retail customers to trade more. These limits are based on the optionprice—the higher the price of the option, the higher the allowable widthof the bid-ask spread. The limits are shown in Table 5.2.
One small note: For option prices $3 and up, options no longer tradein  nickels.  The  smallest  denomination  for  those  options  is  dimes.  So  do
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TABLE 5.2 Option Values and Limits
Option Values
$0 to $1.95$2 to $5$5.10 to $10$10.10 to $20$20.10 and up
Limit
25 cents40 cents50 cents80 cents1 dollar
not try to pay $3.65 for an option. We must make up our mind to make ourpurchase price either $3.60 or $3.70. A pet peeve of many market makersis a retail customer who does not know this information.
Now let’s look at a practical application of legal widths and how theycan affect us. Let us revisit those same CSCO October 22.50 calls with abid-ask of .50–.60. If we decide to be aggressive and pay the ask, we are in-curring 10 cents of slippage (the difference between the bid price and theask price). Now let’s say we were right and CSCO shoots up $5; our callsare now worth somewhere around $5.50! As we look to exit our trade, wemay look forward to a market quote of 5.40–5.60. However, the limit onthe width of those options is 50 cents. Hence the real quote facing us maybe  closer  to  5.20–5.70.  Fifty  cents  of  slippage  is  quite  possible.  We  mayconsole ourselves with the fact that we made some money in our trade,but that’s no excuse for giving up so much on our exit. We can usually di-minish the problem by testing the market and placing limit orders insideof the bid-ask spread.
STRATEGY ROAD MAPS
For  your  convenience,  the  following  subsections  provide  step-by-stepanalyses of the vertical spreads discussed in this chapter.
Bull Call Spread Road Map
In order to place a bull call spread, the following guidelines should beobserved:
1. Look for a bullish market where you anticipate a modest increase in
the price of the underlying stock.
2. Check to see if this stock has options available.3. Review  call  options  premiums  per  expiration  dates  and  strikeprices. Bull call spreads are best placed on stocks that have at least
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60 days until expiration. The utilization of LEAPS options is a goodchoice for this strategy. LEAPS give you the opportunity to put timeon your side.
4. Investigate  implied  volatility  values  to  see  if  the  options  are  over-
priced or undervalued.
5. Explore past price trends and liquidity by reviewing price and volume
charts over the past year.
6. Choose a lower strike call to buy and a higher strike call to sell. Bothoptions must have the same expiration date. In general, a good combi-nation  is  relatively  low  “buy”  strikes  combined  with  higher  “sell”strikes. Get the breakeven low enough so that you can sleep at night.The lower buy strikes lower the breakeven point. Give yourself plentyof room to proﬁt if the stock runs. This is accomplished by choosinghigher sell strikes.
7. Determine the speciﬁc trade you want to place by calculating:
• Limited Risk: The most that can be lost is the net debit of the two
options.
• Unlimited  Reward: Calculated by subtracting the net debit from
the difference in strike prices times 100.
• Breakeven: Calculated by adding the lower strike price to the net
debit.
• Return on Investment: Reward/risk ratio.
8. Create a risk proﬁle for the trade to graphically determine the trade’sfeasibility.  The  risk  proﬁle  for  a  bull  call  spread  visually  reveals  thestrategy’s  limited  risk  and  proﬁt  parameters.  Notice  how  the  maxi-mum proﬁt occurs at the short call strike price.
9. Write down the trade in your trader’s journal before placing the tradewith your broker to minimize mistakes made in placing the order andto keep a record of the trade.
10. Create an exit strategy before you place the trade.
• Consider  doing  two  contracts  at  once.  Try  to  exit  half  the  tradewhen the value of the trade has doubled or when enough proﬁt ex-ists to cover the cost of the double contracts. Then the other tradewill be virtually a free trade and you can take more of a risk, allow-ing it to accumulate a bigger proﬁt.
• If you have only one contract, exit the remainder of the trade whenit is worth 80 percent of the maximum possible value of the spread.
