not been exposed to this type of rhetoric. When brokendown, all of these terms refer to relatively simple concepts that can helpyou to more thoroughly understand the risks and potential rewards of op-tion positions. Having a comprehensive understanding of these conceptswill help you to decrease your risk exposure, reduce your stress levels,and increase your overall proﬁtability as a trader. Learning how to inte-grate  these  basic  concepts  into  your  own  trading  programs  can  have  apowerful  effect  on  your  success.  Since  prices  are  constantly  changing,the Greeks provide traders with the means to determine just how sensi-tive a speciﬁc trade is to price ﬂuctuations. Combining an understandingof  the  Greeks  with  the  powerful  insights  risk  proﬁles  provide  can  helpyou take your options trading to another level.
Option pricing is based on a variety of factors. Each of these factorscan be used to help determine the correct strategy to be used in a market.Volatility is a vital part of this process. Charting the volatility of your fa-vorite  markets  will  enable  you  to  spot  abnormalities  that  can  translateinto healthy proﬁts. Since this is such a complicated subject, a great dealof time, money, and energy is spent to explore its daily ﬂuctuations andproﬁtable  applications.  The  Platinum  site  at  Optionetics.com  providesaccess to these insights as well as daily trading information.
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Straddles,Strangles,and Synthetics
T he successful delta neutral trader looks at a market scenario with a
discerning eye. Delta neutral trading involves hunting for the optimalmathematical relationship among strikes, premiums, and expirationmonths.  The  ﬁnal  strategy  creates  the  highest  probability  of  proﬁtabilityand enables the trader to enjoy consistent returns on investments. For ex-ample, if I’m going to buy stock shares, I’m also going to buy or sell some-thing in the options pit. When I put on one trade, I simultaneously put onanother. These kinds of multiple trade strategies require a trader to con-sider the market from three directions.
1. What if the market goes up?2. What if it goes down?3. What if it doesn’t go anywhere at all?
Do  not  confuse  assessing  these  possibilities  with  trying  to  forecastmarket direction. Delta neutral traders do not need to guess which way themarket will move because they have assessed in advance their reactions tomarket direction. They set up trades that maximize proﬁts and minimizerisk  by  balancing  the  delta  of  the  overall  position—and  then  they  canmake money regardless of market direction.
DELTA NEUTRAL MECHANICS
Setting  up  a  delta  neutral  trade  requires  selecting  a  calculated  ratio  ofshort  and  long  positions  to  create  an  overall  position  delta  of  zero.  As
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noted in the preceding chapter, the delta of 100 shares of stock or one fu-tures contract equals plus or minus 100. Thus, if you’re buying 100 sharesof stock or one futures contract, you are +100 deltas; if you are selling 100shares of stock or one futures contract, you are –100 deltas. That’s a prettysimple  number  to  work  with.  It  is  not  an  abstract  number.  It’s  +100  or–100, and that’s it. You can easily do that much in your head once you getthe  hang  of  it.  No  matter  what  stock  or  futures  contract  it  is—S&Ps,bonds, currencies, soybeans, IBM, Dell, or Intel—it has a delta of plus orminus 100.
Options deltas are a little more complex. They depend on what kindof  option  you  are  trading—at-the-money  (ATM),  in-the-money  (ITM),  orout-of-the-money  (OTM)—which  is  determined  by  the  option’s  strikeprice and its relationship to the price of the underlying asset. Let’s developan example using shares of XYZ currently trading at $90. XYZ has optionsat 80, 85, 90, 95, and 100 (each $5 increment); the 90s are the ATM options.ATM options have deltas of about +50 or –50. Once again, this is a prettyeasy calculation. It could be off a little bit, but plus or minus 50 is the gen-eral rule for an ATM option. This also means that there is a 50–50 chanceof an ATM option closing in-the-money. It’s similar to a coin ﬂip—it can goeither way.
