and December 85calls, the cost of the trade is $7,250. Therefore, employing a strangle is aless expensive alternative.The upside breakeven at expiration is equal to the strike price of thecall plus the double premium paid for the options, or 100 (90 + 10). Thedownside breakeven is simply the strike price of the put minus the doublepremium, or 70 (80 – 10). If the XAU rises above $100 or falls below 70 atexpiration, the trade makes money, which is relatively similar to the straddle (see Figure 7.2).
FIGURE 7.2 XAU December Strangle Risk Graph (Source: www.Optionetics.comPlatinum)
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Like the straddle, the strangle is a limited-risk, unlimited-reward strategythat relies on a strong move in the underlying security. If it doesn’t move,then the trade will begin to see losses due to time decay. This problem is exacerbated by the fact that there are two long options that are both losingvalue. In our example, as long as the XAU trades between the strike prices of80 and 90 at expiration, the trade suffers its maximum possible loss. With thestraddle, the maximum potential loss occurred at 85, which is the strikeprice of both the put and the call. In sum, although the strangle is cheaper,the odds of incurring the maximum potential loss at expiration are greater.However, just as with the straddle, strategists will generally not holdthe strangle until expiration. Instead, the strategist will bank profits if theXAU makes a significant move higher or lower within the first two orthree months after establishing the trade. If it falls below the lowerbreakeven price, the strategist can close the put position for a profit. Or, ifthe underlying asset price rallies above the upside breakeven, the strategist can close the call for a profit.If the index stays between the two strike prices and within a tradingrange, the trade will result in a loss. Therefore, the strategist will want toconsider closing out the position if the underlying asset does not begin tosee movement in one direction or the other. Since time decay will verynegatively impact the position closer to expiration, the strategist will usually want to close the position between 30 and 45 days prior to expiration.
UNDERSTANDING DELTAWhen creating straddles and strangles, the trade can either be neutral orhave a bullish or bearish bias. In order to understand if the position istruly neutral, the strategist can turn to one of the risk measurementscalled the Greeks. The Greek delta is probably the most fundamental ofthese measurements and is the first that needs to be mastered by everybeginning options trader.What Are the Greeks?Options and other trading instruments have a variety of risk exposuresthat can vary dramatically over time or as markets move. Greeks are essentially a set of measurements that explore the risk exposures of a speciﬁc options trade. The Greeks in respect to option trading includegamma, vega, theta, and delta, each one representing a different variablerelative to option pricing.(Continued)
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What Are the Greeks? (Continued)Each risk measurement is named after a different letter in the Greekalphabet (vega is not actually a Greek letter, but it is used in this contextanyway). In the beginning, it is important to be aware of all the Greeks, although understanding delta is the most crucial to trading success. Each ofthe terms deﬁned here has a speciﬁc use in day-to-day trading.• Delta: Change in the price of an option relative to the change of theunderlying security.• Theta: Change in the price of an option with respect to a change inits time to expiration (time value).• Vega: Change in the price of an option with respect to its change involatility.• Gamma: Change in the delta of an option with respect to the changein price of its underlying security.
Delta is a measure of the change in the price of an option relativeto the price change of the underlying asset. For instance, strategistspurchase a call option on a stock because they expect that stock to rise.There is a distinct relationship between the price paid for the option(the current premium reflected in the market) and the price of theunderlying stock.The delta factor addresses the question, “How much does the optionvalue change for a move in the underlying asset?” For instance, if thestock’s price increases by $1.00, will the premium of that option increaseby $1.00? The delta factor is calculated by dividing the amount of price difference of the option by the amount of price difference in the underlyingstock. For example, if the price of the stock option increased by $0.20when the stock price went up $0.40, you would have a delta factor of 0.50.This is determined by dividing 0.20 by 0.40. A delta of 0.50 indicates thatthe option price will increase at half the rate of the stock price.A call option with a delta of 0.50 is common when an option is veryclose to being at-the-money. As the call moves in-the-money, the delta willincrease. A deep-in-the-money option will have a delta approaching 1.00and will move almost one-for-one with the movement of the underlying asset. The delta is never greater than 1.00. In contrast, put options have negative deltas because they decrease in value as the stock rises.The greater the delta factor—positive or negative—the more expensive the option and the higher the loss can be for buyers. Many speculators prefer to use out-of-the-money options because they are cheaper.
