ills_ch8_187-233.qxd 12/17/04 4:32 PM Page 210
210
THE OPTIONS COURSE
In order to see how this works, let’s look at a real-life example. Atthe  end  of  2003,  shares  of  Cisco  (CSCO)  started  to  consolidate  onceagain and this led to the belief that a breakout would soon occur. On De-cember 26, CSCO shares closed at $23.75. The idea was that if the stockbroke 25 to the upside or 22.50 to the downside, a major move would oc-cur. So, a strangle using the April 25 call and the April 22.50 put was en-tered.  The  April  25  calls  cost  $1.05,  as  did  the  April  22.50  puts.  Buyingﬁve  contracts  would  cost  $1,050,  which  was  also  the  maximum  risk  ofthis multiple-contract position.
The nice thing about a strangle, as with a straddle, is that if the stockdoesn’t move as expected, the straddle owner can get out without muchof a loss as long as he or she will not hold onto the options until expira-tion.  This  is  because  time  decay  is  light  when  an  option  is  still  severalmonths away from expiration.
By looking at the risk graph in Figure 8.9, you might notice how themaximum loss is wider than the maximum loss for a straddle. This is be-cause the maximum loss occurs if the underlying closes within the strikesat expiration. The breakevens for this trade are found by adding the debitper contract of 2.10 to the strike of 25, which is $27.10 to the upside. Thedownside is found by subtracting 2.10 from the strike of 22.50, or 20.40.
Cisco  did  break  out  of  this  consolidation  and  did  so  to  the  upside.Once the $25 mark was passed, the gains came fast. The stock reached itspeak on January 20 at $29.39, but the bearish pattern on January 21 wouldhave  taken  us  out  of  the  strangle.  At  that  point,  Cisco  was  trading  at$28.60 and the total proﬁt for the strangle was $1,075—a 102 percent re-turn on investment.
Long Strangle Case Study
Strategy: With the CSCO @ $23.75 a share on December 26, Long 5 AprilCSCO 25 Calls @ 1.05 and Long 5 April CSCO 22.50 Puts @ 1.05.
Market Opportunity: Expect a breakout from consolidation.
Maximum Risk: Limited to initial debit. In this case, the maximum risk is$1,050: (5 × 2.10) × 100.
Maximum Proﬁt: Unlimited to the upside and limited to the downside (asthe underlying can only fall to zero). In this case, $1,075 on January 21.
Downside Breakeven: Lower strike price minus the initial cost per con-tract. In this case, the DB is 20.40: (22.50 – 2.10).
Upside Breakeven: Higher strike price plus the initial cost per contract.In this case, the UB is 27.10: (25.00 + 2.10).
Margin: None.
ccc_fontanills_ch8_187-233.qxd 12/17/04 4:32 PM Page 211
Straddles, Strangles, and Synthetics
211
Today: 112 days left 75 days left 38 days leftExpiry:  0 days left
Close= 
23.75
tiforP
000,4
000,3
000,2
000,1
0
050,1–
15 
20 
25 
30
FIGURE 8.9 Risk Graph of Long Strangle on CSCO (Source: OptioneticsPlatinum © 2004)
SHORT STRANGLE STRATEGY
A  short  strangle  is  simply  the  opposite  of  a  long  strangle—you  sell  anOTM call and an OTM put with different strike prices and the identical ex-piration month. A short strangle has an upside-down U-shaped risk curve,which  tells  us  that  it  has  limited  proﬁt  potential  and  unlimited  risk  (seeFigure 8.10). In fact, your potential proﬁts are less than when you place ashort straddle because OTM premiums cost less than ATM premiums anddeliver a reduced overall credit to the seller. However, your risk is also alittle less than with the straddle because the market has to make a biggermove against you to reach the limits of your proﬁt range. In most cases,
                                              ccc_fontanills_ch8_187-233.qxd 12/17/04 4:32 PM Page 212
212
THE OPTIONS COURSE
FIGURE 8.10 Short Strangle Risk Graph
you will have a margin requirement on this kind of trade. Short stranglesare market neutral strategies as are short straddles. If the market doesn’tmove, you get to keep the premium. If you were expecting a huge move,with lots of volatility, would you sell a straddle or a strangle? Neither, notunless  you  have  a  death  wish.  Increasing  volatility  is  a  signal  for  longstraddles and strangles.
