akeven = (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 because 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 straddleexample:Short 100 Shares of DELL @ $35.10Long 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)] × number of shares.Upside breakeven = [(2 × 35) – 35.10] + 13.70) = $48.60 {[(2 × optionstrike) – price of underlying stock at initiation] + net debit ofoptions}.
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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 ASSIGNMENTAlthough 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 DEFINITIONSAverage Directional Movement Index (ADX): An indicator developedby J. Welles Wilder to measure market trend intensity. It does not give signals 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 directional 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 instrument position constructed so that it is relatively insensitive to theprice movement of the underlying instruments. This is arranged by selecting a calculated ratio of short and long positions with a combined positiondelta of zero.Long straddle: A non-directional option strategy that combines the simultaneous 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 downside (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 options 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 expiration 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.
CHAPTER 9
AdvancedDelta NeutralStrategies
SUMMARYMost successful options traders are continuously accessing risk-rewardprobabilities. Trades that offer limited rewards but high risks are often illadvised. 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 neutral 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 number 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 options (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 EXERCISES1. A ratio spread is a strategy in which an ______________ number of option contracts of the same underlying instrument are bought and sold.116
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A. Even.B. Uneven.2. A ratio call spread involves ______________.A. Buying a lower strike option and selling a greater number of ITMoptions.B. Buying a higher strike option and selling a greater number ofATM options.C. Buying a lower strike option and selling a greater number of OTMoptions.D. Buying a higher strike option and selling a greater number ofOTM options.3. Calculate the values for the following ratio call spread:Long 1 January QQQ 37 Call @ 2.50Short 2 January QQQ 40 Calls @ 1.50Net credit = _________________________________________________Maximum reward = __________________________________________Maximum risk = _____________________________________________Upside breakeven = __________________________________________4. A ratio call spread should be implemented in a/an ______________market.A. Bullish.B. Bearish.C. Either bullish or bearish.5. A ratio put spread involves ______________.A. Buying a higher strike put option and selling a greater number ofOTM put options.B. Buying a lower strike put option and selling a greater number ofOTM put options.C. Buying a higher strike put option and selling a greater number ofITM put options.D. Buying a lower strike put option and selling a greater number ofITM put options.
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6. Calculate the values for the following ratio put spread:Long 1 January QQQ 35 Put @ 2.00Short 2 January QQQ 32 Puts @ 1.25Net credit = _________________________________________________Maximum profit = ____________________________________________Maximum risk = _____________________________________________Downside breakeven = _______________________________________7. A ratio put spread should be implemented in a/an ______________market.A. Bullish.B. Bearish.C. Either bullish or bearish.8. True or False: Never attempt to place a ratio backspread in a marketwith low volatility.9. A call ratio backspread involves ______________.A. Selling a higher strike call and buying a greater number of lowerstrike calls.B. Selling a lower strike call and buying a greater number of higherstrike calls.C. Buying a higher strike call and selling a greater number of lowerstrike calls.D. Buying a lower strike call and selling a greater number of higherstrike calls.10. Calculate the values for the following call ratio backspread:Short 2 January QQQ 35 Calls @ 4.00Long 3 January QQQ 38 Calls @ 2.25Net credit = _________________________________________________Maximum profit = ____________________________________________Maximum risk = _____________________________________________Upside breakeven = __________________________________________Downside breakeven = _______________________________________