Using  these  values,  let’s  create  a  delta  neutral  trade.  If  we  buy  100shares of stock, we have +100 deltas. To get to delta neutral, we have tobalance out the +100 deltas by ﬁnding –100 deltas, perhaps in the form oftwo  short  ATM  options,  which  produce  the  required  –100  deltas.  Thiswould bring our overall position delta to zero.
However, how do you determine which options equal –50? If you buyan ATM call, do you think you’re +50 or –50? Well, since the purchase of acall is a bullish sign, buying an ATM call has a delta of +50, while the pur-chase of a put is a bearish strategy with a delta of –50. The plus and minusjust mean that you expect the market to move up or down. In the easiestof terms, buying calls creates a positive delta; selling calls creates a nega-tive delta. Buying puts creates a negative delta; selling puts creates a posi-tive delta. These rules govern all delta neutral trading opportunities.
Positive Deltas—Market Expectation Up
Negative Deltas—Market Expectation Down
Buy calls.Sell puts.Buy stock.Buy futures.
Sell calls.Buy puts.Sell stock.Sell futures.
Let’s return to our quest for a delta neutral trade. The easiest trade tomake comes in the form of a straddle: the purchase of an ATM call and an
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ATM put with the same strike and expiration date. Figure 8.1 shows thegeneric  risk  graph  for  this  popular  delta  neutral  strategy.  The  lowerbreakeven is the point where the trade will start to generate a proﬁt as thestock continues downward; the upper breakeven is the point at which thetrade will become proﬁtable as the stock moves upward.
As can be readily seen from Figure 8.1, the straddle will be proﬁtablein both signiﬁcant up moves and down moves. The only place where thereis a potential problem is when the stock does not move. Thus, the majorproblem with a straddle is that we are purchasing both options ATM; thus,the entire value of the two premiums is time value. As time value is not“real” in that there is no inherent value in it, and time value decreases tozero as the option approaches expiration, we have the crux of the prob-lem with a straddle: The stock must move, and move soon, to recover themoney that is being lost by the erosion of time in the trade.
There are two ways the trade will be proﬁtable. The ﬁrst is the obvi-ous one of the stock moving signiﬁcantly, which will increase the value ofone option while simultaneously decreasing the value of the other option,although  at  a  slower  rate.  The  other  is  for  both  options  to  increase  invalue. The only way both options will increase in value simultaneously isto  have  the  volatility  of  the  options  increase.  All  other  variables  in  theBlack-Scholes option pricing model will affect puts and calls in oppositedirections. If the volatility of the options increases, then the option premi-ums  will  increase,  and  the  possibility  of  the  stock  moving  will  also  in-crease (the basic concept of what volatility is measuring). Thus, if you canﬁnd a stock with relatively low volatility that is increasing, the value of the
DownsideBreakeven
UpsideBreakeven
Profit
Stock Price
Loss
Max Loss
FIGURE 8.1 Risk Graph of a Delta Neutral Straddle (Long 1 Call and Long 1 Put)
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straddle will increase and also the stock will be likely to move either up ordown—a double chance for proﬁt.
To be successful in trading straddles, we need to ﬁnd a stock whosevolatility  is  low  but  about  to  increase  as  the  stock  begins  to  move.  Thismay sound like real guessing at ﬁrst, but in reality it is not too hard to dis-cover promising candidates. The primary, most reliable reason for an in-crease in volatility and for the stock price to move is news. News can beanything from court decisions to new product discoveries to accountingirregularities  to  earnings  announcements.  Of  the  various  news  possibili-ties,  earnings  reports  are  the  easiest  to  predict,  and  the  most  common.Every quarter, each publicly traded company is required by the Securitiesand Exchange Commission (SEC) to report its earnings. Thus, each pub-licly traded ﬁrm will have four earnings reports each year—four chancesfor  the  stock  to  move  unpredictably.  Further,  each  announcement  willtend to be made at approximately the same point in each quarter.
