also involves a change of directional sentiment.
Mitigating a Loss■
Unravel the trade as described previously.
■
Advanced traders may choose to only partially unravel the spread leg-by-legand create alternative risk profiles (for example, a Bull Call risk profile).
6.3.7 ExampleABCD is trading at $27.65 on May 25, 2004.Buy one June 2004 25 strike call at $3.11.Sell two June 2004 $27.50 strike calls at $1.52.Net Debit
Premium bought  premium sold$3.11  $3.04  $0.07
Maximum Risk
Uncapped
Maximum Reward
[Difference in strikes]  net debit$2.50  $0.07  $2.43
Breakeven Down
Lower strike  net debit$25.00  $0.07  $25.07
Breakeven Up
Higher strike  maximum reward$27.50  $2.43  $29.93
Leveraged Strategies
Or:Buy two June 2004 25 strike call at $3.11.Sell three June 2004 $27.50 strike calls at $1.52.Net Debit
Premium bought  premium sold$6.22  $4.56  $1.66
Maximum Risk
Uncapped
Maximum Reward
[Number of long calls * difference in strikes]  netdebit(2 * $2.50)  $1.66  $3.34
Breakeven Down
Lower strike  (net debit / 2)$25.00  $0.825  $25.83 (rounded)
Breakeven Up
Higher strike  maximum reward$27.50  $3.34  $30.84
Here we can see the difference between the 2:1 and 3:2 ratios, but ultimately neitherexample is an attractive trade.
6.4 Ratio Put SpreadProficiency
Direction
Volatility
Asset Legs
Max Risk
Max Reward
Strategy Type
Uncapped
Capped
Income
Expert
Bullish
Low
■ Two Short Puts■ Long Put*
* Or can be three Short Puts with two Long Puts.
6.4.1 DescriptionThe Ratio Put Spread is the opposite of a Put Ratio Backspread in that we’re net shortoptions. This means we’re exposed to uncapped risk and can only make a limitedreward. As such, this is an undesirable strategy, and you’d be better off trading oneof the long butterflies.Increasing volatility is harmful to this strategy because of our exposure touncapped risk. The best thing that can happen is that the stock doesn’t move at all.The Ratio Put Spread involves buying and selling different numbers of the sameexpiration puts. Typically we sell and buy puts in a ratio of 2:1 or 3:2, so we arealways a net seller. This gives us the uncapped risk potential. It also reduces the netcost of doing the deal such that we create a net credit.
Sell two lower strike puts
Buy higher strike put
Ratio Put Spread
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or:
Sell three lower strike puts
Buy two higher strike puts
Ratio Put Spread
Steps to Trading a Ratio Put Spread1. Sell two or three lower strike puts.2. Buy one or two higher strike puts with the same expiration date. The ratio ofbought to sold puts must be 1:2 or 2:3.■
You will be trying to execute this trade for a net credit.
Steps In■
Try to ensure that the trend is upward and identify a clear area of support.
Steps Out■
Manage your position according to the rules defined in your TradingPlan.
■
If the stock falls below your stop loss, then unravel the entire position or atleast buy back the short puts.
■
In any event, look to unravel the trade at least one month before expiration,either to capture your profit or to contain your losses.
6.4.2 ContextOutlook■
With Ratio Put Spreads, your outlook is neutral to bullish—you are lookingfor decreasing volatility with the stock price remaining rangebound.
Rationale■
To execute a neutral to bullish income trade for a net credit. You are lookingfor the stock to remain at or above the upper breakeven point.
Net Position■
You want to do this as a net credit to maximize your profit potential.
■
Your maximum risk on the trade itself is unlimited. Your maximum reward onthe trade is limited to the difference between the strike prices plus the netcredit (all multiplied by the number of long contracts).
Leveraged Strategies
Effect of Time Decay■
Time decay is helpful to your position—because you are a net seller here (youare selling more contracts than you are buying), you want to be exposed to aslittle time as possible, preferably one month or less. Also remember that youare exposed to unlimited risk here, so you do not want that exposure to last forlong.