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11. Call ratio backspreads are best implemented during periods of______________.A. High volatility in a highly volatile market that shows signs ofincreasing activity to the upside.B. High volatility in a highly volatile market that shows signs ofincreasing activity to the downside.C. Low volatility in a highly volatile market that shows signs ofincreasing activity to the upside.D. Low volatility in a highly volatile market that shows signs ofincreasing activity to the downside.12. Put ratio backspreads are best implemented during periods of______________.A. High volatility in a highly volatile market that shows signs ofincreasing activity to the upside.B. High volatility in a highly volatile market that shows signs ofincreasing activity to the downside.C. Low volatility in a highly volatile market that shows signs ofincreasing activity to the upside.D. Low volatility in a highly volatile market that shows signs ofincreasing activity to the downside.13. A put ratio backspread involves ______________.A. Selling a higher strike put and buying a greater number of lowerstrike puts.B. Selling a lower strike put and buying a greater number of higherstrike puts.C. Buying a higher strike put and selling a greater number of lowerstrike puts.D. Buying a lower strike put and selling a greater number of higherstrike puts.14. Calculate the values for the following put ratio backspread:Short 2 January QQQ 35 Puts @ 2.50Long 3 January QQQ 32 Puts @ 1.25Net credit /debit = ____________________________________________Maximum profit = ____________________________________________
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Maximum risk = _____________________________________________Upside breakeven = __________________________________________Downside breakeven = _______________________________________15. What is the difference between a forward and a reverse volatilityskew?________________________________________________________________________________________________________________________
MEDIA ASSIGNMENTIn Chapter 4, the media assignment used the free options calculator fromthe Chicago Board Options Exchange web site at www.cboe.com to create a risk curve for the long call. Let’s go back to that calculator and repeat the process using a more complex strategy. So, from the CBOE homepage, click on the “Trading Tools” tab and then the “Volatility Optimizer”and then click on “Options Calculator.” Next, select “American” in thestyle box. (Note: If, for some reason the CBOE site is not available, readers can use any online options calculator to complete this assignment.)Start by creating a table with the following column heads: stock price,long call price, value of two long calls, value of short call, and overall position value. Then, on a piece of graph paper (or using a Microsoft Excelprintout), create a risk graph by drawing a horizontal axis and a verticalaxis. Along the horizontal axis, write the numbers 60, 65, 70, 75, 80, 85,and 90 at evenly spaced intervals. From bottom to top, write the numbers–5, –4, –3, –2, –1, 0, 1, 2, 3, 4, 5, 6, 7, 8, 9, and 10 along the vertical axis.Using the chart and the options calculator, let’s create a risk curve fora call ratio backspread. In this example, the call ratio backspread involvesselling an at-the-money call option and buying two out-of-the-money options. Let’s use the strike prices of 65 and 75.Now input some variables into the calculator regarding the long calls.First, let the strike price equal 75; the volatility is 30 percent, the annualinterest rate is 5 percent, and the company pays no dividend (quarterlydividend amount equals 0). Next, in the “Days Left to Expiration” box,click “Days Until Expiration” and enter the number 100. We are going tobuy two long calls that have 100 days remaining until expiration, a strikeprice of 75, volatility of 30 percent, and an underlying security that paysno dividends. At the same time, we will sell short one call with a strikeprice of 65, 100 days left until expiration, and volatility of 30 percent.
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Now, let’s look at the position as the stock price changes. Enter 60into the “Equity Price” box and look at the value of the long call. It has avalue of 45 cents. Since there are two long calls in this trade, the totalvalue of the long calls is 90 cents. Now, the short call is worth $2.20. So,the value of the position is –$1.30. Put a dot on the risk graph where theposition value equals –$130 and the stock price equals 60. Now, repeatthe calculation for the stock prices 70 through 90. When you reach the final equity price value of 90, the long call is worth roughly $1,650 a contract and the two long calls equal $3,300. The short call is worth $2,600 acontract. Subtract the value of the short call from the long calls and thecall ratio backspread is worth $7. Finally, connect the dots and you havejust created a risk curve for this trade. It is U-shaped, but also upwardsloping to the right. (Note: In practice, the risk curve will look a bit different than the one drawn in this example because we have not factoredin the credit received or premium paid for the trade. Nevertheless, therisk curve of any call ratio backspread will take on a shape similar to theone drawn here.)
VOCABULARY LISTCall ratio backspread
Ratio call spread
Forward volatility skew
Ratio put spread
Nondirectional
Ratio spread
Price skew
Reverse volatility skew
Put ratio backspread
Time skew
Ratio backspread
Volatility skew
SOLUTIONS1. A ratio spread is a strategy in which an ______________ number ofoption contracts of the same underlying instrument are boughtand sold.Answer: B—Uneven.Discussion: To create a ratio spread, the strategist will sell one ormore at-the-money or near-the-money options and sell a greater number of out-of-the-money contracts. The trade can be created usingeither puts or calls.
