ases.As shown in Figure 2.18, the put ratio spread has little or no riskto the upside. It makes its maximum profit at expiration if the underlying is near the strike of the written options, and it has theoreticallylarge downside risk if the underlying should plunge too far prior toexpiration.Similar theories apply to ratio put spreads as to ratio call spreads.It is generally best to establish the spread for no debit or a credit andnormally to initiate the position when the underlying is trading at aprice above the higher strike in the spread. Then, if the underlying
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Figure 2.18PUT RATIO SPREAD
declines, there may be a chance to remove it as it passes through thelower strike—the point of eventual maximum profitability.The main difference between ratio call spreads and ratio putspreads, especially for stock and index options, is that stocks tend tofall faster than they rise; so you may find yourself with something ofa “tiger by the tail” if a sudden downward move develops. Overall,though, this is also a reasonable approach to trading spreads.
Backspreads. Strategies in which you own more options thanyou sell, and that therefore have theoretically large or unlimitedprofit potential, are known as backspreads. In essence, they are justthe opposite of ratio call spreads or ratio put spreads. In a largersense, however, any strategy with unlimited profit potential and limited risk is called a backspread by some traders. In this broader definition, even a long straddle would be considered a backspread. For thepurposes of this discussion, we are just going to concentrate on thebackspread strategy that is the opposite of the ratio spreadsdescribed earlier.
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AN OVERVIEW OF OPTION STRATEGIESFigure 2.19CALL BACKSPREAD
Let’s start with a call backspread. In this situation, we sell a callwith a lower striking price and buy more calls at a higher strikingprice. Thus, we have extra long calls in this position, and that provides us with unlimited profit potential (see Figure 2.19). Moreover, ifthe entire position was established for a credit, we have profit potential on the downside as well. If the underlying were to collapse and allthe calls expired worthless, then we would keep the initial credit asour profit. The risk occurs near the higher striking price in thespread. The worst result occurs if the underlying is exactly at thehigher strike at expiration. Thus, the entire profit picture looks something like a long straddle, with the downside profit flattening off atprices lower than the lower strike.Normally, a call backspread is established when the underlying issomewhere in the near vicinity of the upper strike. When establishedin this manner, the strategist is looking for the underlying to make amove in either direction in order to give him some profitability.Another factor that experienced backspreaders look for when theyestablish these types of spreads is cheapness in the options. If theoptions are somewhat “underpriced,” then there is an additional pos-
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sibility that the preponderance of long calls in the spread will benefitfrom an increase in overall premium levels if, in the future, theoptions become more expensive. Moreover, if by some good fortunethe options being sold were relatively expensive in comparison tothose being bought, then the spread has another built-in edge to it.All of these factors came into play in what turned out to be one of the bestbackspreading opportunities of all time: the big upward move in the marketfrom December of 1994 through all of 1995. That rally began with theOEX Index at a level of about 420 in December of 1994. By February, ithad already reached 450, and many market seers were predicting a topafter such an extensive run. Conversely, many bulls were predicting evenhigher prices because of the improving economy and the lack of inflation.Both arguments seemed to make some sense, so there appeared to be thepossibility for a large move in either direction. This satisfied the first criterion in deciding when to use backspreads—that the underlying has the ability to move by a good deal in either direction.Second, OEX options had become rather inexpensive, which is typicalof index options’ action in a bullish trend. So, with the options being cheap,backspreads were a good strategy because, if the options eventually becamemore expensive at a later date, the preponderance of long options in thebackspread would benefit. Third, out-of-the-money OEX calls were selling atmuch cheaper relative prices than their in-the-money call counterparts. Soall three of the main criteria for establishing a backspread were in place inthe late winter of 1994–1995.Backspreads established at that time became wildly profitable as OEXroared its way to levels above 600. Even traders who kept their backspreadsneutral, by rolling the long calls to successively higher strikes as OEX rose inprice, managed to make very large returns—all of this while continuing toremain in a position to benefit from a market drop if one had occurred. Weexamine this strategy thoroughly in Chapter 6.
