is at itsfastest in betweenthe strikes. Noticehow Delta slowsdown when the position is deep ITM orOTM.
Delta
Vega
VegaVolatility is helpful tothe position when itis unprofitable andharmful when it isprofitable.
Gamma
Rho
RhoHigher interest ratesare generally unhelpful to the position.
GammaGamma (acceleration)peaks above theupper (bought) strikeand peaks inverselybelow the lower(sold) strike.
2.4.5 Advantages and DisadvantagesAdvantages■
Short-term income strategy not necessarily requiring any movement of thestock.
■
Capped downside protection compared to a Naked Call.
Disadvantages■
Maximum loss is typically greater than the maximum gain, despite the cappeddownside.
■
High yielding trades tend to mean less protective cushion and are thereforeriskier.
■
Capped upside if the stock falls.
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2.4.6 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.
Mitigating a Loss■
Unravel the trade as described previously.
■
Advanced traders may choose to only partially unravel the spread leg-by-leg.In this way, they will leave one leg of the spread exposed in order to attemptto profit from it.
2.4.7 ExampleABCD is trading at $28.00 on May 12, 2004.Sell the June 2004 30 strike call for 1.00.Buy the June 2004 35 strike call for 0.50.Net Credit
Premium sold  premium bought1.00  0.50  0.50
Maximum Risk
Difference in strikes  net credit5.00  0.50  4.50Maximum risk is greater than your net credit
Maximum Reward
Net credit0.50
Breakeven
Lower strike  net credit30.00  0.50  30.50
Max ROI
11.11%
Cushion
$2.50 or 8.93% from breakeven
2.5 Long Iron ButterflyProficiency
Direction
Volatility
Asset Legs
Max Risk
Max Reward
Strategy Type
Capped
Income
!
Intermediate
Neutral
Low
■ Long Put■ Short Put■ Short Call■ Long Call
Capped
Income Strategies
2.5.1 DescriptionThe Long Iron Butterfly is an intermediate strategy that can be profitable for stocksthat are rangebound. It is, in fact, the combination of a Bull Put Spread and a BearCall Spread. The higher strike put shares the same strike as the lower strike call tocreate the butterfly shape. The combination of two income strategies also makes thisan income strategy. Often, traders will leg into the Long Iron Butterfly, first tradinga Bull Put Spread just below support and then as the stock rebounds off resistanceadding a Bear Call Spread, thereby creating the Long Iron Butterfly.Ideally the stock will remain between the lower and higher strikes, with the maximum profit occurring if the options expire when the stock is priced at the centralstrike price. In this ideal scenario, effectively all the options expire worthless, andyou just keep the combined net credit. The combined net credit serves to widen thearea of your breakevens—in other words, the Bull Put element helps the Bear Callelement, and vice versa.
Buy lowerstrike put
Sell middlestrike put
Sell middlestrike call
Buy higherstrike call
Long IronButterfly
Steps to Trading a Long Iron Butterfly1. Buy one lower strike (OTM) put.2. Sell one middle strike (ATM) put.3. Sell one middle strike (ATM) call.4. Buy one higher strike (OTM) call.■
All options share the same expiration date for this strategy.
■
For this strategy, you must use both calls and puts. A Long Iron Butterfly isthe combination of a Bull Put Spread and a Bear Call Spread.
■
The short put and the short call share the same middle (ATM) strike price.
■
Remember that there should be equal distance between each strike price,while the stock price should generally be as close as possible to the middlestrike price.
Steps In■
Try to ensure that the trend is rangebound and identify clear areas of support and resistance.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
Remember that the Long Iron Butterfly is a combination of other strategies,so it can be unraveled in two-leg chunks.
■
You can unravel the position just before expiration—remember to includeall the commissions in your calculations.
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2.5.2 ContextOutlook■
With Long Iron Butterflies, your outlook is direction neutral. You expect littlemovement in the stock price.