Short Strangle Example
Using XYZ trading at $50 a share in February, let’s create an example byselling one March 55 call at 2.50 and selling one March 45 put at 2.50. Thisis a classic example of selling a strangle. Figure 8.10 shows a risk proﬁleof this short strangle example. Your maximum reward is the net credit ofthe option premiums or $5, which equals $500 a contract: (2.50 + 2.50) ×100 = $500. The maximum risk is unlimited. The upside breakeven occurswhen the underlying asset equals the call strike price plus the net credit.The  upside  breakeven  for  this  trade  is  60:  (55  +  5  =  60).  The  downsidebreakeven  occurs  when  the  underlying  asset  equals  the  put  strike  priceminus the net credit, which is 40: (45 – 5 = 40) in this trade. Therefore theproﬁt range is between 40 and 60.
ccc_fontanills_ch8_187-233.qxd 12/17/04 4:32 PM Page 213
Straddles, Strangles, and Synthetics
213
Short Strangle
Strategy: Sell an OTM call and an OTM put with the same expiration date.
Market Opportunity: Look for a wildly volatile market where you antici-pate a drop-off into a very stable market with low volatility.
Maximum Risk: Unlimited to the upside and limited to the downside (asthe underlying can only fall to zero) beyond the breakevens.
Maximum Proﬁt: Limited to the net credit received.
Upside Breakeven: Call strike price + net credit received.
Downside Breakeven: Put strike price – net credit received.
Margin: Required. Extensive.
Exiting the Position
Let’s take a look at possible exit strategies for the short strangle example:
• XYZ  falls  below  the  lower  breakeven  (40): You  will  want  toclose out the position for the loss since the put is ITM and in dangerof assignment.
• XYZ  falls  within  the  lower  (40)  and  higher  (60)  breakevens:This  is  the  range  of  proﬁtability.  Both  options  expire  worthless  andyou get to keep the double premiums or maximum proﬁt of $500 (mi-nus commissions).
• XYZ  rises  above  the  higher  breakeven  (60): You  will  want to  close  out  the  position  since  the  call  is  ITM  and  in  danger  of assignment.
The  short  strangle  strategy  is  best  used  in  combinations  of  spreadsand  butterﬂies  and  other  option  strategies.  They  can  be  added  to  thesetypes  of  trades  for  extra  protection.  Once  again,  we  do  not  recommendselling a strangle due to the unlimited risk that comes with it; however, itis essential to understand how they work so that you can integrate theminto other trades.
Short Strangle Case Study
A short strangle is a limited reward, unlimited risk strategy that proﬁts ifthe underlying security trades sideways. Though proﬁts can be made us-ing this strategy, it is not one I usually recommend. I’ll say it again: Enter-ing unlimited risk strategies is rarely a good idea! However, it’s importantto understand how the short strangle strategy works.
ccc_fontanills_ch8_187-233.qxd 12/17/04 4:32 PM Page 214
214
THE OPTIONS COURSE
A long strangle requires a large move for the underlying security, so itmakes sense that a short strangle needs a sideways-moving, range-boundstock. However, because we are short two options, the risk is high and themargin required to enter this strategy would be very large. Nonetheless,let’s look at a real-life example of how a short strangle works.
