X puts. The riskcurve slants downward to the left since the trade loses money as the priceof the minx falls. Additionally, the profit is limited to the initial credit received for selling the put. When the underlying instrument’s price risesand remains above the strike price of the put option, the strategist is in theprofit zone. At these levels the options expire worthless and the trader cankeep the initial credit received.
FIGURE 6.4 MNX December Short Put Risk Graph (Source: www.Optionetics.com Platinum)
ccc_fontanills_093-110_ch06.qxd
6/27/06
Basic Strategies Using Put Options
8:25 AM
Page 101
101
The naked put is similar to the sale of calls because the strategist isselling options and bringing in premium to the account. The maximumreward is the premium received for selling the options. However, theposition has a limited but high downside risk.The ideal exit for the naked put sale occurs if the underlying assetprice stays above the put strike price. At that point, the strategist doesnothing and can keep the premium, which is the maximum profit on ashort put position. However, if the underlying shares reverse and start tofall, a loss might occur. We would recommend offsetting the position bypurchasing a put option with the same strike price and expiration to exitthe trade. If the position is not offset and the underlying asset falls belowthe put strike price, the put will be assigned to the put seller.For a stock, assignment involves the delivery of shares. For indexes,like in our example, assignment will involve the delivery of cash equal tothe difference between the settlement value of the index and the strikeprice of the option. For example, assume that at expiration the settlementvalue of the MNX is 125. The difference between the strike price and thesettlement value is 25. Therefore, the loss is equal to $25 per contract, or$25,000 [($25 × 10) × 100]. Obviously, the strategist is taking on a lot ofrisk for a relatively small reward.Given the high-risk, limited reward associated with naked put selling,the strategy is not one that we use very often. The cash-secured put,which is simply a way of entering a stock position at a lower price, is suitable in some situations when the investor wants to buy the stock at alower price. It is no more risky than the covered call strategy discussed inChapter 5. Nevertheless, the strategist will want to exercise caution because, while naked put selling can generate income over time, one badtrade can wipe out a large number of small gains. Instead, the strategistlooking to sell puts should look for ways to mitigate some of that risk byusing limited-risk spreads, like the bull put spread.
BULL PUT SPREADThe bull put spread is a credit spread created by selling a put and purchasing another put with a lower strike price and the same expiration.Like the naked put, the strategy works well in trending or bullish marketswhen the strategist wants to generate income from selling puts. However,unlike the naked put, the risk from the trade is much more limited thanksto the purchase of the long put. That is, if the underlying asset tanks, thegains from the long puts can offset some of the losses from the short put.The long put can also be used to satisfy assignment.
ccc_fontanills_093-110_ch06.qxd
102
6/27/06
8:25 AM
Page 102
THE INDEX TRADING COURSE
The maximum reward of the bull put spread is limited to the net creditreceived from the balance between the purchase and sale of the puts. Themaximum profit occurs when the market closes above the strike price ofthe short put option. At that point, both puts expire worthless and thestrategist can keep the net credit. When establishing a bull put spread, wegenerally recommend using options with 45 days or less until expiration.This will provide less time for the underlying index to move into a positionwhere the short put will be assigned. In addition, the time decay factor iskey to the success of the bull put spread. The trade will generate the bestresults when the short put loses all of its value and expires worthless.Let’s consider another example using the mini-NASDAQ 100. Onceagain, the time is late October and the minx recently printed at 155. Thestrategist sells 10 MNX December 150 puts and collects $1.75 per contract,or $1,750 in total. At the same time, the strategist will buy 10 MNX 140puts for $0.10 a contract. The long puts are used to limit the potentiallosses if the strategist is wrong about the direction of the NASDAQ.Figure 6.5 shows the risk graph of the MNX bull put spread. The riskprofile of a bull put spread slants upward from left to right, displaying itsbullish bias. If the underlying shares rise to the price of the short put, thetrade reaches its maximum profit potential. Conversely, if the price of theunderlying stock falls to the strike price of the long put, the maximum limited loss occurs.