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However, the delta will also be lower and the option will see a smallerpoint change for each point change in the underlying asset.Straddles and strangles are generally created to be delta neutral.For example, the delta of the at-the-money call will equal +0.50 and theat-the-money put will have a delta of –0.50. If the strategist is using thesame number of puts and calls, the positive and negative deltas willoffset each other, leading to a total position delta of zero—a delta neutral trade.Similarly, when creating a strangle, the deltas should offset eachother for the position to be truly neutral. For instance, if the strategistcreates a strangle and the call has a delta of +0.50 and the put has a deltaof –0.30, the overall delta is 0.20 [0.50 + (–0.30) = 0.20]. The strangle willthen have a directional bias that is bullish. It will increase in value by 0.20for every 1 point move higher in the underlying asset and fall in value by0.20 for every 1 point drop in the underlying asset. Ultimately, if the priceof the underlying asset continues to fall, the put’s delta will begin to increase and the call’s delta will decline. It might move toward delta neutrality through time, but the position is not delta neutral at the time that itis established. There is nothing wrong with directional straddles andstrangles, but the strategist should understand when the position has abias one way or the other. Determining a position’s overall delta is aneasy way to find out.
SHORT STRADDLES AND STRANGLESSome newsletter writers and investment services have advocated sellingstraddles and strangles on indexes. The idea is that, unlike a stock thatcan sometimes make a large move in a short time, an index is less likely toexplode in one direction or the other. The reason for this is that an indexholds several, in some cases hundreds of different stocks.Therefore, since indexes tend to be less volatile, the logic follows thatit makes sense to sell index options because these options are more likelyto lose value from time decay and are less likely to move deep-in-themoney, an outcome that could result in a huge loss. By selling straddles orstrangles in a sideways market the trader can bring in a significant amountof premium and have a potentially wide profit area as the market continues to move sideways or trends only modestly.Let’s consider an example using the S&P 500 Index ($SPX). During themiddle of December, with the SPX trading near 1,260, the strategist determines that the market is likely to trade flat during the first quarter of thefollowing year. Consequently, the strategist decides to sell premium in the
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form of a March 1,260 straddle. The calls are sold for $35 a contract andthe puts fetch $25.Figure 7.3 shows the risk/reward of the short straddle. The strategistbrings in $6,000 in premium, which is good. However, the risks are high. Ifthe index falls below the lower breakeven (equal to the put strike priceminus the double premium, or 1,200), the trade begins to lose money. Arally above the higher breakeven (call strike price plus the premium, or1,320) also results in losses for the short straddle. In sum, the breakevensare fairly wide, but the chances of loss can be high and the maximum riskis unlimited to the upside.While selling straddles and strangles on indexes is a popular strategyamong some investors, we do not recommend them because they have unlimited risk. First, the broker generally requires a larger margin deposit tosell naked index options. In addition, it only takes one bad trade to wipeout a large number of profitable ones. In the event of a market crash, likethe one that occurred in October 1987, naked index puts could lead to financial ruin. In short, the risk/reward is simply not compelling enough. Instead, strategists looking to sell premium might want to consider otherstrategies such as the butterfly spread.
FIGURE 7.3 SPX Short Straddle Risk Graph (Source: www.Optionetics.comPlatinum)
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IRON BUTTERFLY SPREADSThe butterfly spread is a popular strategy among options traders andworks well in range-bound markets. It can be created with puts, calls, or acombination of the two. For example, a butterfly with calls will consist ofa long in-the-money call, two short calls with a higher strike price, and another long call with an even higher strike price. It can be thought of as acombination of a bull call spread and a bear call spread. We will consideran example shortly.For now, let’s take a look at the long iron butterfly, a similar strategythat works well in range-bound markets. Unlike the butterfly with onlyputs or only calls, the iron butterfly includes both puts and calls with fourdifferent options contracts. It can be viewed as a combination of a bearcall spread, with a short at-the-money call and a long out-of-the moneycall, along with a bull put spread that consists of a long out-of-the-moneyput and a short at-the-money put. If this is confusing, don’t worry—the example that follows will help clear things up.To create the iron butterfly, the strategist will buy an out-of-themoney call and an out-of-the-money put. At the same time, s/he will sellan at-the-money call and an at-the-money