Rationale■
With Long Iron Butterflies, you are looking to execute a potentially high yielding trade at a net credit whereby your maximum profits occur where the stockfinishes around the middle strike price at expiration.
■
You are anticipating low volatility with the stock price, which will lead you toprofit.
■
If you examine what you’ve done here, you have simply combined a Bull PutSpread with a Bear Call Spread, both of which are net credit spreads. It canalso be seen as a narrow Short Strangle, combined with a wider Long Strangle.
Net Position■
This is a net credit trade.
■
Your maximum risk is the difference between any two strikes less your netcredit. (Remember that all the different strike prices are equidistant to eachother.) Your maximum reward is the net credit you receive.
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■
It’s safest to trade this strategy on a short-term basis, preferably with onemonth or less to expiration.
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 clear areas of supportand resistance.
Selecting the Options■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
Income Strategies■
Lower Strike—Below the current stock price (or below where you think thestock will be at expiration).
■
Middle Strike—As close to ATM (or where you think the stock will be at expiration) as possible.
■
Higher Strike—The same distance above the middle strike as the lower isbelow it; use online tools to find the optimum yields and breakeven points atand before expiration.
■
Expiration—One month or less. Use the same expiration date for all legs.
2.5.3 Risk Profile■
Maximum Risk
[Difference in adjacent strikes  net credit]
■
Maximum Reward
[Net credit received]
■
Breakeven Down
[Middle strike  net credit]
■
Breakeven Up
[Middle strike  net credit]
2.5.4 GreeksKey:ExpirationToday – 3 monthsTime(t) – 1 monthRisk ProfileAs the stock priceremains rangebound,the position is profitable, with maximumprofit occurring at themiddle strike price.DeltaDelta (speed) is at itsgreatest the outerstrikes and is zeroaround the middlestrike.GammaGamma (acceleration)peaks positively outside the outer strikesand peaks inverselyaround the middlestrike, highlightingthe position’s majorturning point andmiddle Delta neutralpoint.
Risk Profile
Theta
ThetaTime decay is helpfulto the position whenit is profitable andunhelpful when it isunprofitable.
Delta
Vega
VegaVolatility is generallyunhelpful to the position unless the stockmoves outside theouter strikes.
Gamma
Rho
RhoHigher interest ratesare generally helpfulto the position whenthe stock price islower and vice versa.
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2.5.5 Advantages and DisadvantagesAdvantages■
Profit from a rangebound stock for no cost and low downside risk.
■
Capped and low risk compared with potential reward.
■
Comparatively high profit potential if the stock remains rangebound.
Disadvantages■
The higher profit potential comes with a narrower range between the wingstrikes.
■
The higher profit potential only comes nearer expiration.
■
Bid/Ask Spread can adversely affect the quality of the trade.
2.5.6 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 thespread as the underlying asset fluctuates up and down. In this way thetrader will be taking smaller incremental profits before the expiration of thetrade.
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.
2.5.7 ExampleABCD is trading at $25.00 on April 12, 2004.Buy the May 2004 20 strike put for $0.30.Sell the May 2004 25 strike put for $1.50.Sell the May 2004 25 strike call for $2.00.Buy the May 2004 30 strike call for $0.50.
Income Strategies
Net Credit
Premiums sold  premiums bought2.70
Maximum Risk
Difference in adjacent strikes  net credit5.00  2.70  2.30
Maximum Reward
Net credit2.70
Breakeven Down
Middle strike  net credit25.00  2.70  22.30
Breakeven Up
Middle strike  net credit25.00  2.70  27.70
Max RO
117.39% if the stock is at the middle strike at expiration
2.6 Long Iron CondorProficiency
Direction
Volatility
Asset Legs
Max Risk
Max Reward
Strategy Type
Capped
Income
!
