_ an option is, the less it costs.Answer: C—Out-of-the-money.Discussion: When an option is OTM, it has no intrinsic value and theodds of the option finishing ITM are lower. The further OTM the option gets, the less it will cost. Buying deep OTM options is a lot likebuying a lottery ticket. If an option is several strikes OTM, it mighthave a delta of 10 to 15, which means there is only a 10 to 15 percentchance the option will finish in-the-money by expiration.12. If a call option’s price is less than its intrinsic value, investors wouldbuy the calls and exercise them, making a guaranteed ______________before commissions.Answer: D—Arbitrage profit.Discussion: This occurs very infrequently, but it is important to understand the concept. If the call option we hold is trading for less
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than the intrinsic value of the option, we are better off exercising theoption and taking the guaranteed profits. If an option is trading for$4.95, but is $5.00 ITM, we could exercise the option and pocket the$0.05 difference.13. On expiration day, all an option is worth is its ______________ .Answer: C—Intrinsic value.Discussion: This should make sense because when time is up, allthat is left is actual value or intrinsic value. An option that is OTM willsee a sharp decrease in value as expiration day approaches.14. The deeper ______________ a call or put option is, the more the optionmoves like the underlying asset.Answer: A—In-the-money.Discussion: As an option moves deeper ITM, its delta increases andthis means the option starts to move more like the underlying security. For example, a deep ITM call might have a delta of 90, whichmeans that for every dollar move in the underlying, the option willincrease by $0.90.15. Name the seven components that contribute to option pricing.Answer:1. The current price of the underlying financial instrument.2. The strike price of the option.3. The type of option (put or call).4. The amount of time remaining until expiration.5. The current risk-free interest rate.6. The volatility of the underlying financial instrument.7. The dividend rate, if any, of the underlying financial instrument.Discussion: All seven of these components have an impact on an option’s price. Some have a larger impact than others. We didn’t discusshow interest rates and dividends affect option prices because their effects are minimal as compared with the other five. Using an optionscalculator, a trader can identify the values for the different Greeks.16. ______________ is defined as the amount by which an underlyingfluctuates in a given period of time.Answer: D—Volatility.Discussion: Volatility is an important component in trading options.Many traders see volatility as a negative, but used the right way,
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volatility is a great tool for making profits. However, we need to understand what is meant by volatility and the different meanings that it has.17. Name and describe the two main kinds of volatility.Answer:1. Historical volatility gauges price movement in terms of past performance and is calculated by using the standard deviation of theunderlying asset’s price changes from close-to-close of trading going back 21 to 23 days (or any predetermined time frame).2. Implied volatility approximates how much the marketplace thinksprices will move and is calculated by using an option pricing model(Black-Scholes for stocks and indexes and Black for futures).Discussion: Historical volatility is the past and though this doesn’thave an impact on the future, it can be a guide to how the stock mightbe expected to trade. Implied volatility, calculated using an optionpricing model, is the volatility that is expected in the future. Much ofthe time, historic and implied volatility run close together, but thereare times when they differ and these divergences are good times toutilize various option strategies.18. Name three things understanding volatility can help you to accomplish.Answer:1. Helps you to choose and implement the appropriate option strategy.2. Holds the key to improving your market timing.3. Helps you to avoid the purchase of overpriced options or the saleof underpriced options.Discussion: All three of these factors are very important, as they allhelp options traders limit risk and maximize profits. By knowing whenimplied volatility is high, we can avoid buying overpriced options andconcentrate on selling them. When IV is low, going long options is often a good strategy, while selling options isn’t. There are various option strategies that take advantage of the different levels of IV.19. ______________ is the Greek term that represents volatility.Answer: D—Vega.Discussion: Vega tells us how much an option’s price will change fora percentage change in IV. A change in IV can have a major impact onan option’s price, so it is important to understand how vega impacts atrade. IV can rise sharply even without movement in the underlyingsecurity, so it is important to know how the option will be affected bythis change in IV. This is what vega tells us.