put. The iron butterfly is established for a credit because the strategist is buying two out-of-the-moneylower-priced options and selling two at-the-money higher-priced options.They are selling a straddle or strangle and then buying out-of-the-moneyoptions as a hedge to limit the risk and lower the margin requirements ofselling index options.Both the risks and the rewards of the long iron butterfly are limited.The success of the trade depends on the stock staying in between the upper and lower breakevens. The higher breakeven is computed as thestrike price of the short call plus the net credit received for the trade. Thedownside breakeven is equal to the short put strike price minus the netcredit. The maximum reward is the net credit received on the trade.Unlike the unlimited risk posed by the short straddle or strangle, thegreatest risk from the iron butterfly is equal to the difference between thestrike prices minus the net credit. Although not included in our calculations, it should also be noted that since this trade involves four contracts,the commissions can be significant. Even though the risks are generallylimited, keeping commissions low will greatly improve the reward potential of the iron butterfly trade.Let’s go back to the short straddle example. Recall we sold the SPX1,260 straddle for a credit of $6,000. The maximum gain was the credit,and that profit would be realized if the index closed at 1,260 at expiration.However, the risks were also high. In fact, there is no limit to the losses
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above the upside breakeven. If the index settles at 1,400 at expiration—an11 percent move higher—the strategist loses $8,000 per spread.To limit the risk, the strategist can sell the 1,260 straddle and buy anout-of-the-money put and an out-of-the-money call. For example, thestraddle can be modified to a long iron butterfly by doing the following:• Sell 1 March 1,260 straddle @ $60 (35 + 25).• Buy 1 March 1,290 call at $20.• Buy 1 March 1,230 put at $17.50.All told, the sale from the short options equals $60 and the cost of thelong options is $37.50. So this trade fetches a net credit of $22.50, or$2,250 per spread. Figure 7.4 shows the risk/reward associated with thisiron butterfly.The maximum profit from the long iron butterfly is equal to the netcredit and will occur if the stock is between the strike prices of the twoshort options at expiration. If the SPX closes at exactly 1,260, all the options expire worthless and the strategist will keep the premium earnedfrom both the bull put spread and the bear call spread. In this example,the maximum profit is $2,250.Ultimately, the strategist wants the index to trade sideways. If themarket makes a dramatic move higher or lower, and the index moves
FIGURE 7.4 SPX March Iron Butterﬂy Risk Graph (Source: www.Optionetics.comPlatinum)
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above or below the breakevens, the long iron butterfly will probably resultin a loss. To compute the downside breakeven, subtract the net creditfrom the strike price of the short put. In this example, the downsidebreakeven is 1,237.50 (1,260 – 22.50). The upside breakeven is calculatedby adding the short call strike price to the net credit. In this example, theupside breakeven is 1,282.50 (1,260 + 22.50).A move above or below the breakeven can result in the maximumpossible risk, equal to the difference between the strike prices minus thecredit. In this case, the maximum risk is $750 per spread [($30 – $22.50) ×100]. In short, the strategist is risking $750 to make $2,250. This is betterthan the unlimited risk that yielded $6,000. Figure 7.4 shows the uniquerisk graph of the butterfly spread. Notice how, unlike the short straddle(see Figure 7.3), the losses are capped thanks to the long call and put.In conclusion, when holding an iron butterfly the strategist wants theunderlying stock to remain between the two breakevens at expiration. Ifthere is a sudden move higher or lower shortly after the trade is entered,the strategist might want to exit the trade unless s/he expects the marketto move back toward the breakevens. As expiration approaches, and theindex falls below the lower breakeven, the strategist will want to let thecall options expire worthless and then exit the bull put spread. Conversely, if the index rises above the breakeven, the strategist will probablywant to let the put options expire worthless, and then exit the bear callspread in order to avoid assignment.
LONG BUTTERFLY SPREADSThe long butterfly is a popular strategy that traders use when they expectthe stock or market to trade within a range. In this example, we will focuson the long butterfly using only call options. In that respect, the long butterfly includes three strike prices and can be thought of as a combinationof a bull call spread and a bear call spread. Lower and middle strike pricesare used to create the bull call spread; middle and higher strike prices areused to create the bear call spread. Sometimes traders refer to the middlestrike prices, which are generally at-the-money, as the body and refer tothe higher and lower strike prices as the wings.The long butterfly is a limited-risk, limited-reward strategy. It workswell when the underlying market makes relatively little movement. Thestrategy generates the maximum profits when the price of the underlyingasset is equal to the strike price of the short options at expiration. Risksarise when the underlying asset moves dramatically higher or lower. However, the maximum risk is equal to the net debit paid for the trade. For
