto potential profitability. The gamma factor associated with this type ofposition has changed a delta neutral position to one that shows directional risk characteristics. For instance, if the underlying instrumentmoves dramatically higher in price, although the number of contracts
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Option Strike Price
Stock Price
FIGURE 13.1 Impact of Stock Movement on the Value of Gamma
on the straddle hasn’t changed, our positive deltas increase. The longcalls’ deltas move from approximately +50 deltas when the position wasestablished, to possibly a delta near +100, if the move is severe enough. Simultaneously, the puts move from a –50 delta to one that is much lowerand possibly approaching 0. This adds up to directional risk that needs tobe adjusted in order to turn open position risk into some realized profitsagainst the initial expense of the position.The adjustment to the delta seeks to get the trader back to a directionally neutral position and is called flattening out or gamma scalping.Regardless of the approach, by adjusting the position—adding stock, selling existing contracts, or redeveloping the position by selling contracts ona different strike—the trader is acting appropriately. Managing the gammaand delta risk is vital to the success of this position type over the long run.
Theta or Time Decay RiskLimited-risk strategies enable traders to sleep better at night. Knowingyour maximum exposure reduces your stress potential because you nolonger have to live with the uncertainty of unlimited risk. However, strategies such as the straddle are established with a very real up-front cost, adebit intrinsically tied (ironically enough) to an option’s extrinsic value.Time may be on our side, but with limited-risk trades that involve extrinsic
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value, time is there for a while but it certainly isn’t permanent. The prepared trader needs to be ready to fend off this natural enemy gracefully.Intrinsic and Extrinsic ValueTo determine the amount of time value (or extrinsic value) remaining in acall or put option, traders can use the following formula:Call time value = (Call strike price + Call option price) – Stock pricePut time value = (Stock price + Put option price) – Put strike priceThe total value of the trade minus the extrinsic value equals intrinsic value.
Intrinsic value is one part of long contract ownership that doesn’t involve the potentially hurtful effect of time decay, or position rot. Does itsound too good to be true? It’s not. While time decay isn’t a problem, thesepositions or contracts are comprised entirely of another one of our Greekfriends, the delta. Unless you are actively pursuing delta or directionalrisk, intrinsic value doesn’t mean a free ride.The other potential component of an option’s value is the extrinsicvalue. Straddle traders in particular need to be very aware of this positioncost. Extrinsic value is also known as the time premium of the option. Thegeneral rule of thumb is that ATM options will have the most amount oftime premium built into their current market price, and the further outthat a trader looks (such as LEAPs), the more extrinsic value one will findin the options listed.Potential value is a good way of thinking about this element of an option’s existing price. Until an option actually expires in-the-money, anypremium paid over the intrinsic value is speculating on price action in theunderlying that does not exist at that moment. The reason why traderswill pay for something that doesn’t exist here and now is to gain the abilityto participate in a move and to do so with the protective value of a purchased contract. It is similar in a sense to the premiums you pay for a lifeinsurance policy. You pay premium for something that gives you no benefits unless something happens—you die.Time decay can be very detrimental when holding options with a lotof extrinsic value, especially for an option that is near- or at-the-moneywith less than 30 days until expiration. Straddle traders need to be awareof this unwanted characteristic and take appropriate action by makingnecessary adjustments before it’s too late. Maybe this means exiting partor all of an already profitable straddle. Or maybe taking appropriate action means taking a smaller, more manageable loss as the position enters
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the theta-wrecking final 30 days of a contract’s life. In either situation—and in all of those gray areas that exist between them—adjusting for timedecay is a necessary, positive action on the part of the trader.
