Points
for one day or two? By how much does the underlying stock haveto move for the trade to be proﬁtable? Figure 6.4 is a different wayto look at a straddle. Assuming a constant volatility estimate, itshows for each day the upside and downside breakeven points forthe DNA March 50 straddle.Perhaps the most surprising aspect of Figure 6.4 is how far apartthe breakeven points are 31 days before expiration, on the day thestraddle was purchased. Why does the stock have to move to $48on the downside, or $50.95 on the upside, to break even? Shouldn’tthe breakeven be the current price of the stock, $50.03?The breakeven is not the current price of the stock because tobreak even we must make up the bid-ask spread on both options.(We assumed that we purchased both options at their offered price;to get back to breakeven we need to get back to theoretical prices,which we have taken as midway between the bid and the offer.).Still, $48 on the downside does require some explanation.If DNA starts moving down, the call value will fall (creating aloss) and the put value will increase (generating a proﬁt). Initially,the call’s delta is 0.53, the put’s ⫺0.47. So as the stock starts dropping, the losses on the call are greater than the gains on the put. Atsome point the call and the put have respective deltas of 0.50 and⫺0.50. But as the stock continues to the downside, the put’s deltagoes below ⫺0.50 and the gains on the put now become greater thanthe losses on the call. So if the stock starts moving to the downside,
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breaking even requires ﬁrst making up for the straddle’s bid-askspread and then getting to the point where the put is gaining valueat a faster rate than the rate at which the call is losing value. If DNA’sprice drops, the straddle initially falls in value before turningaround, and a (small) accrued loss must be recouped before theposition starts generating a proﬁt. But all those nickels and dimesstart to add up, and on the day the position is initiated, the stockneeds to drop by $2 before we can start making money on thedownside.We view Figure 6.4 as the straddle buyer’s road map. If you aregoing to purchase a straddle, how conﬁdent are you that the underlying stock will move outside of the two breakeven lines? Does sucha move appear realistic? Understanding the map may prevent youfrom getting lost.Buying Straddles for Speciﬁc EventsSometimes you just know that a stock is about to move—earningsreports, analyst meetings, contract allocations. One of the betterexamples is the U.S. government’s decision to nominate the leadcontractor for its Joint Strike Fighter. This defense contract couldeventually become the largest in U.S. history and there were twocandidates for the lead position: Boeing (BA) and Lockheed Martin(LMT). Furthermore, the date on which the winner was to beannounced was public knowledge: after the market’s close on Friday, October 26.To some, BA was not the ideal vehicle to trade. Too much of itsrevenue comes from the commercial aircraft side of the business.LMT, on the other hand, was seen as a pure defense play. So at halfpast noon (you never trade on company time) on the day of reckoning you pull up the LMT option chain and ﬁnd the following:LMT:November 50 call:November 50 put:
$50.05$3.30–$3.40$3.10–$3.20
You know that you will have to hold the straddle three calendardays through the weekend. But what is your risk? The Novemberoptions have 22 days until expiration, and on Monday they’ll have
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only 19. And this contract is a make-or-break situation for LMT. Youpunch in your order and buy 10 of the November 50 straddles at$6.60.The news comes out on schedule, and LMT is the winner. This isgood news. But then “bad news” would have been good news to astraddle holder. Monday lunch hour rolls around, and once againyou pull up the LMT option chain.LMT:November 50 call:November 50 put:
$51.41$2.90–$3.00$1.45–$1.55
The stock is up, but not by much. It now appears that LMT wasfavored to win, so this was “already in the market.” But the stockhas still gone up almost $1.50, so this has got to be good for thestraddle holders, right? Not quite. The November 50 straddle is nowbid at $4.35, a $2.25 drop from your purchase price, or $2,250 on a10 lot. Ouch!What happened? For one thing everyone knew when the newswas coming out. And everyone—including the options pros—expected a lot of volatility. So the options, on Friday, were pricedaccordingly. Go back to the Genentech example, where the 31-day50 straddle was offered at $5.35. DNA is not a low-volatility stock.And the 22-day LMT straddle was offered at $6.60 on the Friday thatthe news came out. Also refer back to Figure 6.4 and recall that themajor assumption underlying this graph was that the volatility estimate would remain constant. With LMT, the volatility estimate obviously did not remain constant. It, as they say on the ﬂoor, gotcrushed.By Monday morning a lot of uncertainty had been taken out ofLMT stock. This translated into lower expected volatility and loweroptions prices. The lesson is obvious: if everyone knows aboutsomething, the options will be priced to reﬂect the expected news.Another favorite example is Hewlett-Packard (HPQ, previouslyHWP), which had a habit of reporting earnings after the close onThursday immediately preceding expiration Friday. The volatilityof HWP options was out of this world on the relevant Thursdayafternoon, but that’s not surprising since options with only hoursleft in their trading lives would have to absorb the full impact of a
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technology company’s earnings. By 10:10 on Friday morning thingswere back to normal and HWP options were trading with a moresedate volatility estimate.
