ratio put spread, the following 12 guidelines should beobserved:
1. A ratio put spread can be implemented when a slight fall in the market
is anticipated followed by a sharp rise.
2. Explore past price trends and liquidity by reviewing price and volume
charts over the past year.
3. Check to see if this stock has options available.
4. Review options premiums per expiration dates and strike prices.
5. Investigate  implied  volatility  values  to  see  if  the  options  are  over-priced or undervalued. This strategy is best placed in markets with aforward volatility skew. In this environment, the lower strike options(the ones you want to sell) have higher implied volatility and can beoverpriced. The higher strike options (the ones you want to buy) havelower  implied  volatility  and  are  often  underpriced.  By  trading  thistype of volatility skew, you can capture the implied volatility differen-tial between the short and long options.
6. A  ratio  put  spread  is  created  by  buying  a  higher  strike  put  (ITM  orATM) and selling a greater number of lower strike puts (OTM). Deter-mine which spread to place by calculating:
• Limited Risk: Limited to the downside below the breakeven asthe  stock  can  only  fall  to  zero.  Lower  strike  price  –  (difference in  strikes  –  net  credit)  × 100.  Although  limited,  the  risk  can  besigniﬁcant.
• Limited Reward: Limited. (Difference in strikes × 100) + net credit
(or – net debit].
• Upside Breakeven: None.• Downside Breakeven: Higher strike price – [(difference in strikes× number of short contracts) ÷ (number of short contracts – num-ber of long contracts)] – net credit (or + net debit).
7. Create  a  risk  proﬁle  of  the  most  promising  option  combination  and
graphically determine the trade’s feasibility.
8. 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.
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9. Make an exit plan before you place the trade. If the stock falls belowthe maximum proﬁt point, consider closing the position. The positionbegins losing money if it falls below the breakeven.
10. Contact  your  broker  to  buy  and  sell  the  chosen  options.  Place  thetrade as a limit order so that you limit the net credit/debit of the trade.11. You do have to watch the market closely on this type of trade. Losses
can be substantial if the stock falls sharply.
12. Choose an exit strategy based on the price movement of the underly-ing stock and ﬂuctuations in the implied volatility of the options:
• If the underlying stays the same or rises: Do nothing, let the
puts expire worthless and keep the net credit.
• The underlying stock falls below the short strike price: You
should consider exiting the entire position for a small gain.
• The  underlying  stock  falls  below  the  downside  breakeven:
You should close the position and take the loss.
Call Ratio Backspread Road Map
In  order  to  place  a  call  ratio  backspread,  the  following  14  guidelinesshould be observed:
1. Look for a bullish market where you anticipate a large increase in theprice of the underlying stock. Choose stocks that are leaders in theirﬁelds  and  have  an  increasing  stream  of  earnings  and  quarter-over-quarter growth.
2. Check to see if this stock has options available.
3. Explore past price trends and liquidity by reviewing price and volume
charts over the past year.
4. Review options premiums per expiration dates and strike prices. Placethe position as a credit or as close to at-even as you can. Use options withgreater than 90 days until expiration. LEAPS options are a good choicesince they provide ample opportunity for time to work in your favor.
5. Investigate  implied  volatility  values  to  see  if  the  options  are  over-priced or undervalued. This strategy is best placed in markets witha  reverse  volatility  skew.  In  this  environment,  the  lower  strike options  (the  ones  you  want  to  sell)  have  higher  implied  volatilityand can be overpriced. The higher strike options (the ones you wantto  buy)  enjoy  lower  implied  volatility  and  are  often  underpriced. 
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By  trading  the  reverse  volatility  skew,  you  can  capture  the  impliedvolatility differential between the short and long options.
6. A call ratio backspread is composed of selling the lower strike call(ITM  or  ATM)  and  buying  a  greater  number  of  higher  strike  calls(OTM).  It  is  not  usually  recommended  to  place  positions  with ratios greater than .67; use ratios that are a multiple of 1-to-2 (themost common) or 2-to-3. All options must have the same expirationdate.
7. Look at options with at least 90 days until expiration to give the trade
enough time to move into the money.
8. Determine which spread to place by calculating:
• Limited  Risk: Limited.  [(Number  of  short  calls  × difference  in
strikes) × 100] – net credit (or + net debit).
• Unlimited  Reward: Unlimited  to  the  upside  above  the  upside
breakeven.
• Upside  Breakeven: Higher  strike  call  +  [(difference  in  strikes  ×number of short calls) ÷ (number of long calls – number of shortcalls)] – net credit (or + net debit).