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The reason for this rule is that it usually takes a very long time tosee the last 20 percent of value in a proﬁtable vertical spread. It’sbetter  to  take  the  trade  off  and  look  for  new  trades  where  themoney can be put to better use. We recommend exiting the tradeprior to 30 days before expiration.
11. Contact your broker to buy and sell the chosen call options. Place thetrade as a limit order so that you limit the net debit of the trade.12. Watch the market closely as it ﬂuctuates. The proﬁt on this strategy islimited—a  loss  occurs  if  the  underlying  stock  closes  below  thebreakeven point.
13. Choose an exit strategy based on the price movement of the underly-
ing stock:
• The underlying stock rises above the short strike: The shortcall  is  assigned  and  you  are  obligated  to  deliver  100  shares  (percall) to the option holder at the short strike price. Exercise the longcall  to  buy  the  underlying  stock  at  the  lower  strike  and  deliverthese shares to the option holder. The resulting proﬁt is the maxi-mum proﬁt available.
• The underlying stock rises above the breakeven, but not ashigh as the short strike: Sell a call with the long call strike andbuy a call with the short strike. There should be a small proﬁt re-maining.
• The  underlying  stock  remains  below  the  breakeven,  butabove the long strike: Offset the options by selling a call with thelong strike and buying a call with the short strike to partially miti-gate the initial debit or allow you to pocket a small proﬁt; or waituntil expiration and sell the long call to offset the trade’s net debitand let the short option expire worthless.
• The underlying stock falls below the long option: Let the op-tions  expire  worthless,  or  sell  the  long  call  prior  to  expiration  tomitigate some of the loss.
Bear Put Spread Road Map
In order to place a bear put spread, the following guidelines should beobserved:
1. Look for a bearish market where you anticipate a modest decrease in
the price of the underlying stock.
2. Check to see if this stock has options available.
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3. Review put options premiums per expiration dates and strike prices.
Buy options with at least 60 days until expiration.
4. Investigate implied volatility values to see if the options are overpricedor undervalued. These spreads are best placed when volatility is low.
5. Explore past price trends and liquidity by reviewing price and volumecharts over the past year. Look for chart patterns over the past one tothree years to determine where you believe the stock should be by thedate of expiration.
6. Choose a higher strike put to buy and a lower strike put to sell. Bothoptions  must  have  the  same  expiration  date.  Determine  the  speciﬁctrade you want to place by calculating:
• Limited  Risk: The  most  that  can  be  lost  on  the  trade  is  the  net
debit of the two option premiums.
• Unlimited  Reward: Calculated by subtracting the net debit from
the difference in strike prices times 100.
• Breakeven: Calculated  by  subtracting  the  net  debit  (divided  by
100) from the long strike price.
• Return on Investment: Reward/risk ratio.
7. Create  a  risk  proﬁle  for  the  trade  to  graphically  determine  thetrade’s feasibility. If the underlying stock increases or exceeds theprice of the short put, the trade reaches its maximum risk (loss) po-tential. Conversely, if the price of the underlying stock decreases orfalls below the strike price of the long put, the maximum reward isattained.
8. Write down the trade in your trader’s journal before placing the tradewith your broker to minimize mistakes made in placing the order andto keep a record of the trade.
9. Make an exit plan before you place the trade.
• Consider  doing  two  contracts  at  once.  Try  to  exit  half  the  tradewhen the value of the trade has doubled or when enough proﬁt ex-ists to cover the cost of the double contracts. Then the other tradewill be virtually a free trade and you can take more of a risk allow-ing it to accumulate a bigger proﬁt. If the spread doubles, exit halfof the position.
• If you have only one contract, exit the remainder of the trade when
it is worth 80 percent of its maximum value.
• Exit the trade prior to 30 days before expiration.
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10. Contact your broker to buy and sell the chosen put options. Place the
trade as a limit order to limit the net debit of the trade.