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20. Buying options before implied volatility ______________ can causesome trades to actually end up losing money even when the price ofthe underlying asset moves in your direction.Answer: B—Drops.Discussion: This is called a volatility crush and it is discouragingwhen it happens. It is frustrating to be right about direction, but seeyour option gain nothing or actually lose money. This often happenswhen a pending news announcement is released such as earnings or aFood and Drug Administration (FDA) decision. The idea is that IVrises ahead of the report, but drops sharply once the news is actuallyout. This is why we do not normally want to buy options that areshowing relatively high IV.21. When an option’s actual price differs from the theoretical price byany significant amount, you can take advantage of the situation by______________, expecting the prices to fall back in line as the expiration date approaches.Answer: C—Buying options with low volatility and selling optionswith high volatility.Discussion: Implied volatility is like elastic, stretching to extremesbut normally coming back to an average level. This is called mean reversion and it allows options traders to take advantage of situationswhen the actual price varies from the theoretical price.
MEDIA ASSIGNMENTThe mathematics of options can be rather complicated, but the use of anoptions calculator is important to a trader’s success. We need to knowonly a few different variables and we can calculate the Greeks as well asthe implied volatility of a stock. Experimenting with an options calculatorshould provide some insight to how the Greeks change in relation to various changes in other Greeks or movement by the underlying security.
VOCABULARY DEFINITIONSBlack-Scholes option pricing model: A model used to calculate optionpricing based on a variety of factors including: the risk-free interest rate,the standard deviation of the underlying stock, time left until expiration,and the exercise (strike) price.
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Delta: The amount by which the price of an option changes for everydollar move in the underlying instrument.Extrinsic value: The price of an option less its intrinsic value. An at-themoney or out-of-the-money option’s worth consists of nothing but extrinsic or time value.Gamma: The degree by which the delta changes with respect to changesin the underlying instrument’s price.Historic volatility: A measurement of how much a contract’s price hasfluctuated over a period of time in the past; usually calculated by taking astandard deviation of price changes over a specific time period.Implied volatility: Volatility computed using the actual market price ofan option and a pricing model (Black-Scholes). For example, if the marketprice of an option rises without a change in the price of the underlyingstock or future, implied volatility will have risen.Intrinsic value: The amount by which a market is in-the-money. Atthe-money and out-of-the-money options have no intrinsic value. CallIntrinsic value = underlying – strike price. Put Intrinsic value = strikeprice – underlying.Theta: The ratio of the change in an option’s price to the decrease in itstime to expiration.Time decay: The amount of value lost in an option due to the passage oftime.Vega: The amount by which the price of an option changes when thevolatility changes.
CHAPTER 8
Straddles,Strangles,and Synthetics
SUMMARYThis chapter reviews several delta neutral strategies including straddles,strangles, and synthetic straddles. These strategies are based on optimalmathematical relationships and have a high probability of profitability ifapplied in suitable markets. Examples of each strategy are included to enable the reader to become fully acquainted with the calculations of risk, reward, and breakevens. This chapter covers both limited risk and unlimitedrisk strategies (short straddles and short strangles). Keep in mind that I donot recommend placing unlimited risk strategies; they are included so thatreaders are introduced to the mechanics involved.A long straddle and strangle form a U-shaped risk graph, which visually conveys the unlimited reward and limited risk nature of these deltaneutral strategies. This type of risk graph is also available when trading along synthetic straddle with calls or puts. Short straddles and strangleshave an upside-down U-shaped risk graph, which tells us that the reward islimited and the risk is unlimited.Straddles, strangles, and synthetic straddles are all delta neutralstrategies to start. Synthetic straddles can be adjusted over time, whichmakes them a favorite for many traders. New traders often do not understand how simultaneously buying a put and a call can be profitable.The idea is that as a stock moves, one side of the straddle or stranglewill see a larger gain than the other side will see a loss. If the underlyingasset rises in price, the losing option can only fall to zero, whereas theprofitable option can rise indefinitely.100
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As with any strategy, a trader should view a risk graph before enteringa trade. By finding stocks that have been consolidating but have impending news, a trader can see nice, relatively safer profits using straddles,strangles, and synthetic straddles.