StranglesStrangles, also known as combinations (combos), are sometimesreferred to as “the poor man’s straddle.” Instead of purchasing atthe-money calls and puts, some traders buy an out-of-the-moneycall and an out-of-the-money put on a stock they forecast to be veryvolatile. Strangles are also preferred over straddles when a stock istrading between strike prices, as in the following Bank of America(BAC) example:BAC:May 70 call:May 65 put:
$68.02$1.45–$1.70$1.30–$1.55
A trader who expects BAC to be extremely volatile over the next45 days could purchase both the 70 call at $1.70 and the 65 put at$1.55, for a total outlay of $3.25. This initial cost represents thetrader’s total risk on the position, and the proﬁtability of this combois summarized in Table 6.8.Table 6.8BAC atExpiration
Value of70 Call
Value of65 Put
InitialDebit
Proﬁt/(Loss)
$85
$15
$0
($3.25)
$11.75
$80
$10
$0
($3.25)
$6.75
$75
$5
$0
($3.25)
$1.75
$70
$0
$0
($3.25)
($3.25)
$65
$0
$0
($3.25)
($3.25)
$60
$0
$5
($3.25)
$1.75
$55
$0
$10
($3.25)
$6.75
$50
$0
$15
($3.25)
$11.75
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If BAC remains between $65 and $70 at expiration, both optionswill still be out-of-the-money and will expire worthless, resulting ina $3.25 loss. A move above $73.25 or below $61.75 at expiration willresult in a proﬁt.Figure 6.5 illustrates the strangle’s proﬁtability at expiration, onthe day the trade was initiated (with 46 days until expiration), andat the halfway date (with 23 days remaining). The two latter calculations assume an unchanged volatility assumption.First, notice how the value of the combo changes on the day theposition is established. Or rather, notice how its value does notchange. If BAC rises to $70 or falls to $65, the total value of the strangle remains close to unchanged as the gain on one option is canceledby the loss on the other. Only when one of the options goes in-themoney does the gain on this option more than make up for the losson the other. Conclusion: it is difﬁcult to see how this position willbe proﬁtable unless the stock moves outside one of the two strikes,even if it rises or falls on the day the position was established.A second observation is that with half of the time to expirationgone (with 23 days remaining), the proﬁt and loss line is roughlyhalfway between the initial day proﬁt and loss and that at expiration. Since out-of-the-money options tend to lose value in a linearfashion, this should not be surprising. If a trader expects BAC tomove over the next three weeks and buys a six-week strangle, itwould be safe to say that her risk is approximately one-half the initial premium paid, assuming she will exit the position in threeweeks.
$8
Profit/(Loss)
$6$4
Exp.46 Days23 Days
$2$0($2)($4)$55
$60
$65
$70
BAC Price
Figure 6.5 BAC: Long 65–70 Combo
$75
$80
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Finally, we should point out that strangles, like straddles, have aslightly bullish bias. You will notice that the proﬁt-and-loss graph,except at expiration, is not perfectly symmetrical. Calls have slightlyhigher deltas than puts (assuming the underlying stock is equidistant from the two strike prices) and also have a tendency to retainmore of their time premium as they go in-the-money. (Notice thatthe 23-day proﬁt-and-loss line converges more rapidly with theexpiration date proﬁt-and-loss line as the price of BAC drops.) Creating a combo that is perfectly symmetrical prior to the expirationdate would require purchasing slightly more puts than calls, but thisis a problem the average trader need not worry about.