Vega RiskWhile theta is the risk associated with time decay, vega is the risk in an option’s value that is associated with changes in volatility. As you shouldknow by now, there are different types of volatility, such as future or historical, which relate to what we know or wish we knew about the underlying product’s movement. For the option player, though, implied volatilityis the only kind that is associated solely with the value of the option in themarketplace.Implied volatility is the market’s consensus of the fair value in an optionat any given time. The sum of all the participants that trade a particular contract—from market makers and institutions to the retail investor—reflectsa fluid auction process that can change the market price of an optioncontract, as supply and demand characteristics shift.Suppose a trader wanted to purchase an ATM call on the BiotechHOLDRs (BBH). With the sector proxy having closed that particularevening at $201, the 200 level calls two months out finished off the daywith an offered market price of 6.20. Early the next morning, with the underlying security flat on the session, our friend decides to commit to atrade, but finds that the options are now 6.70 bid and offered at 7.0. Whathappened? Ultimately, we can establish that the implied volatility in thecontract went up. For whatever reason (maybe an institutional player wasa size buyer of calls that morning), the current market price or impliedvolatility of that contract has spiked higher. It might be temporary, as demand for the option fades and more sellers enter the picture. But the impact to the option trader is the same regardless of the circumstancescreating this spike—the price to enter has increased for the time being.At that point, the trader can’t know with any certainty whether the implied volatility will decrease or increase going forward. The movement inthe underlying market and the combined risk acceptance of those participating in the traded options will be the key determinants of how theimplied volatilities react in the days ahead.Vega risk, or the ability for an option’s price to expand and to shrink(i.e., supply outstrips demand, an earnings report is now public), becomesanother factor for which the options strategist must account. This meanslearning to make educated, calculated adjustments to the position duringthe good, profitable situations and being just as proactive when the traderis in need of limiting unwanted risk associated with a volatility crush ordecrease.
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LIMITED-RISK STRATEGIES AND TYPESOF ADJUSTMENTSPosition adjustments can take on a number of different forms. The strategist can buy or sell shares, lock in profits by closing part of the trade, oruse money management to reduce the size of the trade at a profitabilitylevel that has been determined. The trader can also roll the trade up(higher strike) or out (longer term option), or decide to add contracts andchange the risk/reward profile altogether. The reader should be relativelycomfortable at this point with the major risks that reflect the variousstrategies outlined thus far. The remainder of this chapter focuses on theS&P 500 ETF (SPY). With the help of some recent price action, we look ata series of example trades and their adjustments. Gamma scalping (withstock, options or both), rolling positions, reversing, and creating new dynamic spread opportunities as conditions change are some of the adjustments that we look at for various limited-risk strategies.In each example, we give a brief background of the market at the timeand the reason the option strategist may have initiated that particular position. These examples should give the reader a better grasp of optionstrading, a real appreciation for the adjustment process, and increased confidence in locating stronger alternatives that might not have been considered otherwise.
ADJUSTING A STRADDLE (CALL/PUT)The S&P 500 hit some strong selling pressure during the first half of October 2005. Before price action began to unravel, though, the backgroundevidence may have warranted the establishment of a long straddle purchase. Technically, after forging a double topping pattern in early September 2005, the SPY sold off nearly 4 percent. It appeared that the declinemight be gathering momentum. In short, traders might have viewed theaction of the SPY with some skepticism at that time.Double Tops and BottomsDouble tops and double bottoms are reversal formations that occur at theend of trends. These terms refer to the price action of a security or marketaverage when it has declined (advanced) twice to the same approximatelevel, indicating the existence of a support (resistance) level and a possibility that the downward (upward) trend has ended. For example, Figure13.2 shows the SPY meeting resistance at $114 a share in June and July.From that point forward, it fell into a decline. In this case, the pattern is adouble top formation.
