and highest strikes] plus the net credit or minus the net debit.
Effect of Time Decay■
Time decay is helpful to this position when it is profitable and harmful whenthe position is unprofitable. When you enter the trade, typically the stock pricewill be in the profitable area of the risk profile, so from that perspective, timedecay harms the position.
Appropriate Time Period to Trade■
One month or less.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Try to ensure that the trend is rangebound 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—Below the current stock price.
■
Middle Strike—As close to ATM as possible.
■
Higher Strike—Closer to the middle strike than the lower is below it; useonline tools to find the optimum yields and breakeven points at and beforeexpiration.
■
Expiration—Preferably one month or less, but there is a trade-off between timeand profit potential. Use the same expiration for all legs.
Sideways Strategies
5.9.3 Risk Profile[Middle strike  lower strike]  [higher strike  middlestrike]  net credit
■
Maximum Risk
■
Maximum Reward [Higher strike  middle strike]  net credit
■
Breakeven
[Lower strike  max risk]
5.9.4 GreeksKey:ExpirationToday – 3 monthsTime(t) – 1 monthRisk ProfileAs the stock priceremains rangebound,the position is profitable, with maximumreward occurring atthe middle strikeprice.
Risk Profile
Theta
ThetaTime decay is helpfulto the position whenit is profitable andunhelpful when it isunprofitable.
DeltaDelta (speed) peakspositively around thelower strike andinversely around theupper strike.
Delta
Vega
VegaVolatility is generallyunhelpful to the position unless it thestock moves outsidethe outer strikes.
GammaGamma (acceleration)peaks positively asthe risk profile beginsto climb into a profitable position andpeaks inverselyaround the upperstrike.
Gamma
Rho
RhoHigher interest ratesare generally helpfulto the position whenthe stock price islower and vice versa.
5.9.5 Advantages and DisadvantagesAdvantages■
Profit from a sideways or rising stock for very little cost.
■
Capped and low risk.
■
Comparatively high risk/reward ratio if the stock remains rangebound.
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Disadvantages■
The higher profit potential comes with a narrow range between the wingstrikes.
■
The higher profit potential only comes nearer expiration.
■
Bid/Ask Spread can adversely affect the quality of the trade.
5.9.6 Exiting the TradeExiting the Position■
With this strategy, you can simply unravel the spread by buying back theoptions you sold and selling the options 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 will betaking smaller incremental profits before the expiration of the trade.
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.
5.9.7 ExampleABCD is trading at $50.00 on May 17, 2004.Buy the June 2004 45 strike put for $0.98.Sell two June 2004 55 strike puts at $6.12.Buy the June 2004 60 strike put for $10.28.Net Credit
Premiums sold  premiums bought$12.24  $0.98  $10.28  $0.98
Maximum Risk
[Middle strike  lower strike]  [higher strike  middle strike] net credit$10.00  $5.00  $0.98  $4.02
Maximum Reward
Higher strike  middle strike  net credit$60.00  $50.00  $4.02  $5.98
Interim Risk / Reward
Net credit$0.98
Breakeven Down
Lower strike  maximum risk$45.00  $4.02  $49.02
Breakeven Up
N/A here.
Max ROI
148.76% if the stock is priced at $55.00 at expiration.
Interim ROI
24.38% if the stock is priced above $60.00 at expiration.
Sideways Strategies
It’s possible to have two breakevens with the Modified Butterfly, although it’s infinitely preferable to structure the trade so that there is no upper breakeven at all.After all, this is a neutral to bullish strategy, and it wouldn’t make sense for us to losemoney if the stock breaks the way we anticipated, even if we are still cautious aboutthe amount it could move.Note that you should always aim to achieve a net credit with the Modified PutButterfly.
5.10 Long Iron ButterflyThe Long Iron Butterfly is a rangebound income strategy that we covered in Chapter 2, “Income Strategies.” We won’t repeat an entire section on it here because it’smore suitably placed among the other income strategies. However, this is also a natural place for it to be so that you can compare it to the other rangebound and butterfly strategies.Go to Section 2.5 if you want to review this strategy before moving on to the next.
5.11 Long Iron CondorThe Long Iron Condor is also a rangebound income strategy that we covered inChapter 2. We won’t repeat an entire section on it here because it’s more suitablyplaced among the other income strategies. However, this is also a natural place forit to be so that you can compare it to the other rangebound and condor strategies.Go to Section 2.6 if you want to review this strategy before moving on to the nextchapter.
