)  break-evens: This is the range of risk and will cause you to consider closingout the entire position at a loss or purchasing back the shorted stockand possibly holding the call options. The maximum risk for the entireposition is the net cost of $500.
• XYZ rises above the upside breakeven (55): If the stock’s pricerises above the upside breakeven, you will be making money on thecall options faster than you are losing on the shorted stock. You canclose  out  the  shorted  stock  and  one  call  option  and  hold  the  addi-tional option for additional revenue.
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Long Synthetic Straddle with Calls
Market  Opportunity: Look  for  a  market  with  low  volatility  where  youanticipate a volatility increase resulting in stock price movement in eitherdirection beyond the breakevens.
Short Stock and Long Calls
Strategy: Sell 100 shares of underlying stock and buy 2 long ATM calls.
Maximum Risk: [Net debit of options + (option strike price – price of un-derlying at initiation)] × number of shares.
Maximum Proﬁt: Unlimited to the upside and limited to the downside (asthe underlying can only fall to zero) beyond the breakevens.Upside Breakeven: [(2 × option strike price) – price of underlying stockat initiation] + net debit of options.
Downside Breakeven: Price of underlying stock at initiation – net debitof options.
Margin: Required on the short stock.
Long Synthetic Straddle with Calls Case Study
In this example, we want to trade the oil service in anticipation of an ex-plosive  move  higher  or  lower,  but  we  are  not  sure  about  direction.  Thistime, the underlying asset is the Oil Service HOLDRS (OIH), which is anexchange-traded  fund  that  holds  a  basket  of  oil  drilling  companies.  InApril  2003,  with  the  OIH  trading  for  $56  a  share,  we  initiate  a  syntheticstraddle  by  purchasing  two  October  2003  55  calls  for  $5.70  and  sellingshort 100 OIH shares.
The risk graph of the OIH synthetic straddle appears in Figure 8.15. Thetrade is established for a credit equal to the difference between the shortsale  price  minus  the  premium,  or  $4,460:  (56  –  11.40)  × 100.  Success  de-pends on the OIH making a move dramatically higher or lower. The upsidebreakeven  is  $65.40,  or  two  times  the  strike  price,  minus  the  stock  price,plus the options premium. The downside breakeven is simply the price paidfor OIH minus the options premium, or $44.60. The maximum possible lossis $1,040, but will be incurred only if the trade is held until expiration.
Just as in the other example of a long synthetic straddle using puts,the strategist will not want to hold this trade until expiration. Instead, wewill  exit  the  trade  before  the  last  30  days,  or  during  that  period  of  timewhen  time  decay  is  at  its  greatest.  So,  let’s  assume  we  exit  the  trade  45days before the October calls expire. In this case, on August 30, 2003, theOIH was trading for $60 a share and the two calls were each quoted for $6
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Today: 172 days left 115 days left 58 days leftExpiry:  0 days left
Close= 
55.99
tiforP
000,2
000,1
0
000,1–
30 
40 
50 
60 
70 
80
FIGURE 8.15 OIH Synthetic Straddle with Two Calls (Source: OptioneticsPlatinum © 2004)
a contract. So, the stock position resulted in a $4 per share loss, or $400,and the options moved only modestly higher. The strategist could book a$60 proﬁt by closing out the long calls.
So, time decay hurt this position. In the end, the trade lost $360. Itneeded  a  larger  move  in  the  underlying  asset  and  perhaps  more  time to  work  in  the  strategist’s  favor.  Rather  than  closing  the  position  en-tirely,  the  strategist  could  roll  the  position  forward  using  longer-termoptions.
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Long Synthetic Straddle with Calls Case Study
Market  Opportunity: Look  for  a  market  with  low  volatility  where  youanticipate a volatility increase resulting in stock price movement in eitherdirection beyond the breakevens.
Short Stock and Long Calls
Strategy: Sell 100 shares of OIH for $56 and buy 2 long October 2003 55calls for $5.70 a contract.
Maximum Risk: [Net debit of options + (option strike price – price of un-derlying  at  trade  initiation)]  × 100.  In  this  case,  the  max  risk  is  $1,040:[$11.40 + (55 – $56)] × 100.
Maximum Proﬁt: Unlimited to the upside and limited to the downside(as the underlying can only fall to zero) beyond the breakevens. In thisexample, $60.Upside Breakeven: [(2 × option strike price) – price of underlying at initia-tion] + net debit of the options. In this case, 65.40: (2 × 55) – 56 + 11.40.
Downside  Breakeven: Price  of  the  underlying  at  trade  initiation  –  netdebit of options. In this case, 44.60: (56 – 11.40).
