involved you want to be, or can afford to be, in watching the markets. Yourtrades should be interesting but not anxiety producing. If you ﬁnd thatbuying calls and puts causes you too much emotional stress, you may needto consider switching to milder, more casual spread trading. Successfultraders are unemotional, unstressed traders.
STRATEGIES FOR TRENDING MARKETSA lot of money can be made by simply riding a trend. Not only is goingwith the trend wise, but buying and holding a position for weeks is lessstressful than day trading or swing trading.New options traders are often surprised to learn that it is possible tomake greater returns with less risk using combinational strategies suchas vertical debit spreads, horizontal debit spreads, backspreads, andsynthetics. These strategies use two or more different options on thesame underlying to create unique risk/reward proﬁles that single optionpositions cannot provide. Again, spreads are slower acting than singleoption positions. You don’t have to watch them as closely. And a singlecountertrend day won’t be as likely to scare you into exiting your position prematurely.As you have learned, a vertical spread is constructed by buying oneoption and selling another option of the same type (call or put) in the sameexpiration month. When the option bought is more expensive than the option sold, the spread is said to be a debit spread because its opening results in a net debit to your trading account.A horizontal spread (also known as a calendar spread) is constructed by buying one option and selling another option of the sametype (call or put) with the same strike price but in different expirationmonths. The spread is called horizontal because the options differ onlyby month, and in a matrix of options you usually picture the monthsrunning horizontally.As shown in Figure 4.3, using the S&P 100 Index (OEX) and a moderately bullish target (represented by the shaded area), I had the OptionVue 5 options analysis software pick the best trade using each strategy.Clearly the best vertical debit spread and the best horizontal debitspread (tent-shaped line) beat the best simple call purchase within thetarget area. All three strategies can potentially lose 100 percent of the
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FIGURE 4.3 Performance Graph of Vertical and Horizontal Debit Spreads
investment if your forecast is wrong and the OEX declines. However,notice that the horizontal debit spread won’t lose 100 percent until theOEX drops pretty far.With the vertical debit spread, both the long and short legs have thesame expiration date. However, it is important to understand that the horizontal spread does not realize its full potential until the expiration day ofthe short leg. So if the market makes its anticipated move quickly, somepatience will be required as you wait for the spread to mature. Wheneverthis happens, you are likely to think to yourself, “I wish I had simplybought calls.” But remember, a simple call purchase is a fast-moving position, requiring careful attention, discipline, and sometimes nerves of steel.You should remind yourself of this and ask yourself if that is what you really want.Usually, vertical and horizontal debit spreads are the best strategiesfor trending markets. If your forecast is for a moderate move over the nextseveral weeks, these strategies pay better and are less volatile than simpleoption purchases.Two other strategies for trending markets—although with uniquecharacteristics—are backspreads and synthetics. We’ll discuss those soon.Now let’s look at how to use the horizontal spread in a sidewaysmarket.