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6Leveraged StrategiesIntroductionBy leveraged strategies, we mean the ratio backspreads and ratio spreads. These arestrategies where your profits (or losses) are increasingly leveraged because of thedifferent number of options you’re buying or selling as part of the strategy.In this chapter we’re only reviewing four strategies. The ratio backspreads involvebuying more options than selling, so there is uncapped upside at an accelerated rate.The ratio spreads involve selling more options than buying, so there is uncappeddownside at an accelerated rate. No prizes for guessing which type is preferable!If we’re to concentrate on the ratio backspreads, we’ll quickly discover that theygive us limited risk and unlimited reward potential and that they require increasingvolatility, together with a large move in the stock price. Ratio backspreads areadvanced strategies and are fun to play when you’ve mastered other, more straightforward strategies. If you win, you can win big, but whatever happens to the stock,you want it to be dramatic either way!
6.1 Call Ratio BackspreadProficiency
Direction
Volatility
Asset Legs
Max Risk
Max Reward
Strategy Type
Uncapped
Capital Gain
!
Advanced
Bullish
High
■ Short Call*■ Two Long Calls
* Or can be two short calls with three long calls.
Capped
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6.1.1 DescriptionThe Call Ratio Backspread is an exciting strategy that enables us to make acceleratedprofits provided that the stock moves sharply upwards. Increasing volatility is veryhelpful because we’re net long in calls. The worst thing that can happen is that thestock doesn’t move at all, and even a sharp move down can be profitable, or at thevery least, preferable to no movement at all.The Call Ratio Backspread involves buying and selling different numbers of thesame expiration calls. Typically we buy and sell calls in a ratio of 2:1 or 3:2, so weare always a net buyer. This gives us the uncapped profit potential. It also reducesthe net cost of doing the deal such that we can even create a net credit! Furthermore,our risk is capped, though we need to investigate the strategy further in order tounderstand it more.
Sell lower strike call
Buy two higher strike calls
Call Ratio Backspread
Buy three higher strike calls
Call Ratio Backspread
or:
Sell two lower strike calls
Steps to Trading a Call Ratio Backspread1. Sell one or two lower strike calls.2. Buy two or three higher strike calls with the same expiration date. The ratio ofbought to sold calls must be 2:1 or 3:2.■
You will be trying to execute this trade at no cost or for a slight 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 Trading Plan.
■
If the stock falls below your stop loss, then unravel the entire position.
■
In any event, look to unravel the trade at least one month before expiration,either to capture your profit or to contain your losses.
6.1.2 ContextOutlook■
With call ratio backspreads, your outlook is aggressively bullish—you are looking for increasing volatility with the stock price moving explosively upwards.
Leveraged Strategies
Rationale■
To execute a bullish trade for little to no cost while reducing your maximumrisk. You are looking for the stock to rise significantly.
Net Position■
You want to do this as a net credit or zero cost transaction in order to minimize your maximum risk and cost.
■
Your maximum risk on the trade itself is limited to the difference in strikes lessyour net credit, all multiplied by the number of contracts you are selling. Yourreward on the trade is unlimited.
Effect of Time Decay■
Time decay is generally harmful to your position—you want as much time tobe right as possible because you are looking for such a large move.
Appropriate Time Period to Trade■
You will be safer to choose a longer time to expiration, preferably at least sixmonths.
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 bought strike; use onlinetools to find the optimum yields and breakeven points at and beforeexpiration.
■
Expiration—Preferably over six months. Use the same expiration date for bothlegs.
6.1.3 Risk ProfilePlease note that these calculations differ for when the strategy is traded with a 2:1ratio or a 3:2 ratio.
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■
Maximum Risk
[Difference in strike prices]  [net credit received] or [net debit paid]
■
Maximum Reward
[Uncapped]
■
Breakeven Down
[Lower strike  net credit]
■
Breakeven Up
[Higher strike price  (difference in strike prices *number of short calls)/(number of long calls  number ofshort calls)  [net credit received] or  [net debit paid]]
6.1.4 GreeksKey:ExpirationToday – 6 monthsTime(t) – 1 monthRisk ProfileIf the stock priceremains around thehigher strike price, wemake our maximumloss. If it movesexplosively upwards,we make uncappedprofits.DeltaDelta (speed) is at itsgreatest the more thestock rises. The morethe stock falls, theslower the positionbecomes, and henceDelta slows to zero.GammaGamma (acceleration)peaks around thehigher strike price,illustrating the position’s major turningpoint and the fastestrate of change.
