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• XYZ  rises  above  the  upside  breakeven: Similar  to  the  lowerbreakeven, you should exit the trade to make sure you are not as-signed  the  call  side  of  your  position.  The  put  options  can  expireworthless.
Calendar Spread Road Map
In order to place a calendar spread, the following 14 guidelines should beobserved:
1. Look  for  a  market  that  has  been  range-trading  for  at  least  threemonths and is expected to remain within a range for an extended pe-riod of time. A dramatic move by the underlying shares in either direc-tion could unbalance the spread, causing it to widen.
2. Check to see if this stock has options available.3. Review options premiums per expiration dates and strike prices.4. Investigate  implied  volatility  to  look  for  a  time  volatility  skewwhere  short-term  options  have  a  higher  volatility  (causing  you  toreceive  higher  premiums)  than  the  longer-term  options  (the  onesyou will purchase).
5. Explore past price trends and liquidity by reviewing price and volume
charts over the past year.
6. A calendar spread can be bullish or bearish in bias.
• A slightly bullish calendar spread employs an ATM long call witha distant expiration date and an ATM short call with a closer expi-ration date.
• A  slightly  bearish  calendar  spread combines  an  ATM  long  putwith a distant expiration date and an ATM short put with a closerexpiration date.
7. Look at a variety of options with at least 90 days until expiration for
the long option and less than 45 days for the short option.8. Determine the best possible spread to place by calculating:
• Limited  Risk: Limited  to  the  net  debit  when  the  position  isplaced. If you replay the long leg, then your limited risk contin-ues to decrease because you take in additional credit for replay-ing this strategy.
• Limited  Reward: Use  options  software  for  calculation.  The  re-ward  is  limited  but  the  exact  maximum  potential  varies  based  on
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several  factors  including  volatility,  expiration  months,  and  stockprices.
• Breakevens: Since this is a more complex trade you must have anoptions  software  package  available  to  calculate  your  maximumrisk, breakevens, and your return on investment. The Platinum siteat Optionetics.com provides this service.
9. Create  a  risk  proﬁle  of  the  most  promising  option  combination  andgraphically  determine  the  trade’s  feasibility.  A  calendar  spread  haslimited  risk  and  limited  reward.  Since  it  is  a  complicated  strategy,  acomputerized  risk  graph  is  necessary  to  determine  the  needed  vari-ables of maximum proﬁt and breakevens.
10. Write the trade in your trader’s journal before placing the trade withyour  broker  to  minimize  mistakes  made  in  placing  the  order  and  tokeep a record of the trade.
11. Make an exit plan before establishing a calendar spread. If the stockmakes a dramatic move in the wrong direction, consider cutting yourlosses rather than hoping for a turnaround. If the stock goes throughthe short option’s strike price sooner than expected, close the trade toavoid assignment. Ideally, the stock will make a gradual move in theappropriate direction and the short option will expire worthless. Thenanother short option can be sold against the long option or the tradecan be closed for a proﬁt.
12. Contact  your  broker  to  buy  and  sell  the  chosen  options.  Place  thetrade as a limit order so that you limit the net debit of the trade.13. Watch the market closely as it ﬂuctuates. The proﬁt on this strategy islimited—a loss occurs if the underlying stock makes a dramatic movehigher or lower.
14. Choose an exit strategy based on the price movement of the underly-ing stock and the effects of changes in implied volatility on the pricesof the options.
For a bearish calendar spread:
• The  underlying  stock  falls  sharply  to  the  downside: Bothputs would increase in value one-for-one so they would offset eachother. The most you would lose is the net debit.
• The  underlying  stock  stays  within  a  trading  range: If  theshares  fall  within  the  desired  range,  you  will  make  a  proﬁt.  Thelargest proﬁt potential occurs if the shares expire at the ATM strikeprice. You can then sell another short-term put option.
• The underlying stock makes a signiﬁcant move higher: Bothputs would expire worthless and you would lose the premium paid.