On December 10, 2003, shares of the Nasdaq 100 Trust (QQQ) were trad-ing at $34.56 each. At this time, a trader might have believed the stock wasset to trade sideways during the holidays, as the chart had been moving side-ways  for  several  months.  As  a  result,  a  short  strangle  could  be  entered.  Ashort strangle proﬁts as long as the stock closes at expiration in between thetwo  strikes.  Because  this  strategy  beneﬁts  from  time  decay,  usually  short-term options are used. In the case of QQQ, January 2004 options were used.The  January  36  calls  could  be  sold  for  0.50  and  the  January  33  putscould be sold for 0.55. If ﬁve contracts were entered, the total credit of theoption premiums would be $1.05, or $525 for the ﬁve contracts, with unlim-ited risk. The downside breakeven is calculated by subtracting the credit of$1.05 per contract from the lower strike price. The upside breakeven is cal-culated  by  adding  the  credit  to  the  higher  strike.  In  this  example,  thebreakeven points are at 31.95 and 37.05. If the Qs were to close in betweenthese points at expiration in January, a proﬁt would be made.
The  graph  in  Figure  8.11  shows  us  exactly  the  opposite  of  what  wenormally want to see. The proﬁt zone is a very small portion of the graph,with the loss section much larger. This type of risk proﬁle normally meansa  large  amount  of  margin  will  be  needed,  and  this  is  deﬁnitely  the  casewith a short strangle.
Short Strangle Case Study
Strategy: With  the  security  trading  at  $34.56  a  share  on  December  10,2003, sell 5 January 36 calls at 0.50 and 5 January 33 puts at 0.55 on theNasdaq 100 Trust (QQQ).
Market Opportunity: Expect QQQ to trade sideways.
Maximum Risk: Unlimited to the upside and limited to the downside (asthe underlying can only fall to zero) beyond the breakevens.
Maximum Proﬁt: Limited to the initial credit received. In this case, $525:[5 × (.50 + .55)] × 100.
Downside Breakeven: Lower strike – the initial cost per contract. In thiscase, the DB is 31.95: (33 – 1.05).
Upside  Breakeven: Higher  strike  +  the  initial  cost  per  contract.  In  thiscase, the UB is 37.05: (36 +1.05).
Margin: Extensive.
ccc_fontanills_ch8_187-233.qxd 12/17/04 4:32 PM Page 215
Straddles, Strangles, and Synthetics
215
 Today: 37 days left 13 days leftExpiry:  0 days left
Close=  34.56 days left 
tiforP
0
000,1–
000,2–
000,3–
000,4–
000,5–
000,6–
000,7–
20 
 30 
   40 
    50  
FIGURE 8.11 Risk Graph of Short Strangle on QQQ (Source: OptioneticsPlatinum © 2004)
In this case, the Qs did not stay in their range, as they broke out tonew highs in early January. However, a smart trader probably would havelooked to get out on December 29 when the Qs broke above resistance at36. At this point, the risk would have been minimal, but if the holder ofthis  short  strangle  were  to  hold  on  until  expiration,  a  large  loss  wouldhave occurred.
LONG SYNTHETIC STRADDLES
One of my favorite delta neutral strategies is the long synthetic straddle. Itcan  be  especially  proﬁtable  because  you  can  make  adjustments  as  the
                 ccc_fontanills_ch8_187-233.qxd 12/17/04 4:32 PM Page 216
216
THE OPTIONS COURSE
market  moves  to  increase  your  return.  In  this  kind  of  straddle,  you  arecombining options with stock; and as the market moves up or down, youcan make money both ways. Perhaps this seems like a magic trick, espe-cially if you are short stock and long calls. Obviously one leg of the tradewill lose money as the other makes a proﬁt. The difference between theproﬁt and loss determines how much you are going to be able to pocketin  proﬁts  with  certain  types  of  positions.  Many  factors  govern  theamount of proﬁt, including the size of your account, the size of the trade,and whether you can adjust the trade to put yourself back to delta neu-tral after the market makes a move.
So, to review, there are at least three good reasons that a trader mightprefer a synthetic straddle position as opposed to simply buying or sellingstock outright.
1. The synthetic position is less costly, either in cash or margin require-
ments.
2. A  synthetic  position  actually  improves  some  element(s)  of  the  base
position that you are looking to enter.
3. The synthetic position will permit easier adjustments to the trade as
conditions change.
