eta decay.C. Delta neutrality.D. Vega neutrality.2. A sideways market is a market that ______________.A. Has extremely low volatility.B. Moves erratically.C. Stays between consistent resistance and support levels.D. Stays at the same market volume consistently.3. Name the three parts of a butterfly strategy.1. _________________________________________________________2. _________________________________________________________3. _________________________________________________________4. The body of a butterfly spread contains ______________.A. An option with the strike price above the resistance level.B. An option with the strike price below the support level.C. An option with the strike price outside of the support and resistance levels.D. An option with the strike price in between the support and resistance levels.5. The wings of a butterfly spread are comprised of ______________.A. Options with the strike prices outside of the trading range.B. Options with the strike prices at both ends of the trading range.C. Options with the strike prices close to the equilibrium level.D. One option outside the support level and one inside the resistance level.
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6. A long butterfly spread consists of ______________.A. Going long (buying) the wings and going short (selling) the body(the middle strike options).B. Going long (buying) the wings and going long (buying) the body(the middle strike options).C. Going short (selling) the wings and going long (buying) the body(the middle strike options).D. Going short (selling) the wings and going short (selling) the body(the middle strike options).7. Money is made on a long butterfly when the market closes______________.A. Outside of the wings.B. In-between the wings.8. Calculate the values for the following long butterfly trade:Long 1 December IBM 80 Call @ 7.50Short 2 December IBM 85 Calls @ 5.00Long 1 December IBM 90 Call @ 3.00IBM is currently trading at $85.Net debit = __________________________________________________Maximum reward = __________________________________________Maximum risk = _____________________________________________Upside breakeven = __________________________________________Downside breakeven = _______________________________________9. In a long condor, you need to ______________.A. Go long the two inner option strikes of the body and go long thewings.B. Go long the two inner option strikes of the body and go short thewings.C. Go short the two inner option strikes of the body and go long thewings.D. Go short the two inner option strikes of the body and go short thewings.
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10. Calculate the values for the following long condor trade:Long 1 MSFT December 60 Call @ 8.00Short 1 MSFT December 65 Call @ 5.00Short 1 MSFT December 70 Call @ 2.00Long 1 MSFT December 75 Call @ 1.00Net debit = __________________________________________________Maximum reward = __________________________________________Maximum risk = _____________________________________________Upside breakeven = __________________________________________Downside breakeven = _______________________________________11. A long iron butterfly is a combination of ________________________.A. A bear put spread and a bull put spread.B. A bear call spread and a bull call spread.C. A bear call spread and a bull put spread.D. A bear put spread and a bull call spread.12. Calculate the values for the following long iron butterfly trade:Long 1 EBAY January 75 Call @ $2.50Short 1 EBAY January 70 Call @ $5.00Short 1 EBAY January 65 Put @ $2.00Long 1 EBAY January 60 Put @ $1.00Net credit = _________________________________________________Maximum reward = __________________________________________Maximum risk = _____________________________________________Upside breakeven = __________________________________________Downside breakeven = _______________________________________13. A calendar spread is a combination of __________________________.A. A long option and a short option.B. A covered call and a protective put.
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14. A diagonal spread is a combination of ______________.A. A long option and a short option.B. A covered call and a protective put.15. A collar strategy is a combination of ______________.A. A long option and a short option.B. A covered call and a protective put.
MEDIA ASSIGNMENTIn this chapter, we are going to look for stocks that are trading sidewaysor within a range. In order to do so, connect to the Internet with yourbrowser set on www.optionetics.com. At that point, you’ll see the “FreeRanker” on the Optionetics home page. At the time of this writing, it islocated near the bottom right-hand side of the web site.Using the free ranker, you want to look for range-bound stocks. In thiseffort, you can click on the button that says “Quiet.” These stocks are theones that have less volatility relative to historical levels. To be specific, thequiet ranking sorts stocks based on the six-day statistical volatility compared to the 100-day. According to the site, “These stocks are candidatesfor sideways trades like calendar spreads and butterflies.”