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For a bullish calendar spread:
• The underlying stock makes a signiﬁcant move to the down-side: You are in the maximum risk range. Exit the position for theloss on the short call and hold the long call in case of a reversal.• The  underlying  stock  stays  within  the  desired  tradingrange: If the stock falls within a range as expected, you will makea  proﬁt.  The  largest  proﬁt  potential  occurs  if  the  shares  expire  atthe ATM strike price.
• The underlying stock rises above the desired trading range:Your short call is in-the-money and possibly subject to assignment.Close the trade by purchasing the short-term call.
Diagonal Spread Road Map
In order to place a diagonal spread, the following 14 guidelines should beobserved:
1. Look for a market that has been range-bound for at least three monthsand is expected to remain within a range or move modestly higher orlower over an extended period of time. A dramatic move by the un-derlying shares in either direction could unbalance the spread, caus-ing it to widen.
2. Check to see whether this stock has options available.3. Review the option premiums for different expiration dates and strike
prices.
4. Investigate  implied  volatility  to  look  for  short-term  options  with  ahigher  volatility  (causing  you  to  receive  higher  premiums)  than  thelonger-term options (the ones you will purchase). Unlike the calendarspread, look for different strike prices between the long-term optionand the short-term option.
5. Explore past price trends and liquidity by reviewing price and volume
charts over the past year.
6. A diagonal spread can be bullish or bearish in bias.
• A bullish diagonal spread employs a long call with a distant expi-ration and a lower strike price, along with a short call with a closerexpiration date and higher strike price.
• A bearish diagonal spread combines a long put with a distant ex-piration date and a higher strike price along with a short put with acloser expiration date and lower strike price.
7. Look at a variety of options with at least 90 days until expiration for
the long option and less than 45 days for the short option.
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8. Determine the best possible spread to place. To do this, look at:
• Limited Risk: Limited to the net debit when the position is placed.If you sell more than one short option then your limited risk contin-ues to decrease because you take in additional credit for replayingthis strategy.
• Limited Reward: Use software for calculation. The reward is lim-ited but the exact maximum potential varies based on several fac-tors including volatility, expiration months, and stock price.
• Breakevens  and  Return  on  Investment: Since  this  is  a  morecomplex trade you should have a software package available to cal-culate your maximum risk, breakevens, and return on investment.The Platinum site at Optionetics.com provides this service.
9. Create  a  risk  proﬁle  of  the  most  promising  option  combination  andgraphically  determine  the  trade’s  feasibility.  A  diagonal  spread  (seeFigure 10.8) has limited risk and limited reward. It is a more compli-cated strategy, so a computerized risk graph is required to determinethe maximum proﬁt and breakevens.
10. Write the trade in your trader’s journal before placing the trade withyour  broker  to  minimize  mistakes  made  in  placing  the  order  and  tokeep a record of the trade.
11. In most cases, the srategist wants to see the underlying asset make agradual move higher or lower when using the diagonal spread. If thestock makes a dramatic move in the wrong direction, consider cuttinglosses rather than hoping for a reversal. If the stock goes through theshort  option’s  strike  price  sooner  than  expected,  close  the  trade  toavoid assignment. Ideally, the stock will make a gradual move in theappropriate direction and another short option can be sold against thelong option or the trade can be closed at a proﬁt.
12. Contact  your  broker  to  buy  and  sell  the  chosen  options.  Place  thetrade as a limit order so that you limit the net debit of the trade.13. Watch the market closely as it ﬂuctuates. The proﬁt on this strategy islimited—a loss occurs if the underlying stock moves too far in onedirection or the other.
14. Choose an exit strategy based on the price movement of the underly-ing stock and the effects of changes in implied volatility on the pricesof the options.
For a bearish diagonal spread:
• The underlying stock falls below the lower strike: Both putswill  increase  in  value  and  offset  each  other.  The  most  you  wouldlose is the premium. Avoid assignment by closing the trade.