In all, the synthetic straddle is a very powerful trading vehicle. Whenwe account for costs of carry, put and call synthetic straddles are identi-cal and can be used interchangeably. Stockholders and short sellers alikewill be able to adjust the risk picture of a directional stock position to adelta neutral position, thus giving them the opportunity to make moneyin either direction.
Example #1: Long Synthetic Straddle Using Puts
Let’s set up a long synthetic straddle by going long 100 shares of XYZ at$50 a share and long two September XYZ 50 puts with three months untilexpiration at $2.50 a contract. The risk proﬁle for this trade is shown inFigure 8.12.
In this trade, when the market goes up, you have a proﬁt on the stockand  a  smaller  loss  on  the  options  (because  their  delta  decreased).  Thisleaves a net proﬁt. When the market goes down, you have a loss on the un-derlying asset against a bigger proﬁt on the options (because their deltaincreased),  so  again  you  have  a  net  proﬁt.  Either  way,  when  the  marketmoves  you  can  make  additional  proﬁts  by  adjusting  the  trade  back  todelta neutral. The risk is due to the time decay of the options. Risk on thisexample is the cost of the options, or $500: (2 × $2.50) × 100 = $500. Total
ccc_fontanills_ch8_187-233.qxd 12/17/04 4:32 PM Page 217
Straddles, Strangles, and Synthetics
217
FIGURE 8.12 Long Synthetic Straddle (Using Long Puts) Risk Graph
risk is assumed only if you hold the position to expiration and the underly-ing  asset  does  not  move  (or  you  fall  asleep  and  never  make  an  adjust-ment). The maximum proﬁt is unlimited.
The  upside  breakeven  of  a  long  synthetic  straddle  is  calculated  byadding the net debit paid for the options to the price of the underlying as-set. In this case, the upside breakeven is 55: (50 + 5 = 55). The downsidebreakeven is a little trickier. It is calculated using the following equation:[(2 × option  strike  price)  –  price  of  underlying  stock  at  initiation]  –  netdebit of options. In this trade, the downside breakeven is $45: [(2 × 50) –50] – 5 = $45. Thus, this trade makes money if the price of the underlyingmoves  above  $55  a  share  or  below  $45,  assuming  you  make  no  adjust-ments on the trade. Long synthetic straddles are best employed when youexpect a signiﬁcant move in the price of the underlying in either direction.
Exiting the Position
Let’s investigate exit strategies for the long synthetic straddle with puts:
• XYZ  falls  below  the  downside  breakeven  (45): If  the  stock’sprice falls below the downside breakeven, you can exercise one of theputs to mitigate the loss on the stock and sell the other long put for aproﬁt.
ccc_fontanills_ch8_187-233.qxd 12/17/04 4:32 PM Page 218
218
THE OPTIONS COURSE
Long Synthetic Straddle with Puts
Market  Opportunity: Look  for  a  market  with  low  volatility  where  youanticipate a volatility increase resulting in stock price movement in eitherdirection beyond the breakevens.
Long Stock and Long Puts
Strategy: Buy 100 shares of underlying stock and buy two long ATM puts.
Maximum Risk: [Net debit of options + (price of underlying stock at initi-ation – option strike price)] × number of shares.
Maximum Proﬁt: Unlimited to the upside and limited to the downside (asthe underlying can only fall to zero) beyond the breakevens.
Upside Breakeven: Price of underlying stock at initiation + net debit ofoptions.Downside  Breakeven: [(2  × option  strike  price)  –  price  of  underlyingstock at initiation] – net debit of options.
Margin: None. 50% on stock is possible.
• XYZ  falls  within  the  downside  (45)  and  upside  (55)breakevens: This is the range of risk and will cause you to considerclosing out the entire position at a loss or selling just the put options.The maximum risk is the cost of the double premium or $500 paid outfor the puts.
• XYZ rises above the upside breakeven (55): If the stock’s pricerises above the upside breakeven, you will be making money on thestock and losing money on the put options. You can sell the stock togarner the proﬁt and either sell the puts at a loss or hold onto them incase of a reversal.