11. Watch the market closely as it ﬂuctuates. The proﬁt on this strategyis limited—a loss occurs if the underlying stock rises above break-even point.
12. Choose an exit strategy based on the price movement of the underly-
ing stock.
• The underlying stock falls below the short strike: The shortput is assigned and you are obligated to purchase 100 shares (peroption)  of  the  underlying  stock  from  the  option  holder  at  theshort  put  strike  price.  By  exercising  the  long  put,  you  can  turnaround and sell the shares received from the option holder at thehigher long put strike and pocket the difference—the maximumproﬁt available.
• The underlying stock falls below the breakeven, but not aslow  as  the  short  strike: Sell  a  put  with  the  long  put  strike  andbuy  a  put  with  the  short  strike.  There  should  be  a  small  proﬁtremaining.
• The underlying stock remains above the breakeven, but be-low the long strike: Sell a put with the long strike and buy a putwith the short strike, which will partially offset the initial debit orallow you to pocket a small proﬁt; or wait until expiration and sellthe long put to offset the trade’s net debit and let the short optionexpire worthless.
• The underlying stock rises above the long option: Let the op-tions  expire  worthless,  or  sell  the  long  put  prior  to  expiration  tomitigate some of the loss.
Bull Put Spread Road Map
In order to place a bull put spread, the following guidelines should beobserved:
1. Look for a bullish market where you anticipate a modest increase in
the price of the underlying stock.
2. Check to see if this stock has options available.3. Review put options premiums per expiration dates and strike prices.Look  for  combinations  that  produce  high  net  credits.  The  Optionet-ics.com Platinum site allows for searches that will quickly qualify can-didates for you. Since the maximum proﬁt is limited to the net credit
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initially received, try to keep the net credit as high as possible to makethe trade worthwhile.
4. Investigate  implied  volatility  values  to  see  if  the  options  are  over-priced  or  undervalued.  Look  for  options  with  forward  volatilityskews—where the higher strike option you are selling has higher IVthan the lower strike option you are purchasing.
5. Explore past price trends and liquidity by reviewing price and volume
charts over the past year or two.
6. Choose a lower strike put to buy and a higher strike put to sell. Bothoptions must have the same expiration date. Keep the short strike at-the-money.  Try  to  avoid  selling  an  in-the-money  put  because  it  is  al-ready in danger of assignment.
7. Place bull put spreads using options with 45 days or less until expira-tion. Since the proﬁt on this strategy depends on the options expiringworthless, it is best to use options with 45 days or less until expirationto put time decay on your side.
8. Determine the speciﬁc trade you want to place by calculating:
• Limited  Risk: The  most  you  can  lose  is  the  difference  between
strikes minus the net credit received times 100.
• Limited Reward: The net credit received from placing the combi-
nation position.
• Breakeven: Calculated by subtracting the net credit from the shortput strike price. Make sure the breakeven is within the underlyingstock’s trading range.
• Return on Investment: Reward/risk ratio.
9. Create  a  risk  proﬁle  for  the  trade  to  graphically  determine  thetrade’s feasibility. The diagram will show a limited proﬁt above theupside  breakeven  and  a loss  below  the  downsidelimited breakeven. In the best scenario, the underlying stock moves abovethe  higher  strike  price  by  expiration  and  the  short  options  expireworthless.
10. Write down the trade in your trader’s journal before placing the tradewith your broker to minimize mistakes made in placing the order andto keep a record of the trade.
11. Make an exit plan before you place the trade.
• Consider  doing  two  contracts  at  once.  Try  to  exit  half  the  tradewhen the value of the trade has doubled or when enough proﬁt ex-ists to cover the cost of the double contracts. Then the other trade
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will be virtually a free trade and you can take more of a risk, allow-ing it to accumulate a bigger proﬁt.
• If you have only one contract, exit the remainder of the trade whenit is worth 80 percent of the maximum possible value of the spread.The reason for this rule is that it usually takes a very long time tosee the last 20 percent of value in a proﬁtable vertical spread. It’sbetter  to  take  the  trade  off  and  look  for  new  trades  where  themoney can be put to better use.