STRATEGY ROAD MAPS
Long Straddle Road Map
In order to place a long straddle, the following 14 guidelines should beobserved:
1. Look for a market with low volatility about to experience a sharp in-crease in volatility that moves the stock price in either direction be-yond one of the breakevens. The best long straddle opportunities arein markets that are experiencing price consolidation as they are oftenfollowed  by  a  breakout.  To  ﬁnd  these  consolidating  markets,  lookthrough your charts for familiar ascending, descending, or symmetrictriangles. As the stock price approaches the apex (point) of these tri-angles, they build up energy, much like a coiled spring. At some pointthis  energy  needs  to  be  released  and  results  in  the  price  movingquickly. You don’t care in which direction because you are straddling!
2. Check to see if this stock has options available.3. Review options premiums per expiration dates and strike prices.4. Investigate implied volatility values to see if the options are overpricedor undervalued. Look for cheap options at the low end of their impliedvolatility range, priced at less than the volatility of the underlying stock.
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5. Explore past price trends and liquidity by reviewing price and volume
charts over the past year.
6. A long straddle is composed of the simultaneous purchase of an ATM
call and an ATM put with the same expiration month.
7. Place straddles with at least 60 days until expiration. You can also useLEAPS except the premiums are often very high and would be prof-itable only with a very large movement in the underlying stock.
8. Determine which spread to place by calculating:
• Limited Risk: The most that can be lost on the trade is the double
premiums paid.
• Unlimited  Reward: Unlimited  to  the  upside  and  limited  to  the
downside (the underlying can only fall to zero).
• Upside  Breakeven: Calculated  by  adding  the  call  strike  price  to
the net debit paid.
• Downside  Breakeven: Calculated  by  subtracting  the  net  debit
from the put strike price.
9. Create  a  risk  proﬁle  of  the  most  promising  option  combination  andgraphically determine the trade’s feasibility. A long straddle will havea  V-shaped  risk  proﬁle  showing  unlimited  reward  above  and  limitedproﬁt to the downside.
10. Write down the trade in your trader’s journal before placing the tradewith your broker to minimize mistakes made in placing the order andto keep a record of the trade.
11. Make an exit plan before you place the trade. For example, exit thetrade when you have a 50 percent proﬁt at least 30 days prior to expi-ration on the options. If you have a winner, you do not want to see itbecome a loser. In this case, exit with a reasonable 50 percent gain. Ifnot, then you should exit before the major amount of time decay oc-curs, which is during the option’s last 30 days. If you have a multiplecontract position, you can also adjust the position back to a delta neu-tral to increase proﬁt potential.
12. Contact  your  broker  to  buy  and  sell  the  chosen  options.  Place  thetrade as a limit order so that you limit the net debit of the trade.13. Watch the market closely as it ﬂuctuates. The proﬁt on this strategy isunlimited—a  loss  occurs  if  the  underlying  stock  closes  between  thebreakeven points.
14. Choose an exit strategy based on the price movement of the underly-
ing and ﬂuctuations in the implied volatility of the options.
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• The underlying shares fall below the downside breakeven:You can close the put position for a proﬁt. You can hold the worth-less call for a possible stock reversal.
• The underlying shares fall within the downside and upsidebreakevens: This is the range of risk and will cause you to closeout the position at a loss. The maximum risk is equal to the doublepremiums paid.
• The underlying shares rise above the upside breakeven: Youare  in  your  proﬁt  zone  again  and  can  close  the  call  position  for  aproﬁt. You can hold the worthless put for a possible stock reversal.
Long Strangle Road Map
In order to place a long strangle, the following 14 guidelines should beobserved:
1. Look for a relatively stagnant market where you expect an explosionof volatility that moves the stock price in either direction beyond oneof the breakevens. The best long strangle opportunities are in marketsthat are experiencing price consolidation because consolidating mar-kets are often followed by breakouts.
2. Check to see if this stock has options available.3. Review options premiums per expiration dates and strike prices.4. Investigate  implied  volatility  values  to  see  if  the  options  are  over-priced or undervalued. Look for cheap options at the low end of theirimplied volatility range, priced at less than the volatility of the under-lying stock.
5. Explore past price trends and liquidity by reviewing price and volume
charts over the past year.
6. A long strangle is composed of the simultaneous purchase of an OTM
call and an OTM put with the same expiration month.
7. Look at options with at least 60 days until expiration to give the trade
enough time to move into the money.
8. Determine which spread to place by calculating:
• Limited Risk: The most that can be lost on the trade is the double
premiums paid for the options.
