One Strategy
F or All Markets
lL. Lord
www. RandomWalkTrading.com
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Copyright © 2006, Random Walk, LLC
The materials you purchased are copyrighted materiaL It is unlawful to copy,
scan, photocopy, resell the book, place the book on any Internet auction site, or
share with members of any investment club. J.L. Lord spent a fortune and
thousands of hours developing this material and is offering it for sale for greatly
less than the material is worth. Mr. Lord has received as much as $ 1 0,000 an
hour for teaching strategies that are less complete and inclusive than what is
contained in this text. He is not a litigious man; however, he feels he is doing
this proj ect as much for philanthropic reasons as for profit and doesn't want to
feel taken advantage of. At the first sign that any copyright infringement has
taken place, Mr. Lord will likely shut down the sales and let his lawyers take it
from there. Feel free to share the material with members of your immediate
family by lending them your purchased book; however, do not copy, scan, or
resell the book. Fair is fair. Further reading and new court cases involving
copyright material can be found on the US Government's site, FBI website and
MGM v. Grokster.
2
Reason for Disclaimers
At a time when this country produces 1 0 times the attorneys needed to keep
order in society, and far more lawyers than any other civilized (or uncivilized)
society in the world, it is getting to the point of being unpractical to even walk
down the street without an attorney. I had a physician make a mistake in a
procedure that resulted in ending the life of my son, Henry.
Suing the physician would not have brought my son back, which is the only
thing I wanted, and still want to this day. The doctor did not mean to do harm, it
just wasn't his day. No one knows bad days as well as a trader. However, I am
not naive enough to believe that other's share the same beliefs I do, especially
when a "quick dollar" can be made without earning it. As such a disclaimer is
necessary in this sort of forum, and perhaps it is getting to the point of issuing
one to attendees at my next cocktail party, I have enclosed one to make my
attorney happy. Even attorneys are entitled to some happiness, no?
Disclaimer
The material presented in this book is for educational purposes only. J.L. Lord,
Random Walk LLC, RandomWalkTrading (Dot Com), it's agents, employees,
contractors (collectively herein known as "employees"), are to be held harmless
against any civil actions as we are not acting as brokers, advisers or registered
agents. Any material or contact with the firm or its employees is not to be
construed as investment advice or solicitation for funds. Trading involves risk.
Trading in stocks, options, commodities and other derivatives are risky and
subj ects you to risk of losses that can potentially be greater than your original
investment.
The material written by J.L. Lord and Random Walk LLC is not a substitution
for obtaining professional advice. None of the employees, even if registered as
such, are acting as agents, mental health care professionals, accountants or
lawyers. Random Walk LLC and its employees recommend that you obtain
advice from professionals in the respective fields before making any trading
decisions. Any past results mentioned are not indicative of future performance,
and Random Walk LLC, J.L. Lord and their employees indicate that the material
is for illustration and information purposes only.
To make our attorneys really happy, we should state that no one involved with
this proj ect has a clue as to what is going on. J.L. Lord, Random Walk LLC and
everyone involved in this proj ect is a moron and listening to us would be the
least intelligent thing one could do. That should cover just about everything.
3
Why is the Company Called Random Walk?
I have been in the business of trading in some shape or form since 1 986. Can it really be
over 20 years already? I have seen thousands of people pursuing success in all the wrong
ways - 'magic software' that finds trades for you; studying charts that allow you to
interpret what you want to see so rationalize why your decision is right; and, listening to
the so-called experts who rarely have their own money on the line. With this later group
Warren Buffet said it best when he said,
"Wall Street is the only place where people in a Rolls Royce get advicefrom those who
take the subway. "
In other words, all those so-called methods of making money are gimmicks. The only
thing that has been proven to work making money in the markets over the long term is a
sound trading strategy. So many books have been written about theoretical concepts but
when learning to trade I could not get help from anyone who wrote something that was
practical or had step-by-step criteria to help get me on the right track. That is what is
being attempted in this text.
About the only thing that has been proven with the stock market is that the markets move
about over the long run in a random fashion. Tecn
h ical analysis will work for a brief
period of time, but seems to unravel when you need it the most. Fundamental analysis
only works provided you can stay solvent long enough for everyone else participating in
the stock markets to see the same thing you do, and provided the information is provided
or collected by Arthur Anderson or Enron. Most software packages are about as useful in
predicting the future as waving a wand over the Wall Street Journal and chanting "Oogah
Boogah" and hoping the winner pops out in a dream.
The fact that markets move around in a seemingly random and directional less fashion has
been proven by so many PhDs that it is now considered to be an accepted fact. How else
would you explain why the best and brightest "stock pickers" and corporate CEOs can not
beat the stock market consistently trying to pick the direction of their company's stock?
Looking to take a short cut in studying ways to make money with how the markets
actually work, people still jump from the latest fad to the next attempting to catch that big
wave which seems to come for everyone else but them.
This company was set up to teach people how to make money trading with the only things
that have shown to make money consistently in these markets; good trading tactics . It is
my goal not to verbally trash the other methods, but rather help you be able to make
money even if you are trading using a technique to pick your stocks that we do not agree
with. So, if you are an Elliot Wave follower, enjoy reading tea leaves, believe that
astrology is the key to market direction, I will not try to talk you out of it. As long as you
follow the strategies, feel free to use your magic dart to throw at a list of stocks to fmd
that one winner, and I will attempt to take care of the rest.
Remember that if you continue to believe what you have been believing, you will keep
achieving what you have been achieving. Maybe my methodology will not work for you;
however, I am quite confident that it will, as I have seen it work for many others.
4
TABLE OF CONTENTS
Option Fundamentals
9
Calls
Puts
10
11
Call and Put Variables
12
Put
Strike Price
13
Expiration
13
Interest Rates (Rho)
15
Volatility (Vega)
15
Decay (Theta)"
16
Intrinsic Value
17
Settlement
18
Option Analogy
19
Call Option Analogy
20
What makes u p the Value· of an Option
22
Intrinsic Value
22
Time Value
22
Function of Probability
23
Option
Chain Time Values
25
Pricing Increments
26
Bid-Ask Spread
27
Broken Wing Butterfly Spreads (BWB)
29
Introduction
30
Definition
31
Practical definition of BWB
31
Ratio Spread portion
32
Breakeven and maximum profit at expiration
32
"Tail" purchase portion of trade
33
Risk and margin without the "tail"
36
Exact margin guidelines
36
Maximum loss
37
Formula for calculation o f margin
38
How to reduce the risk and margin
39
Risk Graphs
39
Ratio spreads and the Greeks
40
Refresher of option's Greek definitions
5
41
Option's Greeks calculation charts
42
Charts explained
45
Cost analysis
45
Delta analysis
47
Gamma analysis
48
Theta & Vega analysis
49
Why the Greeks work so well
The practical use and mechanics of Ratio Spreads
49
50
OEX option chain
51
How Ratio Spreads react in reality to Price
52
Market stays flat - no time passes
53
Market runs up - no time passes
54
Study of 535 put as Index advances
55
Formula for pricing options after a move
56
OEX example
57
OEX example using calls
61
How Ratio Spreads react in reality to Time
65
Market stays flat - time passes
65
Practical example
66
Illustration of reaction to time and price movement
Setting up
an
example
69
70
How to line up the option chains
70
What was the profit/loss
73
Broken Wing Butterfly Spreads (BWB) Entry Criteria
75
Introduction, circumstances and considerations
76
Step 1
Select an underlying
77
Indexes
77
Stock
79
-
Step 2 - Decide bullish, bearish or neutral
79
OEX option chain
80
Call vs. put spread for even comparison
81
Step 3 - Select the month(s)
82
Front month
82
Back month
83
Step 4 - Determine with which strikes to begin
OEX option chain
83
84
Step 5 - Calculate the cost of small ATM spread
6
85
Step 6
Step
Step
Step
-
85
What do the next 2 OTM options trade for?
85
What is the net debit/credit?