Appropriate Time Period to Trade■
You will be safer to choose a shorter time to expiration, preferably just amonth.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Try to ensure that the trend is upward and identify a clear area of support.
Selecting the Options■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Lower Strike—Around ATM—use online tools to find the optimum point.
■
Higher Strike—One or two strikes higher than the sold strike—use onlinetools to find the optimum yields and breakeven points at and beforeexpiration.
■
Expiration—Preferably less than one month. Use the same expiration date forboth legs.
6.4.3 Risk ProfilePlease note that these calculations differ for when the strategy is traded with a2:1 ratio or a 3:2 ratio.■
Maximum Risk
[Higher strike  difference in strikes * sold contracts] net debit
■
Maximum Reward
[Bought puts * difference in strikes]  net debit (or  netcredit)
■
Breakeven Down
[Higher strike] less [difference in strikes * number of shortcontracts] / [number of short contracts less long contracts]less [net credit received] or plus [net debit paid]
■
Breakeven Up
[Higher strike]  [net debit * number of long contracts]
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6.4.4 GreeksKey:ExpirationToday – 1 yearTime(t) – 1 monthRisk ProfileIf the stock priceremains around thelower strike price, wemake our maximumprofit. If it movesexplosively downwards, we makeuncapped losses.DeltaDelta (speed) is at itsgreatest the lowerthe stock reaches.The more the stockrises, the slower theposition becomes,and hence Deltaslows to zero.
Risk Profile
Theta
ThetaTime decay is predominantly helpful tothe position unlessthe stock rises dramatically.
Delta
Vega
VegaVolatility is predominantly harmful to theposition.
Gamma
Rho
RhoHigher interest ratesare generally helpfulto the position, particularly when thestock falls.
GammaGamma (acceleration)peaks inverselyaround the lowerstrike price, illustrating the position’smajor turning pointand the fastest rateof change.
6.4.5 Advantages and DisadvantagesAdvantages■
Net credit raised.
■
Profitable if the stock remains rangebound.
Disadvantages■
Uncapped risk if the stock rises.
■
More risk if the stock moves.
■
Comparatively complicated trade for the intermediate trader.
Leveraged Strategies
6.4.6 Exiting the TradeExiting the Position■
With this strategy, you can simply unravel the spread by buying back the putsyou sold and selling the puts you bought in the first place.
■
Advanced traders may leg up and down or only partially unravel the spreadas the underlying asset fluctuates up and down. In this way, the trader willbe taking smaller incremental profits before the expiration of the trade. Bybuying back one of the sold puts, you will be creating a Bear Put Spread, amuch safer trade but one that also involves a change of directionalsentiment.
Mitigating a Loss■
Unravel the trade as described previously.
■
Advanced traders may choose to only partially unravel the spread leg-by-legand create alternative risk profiles (for example, a Bear Put risk profile).
6.4.7 ExampleABCD is trading at $27.65 on May 25, 2004.Sell two June 2004 25 strike puts at $0.42.Buy one June 2004 $27.50 strike put at $1.33.Net Debit
Premium bought  premium sold$1.33  $0.84  $0.49
Maximum Risk
[Higher strike  difference in strikes * sold contracts] net debit$27.50  $5.00  $0.49  $22.99
Maximum Reward
[Bought puts * difference in strikes]  net debit1 * $2.50  $0.49  $2.01
Breakeven Down
[Higher strike  difference in strikes * sold contracts] net debit$27.50  $5.00  $0.49  $22.99
Breakeven Up
Higher strike  [net debit * bought contracts]$27.50  $0.49  $27.01
Or:Sell three June 2004 25 strike puts at $0.42.Buy two June 2004 $27.50 strike puts at $1.33.
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Net Debit
Premium bought  premium sold$2.66  $1.26  $1.40
Maximum Risk
[Higher strike  difference in strikes * sold contracts] net debit$27.50  $7.50  $1.40  $21.40
Maximum Reward
[Bought puts * difference in strikes]  net debit[2 * $2.50]  $1.40  $3.60
Breakeven Down
[Higher strike  difference in strikes * sold contracts] net debit$27.50  $7.50  $1.40  $21.40
Breakeven Up
Higher strike  (net debit / 2)$27.50  $0.70  $26.80
Here we can see the difference between the 2:1 and 3:2 ratios, but ultimately neitherexample is an attractive trade.