• Unlimited  Reward: Unlimited  to  the  upside  and  limited  to  the
downside (as the underlying can only fall to zero).
• Upside  Breakeven: Calculated  by  adding  the  call  strike  price  to
the net debit paid.
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• Downside  Breakeven: Calculated  by  subtracting  the  net  debit
from the put strike price.
9. Create  a  risk  proﬁle  of  the  most  promising  option  combination  andgraphically determine the trade’s feasibility. A long strangle will havea  U-shaped  risk  proﬁle  showing  unlimited  reward  above  the  upsidebreakeven and limited proﬁt below the downside breakeven.
10. Write down the trade in your trader’s journal before placing the tradewith your broker to minimize mistakes made in placing the order andto keep a record of the trade.
11. Make an exit plan before you place the trade. For example, exit thetrade when you have a 50 percent proﬁt or at least 30 days prior to ex-piration on the options. Exit with a reasonable 50 percent gain. If not,then you should exit before the major amount of time decay occurs,which occurs during the option’s last 30 days.
12. Contact  your  broker  to  buy  and  sell  the  chosen  options.  Place  thetrade as a limit order so that you limit the net debit of the trade.13. Watch the market closely as it ﬂuctuates. The proﬁt on this strategy isunlimited—a loss occurs if the underlying stock closes at or below thebreakeven points. You can also adjust the position back to a delta neu-tral to increase proﬁt potential if you have a multiple contract position.14. Choose an exit strategy based on the price movement of the underly-ing stock and ﬂuctuations in the implied volatility of the options:
• The underlying shares fall below the downside breakeven:You can close the put position for a proﬁt. You can hold the worth-less call for a possible stock reversal.
• The underlying shares fall within the upside and downsidebreakevens: This is the range of risk and will cause you to closeout the position at a loss. The maximum risk is limited to the premi-ums paid.
• The underlying shares rise above the upside breakeven: Youare  in  your  proﬁt  zone  again  and  can  close  the  call  position  for  aproﬁt. You can hold the worthless put for a possible stock reversal.
Long Synthetic Straddle Road Map
In order to place a long synthetic straddle with puts or calls, the following14 guidelines should be observed:
1. Look  for  a  market  with  low  volatility  about  to  experience  a  sharpincrease in volatility that moves the stock price in either direction
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beyond one of the breakevens. The best long synthetic straddle op-portunities are in markets that are experiencing price consolidationas they are often followed by a breakout.2. Check to see if this stock has options available.3. Review options premiums per expiration dates and strike prices.4. Investigate  implied  volatility  values  to  see  if  the  options  are  over-priced or undervalued. Look for cheap options. Those are options thatare at the low end of their implied volatility range, priced at less thanthe volatility of the underlying stock.
5. Explore past price trends and liquidity by reviewing price and volume
charts over the past year.
6. A long synthetic straddle can be composed by going long two ATM putoptions  per  long  100  shares  or  by  purchasing  two  ATM  call  optionsagainst 100 short shares. Either technique creates a delta neutral tradethat  can  be  adjusted  to  bring  in  additional  proﬁt  when  the  marketmoves up or down.
7. Place synthetic straddles using options with at least 60 days until ex-piration. You can also use LEAPS except the premiums are often veryhigh and may be proﬁtable only with a very large movement in the un-derlying stock.
8. Determine which spread to place by calculating:
• Limited  Risk: For  a  long  synthetic  straddle  using  puts,  add  thenet debit of the options to the stock price at initiation minus theoption strike price and then multiply this number by the numberof  shares.  For  a  long  synthetic  straddle  using  calls,  add  the  netdebit of the options to the option strike price minus the price ofthe  underlying  at  trade  initiation,  and  then  multiply  this  numberby the number of shares. This is assumed only if you hold the po-sition to expiration and the underlying stock closes at the optionstrike price.
• Unlimited  Reward: Unlimited  to  the  upside  and  limited  to  the
downside (as the underlying can only fall to zero).
• Upside Breakeven: Calculated by adding the price of the underly-
ing stock at initiation to the net debit of the options.
• Downside  Breakeven: Calculated  by  subtracting  the  stock  pur-chase  price  plus  the  double  premium  paid  for  the  options  fromtwice the option strike price.
9. Create  a  risk  proﬁle  of  the  most  promising  option  combination  andgraphically determine the trade’s feasibility. A long synthetic straddle
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will have a U-shaped risk proﬁle, showing unlimited reward and lim-ited risk between the breakevens.
10. Write down the trade in your trader’s journal before placing the tradewith your broker to minimize mistakes made in placing the order andto keep a record of the trade.
