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QUESTIONS AND EXERCISES
1.
In  sideways  markets,  option  strategies  can  be  developed  to  takeadvantage of ______________.
A. Gamma decay.B. Theta decay.
C. Delta neutrality.
D. Vega neutrality.
2. A sideways market is a market that ______________.
A. Has extremely low volatility.
B. Moves erratically.
C. Stays between consistent resistance and support levels.
D. Stays at the same market volume consistently.
3. Name the three parts of a butterﬂy strategy.
1. _________________________________________________________
2. _________________________________________________________
3. _________________________________________________________
4. The body of a butterﬂy spread contains ______________.
A. An option with the strike price above the resistance level.
B. An option with the strike price below the support level.
C. An option with the strike price outside of the support and resis-
tance levels.
D. An option with the strike price in between the support and resis-
tance levels.
5. The wings of a butterﬂy spread are comprised of ______________.
A. Options with the strike prices outside of the trading range.
B. Options with the strike prices at both ends of the trading range.
C. Options with the strike prices close to the equilibrium level.
D. One  option  outside  the  support  level  and  one  inside  the  resis-
tance level.
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6. A long butterﬂy spread consists of ______________.
A. Going long (buying) the wings and going short (selling) the body
(the middle strike options).
B. Going long (buying) the wings and going long (buying) the body
(the middle strike options).
C. Going short (selling) the wings and going long (buying) the body
(the middle strike options).
D. Going short (selling) the wings and going short (selling) the body
(the middle strike options).
7. Money  is  made  on  a  long  butterﬂy  when  the  market  closes
______________.
A. Outside of the wings.
B.
In-between the wings.
8. Calculate the values for the following long butterﬂy trade:
Long 1 December IBM 80 Call @ 7.50
Short 2 December IBM 85 Calls @ 5.00
Long 1 December IBM 90 Call @ 3.00
IBM is currently trading at $85.
Net debit = __________________________________________________
Maximum reward = __________________________________________
Maximum risk = _____________________________________________
Upside breakeven = __________________________________________
Downside breakeven = _______________________________________
9.
In a long condor, you need to ______________.
A. Go long the two inner option strikes of the body and go long the
wings.
B. Go long the two inner option strikes of the body and go short the
wings.
C. Go short the two inner option strikes of the body and go long the
wings.
D. Go short the two inner option strikes of the body and go short the
wings.
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10. Calculate the values for the following long condor trade:
Long 1 MSFT December 60 Call @ 8.00
Short 1 MSFT December 65 Call @ 5.00
Short 1 MSFT December 70 Call @ 2.00
Long 1 MSFT December 75 Call @ 1.00
Net debit = __________________________________________________
Maximum reward = __________________________________________
Maximum risk = _____________________________________________
Upside breakeven = __________________________________________
Downside breakeven = _______________________________________
11. A long iron butterﬂy is a combination of ________________________.
A. A bear put spread and a bull put spread.
B. A bear call spread and a bull call spread.
C. A bear call spread and a bull put spread.
D. A bear put spread and a bull call spread.
12. Calculate the values for the following long iron butterﬂy trade:
Long 1 EBAY January 75 Call @ $2.50
Short 1 EBAY January 70 Call @ $5.00
Short 1 EBAY January 65 Put @ $2.00
Long 1 EBAY January 60 Put @ $1.00
Net credit = _________________________________________________
Maximum reward = __________________________________________
Maximum risk = _____________________________________________
Upside breakeven = __________________________________________
Downside breakeven = _______________________________________
13. A calendar spread is a combination of __________________________.
A. A long option and a short option.
B. A covered call and a protective put.
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14. A diagonal spread is a combination of ______________.
A. A long option and a short option.
B. A covered call and a protective put.
15. A collar strategy is a combination of ______________.
A. A long option and a short option.
B. A covered call and a protective put.
MEDIA ASSIGNMENT
In this chapter, we are going to look for stocks that are trading sidewaysor  within  a  range.  In  order  to  do  so,  connect  to  the  Internet  with  yourbrowser  set  on  www.optionetics.com.  At  that  point,  you’ll  see  the  “FreeRanker” on the Optionetics home page. At the time of this writing, it islocated near the bottom right-hand side of the web site.
Using the free ranker, you want to look for range-bound stocks. In thiseffort, you can click on the button that says “Quiet.” These stocks are theones that have less volatility relative to historical levels. To be speciﬁc, thequiet ranking sorts stocks based on the six-day statistical volatility com-pared to the 100-day. According to the site, “These stocks are candidatesfor sideways trades like calendar spreads and butterﬂies.”