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THE HORIZONTAL SPREAD—A GOODSTRATEGY IN A SIDEWAYS MARKETThis section illustrates one of the big advantages of options. There aretimes, often weeks or months, when a stock or the market trades in arange. There is no way to make money (other than day trading smallswings) being long or short the stock. However, you can proﬁtably tradethis type of market with options.The horizontal debit spread is a neutral strategy when constructed using at-the-money options. As such, it is a good strategy to use in a choppy,sideways market. When you can catch the nearby options trading at ahigher IV than the farther out options, you can put on a horizontal debitspread at a considerable advantage.A horizontal debit spread is constructed by selling a nearby optionand simultaneously buying a farther out option of the same type andstrike price. The performance graph for a horizontal debit spread is abroad, tent-shaped curve, peaking over the strike price (of both options).(See Figure 4.4.)Since your best outcome is when the underlying ﬁnishes right on thestrike price, it is possible to be somewhat bullish or bearish by selecting astrike price slightly away from the current price of the underlying. For ex-
FIGURE 4.4 Performance Graph of Horizontal Debit Spread
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ample, with the stock trading at 72, if you are bullish, you might select 80or 85 for the strike price.If you are bullish it is probably best to use calls, and if bearish, puts, inorder to steer clear of shorting in-the-money options. The problem withshorting in-the-money options is the possibility of early assignment (assuming we’re talking about American-style options, which may be exercised at any time by their holder).Early assignment is more likely when short in-the-money options havevery little remaining time value. Depending on the situation, early assignment could be either an important risk or just a nuisance. If early assignment happens with stock puts, you will suddenly be long stock, which,together with your remaining long puts, has almost the same risk/rewardproﬁle in the short run as you had before. So there is no urgency to respond. However, if early assignment happens with cash-based index puts,your short leg is suddenly gone (in a cash transaction), leaving you withthe long leg by itself, which is highly exposed to market movement.It is not difﬁcult to ﬁnd situations where the nearby options are trading at a higher volatility level than the farther out options. A sharp littlesell-off often causes this.At the time of this writing, the nearby options in McDermott (MDR)were trading at an IV (implied volatility) 30+ percentage points higher thanthe farther out options. For example, the March puts were at 138% whilethe May puts were at 100%. This begs the trader to use a horizontal debitspread—buying the Mays and selling the Marches. Again, a horizontaldebit spread may be done at a higher strike price to create a bullish position, or at a lower strike price to create a bearish position. With McDermott stock at 12.40, the strike of choice for the slightly bearish traderwould be 10.0. See Figure 4.5 for a proﬁt diagram of a 20-lot horizontalspread using the 10.0 puts.Thanks in part to the extra “kicker” from selling expensive nearbyoptions, this $700 trade has an amazingly broad proﬁt zone. At the peak(with the underlying at 10 in just 39 days), this trade should producenearly a $3,000 proﬁt. Notice that the dotted line—representing today’stheoretical performance—lies entirely beneath the zero line. The reasonthis trade shows a loss right out of the starting gate is because of transaction costs.Services exist that allow you to search for good opportunities to usehorizontal debit spreads. Just to illustrate how many opportunities can beavailable, at the time of this writing more than 20 stocks come up under asearch where the IVs of the nearbys and next month’s options differed by30 percentage points or more. These included Handspring (HAND), Elan(ELN), Metris (MXT), and ImClone (IMCL).While a big IV differential gives a substantial theoretical advantage
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FIGURE 4.5 Horizontal Debit Spread—McDermott
to the horizontal debit spreader, it is important to realize that the differential might be there for a good reason. One reason could be that thestock is in the midst of a big move and no one knows where the stockprice might settle.Another reason could be anticipated news. The trader needs to beaware if there might be any pending announcement that could move thestock dramatically one way or the other. Expected news is sometimes thecause of price abnormalities in the options. Once the news comes out, ifthe stock moves up or down a signiﬁcant amount, this tends to hurt a horizontal debit spread. However, the horizontal debit spread is sometimesworth doing despite the awareness of pending news, as oftentimes thestock does not move as much as people expected.