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that reason, strategists will implement the long butterfly when they expectthe underlying asset to stay within a range until the options expire.Although we use calls in our next example, the long butterfly can alsobe created using puts. In that case, the strategist establishes the positionby purchasing one out-of-the-money put (wing), selling two at-the-moneyputs (body), and buying one in-the-money put (wing). This would be acombination of a bull put spread and a bear put spread.In this butterfly example, let’s use calls. In early December, sharesof the Select Sector Energy Fund (XLE) are trading at $51. Since thestrategist expects oil and energy stocks to trade flat during the holidaysand into the following year, s/he creates a long butterfly composed ofthe following:• Buy 10 December XLE 50 calls at $2.50.• Sell 20 December XLE 52 calls at $1.50.• Buy 10 December XLE 54 calls at $0.75.Figure 7.5 shows the risk/reward of the butterfly spread. Since the netdebit is the maximum risk, the maximum risk of this trade is $0.25 aspread, or $250. The maximum reward is equal to difference between themiddle and highest strike prices, minus the net debit, or $1,725 [(2 – $0.25)× 10 × 100]. The upside breakeven equals the highest strike price minus
FIGURE 7.5 XLE December Long Butterﬂy Risk Graph (Source: www.Optionetics.com Platinum)
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the net debit, or $53.75 ($54 – $0.25). The downside breakeven equals thelower strike price plus the net debit, or $50.25 ($50 + $0.25). In this example, the strategist is risking $250 to make $1,725. However, the range ofmaximum profitability is small; it is equal to the strike price of the shortoptions, or $52.The exit strategy is often the key factor that makes or breaks a butterfly. If the underlying asset falls below the breakeven in a long butterfly,you will generally want to exit the trade. If not, you can let the options expire worthless later and incur the maximum loss. If the stock is in between the two strike prices, the trade is in the profit zone and you willwant to let the short options expire. At that point, sell the long option witha lower strike price for a profit. If the stock makes a dramatic movehigher, exit the position. If the trader is assigned on the short options, thelong options can be exercised to offset the share position.
RATIO BACKSPREADSBackspreads can be created with puts or calls. The call ratio backspreadis a great long-term strategy when the strategist wants to profit from amove higher in an index, but wants some protection in the event of a sudden move lower. It is created by buying one side of the trade and sellinganother in a disproportionate ratio. We teach the following seven ruleswhen looking for optimal ratio backspreads:1. Choose markets where volatility is expected to increase in the direc-
tion of your trade.2. Avoid markets with consistently low volatility.3. Do not use ratios greater than 0.67—use ratios that are multiples of1:2 or 2:3. For example, if the strategist buys 2 calls for every 1 callsold, the ratio is 0.50. Keep the size of the ratio 0.67 (2:3) or lower.4. In a very slow market, a 0.75 ratio or higher is acceptable only by purchasing the lower strike and selling the higher (for calls). This position will involve more risk.5. To create a call ratio backspread, sell the lower-strike call and buy agreater number of higher-strike calls.6. To create a put ratio backspread, sell the higher-strike put and buy agreater number of lower-strike puts.7. Avoid debit trades. But if you do place a ratio backspread with a debit,you must be willing to lose that amount.
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Let’s consider a call ratio backspread example using the Qs tradingfor $37.70 a share. In early June, the strategist expects an explosive rallyin the NASDAQ during the final six months of the year. A call ratio backspread is set up on the NASDAQ 100 Index Trust (QQQQ) with three longJanuary 40 calls for $1.25 per contract and two short 38 calls for $2.25 percontract. For selling the calls with the 38 strike price, the strategist gets acredit of $4.50. The cost of the three 40 calls is $3.75. Therefore, the totalnet credit for creating the backspread is $0.75, or $75 for the position: [(2× $2.25) – (3 × $1.25)] × 100.Figure 7.6 shows the risk graph of the QQQQ 38/40 call ratio backspread. It slopes upward and to the right and produces the best results ifthe share price moves higher. Ideally, the QQQQ will move above thebreakeven. The upside breakeven at expiration is equal to (1) the higherstrike price plus (2) the value obtained by taking the difference betweenthe two strike prices times the number of short contracts, all divided bythe difference in the number of short and long calls, minus (3) the netcredit. That’s a mouthful. In our example, the upside breakeven equals$43.25:40 + ( 2 × 2)− 0.75 = $43.253−2The potential profit above the upside breakeven is unlimited.