85
Calculate the cost of a medium width ATM spread
87
Pricing charts
88
7 - Calculate the cost of a large width A TM spread
8
9
-
-
Step 10
Step 1 3
Step 14
15
90
Expected range of Ratio and BWB trades
91
Put skew
93
Call skew
93
Find the spread in the next month out
94
April OEX option chain
94
Same trade one month further out results
95
Determine range if underlying moved 5-6%
95
Calculate spread value after underlying moves
95
OEX put option chain
96
Approximating probability
97
-
Step 12
89
What can you expect to see?
-
Step 1 1
Step
What is the ATM option trading for?
�
Compare/contrast price possibilities
99
Determine if front or back month is better
1 00
Same month, same strike
100
Two months, two different strikes
10 1
Which month and strike is better?
1 02
-
-
Compare other indexes
107
Ratio Spread or Broken Wing Butterfly?
108
Ratio spread vs. BWB margin
109
Margin comparison
1 10
-
Converting a Ratio Spread to a BWB
1 10
Margin reduction
1 10
Risk reduction
111
Conclusion
1 14
Important note
1 15
Broken Wing Butterfly Spreads (BWB) Exit Criteria
1 17
Introduction and benefits
1 18
Step 1
Calculate profit/loss on spread
1 19
Establish PIL goal and rolling down area
119
Front and Back month maintenance/closing
1 20
Front month
121
Step 2
Step 3
-
-
-
7
Step 4
Step 5
Step 6
Step 7
Step 8
Step
9
-
-
-
-
-
-
Step 10
Back month
12 1
Watch the markets
121
How often to recalculate PIL points
1 22
Greater than 3 weeks to expiration
1 22
Less than 3 weeks to expiration
1 22
Re-evaluate P/L of the spread
123
Adjusting for time and price movement
1 23
Worksheets
1 24
After re-evaluation, note where spread loses
125
Some action � ay b e necessary
125
Exit for breakeven
Roll the trade further OTM
1 26
Be patient
1 27
Consider the "tail"
1 27
When to close
128
Market running i n wrong direction
1 28
Profit less than 50% of maximum
1 29
-
Time to take the trade off
1 26
131
Risk Ratio Spreads (Aggressive)
133
Index Options
1 35
Why use index options?
136
OEX as
13 9
an
example
Appendix
Terminology
1 42
Types of Orders
1 56
8
Option Fundamentals
www .RandomWalkTradIng.com
9
Option Fundamentals
A lmost everyone reading this text should have at least a remedial understanding
of options and primarily purchased the material in order to understand a correct
way in which to trade the collar with both equity and index options. Included in
this section is an option basics chapter. Should you not be familiar with options
this section will serve you well. It is condensed compared to more text, but is
also the whole "meat " of an option. The author did not feel like wasting your
time with fluff as there is so much practical material to be learned about the
actual strategies. Ifyou are shaky on your option basics, a review of this section
should prove beneficial as some of the examples may be taught differently than
you originally learned them, so a more tangible knowledge of the material may
be gained. Enjoy!
What is an Option?
Options are a part of everyday life in our society. Whether one knows it or not,
virtually everyone reading this text has already bought or sold an option (we will
go into that shortly). Options are all around us from simple daily household
family economics, to the most complicated multi-billion dollar business
transactions. Automobile insurance, life insurance, professional sports contracts,
real estate deals, grocery store coupons, public transportation "transfers",
executive stock option compensation packages , and other common business
deals are forms of option contracts.
Options and the Variables That Make Them What They Are.
Note: For generalization and example purposes, unless otherwise stated, we will be referring to
equity (stock) options.
CALLS AND PUTS
In the simplest terms, we can state that there are two types of options- (I.) calls
and (II.) puts.
I. CALLS
Definition: A call option is a legally binding contract that allows the purchaser
the right (but not the obligation) to purchase a particular number of shares of
stock (lOO shares per contract) at a specified price (the strike price) any time
prior to its expiration (the expiration cycle/month).
Call Option Buyer
The buyer of the call option owns the right to purchase the stock any time he
chooses prior to expiration of said option. The buyer has paid a premium for the
right to buy 1 00 shares (per contract) of stock for the strike price (the agreed to
price) . The buyer has ALL the rights and no obligations.
10
Call Option Seller (Writer)
The seller of the option has the obligation to deliver the stock should the call be
exercised by the owner of the option. The seller has traded an obligation to
deliver/sell the stock (at the strike price) for the premium he received at the time
of the sale.
Question: If we were to buy-to-open (we do not currently have an option
position) one contract of the Disney, July 25 strike call for a debit (cost to us) of
$ 1 . 00, what would we own? What would it cost us? What rights do we have?
What obligations do we possess?
Position: Long 1 (contract) of the DIS, July 25 strike call, for $ 1 .00 (per share).
Answer: We would have the option to buy 1 00 shares of Disney (NYSE ticker
symbol: DIS) stock for $25 regardless of where the actual stock is trading. If the
following day (and it was prior to expiration) DIS stock were trading at $3 5 per ..
share, by owning the call we would have the right to buy the stock for $25 ($ 1 0
lower than were it is currently trading), provided that we exercise our right prior
to the option' s expiration date. This right cost us $1 per share, while every
option contract controls 1 00 shares; this one contract originally cost us $ 1 00 ($1
per share X 1 00 Shares
$ 1 00). Equity options have an American exercise,
meaning we can exercise this option any time we want prior to its expiration.
=
In this example we made a $900 profit on the trade. We own the right to buy the
stock at $25 per share. It is now trading at $35 per share. We can exercise our
right to buy the stock for $25 per share, and simultaneously sell the stock out at
$3 5 per share. We would make $ 10 per share (3 5 - 25
10) X 1 00 shares
$ 1 ,000; however, this right cost us $ 1 per share or $ 1 00. We end up netting a
$900 profit. Not bad on a $ 1 00 investment !
=
=
II. PUTS
Definition: A Qut option is a legally binding contract that allows the purchaser
the right (but not the obligation) to sell a particular number of shares of stock
(100 shares per contract) at a specified price (the strike price) any time prior to
its expiration (the expiration cycle/month). This is regardless of whether or not
the owner of the put currently owns any stock.
Put Option Buyer
The buyer of the put option owns the right to sell the stock any time he chooses
prior to expiration of said option. The buyer has paid a premium for the right to
sell 1 00 shares (per contract) of stock at the strike price (the agreed to price).
The buyer has ALL the rights and no obligations.
11
Put Option Seller (Writer)
The seller of the option has the obligation to buy the stock should the owner of
the option exercise the put. The seller has traded an obligation to possibly buy
the stock (at the strike price) for the premiums he received at the time of the sale.
Question : If we were to buy-to-open one contract of the DIS, July 25 strike put
for a debit (cost to us) of $0.75, what would we own? What would it cost us?
What rights do we have? What obligations do we possess?
Position: Long 1 (contract) of the DIS, July 25 strike put, for $0.75 (per share).
Answer: We would have the option to sell 1 00 shares of Disney (NYSE ticker
symbol: DIS) stock at $25 regardless of where the actual stock is trading. If DIS
stock were trading at $ 1 5 per share, by owning the put we would have the right
to sell the stock at $25 ($ 1 0 higher than were it is currently trading), provided
that we exercise our right prior to the option' s expiration date. We could then go
into the open market, and buy back the stock at a lower cost. This right cost us
$0.75 per share, while every option contract controls 100 shares; this .one
$75). Because
contract would cost us $75 ($0.75 per share X 1 00 Shar es
equity options have an American exercise (see chapter on Terminology or
section on Exercise of Options), we can exercise this option any time we want
prior to its expiration.
=
In this example we made a $925 profit on the trade. We own the right to sell the
stock at $25 per share, and it is now trading at $ 1 5 per share. We can exercise
our right to sell the stock at $25 per share, and simultaneously buy the stock
1 0) X 1 00
back for $ 1 5 per share. We would make $ 10 per share (25 - 1 5
shares
$1,000; however, this right originally cost us $0.75 per share or $75.
