28.qxd  12/9/04  10:39 PM  Page 117
Advanced Delta Neutral Strategies
117
A. Even.
B. Uneven.
2. A ratio call spread involves ______________.
A. Buying a lower strike option and selling a greater number of ITM
options.
B. Buying  a  higher  strike  option  and  selling  a  greater  number  of
ATM options.
C. Buying a lower strike option and selling a greater number of OTM
options.
D. Buying  a  higher  strike  option  and  selling  a  greater  number  of
OTM options.
3. Calculate the values for the following ratio call spread:
Long 1 January QQQ 37 Call @ 2.50
Short 2 January QQQ 40 Calls @ 1.50
Net 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 of
OTM put options.
B. Buying a lower strike put option and selling a greater number of
OTM put options.
C. Buying a higher strike put option and selling a greater number of
ITM put options.
D. Buying a lower strike put option and selling a greater number of
ITM put options.
ccc_opwkbk_ch9_116-128.qxd  12/9/04  10:39 PM  Page 118
118
THE OPTIONS COURSE WORKBOOK
6. Calculate the values for the following ratio put spread:
Long 1 January QQQ 35 Put @ 2.00
Short 2 January QQQ 32 Puts @ 1.25
Net 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 market
with low volatility.
9. A call ratio backspread involves ______________.
A. Selling a higher strike call and buying a greater number of lower
strike calls.
B. Selling a lower strike call and buying a greater number of higher
strike calls.
C. Buying a higher strike call and selling a greater number of lower
strike calls.
D. Buying a lower strike call and selling a greater number of higher
strike calls.
10. Calculate the values for the following call ratio backspread:
Short 2 January QQQ 35 Calls @ 4.00
Long 3 January QQQ 38 Calls @ 2.25
Net credit = _________________________________________________
Maximum proﬁt = ____________________________________________
Maximum risk = _____________________________________________
Upside breakeven = __________________________________________
Downside breakeven = _______________________________________
ccc_opwkbk_ch9_116-128.qxd  12/9/04  10:39 PM  Page 119
Advanced Delta Neutral Strategies
119
11. Call  ratio  backspreads  are  best  implemented  during  periods  of
______________.
A. High  volatility  in  a  highly  volatile  market  that  shows  signs  of
increasing activity to the upside.
B. High  volatility  in  a  highly  volatile  market  that  shows  signs  of
increasing activity to the downside.
C. Low  volatility  in  a  highly  volatile  market  that  shows  signs  of 
increasing activity to the upside.
D. Low  volatility  in  a  highly  volatile  market  that  shows  signs  of 
increasing 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  of
increasing activity to the upside.
B. High  volatility  in  a  highly  volatile  market  that  shows  signs  of
increasing activity to the downside.
C. Low  volatility  in  a  highly  volatile  market  that  shows  signs  of 
increasing activity to the upside.
D. Low  volatility  in  a  highly  volatile  market  that  shows  signs  of 
increasing activity to the downside.
13. A put ratio backspread involves ______________.
A. Selling a higher strike put and buying a greater number of lower
strike puts.
B. Selling a lower strike put and buying a greater number of higher
strike puts.
C. Buying a higher strike put and selling a greater number of lower
strike puts.
D. Buying a lower strike put and selling a greater number of higher
strike puts.
14. Calculate the values for the following put ratio backspread:
Short 2 January QQQ 35 Puts @ 2.50
Long 3 January QQQ 32 Puts @ 1.25
Net credit/debit = ____________________________________________
Maximum proﬁt = ____________________________________________
ccc_opwkbk_ch9_116-128.qxd  12/9/04  10:39 PM  Page 120
120
THE OPTIONS COURSE WORKBOOK
Maximum risk = _____________________________________________
Upside breakeven = __________________________________________
Downside breakeven = _______________________________________
15. What  is  the  difference  between  a  forward  and  a  reverse  volatility
skew?