FIGURE 7.6 QQQQ January Call Ratio Backspread Risk Graph (Source: www.Optionetics.com Platinum)
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If the strategist is wrong and the QQQQ plunges, the trade will stillgenerate a profit because the backspread was created for a net credit. Ifthe fund stays below the lower strike price of $38 per share when expiration passes, all of the calls will expire worthless and the credit stays in theaccount. The downside breakeven is computed as the lower strike priceplus the net credit (divided by the number of short calls), or $38.38 a share[38 + (0.75 ÷ 2)]. Below that price level, the trade will generate the initialnet credit.The maximum possible loss is equal to the difference between thetwo strike prices times the number of short options, minus the credit,times the multiplier. In this example, the maximum risk is equal to $325:[(2 × 2) – 0.75] × 100. The maximum risk at expiration occurs at thestrike price of the long options. At that price, the short options are inthe-money and likely to be assigned, and the long calls will expireworthless.When trading ratio backspreads, the strategist should always considerthe risk of getting pinned to the higher strike price and the possibility ofearly assignment on the short options. The risk of assignment can occur ifthe short options have little time value left. As a general rule, an optionwith $0.25 or less of time value will have a relatively high probability of assignment. At that point, it might be wise to close the backspread. Thesame holds true if it looks as if the price of the underlying index mightmove toward the long call strike price.In addition, we generally recommend exiting ratio backspreads nolater than 30 days prior to expiration. Here are a few exit rules to followwhen dealing with backspreads.
• If the trade has a reasonable profit (50 percent or more), considerclosing out an equal number of short and long positions. Then the remaining long option is working with free money and can be held foradditional profit.• If the underlying stock rises between the upside and downsidebreakeven, exit the entire position with 30 days or less left until expiration. To do so, buy the short options back and sell the long optionsto try to mitigate some of the loss.• It is recommended that you close out the position 30 days prior to expiration unless you feel strongly that the stock will continue to increase (in a call backspread) or decrease (in a put backspread).• Finally, if the underlying stock falls below the downside breakeven ina call ratio backspread (or above the upside breakeven in a put ratiobackspread), let the options expire worthless.
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Calculating the Best RatiosTo ﬁgure out the most effective ratio for the backspread, the strategist mustaccurately calculate the net credit of a trade. This is done in three steps.1. Calculate the full credit realized from the short options (the numberof short options times the short option premium).2. Divide this credit by the debit of the long options (the number of longcontracts times the long option premium).3. Then calculate the maximum risk: the number of short contractstimes the difference in strike prices, plus any debit paid or less anycredit received.You can then use up as much of the credit as you can to make the mostproﬁtable ratio.
Backspreads can also be created with puts. Figure 7.7 shows the riskgraph of a QQQQ 37/35 put ratio backspread. It is basically the same riskgraph as the call ratio backspread, but flipped over. The trade yields thebest results when the price of the underlying asset heads south. However,if established for a credit, it can also produce profits when the underlyingasset moves higher in price.
FIGURE 7.7 Qs Put Ratio Backspread Risk Graph (Source: www.Optionetics.comPlatinum)
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Ratio SpreadsA ratio backspread is the opposite of a ratio spread. A ratio spread is created by selling more options than one is buying. Obviously, this leaves thestrategist with a naked position. For that reason, we don’t advocate ratiospreads and focus instead on credit spreads, backspreads, and otherlower-risk strategies when looking for opportunities to sell premium.
COLLAR SPREADSThe collar is a covered call and a protective put (which involves the purchase of shares and the purchase of puts) wrapped into one. The idea is togain downside protection from the put, but to offset the cost of this protection with the sale of a call. Similar to the covered call, this position willlimit the reward associated with owning the shares. If the shares risehigher, the short call will probably be assigned and the strategist must sellthe shares at the short strike price. This strategy is generally implementedwhen the trader is moderately bullish or neutral on a stock but wants protection in case of a bearish move to the downside.Let’s consider an example using the Select Sector Financials (XLF),which is trading for $22 a share in early December. Since the trade involves options and shares, it is not possible to create collars on indexes.In any event, the strategist expects a gradual move higher in the financialsector and wants to profit from a move higher in the XLF. However, thestrategist is also concerned about potential volatility in the sector due tochanges in interest rates. Therefore, rather than simply being long sharesor calls, a collar is created.The trade consists of 1,000 shares: 10 long June 20 puts at $0.25 and 10short June 23 calls at $1.00. One put is purchased and one call is sold forevery 100 shares. The cost of the trade is equal to the cost of the sharesplus the cost of the puts, minus the credit for selling the calls, all multiplied by the number of contracts and the multiplier, or $21,250: [($22 +0.25) – 1] × 10 × 100.Ideally, the price of the XLF will rise and the shares will gradually increase in value. Meanwhile, the call options will lose value due to time decay.The puts will also lose value, but these contracts were relatively inexpensivecompared to the calls. For example, if XLF closes at exactly $23 a share atJune expiration, the position will see $1.00 per share in profit plus $1.00 percontract for the short calls, which expire worthless. The short puts will alsoexpire worthless, resulting in a $0.25 loss. The profit is $1,750: {[(1.00 + 1.00)– 0.25] × 10 × 100}. This is the maximum profit potential for this collar.
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Figure 7.8 shows the total risk/reward profile