We end up netting a $925 pro.fit. Not bad on a $75 investment!
=
=
CALL AND PUT VARIABLES
The variables that comprise an option' s value, and differentiate one option from
another are strike price, time until expiration, interest rates , volatility, decay, the
price of the underlying (and the option' s intrinsic value), and to a lesser extent,
the method by which the option is settled (cash, futures, stock, American
exercise, European exercise, etc.).
We will briefly touch on those variables before going into the fundamental
functions of calls and puts.
12
I. STRIKE PRICE
The "strike " is the Price that the option is converted into long (call) or short
(put) stock (cash, futures, etc.). Owning the 3 5 -strike call gives the owner the
right to purchase stock for $35 per share any time prior to expiration. Should the
stock be trading at $ 1 00 per share (or any price for that matter), the owner of the
35 call can exercise the option and own the stock for $ 3 5 .
I t would b e undesirable for there t o exist as many strike prices a s possible stock
prices. For the purposes of uniformity and ease of understanding, the exchanges
that list options have devised a system to offer customers predictability in their
choice of strike prices . A systematic approach in determining the choice of strike
prices has been adopted; however, like all rules there are a few exceptions. Stock
splits; public demand, and other influences are at work in complicating a good
thing. For the most part, however, the below rules are adhered to whenever
possible.
Stocks trading between $5 and $25
Stocks trading between $25 and $200
Stocks trading above
$200
Have $2.50 strikes
Have $5.00 strikes
Have $10.00 strikes
Making the determination as to what the value of the strike will be can be looked
at considering that the strike prices always will start from zero and go up. When
looking at a stock that is trading for $24 per share, we can prediCt what strike
prices will exist by starting at zero and working our way up. We are dealing
with a stock that has $2 .50 strike prices (the stock is trading between $5 and $25
per share), and because options generally do not have strike prices below $5 we
will see the strikes looking as follows : $ 5 , $7.50, $ 1 0, $ 1 2. 50, $1 5 , $ 1 7.50, $20,
$22 . 50, $25 , etc.
A $50 stock, according to the rules above, would have $ 5 strike prices. An
example may be strikes as follows: $3 5 , $40, $45 , $50, $55, $60, and $65 .
How many strikes any particular security may have is contingent on several
variables such as the stock' s volatility, recent range the stock has seen and public
demand.
II. EXPIRATION
The cut off date on which the right to exercise the option ends . Options generally
expire at the close of trading (4: 02pm. Eastern Standard Time) on the third
Friday of the named month. For example, July options will expire on the third
Friday of July. If that day is a holiday, then the option will expire the third
Thursday of the month.
13
Expiration Cycles : Most options are traded with a standardized expiration cycle.
This is to add uniformity and predictability in finding expiration months. The
major cycles are :
Cycle Number 1 :
Cycle Number 2 :
Cycle Number 3:
January, April, July, and October
February, May, August, and November
March, June, September, and December
(This cycle is also known as triple witching).
In addition to the cycle, stocks will have option expirations for the closest two
months regardless of the cycle. Usually, after the closest month in a particular
cycle expires the next month we be added. In cycle number one, as the January
options expire, February options will already exist and March will be added. At
first this does not make sense when looking at the individual cycles; however,
the cycles are designed to be able to predict what options exist more than a
couple of months out. Our choices of expiration months will be February, April,
July and October. After February expiration we wiU see March, April, July, and
October options.
Example of how this works:
Suppose it is the last day of trading for January options (regardless of which
cycle it is on) and a stock trades on the first cycle rotation. The two tables below
show what happens. The first table is the last day of trading on January. The
second is what will be available the first day the market opens after the weekend
(almost always the following Monday unless it is a holiday).
CYCLE ONE STOCK OPTION EXPIRATION
LAST DAY OF
TRADING FOR JAN.
1st DAY AFTER
EXPIRATION MONTHS
January
GONE
February
February
April
March
July
April
October
July
*
October
*
Month added
14
III. INTEREST RATES (Rho)
Interest rates play a jUnction in determining the value of an option. In the most
simple understanding, when an option is bought money is taken out of an
account and used to pay for the purchase . Had the option not been purchased,
this money could have stayed in the account and collected interest. We have to
take any possible income lost from the purchase of the option and compare it to
the potential for a profit when owning the option. We will go into more detail on
this later, as interest plays a lesser role than most of the other variables.
IV. VOLATILITY (Vega)
Volatility is a measure of the anticipated price movement that a stock could go
through in a given period of time. The greater the potential for a large movement
in the underlying, the more we can expect an option to trade for (all other
variables remaining constant). Two stocks (named WIN and GOOD) that are
trading for the same price ($5 0 per share); have the same amount of time
remaining until expiration (three weeks remaining); share the same strike price
(55 strike); experience the same interest rate pressure (assign it 6%); may have
options trading at greatly different prices ($4.50 and $0.65 respectively). The
reason is that WIN tends to move an average of $ 6 on a daily basis, while
GOOD has an average range of $ 1 Y2 on a daily basis.
When beginning to trade, most traders quickly learn that the most powerful force
in determining the price of an option is volatility. All the other variables that
impact the price of your option can be moving in the direction that you need;
however, volatility can move against you and the trade becomes a loss.
On the next page is a graph of how our two stocks (WIN and GOOD) trade over
the course of a year. Hypothetically speaking, we can assign volatilities to our
two stocks. We can say that WIN is trading on an 80% volatility and GOOD is
trading on a 3 0%. The graph illustrates the exaggerated movements that WIN
makes in relation to GOOD, thus the WIN options are trading for a greater price.
Think about it, how much would your insurance premiums be if it were
discovered (through blood procedures) that you were genetically predisposed to
cancer? The same metaphor can be used for option pricing.
15
Stock WIN (Highly Volatile) Vs. Stock GOOD (Low Volatility)
100
S
T
0
c
K
90
80
70
/
60
/
/
�,
50
p
R
I
c
E
40
"'\
v'
30
,I
20
10
0
J
F
M
A
M
J
J
A
S
O
N
D
MONTHS
V. DECAY (Theta)
Decay is a measure of how much an option loses value due to the loss of time
value. Every second that passes allows less time for our option to make us
money. If an option on WIN stock went from $2 to $ 1 . 85 in a day ' s time (with
all other variables remaining constant), we could say that the decay of the WIN
option is $0. 1 5 per day at the present time.
The problem with decay is that options lose value in a non-linear fashion. The
closer an option gets to expiration, the more rapidly it loses value. As a matter of
fact, decay is a function of ,the square root of time. We will go into this more
thoroughly in a later chapter, but is not necessary for understanding how options
work.
Graph of an Option's Time Decay
(For mustrative Purposes Only -No Specific Option)
p
9
8
m
6
......
t----
,
------�1'-
4
D
.
�
3
.,
16
I�
1- Time Value 1
""
�'
�
VI. INTRINSIC VALUE
Intrinsic Value is the value of an option after its time value has been removed. It
is an option's worth at the moment of expiration . Intrinsic value is an option' s
real value. An example that relates well to this i s that o f an option on real estate.
If someone were to sell you (for $ 1 ,000) an option to purchase (a call) a piece of
land for $200,000 (strike price) any time before next year, what is that worth?
Not being an expert in real estate you have an appraisal done. If the appraiser
came back and said that not only is the land worth $3 00,000, but he also knows
of a buyer for it, your option would have $ 1 00,000 in intrinsic (or real) value.
You could immediately buy the piece of land by exercising your option and turn
around and sell it to the appraiser' s friend, thus netting a $ 1 00,000 profit ($3 00i<.
sale price $200K purchase price $ lOOK profit). It can be said that that option
has intrinsic value.
-
=
What if the appraisal came back and the land was only worth $ 1 50,000? Would
it make sense to exercise your right to buy the land for $200,000? Of course it
doesn't. In this case the option has no intrinsic value. This does not mean that it
may not make sense to purchase the land contract if you think the land can
appreciate above the option strike before expiration.