7Synthetic StrategiesIntroductionSynthetic strategies are generally those that attempt to mimic other stock, futures, oroptions strategies and use other securities to create the new strategy. As such, we canre-create the underlying asset synthetically using only options. We can re-create longand short positions for straddles by using a combination of buying and selling stocksand options together. We can re-create the same risk profile shape as a Long Call orLong Put by combining other assets together. Often, these synthetic strategies comeinto being when you’re looking to repair an existing strategy.In this chapter, we’ll cover the long and short synthetic straddles, which mimicthose that we discussed in Chapter 4, “Volatility Strategies.” Whereas a long straddle involves buying an ATM call and put together, a Long Synthetic Straddle can beconstructed using the stock with calls or the stock with puts. The advantage ofunderstanding how these synthetic strategies are created is not only the flexibility itaffords us as traders but also the adaptability to morph an existing position intosomething else simply by adding or taking away a leg of the trade. For example, ifyou’re already long in a stock, but you think it may be about to reverse, you couldbuy puts to create either a Synthetic Call or double the number of puts, which wouldcreate a Long Put Synthetic Straddle.Consequently, even Long Call and Put positions have their synthetic equivalents.The beauty of options is that we can create virtually any risk profile, although thatbeauty largely exists in an academic sense if you have the time and passion to pursue it! When it comes to actual trading, it’s best to keep things simple while havinga grasp of the more complex. It’s always best to trade “within yourself,” or in otherwords, to know that your intellect isn’t being stretched by the trade you’re currentlyinvolved in. The “stretching” should happen outside trading hours. When you’remaking trading decisions, you need to concentrate purely on the trading plan inquestion.
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Aside from the synthetic calls, puts, and straddles, we’ll also cover the Long andShort Synthetic Futures, which use options to synthetically re-create the underlyingposition. The combos are variations of the synthetic futures, which both have longand short versions.However, the first strategy we’re going to cover in this chapter is the Collar. TheCollar is a great strategy that somehow doesn’t fit into any other chapter of thisbook! The Collar is similar to a long dated Covered Call, but we add a long put toinsure the downside. The effect is that we buy the stock, insure it with a Long Put,and finance the insurance with a higher strike short call. Where volatility is high andsentiment is bullish, it’s possible to create risk-free collars, notwithstanding the factthat there is the net debit (largely of buying the stock) to consider. As such, the Collaris a low-risk but expensive strategy.In some senses, this is the most challenging chapter to follow, and these are certainly among the more awkward strategies to produce algorithms for, particularlythe synthetic straddles. When you’re attempting these strategies, paper trading orotherwise, use online tools so that you can take the math for granted, and just concentrate on the risk profile you’re creating and whether it fits your intended tradingplan and expectations. Many of the strategies in this chapter will have far-reachingtax consequences of which you and your accountant will need to be aware.
7.1 CollarProficiency
Direction
VolatilityN/A
Asset Legs
Max Risk
Max Reward
Strategy Type
Capped
Capital Gain
!
Intermediate
■ Long Stock
Bullish
Capped
■ Long Put■ Short Call
7.1.1 DescriptionThe Collar is similar to a Covered Call but typically works over a much longer timeperiod and involves another leg—buying a put to insure against the stock falling.The effect is of buying a stock, insuring against a down-move by buying puts, andthen insuring the trade by selling calls.Buy stock
➞
Buy asset
Buy puts
➞
Insure it from falling
Sell calls
➞
Finance the insurance
The risk profile therefore contains a capped downside because of the Long Put anda capped upside because of the Short Call. The level of insurance depends on where
Synthetic Strategies
you place the put strike and the cost of the put. The amount of upside depends onthe position of the higher strike call and how much you receive for selling the call.As such, there is an art to creating a good collar! Typically, high volatility is helpful,particularly in a bull market where demand for calls is higher and where they arepriced higher than the equivalent puts.The nature of a Collar is cautious. Don’t expect wild returns, because the soldcalls will prevent that from happening. The Collar works best over a longer period of time, so you’re rarely looking a more than a 20% return over a year, depending on how much risk you’re prepared to take. However, the trade-off is that therisk, in terms of your outlay on the stock, will be tiny. And that’s the beauty of aCollar.The Collar is particularly useful when you can’t afford to lose much on a trade,but you still want to participate in upside market action over, say, a 12- to 18-monthperiod. You’re happy to place the trade and simply leave it alone until expiration orvery close to it. The disadvantage to a Collar is that you really do have to wait until(near) expiration to fully benefit from the strategy, but bearing in mind that theCollar gives you such low risk, it’s a price you’re willing to pay.