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2. A ratio call spread involves ______________.Answer: C—Buying a lower strike option and selling a greaternumber of OTM options.Discussion: As the name implies, the ratio call spread is establishedwith call options. The strategist will buy one or more calls and sell agreater number of calls with a higher strike price. Common ratiosinclude 1-to-2 and 2-to-3.3. Calculate the values for the following ratio call spread:Long 1 January QQQ 37 Call @ 2.50Short 2 January QQQ 40 Calls @ 1.50Answer:Net credit = [(2 × 1.50) – 2.50] × 100 = $50 [(Short – long premium)× 100].Maximum reward = [1 × (40 – 37) + .50] × 100 = $350 [Number of longcontracts × (difference in strikes + net credit)] × 100.Maximum risk = Unlimited to the upside above the breakeven.Upside breakeven = 37 + [(40 – 37) × 2 ÷ (2 – 1)] + .50 = $43.50 {Lowerstrike + [(difference in strikes × number of short contracts) ÷ (number of short calls – number of long calls)] + net credit}.Discussion: The credit received for the ratio call spread equals thepremium received from the sale of the calls minus the premium paidfor the purchase of the call(s) with the lower strike price(s). In thiscase, it equals $3.00 minus $2.50, or $50 per contract. The maximumreward occurs if both short calls expire worthless and the long callis closed at or near expiration for a profit. In this case, the premiumkept from the long calls if the QQQ reaches exactly $40 equals $300.At that point, the long call yields a $50 profit and the maximum gainis therefore $350.4. A ratio call spread should be implemented in a/an ______________market.Answer: B—Bearish.Discussion: The ratio call spread is best established when the strategist expects the underlying asset to move only modestly higher, remain unchanged, or fall in price. The idea is to keep the optionpremiums from the short calls, so a bullish move in the underlyinginstrument would result in losses.
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5. A ratio put spread involves ______________.Answer: A—Buying a higher strike put option and selling a greaternumber of OTM put options.Discussion: The ratio put spread is similar to the ratio call spread.However, as the name suggests, the strategy uses puts instead ofcalls. In addition, the strategist is buying one or more put options andselling a greater number of puts with a lower strike price.6. Calculate the values for the following ratio put spread:Long 1 January QQQ 35 Put @ 2.00Short 2 January QQQ 32 Puts @ 1.25Answer:Net credit = [(2 × 1.25) – 2] × 100 = $50 [(Short – long premium) × 100].Maximum profit = [(35 – 32) + .50] × 100 = $350 [(Difference in strikeprices + net credit) × 100].Maximum risk = Limited to the downside until the underlying falls tozero ($2,850 is then the maximum loss).Downside breakeven = 35 – [(35 – 32) × 2) ÷ (2 – 1)] – .50 = $28.50{Higher strike – [(difference in strike prices × number of short contracts) ÷ (number of short contracts – number of long contracts)] –net credit}.Discussion: The credit from the ratio put spread is equal to the premium received minus the premium paid, which, in this case, equals$2.50 minus $2.00, or $.50 per spread. The maximum profit occurs ifthe short options expire worthless but the long put increases in valueas much as possible. At $32 a share at expiration, the short puts willexpire worthless, but the long put will be worth $300. Therefore, thetrader keeps all of the premium from the short puts, or $2.50, andmakes another $1 profit on the long put. At that point, the maximumprofit is $350. However, the risks are considerable and the maximumloss of $2,850 will occur if the underlying instrument falls to zero.7. A ratio put spread should be implemented in a/an ______________market.Answer: A—Bullish.Discussion: If the underlying asset makes a sharp drop, the ratio putspread will result in losses. For that reason, it is best establishedwhen the trader is bullish on the underlying instrument and expectsto see a significant move higher or only a modest move lower.
