s price, so when we see options thatare showing IV that is higher than normal, we can beneﬁt by selling the op-tion.  The  same  holds  true  for  options  showing  low  IV  compared  to  pastvalues, as we can buy options to beneﬁt from a rise in IV.
87
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QUESTIONS AND EXERCISES
1. Option  Greeks  are  a  set  of  measurements  that  explore  the
______________ of a speciﬁc trade.
A. Parameters.B. Delta neutral opportunities.
C. Risk exposures.
D. Risk-to-reward ratios.
2. Name the four basic option Greeks.
1. _________________________________________________________
2. _________________________________________________________
3. _________________________________________________________
4. _________________________________________________________
3. Fill in the option Greek term next to its appropriate deﬁnition.
Greek
Deﬁnition
Change in the delta of an option with respect to the change in 
__________ price of its underlying security.
__________
Change in the price of an option relative to the price change of the underlying security.
__________
Change in the price of an option with respect to a change in its time to expiration.
Change in the price of an option with respect to its change in 
__________ volatility.
4. The  two  most  important  components  of  an  option’s  premium  are
______________.
A.
Intrinsic value and extrinsic value.
B. Vega and extrinsic value.
C.
Intrinsic value and vega.
D. Gamma and theta.
5. For a call option, intrinsic value is equal to ______________.
A. The strike price of the call option minus the current price of the
underlying.
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B. The strike price of the call option plus the current price of the
underlying.
C. The current price of the underlying minus the strike price of the
call option.
D. The  current  price  of  the  underlying  plus  the  strike  price  of  the
call option.
6. For a put option, intrinsic value is equal to ______________.
A. The strike price of the put option minus the current price of the
underlying.
B. The strike price of the put option plus the current price of the
underlying.
C. The current price of the underlying minus the strike price of the
put option.
D. The current price of the underlying plus the strike price of the put
option.
7.
If a call or put option is out-of-the-money, the intrinsic value is equalto ______________.
A. The strike price of the option.
B. The price of the underlying.
C. The price of the underlying minus the strike price of the option.
D. Zero.
8. True  or  False:  The  intrinsic  value  of  an  option  does  not  depend  on
how much time is left until expiration.
9. Time value ______________ as an option approaches expiration.
A.
Increases.
B. Decreases.
C. Stays the same.
10. Time value is also known as ______________.
A. Delta.
B. Gamma.
C. Theta.
D. Vega.
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11. The more ______________ an option is, the less it costs.
A. At-the-money.
B.
In-the-money.
C. Out-of-the-money.
12.
If a call option’s price is less than its exercise value, investors wouldbuy the calls and exercise them, making a guaranteed ______________before commissions.
A. Margin.
B. Credit.
C. Debit.
D. Arbitrage proﬁt.
13. On expiration day, all an option is worth is its ______________.
A. Time value.
B. Extrinsic value.
C.
Intrinsic value.
D. Fair market value.
14. The deeper ______________ a call or put option is, the more the option
moves like the underlying asset.
A.
In-the-money.
B. Out-of-the-money.
15. Name the seven components that contribute to option pricing.
1. _________________________________________________________
2. _________________________________________________________
3. _________________________________________________________
4. _________________________________________________________
5. _________________________________________________________
6. _________________________________________________________
7. _________________________________________________________
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16. ______________  is  deﬁned  as  the  amount  by  which  an  underlying
ﬂuctuates in a given period of time.
A. Risk-free interest rate.
B. Liquidity.
C. Dividend payment.
D. Volatility.
17. Name and describe the two main kinds of volatility.
1. _________________________________________________________
_________________________________________________________
2. _________________________________________________________
_________________________________________________________
18. Name three things understanding volatility can help you to accomplish.
1. _________________________________________________________
2. _________________________________________________________
3. _________________________________________________________
19. ______________ is the Greek term that represents volatility.
A. Delta.
B. Gamma.
C. Theta.
D. Vega.
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.
A. Rises.
B. Drops.
C. Stays the same for more than one week.
D. Stays the same for more than one month.
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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 expi-ration date approaches.
A. Selling  options  with  low  volatility  and  buying  options  with  high
volatility.
