. A bull put spread has a ______________.
Answer: A—Limited proﬁt potential with limited risk.Discussion: Just like a debit spread, a credit spread has limited re-ward and limited risk. However, a bull put spread’s higher probabil-ity  of  success  also  means  a  larger  risk.  Nonetheless,  the  risk  islimited and credit spread traders can make substantial proﬁts usingthis strategy.
10. Calculate  the  maximum  reward  and  risk  and  the  breakeven  for  the
following bull put spread trade.
Long 1 June Bank Index ($BKX) 100 Put @ 6.75
Short 1 June BKX 110 Put @ 10.50Answer:
Maximum reward = (10.50 – 6.75) × 100 = $375 (Net credit).
Maximum  risk  =  [(110  –  100)  –  3.75]  × 100  =  $625  [(Difference  in
strikes – net credit)] × 100].
Breakeven = 110 – 3.75 = 106.25 (Higher strike price – net credit).Discussion: A bull put spread is created by combining the sale of ahigher strike put with the purchase of a lower strike put. The goal isto see the underlying asset move higher and for both puts to expireworthless. If so, the strategist will keep the net credit, which is alsothe  maximum  reward.  Since  a  credit  spread  has  a  higher  successrate than a debit spread, the amount at risk normally will often behigher  than  the  possible  reward.  However,  over  time,  a  creditspread  trader  should  see  substantially  more  wins  than  losses.  Aswith any strategy, it is important to look at a risk graph of the tradebefore entering to make sure the reward, risk, and breakeven all ﬁtyour outlook for the stock.
11.
In a ______________, you sell the lower strike call and buy the higherstrike call using the same number of options.Answer: A—Bear call spread.Discussion: As the name implies, a bear call spread is bearish in na-ture, but uses calls to create a credit. As long as the underlying secu-rity  closes  at  expiration  below  the  lower  strike  call,  the  entire  netpremium becomes a proﬁt. This means that we can enter a bear callspread when we think the stock is going to trade sideways or moveslightly lower by expiration.
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12. A bear call spread has a ______________.
Answer: A—Limited proﬁt potential with limited risk.Discussion: I believe in limiting risk in every situation, and for this rea-son  I  never  suggest  selling  naked  options.  Instead  of  selling  a  nakedcall, you may want to consider limiting your risk by entering a creditspread. Yes, the reward is also lowered, but this keeps a trader in thegame without losing large amounts of capital on a trade gone bad.
13. Calculate  the  maximum  reward  and  risk  and  the  breakeven  for  the
following bear call spread trade.
Long 1 December IBM 90 Call @ 7.00
Short 1 December IBM 80 Call @ 11.50Answer:
Maximum reward = (11.50 – 7.00) × 100 = $450 (Net credit).
Maximum risk = [(90 – 80) – 4.50] × 100 = $550 [(Difference between
strikes – net credit) × 100].
Breakeven = 80 + 4.50 = 84.50 (Lower strike price + net credit).Discussion: If IBM were to close at or below $80 at expiration, thenthis  trade  would  achieve  a  maximum  proﬁt  of  $450.  The  maximumproﬁt is equal to the credit received. The risk is calculated by subtract-ing the net credit from the distance between strikes. The breakeven isfound  by  adding  the  net  credit  received  to  the  lower  strike.  In  thiscase, we need IBM to close at $84.50 or below to see a proﬁt.
14.
In  a  ______________,  you  buy  a  higher  strike  price  put  and  sell  alower strike price put.Answer: C—Bear put spread.Discussion: Using bear and put together conveys the bearish bias of adebit  spread.  The  idea  is  that  we  can  lower  the  cost  of  buying  astraight put by selling a lower strike put. Though this limits the maxi-mum  proﬁt,  it  also  lessens  the  trade’s  risk.  If  the  underlying  moveshigher, a spread is going to see a much smaller loss than a straight put.