The  natural  state  of  things  is  for  the  stock’s  price  movement,  andhence volatility, to be relatively low until some announcement, or the an-ticipation  of  an  announcement,  triggers  an  upsurge  in  the  volatility.  Be-tween announcements a ﬁrm’s volatility tends to be low, and then it willrise  as  the  earnings  date  approaches,  dropping  back  down  after  the  an-nouncement and subsequent stock movement.
Thus, to enter a successful straddle trade, a trader only needs to de-termine far enough in advance just when the earnings announcement willbe made, enter the trade, and then wait for the announcement date. In thenormal case, on or about the announcement date the volatility will spikeup and the stock will make its move one way or the other. At that pointyou exit the trade.
What if you went to sleep and waited for the options to expire? Sincethe  trade  is  really  designed  to  take  advantage  of  a  quick  uptick  in  pricemovement and volatility, it’s doubtful that you would want to stay in theposition until expiration. More than likely, you’ll want to exit the trade assoon as the news breaks; that’s when the volatility ticks up and the stockshould move. If you wait much longer, volatility will calm back down andthe stock may return to its previous price, sucking all of your proﬁts fromthe trade.
COMBINING STOCK WITH OPTIONS
Now let’s take a look at trading delta neutral by combining stock with op-tions. Let’s say we’ve entered the market with +100 deltas by purchasing100 shares of stock. To make the overall trade delta neutral, we have two
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choices using ATM options. We can either buy two ATM puts or sell twoATM calls. The question becomes whether it is better to sell ATM calls orbuy ATM puts to get the necessary –100 deltas. When you sell an option,what happens to your account? You receive a credit for the total premi-ums of the options you sold. In other words, you have put money in yourpocket. However, you have also assumed more risk. As usual, there’s nosuch thing as a free lunch. Although putting money in your pocket soundslike a good thing, the unlimited risk you have to assume can be a harrow-ing experience.
So far, setting up a delta neutral trade has been quite simple. However,it  takes  experience  and  skill  to  know  which  strategy  has  the  greaterchance of making money. Since delta neutral trades do not rely on marketdirection, a proﬁt is possible in most cases regardless of whether the mar-ket goes up or down.
Let’s say we create a delta neutral trade by purchasing 100 shares ofstock  and  buying  two  ATM  put  options.  If  the  market  swings  up,  theshares  make  money.  However,  we  are  out  the  premium  paid  on  the  twolong puts. If the market takes a dive, our stock may lose money, but we’llmake  a  proﬁt  on  the  two  puts  by  using  one  as  protection  and  makingmoney on the other one. In other words, the deltas of my two puts will in-crease faster than the delta of the stock. Obviously, a major ingredient toproﬁt making is setting up trades in such a way that your proﬁts outweighyour losses.
However,  options  aren’t  always  at-the-money.  You  can  trade  a  widevariety of options with many different expiration dates. Many traders getcold  feet  deciding  which  options  to  work  with.  In  general,  ATM  optionsare the easiest to work with, but not necessarily the most proﬁtable. Howdo I determine which options to use? Once again, I need to visually see theproﬁt  and  loss  potentials  of  each  trade  by  setting  up  its  respective  riskproﬁle. So, let’s set up an example of a delta neutral trade that consists ofgoing long 100 shares of XYZ at $50 and simultaneously buying two long50 ATM puts at $5. This strategy is called a long synthetic straddle and of-fers risk that is limited to the double premium paid for the ATM puts. Thepurchase of 100 shares of stock creates +100 deltas and the purchase oftwo ATM puts creates –100 deltas.
The  risk  curve  visually  details  the  trade’s  limited  risk  and  unlimitedpotential proﬁt in either direction. The risk graph for this trade (shown inFigure 8.2) creates a curve that is U-shaped. This is what an optimal riskcurve looks like—one with limited risk and unlimited reward in either di-rection. In this example, the maximum risk at option expiration is $1,000:(5 × 2) × 100.