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• The underlying stock falls between the two strike prices: Ifthe shares fall within this range, you will make a proﬁt. The largestproﬁt occurs if the shares fall to the lower strike price (but not be-low) and the short put expires worthless. At that point, the long putwill still have intrinsic and time value. Close the position, or sell an-other short-term put. Check the implied volatility ﬁrst.
• The  underlying  stock  rises  above  the  higher  strike: Bothputs could expire worthless and you would lose the premium paid.
For a bullish diagonal spread:
• The underlying stock falls below the short strike: You are in
the maximum risk range. Exit the position for the loss.
• The underlying stock falls between the two strike prices:If the shares trade at the higher of the two strikes at expiration,then the maximum proﬁt is attained. In that case, the long call re-tains most of its value, but the short-term option expires worth-less. At that point, the position should be closed or another callcan be sold.
• The underlying stock rises above the higher strike: You areat risk of assignment on the short call. Close the trade for a loss.
Collar Spread Road Map
In order to place a collar spread, the following 13 guidelines should beobserved:
1. A collar is utilized to protect a stock holding against market declinesfor a speciﬁc period of time and still participate in a modest increasein the stock price.
2. Check to see if this stock has options.3. Review  out-of-the-money  LEAPS  call  and  at-the-money  LEAPS  put
premiums at various strike prices.
4. Explore past price trends and liquidity by reviewing price and volume
charts over the past year.
5. Investigate  implied  volatility  values  to  see  if  the  options  are  over-
priced or undervalued.
6. This strategy is created by purchasing an ATM put and selling an OTMcall against 100 shares of stock. The idea is to provide protection forthe  long  shares  and  to  offset  the  cost  of  the  put  with  the  premiumfrom the short call.
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7. Determine the best possible trade to place. To do this, calculate the
following:
• Limited  Risk: [(Initial  stock  price  –  put  strike  price)  +  net  debit
(or – net credit)] (cid:2) 100.
• Limited Proﬁt: [(Call strike price – initial stock price) – net debit
(or + net credit)] (cid:2) 100.
• Breakeven: Initial stock price + [(put premium – call premium) ÷
total number of shares (100)].
8. Risk is limited to the downside by the long put. Upside reward is alsolimited by the short call. Create a risk proﬁle for the trade to graphi-cally determine the trade’s feasibility.
9. Write down the trade in your trader’s journal before placing the tradewith your broker to minimize mistakes made in placing the order andto keep a record of the trade.
10. The collar is known as a vacation trade. It is designed to provide low-cost protection when the strategist expects a gradual move in the un-derlying  asset.  If  the  stock  trades  sideways,  do  nothing  and  let  theoptions  expire  or  roll  out  to  a  more  distant  expiration  month.  If  thestock makes a considerable move lower and is trading below the putstrike price at expiration, exercise the put option and sell the stock atthe strike price. If it makes a sharp move higher, do nothing and the calloption will be assigned. To avoid assignment, buy back the call to close.11. Contact your broker to buy the put and sell the call. Choose the most
appropriate type of order (market order, limit order, etc.).
12. Watch the market closely as it ﬂuctuates. The proﬁt and loss on this
strategy is limited.
13. Choose an exit strategy based on price movement of the underlyingstock and the effects of changes in implied volatility on option prices.
• The  underlying  stock  falls  below  the  put  strike  price: Donothing. The shares are covered by the long put. If you exercise theput  and  sell  the  stock,  also  sell  the  call  to  close  because  it  is  nolonger  covered  once  the  stock  is  sold.  If  you  hold  the  short  callwithout owning the stock, you are naked a call and are exposed tounlimited risk to the upside.
• The underlying stock rises above the short call strike price:Do nothing. If the calls are assigned to an option holder, when exer-cised the shares will have to be delivered to the option holder to ful-ﬁll the obligation that comes with the short call. Hold the put and letit expire worthless or try to sell it for any remaining value.