FIGURE 6.5 MNX December Bull Put Spread Risk Graph (Source: www.Optionetics.com Platinum)
ccc_fontanills_093-110_ch06.qxd
6/27/06
Basic Strategies Using Put Options
8:25 AM
Page 103
103
The breakeven occurs when the index price equals the higher strikeprice minus the net credit. In this case, the breakeven equals 148.35 (150 –1.65). This trade makes the maximum profit if the minx closes at orabove 150 at expiration. The risk profile displayed indicates a tradingprice of approximately 155.50 for the underlying with 57 days left untilexpiration. Therefore, the odds are good that it will remain above 150and both puts will expire worthless. If so, the strategist will keep the initial net credit of $1,650.The maximum risk is still high relative to the premium received forthe trade, but is much less than with the naked put. The maximum risk isequal to the difference in strike prices times the number of contracts, minus the net credit. In this trade, the maximum risk is $8,350: [(150 – 140) ×10 × 100] – 1,650.So the risk/reward ratio of this spread is not great. The strategist isrisking $8,350 to make $1,650, a ratio of approximately five-to-one. Whenlooking for bull put spreads, we are generally looking for ratios of two-toone or better, which is difficult to find in the index market but can sometimes be found in the stock market. Nevertheless, the point remains thesame. Like the naked put, the bull put spread brings in premium when thestrategist expects the market to move higher or trend above the strikeprice of the short option. However, the spread will limit some of the shortput risk during a significant market decline. In sum, it usually makes senseto pay a nickel or dime for this type of insurance rather than simply sellingnaked puts.The price action of the underlying asset will determine the best exitstrategy for the bull put spread. Since the maximum profit is limited to thenet credit initially received, the ideal situation is for the underlying indexto rise above the strike price of the short put and for both options to expire worthless. If so, the strategist does nothing and keeps the net credit.If the price of the underlying asset rises above the breakeven, but notabove the short put’s strike price, then assignment is a risk at expiration.The strategist will probably want to close out the trade rather than faceassignment on the short put. However, at that point, the long put can beclosed out at a profit.In the event that the price of the underlying asset falls below thebreakeven, the bull put spread will lose money. With stocks and ETFs,the short put could be assigned once it is in-the-money and close to expiry. If so, the strategist will buy 100 shares per short put, but can exercise the long put to satisfy assignment. Being assigned the short put andexercising the long put will result in the maximum possible loss. With index options, such as in our minx example, the short put cannot be assigned until expiration because the options have the European-stylesettlement feature. Therefore, if the options are near-the-money or in-the-
ccc_fontanills_093-110_ch06.qxd
104
6/27/06
8:25 AM
Page 104
THE INDEX TRADING COURSE
money as expiration approaches, the strategist will probably want toclose out the spread rather than run the risk of assignment at the time ofoption expiration.What Is Pin Risk?Pin risk is the risk an option writer faces when the price of the underlyingasset closes at or very near the strike price of the option. It is an important factor in selling options because if the asset closes at or very near thestrike price upon expiration, the option holder might exercise the optionand the writer will be faced with assignment. Let the seller beware!
COVERED PUTThe covered put is not a trade we establish often, but is a strategy that issometimes used in a bearish market. A covered put consists of selling theunderlying and selling a put to cover the underlying asset’s position. Obviously, it can’t be applied to a cash index, but it can be used with exchangetraded funds like the QQQQ, diamonds, or SPDRs. The covered put tradecan be risky because it involves short selling shares. Meanwhile, the reward on a covered put is limited to the difference in the price of the shortunderlying asset minus the strike price of the short put, plus the credit received for the option premium.In this example, let’s go short 100 shares of the Qs at $41.50 while simultaneously selling one February 2006 41 put for $1.00. The risk graph inFigure 6.6 shows this covered put position. The breakeven is simply theinitial price of the underlying shares plus the premium from the short saleof the put. In this example, the breakeven equals $42.50 ($41.50 + $1.00).At that price, the short position can be covered for a $1.00 loss, but thepremium received from selling the put offsets that loss.The maximum risk is unlimited as the stock price moves above thebreakeven. If the Qs stay above the strike price of the option, the short putwill expire worthless. However, as the price climbs above the breakeven,the position in QQQQ shares will lose money. If the market continues tomove to the upside, the risk is unlimited.The profit potential from the covered put is limited, and equals the difference between the initial price of the shares (at the time the short position is entered) and the strike price of the option, plus the premiumreceived from selling the put. For example, if the Qs fall to $39 a share, theshort put is assigned and the strategist is obligated to buy 100 shares for$41 a share. The strategist uses the shares to cover the short and thatyields a profit of 0.50 a share. In addition, the strategist keeps the premium
ccc_fontanills_093-110_ch06.qxd
6/27/06
Basic Strategies Using Put Options
8:25 AM
Page 105
105
FIGURE 6.6 QQQQ February Covered Put Risk Graph (Source: www.Optionetics.com Platinum)