Placing Spread Orders with Your BrokerA spread order is when you enter an order to trade both legs of a spread simultaneously. As an example, let’s use the following two options:Strike110115
Price3.301.50
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A debit spread order could be given to your broker as follows: “I’m entering a spread order. Buy 15 of the IBM April 110 calls and sell 15 of the IBMApril 115 calls at 1.80 debit.” A spread order gets sent to the ﬂoor on a single ticket, and you will be ﬁlled in both legs simultaneously, or not at all. Ifﬁlled, they will report back to you the prices at which each option traded.It doesn’t make any difference what those prices are as long as they differby 1.80 or less.Spread orders are the safest way to open and close spread positions.The other way to do it is by placing two independent orders. This iscalled legging.Legging can be dangerous. After getting one leg on, the market mightmove adversely, causing you to get a worse price for the second leg—withthe result that you end up paying (debit spread) or receiving (creditspread) a worse net amount than you wanted. However, if the second order can be put through quickly after the ﬁrst one, especially in a calm market, the risk can be managed. Legging is kind of like stepping into a smallboat. You don’t want to spend much time with one foot in the boat and theother foot on the dock!The risk of legging is manageable if the trader has a direct access brokerage, where the trader is allowed to see the bid and asked prices on aparticular option at all the exchanges where that option is traded, and direct his order to the exchange of his choice. The ability to route an orderto the ﬂoor of one’s own choosing is relatively new for the public, and isnothing short of revolutionary. Those using direct access brokerages havea “leg up,” so to speak, on legging. By directing each order to the exchangewith the best price, traders can often leg into or out of a spread at a veryfavorable net price. Or, they may decide to work the ﬁrst leg by directing alimit order to the exchange where the best bid and asked are available, at aprice in between the bid and the asked. Once ﬁlled, they quickly completethe spread by hitting the best bid or offer they can ﬁnd for the other leg.Novice spread traders are sometimes tempted to deliberately delaythe second order in a bet that the market will move favorably in betweentimes and they will get into or out of their spread at a bargain. This can befoolish. The trader is bound to get burned at some point. One should question whether one’s purpose is high stakes gambling or sensible trading. Ifthe trader is interested in using spreads, one would assume that his statedgoal is sensible trading. Therefore the brief stints of gambling are probablyoutside his stated goals!It takes extra capital to do legging. For example, if the trader has only$2,100 in free capital and wants to put on a $2,000 spread, he’ll have to usea spread order. That is because the ﬁrst leg he tries to put on, no matterwhich side he wants to put on ﬁrst, will probably cost more than $2,100and the order will be rejected.
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Unfortunately, unless a spread order is entered at a net price that allows for hitting the bid of one option and the ask of the other, it won’t beﬁlled, in my experience. I don’t know why this is, but if you try to keepback even as little as a tenth of a point, they tend to ignore your order. Forexample, consider the following two options:Strike110115
Bid Price3.301.50
Ask Price3.501.60
Entering a debit spread order, you would need to pay 3.50 to buy the110s, and you would be able to sell the 115s for 1.50. Thus a spread orderplaced at “net debit of 2.00” should be ﬁlled. However, if you place thespread order at a “net debit of 1.90,” they won’t ﬁll you, in my experience.This may be changing. I have heard from more than a couple of tradersthat spread orders are being executed favorably these days at the ISE.
CREDIT SPREADS—SAY “DON’T GO THERE”A vertical credit spread is constructed by buying one option and selling another option of the same type (call or put) in the same expiration month,where the option sold is more expensive than the option bought, resultingin a net credit to your trading account.In contrast to a debit spread, where you simply pay the difference,with a credit spread there is a margin requirement based on the differencein the strike prices. For example, consider the following two put options:Strike Price3035
Price of Option35