Formula for calculating intrinsic value. The easiest way of determining if an
option has intrinsic value is to ask oneself:
"If it
were expiration, how much better
off am
I by owning the option?"
In our example above, if it were the last day in which we had to exercise our
right to buy the land or let the option expire worthless, what would the option be
worth to us? Ask yourself, "How much better off am I by owning the option than
if I simply went out and bought (or sold if puts) the stock in the marketplace?"
Being the last day to exercise our land option we find that the appraisal is
coming in at $300,000. By owning this option (the right to buy it for $200,000)
we are saving/profiting $ 1 00,000. Because it is $ 1 00,000 to our benefit to own
this call, we can say that the call has an intrinsic value of $ 1 00,000. Intrinsic
value can never be less that zero. If it were, one would simply walk away from
the option and not exercise it. If the land were worth less than the option to buy
no one would exercise their' option. They simply would buy the land for the
going rate and let the option expire worthless.
Formula (for calls and puts):
Definition: Intrinsic Value (Call) Stock Price - Strike Price
Definition: Intrinsic Value (Put) Strike Price - Stock Price
=
=
17
Examples : You own the 70 strike call and the 70 strike put when the stock is
trading at $64 per share. Determine the intrinsic value of both the call and the
put?
CALL
Price of the Stock
- Strike Price of the Call
Intrinsic Value (Call)
PUT
Strike Price of the Put
- Price of the Stock
Intrinsic Value (Put)
=
=
$64
- 70
-6 (no intrinsic value)
=
$ 70
- 64
$6 (has intrinsic value)
=
Often traders on the floors of an exchange will refer to an option in terms of its
intrinsic value. There are three terms that all options (calls and puts) are called
depending on the amount of intrinsic value that they have. These terms are as
follows:
In-The-Money
An option is in-the-money (ITM) when it has
intrinsic value.
Out-Of-The-Money
An
At-The-Money
An option is at-the-money (ATM) if the stock price
and the strike price are close to identical.
option is out-of-the-money (OTM) when it has
no intrinsic value.
VII. SETTLEMENT
Equity options are stock settled. An equity option that is exercised on (or prior
to) expiration results in a transfer of a stock position with the stock exchanging
hands at the strike price. Should the owner of a 55-strike call option on the
underlying termed WIN exercise the option, 1 00 shares of stock will be
purchased for $55 per share. This is regardless of what the stock is actually
trading for at the present time.
Other option products will have different methods of settlement. Depending on
how the contract has been structured, options c an be converted into cash, futures,
and other types of settlement values.
18
Put Option Analogy
Another way of looking at options is to picture them in everyday circumstances.
A put option, for example, can be compared to auto insurance. After buying a
car, the first thing a responsible individual does is call his insurance company to
activate his policy. The insurance broker sends an invoice (for say $ 1 ,250) for
one year of coverage on the automobile. The payment you send Mr. Insurance
Man (I.M.) is called the "premium," just like option premium.
By paying the premium, the holder of the insurance policy (put option) has the
right to sell his car back to the insurance company (who has the obligation to buy
it) should the car get stolen (market value decrease). The insurance company
does not want to buy you a new car (at the same price you originally paid-the
strike price/sticker prl ce); however, they are obligated to make you whole again.
The seller of the car's insurance policy was hoping that the car you have insured
through his company increases in value so that you would never want to force
him to buy a new car for you. That way he keeps all the premiums he received
from the sale of the policy and can sell you a new policy the following year (for
an additional $ 1 ,25 0). Mr. I.M. traded a one-year obligation for a premium that
he is allowed to keep.
If you own a put on a stock, the seller of the put option has to make you whole
on the stock for the value of the strike price should the stock decrease in value.
The seller of a put, just like the insurance man, does not want to buy a stock
much higher that where it is currently trading, but is obligated to. He traded an
obligation for the premium in the hopes that the stock would go up in value. Had
the stock gone up in value, the owner of the stock's insurance policy would not
exercise his right to sell the stock, and the seller of the put would be allowed to
keep the premiums he originally received at the sale.
Just as you have options in deciding what type of auto insurance you are going to
purchase, you have choices of how much protection (or appreciation) you can
purchase with equity options. The salesman of the auto insurance will ask you
how much of a deductible you would like, while put options have different
strikes costing various amounts of money. Just like you may pay a higher
premium for a "no deductible" policy, so as to not want to pay a penny out-of­
pocket should you get in an automobile accident, you may want to pay a higher
premium (closer to-the-money strike) for the call or put option so as to take more
of an advantage an expected move in the stock.
.,
19
Call Option Analogy
Land contracts used by many developers employ a call option type transaction.
Builders often want to buy the right to buy a piece of land (call) should they get
the land rezoned for their particular needs (i.e. residential to commercial).
Should the developer's attorneys not be able to get the land rezoned, then the
developer will no longer have a need for the land and, therefore, will chose to
not buy the land. The builder will simply let his land option contract expire
worthless allowing the owner of the land (seller of the call options) to keep the
full amount of premiums received when he sold the option to the developer. The
developer bought the call option and the owner of the property sold the contract
in exchange for a premium.
Gr",phing of Options (Break-even at Expiration)
20
Reading the Graphs.
The graphs are purposely designed for ease of reading and understanding. The
'x' axis (horizontal boarder line) is a line of some possible prices of the stock at
expiration. The 'y' axis (vertical boarder line) is the profit or loss of the position.
The line in _the center of the graph is the representation of the profit/loss of the
option position as it relates to movement of the underlying (stock).
The easiest method of reading the graph is to go to the bottom of the diagram
and find a price that you believe the stock may close at on expiration. From that
number, go straight up vertically until you hit the option graph. Where this
imaginary vertical line intersects the option graph is the point at which you will
draw another imaginary line horizontally to the left until it reaches the 'y'
(vertical) axis. The point at which this imaginary line hits the 'y' axis can be
read off of the graph to determine the profit/loss of the option at that particular
stock price (on expiration).
21
WHAT FACTORS MAKE UP THE VALUE OF AN OPTION?
I have taught hundreds (if not thousands) of people the fundamentals of trading
options. Invariably the most frequently asked question is "How do the price of
options come about?" Or, "who sets the prices at which an option is traded . . . is
it the market-makers?"
Though market-makers do play a role in determining the value of an option,
what pricing really comes down to is supply and demand. The same principles at
work that are determining the price of a stock (buyers and sellers) are
influencing the price of options. What that price is composed is explained next.
There are two variables that make up the price of an option:
- intrinsic wilue (IV) and time value (TV).
Intrinsic Value
Intrinsic value is the easiest to understand, as it is an option' s real value. This
was discussed in the previous pages. In essence, it is the value of how much
better off one is for owning that particular option' s right to buy (call) or sell (put)
the stock than having to go out in the market place and simply place a stock
trade if it were the moment of expiration.
Time Value
Time value is a combination of several variables already mentioned above. They
are time until expiration, the underlying' s volatility, interest rates, as well as
supply and demand (which really is just another way of looking a volatility).
Using the DIS call example from above illustrates time value. The Disney 25strike call for July was trading for $1 when the stock was at $25 . The call has no
intrinsic value as there would be no benefit of owning the right to purchase the
stock for $25 when one could simply purchase the actual stock at $25 . So, why
would anyone want to pay $ 1 for the right to purchase the stock for $25 when
they purchase the actual stock for $25? Because they have time before the
expiration date. Could Disney move to $30 or $40 by the option' s expiration
date? If one believes that the stock could make enough of a move prior to
expiration to justify the $ 1 cost for the right conveyed by owning the option,
then it may make sense to purchase the option. The trader will be buying time.
PRICE OF AN OPTION (PO) = IV (intrinsic value) + TV (time value)
Thus, we can always determine the price of an option if we know the IV and TV.