from selling the put and the total profit is $150 ($50 on the short ETF saleand $100 from the put sale).If the price of the underlying asset rises, the covered put seller canrun into trouble and the strategist will want to exit the position. If the underlying asset price is below the initial short sale price, but above thestrike price, the short put expires worthless and the strategist keeps thepremium. No losses have occurred on the short stock position and another put can be sold at that time. The profit potential begins to diminishas the price of the underlying asset continues to move higher. If it risesabove the breakeven, the short put will expire worthless, but the shortshares will create a loss on the position. Therefore, strategists will needto be careful if the market rallies because the short side of the trade canresult in sizable losses. For instance, if the Qs rise to $50 a share, theshort sale of the shares will result in an $8.50 per share loss, which isonly partially offset by the $1.00 premium from the short put. In otherwords, at that price the trade, which has a maximum profit potential of$150, loses $750.Overall, the risk/reward of the covered put is not very attractive and itis not a strategy that is widely used. As with most short strategies, thistrade is hazardous because it has unlimited risk. The margin will also behigh (stock price plus 50 percent more). Meanwhile, the reward is verylimited. So, like with the covered call, strategists will want to be careful
ccc_fontanills_093-110_ch06.qxd
106
6/27/06
8:25 AM
Page 106
THE INDEX TRADING COURSE
when looking for covered put opportunities. In a bearish market, otherstrategies will offer better risk/reward ratios. The bear call spread has already been discussed. The long put is also a viable strategy when thestrategist is bearish on a market or sector. However, when looking for amarket move to the downside, the strategist may also want to considerthe bear put spread.
BEAR PUT SPREADThe bear put spread is the opposite of the bull put spread discussed earlier. It is a vertical debit spread created by purchasing a put with a higherstrike price and selling a put with a lower strike price. Both options havethe same expiration month. As the name suggests, it is a bearish strategyand is used when the market is expected to fall, or to close below thestrike price of the short put option, which is the point of maximum reward(at expiration).The bear put spread is a popular strategy for a variety of reasons. Forone, the sale of the short put will offset some of the risk of the long putstrategy. In addition, the total investment is far less than that required tosell stock short. Finally, the maximum risk of a bear put spread is limitedto the net debit of the trade.In this example, the strategist is bearish on energy stocks and sets upa bear put spread on the Select Sector Energy Fund (XLE). The fund istrading near $50.25 a share in late November and the strategist expects energy stocks, led by falling crude oil prices, to experience a three-monthperiod of weakness. As a result, a bear put spread is initiated with the purchase of 10 March 50 put options for $2.50 and the sale of 10 March 45puts for $1.00. The cost of the trade is $1.50 per contract, or $1,500 total.Figure 6.7 shows that the risk profile for a bear put spread slants upward from right to left because the profits increase as the share price falls.Once XLE falls to the price of the short put, the trade reaches its maximum profit potential. The maximum profit potential is equal to the difference between the two strike prices minus the net debit, or $3.50 percontract [($50 – $45) – $1.50]. The maximum profit occurs when the shortoption is in-the-money. At that point, if the strategist is assigned the shortput at $45 a share, the long put can be exercised at $50. The profit is $5 acontract, minus the net debit paid for the spread.If the price of the underlying stock rises to the strike price of the longput, the trade suffers its maximum loss. At that point, both options expireworthless and the strategist loses the initial net debit. So the maximumloss is equal to the cost of the trade, or $1,500. In sum, the strategist is
ccc_fontanills_093-110_ch06.qxd
6/27/06
Basic Strategies Using Put Options
8:25 AM
Page 107
107
FIGURE 6.7 XLE March Bear Put Spread Risk Graph (Source: www.Optionetics.comPlatinum)
risking $1,500 to make $3,500, which is a much healthier risk/reward ratioof more than two-to-one.By spreading out the strike prices between the long and short options,it is possible to create greater risk/reward ratios. For example, buying theMarch 50 puts and selling the March 40 puts increases the ratio to almostfour to one. However, the chances of a move down to $40 a share is alsoless likely than a move down to $45. Nevertheless, when the strategist expects an aggressive move lower in the market or sectors, the bear putspread is a viable strategy that offers flexibility, limited risks, and largepotential rewards.As usual, the movement in the price of the underlying index will determine the best exit strategy for the bear put spread. As noted earlier, ifthe strategist is correct and the price of the underlying asset falls, theshort put could be assigned and can be covered by exercising the long put.In the XLE example, if the strategist is assigned the short put at $45 ashare, the long put can be exercised at $50. The profit is $5.00 per contract, minus the net debit paid for the spread. The maximum profit is $350.However, many strategists will prefer to close out the spread rather thandeal with assignment and exercise. So if the options are in-the-money nearexpiration, the two positions in the bear put spread are offset. Althoughthis approach is not likely to yield the maximum potential profit, the resultswill be very close.