• Downside Breakeven: Lower strike price + (net credit ÷ numberof short calls)]. A downside breakeven does not exist if the trade isentered with a net debit.
9. Create  a  risk  proﬁle  of  the  most  promising  option  combination  andgraphically  determine  the  trade’s  feasibility.  A  call  ratio  backspreadrisk  proﬁle  shows  an  unlimited  reward  above  the  upside  breakevenand a limited reward (if entered for a net credit) below the downsidebreakeven.
10. 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.
11. Make  an  exit  plan  before  you  place  the  trade.  How  much  money is the maximum amount you are willing to lose? How much proﬁt doyou want to make on the trade? For example, exit the trade when youhave a 50 percent proﬁt or at least 30 days prior to expiration on theoptions before the major amount of time decay occurs.
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. You do not have to watch the market closely on this type of trade. The
proﬁt on this strategy is unlimited.
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14. Choose an exit strategy based on the price movement of the underly-ing stock and ﬂuctuations in the implied volatility of the options:
• The  underlying  stock  exceeds  the  upside  breakeven: Onceyou have made a reasonable proﬁt (50 percent), you should closeout an equal number of short calls and long positions. Since the re-maining long option is now working with free money, you can af-ford to hold onto it for additional proﬁt. It is recommended that youclose out the position before 30 days to expiration unless you feelstrongly that the stock will continue to increase.
• The  underlying  stock  rises  between  the  upside  and  down-side  breakevens: You  should  exit  the  entire  position—buy  theshort calls back and sell the long calls—and try to mitigate the loss.• The  underlying  stock  falls  below  the  downside  breakeven:Let the options expire worthless, or sell the long call at expirationto mitigate any losses.
Put Ratio Backspread Road Map
In  order  to  place  a  put  ratio  backspread,  the  following  14  guidelinesshould be observed:
1. Look for a bearish, low implied volatility market where you anticipatea  sharp  decline  in  the  price  of  the  underlying  stock  with  increasedvolatility.
2. Explore past price trends and liquidity by reviewing price and volume
charts over the past year.
3. Check to see if this stock has options available.4. Review options premiums per expiration dates and strike prices. Ide-ally use options with at least 90 days until expiration. LEAPS optionsare also a good alternative for put ratio backspreads.
5. Investigate  implied  volatility  values  to  see  if  the  options  are  over-priced or undervalued. This strategy is best placed in markets with aforward volatility skew. In this environment, the higher strike options(the ones you want to sell) have higher implied volatility and can beoverpriced. The lower strike options (the ones you want to buy) enjoylower implied volatility and are often underpriced. By trading the for-ward volatility skew, you can capture the implied volatility differentialbetween the short and long options.
6. A put ratio backspread is created by selling a higher strike put (ITM orATM) and buying a greater number of lower strike puts (OTM). It is
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not recommended to place positions with ratios greater than .67. Useratios that are a multiple of 1 to 2 (the most common) or 2 to 3. Alloptions must have the same expiration date.
7. Look at options with at least 90 days until expiration to give the trade
enough time to move into the money.
8. Determine which spread to place by calculating:
• Limited  Risk: [(Number  of  short  puts  × difference  in  strikes)  ×
100] – net credit or + net debit.
• Limited  Reward: Limited  to  the  downside  below  the  downside
breakeven (as the underlying can only fall to zero).
• Upside  Breakeven: Higher  strike  put  –  (net  credit  ÷ number  ofshort puts). An upside breakeven does not exist if the trade is en-tered with a net debit.
• Downside  Breakeven: Lower  strike  price  –  [(number  of  shortputs × difference  in  strikes)  ÷ (number  of  long  puts  –  number  ofshort puts)] + net credit (or – net debit).
9. Create  a  risk  proﬁle  of  the  most  promising  option  combination  and
graphically determine the trade’s feasibility.
10. 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.
11. Make an exit plan before you place the trade. How much money is themaximum  amount  you  are  willing  to  lose?  How  much  proﬁt  do  youwant  to  make  on  the  trade?  For  example,  exit  the  trade  when  youhave a 50 percent proﬁt or at least 30 days prior to option expiration.12. Contact  your  broker  to  buy  and  sell  the  chosen  options.  Place  thetrade as a limit order so that you limit the net credit/debit of the trade.13. You do not have to watch the market closely on this type of trade. The
proﬁt on this strategy is unlimited.