Buying the 35s and selling the 30s would form a debit spread, and youwould pay the difference (2, or $200 per unit). However, if you were to buythe 30s and sell the 35s, that would form a credit spread. You would receive the difference (2, or $200 per unit), and would be required to put upthe difference between the strike prices (5, or $500 per unit). Note that the$200 you receive counts toward offsetting the margin requirement, so thatthe net amount you have to provide in your brokerage account is just $300per unit. Figure 4.6 shows the risk graph for an example 10-lot creditspread in these puts.As long as the stock price is above $35 on expiration date, both options will expire worthless and you will get to keep the $2,000 credit. If you
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FIGURE 4.6 Credit Spread Performance—GM
are wrong, and the stock price instead decreases substantially, your maximum loss is capped at $3,000—the difference between the strike prices ofthe two options ($5,000) and the $2,000 credit you received.Now you can see why a brokerage holds margin in your account forthis kind of trade. They want to be certain that you have the funds to settleif the trade goes against you. By requiring margin, the $5,000 needed forthe worst possible outcome is already in your account.Note that when you place a credit spread, your price expectation iscompletely opposite that for a debit spread. In the call debit spread, youwant the underlying to go up. This would widen the spread, allowing youto sell it later for a proﬁt. In the call credit spread, you want the underlyingto go down. This would narrow the spread, allowing you to close it laterfor a proﬁt.If this seems a difﬁcult concept to grasp, perhaps this will help: Youcan think of opening a debit spread as going long the spread and opening acredit spread as going short the spread. Just as when you go long a stock,when you go long a spread you hope its value increases. And just as whenyou short a stock, when you short a spread you hope its value decreases(so that you can buy it back later at a lower price).Debit and credit spreads can be formed using puts as well, with their
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performance curves mirror-imaging those of call debit and credit spreads.Table 4.1 summarizes these spreads.Practically, there is little difference between the way debit spreadsand credit spreads perform. Both have upper and lower boundariesto their potential values. Their value can go to a minimum of zero orto a maximum of the difference in strike prices. Neither is there muchdifference in what they cost, nor any practical difference in how youtrade them. So when would one want to use a credit spread instead of adebit spread?There is one distinction, and it is a subtle one. Depending on thestrikes chosen, the credit spread is more often used when you have a conviction of what the underlying will not do (i.e., will not penetrate a support or resistance level). In contrast, the debit spread is used more oftenwhen you have a conviction of what the underlying will do (i.e., will continue its trend).When there is a support level you feel the underlying will not penetrate, you would typically select a put credit spread where the short option is at or just below the support level. Likewise, when there is aresistance level you feel the underlying will not penetrate, you might typically select a call credit spread where the short option is at or just abovethe resistance level.Sometimes the use of credit spreads is motivated more by the desireto sell options while avoiding naked writing. When a trader wants to sellout-of-the-money options to collect time premium (perhaps selling both outof-the-money calls and out-of-the-money puts), he often buys farther out-ofthe-money options at the same time in order to cover his short options andavoid using naked writing (either because of the open-ended risk of nakedwriting or because of its high margin requirements). This creates creditspreads. Just as if he used naked options, the investor is expecting thatthe underlying will not go as far as the strike price of the short options.If he is successful, the short options, as well as the farther out-of-themoney long options, will expire worthless. Naturally, his proceeds areless for having bought the farther out-of-the-money options for protection.
TABLE 4.1 Debit and Credit SpreadsCall debit spreadCall credit spreadPut debit spreadPut credit spread
BullishBearishBearishBullish
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CONDORS—TWO-WINGED CREATURESI wrote in Chapter 2 that credit spreads are one of the safest and most successful strategies available. Building on the concepts just discussed, I’dlike to present what is likely the most popular way of using creditsspreads: a four-legged position called a condor. A condor consists of anout-of-the-money credit spread in calls and an out-of-the-money creditspread in puts. Initially, you try to receive approximately the same creditfor each side and create a balanced, or delta-neutral, position.Traders who prefer to have time decay on their side are attracted tocondors. Many condor traders have positions on continually, sometimes inmore than one expiration month. Day by day, as the