ccc_fontanills_093-110_ch06.qxd
6/27/06
108
8:25 AM
Page 108
THE INDEX TRADING COURSE
The bear put spread breaks even when the price of the underlying asset is equal to the higher strike price put minus the net debit. If the pricefalls below the breakeven but above the strike price of the short put, thetrade can be closed for a small profit. However, above the breakeven andbelow the strike price of the long option, the trade is likely to lead to asmall loss. At that point, it can either be (1) closed out entirely, or (2) thelong put can be offset while the short put expires worthless. If the price ofthe underlying asset rises above both strike prices, the trade is at risk ofsuffering its maximum possible loss, with both puts expiring worthlessand the strategist losing the net debit paid for the spread.
PUT CALENDAR SPREADThe bear put spread works well when the strategist expects an aggressivemove higher or lower, but markets don’t always move vertically. In fact,many times, an index or sector can trade sideways or trend moderatelyone way or the other. In Chapter 5, we showed how a call calendar spreadcould be used to generate profits from a bullish-trending market. Now let’sconsider the opposite with a bearish market and the put calendar spread.The put calendar spread involves the purchase of a long-term put andthe sale of a shorter-term one. Both options have the same strike price. Inorder to profit, the strategist wants the longer-term option to retain itsvalue or appreciate, while the short-term option loses value due to timedecay. Since a volatile move higher or lower will work against this trade,the strategist generally wants sideways trading or a modest move to thedownside when using put calendar spreads.Let’s consider an example using the PHLX Bank Sector Index ($BKX).In mid-May, the strategist determines that the outlook for bank stocks ismoderately bearish due to a recent rise in interest rates and signs of aneconomic slowdown. Profits throughout the sector are expected to stagnate and share prices will therefore flatline during the next few months—maybe even decline during the second half of the year. Consequently,when the PHLX Bank Sector Index hits 100 in mid-May, the strategist establishes a put calendar spread with the purchase of five BKX December100 puts for $4.50 a contract and the sale of five July 100 puts for $2.25 acontract. The net cost of the spread is $1,125 [($4.50 – $2.25) × 5 × 100].The risk and reward of the calendar spread are both limited. The riskis limited to the net debit, or the cost of the trade. If the strategist is wrongand makes no effort to offset the position during the life of the contracts,both puts could expire worthless. Hence, if BKX climbs above the strikeprice of the put options, the net debit paid to enter the spread will be lost.