VOCABULARY LIST
Body
Butterﬂy
Calendar spread
Collar
Condor
Diagonal spread
Directionless
Equilibrium level
Iron butterﬂy
Range-bound
Resistance
Sideways
Support
Theta
Time decay
Trading range
Wasting asset
Wings
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SOLUTIONS
THE OPTIONS COURSE WORKBOOK
1.
In  sideways  markets,  option  strategies  can  be  developed  to  takeadvantage of ______________.Answer: B—Theta decay.Discussion: Theta  is  a  Greek  letter  used  to  deﬁne  how  an  optionsprice  will  change  due  to  the  passage  of  time.  It  is  another  term  fortime decay, which refers to the fact that option premiums lose valueas the expiration date draws closer.
2. A sideways market is a market that ______________.
Answer: C—Stays between consistent resistance and support levels.Discussion: A sideways or range-bound market is the opposite of atrending market. It is a period of quiet trading that sees little pricemovement  in  the  underlying  asset.  Traders  often  use  technical support  and  resistance  levels  to  identify  the  trading  range  of  a sideways market.
3. Name the three parts of a butterﬂy strategy.Answer: Upper wing, body, and lower wing.Discussion: With  a  long  butterﬂy,  the  strategist  sells  two  at-the-money options and buys an in-the-money and an out-of-the money op-tion. In that case, the at-the-money options are considered the body.The  option  with  the  higher  strike  price  is  the  upper  wing  and  theoption with the lower strike price is the lower wing.
4. The body of a butterﬂy spread contains ______________.
Answer: D—An option with the strike price in between the supportand resistance levels.Discussion: Ideally,  the  strategist  will  use  technical  support  andresistance levels to identify the best strike prices to use for the bodyof the butterﬂy spread.
5. The wings of a butterﬂy spread are comprised of ______________.
Answer: B—Options  with  the  strike  prices  at  both  ends  of  the trading range.Discussion: Establishing  the  wings  using  strike  prices  near  the  up-per and lower ends of the trading range will help increase the odds ofsuccess  when  establishing  long  butterﬂies.  Ideally,  if  the  underlying
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instrument revisits the upper or lower bands of the trading range, itwill revert and head back toward the strike price of the body.
6. A long butterﬂy spread consists of ______________.
Answer: A—Going long (buying) the wings and going short (selling)the body (the middle strike options).Discussion: With  a  long  butterﬂy,  the  strategist  sells  two  at-the-money options and buys an in-the-money and an out-of-the moneyoption.
7. Money  is  made  on  a  long  butterﬂy  when  the  market  closes
______________.Answer: B—In-between the wings.Discussion: Ideally, the underlying instrument will stay within a trad-ing range. If it moves towards the middle strike prices (of the shortoptions),  the  short  options  will  expire  worthless  and  the  strategistcan keep the premium.
8. Calculate the values for the following long butterﬂy trade:
Long 1 December IBM 80 Call @ 7.50
Short 2 December IBM 85 Calls @ 5.00
Long 1 December IBM 90 Call @ 3.00
IBM is currently trading at $85.Answer:Net debit = [(7.50 + 3) – (2 × 5)] × 100 = $50 [(Long – short premiums)× 100].Maximum  reward  =  [(85  –  80)  –  .50]  × 100  =  $450  [(Difference  be-tween strikes – net debit) × 100].Maximum risk = $50 (Limited to the net debit paid).
Upside breakeven = (90 – .50) = $89.50 (Highest strike – net debit).
Downside breakeven = (80 + .50) = $80.50 (Lowest strike + net debit).Discussion: The long butterﬂy is a limited risk strategy with a maxi-mum loss equal to the net debit paid. The maximum reward is equalto  the  difference  between  highest  strike  and  the  short  strike  minusthe net debit. Maximum proﬁt is realized when the stock price equalsthe short strike. The upside breakeven equals the highest strike priceminus  the  net  debit  paid,  and  the  downside  breakeven  equals  thelowest strike price plus the net debit paid.
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9.
In a long condor, you need to ______________.Answer: C—Go short the two inner option strikes of the body and golong the wings.Discussion: Just as with the long butterﬂy, the long condor involvesselling  two  options  and  buying  two  options.  However,  the  optionsthat  are  sold  will  have  two  different  strike  prices;  so  with  the  longcondor, the strategist is buying four separate contracts.