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FIGURE 13.2 Double Top Formation for SPY (Source: www.ProﬁtSource.com)
Possibly confirming the technical picture were the implied volatilitylevels on the CBOE Volatility Index ($VIX) at the time. In late September,the VIX had fallen back to the lower end of its range. In addition, with October being notorious for both rattling investors with intermediate-termtechnical lows and also setting the stage for many seasonally strongfourth quarters in the past, a trader might have seen the evidence as a reason for putting on a long delta neutral straddle.Without having to pick a direction, the trader could have positionedhimself for anticipated movement at a relatively affordable price. The lowVIX serves as a guide that S&P 500 options were cheap and therefore astraddle or a strangle would be affordable at that time. The implied levelswere trading above the statistical volatility of the underlying, but theaforementioned evidence may have led a trader to the same conclusion ofa long straddle at the time. Figure 13.3 depicts the technical evidence outlined in the SPY, as the end-of-quarter celebration came to a close on September 30.With the SPY trading at approximately $123, a trader who wanted toexecute the long straddle faces some decisions, including which strike ismost suitable, what type of straddle, and the appropriate amount of timeto stay in the position. The position selection needs to be consistent withexpectations. In this case, the first two decisions can be made rather easily for a trader who wanted to establish a straddle in the SPY. Recall thatmany ETFs provide flexibility in the form of tighter strikes. The SPY happens to be one such product and in fact offers one-point strikes. Hence,let’s use the 123 strike—the ATM strike and a very logical choice to initiate
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FIGURE 13.3 SPY Daily Chart/Straddle Risk Graph (Source: www.Optionetics.com Platinum)
from—to create a delta neutral position using an equal amount of ATMcalls and puts.This brings us to the next point. Should a natural straddle (put pluscall) be used, or would a synthetic version that uses a combination ofstock and options be a wiser solution? For the SPY, because of the liquidity provided in the derivatives market and the absolute dollar price of theunderlying, the natural straddle is generally the better choice. Factorssuch as the amount of capital needed, commission rates on stock versusoptions, and how aggressive the trader is with his adjustments can all playa role in determining the appropriate choice.Straddles—Natural versus SyntheticsA natural straddle is the position described in Chapter 7. It is a strategythat involves the purchase of a put and call, both with the same strikeprices and expiration dates. A synthetic straddle uses shares (or futures) along with options. For example, a delta neutral synthetic straddle can be created by purchasing 100 SPY shares and two at-the-moneySPY puts with deltas of –0.5.
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Now that the strategist has determined that the 123 strike naturalstraddle should be purchased, just how far out in maturity might makesense in this situation? Remember we talked about the time decay effectand how the last 30 days before expiration can lead to quicker losses ifmarket conditions work unfavorably (i.e., the underlying hasn’t movedsufficiently). At the time of this decision, October, November, December,and March are the first four contract months available. With only 21 daysremaining on the October contracts, those might be viewed as being potentially costly. Even though on a dollar basis these contracts are thecheapest, as theta (time decay) accelerates during this period, if the SPYfails to produce enough movement, the straddle player will incur lossesvery quickly as the premium (debit) drops toward zero.Given the remaining three choices, December looks to be a good selection month for our straddle. With 77 days left until maturity, the traderhas nearly 50 trading days before the potentially destructive final 30 daysof a contract’s life. December also allows a trader to participate in a goodpercentage of the price action during the remainder of the fourth quarter—as we emphasized, this was the original basis for evaluating a trade.Now that we’ve determined the December 123 straddle is an appropriateposition, let’s assume that the trader wanted to purchase five contracts onthat day near the end of trading. Using those prices, the trader’s total debitfor buying five calls at 3.30 and five puts for 2.50 is an outlay of $2,900. Using Optionetics Platinum software, the initial risk of the position is shownin Figure 13.3.With the maximum risk exposure of the position known and expiration breakevens of 117.20 and 128.80 (strike price +/– debit), the straddleplayer now needs enough price movement to begin the process of makingadjustments and reducing that initial debit incurred. The position mayalso benefit if implied volatility rises; this is more probable if the marketheads south.Going forward, the broader market, as represented by the SPY, provided the type of price action the straddle player anticipated when establishing the position. Over the course of the next two weeks, the SPYwas hit with uniform but escalating price movement to the downside.The precipitous short-term price hit didn’t go unnoticed by market participants either. The IVs in the broader market spiked up over 30 percent in the VIX during this same period, which amplified the beneficialeffect to the long straddle. The largest relief (or concern?) for the straddle was the delta shift from neutral to a directional short as the indexproxy dropped in price. However, due to the premium increases in themarket (including those for the SPY), the going market price for options (implieds) was also working favorably. Is it time for an adjustment? You betcha.