15. A bear put spread has a ______________.
Answer: A—Limited proﬁt potential with limited risk.Discussion: Sale  of  a  lower  strike  put  lowers  the  initial  debit,  butalso reduces the reward. A straight put makes money as the underly-ing falls all the way to zero. However, a bear put spread is a limited
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reward, limited risk strategy. If you expect the stock to fall sharply,you might be better served using a straight put. If you predetermineyour exit price, then using a debit spread might work best.
16. Calculate  the  maximum  reward  and  risk  for  the  following  bear  put
spread trade.
Long 1 October IBM 95 Put @ 3.75
Short 1 October IBM 90 Put @ 2.50
Maximum  reward  =  [(95  –  90)  –  1.25]  × 100  =  $375  [(Difference  in
strikes – net debit) × 100].
Maximum risk = (3.75 – 2.50) × 100 = $125 (Net debit).
Breakeven = (95 – 1.25) = 93.75 (Higher strike price – net debit).Discussion: The  maximum  risk  for  a  bear  put  spread  is  the  initialdebit to enter the trade. Since a bear put spread combines the sale ofa put with the purchase of a higher strike put, the net debit will belower than when buying a straight put. The maximum reward in thisexample  takes  place  if  IBM  closes  at  or  below  90  at  expiration.  Inthis  case,  a  proﬁt  of  $375  occurs.  This  is  calculated  by  subtractingthe initial debit from the difference in strike prices. The breakevenpoint  is  calculated  by  subtracting  the  net  debit  from  the  higherstrike. Thus, the trade makes a proﬁt if IBM closes at or below $93.75at expiration.
MEDIA ASSIGNMENT
When it comes to trading, practice really does make perfect. To learn theinner workings of the four strategies described in this chapter, take advan-tage of the My Portfolio section of the Optionetics web site to set up andtrack vertical spread trades. Just register at the site and you’re ready tostart  searching  for  promising  trades  that  will  enable  you  to  learn  howthese strategies work using real-world markets.
In addition, the Optionetics web site has hundreds of insightful articlesabout a multitude of topics that can be reviewed. Use the article search fea-ture to ﬁnd articles about the various vertical spreads. Though many articleswill have a recurring theme, we often learn best by repetition and slight vari-ances in the way a topic is taught. Traders can also use the discussion boardson  the  Optionetics  web  site  to  get  feedback  and  information  from  othertraders as well as from various Optionetics writers and instructors.
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VOCABULARY DEFINITIONS
Ask: The  lowest  price  acceptable  to  a  prospective  seller  of  a  security.  Alow demand for a stock translates to the market being offered down to thelowest price at which a person is willing to sell. Off-ﬂoor traders buy at theask price and sell at the bid price. Together, the bid and ask prices consti-tute a quotation or quote, and the difference between the two prices is thebid-ask spread. The bid-ask dynamic is common to all stocks and options.At-the-money (ATM): When the strike price of an option is the same asthe current price of the underlying instrument.Bear call spread: A strategy in which a trader sells a lower strike call andbuys a higher strike call to create a trade with limited proﬁt and limitedrisk. A fall in the price of the underlying increases the value of the spread.Net  credit  transaction;  maximum  loss  =  difference  between  the  strikeprices less net credit; maximum gain = net credit.Bear put spread: A strategy in which a trader sells a lower strike put andbuys a higher strike put to create a trade with limited proﬁt and limitedrisk. A fall in the price of the underlying increases the value of the spread.Net debit transaction; maximum loss = net debit; maximum gain = differ-ence between strike prices less the net debit.Bull call spread: A strategy in which a trader buys a lower strike call andsells a higher strike call to create a trade with limited proﬁt and limitedrisk. A rise in the price of the underlying increases the value of the spread.Net debit transaction; maximum loss = net debit; maximum gain = differ-ence between strike prices less the net debit.Bull put spread: A strategy in which a trader sells a higher strike put andbuys  a  lower  strike  put  to  create  a  trade  with  limited  proﬁt  and  limitedrisk. A rise in the price of the underlying increases the value of the spread.Net credit transaction; maximum loss = difference between strike pricesless credit; maximum gain = net credit.Bid: The bid is the highest price a prospective buyer is prepared to pay fora trading unit of a speciﬁed security. If there is a high demand for the un-derlying asset, the prices are bid up to a higher level. Off-ﬂoor traders sellat the bid price and buy at the ask price.Bid-asked spread: The difference between bid and offer prices. The termasked is usually used in over-the-counter trading. The term offered is usedin exchange trading. The bid and asked, or offered, prices together com-prise a quotation, or quote.Credit spread: The difference in value of two options, where the value ofthe one sold exceeds the value of the one purchased to create a net creditfor the combined position.