10. Calculate the values for the following long condor trade:
Long 1 MSFT December 60 Call @ 8.00
Short 1 MSFT December 65 Call @ 5.00
Short 1 MSFT December 70 Call @ 2.00
Long 1 MSFT December 75 Call @ 1.00Answer:Net  debit  =  [(8  +  1)  –  (5  +  2)]  × 100  =  $200  [(Long  –  short  premi-ums) × 100].Maximum reward = [(35 – 30) – 2] × 100 = $300 [(Difference betweenstrikes – net debit) × 100].Maximum risk = $200 (Limited to the net debit).
Upside breakeven (75 – 2) = $73 (Highest strike – net debit).
Downside breakeven (60 + 2) = $62 (Lowest strike + net debit).Discussion: The maximum risk of the long condor is the debit paid.The best reward is equal to the difference between the strike pricesminus  the  net  debit.  The  upside  breakeven  is  equal  to  the  higheststrike price minus the net debit. The lowest strike price is equal to thedownside breakeven plus the net debit.
11. A long iron butterﬂy is a combination of ______________.Answer: C—A bear call spread and a bull put spread.Discussion: The long iron butterﬂy is a strategy that consists of fouroptions with the same expiration date and different strike prices. To es-tablish the trade, the strategist will buy one higher strike call and sellone  lower  strike  call,  which  is  the  same  as  a  bear  call  spread. Thestrategist will also sell a put and buy a lower strike put, which is thesame as a bull put spread. The short puts and calls will be at- or near-the-money. The long puts and calls will be out-of-the-money. The ideais to see the underlying asset stay in a range and for the short optionsto expire with little or no value. The long options serve as a hedge inthe event of a signiﬁcant move higher or lower in the underlying asset.
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12. Calculate the values for the following long iron butterﬂy trade:
Long 1 EBAY January 75 Call @ $2.50
Short 1 EBAY January 70 Call @ $5.00
Short 1 EBAY January 65 Put @ $2.00
Long 1 EBAY January 60 Put @ $1.00Answer:Net credit = [(5 + 2) – (2.50 + 1)] × 100 = $350 [(Short – long premi-ums) × 100].Maximum reward = $350 (Limited to the net credit).Maximum risk = [(75 – 70) – 3.50] × 100 = $150 [(Difference betweenlong and short strikes – net credit) × 100].Upside breakeven = (70 + 3.50) = $73.50 (Strike price of upper shortcall + net credit).
Downside  breakeven  =  (65  –  3.50)  =  $61.50  (Strike  price  of  lowershort put—net credit).Discussion: The long iron butterﬂy is established for a credit, whichis equal to the premium received for the short options minus the pre-mium  paid  for  the  long  options.  The  maximum  reward  is  the  netcredit.  The  maximum  risk  is  equal  to  the  difference  between  thestrike prices minus the credit. The upside breakeven equals the shortcall strike price plus the credit. The downside breakeven equals thestrike price of the short put minus the credit.
13. A calendar spread is a combination of ______________.
Answer: A—A long option and a short option.Discussion: In  the  calendar  spread,  the  strategist  is  buying  a  long-term option and also selling a short-term option. Both options havethe  same  strike  prices,  but  different  expiration  dates.  Calendarspreads can be created with either puts or calls.
14. A diagonal spread is a combination of ______________.
Answer: A—A long option and a short option.Discussion: Diagonal spreads can be constructed in different ways.In any situation, however, the strategist is buying an option and alsoselling an option. The options will have different expiration dates anddifferent strike prices. For instance, a diagonal spread can be createdby  purchasing  a  longer-term  out-of-the-money  call  and  simultane-ously selling a shorter-term at-the-money call.
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15. A collar strategy is a combination of ______________.Answer: B—A covered call and a protective put.Discussion: A collar is created around a stock by purchasing a putoption and selling a call option. In most cases, both the call and theput will be out-of-the-money. The strategy is similar to the protectiveput, but the cost of the put is offset with the sale of a call. The collarhas limited risks and limited rewards.
MEDIA ASSIGNMENT
This chapter encourages readers to visit the Optionetics.com home pageand use the free ranker to search for stocks with low volatility. By click-ing on the “Quiet” button, readers can generate a list of stocks that haverelatively  low  levels  of  statistical  volatility  relative  to  the  past.  Sub-scribers using Optionetics.com Platinum will be able to provide more re-ﬁned screens that can produce a list of low-volatility stocks. Often, thesecompanies are in industries with stable proﬁts like consumer products,groceries, or pharmaceuticals.