• The  underlying  stock  closes  at  the  initial  stock  price: Calland put expire worthless. Sell the stock or create a new collar.
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CONCLUSION
When trading stocks, we can proﬁt in two kinds of markets: when stocksmove up or when they move down. However, with options, we can alsoproﬁt in sideways-trading markets that occur quite often. This chapter in-troduced  an  array  of  innovative  strategies  that  are  designed  to  proﬁt  insideways  markets,  which  are  more  common  than  one  might  think.  Justtake a look at a long-term chart of a stock or index and notice how manytimes they see little net movement over time. Instead of sitting out duringtimes of consolidation, you may want to look at sideways-trading strate-gies like calendar and diagonal spreads, butterﬂies and condors, and col-lars.  These  strategies  take  advantage  of  sideways  trading  in  differentways, with each having its place.
Regardless  of  the  market  environment,  there  are  always  numerousstocks  trading  in  a  channel.  These  are  quickly  recognized  when  viewingcharts,  as  they  have  distinct  support  and  resistance  points.  We  can  alsouse ascending or descending channels by extrapolating where the stockwill be by expiration.
However,  we  have  a  dilemma  when  looking  for  good  butterﬂy  andcondor candidates. This dilemma develops because we want high IV to geta better entry price, but IV is normally low on stocks in a trading range.However, when a stock is making numerous sharp moves within its chan-nel, we can get a high IV reading even though a trading range has devel-oped. A drop in IV helps our trade, so we would like to use options thatare showing relatively high IV, which is expected to drop. One way to ﬁndthese trades is to look at a list of the largest declining stocks during a trad-ing session. When a stock drops dramatically in one or two sessions, it of-ten enters a consolidation phase. This is the best of both worlds: First wehave  a  stock  that  has  had  a  spike  in  its  options’  IV,  but  IV  should  fallsharply as the stock consolidates.
Another way to ﬁnd candidates for this strategy is to get a list of high-IV  stocks  and  look  at  their  charts.  The  easiest  chart  pattern  to  see  is  astock in a trading range. By eyeballing dozens of stocks that have high-IVoptions, we can often ﬁnd great candidates to use for a butterﬂy strategy.When  looking  at  a  chart  with  moving  average  convergence/divergence(MACD), look for a MACD pattern that is moving sideways near the zeroline. This is also a sign of a consolidating stock.
As  with  any  strategy,  there  are  ways  to  make  a  butterﬂy  more  prof-itable, albeit with higher risk. The one thing to remember when trading abutterﬂy is that it is hard to make a proﬁt until expiration or near it. Thus,be aware when entering long-term butterﬂy trades that it will be tough tosee a proﬁt in the short term. Nonetheless, a butterﬂy spread is an excel-lent strategy for making a proﬁt in a sideways-trading market, but make
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sure you understand the risks and are willing to accept the possible con-sequences if the stock does not stay within your channel.
This chapter also took a good look at calendar and diagonal spreads.These versatile spreads can be constructed using calls or puts. I usuallybase my selections by calculating the best possible reward-to-risk ratios.To accurately assess the situation, you have to be willing to do the calcu-lations.  The  same  holds  true  for  collars.  I  look  for  the  right  market  byscanning charts until I locate one with strong support and resistance lev-els. Collars, or hedge wrappers, can be used either to hedge a stock you al-ready own or to enter a new strategy, looking to proﬁt from the move ofan underlying security. The strategy consists of buying actual stock (we’llassume 100 shares), buying a put, and selling a call. This combines the ef-fects  of  a  covered  call  with  a  protective  put  kicker.  Depending  on  whatstrikes a trader uses, a collar can be neutral, bearish, or bullish.
When I see a market with strong support and resistance levels, I takea ruler and draw the lines before choosing which options to buy and sell.In  many  cases,  I  am  willing  to  accept  a  lower  proﬁt  potential  for  an  ex-panded proﬁt zone. Although you can calculate these risk/reward scenar-ios by hand, a good options analysis program is worth the investment. Itwill  save  you  a  great  deal  of  time  and  avoid  costly  errors.  Besides,  onegood trade could certainly pay for the software.