Risk Profile
Theta
ThetaTime decay is predominantly harmfulto the position unlessthe stock falls dramatically.
Delta
Vega
VegaVolatility is predominantly helpful to theposition.
Gamma
Rho
RhoHigher interest ratesare generally helpfulto the position, particularly when thestock rises.
6.1.5 Advantages and DisadvantagesAdvantages■
Reduced cost of making the trade.
■
Capped risk (especially if the underlying stock moves with high volatility).
■
Uncapped and high leverage reward if the stock price rises.
Leveraged Strategies
Disadvantages■
More risk if the stock does not move.
■
Comparatively complicated trade for the intermediate trader.
6.1.6 Exiting the TradeExiting the Position■
With this strategy, you can simply unravel the spread by buying back the callsyou sold and selling the calls 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 will betaking smaller incremental profits before the expiration of the trade. By sellingone of the bought calls, you will be creating a Bear Call Spread, a less aggressive trade but one that 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 Bear Call risk profile).
6.1.7 ExampleABCD is trading at $27.65 on May 25, 2004.Sell one January 2005 25 strike call at $4.90.Buy two January 2005 30 strike calls at $2.50.Net Debit
Premium bought  premium sold$5.00  $4.90  $0.10
Maximum Risk
Difference in strikes  net debit$5.00  $0.10  $5.10
Maximum Reward
Uncapped
Breakeven Down
Lower strike  net creditN/A because net debit here
Breakeven Up
Higher strike  (difference in strikes) / (long calls short calls)  net debit (or  net credit)$30.00  ($5.00 / 1)  $0.10  $35.10
Or:Sell two January 2005 25 strike calls at $4.90.Buy three January 2005 30 strike calls at $2.50.
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Net Credit
Premiums sold  premiums bought$9.80  $7.50  $2.30
Maximum Risk
Number of short calls * difference in strikes  netcredit(2 * $5.00)  $2.30  $7.70
Maximum Reward
Uncapped
Breakeven Down
Lower strike  (net credit / 2)$25.00  $1.15  $26.15
Breakeven Up
Higher strike  (difference in strikes * 2) / (long calls short calls)  net debit (or  net credit)$30.00  ($10.00 / 1)  $2.30  $37.70
Here we can see the difference between the 2:1 and 3:2 ratios.The 3:2 ratio here gives us a net credit, but our breakeven is pushed out further,and we accept more risk. The 2:1 only costs $0.10 and gives us less risk with a lowerbreakeven point. Without a shadow of doubt, we’d go for the 2:1 in this example. Inreality we’d try a number of strikes ITM, ATM, and OTM in order to determine ouroptimum trade. Typically, the best way to do this is to compare the upper breakevenpoints and maximum risk for each alternative.
6.2 Put Ratio BackspreadProficiency
Direction
Volatility
Asset Legs
Max Risk
Max Reward
Strategy Type
Uncapped
Capital Gain
!
Advanced
Bearish
High
■ Two Long Puts
Capped
■ Short Put*
* Or can be two Short Puts with three Long Puts.
6.2.1 DescriptionThe Put Ratio Backspread is almost the precise opposite of the Call Ratio Backspread.It enables us to make accelerated profits, provided that the stock moves sharplydownwards. Increasing volatility is very helpful because we’re net long in puts. Theworst thing that can happen is that the stock doesn’t move at all, and even a sharpmove up can be profitable, or at the very least, preferable to no movement at all.The Put Ratio Backspread involves buying and selling different numbers of thesame expiration puts. Typically we buy and sell puts in a ratio of 2:1 or 3:2, so we arealways a net buyer. This gives us the uncapped profit potential. It also reduces thenet cost of doing the deal such that we can even create a net credit! Furthermore, ourrisk is capped, though we need to investigate the strategy further in order to understand it better.
Leveraged Strategies
Buy two lower strike puts
Sell higher strike put
Put Ratio Backspread
Sell two higher strike puts
Put Ratio Backspread
or:
Buy three lower strike puts
Steps to Trading a Put Ratio Backspread1. Buy two or three lower strike puts.2. Sell one or two higher strike puts with the same expiration date. The ratio ofbought to sold puts must be 2:1 or 3:2.■
You will be trying to execute this trade at no cost or for a slight net credit.
Steps In■
Try to ensure that the trend is downward and identify a clear area ofresistance.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
If the stock rises above your stop loss, then unravel the entire position.