It  is  often  helpful  to  generate  a  price  chart  of  promising  stocks.  Bycharting the quiet stocks, traders should be able to identify support andresistance levels, which can also help identify potential candidates for thevarious  range-bound  strategies  discussed  in  this  chapter.  As  usual,  newtraders are encouraged to paper trade and back-test these strategies forrange-bound markets before actually putting money on the line.
VOCABULARY DEFINITIONS
Body: The inner part of a butterﬂy spread. In the case of the long butterﬂy,it represents the options that are being sold and that have strike pricesbetween the highest and lowest strike prices.
Butterﬂy: The sale (or purchase) of two identical options, together withthe purchase (or sale) of one option with an immediately higher strike andone option with an immediately lower strike. All options must be the sametype, have the same underlying, and have the same expiration date.
Calendar spread: A spread consisting of the purchase of one long-termoption  and  the  sale  of  one  short-term  option  of  the  same  type  with  thesame exercise price.
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Collar:  A type of strategy that involves buying shares, selling calls, andbuying puts. It is a combination of a covered call and a protective put.
Condor: The sale (or purchase) of two options with consecutive exerciseprices, together with the purchase (or sale) of one option with an immedi-ately lower exercise price and one option with an immediately higher ex-ercise price.
Diagonal  spread:  A  two-sided  spread  consisting  of  buying  a  long-termoption and selling a shorter-term option with different strike prices. Op-tions are of the same type and have the same underlying asset.
Directionless: Refers  to  an  investment  that  lacks  direction  and  is not  trending  higher  or  lower.  Certain  options  strategies  work  well when the underlying asset is not moving higher or lower (i.e., when it isdirectionless).
Equilibrium  level: The  level  where  supply  meets  demand.  The  meanbetween an asset’s support price and resistance price.
Iron butterﬂy: The combination of a long (or short) straddle and a short(or long) strangle. All options must have the same underlying and have thesame expiration.
Range-bound: Refers  to  an  investment  or  market  that  is  not  trendinghigher or lower, but rather remaining within a narrow price span.
Resistance: A price level that serves as a ceiling to higher prices. A stockmight turn away from this price level on a few occasions.
Sideways: An investment or market that lacks clear direction and tendsto show relatively little price change.
Support: A price level at which a stock or market begins seeing increas-ing demand or buying interest. It serves as a ﬂoor to lower prices. A majorsupport area is one that has been tested on several occasions and over asustained  period  of  time.  When  a  major  support  area  is  broken  and  thestock or market begins to falter, a more meaningful move to the downsidemay occur. For that reason, technicians consider major support areas tobe signiﬁcant.
Theta: The Greek letter that refers to the loss in an option’s value due tothe passage of time. Theta is expressed as a number such as –.10 or –.05.
Time  decay: The  process  of  options  losing  value  as  the  expiration  dateapproaches.
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Trading range: The recent high and low prices of a stock or other invest-ment that serve as resistance and support.
Wasting  asset: An  investment  that  loses  value  over  time.  Options  haveset expiration dates and lose value as time passes, so they are consideredwasting assets.
Wings: A term to describe a portion of a butterﬂy or condor. In a long but-terﬂy, for instance, the wings are the options that are purchased and havethe highest and lowest strike prices. The body consists of the short optionswith the middle strike prices.
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CHAPTER 11
Increasing YourProﬁts withAdjustments
SUMMARY
Experienced  options  traders  are  continuously  assessing  the  risk/rewardproﬁle of open positions because as the underlying asset changes in value,so will other factors. For instance, the delta of a position can change dra-matically as the underlying asset moves higher or lower. So, to stay deltaneutral  in  a  strategy  like  a  long  synthetic  straddle,  an  options  strategistmust  often  make  modiﬁcations  to  the  position.  This  may  include  buyingmore contracts or shares or selling them. When a strategist makes changesto a position due to price movements in the underlying asset, the strategistis  making  an  adjustment  to  the  position.  The  strategist  does  not  need  totell the broker that an adjustment is being made. Instead, the trader simplyenters the order to buy or sell more options or shares in order to bring theposition back to delta neutral.