Or, we can solve for time value if we know the price of the option, for
calculating IV (the other variable needed to calculate TV) is relatively easy to
compute. Lastly, we can calculate the IV of an option if we only know the option
price and time premium. The equations for these are on the next page.
22
+
=
Intrinsic Value
Time Value
Price of Option
Price of Option
- Time Value
Intrinsic Value
. Price of Option
- Intrinsic Value
Time Value
=
=
Walking through an example we may need to find the time value of an option on
a stock given the following information:
JKL Stock = $72 per share
JKL 70 strike call is trading at $4.75.
Question : What is the TV (time value) of the 70 strike call?
Answer: We need to use the second formula right above as it is the variable time
value that we are looking for. Inserting the data that we know into the formula
we get this :
Price o f Option
- Intrinsic Value
Time Value
=
$4.7 5
$2.00
$2.75
=
We now know that the above option has $2.75 of time value. If this were the
moment of expiration (all other variables remaining c onstant) our· option would
be trading at only $2.00 (its intrinsic value).
For the most of the textbook we will use equity (stock) options in our
example(s). This will serve to establish consistency throughout the text. In other
chapters we will go into futures underlying contracts, cash settled contracts, as
well as others. There will be chapters on other types of options should you wish
to take these strategies and apply them to another product.
Option Pricing As A Function Of Probability
All option price calculations are based on probabilities. What is the option' s
probability o f having value at expiration? The answer to this question i s the main
ingredient in valuing an option. A knowledge of probabilities is not necessarily
needed, but it helps. The text and the subsequent criteria are designed to work
without much knowledge. However, the remaining portion of this section is
based on the assumption that the reader has at least an elementary knowledge of
probabilities and the normal distribution curve.
Looking at an option chain (option chain: a list of all options for a particular
stock ranked in order of strike price) of any stock reveals an interesting picture.
Even for the first time observer, there appears to be an almost poetic symmetry
.and landscape in an option chain. On first glance the viewer notices the options
prices falling (with the call chain) in value with each progressive lower strike. At
a later time the trader will notice that this is only true because of the intrinsic
23
value in the options, but removing the intrinsic value from options (leaving time
value only) paints a different picture. The options no longer decrease in value.
They form a normal distribution curve-the Bell Curve.
More volatile stocks, stocks that can move to the extremes of a price line, have
more elongated curves as it is anyone ' s guess as to where the stock will close on
expiration. Stocks that remain very stable over a given time period usually have
very narrow normal-distribution curves as the probability of the stock making a
large move is remote. A stock that is trading for $ 1 00 per share (LARG), but can
move to either $60 or $ 1 40 in a month will have a wide and tall normal
distribution curve reflecting the uncertainty of a possible closing price. A stock
that is trading for $ 1 00 (SML), but can move to only $90 or $ 1 1 0, will have a
narrow and short time value curve due to the unexpected likelihood of moving a
great distance in a given time period.
The graphs below illustrate two stock' s time values (intrinsic value was
removed) as a function of volatility.
Low Vol. stocc
l SMl
HIGH V01..SWCK: lARG
'12 'r-"
"
,,,"
,",
,."
'
Although both stocks are trading for $100 per share, the stock LARG is much
more volatile. LARG's time value graph illustrates the real possibility of the
stock reaching either end of the strike price range by expiration. Stock SML is a
very stable stock whose chart shows that the possibility of the stock reaching
either $70 or $13 0 by expiration is very remote. Both charts, however, are
normal distribution curves whose shape is determined by the stock's implied
(current) volatility.
You will notice that as a result of the higher volatility, stock LARG ATM (at­
the-money) call is trading for $ 1 1 while the ATM call on SML is trading for
$3.25. A trader would obviously be willing to pay more money for an ATM call
on a stock that can move $20 in a day as opposed to an ATM call on a stock that
takes a year to move by the same $20.
24
Option Chain Time Values
Do not confuse the time value of an option with the total price on an option. The
two charts on the previous page depict the time value only. One has to add the
intrinsic (real value of an option to the time value to derive the total cost of an
option. Looking at an option chain shows that the lower the strike price the
higher the cost of an option because of the time value. (The reverse is true of
puts).
The chart below depicts both the time value and option price to clarify this
concept for those who may be a bit confused. I am using the DJX index chain
when the index was trading for $ 1 08. 1 1 . Do not let trading an index throw you
off as they trade just like a stock most of the time. I chose an index to show a
smoother transition of time values throughout the strike range.
Time Value ONLY
$1.15
$1.10
$1.05
$1.00
$0.95
$0.90
$0.85
$0.80
$0.75
$0.70
$0.65
$0.60
$0.55
$0.50
$0.45
$0.40
$0.35
$0.30
$0.25
$0.20
$0.15
$0.10
$0.05
$0.00
Strike Price
103
104
105
106
107
108
109
110
111
112
113
Option Price
Minus Intrinsic Value
$5.20 $4.20 $3.30 $2.50 $1.85 $1.20 $0.70 $0.35 $0.15 $0.10 $0.05
$5.11 $4.11 $3.11 $2.11 $1.11 $0.11 $0.00 $0.00 $0.00 $0.00 $0.00
Equals Time Value
$0.09 $0.09 $0.19 $0.39 $0.74 $1.09 $0.70 $0.35 $0.15 $0.10 $0.05
.,
25
Option Pricing Increments for Equity Options
A systematic approach to pricing options was undertaken to assure uniformity.
Equity options trading under $3 are traded in $0.05 increments, while options
that have over $3 in value are traded in $0. 1 0 increments. So one could expect to
see an option trading for $2.95; however, you would not see an equity option
trading for $ 3 . 5 5 . It would have to trade for either $ 3 . 5 0 or $3 . 60.
Increments
$3
Owr $3
Options Under
Options
$0.05
$0. 10
26
Examples
$ 1.00, $ 1.05, $ 1. 10,
$3.00, $3.10, $3.20,
etc.
etc.
Bid-Ask Spread
The Bid-Ask spread is the difference in price from where the market participants
are willing to purchase the option (or stock, bond, etc.) and where they are
willing to sell it.
Bid The "bid" is the highest price a market participant is willing to pay for the
option at that moment. You may be willing to buy an option for $ 1 , but if
someone is willing to pay $ 1 .20, that price of $ 1 .20 is the highest someone is
willing to pay - thus it is the bid.
-
Ask The "ask" is the lowest price a market participant is willing to sell an
option at. You may have purchased an option for $3 and be losing money on it.
If you put an order in to sell it at $3 in an attempt to break-even on the trade, but
someone else is trying to sell the same option at $2.50, that price will be
considered the ask price.
-
Spread - The difference between the bid price and the ask price is called the
spread, price spread or bid-ask spread. You may hear a broker referring to the
"spread" as being $2.00 at $2.30. This means that the bid price is $2.00 and the
ask price is $2.30. Or he may say the spread is $0. 3 0 meaning the difference
between the bid and ask price ($2.00 and $2.30) is $0.30. This is a time when
you have to think about what is being said and compare it to what things are
trading for, but you are much better off asking him to clarify what he is saying. It
may be intimidating to ask a "professional" what he means as you may come
across as being uneducated or a novke; however, it is better to ask him questions
than to have it cost money.
Bid-Ask Spread Exampl e
Bid
Ask
S pread
$2.00
$2 .30
$0.30
27
[page intentionally blank]
28
Broken Wing Butterfly Spreads
(BWB)
www .RandomWalkTrad!ng.com
29
Broken Wing Butterfly Spreads
C all Broken Wing Butt...,
Introduction
and
Opinions
Please thoroughly read each piece of information in this section pertaining to the
broken wing butterfly. I am very pleased about having this strategy as one of the
foundation trades presented to my readers as I feel that this strategy, as
evidenced by the amount of floor traders making a handsome living on some
variation of this spread, will likely be what you will want to consider as one of
your core strategies implemented.
.
When reading the text you will notice how powerful a strategy this is by viewing
varying scenarios and outcomes should the underlying (stock, bond, commodity,
index, etc.) move in the anticipated direction, against you, or even remain
constant. Very few strategies exist iri which the trader' s upside profit potential so
greatly outweighs the downside risk.