VOCABULARY LISTBody
Range-bound
Butterfly
Resistance
Calendar spread
Sideways
Collar
Support
Condor
Theta
Diagonal spread
Time decay
Directionless
Trading range
Equilibrium level
Wasting asset
Iron butterfly
Wings
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SOLUTIONS1. In sideways markets, option strategies can be developed to takeadvantage of ______________.Answer: B—Theta decay.Discussion: Theta is a Greek letter used to define how an optionsprice will change due to the passage of time. It is another term fortime decay, which refers to the fact that option premiums lose valueas the expiration date draws closer.2. A sideways market is a market that ______________.Answer: C—Stays between consistent resistance and support levels.Discussion: A sideways or range-bound market is the opposite of atrending market. It is a period of quiet trading that sees little pricemovement in the underlying asset. Traders often use technicalsupport and resistance levels to identify the trading range of asideways market.3. Name the three parts of a butterfly strategy.Answer: Upper wing, body, and lower wing.Discussion: With a long butterfly, the strategist sells two at-themoney options and buys an in-the-money and an out-of-the money option. In that case, the at-the-money options are considered the body.The option with the higher strike price is the upper wing and theoption with the lower strike price is the lower wing.4. The body of a butterfly spread contains ______________.Answer: D—An option with the strike price in between the supportand resistance levels.Discussion: Ideally, the strategist will use technical support andresistance levels to identify the best strike prices to use for the bodyof the butterfly spread.5. The wings of a butterfly spread are comprised of ______________.Answer: B—Options with the strike prices at both ends of thetrading range.Discussion: Establishing the wings using strike prices near the upper and lower ends of the trading range will help increase the odds ofsuccess when establishing long butterflies. Ideally, if the underlying
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instrument revisits the upper or lower bands of the trading range, itwill revert and head back toward the strike price of the body.6. A long butterfly spread consists of ______________.Answer: A—Going long (buying) the wings and going short (selling)the body (the middle strike options).Discussion: With a long butterfly, the strategist sells two at-themoney options and buys an in-the-money and an out-of-the moneyoption.7. Money is made on a long butterfly when the market closes______________.Answer: B—In-between the wings.Discussion: Ideally, the underlying instrument will stay within a trading range. If it moves towards the middle strike prices (of the shortoptions), the short options will expire worthless and the strategistcan keep the premium.8. Calculate the values for the following long butterfly trade:Long 1 December IBM 80 Call @ 7.50Short 2 December IBM 85 Calls @ 5.00Long 1 December IBM 90 Call @ 3.00IBM is currently trading at $85.Answer:Net debit = [(7.50 + 3) – (2 × 5)] × 100 = $50 [(Long – short premiums)× 100].Maximum reward = [(85 – 80) – .50] × 100 = $450 [(Difference between strikes – net debit) × 100].Maximum risk = $50 (Limited to the net debit paid).Upside breakeven = (90 – .50) = $89.50 (Highest strike – net debit).Downside breakeven = (80 + .50) = $80.50 (Lowest strike + net debit).Discussion: The long butterfly is a limited risk strategy with a maximum loss equal to the net debit paid. The maximum reward is equalto the difference between highest strike and the short strike minusthe net debit. Maximum profit is realized when the stock price equalsthe short strike. The upside breakeven equals the highest strike priceminus the net debit paid, and the downside breakeven equals thelowest strike price plus the net debit paid.
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9. In a long condor, you need to ______________.Answer: C—Go short the two inner option strikes of the body and golong the wings.Discussion: Just as with the long butterfly, the long condor involvesselling two options and buying two options. However, the optionsthat are sold will have two different strike prices; so with the longcondor, the strategist is buying four separate contracts.10. Calculate the values for the following long condor trade:Long 1 MSFT December 60 Call @ 8.00Short 1 MSFT December 65 Call @ 5.00Short 1 MSFT December 70 Call @ 2.00Long 1 MSFT December 75 Call @ 1.00Answer:Net debit = [(8 + 1) – (5 + 2)] × 100 = $200 [(Long – short premiums) × 100].Maximum reward = [(35 – 30) – 2] × 100 = $300 [(Difference betweenstrikes – net debit) × 100].Maximum risk = $200 (Limited to the net debit).Upside breakeven (75 – 2) = $73 (Highest strike – net debit).Downside breakeven (60 + 2) = $62 (Lowest strike + net debit).Discussion: The maximum risk of the long condor is the debit paid.The best reward is equal to the difference between the strike pricesminus the net debit. The upside breakeven is equal to the higheststrike price minus the net debit. The lowest strike price is equal to thedownside breakeven plus the net debit.11. A long iron butterfly is a combination of ______________.Answer: C—A bear call spread and a bull put spread.Discussion: The long iron butterfly is a strategy that consists of fouroptions with the same expiration date and different strike prices. To establish the trade, the strategist will buy one higher strike call and sellone lower strike call, which is the same as a bear call spread. Thestrategist will also sell a put and buy a lower strike put, which is thesame as a bull put spread. The short puts and calls will be at- or nearthe-money. The long puts and calls will be out-of-the-money. The ideais to see the underlying asset stay in a range and for the short optionsto expire with little or no value. The long options serve as a hedge inthe event of a significant move higher or lower in the underlying asset.