This last point—that the backspread trader was always in position to benefit from an unforeseen market drop (or even a crash)—iswhat, in my opinion, makes the backspread strategy superior to thelong straddle strategy. For in the backspread, you merely have tokeep rolling your long calls up to higher strikes if the market rises.Your short calls remain where they were and provide downside profitpotential if the downward move ever comes. However, with a long
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straddle, if you merely roll your long calls up to higher strikes after arally, you’ve done nothing for your downside profit because the putsthat you own will then be quite far out-of-the-money. To gain downside potential, you would have to roll the puts to higher strikes aswell. In essence, you have to move the entire straddle to a higherstrike. The backspread trader has a much easier time adjusting andkeeping neutral during a long rally.Put Backspreads. Put backspreads are just the opposite of putratio spreads: you sell a put with a higher strike price and simultaneously buy a larger number of puts with a lower strike price. The position is normally established for a credit, with the underlying tradingnear the lower striking price.The resultant position has profitability, as shown in Figure 2.20.There is limited upside profit potential, equal to the amount ofthe initial credit taken in when the spread is established. Downsideprofit potential is quite large, due to the excess long puts in the
Figure 2.20PUT BACKSPREAD
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spread. The maximum risk occurs at the striking price of the longputs at expiration.The ideal situation for put backspreads is to find cases where theputs with higher strikes (the ones you are going to sell) are relativelymore expensive than puts with lower strikes (the ones you are goingto buy). This would be the case in grain futures options and metals(gold and silver) futures options at almost any time. Thus, one of thebest ways to play for a downward move in those markets—if you areinterested in a limited-risk strategy that can also make money if youare wrong and prices rise—is with a put backspread.
More Complex ConstructionsObviously, other strategies can be constructed by combining thestrategies discussed in this chapter or by modifying them. For example, the butterfly spread is a strategy that is the combination of botha bull spread and a bear spread, where both are credit spreads. Sucha strategy is also the same as selling a straddle and protecting yourrisk by buying both an out-of-the-money call and an out-of-themoney put. The butterfly spread has profitability as shown in Figure2.21. There are actually several ways to establish a butterfly spread; inaddition to the two ways just mentioned, it can be established with allcalls or with all puts (using three different strikes in either case). Manytraders who protect their naked straddles with out-of-the-moneyoptions are using the butterfly spread, although they may not necessarily call it by that name. Incidentally, if you sell a naked combination,or strangle (different strikes for the put and the call), and then protectthat position with out-of-the-money options, your position involvesfour striking prices and is sometimes known as a condor.It has become fashionable for underwriters and exchanges to create securities that are actually one of these option strategies and tothen sell the security as a single unit to investors. For example, someof the larger investment banking houses created a security calledPERCS (Preferred Equity Redemption Cumulative Stock). A PERCSis a preferred stock. These are issues on some of the largest corporations—General Motors, for example. A PERCS has a fixed life,such as three years. During that time, it yields far more than the
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AN OVERVIEW OF OPTION STRATEGIESFigure 2.21BUTTERFLY SPREAD
underlying stock does. At the end of three years (or whatever timeperiod is specified when the PERCS is initially issued), the PERCSbecomes shares of the underlying stock itself, with one exception: ifthe underlying has risen too far, then the value of the PERCS is limited to a fixed price. If the underlying is above that price, then thePERCS holder receives cash for his preferred shares at the end of thethree years, rather than receiving shares of the underlying stock.What you really have here is the equivalent of a covered write ofa three-year option, but it’s not sold that way, nor is the word optionever mentioned when PERCS are sold. Consider the premiumreceived from writing a covered call that is a three-year, out-of-themoney option; it would be rather large. Suppose that the premium isdistributed to the stockholder in quarterly amounts over the threeyear period. Then, it would appear to the stockholder as if he werereceiving an extra dividend. Furthermore, if the option expiresworthless at the end of three years, then what is left is commonstock. On the other hand, if the underlying climbs in price and risesabove the striking price of the written call, then at the end of threeyears, the investor would be called out of his stock and he wouldreceive cash. These qualities exactly describe the PERCS.