Intermediate
Neutral
Low
■ Long Put
Capped
■ Short Put■ Short Call■ Long Call
2.6.1 DescriptionThe Long Iron Condor is an intermediate strategy that can be profitable for stocksthat are rangebound. A variation of the Long Iron Butterfly, it is in fact the combination of a Bull Put Spread and a Bear Call Spread. The higher strike put is lowerthan the lower strike call in order to create the condor shape. The combination oftwo income strategies also makes this an income strategy. Traders often will leg intothe Long Iron Condor, first trading a Bull Put Spread just below support and thenas the stock rebounds off resistance adding a Bear Call Spread, thereby creating theLong Iron Condor.Ideally the stock will remain between the two middle strikes, with the maximumprofit occurring if the options expire between these. In this ideal scenario, effectively all the options expire worthless, and you just keep the combined net credit. Thecombined net credit serves to widen the area of your breakevens—in other words,the Bull Put element helps the Bear Call element, and vice versa.
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Buy lowerstrike put
Sell middle lowerstrike put
Sell middle higherstrike call
Buy higherstrike call
Long IronCondor
Steps to Trading a Long Iron Condor1. Buy one lower strike (OTM) put.2. Sell one lower middle strike (OTM) put.3. Sell one higher middle strike (OTM) call.4. Buy one higher strike (OTM) call.■
All options share the same expiration date for this strategy.
■
For this strategy, you must use both calls and puts. A Long Iron Condor isthe combination of a Bull Put Spread and a Bear Call Spread.
■
The short put strike is lower than the short call strike.
■
Remember that there should be equal distance between each strike price,while the stock price should generally be between the two middle strikes.
Steps In■
Try to ensure that the trend is rangebound and identify clear areas of support and resistance.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
Remember the Long Iron Condor is a combination of other strategies, so itcan be unraveled in two-leg chunks.
■
You can unravel the position just before expiration—remember to includeall the commissions in your calculations.
2.6.2 ContextOutlook■
With Long Iron Condors, your outlook is direction neutral. You expect littlemovement in the stock price.
Rationale■
With Long Iron Condors, you are looking to execute a potentially high-yieldingtrade at a net credit, whereby your maximum profits occur where the stockfinishes between the middle strikes at expiration.
Income Strategies■
You are anticipating low volatility with the stock price, which will lead you toprofit.
■
If you examine what you’ve done here, you have simply combined a BullPut Spread with a Bear Call Spread, both of which are net credit spreads. Itcan also be seen as a narrow Short Strangle combined with a wider LongStrangle.
Net Position■
This is a net credit trade.
■
Your maximum risk is the difference between any two strikes less your netcredit. (Remember that the all the different strike prices are equidistant to eachother.) Your maximum reward is the net credit you receive.
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■
It’s safest to trade this strategy on a short-term basis, preferably with onemonth or less to expiration.
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 clear areas of supportand resistance.
Selecting the Options■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Lower (put) Strikes—Below the current stock price (or below where you thinkthe stock will be at expiration).
■
Higher (call) Strikes—Above the current stock price (or above where youthink the stock will be at expiration).
■
Expiration—One month or less. Use the same expiration date for all legs.
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2.6.3 Risk Profile■
Maximum Risk
[Difference in adjacent strikes  net credit]
■
Maximum Reward
[Net credit received]
■
Breakeven Down
[Middle short put strike  net credit]
■
Breakeven Up
[Middle short call strike  net credit]
2.6.4 GreeksKey:ExpirationToday – 3 monthsTime(t) – 1 monthRisk ProfileAs the stock priceremains rangebound,the position is profitable, with maximumprofit occurringbetween the middlestrikes.
Risk Profile
Theta
ThetaTime decay is helpfulto the position whenit is profitable andunhelpful when it isunprofitable.
DeltaDelta (speed) is at itsgreatest the outerstrikes and is zerobetween the middlestrikes.
Delta
Vega
VegaVolatility is generallyunhelpful to the position unless the stockmoves outside theouter strikes.
Gamma
Rho
RhoHigher interest ratesare generally helpfulto the position whenthe stock price islower and vice versa.