QUESTIONS AND EXERCISES1. Setting up a delta neutral trade requires selecting a calculated ratioof short and long positions to create an overall position delta of______________.A. +100.B. –100.C. +50.D. Zero.2. The delta of 100 shares of stock or one futures contract equals plus orminus ______________.A. 500.B. 100.C. 50.D. Zero.3. The delta of an option depends on its ______________.A. Expiration date.B. Volatility.C. Strike price.D. Premium.4. Name two ways of creating a delta neutral trade with ATM options ifyou are buying 100 shares of stock.1. _________________________________________________________2. _________________________________________________________5. Name two ways of creating a delta neutral trade with ATM options ifyou are selling 100 shares of stock.1. _________________________________________________________2. _________________________________________________________
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6. By purchasing futures and buying puts, a U-shaped risk graph is createdthat reflects ______________.A. Limited profit potential with limited risk.B. Limited profit potential with unlimited risk.C. Unlimited profit potential with unlimited risk.D. Unlimited profit potential with limited risk.7. By purchasing stock and selling calls, an upside-down U-shaped riskgraph is created that reflects the trade’s ______________.A. Limited profit potential with limited risk.B. Limited profit potential with unlimited risk.C. Unlimited profit potential with unlimited risk.D. Unlimited profit potential with limited risk.8. By selling 100 XYZ shares and buying 2 ATM calls, what kind of riskcurve are you creating?A. U-shaped risk curve with unlimited profit potential and limited risk.B. U-shaped risk curve with limited profit potential and unlimited risk.C. Upside-down U-shaped risk curve with unlimited profit potentialand limited risk.D. Upside-down U-shaped risk curve with limited profit potentialand unlimited risk.9. By selling 100 XYZ shares and selling two ATM puts, what kind of riskcurve are you creating?A. U-shaped risk curve with unlimited profit potential and limited risk.B. U-shaped risk curve with limited profit potential and unlimited risk.C. Upside-down U-shaped risk curve with unlimited profit potentialand limited risk.D. Upside-down U-shaped risk curve with limited profit potentialand unlimited risk.10. Buying a straddle involves buying both a call and a put with______________.A. Different strike prices and identical expiration months.B. Identical strike prices and different expiration months.C. Identical strike prices and expiration months.D. Different strike prices and expiration months.
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11. To place a long straddle, it is optimal to locate a market with______________.A. High volatility expecting a volatility decrease.B. Low volatility expecting a volatility increase.C. Continuous high liquidity.D. Continuous low liquidity.12. Long straddles create what kind of risk profiles?A. V-shaped risk curves with unlimited profit potential and limitedrisk.B. V-shaped risk curves with limited profit potential and unlimitedrisk.C. Upside-down V-shaped risk curves with unlimited profit potentialand limited risk.D. Upside-down V-shaped risk curves with limited profit potentialand unlimited risk.13. How is the upside breakeven of a long straddle calculated?____________________________________________________________14. How is the downside breakeven of a long straddle calculated?____________________________________________________________15. Calculate the values for the following long straddle:Long 1 November ATM DELL 35 Call @ 2.45Long 1 November ATM DELL 35 Put @ 2.20DELL is currently trading at $35.10.Put cost = __________________________________________________Call cost = __________________________________________________Maximum reward = __________________________________________Maximum risk = _____________________________________________Upside breakeven = __________________________________________Downside breakeven = _______________________________________Range of profitability = _______________________________________
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16. Short straddles create what kind of risk profiles?A. V-shaped risk curves with unlimited profit potential and limitedrisk.B. V-shaped risk curves with limited profit potential and unlimitedrisk.C. Upside-down V-shaped risk curves with unlimited profit potentialand limited risk.D. Upside-down V-shaped risk curves with limited profit potentialand unlimited risk.17. Calculate the values for the following short straddle:Short 1 July SMH 37.50 Call @ 1.50Short 1 July SMH 37.50 Put @ 1.25SMH is trading at $37.71.Put credit = _________________________________________________Call credit = _________________________________________________Maximum reward = __________________________________________Maximum risk = _____________________________________________Upside breakeven = __________________________________________Downside breakeven = _______________________________________Range of profitability = _______________________________________18. Strangles are quite similar to straddles, except ______________.A. The options have different expiration months.B. One option is short and the other is long.C. The options are ITM instead of ATM.D. The options are OTM instead of ATM.19. Long strangles involve buying both an OTM call and an OTM putwith ______________.A. Different strike prices and identical expiration months.B. Identical strike prices and different expiration months.C. Identical strike prices and expiration months.D. Different strike prices and expiration months.