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8. True or False: Never attempt to place a ratio backspread in a marketwith low volatility.Answer: False.Discussion: Placing ratio backspreads in markets with low volatilityis not recommended. However, if you do choose to trade a slow market, follow these three rules: (1) Use a .75 ratio or higher, (2) buy thelower strike, and (3) sell the higher strike.9. A call ratio backspread involves ______________.Answer: B—Selling a lower strike call and buying a greater numberof higher strike calls.Discussion: The call ratio backspread is established using call options.The strategist will simultaneously sell one or more calls and buy agreater number of calls with the same expiration date. Ratios of 1-to-2or 2-to-3 are commonly used.10. Calculate the values for the following call ratio backspread:Short 2 January QQQ 35 Calls @ 4.00Long 3 January QQQ 38 Calls @ 2.25Answer:Net credit = [(2 × 4) – (3 × 2.25)] × 100 = $125 [(Short – long premium)× 100].Maximum profit = Unlimited above the upside breakeven.Maximum risk = [2 × (38 – 35) – 1.25] × 100 = $475 {[(Number of shortcalls × difference in strikes) – net credit] × 100}.Upside breakeven = 38 + [(38 – 35) × 2] ÷ (3 – 2) – 1.25 = $42.75{Higher strike + [(difference in strikes × number of short calls) ÷(number of long calls – number of short calls)] – net credit}.Downside breakeven = 35 + 1.25 = $36.25 (Short strike + net credit).Discussion: The credit received, or debit paid, in a call ratio backspread equals the premium of the short options minus the premiumfor the long options—in this case, $8.00 minus $6.75, or $125 perspread. The maximum profit is unlimited as the stock moves higher. Acall ratio backspread is best placed in a market where you anticipatea sharp rise with increasing volatility.11. Call ratio backspreads are best implemented during periods of______________.Answer: C—Low volatility in a highly volatile market that showssigns of increasing activity to the upside.
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Discussion: The call ratio backspread yields the greatest profitswhen the underlying instrument makes a significant move higher. If,however, the underlying instrument falls sharply, the strategist cankeep the initial net credit. For that reason, it is best established for acredit, and this can usually be accomplished when volatility is low.12. Put ratio backspreads are best implemented during periods of______________.Answer: D—Low volatility in a highly volatile market that showssigns of increasing activity to the downside.Discussion: The put ratio backspread is a bearish strategy that generates the most profits when the underlying security makes an explosive move to the downside.13. A put ratio backspread involves ______________.Answer: A—Selling a higher strike put and buying a greater numberof lower strike puts.Discussion: The ratio put backspread is established by purchasingone or more puts and selling a greater number of puts with a lowerstrike price with the same expiration date. Ratios of 1-to-2 or 2-to-3are often used to establish backspreads.14. Calculate the values for the following put ratio backspread:Short 2 January QQQ 35 Puts @ 2.50Long 3 January QQQ 32 Puts @ 1.25Answer:Net credit = [(2 × 2.50) – (3 × 1.25)] × 100 = $125 [(Short – long premium) × 100].Maximum profit = $2,725 (Limited to the downside as the underlyingfalls to zero).Maximum risk = [2 × (35 – 32)] – 1.25 × 100 = $475 [(Number of shortputs × difference in strikes) – net credit] × 100.Upside breakeven = (35 – 1.25) = $33.75 (Higher strike – net credit).Downside breakeven = 32 – [2 × (35 – 32) ÷ (3 – 2)] + 1.25 = $27.25{Lower strike – [(number of short puts × difference in strikes) ÷(number of long puts – number of short puts)] + net credit}.Discussion: The net credit (or net debit) from the put ratio backspread is equal to the premium received minus the premium paid. Ifthe underlying instrument rallies, the strategist can let the puts expire
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worthless and keep the net credit. The maximum profit, however, occurs if the underlying asset falls sharply. In this case, the maximumprofit is equal to $2,725. The maximum risk, meanwhile, is limited andequal to the difference in the strike prices times the number of shortoptions minus the net credit.15. What is the difference between a forward and a reverse volatility skew?Answer: With a forward price skew, the options with the higherstrike prices have higher implied volatility than the options withlower strike prices. The reverse volatility skew, in contrast, will havehigher implied volatility in the lower strike prices when compared tothe higher strike prices.Discussion: Ratio backspreads and other types of vertical spreads cantake advantage of volatility skews. For example, with a forward skew,strategists can sell the options with the higher strike price and buythose with the lower strike price. On the other hand, strategists can buythe higher strike price and sell the lower one if a reverse volatility skewexists. The type of spread, and whether to use puts or calls, will dependon the outlook for the underlying asset. For instance, if a contract has areverse skew and the strategist is bullish on the underlying asset, a callratio backspread might be the appropriate strategy to employ.