Buying Volatility: Call Back SpreadsBuying straddles and strangles creates unbiased long volatility positions. What we mean by unbiased is that the buyer doesn’t carewhether the underlying stock goes up or down, as long as it movessigniﬁcantly. But sometimes traders expect a stock to be very volatilebut also to have a bias.For example, a trader has been following the shares of SouthwestAirlines (LUV) and is expecting this stock to be very volatile overthe next few months. Her forecast is for “high volatility” (an unbiased forecast), but when asked if she believes there is a greater probability of the stock’s moving one way or another, her answer is“higher” (a biased forecast). If her expectations were purely bullish,she could simply purchase call options. But we are making a subtledistinction between two forecasts: “I’m bullish” and “I expect a lotof volatility, most probably to the upside.” To see the type of position the trader with the second outlook should consider, let’s ﬁrstlook at some option quotes:LUV:June 15 call:June 15 put:June 17 1⁄2 call:June 17 1⁄2 put:June 20 call:June 20 put:
$18.39$3.50–$3.80$0.20–$0.30$1.75– $1.85$0.75–$0.85$0.60–$0.65$2.05–$2.25
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Table 6.9LUV atExpiration
Value ofShort 15 Call
Value ofLong 17 1⁄2 Calls
InitialDebit
Proﬁt/(Loss)
$27.50
($12.50)
2 ⫻ $10.00
($0.20)
$7.30
$25
($10.00)
2 ⫻ $7.50
($0.20)
$4.80
$22.50
($7.50)
2 ⫻ $5.00
($0.20)
$2.30
$20
($5.00)
2 ⫻ $2.50
($0.20)
($0.20)
$17.50
($2.50)
$0
($0.20)
($2.70)
$15
$0
$0
($0.20)
($0.20)
$12.50
$0
$0
($0.20)
($0.20)
Our trader (with the biased forecast) could write one of the June15 calls and purchase two of the June 17 1⁄2 calls. Traders usually tryto establish this position for even money or for a small credit. Usingthe quotes above, buying two options at $1.85 and writing one at$3.50 would actually cost $0.20. She could enter the order for evenmoney and hope for a good ﬁll, but let’s stick with our $0.20 initialdebit.Writing a call when you are “mostly” bullish may appear counterintuitive. But this call is written to ﬁnance the purchase of twocalls, so our trader ends up net long one call. It is probably best tostart by looking at the position’s proﬁtability at option expiration,as is shown in Table 6.9.The strategy’s proﬁt and loss at expiration is illustrated in Figure 6.6.If our investor’s forecast of LUV being volatile to the upside iscorrect, she will effectively capture all of the stock’s rise once itreaches her breakeven point of $20.20. If her volatility forecast is correct but LUV heads south instead of rallying, she will show a verysmall loss, as long as LUV drops to or below $15. Her risk lies in arelatively ﬂat stock price (i.e., her expectation of high volatility notbeing realized), with the worst-case scenario having LUV tradingat $17.50 at option expiration. At this price, the two long calls areworthless and the short 15 call must be covered at $2.50, for a $2.70loss on the strategy (the initial $0.20 debit plus the $2.50 required torepurchase the short call).
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$8
Profit/(Loss)
$6$4$2$0($2)($4)$12.50
$15.00
$17.50
$20.00
$22.50
$25.00
$27.50
LUV Price at Expiration
Figure 6.6 LUV: Call Back Spread
Back spreads are sometimes referred to as pay later options, butthis is a bit of a misnomer. True, the initial debit can be very small(as in our example) or even nonexistent, but the position doesinclude a call credit spread that will have to be properly margined.The cash may not come out of the account until expiration, but brokerage ﬁrms want it ready and available.Comparison to Other StrategiesOur mostly bullish trader could have simply purchased a calloption. The 17 1⁄2 strike was offered at $1.85 and would have providedher with a lower upside breakeven ($19.15 versus $20.20 for the backspread), lower risk ($1.85 versus $2.70) if LUV is at $17.50 at expiration, but a larger loss ($1.85 versus $0.20) if LUV drops below $15.There is no need to create back spreads by writing one option andbuying two. A more bullish position could have been initiated bywriting the June 17 1⁄2 call at $1.75 and purchasing three of the June20 calls at $0.65, for an initial debit of $0.20. This position is morebullish because the upside breakeven has been raised to $21.35, butabove that price the value of the spread increases by $2 for every $1LUV rallies. You can also see how, by varying the ratio of optionsbought to options written, positions can be initiated for even money.For example, writing three of the June 17 1⁄2 calls and buying eight of
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Table 6.10Strike Price
30% Volatility
60% Volatility
$45
$5.60
$7.14
$50
$2.20
$4.27
$55
$0.61
$2.44
the 20s would generate a very small credit (premium received:$175 ⫻ 3 ⫽ $525; premium paid: $65 ⫻ 8 ⫽ $520).The Impact of VolatilityHow does higher volatility impact back spreads? Traders will naturally want to establish these types of positions on more volatilestocks, whose options typically trade with higher implied volatility. To ﬁnd out, we calculated selected theoretical option pricesunder two volatility assumptions, 30% and 60%, and present thesein Table 6.10.The values in this table assume a $50 stock price, a 4% risk-freeinterest rate, and no dividends. First, look at writing one 45 strikecall and purchasing two of the 50s. Under the 30% volatilityassumption this position could be established for a $1.20 credit, butunder the 60% volatility assumption there would be a $1.40 debit.So volatility does matter, and a call back spread’s breakeven pointwill rise as the options volatility increases. We can also test the 50–55back spread with a 30% volatility, where writing one of the 50 callsand buying two of the 55s generates a $0.98 credit. With the highervolatility a trader would have to pay $0.61 for the same 50–55 backspread.