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20. A long strangle has ______________________________________.A. Limited profit potential and limited risk.B. Limited profit potential and unlimited risk.C. Unlimited profit potential and unlimited risk.D. Unlimited profit potential and limited risk.21. Calculate the values for the following long strangle example:Long 1 November DELL 40 Call @ 0.65Long 1 November DELL 30 Put @ 0.70DELL is currently trading at $35.10.Put cost = __________________________________________________Call cost = __________________________________________________Maximum reward = __________________________________________Maximum risk = _____________________________________________Upside breakeven = __________________________________________Downside breakeven = _______________________________________Range of profitability = _______________________________________22. True or False: Fixed straddles can be adjusted as the market movesback and forth.23. Name two ways of creating a long synthetic straddle using a stock.1. _________________________________________________________2. _________________________________________________________24. Calculate the values for the following long synthetic straddleexample:Long 100 Shares of DELL @ $35.10Long 2 November DELL 35 Puts @ 2.20Stock cost = _________________________________________________Put cost = ___________________________________________________
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Maximum reward = __________________________________________Maximum risk = _____________________________________________Upside breakeven = __________________________________________Downside breakeven = _______________________________________Range of profitability = _______________________________________25. Calculate the values for the following long synthetic straddleexample:Short 100 Shares of DELL @ $35.10Long 2 November DELL 35 Calls @ 6.85Stock cost = _________________________________________________Call cost = __________________________________________________Maximum reward = __________________________________________Maximum risk = _____________________________________________Upside breakeven = __________________________________________Downside breakeven = _______________________________________Range of profitability = _______________________________________
MEDIA ASSIGNMENTDelta neutral strategies take away the necessity to predict market direction. However, we still need to find stocks that are expected to showvolatility and to choose options with low implied volatility. For this mediaassignment, identify several securities that are good candidates for deltaneutral strategies. Before entering the data into the Optionetics Platinumsite, take the time to manually calculate the details of the trade, includingthe breakeven points, maximum risk and profit, and the range of profitability. After you have calculated this data, plug it into Optionetics Platinum (or some other options program) and see if your calculations arecorrect. As an added bonus, check out the risk graphs as well. Comparethe risk graphs for various strategies, including straddles, strangles, andlong synthetic straddles.
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VOCABULARY LISTAverage Directional MovementIndex (ADX)DeltaDelta neutral trade
Long synthetic straddleRisk graphStraddleStrangle
Long straddleLong strangle
SOLUTIONS1. Setting up a delta neutral trade requires selecting a calculated ratioof short and long positions to create an overall position delta of______________.Answer: D—Zero.Discussion: The idea with a delta neutral trade is to get the overalldelta as close to zero as possible. Of course, there will be trades thathave slightly positive or negative deltas, but this doesn’t mean theywon’t have a similar risk graph to a perfectly delta neutral trade.2. The delta of 100 shares of stock or one futures contract equals plus orminus ______________.Answer: B—100.Discussion: Unlike options, futures and stocks do not have fractional deltas. They have deltas equal to 1.00. This allows a trader toset up strategies that incorporate options, stock, and/or futuresto create delta neutral strategies. Obviously, if we buy 100 sharesof stock and sell 100 shares of the same stock, there is no wayto make a profit. However, by creating synthetic positions, wecan make a profit using options without needing to predict marketdirection.3. The delta of an option depends on its ______________.Answer: C—Strike price.Discussion: One definition of delta is that it tells the trader the odds ofan option finishing in-the-money by expiration. Thus, the farther awaythe option strike is from the stock price (in the unprofitable direction),
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the lower the delta. In-the-money options have deltas generally above50, while out-of-the-money options have deltas below 50.4. Name two ways of creating a delta neutral trade with ATM options ifyou are buying 100 shares of stock.Answer: Buy two ATM puts or sell two ATM calls.Discussion: One hundred shares of stock equals +100 deltas, so weneed to create a combination of options that equal –100 deltas. Theeasiest way to create –100 deltas is to sell two ATM calls or to buytwo ATM puts. Though the delta might not be exactly –100, usingATM options will make the delta close enough to this figure.5. Name two ways of creating a delta neutral trade with ATM options ifyou are selling 100 shares of stock.Answer: Buy two ATM calls or sell two ATM puts.Discussion: To offset –100 deltas that comes from selling the stock,you can buy two ATM calls or sell two ATM puts to bring in +100delta. The idea is that anything bullish creates a positive delta andanything bearish creates a negative delta.6. By purchasing futures and buying puts, a U-shaped risk graph is created that reflects ______________.Answer: D—Unlimited profit potential with limited risk.Discussion: This is the optimal type of risk graph delta neutraltraders like to see. Though not all options strategies are created withunlimited reward and limited risk, this is what we strive to achieve.7. By purchasing stock and selling calls, an upside-down U-shaped riskgraph is created that reflects the trade’s ______________.Answer: B—Limited profit potential with unlimited risk.Discussion: An upside-down U is exactly the opposite of whatdelta neutral traders want to see, as it shows unlimited risk and limited profits. Though this type of trade might be profitable most ofthe time, it takes only one trade that goes wrong to erase an entiretrading account.8. By selling 100 XYZ shares and buying two ATM calls, what kind ofrisk curve are you creating?Answer: A—U-shaped risk curve with unlimited profit potential andlimited risk.