Buy stock
Buy ATM put
Sell OTM call
Collar
Steps to Trading a Collar1. Buy the stock.2. Buy ATM (or OTM) puts.3. Sell OTM calls.■
The closer the put strike is to the price you bought the stock for, the betterinsurance you’ll have if the stock falls. However, the better insurance youhave in that regard, the more it will cost you!
Steps In■
Some traders prefer to select stocks between $10.00 and $50.00, consideringthat above $50.00 would be expensive to buy the stock. Ultimately it’s whatyou feel comfortable with.
■
Try to ensure that the trend is upward and identify a clear area of support.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
At expiration, you hope that your call will be exercised and that you’vemade your maximum profit.
■
If the stock remains below the call strike but above your stop loss, let thecall expire worthless and keep the entire premium.
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The point of a Collar is that you set the put strike at or above your stoploss, creating a minimum risk trade. Therefore, you are at liberty to keepthe position until expiration.
7.1.2 ContextOutlook■
With Collars, your outlook is conservatively bullish. This is supposed to be avery low-risk strategy.
Rationale■
To execute a long-term trade that is inherently low-risk. You will have to useonline tools to determine how little risk you’re going to take.
■
Obviously, with any long-term trade that takes money out of your account,there is “opportunity cost.” This is the interest that you could have made onthe net debit amount had you invested it in bonds or received simple interestpayments on it.
Net Position■
This is a net debit trade because money will come out of your account to payfor the stock. This is different from actual risk. If you select the right strikeprices for the bought put and sold call, you may even be able to execute thistrade with no risk at expiration, even though money has been debited fromyour account in order to make the trade. You will need to verify the riskprofile with the option prices and available strikes—it’s not always possibleto create a risk-free trade, but your best chance will come with longer toexpiration during bullish market conditions, where puts are priced cheaperthan calls!
■
If you are lucky with the availability of both friendly options premiums andstrikes, you may be able to structure a low-risk, risk-free, or even a guaranteedreturn trade. This is because your long position in the stock will rise up tothe point of the sold call strike price, giving you a profitable (albeit limited)upside. If the stock falls, then the ATM put (your insurance) will rise in value,and you will retain the premium received by having sold the OTM call. Thiscombination will offset the fall in value of the long stock.
Effect of Time Decay■
Time decay will be helpful with the sold call; it will be unhelpful to the boughtput and will have no effect on the stock you have bought.
■
The net effect is that time decay is helpful here when the position is profitableand harmful when the position is loss-making.
Synthetic Strategies
Appropriate Time Period to Trade■
It’s more likely that you will find the better Collar opportunities (in termsof risk containment) further out in time. Between one to two years isrecommended to give yourself more opportunities for a Collar to besuccessful. Do not expect inordinately high yields here—this is a risk-aversestrategy!
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Select a stock price range you feel comfortable with. Some traders prefer lowerpriced stocks; others don’t care. Ultimately it’s more important that the stockrises . . . or at least doesn’t fall.
■
Try to ensure that the trend is upward and identify a clear area of support.
Selecting the Options■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Put Strike—Look for either the ATM or just OTM (lower) strike below thecurrent stock price; it depends how much insurance you want.
■
Call Strike—Look for one or two (or more) strikes above the current stockprice. Use online tools to evaluate your risk/reward scenarios.