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Other securities have been listed that resemble covered writing orother option strategies, and more of these securities are being listedall the time. Most are similar to PERCS but have names like ELKS(Equity-Linked Securities) or SUNS (Stock Upside Note Securities).Moreover, there are securities called structured products that areguaranteed to return a specific amount, while allowing for the possibility of appreciation if the stock market rises during that time. Thesesecurities are the equivalent of taking some money and buying azero-coupon bond with part of it, so that you are guaranteed returnof principal, and then buying an option with the balance so you havesubstantial upside potential.One of the earliest publicly traded structured products was a Stock IndexSecurities, traded under the symbol SIS on the AMEX. It was based on thevalue of the Midcap 400 Index (symbol: MID). The SIS value at expirationwas calculated by the following formula:Cash Value = 10 + 11.5 × (MID/166.10 – 1)At a minimum, the security was to be worth $10 at maturity on6/20/2000 (it was issued on 6/20/1993). However, if MID were abovethe strike of 166.10 at maturity, then the holder was entitled to the $10plus 1.15 times the percentage appreciation of the MID Index above thestrike of 166.10.The SIS securities were issued by PaineWebber; so, in effect, they weredebt of PaineWebber Corporation. So if PaineWebber were to be insolventon the maturity date, the “guaranteed” portion of the security would havebeen in jeopardy (in reality, PaineWebber had actually been acquired by thematurity date—and thus was quite solvent). Due partially to the potential forinsolvency and the fact that the Internal Revenue Service (IRS) taxes thesesecurities as a zero-coupon bond (making holders pay taxes annually on their“discount” at which they bought it, if any), the SIS stock traded at sometimesextreme discounts to the cash value formula for several years. This is somewhat akin to a closed-end mutual fund trading below net asset value.For example, with MID trading at 185 in early 1995, SIS was selling for$9 per share. The cash settlement value of SIS, with MID at 185, was11.31 (10 + 11.5 × (185/166.1 – 1)). Thus, you could have bought thestock at 9 when it, in essence, had a net asset value of 11.31. Even with atax consideration, this was a very attractive discount. Any closed-end mutualfund trading with that type of discount and having the quality of securities of
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the Midcap 400 would certainly be considered an attractive buy by manyinvestors.As the market rallied throughout the life of the SIS security, MID rose to505.59 by 6/20/2000. Thus, SIS matured at a cash value of 33.50. Owners of the SIS security thus saw them removed from their accounts andreplaced by $33.50 of cash per share.
There are other securities like the one just described. You canobtain their terms by visiting the web site of the appropriateexchange where they are traded—the American Stock Exchange,the New York Stock Exchange, or the Chicago Board OptionsExchange (CBOE—yes, the CBOE does trade some stocks, particularly structured products such as these).
Using an Option ModelEven the most experienced option traders check an option’s theoretical value with a model before making a transaction. Thus, it shouldbe even more mandatory for an inexperienced option trader to dothe same. Without getting into the technical aspects of option modeling—the subject is discussed in Appendix C—traders should knowthat there are relatively easy and inexpensive ways to gain access toan option model.There are six things required in order for an option’s theoreticalvalue to be calculated: the stock price, the strike price, the expirationdate, the short-term interest rate, the volatility of the underlying security, and the amount of the dividend (if there is one). These items canbe either typed in by the user or supplied from a larger computersomewhere.A scientific calculator, such as the better ones manufactured byTexas Instruments or Hewlett-Packard, are quite capable of calculating option theoretical values. You can buy the program that performs the calculations. Obviously, you have to enter the data itemsby hand if you choose this method.Computers, of course, are a better alternative for evaluatingoptions. Simple option calculation programs that calculate theimplied volatility or theoretical value can be bought for $100 or less.
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The user is generally required to input the underlying price, the strikeprice, the expiration date, and so on. If implied volatility is desired,then the user has to type in the price of the option in question, andthe program will return implied volatility as an output.More expensive calculation programs are available, and these aregenerally tied to a data source so that you don’t have to enter anything other than the trading symbol of the underlying security. Notonly are these types of programs more expensive to buy, but youmust also pay for the data that is automatically being fed into them.All of these approaches are valid, depending on your needs, andthey are discussed in more detail in Chapter 7. Just make sure thatyou do indeed have access to a model and that you use it before making trades. Then you will know whether the option you are trading isexpensive or cheap. We are not saying that you must only buy“cheap” options; we are saying that you should know if the optionyou are buying is cheap or not. If it’s expensive, that’s okay, but youare at least aware that you are buying an option that might lose valueif implied volatility decreases, even though the underlying securityrises slightly in price.