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Discussion: This position is called a long synthetic straddle usingcalls. The U shape is created because the trade profits on a sharpmove lower or a sharp move higher. If the stock stays flat, then a losswould most likely be incurred.9. By selling 100 XYZ shares and selling two ATM puts, what kind of riskcurve are you creating?Answer: D—Upside-down U-shaped risk curve with limited profitpotential and unlimited risk.Discussion: This trade is a short synthetic straddle using puts. Byselling both the stock and the puts, the maximum profit is the creditreceived from selling the puts and stock. However, if the underlyingmoves sharply in either direction, a large loss can be incurred.10. Buying a straddle involves buying both a call and a put with______________.Answer: C—Identical strike prices and expiration months.Discussion: Composed of both a long ATM call and a long ATM put, astraddle makes money when the underlying asset moves sharply in either direction. As the stock moves higher, the call increases in valuefaster than the put loses money. The opposite also holds true, with adecline in the stock’s price increasing the value of the put faster thanthe loss incurred in the call.11. To place a long straddle, it is optimal to locate a market with______________.Answer: B—Low volatility expecting a volatility increase.Discussion: A long straddle consists of buying two options. Impliedvolatility has a major impact on the price of an option, so we want tobuy options that have historically low IV. This puts the odds of success higher for a straddle trader. Straddle traders also want to see avolatility increase because this means a larger move in the underlying security.12. Long straddles create what kind of risk profiles?Answer: A—V-shaped risk curves with unlimited profit potential andlimited risk.Discussion: Just like a long synthetic straddle, a straddle has unlimited profit potential and limited risk. This is what we are looking forwhen we enter a delta neutral trade.
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13. How is the upside breakeven of a long straddle calculated?Answer: Upside breakeven = strike price + net debit.Discussion: The upside breakeven at expiration is calculated byadding the net debit required to enter the trade to the strike price.However, this doesn’t mean that a profit can’t be made before expiration on a smaller move if volatility increases in magnitude.14. How is the downside breakeven of a long straddle calculated?Answer: Downside breakeven = strike price – net debit.Discussion: The downside breakeven at expiration is calculated bysubtracting the net debit required to enter the trade from the strikeprice. However, this doesn’t mean that a profit can’t be made beforeexpiration on a smaller move if volatility increases in magnitude. Youwill rarely hold a straddle until expiration, anyway.15. Calculate the values for the following long straddle:Long 1 November ATM DELL 35 Call @ 2.45Long 1 November ATM DELL 35 Put @ 2.20DELL is currently trading at $35.10.Answer:Put cost = 2.20 or $220.Call cost = 2.45 or $245.Maximum reward = Unlimited to the upside and limited to the downside (as the underlying can only fall to zero) beyond the breakevens.Maximum risk = (2.45 + 2.20) × 100 = $465 (Total debit).Upside breakeven = (35 + 4.65) = $39.65 (Call strike + net debit).Downside breakeven = (35 – 4.65) = $30.35 (Put strike – net debit).Range of profitability = Above $39.65 and below $30.35.Discussion: The breakeven points, maximum risk and reward, andtotal costs are important values to understand before entering atrade. These values can be figured manually, or you can use a program like Optionetics Platinum to calculate these details. Either way,it is very important to assess a trade’s risks before jumping in andputting real money on the line.16. Short straddles create what kind of risk profiles?Answer: D—Upside-down V-shaped risk curves with limited profitpotential and unlimited risk.