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Besides wanting and needing to make adjustments in order to provide relief from the initial cost of the position, when and where thestrategist sets up those decision points will ultimately change the risk/reward profile of the position. This can be a highly mechanical decisionthat maintains the theoretical neutrality of the initial position, or it can beone that allows the trader to make adjustments based on an ongoing interpretation of market dynamics. There is no right or wrong selectionhere, and some traders will find they approach straddle adjustments fromthe gray area between those two extremes. Rather than thinking about aright or wrong approach to adjustments, developing a consistent and realistic style that fits your own risk tolerance level is a very importantelement of being successful.Back to our example, the adjustments we ultimately used fell somewhere between two extremes. This was done to reflect the trader’s appreciation for the technical conditions in place and the changingfundamentals, and seems to be a consistent approach given the reasonsfor entry. After the SPY broke down, carving out a series of lower highsand lows, the straddle was working to the trader’s advantage and theopportunity existed to make a consistent adjustment.It seemed then that market pessimism had reached an extreme. VIXhit a multimonth high on October 13 (see Figure 13.4). The day before, putvolume across the U.S. market had swelled. On Wednesday, October 12,put volume across the six U.S. exchanges rose to 4.54 million contractscompared to 4.21 million calls. The following day 4.30 million puts werepurchased compared to 3.99 million calls. So, in a relatively rare occurrence, more puts than call options traded during two consecutive trading
FIGURE 13.4 VIX Spike on October 13 (Source: www.ProﬁtSource.com)
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sessions. It had only occurred one other time that year, when the marketbottomed out on April 14 and 15. It was a sign that pessimism had reachedan extreme and perhaps a bottom was in.On October 13, the trader has now turned bullish on the SPY. However, a bearish directional (delta) straddle position now exists withroughly –250 delta. To flatten out this risk, a purchase of 250 shares of theSPY can be completed or adjustments in the options made. We’ve alreadyexplained the benefits for using options when it comes to this particularinstrument. Now, with the implied volatility levels having picked up favorably, the decision to sell some of the long vega is in line with a disciplinedand consistent approach.In this case, the strategist takes advantage of the decline in the SPYand the spike in IV to sell some puts. Selling three of the existing puts atthe market price of $6 a contract brings the position close to flat. Usingthe Optionetics Platinum software, we can see how our risk profile looksafter this step is made (see Figure 13.5). By making this adjustment wehave reduced our maximum risk by 62 percent to $1,100, from the initial$2,900 debit. This reduction results from the banked put profits, as wetook some money off the table.Also, notice how we have changed our reward profile versus the original straddle position. The taking in of positive deltas to flatten out the
FIGURE 13.5 Risk Proﬁle Adjusted Delta Neutral on October 13 (Source:www.Optionetics.com Platinum)
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position has ultimately shifted what the position profile looks like becausethe position is no longer a contract neutral straddle. While the positioncan make further profits on the downside, the biggest potential profitsnow lie in directional movement to the upside. The adjustment has shiftedthe contract count in favor of the calls. The new position is long five callsand long two puts. However, since the position is long more call contracts,the trader does have very real directional risk to the upside if price movement in the SPY is not powerful enough. There is still $1,100 of expirationrisk if the trader does nothing and the SPY settles at the 123 strike. At thatpoint, all of the options expire worthless.An adjustment was made based on events that unfolded, and at aprice level that appeared to keep the position consistent with changes inthe underlying. However, a trader in this fortunate situation could look atother alternatives. For instance, the trader could call it a day, so to speak,and close out the remaining put contracts for the current price of $6. Thiswould leave the trader long five December 123 Calls for a very small creditof $100 (existing debit of –$1,100 plus credit of $1,200 on sale of remainingputs). As an alternative, the trader could decide to close out the entire position. With the calls bid for $0.80 at the time, this action would result inclosing the straddle for a net profit of $500. Furthermore, a trader mighttake the proceeds and use them toward establishing another limited-riskposition based on risk and reward preference. The point is that the traderhas the ability to be creative with adjustments while reducing risk andmaximizing rewards.The adjustment shown here is a classic example of moving the straddle position toward a profitable trade and maintaining the delta neutral integrity. It is consistent with the trader’s current view resulting in adecision to maintain that position type (uneven contracts). Going forward, another similar adjustment might be made, given the proper marketopportunity. That, of course, would reduce the straddle risk even further.However, depending on new market conditions and how the trader wantsto approach it, this type of adjustment may not be the strongest alternative. With this particular straddle, there is still plenty of time left beforethe December position approaches the last 30 days of its contract life. Although the trade has been properly maintained thus far, as conditionschange, the strategist will always be looking to obtain a risk profile that isin line with his expectations and risk tolerance levels.
DIRECTIONAL LONG ADJUSTMENTBy October 19, the SPY has held its lows and is moving higher. However,during this period the strategist in our example has yet to make any
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further adjustments. Unfortunately, trading has turned range-bound andchoppy—