Buying Volatility: Put Back SpreadsIf you have read the previous section, it will not come as a surprisethat a put back spread involves purchasing more puts than are written and that the strategy is used when high volatility is expected
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The Options Strategist
with a greater probability that the underlying stock will move lower.Some option prices on Intel (INTC) with which to start:INTC:May 27 1⁄2 put:May 30 put:May 32 1⁄2 put:
$30.03$0.75–$0.80$1.65–$1.70$3.10–$3.30
The more conservative of the two back spreads we will consider(and we deﬁne conservative as having the higher downsidebreakeven point) can be established by writing one of the May 32 1⁄2puts at $3.10 and purchasing two of the 30 puts at $1.70, for a netdebit of $0.30. Note that May options have approximately sevenweeks until they expire. Table 6.11 looks at the value and profitability of this back spread at option expiration.The proﬁt-and-loss numbers at expiration are illustrated in Figure 6.7.The put back spread looks like a mirror image of the call backspread: a move to the upside above $32.50 and all options expireworthless, leaving a small $0.30 loss. An unchanged stock priceresults in a $2.80 loss, the worst-case scenario. Below $27.20 proﬁtsaccrue on a dollar-for-dollar basis with the fall of the stock. Compare the 32 1⁄2–30 put back spread to the purchase of the 30 put at$1.70 and you ﬁnd that the back spread has a slightly higher risk
Table 6.11INTC atExpiration
Value ofShort 32 1⁄2 Put
Value ofLong 30 Puts
InitialDebit
Proﬁt/(Loss)
$35
$0
$0
($0.30)
($0.30)
$32.50
$0
$0
($0.30)
($0.30)
$30
($2.50)
$0
($0.30)
($2.80)
$27.50
($5.00)
2 ⫻ $2.50
($0.30)
($0.30)
$25
($7.50)
2 ⫻ $5.00
($0.30)
$2.20
$22.50
($10.00)
2 ⫻ $7.50
($0.30)
$4.70
$20
($12.50)
2 ⫻ $10.00
($0.30)
$7.20
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$8
Profit/(Loss)
$6$4$2$0($2)($4)$20.00
$22.50
$25.00
$27.50
$30.00
$32.50
$35.00
INTC Price at Expiration
Figure 6.7 INTC: Put Back Spread
($2.80 versus $1.70) and a lower breakeven point on the downside($27.20 versus $28.30), and it virtually breaks even if INTC ralliesabove $32.50 (a $0.30 loss versus a $1.70 loss on the long put). Thespread’s maximum loss is realized only if INTC is trading at $30 atexpiration (with the long put, the maximum loss is realized for anyINTC price below $30 at expiration). Another way to look at this isthat the long put loses $1.70 for any stock price below $30, while theback spread loses $1.70 or more (to a maximum of $2.80) if INTC istrading between $28.90 and $31.10 at expiration.Alternative SpreadsTwo other put back spreads can be created using the options we justquoted: a 30–27 1⁄2 spread and a 32 1⁄2–27 1⁄2 spread. Table 6.12 gives theessential statistics of these two plus those of the 30–27 1⁄2 spreaddescribed above.The ratios chosen are the ones that allow the position to be established for as close to even money as possible. (Another alternativeis to establish the 32 1⁄2–27 1⁄2 spread with a 1:3 ratio, for an initial creditof $0.70.) The initial credit or debit also represents the proﬁt or lossof the strategy if INTC rallies above the higher strike price of thetwo options. The risk is equal to the spread (the difference betweenthe two strikes) plus or minus the initial debit or credit. And themaximum loss is realized at the long option’s strike price.
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The Options Strategist
Table 6.1230–27 1⁄2Spread
32 1⁄2–30Spread
32 1⁄2–27 1⁄2Spread
Spread Ratio
1:2
1:2
1:4
Initial Credit (Debit)
$0.05
($0.30)
($0.10)
Downside Breakeven
$25.05
$27.20
$25.80
Risk
$2.45
$2.80
$5.10
Maximum Loss at
$27.50
$30
$27.50
The most aggressive of the three spreads presented is the 32 1⁄2–27 1⁄2,which has more than $5 of risk. Of course, if INTC drops below thisspread’s breakeven point, then the value of the spread increases by$3 for every $1 the stock falls. It is the higher risk–higher rewardspread of this trio.Only three put back spreads were possible in our example becausewe limited the number of INTC options we quoted. Actually, therewere many more strikes available. The number of possibilities canfeel overwhelming when you are considering establishing a backspread. To keep your trading as simple as possible, follow theseguidelines:■
Forget about options more than one strike away from the stock’sprice.