Long Synthetic Straddle Using Puts Case Study
In this example, we want to ﬁnd a stock or market that has been tradingquietly, but could make an explosive move higher or lower. Studying thechart of the PHLX Semiconductor Index ($SOX) in April 2003, we arriveat the conclusion that the chip index is due for an explosive move in thenear future. We are not sure of the direction and decide to set up a deltaneutral strategy. However, it is not possible to set up a synthetic straddleon the Semiconductor Index. Why? It’s a cash index. Instead, we decideto implement this trade on the Semiconductor HOLDRS (SMH), which isan  exchange-traded  fund  that  holds  a  basket  of  semiconductor  stocks.
ccc_fontanills_ch8_187-233.qxd 12/17/04 4:32 PM Page 219
Straddles, Strangles, and Synthetics
219
Holding Company Depositary Receipts (HOLDRS) are exchange-tradedfunds that hold baskets of stocks from speciﬁc industry groups. HOLDRStrade on the American Stock Exchange and can be bought or sold in lotsof  100  shares.  For  example,  investors  can  buy  or  sell  BiotechnologyHOLDRS (BBH), Semiconductor HOLDRS (SMH), or Oil Service HOLDRS(OIH). In all, the American Stock Exchange offers trading in 17 differentHOLDRS.  Options  are  also  available  on  these  exchange-traded  fundsand  can  be  used  to  proﬁt  from  trends  related  to  speciﬁc  sectors  or industry groups.
First, we notice that the SMH is trading for $26.50 a share during themonth of April. We establish a long synthetic straddle by purchasing twonear-the-money  puts  and  100  shares  of  Semiconductor  HOLDRS.  Thenear-the-money puts have a strike price of 25 and expire in January 2004.The put premium is initially $3.20 and the trade is entered for a net debitof $3,290.
The SMH synthetic straddle will have a slightly bullish bias due to thefact  that  the  put  options  are  slightly  out-of-the-money.  The  delta  of  oneJanuary 25 put at initiation is approximately 32. As a result, this positionhas a positive delta of roughly 36. We could make the position almost per-fectly delta neutral by purchasing three January 25 puts. But for the pur-poses  of  illustration,  let’s  assume  the  trade  is  established  using  theaforementioned number of shares and contracts.
The risk curve in Figure 8.13 shows the proﬁt and loss potential asso-ciated with this trade until expiration. The maximum proﬁt is unlimited tothe upside as SMH moves higher. The maximum risk is limited and equalto the net debit, or $640 plus the difference in price between the SMH andthe strike price multiplied by the number of shares, or $1.50 × 100. There-fore, the maximum risk is $790, but will occur only if the options are helduntil  expiration.  The  upside  breakeven  is  computed  as  the  stock  priceplus  the  net  debit  of  the  options,  or  32.90:  (26.50  +  6.40).  The  downsidebreakeven is equal to 2 times the strike price minus the price of the stockminus the net debit of the options. In this case, 17.10: (50 – 26.50) – 6.40 =17.10.  Therefore,  the  trade  requires  a  large  move,  above  32.90  or  below17.10, to earn a proﬁt at expiration.
In all likelihood, the strategist would not hold this position until expi-ration because time decay is greatest 30 days before expiration. Let’s sup-pose  instead,  the  trade  was  closed  60  days  before  expiration,  or  onNovember 21, 2003. How would this trade have fared? At the time the posi-tion  was  closed,  the  Semiconductor  HOLDRS  were  well  above  the  entryprice and near $41 a share. The puts were deep out-of-the-money and prac-tically  worthless.  The  strategist  could  take  the  proﬁts,  which  equal  thevalue of the shares minus the cost of the trade, or $4,100 minus $3,290 or$810 (25 percent), and then hold onto the two put options as lottery tickets.