14. Choose an exit strategy based on the price movement of the underly-ing stock and ﬂuctuations in the implied volatility of the options:
• The  underlying  stock  falls  below  the  downside  breakeven:Once you have made a reasonable proﬁt (50 percent +), you shouldclose out an equal number of short and long puts. Since the otherlong option is now working with free money, you can afford to holdonto it for additional proﬁt. It is recommended that you close outthe position before 30 days until expiration unless you feel stronglythat the stock will continue to decrease.
• The underlying stock rises between the downside and upsidebreakevens: You should exit the entire position and take the loss.
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CONCLUSION
Ratio backspreads are great strategies that when ideally placed provide acredit for the position with unlimited reward potential. In general, thesetype  of  strategies  consist  of  selling  one  or  more  options  that  are  at-the-money and simultaneously buying a larger number of options that are fur-ther  out-of-the-money  where  all  options  have  the  same  expiration  dateand underlying stock or index.
Ratio  backspreads  are  quite  popular.  The  key  to  ﬁnding  one  lies  inidentifying  the  correct  volatility  conditions  that  will  allow  you  to  placethem for a credit (or even). The Optionetics.com Platinum web site offersa variety of great tools to help search for these conditions.Vacation trading criteria include the following issues.
• Look for a market where you anticipate a large directional move:• Up with a reverse volatility skew—call ratio backspreads.• Down with a forward volatility skew—put ratio backspreads.
• Buy  and  sell  options  with  at  least  90  days  or  greater  till  expiration.
LEAPS are ideal as the time factor will work for you.
• Once you are deep in-the-money, you may want to consider an adjust-ment by closing out one long and one short position and continuing tohold one long position.
• Exit strategy: Look for your target proﬁt and exit before 30 days to ex-piration. Your maximum risk is usually very low, so you can chose tostay in the trade and look for a turnaround or get out before a largepercentage loss.
Volatility plays a key role in ratio backspreads. By searching for theright  volatility  combination  you  can  create  a  position  that  gives  you  ahigh probability for a healthy reward. Developing a good feel for volatil-ity  is  an  important  part  of  being  able  to  pick  the  right  market  and  theoptimal strategy. Markets that go up rapidly most likely will come downfast. The faster they go down, the faster they go up. If you are in a mar-ket that is going straight to the moon, start looking for opportunities forput  ratio  backspreads.  Why?  When  the  markets  are  going  straight  up,traders  pump  up  the  call  prices  because  of  increased  volatility.  Thisalso means that the market may very well be positioning itself for a se-vere correction to the downside. Many times you can get better priceson  the  put  side  of  a  trade,  because  people  tend  to  buy  calls  whenvolatility increases. There is simply a greater demand for calls in a fast-moving market to the upside. If the market is going down and you ex-pect continuation, do a put ratio backspread. If you expect a reversal,do a call ratio backspread.
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The best way to learn how these strategies react to market movementis  to  experience  them  by  paper  trading  markets  that  seem  promising.Once  you  have  initiated  a  paper  trade,  revisit  the  trade  every  week  tolearn  how  market  forces  affect  these  kinds  of  limited  risk/unlimited  re-ward strategies.
One of the most important actions in trading is exiting a trade. Papertrading is also a practical way of learning how to exit a trade by monitor-ing the market for proﬁts or losses. Any ﬁctitious losses can be chalked upto experience (rather than a real loss) and all winning trades will inspireconﬁdence.
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CHAPTER 10
TradingTechniques forRange-BoundMarkets
A large  percentage  of  markets  trend  sideways  within  a  consistent
trading range throughout the trading year. In many cases, you mayﬁnd  stock  shares  or  futures  that  have  been  trading  sideways  forsome time. While these markets do not produce much in the way of proﬁtsfor  the  traditional  buy-and-hold  stock  trader,  they  do  provide  optionstraders with amazing limited risk opportunities. This chapter takes a closelook at these options strategies and how they can be employed to exploitsideways movement as well as the time value of options (otherwise knownas the time premium).
As previously discussed, option pricing includes time value and intrin-sic  value.  The  intrinsic  value  of  an  option  is  the  value  an  in-the-money(ITM) option has if it were exercised at that point. For example, if I own anIBM 70 December call option, and IBM is trading at $80, the option has $10of intrinsic value. This is due to the fact that the strike price of the call op-tion is below the current trading price of the underlying asset. If the optionhas a market price of $12, then the remaining $2 of the call option is thetime value.