You can also create a long synthetic straddle by selling 100 sharesof stock and buying 2 ATM calls. This trade has a relatively low margin
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FIGURE 8.2 Delta Neutral Long Synthetic Straddle Risk Graph
requirement and moderate risk. The risk graph for this trade is similarto  the  one  shown  in  Figure  8.2.  Its  U-shaped  curve  reﬂects  unlimitedproﬁt  potential  and  risk  that  is  limited  to  the  total  premium  paid  or$1,000: (5 × 2) × 100.
Thus, as long as you are buying the options, the strategy is known as along  synthetic  straddle.  Conversely,  you  can  create  a  short  syntheticstraddle by  either  purchasing  100  shares  of  stock  and  selling  two  ATMcalls  or  selling  100  shares  of  stock  and  selling  two  ATM  puts.  With  thisstrategy, your proﬁt is limited to the credit received on the short puts andthe risk is unlimited in either direction. Thus, the risk curve of a short syn-thetic straddle looks like an upside-down U. These trades involve shortingoptions, which can be extremely risky. If the market crashes you stand tolose a great deal of money. Conversely, if it moves up quickly you will alsolose  money.  I  prefer  to  teach  traders  to  create  trades  with  U-shapedcurves, not upside-down U-shaped curves. Although the latter can be prof-itable,  they  often  require  traders  to  move  quickly  when  things  are  notworking out right. Typically, I favor buying stocks and buying puts.
Although  all  four  of  these  examples  are  delta  neutral  trades,  I  urgeyou  to  avoid  unlimited  risk  until  you  are  have  developed  a  strong  trackrecord. There are a variety of factors that you need to be familiar with tohelp you to determine which strategy has the best proﬁt-making potentialfor a particular market. Once the underlying instrument moves far enough
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away from its initial position, you should be able to make money on one ofthe  legs  in  your  trade.  Additionally,  multiple  contract  positions  enabletraders to make positive or negative adjustments depending on how manydeltas your overall position has moved and how many contracts make upthe trade.
Which strategy do I prefer? In general, I prefer lower-risk trades. Theyare much less stressful. However, before I would place a trade either way,I would set up a risk proﬁle of each possible strategy. This is by far thebest  way  to  ﬁnd  an  answer  to  the  question  of  buying  versus  selling  op-tions. In general, whenever you are buying options as part of a delta neu-tral  trade,  you  are  creating  a  risk  graph  with  a  U-shaped  curve;  andwhenever you are selling options as part of a delta neutral trade, you arecreating  an  upside-down  U-shaped  curve.  I  prefer  to  work  with  tradeswith upward U-shaped curves because they feature limited risk—a muchsafer strategy, especially for beginners. However, as you progress up yourown trader’s learning curve, opportunities will present themselves whereyou may want to take a higher risk in order to receive a potentially higherreward. Remember, every trade is unique.
LONG STRADDLE STRATEGY
For many traders, straddles have become a staple trading strategy in to-day’s unforgiving market conditions. The idea of risking $500 a week on aposition to make $250 (or a 50 percent return) in three to four weeks deﬁ-nitely  works  for  me.  A  straddle  is  an  innovative  strategy  that  can  trulybeneﬁt traders looking for a continuous income stream and it’s probablythe easiest of the delta neutral trades to create. A straddle consists of be-ing long one ATM call and long one ATM put, both with the same strikeprice and expiration date. By calculating the deltas, you will note that theyadd up to zero (long ATM call = +50; long ATM put = –50). Thus, the strikeprices of the straddle must be purchased at-the-money for the trade to bedelta neutral. If the strikes are at anything other than the stock price, thenthe trade will not be delta neutral; it will have either a negative or a posi-tive delta bias depending on whether the strikes are above or below thestock price.
The  idea  behind  the  straddle  is  that  as  the  stock  moves  upward  inprice,  the  long  call  becomes  more  valuable.  Although  the  long  put  willlose value at the same time, it will not lose value as fast as the call willgain value. In addition, there is a lower limit as to just how much value theput can lose—it can fall only to zero. Thus, as the stock rises in price, thenet effect is that the straddle gains in value.