B. Selling or buying options with low volatility.
C. Buying  options  with  low  volatility  and  selling  options  with  high
volatility.
D. Buying or selling options with high volatility.
MEDIA ASSIGNMENT
The  Greeks  are  an  integral  part  of  understanding  the  risk  associatedwith various options strategies. As a result, it is important to grasp howthese  factors  impact  a  trade.  One  of  the  best  ways  to  see  how  theGreeks  work  is  to  experiment  with  an  options  calculator.  If  you  haveaccess  to  the  Optionetics  Platinum  site  (you  can  always  sign  up  for  afree  two-week  trial  at  www.optionetics.com/platinum),  there  is  an  op-tions  calculator  that  can  be  used.  Or  you  can  use  the  calculator  avail-able  at  www.cboe.com.  By  entering  different  variables  for  impliedvolatility,  expiration,  and  strike  price,  we  get  changes  in  the  Greeks.Seeing how the Greeks relate to each other is a great way to gain a bet-ter understanding of them and the risks associated with various optionsstrategies.
VOCABULARY LIST
Black-Scholes option pricingmodel
Delta
Extrinsic value
Gamma
Historic volatility
Implied volatility
Intrinsic value
Theta
Time decay
Vega
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SOLUTIONS
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1. Option  Greeks  are  a  set  of  measurements  that  explore  the
______________ of a speciﬁc trade.Answer: C—Risk exposures.Discussion: Each Greek encompasses various aspects of an option’srisk. By understanding the Greeks you gain a better understanding ofthe risks of a trade. You can also make adjustments to a trade onceyou  understand  the  delta  dynamic.  The  key  to  successfully  tradingoptions is to maximize proﬁts while minimizing risks. Understandinghow to apply the Greeks is a prime factor in being able to accomplishthis task.
2. Name the four basic option Greeks.
Answer: Delta, gamma, theta, and vega.Discussion: Since  each  option  Greek  covers  a  speciﬁc  risk,  under-standing each value is important to successful options trading. Deltais the most common and best-known Greek and rightfully so, but thisdoesn’t  mean  the  other  Greeks  aren’t  important.  Depending  on  thetype of trade entered, a different Greek might be the most important.When selling short-term options, theta is very important. If you don’twant to see a sharp move in the stock, pay attention to gamma. Notonly is it important to understand each Greek individually, but it alsois valuable to understand how they relate to each other.
3. Fill in the option Greek term next to its appropriate deﬁnition.
Answer:
Greek
Deﬁnition
Gamma
Change in the delta of an option with respect to the change in price of its underlying security.
Delta
Theta
Vega
Change in the price of an option relative to the price change of the underlying security
Change in the price of an option with respect to a change in its time to expiration.
Change in the price of an option with respect to its change in volatility.
Discussion: These Greeks cover the basics of risk management foran  option  trade.  Depending  on  the  strategy  implemented,  different
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Greeks might have the most impact on the trade. We often ﬁnd thatall  the  Greeks  are  important  for  certain  trades,  though  one  or  theother might be the Greek that is the biggest risk to the trade. Once weunderstand the risks in the trade, we can make adjustments by offset-ting the risks. For example, if we want to stay delta neutral and weﬁnd that a trade has become heavy on delta, we can buy puts or sellcalls to adjust the delta back to zero.
4. The  two  most  important  components  of  an  option’s  premium  are
______________.Answer: A—Intrinsic value and extrinsic value.Discussion: Intrinsic and extrinsic value combine to make up the totalvalue of an option. If an option is ATM or OTM it is made up completelyof extrinsic (time) value. If this is the case, the option has higher thetarisk.  An  ITM  option  is  made  up  of  both  intrinsic  and  extrinsic  value.However,  as  the  option  moves  further  ITM,  its  extrinsic  value  de-creases—the more it is worth and the less time value it has. The fartherOTM an option gets, the less it is worth and the more theta is a problem.
5. For a call option, intrinsic value is equal to ______________.
Answer: C—The  current  price  of  the  underlying  minus  the  strikeprice of the call option.Discussion: A call option is ITM when the price of the underlying isabove the strike price. If a call option is ITM, the intrinsic value willnot be impacted by the passage of time. However, movement in theunderlying will have a dramatic impact on the price of the option.