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Debit spread: The difference in value of two options, where the value ofthe long position exceeds the value of the short position to create a netdebit for the combined position.In-the-money (ITM): If you were to exercise an option and it would gen-erate a proﬁt at the time, it is known to be in-the-money. A call option is in-the-money  if  the  strike  price  is  less  than  the  market  price  of  theunderlying  security.  A  put  option  is  in-the-money  if  the  strike  price  isgreater than the market price of the underlying security.Intrinsic value: The amount by which a market is in-the-money. Out-of-the-money options have no intrinsic value. Call Intrinsic value = underly-ing – strike price. Put Intrinsic value = strike price – underlying.Leg in: When a trader enters each part of a spread separately instead ofentering the trade as one order with his or her broker.Limit order: An order to buy a stock at or below a speciﬁed price or tosell  a  stock  at  or  above  a  speciﬁed  price.  For  instance,  you  could  tell  abroker, “Buy me 100 shares of XYZ Corporation at $8 or less” or “Sell 100shares of XYZ at $10 or better.”Out-of-the-money (OTM): Refers to an option whose exercise price hasno intrinsic value. A call option is out-of-the-money if its exercise or strikeprice is above the current market price of the underlying security. A putoption  is  out-of-the-money  if  its  exercise  or  strike  price  is  below  thecurrent market price of the underlying security.Slippage: The difference between estimated transaction costs and actualtransaction costs. The difference is usually composed of price revisions orspread and commission costs.Time value: The amount by which the current market price of an optionexceeds its intrinsic value. The intrinsic value of a call is the amount bywhich the market price of the underlying security exceeds the strike priceat which the option may be exercised. The intrinsic value of a put is calcu-lated as the amount by which the market price of the underlying securityis below the exercise price.Vertical spread: A spread in which one option is bought and one optionis sold, where the options are of the same type, have the same underlying,and have the same expiration date, but have different strike prices.
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CHAPTER 6
DemystifyingDelta
SUMMARY
In this chapter, the reader is introduced to the basics of delta neutral trad-ing. Two of the most important market characteristics—volatility and liq-uidity—are discussed at length. In addition, the Greek options term deltais explored in detail and the mechanics of delta neutral trading are intro-duced. In order to utilize the various strategies that can be created usingoptions, futures, and stock, traders need to understand how volatility andliquidity impact these trading tools.
Delta neutral trading is a common way for ﬂoor traders to minimizerisk.  However,  retail  traders  can  also  use  delta  neutral  strategies  tomake  proﬁts  while  minimizing  risk.  In  order  to  fully  understand  deltaneutral  trading,  traders  must  develop  a  strong  understanding  of  deltaand how it is calculated. In general, long calls and short puts have posi-tive deltas, whereas short calls and long puts have negative deltas. Onehundred  shares  of  stock  correspond  to  a  ﬁxed  delta  of  plus  100  deltaswhen purchased and minus 100 deltas when sold short. A delta neutraltrade combines long and short deltas to create an overall position deltaof zero.