12. Contact your broker to buy and sell the chosen put options. Place thetrade as a limit order so that you maximize the net credit of the trade.13. Watch the market closely as it ﬂuctuates. The proﬁt on this strategy islimited—a  loss  occurs  if  the  underlying  stock  falls  below  thebreakeven point.
14. Choose an exit strategy based on the price movement of the underly-
ing stock:
• The  underlying  stock  rises  above  the  short  strike: Optionsexpire  worthless  and  you  keep  the  initial  credit  received  (maxi-mum proﬁt).
• The  underlying  stock  rises  above  the  breakeven,  but  notas high as the short strike: The short put is assigned and youare then obligated to purchase 100 shares from the option holderof  the  underlying  stock  at  the  short  strike  price.  You  can  eitherkeep the shares in hopes of a reversal or sell them at the currentprice  for  a  small  loss,  which  is  not  completely  balanced  out  bythe initial credit received. To bring in additional money, sell thelong put.
• The  underlying  stock  remains  below  the  breakeven,  butabove the long strike: The short put is assigned and you are thenobligated to purchase 100 shares of the underlying stock from theoption  holder  at  the  short  strike  price.  You  can  either  keep  theshares in hopes of a reversal or sell them at the current price for asmall  loss,  which  is  not  completely  balanced  out  by  the  initialcredit received. To mitigate this loss, sell the long put.
• The underlying stock falls below the long option: The shortput is assigned and you are then obligated to purchase 100 sharesof the underlying stock from the option holder at the short strikeprice. By exercising the long put, you can sell these shares at thelong strike price. This loss is partially mitigated by the initial creditreceived and results in the trade’s maximum loss.
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Bear Call Spread Road Map
In order to place a bear call spread, the following guidelines should beobserved:
1. Look for a moderately bearish market where you anticipate a modest
decrease in the price of the underlying stock—not a large move.
2. Check to see if this stock has options.3. Review call options premiums per expiration dates and strike prices.Look  for  combinations  that  produce  high  net  credits.  The  Optionet-ics.com  Platinum  site  allows  for  searches  that  will  quickly  qualifypromising candidates for you. Since the maximum proﬁt is limited tothe net credit initially received, keep the net credit as high as possibleto make the trade worthwhile.
4. Investigate  implied  volatility  values  to  see  if  the  options  are  over-priced  or  undervalued.  Look  for  options  with  a  reverse  volatilityskew—lower strike options have higher implied volatility and higherstrike options have lower implied volatility.
5. Explore past price trends and liquidity by reviewing price and volume
charts over the past year or two.
6. Choose a higher strike call to buy and a lower strike call to sell. Bothoptions must have the same expiration date. Place bear call spreadsusing options with 45 days or less until expiration.
7. Determine the speciﬁc trade you want to place by calculating:
• Limited  Risk: The  most  you  can  lose  is  the  difference  in  strike
prices minus the net credit times 100.
• Limited Reward: The maximum reward is the net credit received
from placing the combination position.
• Breakeven: Lowest strike price plus net credit received• Return on Investment: Reward/risk ratio.
8. Create a risk proﬁle for the trade to graphically determine the trade’sfeasibility. The risk graph of a bear call spread slants downward fromleft to right, displaying its bearish bias. If the underlying stock falls to orpast the price of the short put, the trade reaches its maximum proﬁt po-tential. Conversely, if the price of the underlying stock rises to or ex-ceeds the strike price of the long put, the maximum limited loss occurs.9. Write down the trade in your trader’s journal before placing the tradewith your broker to minimize mistakes made in placing the order andto keep a record of the trade.
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10. Make an exit plan before you place the trade.
• Consider  doing  two  contracts  at  once.  Try  to  exit  half  the  tradewhen the value of the trade has doubled or when enough proﬁt ex-ists to cover the cost of the double contracts. Then the other tradewill be virtually a free trade and you can take more of a risk, allow-ing it to accumulate a bigger proﬁt.