____________________________________________________________
____________________________________________________________
MEDIA ASSIGNMENT
In Chapter 4, the media assignment used the free options calculator fromthe Chicago Board Options Exchange web site at www.cboe.com to cre-ate a risk curve for the long call. Let’s go back to that calculator and re-peat 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, read-ers 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 posi-tion  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 op-tions. 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.
ccc_opwkbk_ch9_116-128.qxd  12/9/04  10:39 PM  Page 121
Advanced Delta Neutral Strategies
121
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 ﬁ-nal equity price value of 90, the long call is worth roughly $1,650 a con-tract 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 dif-ferent 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 LIST
Call ratio backspread
Forward volatility skew
Nondirectional
Price skew
Put ratio backspread
Ratio backspread
SOLUTIONS
Ratio call spread
Ratio put spread
Ratio spread
Reverse volatility skew
Time skew
Volatility skew
1. A ratio spread is a strategy in which an ______________ number ofoption  contracts  of  the  same  underlying  instrument  are  bought and 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 num-ber  of  out-of-the-money  contracts.  The  trade  can  be  created  usingeither puts or calls.
ccc_opwkbk_ch9_116-128.qxd  12/9/04  10:39 PM  Page 122
122
THE OPTIONS COURSE WORKBOOK
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 @ 2.50
Short 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) ÷ (num-ber 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 strate-gist  expects  the  underlying  asset  to  move  only  modestly  higher,  re-main  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.
ccc_opwkbk_ch9_116-128.qxd  12/9/04  10:39 PM  Page 123
Advanced Delta Neutral Strategies
123
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 @ 2.00
Short 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 con-tracts) ÷ (number of short contracts – number of long contracts)] –net credit}.Discussion: The credit from the ratio put spread is equal to the pre-mium  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.
ccc_opwkbk_ch9_116-128.qxd  12/9/04  10:39 PM  Page 124
124
THE OPTIONS COURSE WORKBOOK
8. True or False: Never attempt to place a ratio backspread in a market
with low volatility.Answer: False.Discussion: Placing ratio backspreads in markets with low volatilityis not recommended. However, if you do choose to trade a slow mar-ket, 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 @ 4.00
Long 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  back-spread 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.
ccc_opwkbk_ch9_116-128.qxd  12/9/04  10:39 PM  Page 125
Advanced Delta Neutral Strategies
125
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 gen-erates the most proﬁts when the underlying security makes an explo-sive 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 @ 2.50
Long 3 January QQQ 32 Puts @ 1.25Answer:Net credit = [(2 × 2.50) – (3 × 1.25)] × 100 = $125 [(Short – long pre-mium) × 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  back-spread is equal to the premium received minus the premium paid. Ifthe underlying instrument rallies, the strategist can let the puts expire
ccc_opwkbk_ch9_116-128.qxd  12/9/04  10:39 PM  Page 126
126
THE OPTIONS COURSE WORKBOOK
worthless and keep the net credit. The maximum proﬁt, however, oc-curs 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 ASSIGNMENT
In  this  chapter,  we  once  again  use  the  free  options  calculator  at  theChicago Board Options Exchange web site to create a risk curve (in Chap-ter 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
65
70
75
80
85
90
0.45
1.25
2.80
5.15
8.40
12.30
16.50
0.90
2.50
5.60
10.30
16.80
24.60
33.00
2.20
4.50
7.80
11.80
16.25
21.00
26.00
–1.30
–2.00
–2.20
–1.50
0.55
3.60
7.00
ccc_opwkbk_ch9_116-128.qxd  12/9/04  10:39 PM  Page 127
Advanced Delta Neutral Strategies
127
After creating the table, plotting the risk curve is relatively straight-forward.  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.
109876543210–1–2–3–4–5
60  65  70  75  80  85  90
Call Ratio Backspread Risk Curve
VOCABULARY DEFINITIONS
Call 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 ex-piration date, but different strike prices, have different levels of impliedvolatility.
ccc_opwkbk_ch9_116-128.qxd  12/9/04  10:39 PM  Page 128
128
THE OPTIONS COURSE WORKBOOK
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  of implied 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.
ccc_opwkbk_ch10_129-140.qxd  12/9/04  10:42 PM  Page 129
CHAPTER 10
TradingTechniques forRange-BoundMarkets
SUMMARY
Sometimes 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 re-quire  signiﬁcant  movement  to  cover  the  costs  of  the  double  option  pre-mium.  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  move-ment. These approaches take advantage of the fact that options are wast-ing 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  is acceptable to you.
129
ccc_opwkbk_ch10_129-140.qxd  12/9/04  10:42 PM  Page 1