Furthermore, if an IBM 90 put option costs $13, it would have $10 ofintrinsic value and $3 of time value. Intrinsic value is not lost due to thepassage of time. Intrinsic value is lost only when the underlying asset—inthis  case  IBM—moves  against  your  option’s  position.  In  this  example,  ifIBM moves down, the call options lose intrinsic value. If IBM moves up,the put options lose intrinsic value.
Time value is lost due to time decay (also referred to as the theta de-cay) of the option. Options lose the most time value in the last 30 days
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of the life of the option—the closer the expiration date, the faster thetheta  decay.  Therefore,  the  last  day  will  have  the  fastest  loss  of  valuedue to time.
Since options lose value over time if markets do not move, this basicoption characteristic can be used to create strategies that work in marketsthat are moving sideways. Before we can explore the speciﬁc strategies,however, you need to be able to spot a sideways (or range-bound) market.A sideways market is a market that has traded between two numbersfor a speciﬁed period of time. The minimum time frame I prefer to use istwo months. However, for our purposes, a longer time frame can mean amore stable sideways market. As previously reviewed, these two numbersare referred to as the support and resistance levels. For example, if everytime IBM dips to around $70 per share it rebounds, this would establishthe support. If IBM would then trade up in price to reach $90 and then selloff again, this would establish the resistance. These two levels can then beused to employ an effective options strategy that would allow us to collecttime premium.
How do you ﬁnd these range-bound markets? I like to scan the vari-ous markets by eyeballing the charts. If I spot a market that appears to begoing  sideways,  I  take  a  ruler  and  try  to  draw  a  support  and  resistanceline. If this is easily accomplished, I then look for the most effective op-tions strategy to take advantage of the given market. Three of my favoritesideways strategies are the long butterﬂy, long condor, and long iron but-terﬂy  spreads.  Additionally,  we  will  also  explore  three  more  advancedrange-trading strategies: the calendar spread, the diagonal spread, and thecollar spread. 
LONG BUTTERFLY
The long butterﬂy is a popular strategy that traders use when they ex-pect the stock or market to trade within a range. The butterﬂy can bestructured using calls, puts, or a combination of puts and calls. In thisbook, we will focus on the long butterﬂy using only call options. In thatrespect,  the  long  butterﬂy  includes  three  strike  prices  and  can  bethought of as a combination of a bull call spread and a bear call spread.Lower and middle strike prices are used to create the bull spread andmiddle  and  higher  strike  prices  are  used  to  create  a  bear  call  spread.Sometimes,  traders  refer  to  the  middle  strike  prices,  which  are  gener-ally  at-the-money,  as  the  body and  call  the  higher  and  lower  strikeprices the wings.
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The long butterﬂy is a limited risk/limited reward strategy. It workswell  when  the  underlying  stock  makes  relatively  little  movement.  Thestrategy generates the maximum proﬁts when the price of the underly-ing  asset  is  equal  to  the  strike  price  of  the  short  options  at  expiration.The risks arise when the underlying asset moves dramatically higher orlower. However, the maximum risk is equal to the net debit paid for thetrade.  For  that  reason,  the  strategist  will  implement  the  long  butterﬂywhen expecting the underlying asset to stay within a range until the op-tions expire.
As a side note, although we will be using calls in our next example,the long butterﬂy can also be created using puts. In this case, the strate-gist will establish the position by purchasing one OTM put (wing), sell-ing two ATM puts (body), and buying one ITM put (wing). This wouldbe a combination of a bull put spread and a bear put spread.
Some strategists prefer to use the so-called long iron butterﬂy, a tradethat  is  created  as  a  combination  of  a  bear  call  spread  (a  short  ATM  calland a long OTM call) and a bull put spread (a long OTM put and a shortATM put). The short put should have a lower strike price than the shortcall.  Therefore,  unlike  the  long  butterﬂy,  the  iron  butterﬂy  includes  fourstrike prices instead of three. In any case, whether trading long butterﬂieswith puts and calls or trading long iron butterﬂies, the goal is to see theunderlying  stock  trade  sideways  and  for  the  short  options  to  lose  valuedue to time decay and expire.
Long Butterﬂy Mechanics
To  illustrate,  let’s  consider  an  example  using  a  hypothetical  company,XYZ.  During  the  month  of  January,  shares  are  trading  for  $70  and  havebeen  trading  in  a  range  between  $65  and  $75  during  the  past  severalmonths. So, the strategist believes the stock will remain within that rangeand  gravitate  toward  $70  from  now  until  May  expiration.  As  a  result,  along butterﬂy is created using calls on XYZ.