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Of course, if the stock falls in price, the opposite will happen. The longput  will  continue  to  gain  in  value  while  the  long  call  will  lose  value,  butonly until it reaches zero as well. Thus, if the stock loses value, the totalstraddle position will gain in value. Since buying a straddle involves buyingboth an ATM call and an ATM put (with identical strike prices and expira-tion months), buying a straddle can be fairly expensive. Your total risk onthe position is the cost of the double premiums. For you to gain a proﬁt,the market has to move sufﬁciently to make up the cost of that double pre-mium. However, at least there are no margin requirements to worry about.To place a long straddle, you need to locate a market with impendinghigh  volatility.  For  example,  you  might  want  to  buy  shares  ahead  of  anearnings report or during a period of low volatility in anticipation of a pe-riod of high volatility. One of the most volatile days of the month for thestock market is the ﬁrst Friday of each month when the employment re-port  is  released.  This  is  the  mother  of  all  economic  reports  and  has  theability to move the market in an absolutely psychotic fashion, typically re-sulting in a highly volatile day. The volatility might even pick up startingon Thursday, so I often place a straddle on the previous Wednesday. Oneimportant thing to remember about straddles is that you don’t have to pre-dict  market  direction.  Regardless  of  whether  it  moves  up  or  down,  youcan make some money. The essential factor is volatility.
Two other reports have an effect on market volatility, especially the ﬁ-nancial markets: the Consumer Price Index (CPI) and the Producer Price In-dex (PPI). Unfortunately, these reports do not have a ﬁxed date of release,although they usually come out the week after the employment report (i.e.,the second week of the month). You should mark these dates on your calen-dar as a reminder. Actually, any report can move the market if the informa-tion  is  unexpected  regarding  housing  starts,  durable  goods,  or  any  of  theleading economic indicators. However, the ones to pay particular attention toare the previously mentioned big three. You may have an opportunity to buya straddle a couple of days before they are released and make some money.
The major disadvantage of a straddle is time decay. There is a substan-tial time premium to be lost if you do not choose your maturities properlyand follow the rules for how long to hold these positions. The other disad-vantage to straddles is that if the implied volatility of the options declines(a.k.a.  vega  risk),  you  are  faced  with  a  substantial  penalty  because  youhave had to pay the double premium of the options. That’s why it’s so im-portant to buy cheap (low volatility) options in the ﬁrst place.
Long Straddle Mechanics
Let’s create a long straddle by going long 1 September XYZ 50 Call @ 2.50and long 1 September XYZ 50 Put @ 2.50 with XYZ currently trading for
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$50 a share. The maximum proﬁt of this trade is unlimited. Both optionshave  the  same  expiration  month  and  the  same  strike  price.  Let’s  take  alook  at  a  long  straddle’s  risk  proﬁle.  To  visualize  the  risk  proﬁle  of  astraddle,  it  can  be  helpful  to  imagine  what  each  leg  of  the  trade  lookslike. As previously deﬁned, buying a straddle requires the purchase of acall  and  a  put  at  the  same  strike  price  and  the  same  expiration  period.Since  risk  curves  of  complex  strategies  are  only  combinations  of  morebasic trades, the risk proﬁle of a long straddle is a combination of a longcall risk curve and a long put risk curve. When combined, they create a V-shaped  curve  (see  Figure  8.3).  This  important  factor  tells  us  that  longstraddles have unlimited proﬁt potential and limited risk (the price of thetwo premiums).
When you create a long straddle, it is very important to determine thetrade’s range of proﬁtability. To accomplish this, you need to calculate theupside breakeven and the downside breakeven. The upside breakeven oc-curs when the underlying asset’s price equals the strike price plus the totalpremium. In this example, the upside breakeven is 55: 50 + (2.50 + 2.50) =55.  The  downside  breakeven  occurs  when  the  underlying  asset’s  priceequals the strike price minus the total premium. In this case, the downsidebreakeven equals 45: 50 – (2.50 + 2.50) = 45. XYZ has to move below $45 orabove $55 for the straddle to make money by expiration.