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QUESTIONS AND EXERCISES
1. Locating  opportunities  for  delta  neutral  trades  depends  on  ﬁnding
markets with ______________.
A. High liquidity and high volatility.B. High liquidity and low volatility.
C. Low liquidity and high volatility.
D. Low liquidity and low volatility.
2. True or False: The higher an asset’s volatility, the higher the prices of
its options.
3. A market’s ______________ can be deﬁned as the amount of volumethat enables a trader to buy or sell a security or derivative and receivefair value for it.
A. Volatility.
B. Equilibrium level.
C. Support.
D. Liquidity.
4. True or False: Delta neutral strategies are suitable for day trading.
5. A stock option’s delta can be calculated by ______________ and mul-
tiplying by 100.
A. Dividing the change in the premium by the change in the price of
the underlying.
B. Dividing the change in the price of the underlying by the change
in the premium.
C. Multiplying the change in the premium by the change in the price
of the underlying.
D. Multiplying  the  change  in  the  price  of  the  underlying  by  the
change in the premium.
6. One hundred shares of stock have ﬁxed deltas of ______________.
A. Plus 50.
B. Minus 50.
C. Plus or minus 50.
D. Plus or minus 100.
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7. Long call options have ______________ deltas.
A. Positive.
B. Negative.
8. Short put options have ______________ deltas.
A. Positive.
B. Negative.
9. As  a  rule  of  thumb,  the  deeper  ______________  your  option  is,  the
higher the delta.
A.
In-the-money.
B. Out-of-the-money.
10. ______________ options have a delta of plus or minus 50.
A.
In-the-money.
B. Out-of-the-money.
C. At-the-money.
11. When an option is very deep ______________, it will start acting very
much like the underlying stock.
A.
In-the-money.
B. Out-of-the-money.
C. At-the-money.
MEDIA ASSIGNMENT
Understanding how delta impacts a trade is vital to learning how to tradedelta  neutral.  Though  there  are  many  trading-related  web  sites,  therearen’t many sites that provide the delta for an option. If you have access tothe Optionetics Platinum site or if you use an options program from an-other source, take the time to learn about delta. If you don’t have any ofthese, you can use an options calculator to ﬁgure the delta of an option.Your assignment is to look at different options and decide what delta youthink would be associated with that option. After you have done this withseveral options, check the actual data to see how close you were. After awhile,  you’ll  be  surprised  how  accurate  your  initial  decision  about  thedelta is compared with the actual delta.
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VOCABULARY LIST
Delta
Derivatives
Liquidity
Long-term equity anticipationsecurities (LEAPS)
Position delta
Skew
Tick
Volatility
SOLUTIONS
1. Locating  opportunities  for  delta  neutral  trades  depends  on  ﬁnding
markets with ______________.Answer: A—High liquidity and high volatility.Discussion: Delta  neutral  trades  rely  on  magnitude  of  movementin  the  underlying  security.  High  volatility  often  scares  away  newtraders;  but  an  experienced  trader  usually  thrives  on  volatility.When a stock or an index shows a lot of movement, this volatilityenables delta neutral traders to make proﬁts even while minimizingrisk. However, in order to take advantage of high volatility, a tradermust understand the characteristics of volatility and delta. High liq-uidity is also needed to get your order ﬁlled at a good price whenentering and exiting a trade.
2. True or False: The higher an asset’s volatility, the higher the prices of
its options.Answer: True.Discussion: Volatility  tells  a  trader  how  much  the  stock  is  ex-pected  to  move.  This  means  the  higher  the  volatility,  the  greater the chance of a move of sufﬁcient magnitude in the underlying as-set. An option premium is like an insurance premium, which meanswe  pay  more  when  there  is  more  associated  risk.  If  volatility  ishigh,  the  stock  is  expected  to  move  a  great  deal  more;  thus  the premium  to  enter  a  call  or  put  is  higher.  A  delta  neutral  traderthrives  on  high  volatility,  as  it  increases  the  chances  of  marketmoves  of  high  magnitude,  which  provides  for  a  number  of  proﬁt-making opportunities.