■
Start with the at-the-money option because you will probablywant to include it as one of your long or short positions.
■
The wider the spread or the higher the ratio of long to shortoptions, the riskier the position.
In-the-Money Short PutA last reminder: if a put back spread is established and the underlying stock moves down (the best-case scenario), the short put willbecome deeper and deeper in-the-money, and, as was pointed outearlier, short puts are prone to being assigned early. Early assignment would not hurt the proﬁtability of the strategy but may require
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a fair amount of cash relative to the capital being used for thespread. We would therefore advise monitoring closely all in-themoney puts and perhaps taking action when most of their time premium has disappeared.
Selling Volatility: Straddles and Front SpreadsIt is a tautology to claim that for every buyer there is a seller. But itis a useful reminder that for every “buyer” of a back spread there isa “seller” of a front spread. We now take a brief look at the latter.The constant in all back spreads is that the position is long moreoptions than it is short. This means that every short option is to acertain extent covered. The corollary is that in all front spreads therewill be a greater number of short options than long ones, leaving atleast some of the short options uncovered. This renders thesespreads very risky and inappropriate for most traders.Front spreads, whether constructed with puts or calls, are shortvolatility plays. This means that these positions will be proﬁtable aslong as the underlying stock remains within a narrow trading range.Before we look at front spreads, a quick sidebar on the purest of theshort volatility positions, short straddles.To illustrate, take Hind Quarter Stock (HQS) trading at exactly$25. A trader is convinced this stock is going nowhere over the next45 days and decides to write the 25 straddle, writing the 25 call for$2.10 and the 25 put for $1.90. The trader’s account is credited $4 forwriting the straddle. If HQS closes at exactly $25 on expiration Friday, both the call and the put will expire worthless and the traderwill have earned the full $4. But HQS is more likely to move awayfrom $25, either up or down, and the trader will have to cover eitherthe call or the put, depending on the direction the stock takes. Table6.13 summarizes the value of the short 25 straddle at expiration.The good news is that the straddle writer will see one of the twooptions expire worthless. The bad news is that he could be forcedto buy back the other option for more than the $4 initial credit,resulting in a loss. Potential losses are substantial to the downside(if HQS becomes worthless the 25 put would be worth $25, for a losson the strategy of $21) and theoretically unlimited to the upside(HQS could get taken over at $40, $45, or $75). The risk of the strat-
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Table 6.13HQS atExpiration
Value ofShort 25 Put
Value ofShort 25 Call
InitialCredit
Proﬁt/(Loss)
$33
$0
($8.00)
$4.00
($4.00)
$31
$0
($6.00)
$4.00
($2.00)
$29
$0
($4.00)
$4.00
$0
$27
$0
($2.00)
$4.00
$2.00
$25
$0
$0
$4.00
$4.00
$23
($2.00)
$0
$4.00
$2.00
$21
($4.00)
$0
$4.00
$0
$19
($6.00)
$0
$4.00
($2.00)
$17
($8.00)
$0
$4.00
($4.00)
Profit/(Loss)
egy makes it of little appeal to the average trader. Potential proﬁtand loss is illustrated in Figure 6.8.Back to our front spreads. Take a trader who has been followingExxon Mobil (XOM). He feels the stock is going nowhere over thenext month and a half but is unwilling to write a straddle becauseof the potential downside risk in the stock. In other words, ourtrader does not see XOM moving much, but if it does move, heexpects it to head south. With XOM trading at $43.41 he initiates a$5$4$3$2$1$0($1)($2)($3)($4)($5)$17
$19
$21
$23
$25
HQS Price at Expiration
Figure 6.8 Short HQS 25 Straddle
$27
$29
$31
$33
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Table 6.14XOM atExpiration
Value ofLong 40 Call
Value ofShort 42 1⁄2 Calls
InitialDebit
Proﬁt/(Loss)
$52.50
$12.50
2 ⫻ ($10.00)
($0.10)
($7.60)
$50
$10.00
2 ⫻ ($7.50)
($0.10)
($5.10)
$47.50
$7.50
2 ⫻ ($5.00)
($0.10)
($2.60)
$45
$5.00
2 ⫻ ($2.50)
($0.10)
($0.10)
$42.50
$2.50
$0
($0.10)
$2.40
$40
$0
$0
($0.10)
($0.10)
$37