Certainly a $5.00 vertical call spread purchased for $ l .00 offers an excellent
risk/reward ratio, however, at what cost? If a trader purchases a vertical spread
for $ 1 , he has to make the full profit potential on the spread once to simply break
even should four other long vertical spreads expire worthless. Suppose the odds
of making the full $5 (a $4 profit after the spread' s $ l . 00 cost) was measured at
1 7%? Would that trade even make sense to do? Are they any real odds in doing
this trade?
Random Walk, LLC. is dedicated to your success only, so even though we may
teach the vertical spread as a means to an end; favorable under a few
circumstances; a good way to sell premium (as opposed to naked straddle sales)
and as a conduit by which to teach more complicated strategies, we will save
those remedial trades for others.
30
Broken Wing Butterfly Definition One
Simply put, a broken wing butterfly is the sale of a ratio spread in which "tails "
are purchased to reduce margin and risk exposure.
Broken Wing Butterfly Definition Two
Another way 'of imagining this spread is to take a normal butterfly cmd pull the
furthest out-of-the-money strike options one or more strike prices further out-of­
the-money.
Broken Wing Butterfly Definition Three
This position can also be thought of as the purchase of a butterfly spread, and
the simultaneous sale of a further out-of-the money vertical spread to pay for the
butterfly being purchased.
l1... _.",.· t..,y
-�'¥... .
Deimititm Three '
Def"mition One
brio Portion
Buy I ct. 954trik::e put
SeR:2 � 90-strike put.
. Normal Butterlb"
Buy} ct. 95-sbike put
Sel l d:'9�i:e l:Jm
Buy • d. '5��;put
.
TaiI�
.
..
� l ct. s:<i���;
jt� Wm,Bmtdy
;'$uy} ·ct 9$-sbike':pm
:5eJ: .2 d. 90-sttike put
�i1 et , IS .-iu: p•
.Buy.l�,�,��e;pm
. .·
Nolmai�
Buy l d. t5�e put
Sel1 2 ct, .90..;l>'frib put.
Buy I ct. 85..,$tJike pm '*
'VStieiH PUt SJtead Sale
;=������t:�··
thi! aj�
1J " ;'''i:tmJEiiII
.
. �,. ; .
Ctmcel:ff«h oi_ DUI.
'*
.'
Practical Definition of Broken Wing Butterfly
A broken wing butterfly is an excellent spread for those traders that like to sell
premium and buy butterfly spreads individually as two separate trades, as this
spread is the sum of both strategies. Essentially the third definition above best
describes what the spread consists of; however, it is also not uncommon for
people to think of this position as a short ratio spread (definition one) whereby
"tails" are purchased to lower the risk and margin exposure.
These trades will often be referred to as "risk butterfly spreads." We intend to
purchase the closer-to-the-money (CTTM) option and sell twice as many options
that are generally I -strike further out-of-the-money (FOTM). However, when
doing this trade in indexes, we can often split the strike further apart than one
strike price, which is favorable compared to being closer together. This will be
illustrated shortly, but suffice to say, " Which would you rather own - a $5
butterfly spread or a $1 0 butterfly spread? "
31
Ratio Spread Portion of Trade
Another simple method to understand the broken wing butterfly spread is : a
broken wing butterfly is the sale of a ratio spread in which "tails " are
purchased to reduce margin and risk exposure. To break it down into two
components ( 1 ) the ratio spread, and (2) the "tail".
-
Sell of Ratio
Our Ratio Spread
Buy 1 ct. 95-strike put
Sell 2 ct. 90-strike put
Buy of Ratio
Typical Ratio Spread
Buy 2 ct. 90-strike put
Sell 1 ct. 95-strike put
Note: For the rest of this chapter, any examples using this particular equity or
index will use the following market prices:
85-Put $0.90
80-Put = $0.40
95-Put = $3.00
90-Put = $1 .80
=
Careful examination of the positions above reveals that the two positions are
exact opposite transactions. If you were looking to sell the ratio spread, the
trader who took the other side of the trade has ended up purchasing the ratio
spread. What was a debit for one person was a credit for the other. Coincidently
the two positions have the exact opposite, as would be expected, risk and reward
exposure. You will note that the seller of the ratio spread has the greatest amount
of risk should the underlying make a dramatic move in the correct direction, but
too great of a directional move. This is why the seller of the ratio spread (us),
will usually purchase "tails" (FOTM options) for protection against a
catastrophic move.
However, we will show that the tails of the ratio butterfly really do not need to
be purchased, under almost every situation, for the position to perform in a low
risk fashion. Contrary to one ' s intuition that much risk exists as a result of one
more unit (put or call contract) being sold than purchased, the combined position
(provided the strike selections are chosen well) acts in reality much as a well
hedged position. In other words, no matter what method one chooses to analyze
the position, being "greeks", practical performance, etc . , it is difficult to lose
money on the position. Different methods of proving this statement will be
addressed shortly.
Break-even and Maximum Profit of Short Ratio Spread at Expiration
We will see that the ratio spread (even without the protective puts) is a fairly safe
position, should you at least give it a minimal amount of attention and
management. The criteria will seldom allow us to hold onto one of these until
expiration if the market is going in the desiredtdirection, but a fortune could be
32
made in such instances. Thus, if you see the spread is working out perfectly and
expiration is close, the criteria may suggest that you hold onto the position
longer. Should this be the scenario, understanding the position' s break-even
points and maximum profit point at expiration will be critical in protecting
oneself. The following guidelines are a simple approach to understanding the
necessary prices of break-even and maximum profit.
Break-even ofShort Ratio Spread
1 : 2 CALL Ratio Break-even
=
Strike Sold + [diff. in strike prices] + [minus debit/plus credit] .
1 : 2 PUT Ratio Break-even
=
Strike Sold - [diff. in strike prices] + [plus debit/minus credit] .
Example:
Using the ratio spread break-even formula listed above; we can easily calculate
the exact break-even point on our example ratio spread consisting of:
Piece Number
1:
Buy 1 , 95 Put for ($3 . 00)
Piece Number 2: Sell 2, 90 Puts at $ 1 .80 per contract ($3 . 60 total)
Formula:
1 :2 PUT Ratio Break-even
=
Strike Sold - [diff. in strike prices]
+
[plus debit/minus credit] .
Work:
=
90 strike - [ $5 (note: 95-90
=
$5) ]
+
[ minus $0.60 credit (note: $3debit
+ $3 .60 credit + $0.60)]
=
=
=
$90 - [$5] + [-$0.60]
$84.40 break-even
33
1 :3, 1 :4, etc. Ratio Sales
Once one perfects the ratio sale strategy, I t will not be uncommon for one to find
trades that tum out to be a better position by adjusting the ratio quantity. Ratio
spreads consisting of 3 or more sales for every purchase, especially if the
distance between the strike prices bought and sold are further apart that
one strike (see criteria) are sometimes preferable to the "plain vanilla 1 :2"
ratio. Should you elect to increase the ratio size, it will become important for
you to understand the break-even points, which will be a slightly different
calculation than the 2 : 1 ratio.
Ratio Break-Even Formulas
1 : 2 Call Ratio Break-even
=
Strike Sold + [diff. in strike prices]
[minus debit/plus credit] .
+
1 : 2 PUT Ratio Break-even
=
Strike Sold - [diff. in strike prices]
1 :3
=
[plus debit/minus credit] .
+
Call Ratio Break-even
Strike Sold + (Yz diff. in strike prices]
+
[minus debit/plus credit] .
1 : 3 PUT Ratio Break-even
=
Strike Sold - [Yz diff. in strike prices] + [plus debit/minus credit] .
1 : 4 Call Ratio Break-even
=
Strike Sold + [1/3 diff. in strike prices] + [minus debit/plus credit] .
1 : 4 PUT Ratio Break-even
=
Strike Sold - [113 diff. in strike prices] + [plus debit/minus credit] .