■
In any event, look to unravel the trade at least one month before expiration,either to capture your profit or to contain your losses.
6.2.2 ContextOutlook■
With put ratio backspreads, your outlook is aggressively bearish—you arelooking for increasing volatility with the stock price moving explosivelydownwards.
Rationale■
To execute a bearish trade for little to no cost while reducing your maximumrisk. You are looking for the stock to rise significantly.
Net Position■
You want to do this as a net credit or zero cost transaction in order to minimize your maximum risk and cost.
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Your maximum risk on the trade itself is limited to the difference in strikes lessyour net credit, all multiplied by the number of contracts you are selling. Yourreward on the trade is uncapped until the stock falls to zero.
Effect of Time Decay■
Time decay is generally harmful to your position—you want as much time tobe right as possible because you are looking for such a large move.
Appropriate Time Period to Trade■
You will be safer to choose a longer time to expiration, preferably at least sixmonths.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Try to ensure that the trend is downward and identify a clear area ofresistance.
Selecting the Options■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Lower Strike—One or two strikes lower than the sold strike; use online toolsto find the optimum yields and breakeven points at and before expiration.
■
Higher Strike—Around ATM; use online tools to find the optimum point.
■
Expiration—Preferably over six months. Use the same expiration date for bothlegs.
6.2.3 Risk ProfilePlease note that these calculations differ for when the strategy is traded with a 2:1ratio or a 3:2 ratio.■
Maximum Risk
[Difference in strike prices]  [net credit received] or [net debit paid]
■
Maximum Reward
[Uncapped] until the stock falls to zero
■
Breakeven Down
[Lower strike price  (difference in strike prices *number of short puts) / (number of long puts number of short puts)  [net credit received] or [net debit paid]]
■
Breakeven Up
[Higher strike less net credit]
Leveraged Strategies
6.2.4 GreeksKey:ExpirationToday – 6 monthsTime(t) – 1 monthRisk ProfileIf the stock priceremains around thelower strike price, wemake our maximumloss. If it movesexplosively downwards, we makeuncapped profits.DeltaDelta (speed) is at itsgreatest (inversely)the more the stockfalls. The more thestock rises, the slowerthe position becomes,and hence Deltaslows to zero.GammaGamma (acceleration)peaks around thelower strike price,illustrating the position’s major turningpoint and the fastestrate of change.
ThetaTime decay is predominantly harmfulto the position unlessthe stock rises dramatically.
Risk Profile
Theta
Delta
Vega
VegaVolatility is predominantly helpful to theposition.
Gamma
Rho
RhoHigher interest ratesare generally unhelpful to the position,particularly when thestock falls.
6.2.5 Advantages and DisadvantagesAdvantages■
Reduced cost of making the trade.
■
Capped risk (especially if the underlying stock moves with high volatility).
■
Uncapped and high leverage reward if the stock price declines.
Disadvantages■
More risk if the stock does not move.
■
Comparatively complicated trade for the intermediate trader.
6.2.6 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.
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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 will betaking smaller incremental profits before the expiration of the trade. By sellingone of the bought puts, you will be creating a Bull Put Spread, a less aggressivetrade but one that 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 Put risk profile).
6.2.7 ExampleABCD is trading at $27.98 on May 25, 2004.Buy two January 2005 25 strike puts at $2.15.Sell one January 2005 30 strike put at $4.20.Net Debit
Premium bought  premium sold$4.30  $4.20  $0.10
Maximum Risk
Difference in strikes  net debit$5.00  $0.10  $5.10
Maximum Reward
Lower strike  maximum risk$25.00  $5.10  $19.90
Breakeven Down
Lower strike  maximum risk$25.00  $5.10  $19.90
Breakeven Up
N/A because we have a net debit here.
Or:Buy three January 2005 25 strike puts at $2.15.Sell two January 2005 30 strike put at $4.20.Net Credit
Premiums sold  premiums bought$8.40  $6.45  $1.95
Maximum Risk
Number of short puts * difference in strikes  net credit(2 * $5.00)  $1.95  $8.05
Maximum Reward
Lower strike  maximum risk$25.00  $8.05  $16.95
Breakeven Down
Lower strike  maximum risk$25.00  $8.05  $16.95
Breakeven Up
Higher strike  (net credit / 2)$30.00  $0.975  $29.03 (rounded)
Here we can see the difference between the 2:1 and 3:2 ratios.The 3:2 ratio here gives us a net credit, but our breakeven is pushed down further,and we accept more risk. The 2:1 only costs $0.10 and gives us less risk with a morefavorable breakeven point. Without a shadow of doubt, we’d go for the 2:1 ratio in
Leveraged Strategies
this example. In reality, we’d try a number of strikes ITM, ATM, and OTM in orderto determine our optimum trade. Typically, the best way to do this is to compare thelower breakeven points and maximum risk for each alternative.