MEDIA ASSIGNMENTIn this chapter, we once again use the free options calculator at theChicago Board Options Exchange web site to create a risk curve (in Chapter 4 we created a curve for the long call). This chapter’s example focuseson the call ratio backspread. Before plotting the graph, the reader shouldhave generated a table similar to the one shown.
Stock Price
Long Call Price
Value of TwoLong Calls
Value ofShort Call
Position Value
60
0.45
0.90
2.20
–1.30
65
1.25
2.50
4.50
–2.00
70
2.80
5.60
7.80
–2.20
75
5.15
10.30
11.80
–1.50
80
8.40
16.80
16.25
0.55
85
12.30
24.60
21.00
3.60
90
16.50
33.00
26.00
7.00
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After creating the table, plotting the risk curve is relatively straightforward. We plot the coordinates where the stock price (first column)and the value of the options trade (last column) intersect. For instance,when the stock price equals $85, the value of the call ratio backspreadequals $3.60. Once all eight coordinates are plotted on the risk curve,connect the dots and the risk curve should look like the one shown inthe figure.109876543210–1–2–3–4–560 65 70 75 80 85 90Call Ratio Backspread Risk Curve
VOCABULARY DEFINITIONSCall ratio backpread: A spread that involves selling a call and buying agreater number of calls with a higher strike price and the same expirationmonth.Forward volatility skew: A type of volatility skew in which the optionwith the higher strike price has a higher implied volatility than the optionwith the lower strike price.Nondirectional: A type of options strategy that will profit whether theunderlying asset moves higher or lower. Its success does not depend on amove in a specific direction. Straddles and strangles are examples ofnondirectional trades.Price skew: A type of volatility skew where options with the same expiration date, but different strike prices, have different levels of impliedvolatility.
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Put ratio backspread: A strategy that involves selling a put option andbuying a greater number of put options with a lower strike price. Theexpiration dates of all the put options are the same.Ratio backspread: A spread in which more options are purchased thansold and where all options have the same underlying and expiration date,but different strike prices.Ratio call spread: A spread strategy that involves buying a call andselling a greater number of calls with a lower strike price and the sameexpiration date.Ratio put spread: A strategy of buying put options and selling agreater number of put options with the same expiration date but alower strike price.Ratio spread: A strategy that involves buying and selling options (all putsor all calls) with the same expiration date, but different strike prices. Thenumber of long contracts and short contracts are not equal.Reverse volatility skew: A type of volatility skew where options thathave the same expiration date have higher implied volatility among thelower strike prices when compared to the higher strike prices.Time skew: A type of skew where options that have the same strikeprices, but different expiration dates, have vastly different levels ofimplied volatility.Volatility skew: When options on the same underlying asset but withdifferent strike prices and/or expiration dates have different levels ofimplied volatility. One of the most common volatility skews occurs whenthe short-term options have a much higher level of implied volatilitycompared to the longer-term options.
CHAPTER 10
TradingTechniques forRange-BoundMarkets
SUMMARYSometimes the markets just don’t move much. For many traders, the lackof direction or volatility can prove frustrating. After all, if markets aremoving sideways, how can a trader generate profits from bullish or bearishstrategies? Straddles and strangles won’t work very well, either, as they require significant movement to cover the costs of the double option premium. Fortunately, there are a few options strategies that can generateprofits in sideways-moving markets.This chapter explores some of the strategies that can deliver profitswhen the underlying instrument trades quietly and without much movement. These approaches take advantage of the fact that options are wasting assets and lose value with the passage of time. Examples include thelong butterfly, long condor, and the long iron butterfly, as well as calendarspreads and collars. These strategies can be used to profit from time decayand thus can help options traders generate profits even in low-volatility orrange-bound markets.Although the real excitement in trading may come from jumping ona big trend and watching your chosen stock double every month or youroptions double or triple by the end of the week, in the real world thatseldom happens. If you accept the fact that the majority of stocks arenot going to move significantly from month-to-month, you can makeconsistent, although modest, profits using sideways strategies. Andsince the risk is defined, you will not take on any more risk than isacceptable to you.129
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QUESTIONS AND EXERCISES1. In sideways markets, option strategies can be developed to takeadvantage of ______________.A. Gamma decay.B. Th