In  this  case,  the  strategist  goes  long  one  May  XYZ  65  call  for  $8,buys  one  May  XYZ  75  call  for  $2,  and  sells  two  XYZ  70  calls  for  $4.50each.  The  net  debit  of  the  trade  is  $1,  or  $100  for  one  long  butterﬂy,which  also  represents  the  maximum  risk.  The  maximum  reward  isequal  to  the  difference  between  the  middle  and  highest  strike  prices,minus  the  net  debit  times  100.  In  this  example,  the  maximum  proﬁtequals  $400  [(5  –  1)  × 100  =  $400]  per  contract.  This  will  occur  if  theXYZ is trading for $70 a share at expiration. The risk graph of this tradeis shown in Figure 10.1.
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FIGURE 10.1 Long Butterﬂy Risk Graph
Exiting the Position
• The  underlying  asset  falls  below  the  downside  breakeven(66): The  strategist  will  generally  want  to  let  the  options  expireworthless and incur the maximum loss.
• The  stock  is  in  between  the  breakevens  (66  and  74): Thetrade is in the proﬁt zone and the strategist should let the short op-tions  expire.  If  possible,  sell  the  long  option  with  a  lower  strikeprice for a proﬁt.
• The  stock  makes  a  dramatic  move  higher  than  the  upsidebreakeven  (74): Exit  the  position  or,  if  the  short  options  are  as-signed, exercise the long options to offset them.
Long Butterﬂy Case Study
A  long  butterﬂy  is  a  strategy  best  used  when  a  trader  expects  sidewaysmovement in a stock or index. A long butterﬂy can use either all calls orall puts and is the combination of two spreads. If calls are used, we arecombining a bull call spread and a bear call spread. For puts, it is the com-bination of a bull put spread and a bear put spread. The idea of the butter-
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Long Butterﬂy
Strategy: Buy lower strike option, sell two higher strike options, and buya higher strike option (all calls and puts) with the same expiration date.
Market Opportunity: Look for a range-bound market that is expected tostay between the breakeven points for an extended period of time.
Maximum  Risk: Limited to the net debit paid. [(Long premiums – shortpremiums) × 100].
Maximum  Proﬁt: Limited.  (difference  between  the  middle  strike  priceand  the  higher  strike  price  –  net  debit)  × 100.  Max  proﬁt  occurs  at  theshort strike price.
Upside Breakeven: Higher strike price – net debit.
Downside Breakeven: Lower strike price + net debit.
Margin: The broker will generally require the collateral equal to the debitfor both the bear call spread and the bull call spread.
ﬂy is derived from the purchase of the “wings” of the trade and the sale ofthe “body.”
A butterﬂy is a limited risk, limited reward strategy. The initial entry feeinto a butterﬂy creates a net debit, which is also the maximum risk of theposition.  The  maximum  reward  is  calculated  by  subtracting  the  net  debitfrom the difference between strike prices. For example, if we enter a 35-40-45 call butterﬂy, we would buy a 35 call, sell two 40 calls, and buy a 45 call.If our net debit was $3, our maximum risk would be $300 and our maximumreward would be $200: (5 – 3) × 100 = $200. The maximum proﬁt occurs ifthe underlying security closes at the middle strike price at expiration.
In mid-October 2003, a trader might have looked at IBM and expectedit to trade sideways through November’s option expiration on the 21st. OnOctober 16, IBM closed at $89.28 and it seemed likely that the stock wouldconsolidate near $90 after a signiﬁcant decline. As a result, we could haveentered a butterﬂy using the 85-90-95 put options or call options. However,let’s  use  the  calls  because  they  offered  just  a  slightly  better  entry.  Sincethis trade beneﬁts from time erosion and because we don’t want to givethe stock too much time to move out of its range, it’s usually best to usefront month options when trading a butterﬂy.
The  November  85  call  could  be  purchased  for  $5.20.  The  90  callscould be sold for $2. The 95 call would cost 0.60, leaving us with a totaldebit of $1.80. Let’s say we decide to place a total of ﬁve contracts; the netdebit  would  be  $900,  which  is  also  the  maximum  risk.  The  maximumproﬁt  is  found  by  subtracting  the  debit  of  1.80  from  the  difference  in
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spreads (5 points) to get $320: (5 – 1.80) × 100 = $320. Thus, if IBM were toclose  at  $90  on  expiration, 