• If you have only one contract, exit the remainder of the trade when
it is worth 80 percent of its maximum value.
11. Contact your broker to buy and sell the chosen call options. Place thetrade as a limit order so that you maximize the net credit of the trade.12. Watch the market closely as it ﬂuctuates. The proﬁt on this strategy islimited—a  loss  occurs  if  the  underlying  stock  rises  above  thebreakeven point.
13. Choose an exit strategy based on the price movement of the underly-
ing stock:
• The underlying stock falls below the short strike: Let the op-tions  expire  worthless  to  make  the  maximum  proﬁt  (the  initialcredit received).
• The underlying stock falls below the breakeven, but not aslow  as  the  short  strike: The  short  call  is  assigned  and  you  arethen obligated to deliver 100 shares of the underlying stock to theoption holder at the short strike by purchasing these shares at thecurrent  price.  The  loss  is  offset  by  the  initial  credit  received.  Byselling the long call, you can bring in an additional small proﬁt.
• The underlying stock remains above the breakeven, but be-low the long strike: The short call is assigned and you are thenobligated to deliver 100 shares of the underlying stock to the optionholder  at  the  short  strike  price  by  purchasing  these  shares  at  thecurrent  price.  This  loss  is  mitigated  by  the  initial  credit  received.Sell the long call for additional money to mitigate the loss.
• The  underlying  stock  rises  above  the  long  option: Theshort  call  is  assigned  and  you  are  then  obligated  to  deliver  100shares  of  the  underlying  stock  to  the  option  holder  at  the  shortstrike. By exercising the long call, you can turn around and buythose shares at the long call strike price regardless of how highthe underlying stock has risen. This limits your loss to the maxi-mum  of  the  trade.  The  loss  is  partially  mitigated  by  the  initialcredit received on the trade.
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CONCLUSION
The four vertical spreads covered in this chapter—bull call spread, bear putspread, bull put spread, and bear call spread—are probably the most basicoption strategies used in today’s markets. Since they offer limited risk andlimited proﬁt, close attention needs to be paid to the risk-to-reward ratio.Never take the risk unless you know it’s worth it! Each of these strategiescan be implemented in any market for a fraction of the cost of buying orselling the underlying instruments straight out.
In general, vertical spreads combine long and short options with thesame  expiration  date  but  different  strike  prices.  Vertical  trading  criteriainclude the following steps:
1. Look  for  a  market  where  you  anticipate  a  moderately  directional
move up or down.
2. For debit spreads, buy and sell options with at least 60 days until expi-ration. For credit spreads, buy and sell options with less than 45 daysuntil expiration.
3. No  adjustments  can  be  made  to  increase  proﬁts  once  the  trade  is
placed.
4. Exit strategy: Look for 50 percent proﬁt or get out before a 50 percent
loss.
In general, volatility increases the chance of a vertical spread makinga proﬁt. By watching for an increase in volatility, you can locate trendingdirectional  markets.  In  addition,  it  can  often  be  more  proﬁtable  to  haveyour  options  exercised  if  you’re  in-the-money  than  simply  exiting  thetrade. This isn’t something you really have any control over, but it is im-portant to be aware of any technique for increasing your proﬁts.
These strategies can be applied in any market as long as you under-stand the advantage each strategy offers. However, learning to assess mar-kets  and  forecast  future  movement  is  essential  to  applying  the  rightstrategy. It’s the same as using the right tool for the right job; the right toolgets the job done efﬁciently and effectively. Each of the vertical spreadshas its niche of advantage. Many times, price will be the deciding factoronce you have discovered a directional trend.
The best way to learn how these strategies react to market movementis to experience them by paper trading markets that seem promising. Youcan  use  quotes  from  The  Wall  Street  Journal or  surf  the  Internet  to  anumber of sites including www.cboe.com (for delayed quotes) or www.optionetics.com. Once you have initiated a paper trade, follow it each dayto learn how market forces affect these kinds of limited risk strategies.