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3. A market’s ______________ can be deﬁned as the amount of volumethat enables a trader to buy or sell a security or derivative and receivefair value for it.Answer: D—Liquidity.Discussion: When a stock or option has low liquidity, the price tendsto be skewed. Retail traders buy at the ask and sell at the bid, so it isimportant to ﬁnd options with high liquidity so the bid-ask spread isnot too wide. Slippage is the amount of money lost by buying at theask  and  selling  at  the  bid.  With  options  that  have  low  liquidity,  thespread will often be large and it will be difﬁcult to get fair value forthe options.
4. True or False: Delta neutral strategies are suitable for day trading.
Answer: False.Discussion: Though delta neutral trades are used by ﬂoor traders tohedge risk, it is usually not suitable to day trade this type of strategy. Irecommend trying to reduce risk and stress by utilizing delta neutraltrading techniques over a longer trading period.
5. An option’s delta can be calculated by ______________ and multiply-
ing by 100.Answer: A—Dividing the change in the premium by the change in theprice of the underlying.Discussion: Options  are  derivatives,  so  their  price  is  derived  fromthe movement of the underlying security. Delta measures the move inan option’s price as compared to a move in the underlying security.For  example,  if  a  stock  moves  $1  and  the  option  moves  higher  by$0.50, then the delta is considered to be 50. An ATM option normallyhas a delta near 50, with ITM options seeing higher deltas and OTMoptions seeing lower deltas. A delta of 50 means that the underlyinghas a 50 percent chance of becoming in-the-money by expiration.
6. One hundred shares of stock have ﬁxed deltas of ______________.
Answer: D—Plus or minus 100.Discussion: One hundred shares of long stock have a delta of +100.One  hundred  shares  of  short  stock  have  a  delta  of  –100.  No  matterhow the stock price ﬂuctuates, the delta of plus or minus 100 will re-main ﬁxed. It is important to understand what the delta is for differ-ent  securities  so  that  combinations  can  be  formed  to  create  deltaneutral trades.
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7. Long call options have ______________ deltas.
Answer: A—Positive.Discussion: A long call would have a delta between 0 and 100. A longcall can’t have a delta higher than 100 because the most a call optioncan move is point-for-point with the underlying security. The deeperITM the call option gets, the closer to 100 the delta will become. Thefarther OTM the option gets, the closer to zero the delta gets.
8. Short put options have ______________ deltas.
Answer: A—Positive.Discussion: With  a  short  put,  a  trader  proﬁts  as  the  stock  moveshigher, and this means the delta is positive. (A long put would have anegative delta because the option makes money as the underlying de-clines.) Though in general Optionetics doesn’t advocate trading shortputs, or any naked options, there are times when using these types ofoptions is advisable to create delta neutral trades.
9. As  a  rule  of  thumb,  the  deeper  ______________  your  option  is,  the
higher the delta.Answer: A—In-the-money.Discussion: As an option moves deeper in-the-money, it starts to mir-ror the movement of the underlying. A very deep ITM option will havevery little time value and will start to trade nearly point-for-point withthe underlying security. The opposite also holds true: An option thatis far OTM will see little movement for each point move in the under-lying security.
10. ______________ options have a delta of plus or minus 50.
Answer: C—At-the-money.Discussion: In  most  cases,  ATM  options  have  a  delta  that  is  veryclose to 50. Another way of looking at this is to say that an ATM op-tion has a 50/50 proposition of ﬁnishing in-the-money. A straddle is acommon delta neutral strategy that uses an ATM put and an ATM call,which produces an overall delta near zero.