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12. Calculate the values for the following long iron butterfly trade:Long 1 EBAY January 75 Call @ $2.50Short 1 EBAY January 70 Call @ $5.00Short 1 EBAY January 65 Put @ $2.00Long 1 EBAY January 60 Put @ $1.00Answer:Net credit = [(5 + 2) – (2.50 + 1)] × 100 = $350 [(Short – long premiums) × 100].Maximum reward = $350 (Limited to the net credit).Maximum risk = [(75 – 70) – 3.50] × 100 = $150 [(Difference betweenlong and short strikes – net credit) × 100].Upside breakeven = (70 + 3.50) = $73.50 (Strike price of upper shortcall + net credit).Downside breakeven = (65 – 3.50) = $61.50 (Strike price of lowershort put—net credit).Discussion: The long iron butterfly is established for a credit, whichis equal to the premium received for the short options minus the premium paid for the long options. The maximum reward is the netcredit. The maximum risk is equal to the difference between thestrike prices minus the credit. The upside breakeven equals the shortcall strike price plus the credit. The downside breakeven equals thestrike price of the short put minus the credit.13. A calendar spread is a combination of ______________.Answer: A—A long option and a short option.Discussion: In the calendar spread, the strategist is buying a longterm option and also selling a short-term option. Both options havethe same strike prices, but different expiration dates. Calendarspreads can be created with either puts or calls.14. A diagonal spread is a combination of ______________.Answer: A—A long option and a short option.Discussion: Diagonal spreads can be constructed in different ways.In any situation, however, the strategist is buying an option and alsoselling an option. The options will have different expiration dates anddifferent strike prices. For instance, a diagonal spread can be createdby purchasing a longer-term out-of-the-money call and simultaneously selling a shorter-term at-the-money call.
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15. A collar strategy is a combination of ______________.Answer: B—A covered call and a protective put.Discussion: A collar is created around a stock by purchasing a putoption and selling a call option. In most cases, both the call and theput will be out-of-the-money. The strategy is similar to the protectiveput, but the cost of the put is offset with the sale of a call. The collarhas limited risks and limited rewards.
MEDIA ASSIGNMENTThis chapter encourages readers to visit the Optionetics.com home pageand use the free ranker to search for stocks with low volatility. By clicking on the “Quiet” button, readers can generate a list of stocks that haverelatively low levels of statistical volatility relative to the past. Subscribers using Optionetics.com Platinum will be able to provide more refined screens that can produce a list of low-volatility stocks. Often, thesecompanies are in industries with stable profits like consumer products,groceries, or pharmaceuticals.It is often helpful to generate a price chart of promising stocks. Bycharting the quiet stocks, traders should be able to identify support andresistance levels, which can also help identify potential candidates for thevarious range-bound strategies discussed in this chapter. As usual, newtraders are encouraged to paper trade and back-test these strategies forrange-bound markets before actually putting money on the line.
VOCABULARY DEFINITIONSBody: The inner part of a butterfly spread. In the case of the long butterfly,it represents the options that are being sold and that have strike pricesbetween the highest and lowest strike prices.Butterfly: The sale (or purchase) of two identical options, together withthe purchase (or sale) of one option with an immediately higher strike andone option with an immediately lower strike. All options must be the sametype, have the same underlying, and have the same expiration date.Calendar spread: A spread consisting of the purchase of one long-termoption and the sale of one short-term option of the same type with thesame exercise price.