SUMMARYThe broad overviews of the various strategies expressed in this chapter should be enough of a foundation for understanding the materialin later chapters. As explained in the Preface to this book, it was notour intention to detail the explicit calculations of break-even pointsand explain follow-up actions for these basic strategies.
3
The VersatileOption
In this chapter and in the two succeeding chapters, we are going toaddress the use of options in ways that don’t require much in the wayof theoretical evaluation of options (we are always in favor of anoption trader using a model to evaluate an option before buying orselling it). These techniques, strategies, and trading methods are veryuseful and can be extremely profitable. It’s just that they aren’t somathematical; they are of a more practical variety and, as such, mayappeal to a broader audience of traders and short-term investors.
OPTIONS AS A DIRECTSUBSTITUTE FOR THEUNDERLYINGOptions can be useful in a number of ways—ways that go beyond thebasic profit and loss of predefined strategies. Some of them dependon an understanding of basic equivalent positions. For example, inthis segment we show you how to avoid ever having to worry aboutlimit moves in futures contracts ever again. We also discuss ways inwhich using options can actually make your use of capital more efficient than merely trading stock.Recall that two positions are equivalent if they have the sameprofitability, that is, their profit graphs have the same shape. One ofthe most important equivalences is the following: a long position inthe underlying security is equivalent to being both long a call andshort a put with the same terms. Conceptually, you can see that thelong call gives you unlimited upside profit potential (just as being long
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the stock does), while being short the put gives you large downsiderisk (again, just as owning the stock would). An example may help toclarify this statement.Example: With Microsoft trading at 92, in July 1995, the Aug 90 call wastrading at 6 while the Aug 90 put was trading at 4. An option position thatis equivalent to owning the common stock can be constructed by buying theAug 90 call for 6 and selling the Aug 90 put at 4. We can verify this with aprofit table.
Stock Price atAugust Expiration
Profit onLong Stock($)
Profit onLong Call($)
Profit onShort Put($)
TotalOptionProfit($)
708090100110
–2,200–1,200–200+800+1,800
–600–600–600+400+1,400
–1,600–600+400+400+400
–2,200–1,200–200+800+1,800
Note that the totals in the second column (Profit on Long Stock) andthe last column (Total Option Profit) are the same. This means that theoption position and a long stock position are equivalent.
This is an important concept that should be routinely understoodand used by all traders. First of all, it allows you to use options insteadof the underlying. Using the Microsoft stock as an example again,note that if you bought 100 shares for cash, you would have to invest$9,200 plus a stock commission. However, the collateral requirement for the option position is this: first, the call option has to bepaid for ($600), and then the naked put must be collateralized. Therequirement for the naked put is 20 percent of the stock’s price plusthe put premium, less the out-of-the-money amount. So the nakedput requires $1,840 (20 percent of $9,200), plus $400 (the price ofthe put), less $200 (the two points that the put is out-of-the-money),for a total collateral requirement of $2,040 for the naked put. Thenet collateral requirement for the option position is thus:
OPTIONS AS A DIRECT SUBSTITUTE FOR THE UNDERLYINGPositionLong CallNaked PutPut PremiumTotal
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Requirement$ 600+2,040–400_______$2,240
Therefore, one can have nearly the same profitability as a stocktrader for a much smaller collateral requirement. In the precedingMicrosoft example, the profit was exactly the same whether youbought the stock or used the option strategy. However, if you look atmost option prices, the option strategy will not generally haveexactly the same profit and loss potential as the underlying stock,although it will be quite close. There are two reasons for this usuallysmall differential: dividends and interest rates.The stockholder receives the dividend (if there is one), while theoption trader does not. The option trader can partially offset the lossof dividend if he uses U.S. Treasury bills (T-bills) as collateral for theposition, since he can earn interest on the $2,000 or so of collateralwhile the position is in place.The stock trader is tying up a lot more money. If the optiontrader invests the difference between the full cost of buying the stockand the collateral he needs for the option position—about $7,000 inthe previous example—in certificates of deposit or in T-bills, he willearn a substantial amount of interest. Without going into detailed calculations to prove it, we state that the difference in the profitability ofowning the stock or being in the option position can be offset byinvesting the $7,000 in short-term, interest-bearing instruments untilthe options’ expiration date.There is one other material comparison: the option trader isdealing with two bid–asked spreads and must pay two commissionsto enter the position. The stock trader only has to be concerned withone of each of those items. In these days of discount commissions,the bid–asked spread is the more important consideration of the twoand can be a serious one. Especially if you’re dealing with relativelyilliquid, or thinly traded, options, you may find that the option position becomes much more expensive than is necessary. In a situationsuch as this, it’s often a good idea to use an option model to check