GammaGamma (acceleration)peaks positively outside the outer strikesand peaks inverselyaround the middlestrikes, highlightingthe position’s majorturning point and middle Delta neutral point.
2.6.5 Advantages and DisadvantagesAdvantages■
Profit from a rangebound stock for no cost and low downside risk.
■
Capped and low risk compared with potential reward.
■
Comparatively high profit potential if the stock remains rangebound.
Income Strategies
Disadvantages■
The higher profit potential comes with a narrower range between the wingstrikes.
■
The higher profit potential only comes nearer expiration.
■
Bid/Ask Spread can adversely affect the quality of the trade.
2.6.6 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.
2.6.7 ExampleABCD is trading at $27.50 on April 12, 2004.Buy the May 2004 20 strike put for $0.25.Sell the May 2004 25 strike put for $1.25.Sell the May 2004 30 strike call for $1.30.Buy the May 2004 35 strike call for $0.35.Net Credit
Premiums sold  premiums bought1.95
Maximum Risk
Difference in adjacent strikes  net credit5.00  1.95  3.05
Maximum Reward
Net credit1.95
Breakeven Down
Lower middle strike  net credit25.00  1.95  23.05
Breakeven Up
Upper middle strike  net credit30.00  1.95  31.95
Max ROI
63.93% if the stock is between the middle strikes at expiration
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2.7 Covered Short StraddleProficiency
Direction
Volatility
Asset Legs
Max Risk
Max Reward
Strategy Type
Uncapped
Capped
Income

N/A
Advanced
Bullish
■ Long Stock■ Short Put■ Short Call
2.7.1 DescriptionThe Covered Short Straddle is the most risky type of income strategy and is notrecommended!The concept is to increase the yield of the Covered Call by selling a put at thesame strike as the sold call. In this way, we take in the additional income from thesold put; however, there is a significant price to pay in terms of risk.First, the sold put adds significant extra risk to the trade. The amount of potential risk added is the put strike less the put premium received. Say if we trade aCovered Call on a $24.00 stock, taking in $1.00 for the call, our risk and breakevenis $23.00. If we sold a put for another $1.00, our initial yield on cash would bedoubled . . . but our risk would have increased by another $24.00 ($25.00  $1.00),making our total risk $47.00 if the stock falls to zero. Although this is unlikely tooccur in just one month, the position can become loss-making at approximately double the speed as a simple Covered Call position, so if the stock starts to fall, we’re introuble much more quickly.Second, with a Covered Short Straddle, we are almost certain to be exercisedbecause we have shorted both the put and the call at the same strike price. So unlessthe stock is at the strike price at expiration, we face a certain exercise, which manypeople are uncomfortable with. If the stock is above the strike at expiration, thenwe’re quite happy because our sold put expires worthless, our sold call is exercised,and we simply deliver the stock we already own. However, if the stock is below thestrike at expiration, then our call expires worthless, our sold put is exercised, and weare required to purchase more stock at the strike price. With a falling stock, this canbe pricey and undesirable.I’ve seen this taught as a viable strategy . . . don’t do it! There are better waysto enhance the income of a Covered Call, which we’ll go through later in thischapter!
Buy stock
Sell put
Sell call
Covered Short Straddle
Income Strategies
Steps to Trading a Covered Short Straddle1. Buy (or own) the stock.2. Sell puts with a strike price lower than where you think the stock will be atexpiration.3. Sell calls with the same strike and expiration.■
Generally, only sell the straddle element on a monthly basis. In this wayyou will capture more in premiums over several months, provided you arenot exercised. Selling premium every month will net you more over a period of time than selling premium a long way out. Remember that wheneveryou are selling options premium, time decay works in your favor. Timedecay is at its fastest rate in the last 20 trading days (i.e., the last month), sowhen you sell option premiums, it is best to sell them with a month left,and do it again the following month.
■
Remember that your maximum gain is capped when the stock reaches thelevel of the (call) strike price.