These  strategies  can  be  exited  by  simply  doing  the  opposite  of  theoriginal  trade.  If  you  bought  options,  you  sell  them;  and  if  you  sold  op-tions, you buy them back. If you are exiting at expiration, then you can letthe short options that are worthless simply expire. If any of the short op-tions  have  value,  you  can  buy  them  back  for  a  proﬁt.  Try  to  limit  yourcommissions when you are placing and exiting these trades, as commis-sions can be a big part of the cost of trading.
Trading sideways markets can be a very conservative specialty. If youdecide  to  trade  markets  that  have  established  strong  support  and  resis-tance levels, never forget that markets can change erratically. Always bevigilant to the changing nature of the markets you are trading. If the mar-ket starts to move above the option strikes you purchased, make a bullishadjustment. If the market appears to be making a real move downward,make a bearish adjustment. Learning to be ﬂexible in your trading approachwill lead to longer-term success.
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CHAPTER 11
Increasing YourProﬁts withAdjustments
You can create the best trade in the world, but what you do after the
trade is placed is crucial to your success. When you put on a tradethat  is  perfectly  delta  neutral  and  the  market  makes  a  move,  itchanges your overall position delta. Your trade is no longer delta neutral.At  this  point,  you  can  choose  to  maintain  or  exit  the  trade,  or  return  todelta neutral by making adjustments. To bring a trade back to delta neutral(a  position  delta  of  zero),  an  adjustment  can  be  made  by  purchasing  orselling options and stocks (or futures) to offset your position. Determiningwhich adjustment to make is a decision dependent on analysis and marketexperience.
In  general,  when  delta  neutral  trading  guides  your  decision-makingprocess, you know when and how to make an adjustment to your position.To a certain extent, adjustments are the real meat of delta neutral trading.As you become more experienced with this process, your proﬁts will re-ﬂect your increased proﬁciency. This is where the professional ﬂoor traderneeds to excel to survive. Off-ﬂoor traders have more time to think aboutand execute the optimal hedge.
When you are trading delta neutral, it can be helpful to think of oneside of the trade as your hedge and the other side as your directional bet.In many cases, even if you are 100 percent wrong about market directionyou can still make a proﬁt. I prefer to hedge with the options and bet onthe  direction  of  the  stock  (or  the  futures).  Theoretically  speaking,  if  themarket  moves  10  points  up  or  down,  you  should  be  able  to  squeeze  thesame amount of proﬁt out of the trade. However, when you start factoringin  things  like  time  decay  and  volatility,  this  ﬁgure  may  change.  For  that
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reason, the trader will often adjust the position in order to shift back toneutral. Let’s consider some examples.
VARIABLE DELTAS
Before  we  show  some  working  examples  of  adjustments,  keep  in  mindthat there are two types of deltas: ﬁxed deltas and variable deltas. A ﬁxeddelta  means  something  that  never  changes,  something  that  always  staysthe  same.  For  example,  if  you  buy  100  shares  of  XYZ  selling  at  $25  pershare and then sell it for $30, you will have 5 points deposited into youraccount, or $500. Conversely, if you buy 100 shares at $25 a share and itgoes down to $20, you lose 5 points—$500 will be drained out of your bro-kerage account. Either way, the delta of the shares remains the same. Thisis  a  ﬁxed  delta.  Buying  and  selling  futures  is  also  an  example  of  ﬁxeddeltas. The deltas will remain at +100 for each 100 shares of stock you arelong and –100 for every 100 shares you short sell.
What  is  a  variable  delta?  Deltas  change  because  of  the  passing  oftime and due to market movement, which also changes prices. Optionsat different strikes have different deltas that vary as the underlying secu-rity changes.