■
Expiration—Typically the best Collars can be found with at least one year toexpiration. You can, if you want to experiment, buy only a six-month put ifyou think you only need insurance for a set period of time, but the authenticCollar uses the same expiration dates for both put and call. Use online tools toexperiment with the strikes and expiration dates for your optimum trade.
7.1.3 Risk Profile■
Maximum Risk
[Stock price  put premium]  [Put strike  call premium].If this gives a negative figure, then you have a risk-freetrade.
■
Maximum Reward [Call strike  put strike  the risk of the trade]
■
Breakeven
[Stock price  call premium  put premium]
Look to create a strategy with minimal risk.
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7.1.4 GreeksKey:ExpirationToday – 1 yearTime(t) – 1 monthRisk ProfileAs the stock rises, wemake profits. As thestock falls, our risk iscontained by thebought put.
Risk Profile
Theta
ThetaTime decay is helpfulwhen the position isprofitable and harmful when the positionis loss-making.
DeltaDelta (speed) is positive and peaksbetween the strikeprices.
Delta
Vega
VegaVolatility is helpfulwhen the position isloss-making andharmful when theposition is profitable.
GammaGamma (acceleration)peaks positivelybelow the lowerstrike and inverselyabove the higherstrike.
Gamma
Rho
RhoHigher interest ratesare generally unhelpful to the position.
7.1.5 Advantages and DisadvantagesAdvantages■
Give yourself maximum protection against a fall in the underlying stockprice.
■
With volatile stocks, you can create a very low risk or even risk-free trade.
■
You can create a high yield on risk.
Disadvantages■
Works best for long-term strategies (over one year), so it is slow.
■
Maximum upside only occurs at expiration.
■
Creates only a low reward on capital expended.
Synthetic Strategies
7.1.6 Exiting the TradeExiting the Position■
If executed correctly, you will not need to exit this trade early because thereshould be very little risk. If you used margin and require the margined cashurgently, you may need to unwind the trade; however, this strategy is unsuitable if you need the cash before expiration.
■
Advanced traders may leg up and down as the underlying asset fluctuates upand down. In this way the trader will be taking smaller incremental profitsbefore the expiration of the trade.
Mitigating a Loss■
This shouldn’t be an issue with the Collar!
7.1.7 ExampleABCD is trading at $19.45 on May 29, 2004.Buy 1,000 shares of stock at $19.45.Buy 10 January 2006 20 strike puts at $6.50.Sell 10 January 2006 25 strike calls at $5.00.Net Debit
Stock bought  premium bought  premium sold$19.45  $6.50  $5.00  $20.95$20,950
Maximum Risk
Stock price  put premium  put strike  call premium$19.45  $6.50  $20.00  $5.00  $0.95$950.00
Maximum Reward
Call strike  put strike  risk of trade$25.00  $20.00  $0.95  $4.05$4,050
Breakeven
Stock price  call premium  put premium$19.45  $5.00  $6.50  $20.95
Max Yield on Risk
426.32%
Max Yield on Net Debit
19.33%
Notice how low the maximum risk is: just $950.00 compared to the net debit of$20,950. As such, the yield on risk is very high in comparison with the maximumyield on the net debit. However, because you’re buying the stock, the Collar is anexpensive strategy, but depending on your situation, it can be a great way toparticipate in a market upturn without risking much.
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7.2 Synthetic CallProficiency
Direction
Volatility
Asset Legs
N/ANovice
Bullish
Max Risk
Max Reward
Strategy Type
Uncapped
Capital Gain
!