ccc_fontanills_093-110_ch06.qxd
6/27/06
Basic Strategies Using Put Options
8:25 AM
Page 109
109
If the bank index plummets, however, the put calendar spread will alsofall into the red because a tumble below the strike price of the short option will increase the odds of assignment at expiration (BKX settles European-style). In that case, the strategist will either (1) pay the differencebetween the strike price of the settlement value of the underlying index,or (2) exercise the long option to satisfy assignment. For instance, if BKXfalls to $95 at expiration and the short put is assigned, the strategist suffers a five-point loss on the short put. On five contracts, the loss totals$2,500. Although the long put has also appreciated in value, it is notenough to offset the loss from the short put. In sum, the strategist doesnot want to see an aggressive move higher or lower after entering a putcalendar spread.Instead, the strategist hopes that the bank index will trade near 100during the life of the short option. Figure 6.8 shows the risk graph of theBKX put calendar spread when the short option reaches expiration. Assuming BKX closes at exactly 100 when the July options expire, the shortput expires worthless but the long put still retains much of its value. Inthis case, the spread reaches its maximum profit potential.Once the short option expires, the strategist has several courses of action from which to choose. If the price of the underlying index remainsstable, the strategist might sell another put option after expiration of the
FIGURE 6.8 BKX December/July Put Calendar Spread Risk Graph (Source: www.Optionetics.com Platinum)
ccc_fontanills_093-110_ch06.qxd
110
6/27/06
8:25 AM
Page 110
THE INDEX TRADING COURSE
initial short put. However, if the underlying asset moves against the strategist during the life of the short put, the best approach is probably to exitthe entire position when the short put has little time value remaining.Finally, if the shares tumble and the long put has significant time value,it is better to close the position rather than face assignment since thestrategist will lose the time value that remains in the long contract. Thestrategist can also choose to do nothing if the short put expires worthlessand simply hold a long put position (basically converting the calendarspread to a long put). The resulting position will generate profits if theprice of the underlying asset falls over the remaining life of the long put.
CONCLUSIONSuccessful options traders make money whether the market goes up,down, or sideways. Put options are often used in bearish or down markets. For example, investors often use puts to protect portfolios using thestrategy known as the protective put. In this trade, the strategist has a position in the underlying asset, but buys puts as insurance in case the shareprice moves lower. In that case, the investor is using the puts as protection or as a hedge.When the strategist wants to profit from a short-term move lower inthe market, long puts and bear call spreads make a lot of sense. Both offerlimited risk and high rewards. However, the risks associated with longputs can be significant because a move in the wrong direction can resultin a 100 percent loss of the initial investment. Time decay is also workingagainst the long option position. Bear put spreads can be used to mitigatesome of risk of time decay and/or a wrong move in the market.In a trending market or one that is expected to move modestly higheror lower, the strategist can use bull put spreads or put calendar spreads.The bull put spread can be used when the options strategist wants to sellputs while limiting some of the risk of naked put selling. Calendarspreads, on the other hand, work better when the strategist expects themarket to trend sideways or lower and wants the potential to profit fromtime decay. Once the short put has expired, this position can also benefitfrom a longer-term move lower in the price of the underlying index.
ccc_fontanills_111-132_ch07.qxd
6/27/06
8:26 AM
Page 111
CHAPTER 7
Complex andAdvancedStrategies
I
n options parlance, a complex trade is not one that is necessarily complicated or difficult to understand. Instead, it is a trade that involvesmore than one type of contract. There are numerous examples and several are covered in this chapter. Therefore, the reader should not be discouraged by the terms complex or advanced strategies.Now, one might ask, “When do traders use more advanced strategies?”As seen with the call and put examples, trades can be structured to profit ifthe underlying index moves up, down, or sideways. Ideally, the strategist willhave strategies for every type of market environment in his or her tradingarsenal. Complex and advanced strategies simply give traders more tools.Some strategies can generate profits regardless of market direction. Inother words, it doesn’t matter if the market moves higher or lower—whatmatters is the magnitude of the move. Examples include straddles, strangles, and backspreads, which are explored throughout this chapter. Thesetrades work well when the strategist expects an explosive move higher orlower in the market or sector. In addition, we introduce three more advanced trades in this chapter: the collar, the diagonal spread, and the butterfly. These strategies produce profits in a range-bound or sideways market.