■
You need to ensure that the strike price is below the level at which youthink the stock will be at expiration; otherwise the sold put will beexercised, and you’ll have to buy more stock.
■
If trading U.S. stocks and options, you will be required to buy (or be longin) 100 shares for every options contract that you sell.
Steps In■
Preferably between $10.00 and $50.00. Above $50.00, it would be expensive.
■
Try to ensure that the trend is upward or rangebound and identify a cleararea of support.
Steps Out■
Manage your position according to the rules defined in your Trading Plan.
■
If the stock closes above the strike at expiration, your call will be exercised.You will deliver the stock at the strike price, and you will have profitedfrom both the option premiums you received and the uplift (if any) in stockprice to reach the strike price. Exercise is automatic.
■
If the stock remains or falls below the strike, your put will be exercised,forcing you to buy more shares at the strike price. This could becomeexpensive.
■
If the stock is resting at the strike price at expiration, then you’ll make aprofit—but this is a highly risky strategy, and it’s unlikely that the stockwill close precisely on the strike price anyway.
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2.7.2 ContextOutlook■
With covered short straddles, your outlook is bullish. You expect a steady rise.
Rationale■
With covered short straddles, you are enhancing the yield of a covered call byintroducing the sale of puts in addition to the calls you have sold against thestock you have bought. This has the effect of increasing your yield.
■
The hope is that if the stock rises, your sold puts will expire worthless, andyou will keep the premium, whereas if your calls are exercised, you alreadyown the stock to deliver. The biggest problem is if the stock plummets—yoursold calls will expire worthless, enabling you to keep the premium, but youwill be exercised on your sold puts, in which case you will have to buy morestock. Therefore, only use this strategy on stocks that you want to continueholding and adding to your position. This is a high-risk strategy.
Net Position■
This is a net debit transaction because you are paying for the stock and areonly taking in small premiums for the sold put and call options. You canincrease your yield by purchasing the stock on margin, thereby doubling youryield if you use 50% margin—this is even more risky, however, if the stock fallsbelow the strike price.
■
Your maximum risk is the price you pay for the stock, plus the (put) strikeprice, less the premiums you receive for the sold call and put. This is highrisk.
Effect of Time Decay■
Time decay is helpful to your trade here because it should erode the value ofthe options you sold.
Appropriate Time Period to Trade■
Sell the options on a monthly basis.
Selecting the Stock■
Choose from stocks with adequate liquidity, preferably over 500,000 AverageDaily Volume (ADV).
■
Preferably between $10.00 and $50.00. Above $50.00, it would be expensive tobuy the stock.
■
Try to ensure that the trend is upward or rangebound and identify a clear areaof support.
Income Strategies
Selecting the Option■
Choose options with adequate liquidity; open interest should be at least 100,preferably 500.
■
Strike—Choose a strike that you feel is lower than where the stock will be atexpiration. You do not want the put to be exercised because it means you’llhave to buy more stock, which could be very expensive.
■
Expiration—Look at either of the next two expirations and compare monthlyyields. Use the same expiration date for both put and call. Look for over 5%monthly initial cash yield.
2.7.3 Risk Profile[Stock price paid  strike price  put premium  callpremium]
■
Maximum Risk
■
Maximum Reward Limited to the premiums received for the sold calls and putsplus [the strike price] less [the purchase price of the stock]
■
Breakeven
The [strike price] less [half of the options premiumsreceived] plus [half of the difference between the stockprice and the strike price]
2.7.4 Greeks
Risk ProfileAs the stock pricerises above the strikeprice, the positionreaches its maximumprofit potential. Asthe stock falls belowthe strike, the position falls at twice thespeed because of thesold puts.DeltaDelta (speed) is positive and falls to zeroas the asset price risesabove the strike pricewhere the maximumprofit is achieved andthe position speedslows down.GammaGamma (acceleration)is always negativewith this positionbecause you are anet seller of options.