6. For a put option, intrinsic value is equal to ______________.
Answer: A—The  strike  price  of  the  put  option  minus  the  currentprice of the underlying.Discussion: A put option is ITM when the underlying is trading be-low the strike price. If a put option is ITM, the intrinsic value willnot be impacted by the passage of time. However, movement in theunderlying will have a dramatic impact on the price of the option.
7.
If a call or put option is out-of-the-money, the intrinsic value is equalto ______________.Answer: D—Zero.Discussion: Both OTM and ATM options have the largest amount oftime  value  for  an  option  series.  This  means  that  theta  will  have  amajor impact on the price of the option going forward. ATM optionsnormally have the most liquidity as well.
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8. True  or  False:  The  intrinsic  value  of  an  option  does  not  depend  on
how much time is left until expiration.Answer: True.Discussion: Only  extrinsic  value  is  affected  by  the  passage  of  time.This  is  why  it  is  important  to  understand  what  extrinsic  and  intrinsicvalue measure so that the proper risk management can be used. For ex-ample, you rarely want to be long options with less than 30 days untilexpiration.  Why?  Because  theta  has  a  more  dramatic  impact  on  timevalue during the last 30 days of an option’s life.
9. Time value ______________ as an option approaches expiration.
Answer: B—Decreases.Discussion: As the name infers, time has value. Thus, as time passes,its value decreases. However, time decay or theta accelerates in thelast 30 days of an option’s life. This is why we suggest buying optionswith at least 90 days until expiration so that time decay is not a majorfactor. We also do not normally hold long options once we have lessthan 30 days until expiration.
10. Time value is also known as ______________.
Answer: C—Theta.Discussion: Theta  is  the  Greek  that  represents  time  decay  and  timevalue. Theta tells us how much the option will lose each day due to timedecay. If we sell an option, theta is positive. The option will increase invalue due to the passage of time and the impact of time decay.
11. The more ______________ 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 op-tion 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 un-derstand  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 option
moves 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 secu-rity.  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 op-tion’s price. Some have a larger impact than others. We didn’t discusshow interest rates and dividends affect option prices because their ef-fects 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  underlying
ﬂuctuates 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 under-stand 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  per-formance and is calculated by using the standard deviation of theunderlying asset’s price changes from close-to-close of trading go-ing 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 sale
of 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 of-ten a good strategy, while selling options isn’t. There are various op-tion 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 expi-ration 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 re-version and it allows options traders to take advantage of situationswhen the actual price varies from the theoretical price.
MEDIA ASSIGNMENT
The 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 vari-ous changes in other Greeks or movement by the underlying security.
VOCABULARY DEFINITIONS
Black-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-the-money or out-of-the-money option’s worth consists of nothing but extrin-sic 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.  At-the-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.
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CHAPTER 8
Straddles,Strangles,and Synthetics
SUMMARY
This  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 en-able the reader to become fully acquainted with the calculations of risk, re-ward, 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 visu-ally  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  un-derstand 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 impend-ing  news,  a  trader  can  see  nice,  relatively  safer  proﬁts  using  straddles,strangles, and synthetic straddles.
QUESTIONS AND EXERCISES
1. 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 or
minus ______________.
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 if
you are buying 100 shares of stock.
1. _________________________________________________________
2. _________________________________________________________
5. Name two ways of creating a delta neutral trade with ATM options if
you 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 created
that 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 risk
graph 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 risk
curve 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 potential
and limited risk.
D. Upside-down  U-shaped  risk  curve  with  limited  proﬁt  potential
and unlimited risk.
9. By selling 100 XYZ shares and selling two ATM puts, what kind of risk
curve 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 potential
and limited risk.
D. Upside-down  U-shaped  risk  curve  with  limited  proﬁt  potential
and unlimited risk.
10. Buying  a  straddle  involves  buying  both  a  call  and  a  put  with
______________.
A. Different strike prices and identical expiration months.
B.
C.
Identical strike prices and different expiration months.
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 vol