34
Maximum Profit Formula
Recalling that the sale of a ratio spread can be interpreted as a long a vertical
spread (either call or put) combined with the sale of an extra unit at the strike
price of the vertical spread's option sale, intuition would dictate that the
maximum profit of the vertical portion of the spread is at (or beyond) the strike
price sold. This fact combined with the desire to see the extra unit sold expire
worthless would tell the reader that the maximum profit is at the point where
the underlying closes on expiration at the strike sold. Should the stock close
at the strike price sold, the extra unit sold will expire worthless and the
maximum profit of the vertical spread purchased will be actualized. This is the
best of both worlds. With this intuitive approach understood a formula can be
embraced. Said formula is as follows :
Sale of Ratio Spread Maximum Profit
=
Distance Between Strikes + [plus credit/minus debit] .
Example from Above:
Distance Between Strikes + [plus credit/minus debit] .
$5.00 (95 put - 90 put $5) + [$0.60 credit ($3 debit + $3 . 60 credit
=
=
=
=
=
$0.60)]
$5.60 maximum profit (almost always at expiration).
"Tail" Purchase Portion of Trade
Unless the underlying that the ratio is being placed in is very inexpensive (a
cheap stock), the extra option unit being sold will provide much potential risk
exposure. Even though we will show that the risk exposure is miniscule
compared to what intuition would dictate, there will be much margin for the
trade. To clean up the potential risk of �tandard !leviation moves of 3 SD' s
o r greater, and t o clean u p extraordinary margin requirements, purchasing
what most would consider a "garbage" or useless tail will greatly help in
eliminating the risk and margin exposure.
In the 95-90 ratio spread example above, we have shown that the 90 strike puts
were sold one extra time, or you could say the 95-90 put vertical was purchased
(buying the 95 put 1 time, and selling the 90 put 1 time) and a naked 90 put was
also sold. The extra sale of this 1 unit of 90-strike puts will be viewed by
brokerage firms as a considerable amount of risk. Should the underlying decline
to $0, as the put sale will result in a loss of $90 (as it was the 90-strike put sold)
minus whatever premiums were received from the sale of the put. Certainly the
purchase of $5 vertical spread will actualize a $5 profit, which will partially
offset the $90 loss, but many brokerage firms will not even look at the gain as a
potential partial offset. Thus, the brokerage firm will require the customer to
"
35
have enough capital in their account to keep the account positive in value should
the worst of scenarios actually happen.
Risk and Margin Cost without the "Tail" Put
In the 95-50 ratio example above, the most punitive a brokerage firm could
expect to be would be to margin the example trade at $8,820 for just one
contract. Ignoring the put spread purchase and simply looking at the sale of the
90-strike put at $ 1 .80 reveals a potential, albeit very unlikely, maximum risk of
$90 per share which equates to $9,000 for one option contract ($90 per share x 1
contract x 1 00 shares per contract $9,000). This will be partially offset by the
total premium of $ 1 80 ($ 1 . 80 premium x 1 contract x 1 00 shares per contract
$ 1 80) received from the put sale. Thus, the $ 1 80 of received premiums will
assist in offsetting a maximum loss of $9,000, net resulting in a maximum loss
of $8,820.
=
=
Maximum Risk ExposurelMargin
Maximum Loss Potential of Put Sale
+ Premiums Received From Put Sale
Total Maximum Loss Potential/Margin
=
=
=
($9,000)
$ 1 80
($8 ,820)
On the positive side of reality, unless this is a retirement account, most
brokerage firms will give some margin relief on this position in the same way
they would allow the client to buy stock (which is essentially the same position
as a put sale) on 50% margin. The exact rule on margin relief for a position such
as this varies from one brokerage firm to the next, and also varies if the
underlying is an equity (stock) or an index. Understand that stocks have gone to
zero unexpectedly overnight, "but it is unlikely that an entire index would go out
worthless overnight. Therefore, the indexes often have half the margin
requirements that equities have. The loss of a put sale can be quantified as an
underlying that can't trade below zero; however, the maximum loss on a call sale
can't be quantified because it is theoretically possible for an underlying to close
at infmity, call ratio positions are sometimes margined even more harshly than
the put ratio spread.
Exact Margin Requirement Guideline
Margin on a Sale of a Naked Option (Stock) is calculated at Yz the value of
the equity, plus the premiums received. This definition states that the
brokerage firm will want the naked option seller to put up half of the value of the
stock. The premiums received will not be considered as relief, but as additional
margm.
36
Using the 95-90 put ratio trade as an example reveals that the margin will
provide much relief compared to if margin were not available; however the
margin on this ratio spread will still be quite expensive at $4,320. We would
be required to put up $4,500 for the put sale, as Y2 the value of the 90-strike is
$45 . , The premiums received from the put sale would also be kept for margin
purposes only, thus the $ 1 80 received would also be held.
Total Margin Ratio Spread Requirement for Our Stock Example
Y2 Maximum Loss Potential of Put S ale
+ Premiums Received From Put Sale
Total Maximum Loss PotentiallMargin
=
=
=
($4,500)
,
$ 1 80
($4,320)
Note:
As mentioned earlier, because of the greatly reduced chance of an index going
to zero or irifinity (when compared to that of a stock), many brokerage firms
reduce the equation to % for index options. They will calculate margin on the
above example position at 25% of the index value, plus premiums received If
the above example were a $100 index such as the DJX, margin would be 25% of
the 90-strike ($2, 250), plus the ($1 80) premiums received, or '$2, 430. This
$2, 430 is obviously a lot better than the full margin of $8, 820 (no margin relief)
for an equity, but is still quite expensive.
Maximum Loss
The maximum loss on this position can be extreme should something
extraordinary happen in the markets. Stocks have been known to double or
approach close to zero in a day. This is one reason that you will see the criteria
recommending placing these trades in an index. Furthermore, it is a safe
argument to make that a devastating loss is unlikely with this position
placed in an index, provided someone is rather frequently monitoring the
position and exiting (or rolling down or up) the position during the
necessary times. The maj or disasters I have seen occur by people using this
strategy are usually the result of putting the trade on at the wrong strikes, not
moving the position when needed, or leaving the position on when it should be
taken off.
37
Theoretical Maximum Loss
Calls = Infinity. Due to the fact that there is a theoretical possibility for a stock
to go from its current price (of let ' s say $58) up $ 1 0,000 (to close at $ 1 0,05 8),
there is a virtually unlimited loss possibility. Though probably in the same
statistical bracket as us watching our sun deplete all of its hydrogen in our
lifetime, anything is theoretically possible.
Puts = Roughly the Stock's Value. This should make sense intellectually, but
the word "roughly" is not embraced by most people, thus an exact calculation
can be determined by using the following equation.
Maximum Loss of Ratio Spreads on Puts
=
Zero - Strike Price Sold + (Difference Between Strikes]
+ (+ credits or - debits]
Margin Formula for the Sale of a
1:2 Ratio
Spread
(Note: The figure will be a negative number which indicates the margin will be
debited from your usable risk capital.)
Margin Stock Ratio 1 :2 Spread STOCK =
112 Value of the Stock - (Difference Between Strikes] + (- Credits or
+Debits]
Margin Index Ratio 1 :2 Spread INDEX =
114
Value of the Stock - (Difference Between Strikes] + [- C redits or
+Debits]
38
How to Reduce Risk and Margin
As a result of the margin expense of holding onto a ratio spread, and often as
insurance against a catastrophe, traders will buy a far out-of-the-money option to
reduce or eliminate the exposure - both margin and risk. Furthermore, they will
usually NOT purchase the put an equal distance away from the put sales and put
purchase (or calls), as this would result in a butterfly position which is NOT
what we are looking to initiate. The above example was a trade where the
distance between the puts purchased (95-strike) and the puts sold ($90-strike) is
$ 5 . Should the trader elect to buy the 85-strike put (another $5 away from the
90-strike) for insurance they would end up with the 95-90-85 put butterfly.