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what the theoretical difference between the call and the put priceshould be. Then you have some idea as to how to enter the order. Acontinuation of the same example illustrates this concept.Example: Again assume that Microsoft is at 92, but this time you’re interested in using the Oct 90 puts and calls in order to establish an option position that is equivalent to a long put position. The actual prices of theOctober options (in July) were:Option
Bid–Offer
Oct 90 callOct 90 put
9.00–9.506.00–6.50
Since there is a half point spread on each option, you might be in danger of “overpaying” for the option position if you merely buy the call andsell the put with a market order. At the market, buying the call and sellingthe put would cost a debit of 3.50 points (9.50 minus 6.00).Here’s where using an option model comes in handy. If we input 92 asthe stock price, 90 as the striking price, October as the expiration date,and the current T-bill interest rate (it makes no difference what volatility weuse), the model will tell us that with the stock at 92, the call should sell for3.27 more than the put. So, one might enter an option order as a spread:“Buy the Oct 90 call and sell the Oct 90 put for a debit of 3.30 points.”Using the model in this way would prevent overpaying for the position(recall that it costs 3.50 at the “market” prices).If the price of the underlying changes, the prices of the put and the callwould change in a relative manner also. For example, with Microsoft at 91,the call should then sell for 2.27 more than the put. The model is useful inshowing you this information also. So, if you don’t receive an executionright away and then Microsoft changes in price, you’ll know how to adjustyour option order as well.
Equivalent Short StockSimilarly, a short position in the underlying security is equivalentto being both long a put and short a call with the same terms.There are more benefits to the option equivalent position, whencomparing it to a short sale of stock, than there were for long stock.
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First, you’re able to benefit from the reduced collateral requirements—you can “equivalently” short stock on just over 20 percentmargin, as opposed to the 50 percent required for shorting theactual stock itself. This benefit is quite similar to the same one forlong stock.When shorting stock, an uptick is required in order to establishthe position, in both listed and Nasdaq stocks. However, an uptick isnot required to enter into the option position, so it is easier to establish an “equivalent” short sale in a down market. This is especiallyuseful in situations where a stock is breaking down quickly. This mayinvolve a stock that has broken down through a major support level,or it may involve a lot of stocks when the market goes into one of itsfamous nosedives. With the option equivalent strategy, you canalways get “short” (or the equivalent thereof) right away. You mayhave to use market orders, which give up something in terms ofprice, but at least you can get the basic position established.The final benefit for the option position as compared to a shortsale is that you don’t have to actually borrow the stock to enter intothe option position; again, a time-saving and convenient benefit ofthe option position. It can sometimes take a long time to find stockto borrow, or your broker may not be able to find the stock at all.With the option equivalent strategy, you don’t really need to worryabout whether the stock is borrowable or not, with the exceptionpointed out in the next paragraph.There is one possible complication with the equivalent short position: it should be noted, that if the stock is truly difficult to borrow,then you must be careful how you apply the option strategy. You maynot be able to sell in-the-money calls as part of your strategy. Thisproblem can be avoided by using a higher striking price—if oneexists—so that the put is in-the-money and not the call. In the case of“unborrowable” stock, in-the-money calls may be so cheap that youwould have to sell them at or below parity; if that happened, youmight receive an early (perhaps immediate) assignment notice—thereby making you short the stock, which you could not fulfill sinceyou can’t find the stock to borrow. Your broker would then buy you inat the market and probably wouldn’t be too happy with you, either.Your account might even be restricted if he feels you intentionallysold in-the-money calls on a stock that was clearly not borrowable.