FIGURE 8.3 Long Straddle Risk Graph
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Strategy: Purchase an ATM call and an ATM put with the same strike priceand the same expiration date.
Market  Opportunity: Look  for  a  market  with  low  implied  volatility  op-tions where a sharp volatility increase is anticipated.
Maximum Risk: Limited to the net debit paid.
Maximum Proﬁt: Unlimited to the upside and limited to downside (as theunderlying  can  only  fall  to  zero)  beyond  the  breakevens.  Proﬁt  requiressufﬁcient market movement but does not depend on market direction.
Upside Breakeven: ATM strike price + net debit paid.
Downside Breakeven: ATM strike price – net debit paid.
Exiting the Position
The following exit strategies can be applied to the long straddle example:
• XYZ falls below the downside breakeven (45): You can offset theput by selling a put for a proﬁt. You can hold the essentially worthlesscall for a possible stock reversal.
• XYZ  falls  within  the  downside  (45)  and  upside  (55)  break-evens: This is the range of risk and will cause you to close out the po-sition  at  a  loss.  Simply  sell  the  ATM  options  to  exit  the  trade.  Themaximum risk is equal to the double premiums paid out or $500.
• XYZ  rises  above  the  upside  breakeven  (55): You  are  in  yourproﬁt zone again. You can close the call position for a proﬁt and holdthe worthless put for a possible stock reversal.
Long Straddle Case Study
A long straddle is the simultaneous purchase of a call and a put using thesame strike and the same expiration month. Since it involves the purchaseof a double premium, the cost to enter is often high. This being the case, along straddle should be used on options that have low implied volatility.When a trader expects a large move in a stock, but isn’t sure about the di-rectional bias of the move, a straddle is a good strategy to employ.
A straddle is a limited risk, unlimited reward strategy that relies on astrong  move  in  the  underlying  security.  The  maximum  risk  is  the  totaldebit  paid  to  enter  the  trade.  In  order  to  ﬁnd  the  breakeven  points,  wehave  to  add  the  debit  of  the  trade  onto  the  strike  price  for  the  upside
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breakeven and subtract it from the strike for the downside breakeven. Inorder to see how this works, let’s look at a real-life example.
At  the  beginning  of  2003,  shares  of  Cisco  (CSCO)  started  to  form  achart pattern called a descending triangle. This formation often precedesa major move in a stock, but the direction of the move is hard to deter-mine. Therefore, an options trader might want to use a straddle to beneﬁtfrom a move in either direction. On April 10, 2003, Cisco shares closed at$13.21  after  bouncing  from  the  support.  The  triangle  was  becomingsmaller, telling us that the stock was about to break out—yet the directionof the break was still hard to determine. Therefore, we entered a straddle.The October 12.50 puts could be purchased for 1.55 a share and theOctober  12.50  calls  could  be  purchased  at  2.25.  Buying  ﬁve  contractswould cost $1,900: [5 × (1.55 + 2.25)] × 100. This is also our maximum risk.The  nice  thing  about  a  straddle  is  that  if  the  stock  doesn’t  move  as  ex-pected, the straddle owner can get out without much of a loss as long asthe  options  are  not  held  until  expiration.  This  is  because  time  decay  islight when an option is several months away from expiration.
Looking  at  the  risk  graph  for  this  trade  in  Figure  8.4,  notice  how  themaximum loss occurs only if CSCO shares close at $12.50 on expiration day.(Each line provides an idea of what the trade would be worth given a movewithin a certain time period; the lowest line shows the trade at expiration.)To calculate the breakevens for this trade, add the net debit per con-tract  of  3.80  to  the  strike  of  12.50