STRADDLESThe long straddle is an options strategy employed when strategists expect an explosive move in the underlying asset but are unsure about the111
ccc_fontanills_111-132_ch07.qxd
112
6/27/06
8:26 AM
Page 112
THE INDEX TRADING COURSE
direction. The trade is comprised of the simultaneous purchase of a calland a put using the same strike and the same expiration month. It is generally established using at-the-money options or options with strike pricesas close to the price of the underlying index as possible.Since the long straddle involves the purchase of a long call and along put, the cost of the double premiums is often high. Hence, thestrategist must expect a large move in a stock to ensure a profit. Whenthe actual direction of the move is uncertain, a long straddle can beused. If the price spikes higher, the call will begin to generate profits. Incontrast, the put will increase in value if the price of the underlying asset falls.The long straddle is a limited-risk, unlimited-reward strategy. Themaximum risk is the total debit paid to enter the trade, or the cost of theput and the call. The maximum profit is unlimited as the underlying assetmoves higher. The profit to the downside, from the put, is limited by amove by the underlying asset to zero. The breakevens are computed byadding the cost of the double premiums to the strike price for the upsidebreakeven. The downside breakeven is equal to the strike price minus thecost of the trade.Let’s see how this trade can work in real life. During the month of August 2004, the strategist looks at the PHLX Gold and Silver Mining Index($XAU) and it appears that the sector might be due for a big move in onedirection or the other, but it isn’t clear whether that move will be higheror lower.So the strategist sets up a long straddle with the gold index tradingnear 85.75. The strategist decides to buy five XAU December 85 puts for$7.00 each and five XAU December 85 calls for $7.50. The total cost of thetrade is $7,250, or [($7.00 + $7.50) × 5 × 100]. The upside breakeven at expiration is equal to the double premium ($14.50) of the options plus thestrike price, or $99.50 ($85 + $14.50). The downside breakeven is simplythe strike price minus the double premium, or $70.50 ($85 – $14.50). IfXAU rises above 99.50 or falls below 70.50 by expiration, the trade willmake money.The risk/reward of the long straddle is plotted in Figure 7.1. Thebiggest loss would occur at expiration if XAU settles at 85 and both theput and call expire worthless. The maximum profit potential is theoretically unlimited as the index moves higher, and is limited to the indexfalling to zero on the downside. Since the trade is entered in August andthe options expire in December, it has approximately four months toplay out.In most cases, the long straddle is not held until expiration and therefore the gold index will not necessarily need to rise above or below the
ccc_fontanills_111-132_ch07.qxd
6/27/06
Complex and Advanced Strategies
8:26 AM
Page 113
113
FIGURE 7.1 XAU December Long Straddle Risk Graph (Source: www.Optionetics.com Platinum)
breakevens to make money. The faster it moves in one direction, the better. For example, if the index rallies 10 percent during the first week, theprofit from the call will probably be enough to yield a profit on the trade.In this example, the index did rally. Less than one month later, XAU wastrading near 103 and the call was bid at $19.00. At that point, the calloption alone was worth more than the $14.50 paid to establish the trade.Obviously, the put had lost most of its value.The success of the straddle depends on identifying an explosive indexor market and then entering the trade before the move gets under way.The exit is equally important. If the underlying asset falls below the lowerbreakeven price, the strategist can close the put position for a profit. If theindex stays between the two breakevens and within a trading range, thetrade will result in a loss. Therefore, the strategist will want to considerclosing out the position when the price of the underlying asset does notmove. In addition, since time decay is a killer during the last 30 days of anoption’s life, the long straddle should usually be closed out between 30and 45 days prior to expiration. However, if the underlying asset price rallies above the upside breakeven, the strategist is in the profit zone againand can close the call for a profit and simply hold the put for a possiblereversal in the index.
ccc_fontanills_111-132_ch07.qxd
114
6/27/06
8:26 AM
Page 114
THE INDEX TRADING COURSE
STRANGLESStrangles are quite similar to straddles, except the choice of strike pricesis quite different. A straddle uses at-the-money options while the puts andthe calls in strangles are out-of-the-money. Since the options are out-ofthe-money, strangles are usually much cheaper than straddles, which iswhy many options strategists prefer strangles. The difference, however, isthat the area of maximum risk is larger because there is a greater chancethat both the puts and calls expire worthless.Let’s create an example, again using the PHLX Gold and Silver MiningIndex trading near 85.75. The strategist decides to purchase five XAU December 80 puts for $4.50 each and five XAU December 90 calls for $5.50.The total cost of the trade is $5,000 [($4.50 + $5.50) × 5 × 100]. Recall thatin our straddle, which involved the December 85 puts