market chops its waysideways (which it does more than half the time), they watch their equitybuild as the credit spreads decay. When the market moves, they adjusttheir positions to make them delta-neutral again.Since a condor consists of credit spreads, its risk is absolutely limited.Even if the market opened with a gap up or down 1,000 points, you wouldn’tbe ruined. And you’re always going to win on one side. For instance, say youreceived a 2-point credit for the call spread, and the same credit for the putspread. Each spread has a 10-point strike difference. If the market takes asevere dive, the put credit spread will go to its maximum value of 10, generating an 8-point loss. However, you win on the call side, with the 2-pointcredit, so your net loss is only 6.To trade condors, you need an index or high-priced stock with highliquidity options and many strikes to work with. A lot of strikes areneeded, at relatively small intervals, in order to give you the ﬂexibilityneeded for putting credit spreads on just the right distance away from themoney. Also, indexes are preferred over individual stocks because indexesdon’t have anywhere near as much of a tendency to jump.It is important to open the credit spreads far enough away from themoney so that they have a decent probability of expiring worthless. Thefarther away from the money you can go, the greater the probability ofthe spreads expiring worthless without having to make any costly adjustments. However, the farther away options have lower premiums. Infact, beyond a certain point, those premiums fall off rapidly. Thus youare sometimes pushed into using closer-to-the-money strikes than youreally want to.For an example, let’s look at building a prospective condor in the OEXoptions. The OEX was at 463 at the time of this writing, and more thanseven out-of-the-money strikes were available in both the calls and theputs. Figure 4.7 shows the matrix. Remember, the “>” marks on the left indicate the at-the-money strikes—one among the calls and one among the
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FIGURE 4.7 Condor on OEX Matrix
puts. Out-of-the-money strikes in the calls lie above that mark, and the outof-the-money strikes in the puts lie beneath that mark.To get some idea of how far away from the money to go, the ﬁrst thinga trader might want to do is get some idea how far the OEX could movewithin a given time frame. The OptionVue 5 software comes with a probability calculator that can be used for this purpose. Inputting the currentprice, volatility, and a time frame equal to the remaining life in the secondmonth options (the nearbys were expiring in less than a week, so we’relooking to the second month this time), we ﬁnd that a ﬁrst standard deviation move for the OEX could take it down to 426 or up to 495. In otherwords, there is a 68% chance of the OEX being between these two prices atthe end of the projected time frame. We’d like to go even farther awayfrom the money if possible, to get a better chance of success without adjustment. (See Figure 4.8.)However, referring again to Figure 4.7, we ﬁnd that only at one standard deviation are the option premiums still worth doing. Any further
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FIGURE 4.8 Probability Calculator
away and the premiums are too low to be worth selling. So, as is often thecase, we are practically constrained to doing a one standard deviation condor. Figure 4.9 provides the graphic analysis of the condor that was entered in the matrix of Figure 4.7.The lines of progression show how this position develops proﬁtabilityover time. Projected all the way to expiration, the analysis shows that thisposition has a 66% probability of success. If necessary, adjustments can,and usually do, increase the probability of success of the actual trade, butthey also reduce its yield.Note that condors are only practical if your commissions are very low.That is because you’ll be trading a lot of options, especially when you consider the occasional adjustments.Condor traders are risk-averse traders. Besides having absolutely limited risk, a condor is also a very slow-acting position. Even a relatively bigone-day market move affects the condor very little, because one wing ofthe condor beneﬁts while the other is hurt. Be careful, though, if your position includes a close-to-the-money credit spread in the ﬁnal days beforeexpiration. If you are short a close-to-the-money option in the ﬁnal week,
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FIGURE 4.9 Graphic Analysis of Condor
you might want to consider closing that position early to avoid the possibility of being hurt by it.So for the trader who enjoys actively managing a position in severaloptions and seeing his account value grow almost daily, who doesn’tfeel he can predict the direction of the market or doesn’t want to try, thelimited-risk, slow-moving condor might be just the thing.