6.3 Ratio Call SpreadProficiency Direction Volatility
Asset Legs
Max Risk
Max Reward Strategy Type
Expert
Bearish
Low
■ Long Call*
Uncapped Capped
Income
■ Two Short Calls
* Or can be two long calls with three short calls.
6.3.1 DescriptionThe Ratio Call Spread is the opposite of a Call Ratio Backspread in that we’re netshort options. This means we’re exposed to uncapped risk and can only make a limited reward. As such, this is an undesirable strategy, and you’d be better off tradingone of 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 Call Spread involves buying and selling different numbers of the sameexpiration calls. Typically we sell and buy calls 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.
Buy lower strike call
Sell two higher strike calls
Ratio Call Spread
Sell three higher strike calls
Ratio Call Spread
or:
Buy two lower strike calls
Steps to Trading a Ratio Call Spread1. Buy one or two lower strike calls.2. Sell two or three higher strike calls with the same expiration date. The ratio ofbought to sold calls 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 downward and identify a clear area of resistance.
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Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
If the stock rises above your stop loss, then unravel the entire position.
■
In any event, look to unravel the trade at least one month before expiration,either to capture your profit or to contain your losses.
6.3.2 ContextOutlook■
With Ratio Call Spreads, your outlook is neutral to bearish—you are lookingfor decreasing volatility with the stock price remaining rangebound.
Rationale■
To execute a neutral to bearish income trade for a net credit. You are lookingfor the stock to remain below the upper breakeven point.
Net Position■
You want to do this as a net credit to maximum 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).
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 you areexposed to unlimited risk here, so you do not want that exposure to last for long.
Appropriate Time Period to Trade■
You will be safer to choose a shorter time to expiration, preferably just a month.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Try to ensure that the trend is downward and identify a clear area of resistance.
Selecting the Options■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Lower Strike—ITM (below or at the current stock price); use online tools tofind the optimum point.
Leveraged Strategies■
Higher Strike—ATM—one or two strikes higher than the bought strike; useonline tools to find the optimum yields and breakeven points at and beforeexpiration.
■
Expiration—Preferably less than one month. Use the same expiration date forboth legs.
6.3.3 Risk ProfilePlease note that these calculations differ for when the strategy is traded with a 2:1ratio or a 3:2 ratio.■
Maximum Risk
[Uncapped]
■
Maximum Reward
[Difference in strike prices]  [net debit] or  [net debit]
■
Breakeven Down
[Lower strike  (net debit/number of long contracts)]
■
Breakeven Up
[Lower strike price]  [difference between strikes *number of short contracts] / [number of short contracts number of long contracts]  [net credit received] or [net debit paid]
6.3.4 Greeks
Risk ProfileIf the stock priceremains around thehigher strike price, wemake our maximumprofit. If it movesexplosively upwards,we make uncappedlosses.DeltaDelta (speed) is at itsgreatest (inversely)the more the stockrises. The more thestock falls, the slowerthe position becomes,and hence Delta slowsto zero.GammaGamma (acceleration)peaks inverselyaround the higherstrike price, illustrating the position’smajor turning pointand the fastest rateof change.
Key:ExpirationToday – 2 monthsTime(t) – 1 weekRisk Profile
Theta
ThetaTime decay is predominantly helpful tothe position unlessthe stock falls dramatically.
Delta
Vega
VegaVolatility is predominantly harmful to theposition.
Gamma
Rho
RhoHigher interest ratesare generally unhelpful to the position,particularly when thestock rises.
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6.3.5 Advantages and DisadvantagesAdvantages■
Net credit raised.
■
Profitable if the stock remains rangebound.
Disadvantages■
Uncapped risk if the stock price rises.
■
More risk if the stock moves.
■
Comparatively complicated trade for the intermediate trader.
6.3.6 Exiting the TradeExiting the Position■
With this strategy, you can simply unravel the spread by buying back the callsyou sold and selling the calls 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 will betaking smaller incremental profits before the expiration of the trade. By buyingback one of the sold calls, you will be creating a Bull Call Spread, a much safertrade but one that