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Collar: A type of strategy that involves buying shares, selling calls, andbuying puts. It is a combination of a covered call and a protective put.Condor: The sale (or purchase) of two options with consecutive exerciseprices, together with the purchase (or sale) of one option with an immediately lower exercise price and one option with an immediately higher exercise price.Diagonal spread: A two-sided spread consisting of buying a long-termoption and selling a shorter-term option with different strike prices. Options are of the same type and have the same underlying asset.Directionless: Refers to an investment that lacks direction and isnot trending higher or lower. Certain options strategies work wellwhen the underlying asset is not moving higher or lower (i.e., when it isdirectionless).Equilibrium level: The level where supply meets demand. The meanbetween an asset’s support price and resistance price.Iron butterfly: The combination of a long (or short) straddle and a short(or long) strangle. All options must have the same underlying and have thesame expiration.Range-bound: Refers to an investment or market that is not trendinghigher or lower, but rather remaining within a narrow price span.Resistance: A price level that serves as a ceiling to higher prices. A stockmight turn away from this price level on a few occasions.Sideways: An investment or market that lacks clear direction and tendsto show relatively little price change.Support: A price level at which a stock or market begins seeing increasing demand or buying interest. It serves as a floor to lower prices. A majorsupport area is one that has been tested on several occasions and over asustained period of time. When a major support area is broken and thestock or market begins to falter, a more meaningful move to the downsidemay occur. For that reason, technicians consider major support areas tobe significant.Theta: The Greek letter that refers to the loss in an option’s value due tothe passage of time. Theta is expressed as a number such as –.10 or –.05.Time decay: The process of options losing value as the expiration dateapproaches.
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Trading range: The recent high and low prices of a stock or other investment that serve as resistance and support.Wasting asset: An investment that loses value over time. Options haveset expiration dates and lose value as time passes, so they are consideredwasting assets.Wings: A term to describe a portion of a butterfly or condor. In a long butterfly, for instance, the wings are the options that are purchased and havethe highest and lowest strike prices. The body consists of the short optionswith the middle strike prices.
CHAPTER 11
Increasing YourProfits withAdjustments
SUMMARYExperienced options traders are continuously assessing the risk/rewardprofile of open positions because as the underlying asset changes in value,so will other factors. For instance, the delta of a position can change dramatically as the underlying asset moves higher or lower. So, to stay deltaneutral in a strategy like a long synthetic straddle, an options strategistmust often make modifications to the position. This may include buyingmore contracts or shares or selling them. When a strategist makes changesto a position due to price movements in the underlying asset, the strategistis making an adjustment to the position. The strategist does not need totell the broker that an adjustment is being made. Instead, the trader simplyenters the order to buy or sell more options or shares in order to bring theposition back to delta neutral.This chapter explores the process of adjustments. For instance, howdo changes in the market influence the overall position delta of the trade?If the move is significant, it might be time to adjust the trade. Often, bymaking an adjustment, a trader can increase profits on the trade by bringing the trade back to delta neutral. In addition, adjustments can be madeto lock in profits or to help salvage the value of a losing trade. The mostimportant factor to understand is that option positions are not just openedand closed. In many cases, they can be modified with adjustments toimprove their overall risk/reward profiles.
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QUESTIONS AND EXERCISES1. Name three things you can do when the market moves and your tradeis no longer delta neutral.1. _________________________________________________________2. _________________________________________________________3. _________________________________________________________2. An adjustment can be made by ______________ to offset your position to bring it back to delta neutral.A. Buying or selling options.B. Buying or selling futures.C. Buying or selling stocks.D. All of the above.3. Name the two sides of a delta neutral trade.1. _________________________________________________________2. _________________________________________________________4. Stock has a ______________ delta.A. Fixed.B. Variable.C. Fixed or variable.5. Options have ______________ deltas.A. Fixed.B. Variable.C. Fixed or variable.6. ATM options are easy to work with because they have ______________.A. Low liquidity and thin price spreads.B. Low liquidity and large price spreads.C. High liquidity and thin price spreads.D. High liquidity and large price spreads.7. Time-based adjustments are based on ______________.A. The number of days left until expiration.B. Regular intervals (days, weeks, months, etc.).