11. Make  an  exit  plan  before  you  place  the  trade.  For  example,  exit  thetrade when you have a 50 percent proﬁt at least 30 days prior to expi-ration  on  the  options.  If  not,  then  you  should  exit  before  the  majoramount of time decay occurs, which is during the option’s last 30 days.You  can  also  adjust  the  position  back  to  a  delta  neutral  to  increaseproﬁt potential depending on how many contracts you are trading.12. Contact  your  broker  to  buy  and  sell  the  chosen  options.  Place  thetrade as a limit order so that you limit the net debit of the trade.13. Watch the market closely as it ﬂuctuates. The proﬁt on this strategy isunlimited—a  loss  occurs  if  the  underlying  stock  closes  between  thebreakeven points.
14. Choose an exit strategy based on the price movement of the underly-ing shares and ﬂuctuations in the implied volatility of the options.
Exiting the long synthetic straddle with puts:
• The underlying shares fall below the downside breakeven:If the stock’s price falls below the downside breakeven, you can ex-ercise one of the puts to mitigate the loss on the stock and sell theother put for a proﬁt.
• The underlying shares fall within the downside and upsidebreakevens: This  is  the  range  of  risk  and  will  cause  you  to  con-sider closing out the entire position at a loss or selling just the putoptions. The maximum risk is the cost of the double premium paidout for the puts.
• The  underlying  shares  rise  above  the  upside  breakeven:If  the  stock’s  price  rises  above  the  upside  breakeven,  you  will  bemaking  money  on  the  stock  and  losing  money  on  the  put  options.You can sell them at a loss or hold onto them in case of a reversal.
Exiting the long synthetic straddle with calls:
• The underlying shares fall below the downside breakeven:If  the  stock’s  price  falls  below  the  downside  breakeven,  you  canpurchase the shorted stock and let the calls expire worthless.
• The underlying shares fall within the downside and upsidebreakevens: This  is  the  range  of  risk  and  will  cause  you  to  con-
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sider closing out the entire position at a loss or purchasing back theshorted stock and possibly holding the call options.
• The  underlying  shares  rise  above  the  upside  breakeven:If  the  stock’s  price  rises  above  the  upside  breakeven,  you  will be  making  money  on  the  call  options  faster  than  you  are  losingon  the  shorted  stock.  You  can  close  out  the  shorted  stock and one call option and hold the additional option for additionalrevenue.
CONCLUSION
Every  trader,  no  matter  how  new  or  experienced,  has  wished  they had bought the opposite side of a trade at one time or another. Maybewe  felt  strongly  about  earnings  for  a  company  and  found  out  thatthough the news was good, the stock fell on the actual report. There areseveral  different  technical  patterns  that  signal  a  strong  move  is  likely,but  the  direction  is  hard  to  predict.  Fortunately,  there  are  a  number of  option  strategies—straddles,  strangles,  and  synthetic  straddles—that take advantage of large moves without the need to predict marketdirection.
A straddle is a delta neutral strategy that is made up of buying an ATMcall and an ATM put. A strangle is similar but uses OTM options instead.The  obvious  question  new  traders  have  is  how  do  these  types  of  tradesmake money? Any price movement means either a call value gain and a putloss, or a put gain and a call loss. However, the delta will increase more onthe side of the trade that gains than it will decrease on the side that is los-ing value.
The other way we proﬁt in a straddle is if implied volatility increasesfor the options. Since we are buying both sides of the trade, a rise in IVwill beneﬁt both the put and the call. However, this can also work in re-verse, so we need to be conﬁdent that IV will either rise or at least stayconstant. IV increases on pending news events, like earnings or FDA deci-sions. However, once the news has been announced, IV usually implodesand can lead to a volatility crush.
A  straddle  is  a  limited  risk/unlimited  reward  strategy,  but  tradersshould still set proﬁt goals. Many straddle traders look to make 50 percentproﬁt on a straddle, but might use adjustments to lower risk, while hold-ing on for higher proﬁts. For example, once one side of a straddle pays forthe whole trade, we can sell this side and hold on for a gain in the otherside of the straddle. Of course, this would be contingent on the belief thestock was about to reverse course.
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The  strategist  purchases  straddles  and  strangles  when  there  are  ex-pectations that the stock will make a signiﬁcant move higher or lower, butthe direction is uncertain. A sideways-moving stock will result in losses tothe straddle or strangle holder. However, although a stock needs to makea rather large move to make a proﬁt on a straddle (or a strangle), we alsocan get out without much of a loss if the stock doesn’t move within a giventime  frame.  However,  this  is  only  the  case  if  we  purchase  options  withenough  time  left  until  expiration.  Time  decay  is  the  biggest  enemy  wehave with a straddle, and time decay picks up speed the last 30 days of anoption’s life.