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Whenever a partial tender offer for stock is pending, there is a very highprobability that all existing in-the-money calls will be assigned early. This situation has occurred many times over the years since listed options begantrading, but there is always a story of someone who thinks he can make freemoney. He can’t, and he sometimes learns an expensive lesson.Suppose that a partial tender for half of a company is in progress:$100 per share will be paid for 50 percent of the stock. The stock is tradingat 80, though, because the remainder of the company is expected to tradeat a price of 60 in the open market when the partial tender is completed.Thus, the stock will drop in price by $20 after the tender date is past.A quick $20 could be made by any trader who shorted the stock. However, this stock cannot be borrowed because all stockholders want theirshares in hand so they can tender them and receive $100 a share for half ofthem. So a trader cannot short it.In-the-money calls on this stock will be selling at parity—for example, aFeb 60 call would be selling at 20 (the stock is at 80, so this is parity). Invariably, some fairly novice option trader, who knows that the stock will dropbut can’t find any stock to borrow, sells the Feb 60 call for 20 points, as anopening transaction. He can do this because one does not have to borrowan option in order to sell it short. He figures he will cover the option afterthe stock drops to 60 and make a fortune.What really happens is that the call is exercised by the person whobought it (that person buys stock in this manner and tenders the stock toreceive the partial tender price). This exercise results in the novice optiontrader being assigned on his short call. He normally doesn’t find out aboutthis until the day after the tender is over; that is, the stock is all set to begintrading at 60 when he receives the assignment notice. So, he quicklybecomes short stock; and since the stock can’t be borrowed, his brokeragefirm will not be happy. First, they will buy him in. But it won’t be just a normal buy in the open market at 60. In fact, they will buy him in for cashbecause the stock is owed to someone who has already tendered and needsthe stock immediately. The cash market price is going to be somethinghigher than 80, so the novice trader ends up with a loss on the trade andperhaps restrictions on his trading account.
The point is that you can expect to be assigned on any call thatis sold below parity. The call is trading there for a reason—whetherthat be an impending tender offer, an impending dividend, or theapproach of expiration. If you sell a call at or below parity, you
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should be prepared to be short the stock by assignment in a veryshort time, probably as soon as the next day. If you have reason toexpect that the stock is not borrowable, then don’t sell an in-themoney call trading near parity, for you will only create problems foryourself.
Single Stock FuturesOne viable use of single stock futures is to replace the optionoriented strategies described in the previous pages. Selling singlestock futures, for example, is a lot simpler way to short a stock thanis buying a put and selling a call. First of all, there is only one set ofbid–asked spreads to deal with and one commission where the singlestock futures are concerned. Conversely, someone looking to buystock on margin—or perhaps thinking of buying an option becauseof the leverage involved—might choose to buy single stock futures.Single stock futures owners are not entitled to a stock’s dividend.So single stock futures will trade at a discount to the actual stockprice if a large dividend is involved. But they will trade at a premiumotherwise, and that premium is related to short-term interest rates. Infact, the net effect is that the futures contract will trade with the samepremium as the equivalent stock position using options will—asshown in the previous Microsoft example.The most important thing that a trader must understand aboutsingle stock futures is that they have tremendous leverage. Only 20percent of the stock price is required as initial margin. So, for example, if IBM is trading at 90 and a trader buys a single stock future onIBM, his initial margin would be $1,800 (20 percent of $9,000).Since the single stock futures are worth $100 per point of movement, his margin would be wiped out if IBM fell to 72, that is, if itdeclined by 18 points or 20 percent. Moreover, if some unforeseencircumstance should occur and IBM should fall by more than 18points, then the single stock futures trader would lose more than 100percent of his initial investment. Short sellers face similar peril if astock should rise by more than 20 percent.Even so, when one wants a derivative to mimic stock price movements, nothing serves the purpose better than a single stock futures
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contract, as long as one is willing to assume the risk that such leverage entails.
Defending against a Limit Movein Futures ContractsAll futures contracts are limited in the amount by which their pricecan change in any one day. The exchange where the future is tradeddetermines the size of that daily limit.