This chapter explores the process of adjustments. For instance, howdo changes in the market inﬂuence the overall position delta of the trade?If  the  move  is  signiﬁcant,  it  might  be  time  to  adjust  the  trade.  Often,  bymaking an adjustment, a trader can increase proﬁts on the trade by bring-ing the trade back to delta neutral. In addition, adjustments can be madeto lock in proﬁts or to help salvage the value of a losing trade. The mostimportant factor to understand is that option positions are not just openedand  closed.  In  many  cases,  they  can  be  modiﬁed  with  adjustments  toimprove their overall risk/reward proﬁles.
141
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QUESTIONS AND EXERCISES
1. Name three things you can do when the market moves and your trade
is no longer delta neutral.
1. _________________________________________________________
2. _________________________________________________________
3. _________________________________________________________
2. An  adjustment  can  be  made  by  ______________  to  offset  your  posi-
tion to bring it back to delta neutral.
A. Buying or selling options.
B. Buying or selling futures.
C. Buying or selling stocks.
D. All of the above.
3. Name the two sides of a delta neutral trade.
1. _________________________________________________________
2. _________________________________________________________
4. Stock has a ______________ delta.
A. Fixed.
B. Variable.
C. Fixed or variable.
5. Options have ______________ deltas.
A. Fixed.
B. Variable.
C. Fixed or variable.
6. ATM options are easy to work with because they have ______________.
A. Low liquidity and thin price spreads.
B. Low liquidity and large price spreads.
C. High liquidity and thin price spreads.
D. High liquidity and large price spreads.
7. Time-based adjustments are based on ______________.
A. The number of days left until expiration.
B. Regular intervals (days, weeks, months, etc.).
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C. The movements of the sun.
D. All of the above.
8. Event-based adjustments are most likely to occur ______________.
A. When a special event dictates the adjustment.B. At regular intervals (days, weeks, months, etc.).
C. Based on an expected event that is known beforehand.
D. All of the above.
9. What is the key advantage of using an at-the-money option?
A.
B.
It will have several strike prices.
It is more likely to have high open interest and liquidity.
C. The  strike  price  will  be  slightly  above  the  market  value  of  the
underlying instrument.
D. The  strike  price  will  be  slightly  below  the  market  value  of  the
underlying instrument.
10. Calls have ______________ deltas.
A. Negative.
B. Fixed.
C. Positive.
D. None of the above.
11. Puts have ______________ deltas.
A. Negative.
B. Fixed.
C. Positive.
D. None of the above.
MEDIA ASSIGNMENT
In this media assignment, we are going to return to the free options cal-culator  at  the  Chicago  Board  Options  Exchange  (CBOE)  and  computethe deltas of various options positions. Once your PC is booted and on-line,  type  www.cboe.com  into  the  web  browser,  which  will  take  you  tothe  Chicago  Board  Options  Exchange  web  site.  From  the  CBOE  homepage,  click  the  “Trading  Tools”  tab,  then  the  “Volatility  Optimizer,”  and
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then  click  on  “Options  Calculator.”  Next,  select  “American”  in  the  stylebox.  (Note: If  the  calculator  on  the  CBOE  site  is  not  available,  readerscan  use  any  options  calculator  that  includes  the  variable  delta  to  com-plete this assignment.)
Next,  input  some  variables  into  the  calculator.  First,  let  the  stockprice equal 60 and the strike price equal 75; the volatility is 30 percent, theannual interest rate is 5 percent, and the company pays no dividend (quar-terly  dividend  amount  equals  0).  Next,  in  the  “Days  Left  to  Expiration”box, click “Days Until Expiration” and enter the number 100. We are goingto  look  at  an  options  contract  with  100  days  remaining  until  expirationthat has a strike price of 75 and volatility of 30 percent, with an underlyingsecurity trading at $60 that pays no dividends. Now, write down the deltaof the put and the delta of the call.
Let’s assume that the stock price begins to climb higher. Change theequity price to 70. What are the deltas now? What about at 75? Now, as-sume we buy a straddle using one put and one call. What is the delta ofthis position? Or, assume that we buy 100 shares and buy two puts. Whatis  the  position  delta?  Finally,  assume  that  the  stock  price  climbs  to  80.What are the deltas of the put and the call? What are the position deltas ofthe straddle and the long synthetic straddle? In the case of the straddle,what can we do to get back to delta neutral?
VOCABULARY LIST
Adjustment
Directional trade
Event-based adjustment
Fixed delta
Liquidity
Negative delta
SOLUTIONS
Open interest
Positive delta
Thin spreads
Time-based adjustment
Variable delta
1. Name three things you can do when the market moves and your trade
is no longer delta neutral.Answer: Exit  the  trade,  maintain 