11. When an option is very deep ______________, it will start acting very
much like the underlying stock.Answer: A—In-the-money.Discussion: An  options  contract  will  start  to  move  point  for  pointwith the underlying once it is very deep in-the-money. Some traders
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85
like to use deep ITM LEAPS as a proxy for buying a stock. This is be-cause they get nearly a point move in the option for each point movein the underlying security, but the initial capital outlay is smaller.
MEDIA ASSIGNMENT
This media assignment asks the reader to calculate the deltas associatedwith  various  options.  Though  we  can  ﬁnd  this  data  on  various  softwareprograms, it is good to have a basic understanding initially when lookingat various option trades. Take some time to set up a few trades using thestrategies already covered in this book and calculate each trade’s overallposition  delta.  Keep  in  mind  how  the  delta  impacts  the  trade.  By  thor-oughly understanding this concept, you will be able to create winning op-tions trades and have an easier time making additional proﬁts by adjustinga trade back to delta neutral.
VOCABULARY DEFINITIONS
Delta: The amount by which the price of an option changes for everydollar move in the underlying instrument.Derivatives: Derivatives are ﬁnancial instruments whose value is basedon the market value of an underlying asset such as a stock, bond, or com-modity.  Examples  of  derivatives  are  futures  contracts,  options,  and  for-ward  contracts.  Derivatives  are  generally  used  by  institutional  investorsto increase overall portfolio return or to hedge portfolio risk.Liquidity: The ease with which an asset can be converted to cash in themarketplace. A large number of buyers and sellers and a high volume oftrading activity provide high liquidity. Liquidity is a concern for any moneythat  may  be  required  on  short  notice,  whether  for  emergencies  or  forplanned purchases.Long-term  equity  anticipation  securities  (LEAPS): LEAPS  arelong-term  stock  or  index  options  with  expiration  dates  up  to  threeyears  in  the  future.  Like  all  options,  they  are  available  in  two  types:calls and puts.Position  delta: The sum of all positive and negative deltas in a hedgedposition.Skew: A descriptive measure of lopsidedness in a distribution. It is es-pecially important for options trading when there is volatility skew and
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prices are greater or less than they should be at various strikes and/orexpirations.Tick: The  smallest  possible  movement  (up  or  down)  in  the  price  of  a security.Volatility: The  magnitude  of  price  (or  yield)  changes  over  a  predeﬁnedperiod of time. The amount by which an underlying instrument ﬂuctuatesin a given period of time. Options often increase in price when there is arise  in  volatility  even  if  the  price  of  the  underlying  doesn’t  move  any-where.  Volatility  is  a  primary  determinant  in  the  valuation  of  options.There are two main types of volatility: historical and implied.
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CHAPTER 7
TheOtherGreeks
SUMMARY
The option Greeks are a set of measurements that provide insight into atrade’s risk exposure. This chapter reviews the four basic option Greeks—delta, gamma, theta, and vega—while analyzing their trading applications.In  addition,  the  chapter  examines  how  intrinsic  value,  time  value,  andvolatility impact option premiums.
The Greeks help options traders minimize risk by telling us how thevalue of a trade will change due to ﬂuctuations in price, time, and volatil-ity. An option has two types of value: intrinsic and extrinsic. Intrinsic valueis the real value of an option and is the amount an option is in-the-money.Intrinsic  value  is  not  affected  by  theta,  or  the  passing  of  time.  Extrinsicvalue, or time value, is impacted by theta. The deeper ITM an option is, theless extrinsic value the option has. An ATM or OTM option has no intrinsicvalue and is completely made up of extrinsic or time value. Since each op-tion  comes  with  an  expiration  date  and  as  each  day  passes  some  timevalue is lost, options are called wasting assets. This is why it is importantto understand theta and how it impacts an option’s price over time.
Volatility  has  two  meanings  in  the  options  ﬁeld—one  being  historicvolatility, the other implied volatility (IV). By understanding the volatilityof  the  underlying  security,  we  can  ﬁnd  discrepancies  in  pricing.  Impliedvolatility is a major part of an option’