THE BACKSPREAD—A DIRECTIONAL STRATEGYTHAT COSTS NOTHING IF YOU ARE WRONGI’m a great believer in using the right tool for the job. The backspread isan amazing little strategy when you expect a potentially big price move,but at the same time you realize that there is a chance you could be wrongand no move whatsoever develops. One example when it would be appropriate to use a backspread might be when a drug company is approachinga deadline for FDA approval of a new product. Another good time to use abackspread is when bottom ﬁshing near what you think is the end of amarket sell-off.A backspread is constructed by shorting a near-the-money option andbuying a larger quantity of options of the same type (calls or puts) at a far-
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ther out-of-the-money strike. A 2 × 1 ratio is most common. Normally youtry to select the options in such a way that the options you’re shortingbring in a sufﬁcient credit to cover the cost of the options you’re buying,resulting in a net cash ﬂow of nearly zero.Since in a backspread you are net long options, the proﬁt potential isunlimited. At the same time, the sale of a smaller number of more expensive options effectively pays for the options purchased, with the resultthat if both legs of the backspread expire worthless, it costs you nothing.The short leg of the backspread also effectively eliminates time decay asa worry.If all that sounds too good to be true, I’ll tell you what the catch is.There is a price zone where the backspread loses money. It occurs whenthe underlying moves in the desired direction by only a small amount.Let’s illustrate using a call backspread in Sun Microsystems (SUNW)options (see Figure 4.10). Caught in the recession of 2001, Sun stockdropped way down. However, many expect a recovery; we just can’t besure when. If you go along with this, a call backspread might be a perfect way to play it. (Note that backspreads can be constructed in putsjust as well as in calls. Put backspreads behave in a mirror-image fashion to call backspreads.)This particular 2 × 1 backspread costs $2,250 to put on. (The cost of a
FIGURE 4.10 Call Backspread
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backspread arises from the collateral requirement for a 1 × 1 creditspread plus the cost of the extra calls purchased.) Note that this positionloses money when Sun is in a range from 10.25 to 14.79—the “deadzone.” However, it is very difﬁcult to lose all your money, as Sun wouldhave to ﬁnish at precisely 12.50 (the long leg’s strike price) on expirationday. Contrast this with simple option buying—where it is very easy tolose all your money!Big proﬁts can be made if Sun moves above 15. Below 10, you gain$263 no matter how far Sun may fall.Noteworthy is the outstanding risk/reward characteristic of the T+39line (the dashed line), representing the halfway point in the life of thisposition. If the expected rally happens within this time frame, you’regolden. If not, you may consider closing the position at this time for justa small loss.
A VariationBy ﬁddling with the ratio of calls bought to calls sold, it’s possible to construct a backspread that produces a sizable credit when you put it on. Figure 4.11 illustrates a position that probably should be considered bearish,as it makes money from the current price on down. However, notice that
FIGURE 4.11 A Bearish Backspread
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the loss zone is wider than in the previous example. And to the upside,only a move above 18.20 would make the trade proﬁtable. It was constructed by selling 15 at-the-moneys and buying 20 out-of-the-moneys. This$2,800 investment makes $960 if the market goes down; not bad, but notgreat either.Note that, compared to the original backspread, we took this positionhalfway to being a vertical credit spread. If you’re truly bearish and don’tcare about the upside potential of this stock, perhaps you should go all theway and make it into a vertical credit spread.
Gold BugLet’s look at a real-life example of where the backspread was the perfectstrategy to use. At the time of this writing, gold plateaued for a few days after having jumped 20 points on Japanese buying in the wake of an important change in bank policy. Refer to the price chart in Figure 4.12. Can yousee a pattern here?Each time gold jumps to a higher level, it falls all the way backdown. Gold just doesn’t seem to want to drift lower. If you assume thatthis pattern should repeat itself, you would have to say that if gold begins to drop, it will fall at least 15 to 20 points. In other words, it is notlikely that gold would fall just 5 points or so and stay there. We should
FIGURE 4.12 Gold Price Chart
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also be prepared for gold to move higher; it probably won’t, but we don’twant to be hurt if it does.Now, one way to play this would be to place a stop order to buy puts ifgold falls below, say, 295. However, we might be ﬁlled at a high price if goldgaps down. Or if gold dropped enough to hit our stop, then went back up,we’d be looking at a loss.It might be better to construct an appropriate backspread and put ourposition on right away. Figure 4.13 shows an example of a 2 × 1 put backspread that would work well here