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C. The movements of the sun.D. All of the above.8. Event-based adjustments are most likely to occur ______________.A. When a special event dictates the adjustment.B. At regular intervals (days, weeks, months, etc.).C. Based on an expected event that is known beforehand.D. All of the above.9. What is the key advantage of using an at-the-money option?A. It will have several strike prices.B. It is more likely to have high open interest and liquidity.C. The strike price will be slightly above the market value of theunderlying instrument.D. The strike price will be slightly below the market value of theunderlying instrument.10. Calls have ______________ deltas.A. Negative.B. Fixed.C. Positive.D. None of the above.11. Puts have ______________ deltas.A. Negative.B. Fixed.C. Positive.D. None of the above.
MEDIA ASSIGNMENTIn this media assignment, we are going to return to the free options calculator at the Chicago Board Options Exchange (CBOE) and computethe deltas of various options positions. Once your PC is booted and online, type www.cboe.com into the web browser, which will take you tothe Chicago Board Options Exchange web site. From the CBOE homepage, click the “Trading Tools” tab, then the “Volatility Optimizer,” and
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then click on “Options Calculator.” Next, select “American” in the stylebox. (Note: If the calculator on the CBOE site is not available, readerscan use any options calculator that includes the variable delta to complete this assignment.)Next, input some variables into the calculator. First, let the stockprice equal 60 and the strike price equal 75; the volatility is 30 percent, theannual interest rate is 5 percent, and the company pays no dividend (quarterly dividend amount equals 0). Next, in the “Days Left to Expiration”box, click “Days Until Expiration” and enter the number 100. We are goingto look at an options contract with 100 days remaining until expirationthat has a strike price of 75 and volatility of 30 percent, with an underlyingsecurity trading at $60 that pays no dividends. Now, write down the deltaof the put and the delta of the call.Let’s assume that the stock price begins to climb higher. Change theequity price to 70. What are the deltas now? What about at 75? Now, assume we buy a straddle using one put and one call. What is the delta ofthis position? Or, assume that we buy 100 shares and buy two puts. Whatis the position delta? Finally, assume that the stock price climbs to 80.What are the deltas of the put and the call? What are the position deltas ofthe straddle and the long synthetic straddle? In the case of the straddle,what can we do to get back to delta neutral?
VOCABULARY LISTAdjustment
Open interest
Directional trade
Positive delta
Event-based adjustment
Thin spreads
Fixed delta
Time-based adjustment
Liquidity
Variable delta
Negative delta
SOLUTIONS1. Name three things you can do when the market moves and your tradeis no longer delta neutral.Answer: Exit the trade, maintain the trade as is, or make anadjustment.Discussion: There are advantages and disadvantages to each ofthe three courses of action. So, ultimately, the best alternative will
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depend on the specific situation. Since the key to profitable tradinglies in assessing the available choices, learning the benefits of adjusting can help you to become a more profitable trader.2. An adjustment can be made by ______________ to offset your position to bring it back to delta neutral.Answer: D—All of the above (buying or selling options, futures, orstocks).Discussion: Delta neutral trades are created by simultaneouslypurchasing (or selling) the underlying asset (stocks, futures, exchangetraded funds, etc.) along with the purchase (or sale) of optionscontracts.3. Name the two sides of a delta neutral trade.Answer: Hedge and directional bet.Discussion: You can think of a delta neutral position as two trades.The first is a directional bet on a market, stock, or futures contract.The other is a hedge in case the directional bet goes awry.4. Stock has a ______________ delta.Answer: A—Fixed.Discussion: Delta is the measure of the price change of a derivativerelative to the price change of an underlying asset. The delta of an options contract can change as the price of the underlying asset moveshigher or lower. It varies. However, stocks (and futures contracts) always have a delta equal to 100. If a stock price moves up $1, the position increases in value by $1 times the number of shares. It nevervaries; it is fixed.5. Options have ______________ deltas.Answer: B—Variable.Discussion: Each options contract has a unique delta that changesover time. It can range between 0 and 100. An option with a high deltawill move very much like the price of the underlying asset. For instance, a contract with a delta of 100 will experience a one-to-oneprice movement with the price changes of the underlying asset.Importantly, however, the delta can change over time. It is variable.6. ATM options are easy to work with because they have ______________.Answer: C—High liquidity and thin price spreads.Discussion: At-the-money options tend to attract the most amountof interest and are often more liquid than other strike prices for that