ccc_fontanills_ch8_187-233.qxd 12/17/04 4:32 PM Page 220
220
THE OPTIONS COURSE
Today: 263 days left 176 days left 88 days leftExpiry:  0 days left
Close= 
26.47
tiforP
008
006
004
002
0
002–
004–
006–
008–
20 
30
FIGURE 8.13 SMH Synthetic Straddle with Two Puts (Source: OptioneticsPlatinum © 2004)
Example #2: Long Synthetic Straddle with Calls
You  can  also  create  a  long  synthetic  straddle  by  selling  short  the  stockand buying call options to create an overall delta neutral position. Whenthe  market  goes  up,  you  have  a  loss  on  the  underlying  asset,  but  againyou have a bigger proﬁt on the options (their delta increases). When themarket  goes  down,  you  have  a  proﬁt  on  the  underlying  stock  and  asmaller loss on the options (their delta decreases). Either way, as long asthe market moves beyond the breakevens, the trade harvests a net proﬁt.Both trades are placed in markets where a rise in volatility is anticipatedand the stock and options are liquid—that is, they have a sufﬁcient num-ber of shares (or contracts) trading that there is no problem entering orexiting the trade.
                                ccc_fontanills_ch8_187-233.qxd 12/17/04 4:32 PM Page 221
Straddles, Strangles, and Synthetics
221
Long Synthetic Straddle with Puts Case Study
Market  Opportunity: Look  for  a  market  with  low  volatility  where  youanticipate a volatility increase resulting in stock price movement in eitherdirection beyond the breakevens.
Long Stock and Long Puts
Strategy: Buy 100 shares of Semiconductor HOLDRS for $26.50 and sell 2SMH January 25 puts @ $3.20. Entry debit equals $3,290.
Maximum Risk: [Net debit of options + (price of underlying stock at ini-tiation – option strike price)] × number of shares. In this case, the max riskis $790: [$6.40 + ($26.50 – 25)] × 100.
Maximum Proﬁt: Unlimited to the upside and limited to the downside (asthe underlying can only fall to zero). In this example, $810.
Upside Breakeven: Price of underlying at trade initiation + net debit ofoptions. In this case, the UB is 32.90: (26.50 + 6.40).Downside Breakeven: [(2 × option strike price ) – price of underlying attrade initiation] – net debit of options. In this case, the DB is 17.10: [(2 ×25) – 26.50] – 6.40.
Let’s examine a long synthetic straddle by shorting the stock and buy-ing  two  September  XYZ  50  calls  @  2.50  against  XYZ  trading  at  $50  pershare. The maximum risk is limited to the net cost of the calls plus the dif-ference in the call strike price minus the price of the stock at trade initia-tion. In this example, the maximum loss is limited to $500: [(2 × 2.50) + (50– 50)] × 100 = $500. The reward is unlimited above the upside and belowthe downside breakevens. The downside breakeven is calculated by sub-tracting the net debit of the options from the stock price at trade initia-tion.  In  this  example,  the  downside  breakeven  is  45:  (50  –  5  =  45).  Theupside breakeven is calculated by adding net debit of the options to twotimes the strike price minus the initial stock price. In this example, the up-side breakeven is 55: [(2 × 50) – 50] + 5 = 55. So, the trade theoreticallywill make a proﬁt if the underlying rises above the upside breakeven (55)or falls below the downside breakeven (45). The risk proﬁle of this tradeis shown in Figure 8.14. As you can see, this risk graph is identical in for-mat to the put synthetic straddle. Both offer a visual look at the strategy’sunlimited reward beyond the upside and downside breakevens.
Note: Although Figure 8.14 is identical to the risk proﬁle for the exam-ple of the long synthetic straddle using puts (Figure 8.12), this is due tothe similarity of the option premium values as well as the cost of the un-derlying asset.
ccc_fontanills_ch8_187-233.qxd 12/17/04 4:32 PM Page 222
222
THE OPTIONS COURSE
FIGURE 8.14 Long Synthetic Straddle (Using Long Calls) Risk Graph
Exiting the Position
Let’s investigate exit strategies for the long synthetic straddle:
• XYZ  falls  below  the  downside  breakeven  (45): If  the  stock’sprice  falls  below  the  downside  breakeven,  you  can  purchase  theshorted stock and let the calls expire worthless.
• XYZ  falls  within  the  downside  (45)  and  upside  (55