A long synthetic straddle consists of long stock and long puts or shortstock  and  long  calls  to  create  a  delta  neutral  trade.  Most  of  the  time,  along  synthetic  straddle  utilizes  at-the-money  (ATM)  options.  Remember,ATM options normally have a delta near 50, or in this case –50. However,the maximum risk is not the entire debit, just the cost of the options. Riskoccurs if the stock does not move by expiration and the time value of thelong options erodes away.
The beneﬁt to trading a long synthetic straddle is the adjustments thatcan be made. As the stock moves up and down, we can adjust the tradeback  to  delta  neutral  to  lock  in  proﬁts.  Many  traders  make  adjustmentswhen the total delta of the trade is up or down 100. We can make these ad-justments by selling or buying stock or by selling or buying the options.This strategy is a great long-term tool, but make sure you understand therisks before entering this type of trade.
Used  appropriately,  the  nondirectional  strategies  reviewed  in  thischapter can be nice proﬁt producers, without a lot of risk. However, it isimportant to understand the basic rules and to know the associated risks.As with any strategy, a risk graph should always be created before enter-ing the trade.
When you put on a long synthetic straddle, you are placing a hedgetrade.  All  you  are  paying  for  is  the  cost  of  the  options.  If  your  broker requires  you  to  have  margin  on  the  stock  side,  then  try  to  ﬁnd  some-one  who  will  give  you  a  cross-margin  account.  There  are  companies out there that offer cross margining, although it is a relatively new con-cept  to  the  public.  Putting  on  a  synthetic  straddle  is  not  new;  just  theconcept of looking at it as a low-risk trade from the brokerage ﬁrm sideis new.
These trades are referred to as synthetic primarily because the twoATM options behave like the underlying stock (two ATM options = +100or  –100  deltas).  They  create  a  synthetic  instrument  that  moves  as the  underlying  asset  changes.  When  you  initiate  the  position,  you  arecompletely  offsetting  the  other  side  to  create  a  perfect  delta  neutral
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trade. As the market moves, you will gain more on the winning side ofthe  trade  or  in  adjustment  proﬁts  than  you  will  relinquish  on  the losing portions of the trade. It works because you are combining a ﬁxeddelta with a variable delta. Adjustments can be made when the marketmakes  a  move.  If  the  market  moves  so  that  the  overall  trade  is  +100deltas, then you can sell short 100 shares of stock. If the market movesand  the  overall  position  delta  becomes  –100,  you  can  buy  another  fu-tures  contract  or  100  shares  of  stock.  Either  way,  the  trade  returns  todelta neutral.
As a beginner, you should play it safe and place trades that offer lim-ited  risk.  Although  it  may  be  tempting  to  go  short  options  since  a  saleplaces money directly in your trading account over time, I do not recom-mend selling options until you are truly well-versed in delta neutral trad-ing.  Remember  that  when  you  sell  options  you  do  get  a  credit,  but  youonly earn this credit as the options lose value over time.
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CHAPTER 9
Advanced Delta NeutralStrategies
Understanding the mechanics of a variety of delta neutral strategies is
vital to becoming a proﬁtable nondirectional trader. Instead of beingoverwhelmed  by  the  complex  nature  of  market  dynamics,  you  canimplement a delta neutral strategy that takes advantage of market condi-tions. Determining which strategy best ﬁts the situation can easily be de-duced  through  the  use  of  risk  proﬁles  and  relatively  easy  mathematicalcalculations. Delta neutral trading is all about empowering traders to max-imize  their  returns  and  minimize  their  losses.  Although  professionaltraders  have  used  delta  neutral  strategies  on  the  major  exchanges  foryears, off-ﬂoor traders are rarely aware of these strategies.
We have already explored the basic delta neutral trading techniques.It’s time to turn the spotlight on some advanced strategies: ratio spreadsand  ratio  backspreads.  Ratio  spreads  are  interesting  strategies  that  pro-vide a wide proﬁt zone; however, they also have unlimited risk. Ratio back-spreads, in contrast, offer limited risk with unlimited reward potential.
RATIO CALL SPREAD
A ratio spread is a strategy in which an uneven number of contracts withthe same underlying instrument are bought and sold. Unlike straddles andstrangles,  which  use  a  1-to-1  ratio  of  the  same  kind  of  options,  ratiospreads offset an uneven number of different types of options. A ratio callspread is useful when a trader sees a slight rise in a market followed by asell-off. If this trade is done at a credit, the chance for success increases.
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