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Discussion: A short straddle or strangle creates an upside-downV-shaped risk graph. This is not the kind of risk profile that a deltaneutral trader wants to see. Though this type of trade might have ahigh winning percentage in sideways-moving markets, it takes onlyone sharp move to wipe out a trading account.17. Calculate the values for the following short straddle:Short 1 July SMH 37.50 Call @ 1.50Short 1 July SMH 37.50 Put @ 1.25SMH is trading at $37.71.Answer:Put credit = 1.25 or $125.Call credit = 1.50 or $150.Maximum reward = (1.25 + 1.50) × 100 = $275 (Limited to the netcredit).Maximum risk = Unlimited to the upside and limited to the downside(as the underlying can only fall to zero) beyond the breakevens.Upside breakeven = (37.50 + 2.75) = $40.25 (ATM strike price + netcredit).Downside breakeven = (37.50 – 2.75) = $34.75 (ATM strike price – netcredit).Range of profitability = Between $34.75 and $40.25.18. Strangles are quite similar to straddles, except ______________.Answer: D—The options are OTM instead of ATM.Discussion: Strangles have a similar risk profile to a straddle, exceptthat the maximum loss area is wider. However, the initial cost to enter a strangle is lower. Keep in mind that the underlying asset has tomake a larger move for the trade to become profitable.19. Long strangles involve buying both an OTM call and an OTM put with______________Answer: A—Different strike prices and identical expiration months.Discussion: By using OTM options, the trader’s cost to enter a strangle is less than the cost to enter a straddle. However, because the options are OTM, the underlying security has to see a larger move togarner a profit.
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20. A long strangle has ______________.Answer: D—Unlimited profit potential and limited risk.Discussion: Just like a straddle, a strangle has limited risk and unlimited profit potential. The main difference is that there is a widerarea between the two strike prices where the maximum loss is incurred. Whether to use a straddle or a strangle is a personal decisionand should be based on the outlook for the stock and the risk graph.21. Calculate the values for the following long strangle example:Long 1 November DELL 40 Call @ 0.65Long 1 November DELL 30 Put @ 0.70DELL is currently trading at $35.10.Answer:Put cost = 0.70 or $70.Call cost = 0.65 or $65.Maximum reward = Unlimited to the upside and downside beyondthe breakevens.Maximum risk = (.70 + .65) × 100 = $135 (Total debit).Upside breakeven = (40 + 1.35) = $41.35 (Call strike + net debit).Downside breakeven = (30 – 1.35) = $28.65 (Put strike – net debit).Range of profitability = Above $41.35 and below $28.65.Discussion: The cost to enter a strangle is lower than the cost of astraddle. However, by comparing the straddle and strangle example,we can see that a strangle takes a much larger move to break evenand make a profit. The maximum risk area is also much larger, fallingbetween the two breakevens. A straddle sees a maximum loss only ifthe underlying closes right on the ATM strike price.22. True or False: Fixed straddles can be adjusted as the market movesback and forth.Answer: False.Discussion: Fixed straddles cannot be adjusted. If you want to beable to make adjustments as the trade progresses, then look at usinglong synthetic straddles.23. Name two ways of creating a long synthetic straddle using a stock.Answer:1. Sell 100 shares and buy two ATM calls.2. Buy 100 shares and buy two ATM puts.
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Discussion: A long synthetic straddle is a delta neutral trade thatconsists of shares of stock against long options. A long syntheticstraddle with multiple contracts can be adjusted back to delta neutralas the trade progresses. The risk profile is similar to a straddle buthas a U-shaped risk curve instead of a V-shaped one. A trader doesn’tneed to use ATM options, but this is the easiest way to create a longsynthetic straddle.24. Calculate the values for the following long synthetic straddleexample:Long 100 Shares of DELL @ $35.10Long 2 November DELL 35 Puts @ 2.20Answer:Maximum reward = Unlimited.Maximum risk = [(2 × 2.20) + (35.10 – 35)] × 100 = $450 {Net debit ofoptions + [(Price of underlying stock at initiation – option strikeprice) × number of shares]}.Upside bre