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reason. The spreads, or difference between bids and offers, willoften be smaller as well. This is especially true for the near-term orfront-month options.7. Time-based adjustments are based on ______________.Answer: B—Regular intervals (days, weeks, months, etc.).Discussion: Strategists sometimes use regular time intervals todecide when to adjust a position. For instance, a trader might decideto adjust the position every two weeks. This is an example of a timebased adjustment.8. Event-based adjustments are most likely to occur ______________.Answer: A—When a special event dictates the adjustment.Discussion: Some options traders wait for a specific event to dictatewhen an adjustment should be implemented on an open position.Earnings announcements, takeover talk, and management shake-upsare examples of events that might trigger an adjustment to an openstock option position.9. What is the key advantage of using an at-the-money option?Answer: B—It is more likely to have high open interest and liquidity.Discussion: At-the-money options tend to have higher levels of openinterest when compared to other strike prices. High open interest, inturn, is a sign of liquidity and robust levels of trading activity. Theseoptions tend to be more liquid than others.10. Calls have ___________ deltas.Answer: C—Positive.Discussion: As the price of the underlying asset moves higher, thecall will appreciate in value. Thus, the call option has a positive delta.Calls move in the same direction as the price of the underlying asset.11. Puts have ___________ deltas.Answer: A—Negative.Discussion: As the price of the underlying asset moves higher,the put option will lose value. As the price of the underlying assetfalls, the put will increase in value. Therefore, puts have negativedeltas. They move in the opposite direction to the price of theunderlying asset.
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MEDIA ASSIGNMENTIn this chapter, readers are encouraged to use the options calculator at theChicago Board Options Exchange to find the deltas of a call, a put, a straddle, and a long synthetic straddle. Readers should notice that as the stockprice moves higher, the delta of the call increases. Meanwhile, the delta ofthe put also increases (becomes less negative). Using the numbers providedwould produce a table similar to the one shown.Stock Price
Call Delta
Put Delta
60
0.10
–0.97
70
0.39
–0.63
75
0.57
–0.45
80
0.72
–0.29
The reader is also asked to compute the delta of the straddle when thestock price equals the strike price of 75. At that time, the position wouldhave a delta of +12 (57 – 45). The long synthetic straddle, which would include 100 shares and two puts, would have a positive delta of 100 minus45 minus 45, or +10. Finally, the last question asks to compute the positiondeltas of the straddle and the long synthetic straddle when the stock pricereaches 80. In that case, the straddle would have a delta of 43 (72 – 29)and the long synthetic straddle would have a delta of 42 (100 – 29 – 29).So, what could the strategist do with the long synthetic straddle to movethe position closer to delta neutral? Buy one more put, which would givethe position a delta of only +13.
VOCABULARY DEFINITIONSAdjustment: Making a change to a trade in order to bring it back to deltaneutral and alter the reward/risk ratio. Traders often make adjustments todelta neutral strategies like long straddles and long synthetic straddles.Directional trade: A trade that requires the underlying asset to move inone direction in order to produce profits. To make a profit, the trader mustdetermine before placing a directional trade which way the asset will go.Buying stocks is an example of a directional bet because the stock pricemust move higher in order to generate profits.Event-based adjustment: A type of adjustment to an options contractthat is based on a specific event like an earnings announcement, a profitreport, or a management change.
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Fixed delta: A delta figure that does not change due to any price changes.Stocks and futures contracts have a fixed delta of plus or minus 100.Liquidity: The ease with which an asset can be converted to cash in themarketplace. A large number of buyers and sellers and a high volume oftrading activity provide high liquidity. Liquidity is a concern for any moneysthat may be required on short notice, whether for emergencies or forplanned purchases.Negative delta: A delta that moves opposite to the price of the underlying