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CHAPTER 6
DemystifyingDelta
D elta  neutral  trading  is  the  key  to  my  success  as  an  options  trader.
Learning how to trade delta neutral provides traders with the abilityto  make  a  proﬁt  regardless  of  market  direction  while  maximizingtrading  proﬁts  and  minimizing  potential  risk.  Options  traders  who  knowhow to wield the power of delta neutral trading increase their chances ofsuccess by leveling the playing ﬁeld. This chapter is devoted to providing asolid understanding of this concept as well as the mechanics of this innov-ative trading approach.
In  general,  it  is  extremely  hard  to  make  any  money  competing  withﬂoor  traders.  Keep  in  mind  that  delta  neutral  trading  has  been  used  onstock exchange ﬂoors for many years. In fact, some of the most successfultrading  ﬁrms  ever  built  use  this  type  of  trading.  Back  when  I  ran  a  ﬂoortrading operation, I decided to apply my Harvard Business School skills toaggressively  study  ﬂoor  trader  methods.  I  was  surprised  to  realize  thatﬂoor traders think in 10-second intervals. I soon recognized that we couldtake this trading method off the ﬂoor and change the time frame to make itsuccessful for off-ﬂoor traders. Floor traders pay large sums of money forthe  privilege  of  moving  faster  and  paying  less  per  trade  than  off-ﬂoortraders.  However,  changing  the  time  frame  enabled  me  to  compete  withthose  with  less  knowledge.  After  all,  99  percent  of  the  traders  out  therehave  very  little  concept  of  limiting  risk,  including  money  managers  incharge of billions of dollars. They just happen to have control of a greatdeal of money so they can keep playing the game for a long time. For ex-ample, a friend once lost $10 million he was managing. Ten minutes later Iasked  him,  “How  do  you  feel  about  losing  all  that  money?”  He  casually
164
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replied,  “Well,  it’s  not  my  money.”  That’s  a  pretty  sad  story;  but  it’s  thetruth. This kind of mentality is a major reason why it’s important to man-age your accounts using a limited risk trading approach.
Delta neutral trading strategies combine stocks (or futures) with op-tions, or options with options in such a way that the sum of all the deltasin  the  trade  equals  zero.  Thus,  to  understand  delta  neutral  trading,  weneed to look at “delta,” which is, in mathematical terms, the rate of changeof the price of the option with respect to a change in price of the underly-ing stock.
An overall position delta of zero, when managed properly, can en-able a trade to make money within a certain range of prices regardlessof  market  direction.  Before  placing  a  trade,  the  upside  and  downsidebreakevens  should  be  calculated  to  gauge  the  trade’s  proﬁt  range.  Atrader  should  also  calculate  the  maximum  potential  proﬁt  and  loss  toassess  the  viability  of  the  trade.  As  the  price  of  the  underlying  instru-ment changes, the overall position delta of the trade moves away fromzero.  In  some  cases,  additional  proﬁts  can  be  made  by  adjusting  thetrade back to zero (or delta neutral) through buying or selling more op-tions, stock shares, or futures contracts.
If you are trading with your own hard-earned cash, limiting your riskis an essential element of your trading approach. That’s exactly what deltaneutral trading strategies do. They use the same guidelines as ﬂoor tradingbut  apply  them  in  time  frames  that  give  off-ﬂoor  traders  a  competitiveedge in the markets.
Luckily,  these  strategies  don’t  exactly  use  rocket  science  mathemat-ics. The calculations are relatively simple. You’re simply trying to create atrade that has an overall delta position as close to zero as possible. I canlook  at  a  newspaper  and  make  delta  neutral  trades  all  day  long.  I  don’thave to wait for the S&Ps to hit a certain number, or confuse myself bystudying too much fundamental analysis. However, I do have to look forthe right combination of factors to create an optimal trade.
An optimal trade uses your available investment capital efﬁciently toproduce  substantial  returns  in