If you buy 500 shares and sell 500 shares at $25 per share, your over-all position is delta neutral. But there’s something faulty in this reason-ing.  This  kind  of  trade  goes  ﬂat.  Although  this  combination  creates  anoverall position delta of zero, since both deltas are ﬁxed, this trade can-not be adjusted, and will not increase or decrease in value. Options, incontrast, have variable deltas that change as the underlying price moves.When  the  overall  position  delta  moves  away  from  zero,  you  can  applyadjustments to bring the trade back to delta neutral and thereby gener-ate additional proﬁts.
As we have already discussed, delta is at the cornerstone of learningdelta  neutral  trading.  As  previously  shown,  one  future  or  100  shares  ofstock  has  a  ﬁxed  delta  of  plus  or  minus  100  while  ATM  options  have  adelta of plus or minus 50. If you buy 200 shares and get a delta of +200,you can buy four ATM puts or sell four ATM calls to create a delta neutraltrade:  200  +  (4  × –  50)  =  0.  The  type  of  options  you  choose  determineswhether the position has a long or a short focus. The plus or minus signof the delta depends on which direction best takes advantage of the mar-ket circumstances. Buying a call or selling a put takes advantage of a ris-ing market and therefore has a corresponding plus sign. Buying a put orselling a call takes advantage of a decreasing market and therefore has aminus sign.
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Mathematically, this is quite easy to understand. But why do deltas actthe way they do? Perhaps a simple analogy will convey the meaning of adelta. When you slam on the brakes of your car, the process from the timeyou hit the brakes until the time your car stops is like a delta curve. Nearthe  end  of  the  stopping,  you  tend  to  experience  more  deceleration  thanwhen you ﬁrst hit the brakes—even with antilock brakes. Right at the pre-cise point where you completely stop, everybody kind of jogs forward abit for a little whiplash action. This is exactly like the movement of a deltaat expiration.
ADJUSTING A STRADDLE
One  of  the  advantages  of  trading  straddles  is  the  ability  to  easily  adjustthem.  The  adjustment  process  is  designed  to  bring  in  additional  proﬁtswhile maintaining the delta neutral status of the trade. The adjustment strat-egy used depends on a wide variety of trade speciﬁcs. This chapter is de-signed to explore the reasons why adjustments are an effective trading tool.A delta neutral trade is one in which the overall delta of the combinedposition equals zero. This means that both sides of a delta neutral tradebalance each other out, thereby reducing the overall risk of the trade. Thetrade makes money when one leg of the trade moves in-the-money enoughto pay for the cost of placing the overall trade.
Straddles  and  strangles  are  nondirectional  delta  neutral  trades  thatrely on increases and decreases in volatility movement to make a proﬁt.Straddles  use  ATM  options  with  identical  strike  prices  and  expirationdates.  A  long  straddle  is  usually  applied  in  markets  where  a  large  pricemovement is anticipated; but the direction of the move is unclear. Uponentering a straddle, the underlying stock price changes to some degree inone direction or the other. As the price ﬂuctuates, the position is no longerdelta neutral. An increase in the underlying stock price creates a positivedelta, and a decrease creates a negative delta. The trade thereby changesits  nature  to  becoming  either  bullish  or  bearish,  and  the  resulting  proﬁtbecomes more reliant on the future direction of the underlying stock.
Let’s  look  at  an  example  to  see  how  an  adjustment  can  change  thisscenario. If you’re holding a straddle and the price of the underlying stockrises, the delta becomes positive and you have a proﬁt on the call side ofthe position. At this point you may not want to lose the proﬁt you alreadyhave, so you have three choices:
1. Close the position, take your proﬁts and move on. Although this may bethe most prudent move to make, you can no longer participate in any fu-ture moves. You have put a limit on your gains, as well as your losses.
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2. Sit  tight  and  do  nothing. Just  continue  the  trade,  hoping  the  pricewill  continue  to  rise  and  your  proﬁts  will  increase.  If 