Key:ExpirationToday – 1 monthTime(t) – 5 daysRisk Profile
Theta
ThetaTheta is positive,illustrating that timedecay is helpful tothe position.
Delta
Vega
VegaVega is negative,illustrating thatvolatility is harmful tothe position.
Gamma
Rho
RhoHigher interest ratesare harmful to theposition when it isprofitable and helpfulwhen the position isunprofitable.
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2.7.5 Advantages and DisadvantagesAdvantages■
Generate monthly income.
■
Greater income potential than a Covered Call.
Disadvantages■
Very risky if the stock falls. The sold put means that the risk is effectively doubled, and the rate at which you lose money in the event of the stock decliningis also doubled.
■
Unless the stock price is at the strike price at expiration, you face certain exercise of either the put or call. If the stock falls and the put is exercised, you’llhave to buy more stock at the strike price.
■
Expensive strategy in terms of cash outlay.
■
Capped upside if the stock rises.
■
Uncapped downside potential. This is not a recommended strategy.
2.7.6 Exiting the TradeExiting the Position■
If the share rises above the (call) strike price, you will be exercised at expiration (or before) and therefore make a profit.
■
If the share falls below the (put) strike price, you will be exercised at expiration(or before) and will have to buy more stock at the put exercise price. Your soldcalls will expire worthless, and you will keep the premium.
■
If the share is at the strike price at expiration, you will have successfullyreduced your cost of entry because the premiums you took in will offset theprice you paid for the stock. You will retain the option premiums you soldbecause they will both expire worthless.
Mitigating a Loss■
Either sell the share or sell the share and buy back the call option you sold. Ifthe put is exercised, then you will be required to buy the stock at the put strikeprice.
■
Please note that Covered Short Straddles are highly risky, and you shouldensure that you have enough cash in your account to fulfill the exercise obligations you may have on the downside.
Income Strategies
2.7.7 ExampleABCD is trading at $28.20 on February 25, 2004.Buy the stock for $28.20.Sell the March 2004 30 strike put for $2.60.Sell the March 2004 30 strike call for $0.90.You Pay
Stock price  option premiums28.20  2.60  0.90  24.70
Maximum Risk
Stock price  put strike  put premium  call premium28.20  30.00  2.60  0.90  54.70Maximum risk of 54.70 is more than double your net debit here!
Maximum Reward
Limited to the options premiums received  the strike price the stock price paid0.90  2.60  30.00  28.20  5.30
Breakeven
Strike price  half the premiums received  half the differencebetween stock price and strike price27.35
Initial Cash Yield
12.41%
Maximum Yield on Risk
6.40%
2.8 Covered Short StrangleProficiency
Direction
VolatilityN/A
Asset Legs
Max Risk
Max Reward
Strategy Type
Uncapped
Capped
Income

Advanced
Bullish
■ Long Stock■ Short Put■ Short Call
2.8.1 DescriptionThe Covered Short Strangle is another risky income strategy, though it is certainlyan improvement on the Covered Short Straddle.The concept is to increase the yield of the Covered Call by selling an OTM (lowerstrike) put. In this way we take in the additional income from the sold put; however,if the stock price falls below the put strike, there is a significant price to pay in termsof risk.
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The sold put adds significant extra risk to the trade. The amount of potential riskadded is the put strike less the put premium received. Say if we trade a Covered Callon a $24.00 stock, taking in $1.00 for the $25 strike call, our risk and breakeven is$23.00. If we sold a $22.50 strike put for another $1.00, our initial yield on cash wouldbe doubled . . . but our risk would have increased by another $21.50 ($22.50  $1.00),making our total risk $44.50 if the stock falls to zero. Although this is unlikely tooccur in just one month, the position can become loss-making at approximately double the speed as a simple Covered Call position, so if the stock starts to fall, we canbe in trouble much more quickly.If the stock falls below the put strike at expiration, the call will expire worthless (sowe keep the premium), the put will be exercised, and we’ll have to buy more stock atthe put strike price. With a falling stock, this can