■ Long Stock
Capped
■ Long Put
7.2.1 DescriptionI know we touched on this before, but . . . have you ever taken a red-hot stock tip?Did you buy the stock? Did it go up or down? If it went down, I’ll bet you wishedyou’d bought some insurance! Well, that’s what a Synthetic Call is. Basically, we buythe stock, but we insure against a downturn by buying an ATM or slightly OTM(lower strike) put. The net effect is that of creating the same shape as a standard longcall but with the same leverage as buying the stock.In simple terms, this means that we’re capping our downside in case the stockunexpectedly drops through our stop loss. The long put will increase in value if thestock collapses, thereby countering the loss in value of the long stock position. Thismakes the Synthetic Call a very useful strategy for backing a hunch (not a very scientific way to trade, but that’s why you’d look to insure it) or for speculating before,say, an earnings report or an FDA decision (for a drug stock).The risk profile therefore contains a capped downside because of the long put andan uncapped upside because of the long stock position. The result looks like a longcall but isn’t one! The level of insurance depends on where you place the put strikeand the cost of the put.
Buy stock
Buy put
Synthetic Call
Steps to Trading a Synthetic Call1. Buy the stock.2. Buy ATM (or OTM) puts.■
The closer the put strike is to the price you bought the stock for, the betterinsurance you’ll have if the stock falls. However, the better insurance youhave in that regard, the more it will cost you!■ Notice that you have created the risk profile of a call option (but you havepaid a lot more for it). What you are doing is capping your downside riskby buying the put option, having bought the stock.Steps In■
Some traders prefer to select stocks between $10.00 and $50.00, consideringthat above $50.00 would be expensive to buy the stock. Ultimately it’s whatyou feel comfortable with.■ Try to ensure that the trend is upward and identify a clear area of support.
Synthetic Strategies
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
If the stock falls, then you may need to unravel the entire trade because thestock is behaving contrary to your expectations.
■
Remember to buy more time than you strictly require so that you avoid thefinal month of time decay.
■
If the stock falls below your stop loss, then either sell the stock and keepthe put or unravel the entire position.
7.2.2 ContextOutlook■
With synthetic calls, your outlook is conservatively bullish. This is a low-riskstrategy.
Rationale■
To buy a stock for the medium or long term with the aim of underwriting yourdownside in the meantime.
■
If the stock rises, you will make profit.
■
If the stock falls, you will lose money, but your losses will be capped at thelevel of the put strike price.
Net Position■
This is a net debit trade because you’re buying both the stock and the put.
■
Your maximum risk is limited if the stock falls.
Effect of Time Decay■
Time decay is harmful to the value of the put you bought.
Appropriate Time Period to Trade■
Buy the puts with as long a time to expiration as you need the insurance for, plusat least one extra month so that you can avoid the worst effects of time decay.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Select a stock price range you feel comfortable with. Some traders prefer lowerpriced stocks; others don’t care. Ultimately it’s more important that the stockrises . . . or at least doesn’t fall.
■
Try to ensure that the trend is upward and identify a clear area of support.
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Selecting the Options■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Strike—Look for either the ATM or just OTM (lower) strike below the currentstock. If you’re confident of the stock rising, then choose a lower strike; ifyou want maximum insurance, choose the ATM strike, which will be moreexpensive.
■
Expiration—Depends on how long you want the insurance for. If it’s just to getpast an earnings report, then just buy enough time to cover that event plus onemore month to avoid the worst effects of time decay.
7.2.3 Risk Profile■
Maximum Risk
[Stock price  put premium  put strike price]
■
Maximum Reward
[Uncapped]
■
Breakeven
[Strike price  put premium  stock price  put strikeprice]
7.2.4 GreeksKey:ExpirationToday – 6 monthsTime(t) – 1 monthRisk ProfileAs the stock rises, wemake profits. As thestock falls, our risk iscontained by thebought put.
DeltaDelta (speed) is positive and peaks as weget deep ITM.
GammaGamma (acceleration)peaks positivelyaround the strikeprice.
Risk Profile
Theta
Delta
Vega
Gamma
Rho
ThetaTime decay is harmfulto the positionbecause we are longin options.
VegaVolatility is helpful tothe position becausewe are long inoptions.
RhoHigher interest ratesare generally unhelpful to the position.
Synthetic Strategies
7.2.5 Advantages and DisadvantagesAdvantages■
Buying the put insures your long stock against a catastrophic decline, thus capping your downside risk more effectively than just a stop loss on the stockalone, particularly in the event of a gap down.
■
Upside is uncapped.