Though a good trade if placed for the right cost, moving the garbage puts/hedge
options one or more strikes even further OTM reduces the cost (or increases the
credit) without greatly upsetting the profit potential of the trade or incurring too
much additional risk. Though this last statement does not sound logical, we will
shortly begin to look at the practical side of how both the buy (95-strike) and sell
(90-strike) options of the ratio spread move in somewhat an equal and opposite
manner.
Graph of Ratio, Garbage Put, Ratio and Put, and Combination
Many individuals find that graphic al representations of multiple option position
combined to make a single spread are the best method of understanding exactly
how a position works. If this is of help to the reader, then it will also likely assist
in the understanding of the margin of a ratio that is combined with a hedging put
to create the broken wing butterfly. - A glance at the last of the four graphs will
quickly prove to the reader that the position no longer has unlimited risk
exposure once the hedging put is purchased. But first, below is an illustration
that may help some.
90
9S
" i:
39
B uy
Ratio
Sprea�wlth Protectille Put
a
Protective Put
BROKE N WIN G BUT,TERFL Y
We know that short ratio and broken wing butterfly (BWB) spreads can be very
costly in terms of tying up margin money. Selecting a small price stock or index
can help make the margins more manageable; however, should the best trades
end up being in an index such as the SPX or OEX (Standard and Poor' s 500
Index options and Standard and Poor's 1 00 Index options respectively), one can
expect a very large margin requirement. This is why many traders will elect to
purchase the OTM puts to lower this margin, and turn the short ratio spread into
a broken wing butterfly.
Ratio Spreads and the "Greeks"
We now get into the explanation of how the ratio spread moves as the underlying
moves in the anticipated direction, opposite the anticipated direction, or remains
stable for an extended period of time. A desire to embrace the material and a few
reads should be enough for the trader to comprehend the material. A few more
reads and walking oneself through a few examples will usually make the
...
40
material tangible; however, some people may find the concepts of the greeks a
bit vague or confusing. Do not let yourself get discouraged as this is a natural
response, but most people will eventually understand if they do not give up.
This section is a supplement that will allow those familiar with the "greeks" get
a different perspective on the material that they can digest and accept as gospel
(as math doesn' t lie) .
Note: It is not mandatory to have an understanding of the greeks in order to _
understand this strategy. Again, this section on the greeks is just a supplement.
Many options traders on the floor traded these positions long before an
understanding of the greeks was available to them. I know of many traders that
still have almost no understanding of the greeks (including delta) and trade
these positions quite successfully.
Using the example that we have been using throughout the text we can show the
reader that the position is surprisingly safe compared to what intuition tells him.
We will see that the greeks usually offset each other very closely with the
exception of theta (time decay). Most of these spreads will initially have some
positive theta working in your favor (or it will begin to become positive theta
soon), and the positive theta will increase as time approaches expiration, thus
resulting in a position that begins to work more favorably every day.
A
Quick Refresher of Greek Definitions
Delta:
Delta is the mathematical calculation used to measure how
much an option moves as the underlying moves 1 point or $ 1 .
Gamma:
Gamma is the mathematical calculation used to measure how
much delta changes as the underlying moves 1 point or $ 1 .
Theta:
Theta is the mathematical calculation used to measure how
much an option loses in value as one day of time passes.
Vega:
Vega is the mathematical calculation used to measure how
much an option will increase or decrease with respect to a 1
point or 1 % change in implied volatility.
41
Option' s Greeks Calculation Charts
The charts on the next two pages will be used to easily calculate how the ratio
spread (without the tail) and the broken wing butterfly spread (with the tails)
have very little risk when measured in deltas, gammas, thetas, and vegas. The
first thought that comes to mind when thinking of the spread in your mind's eye
is, "what about the risk of that naked option that is not conjoined with the long
option ? " The lack of understanding of how the position behaves as the market
moves in different possible directions gives the uneducated trader a sense of
great risk; however, the charts below will illustrate that the positions are actually
much better positioned to withstand adverse market fluctuations than many
trades that most people would consider "safe strategies".
Option's Greeks Chart Details
The first chart is of options with
I month until expiration (call it March exp.)
The second chart is of options with 2 months until expiration (call it April exp.)
42
.j:>.
VJ
t
Charts Explained
The data that is compared between the two individual months is of major
importance when analyzing the material. In other words, the math cells have
been added to show the reader that the math was not made up, but the
calculations are of little value at this time. What is important in using the above
two charts are the net results of the analysis found on the bottom rows labeled,
"RATIO TOTALS" and "BROKEN WING TOTALS". It is here that we are
going to focus our direct attention.
Note: When viewing the two charts it helps to remember that a stock whose
options have two months remaining until expiration will be trading next month,
provided all variables except time remain constant, the same as the near month.
This is helpful in sho �ing in a static environment what will happen to the April
options should a month go by without any change in the price of the underlying
and vega.
The interesting items are the data found on the last rows of the individual charts
which prove that both the ratio and broken wing butterfly positions are relatively
inert as a spread package, and remains so as time approaches expiration. For ease
and continuity in explaining the critical information we will break the important
ingredients down into categories of cost, delta, gamma, theta and vega.
Given information
Stock
=
$ 1 00
Expiration of April
=
Expiration of March
2 months.
=
I
month.
In the following examples, we are assuming that the spread was purchased at the
time when April had exactly two months remaining until expiration, and we held
on to the position for exactly one month (which allows one to make assumptions
that the March options are currently trading for what the April options will be
trading for in one month' s time.)
Cost Analysis
Cost April
The April chart reveals that the ratio spread can be purchased for a $0.60 credit
($2. 40 debit, $1. 50 credit x 2 net $0. 60 credit) and the broken wing butterfly
could be purchased for a $0. 1 0 credit ($2. 40 debit, $1. 50 credit x 2, $0. 50. debit
$0. 1 0 credit). After having purchased the spread, the trader decides to go away
and not look at the position for exactly one month and is surprised to find out
that the underlying is at almost the exact price it was a month earlier. What
=
=
45
happened to the position he initiated the previous month? A look at the chart of
March options can be used to closely estimate what the position is worth exactly
one month later.
Cost March
The March chart reveals that the ratio spread Can be purchased for a· $0.25 debit
($1 . 25 debit, $. 50 credit x 2
net $0. 25 debit) and the broken wing butterfly
could be purchased for a $0.40 debit ($1 . 25 debit, $. 50 credit x 2, $0. 1 5 debit
net $0. 40 debit).
=
=
Note: The important thing to remember when viewing the spreads in this fashion
is that in April we purchased the spread, thus we would likely want to sell out
our position for a profit. Pricing this as a purchase may confuse a few, so
remember that any spread purchasedfor a debit could also be soldfor a credit.
This if we decided to sell this spread, a purchase debit becomes a sale credit. .
Cost Summary
Ratio Spread: Comparing the spread in April to that of March shows that the
trader who held onto the ratio spread made a profit of $0. 85. He initiated the
spread for a credit of $0.60 and took it off for a credit of $0.25 ! Only the greedy
and unrealistic can complain about placing a trade that receives a credit, and then
getting paid again to take the trade off. This certainly doesn't ever happen with
vertical spreads, time spreads or straddles.
Broken Wing Butterfly: Comparing the broken wing spread in April to that of
March shows that the trader who held onto the position for one month made a
profit of $0.50. He initiated the spread for a credit of $0. 1 0 and took it off for a
credit of $0.40 ! Again, only the greedy and unrealistic can complain about
placing a trade that receives a credit, and then getting paid again to take the trade
off.
C omparison of Ratio to the Broken Wing Butterfly: The ratio spread allowed
us to actualize an $0.85 credit, whereas the broken wing was slightly less
profitable, and only allowed a profit of $0.50. First consideration of these prices
would make one jump to the conclusion that the ratio spread is the b�tter of the
two trades.
Which spread is the better is really contingent on how you trade, your tolerance
for pain and/or risk exposure, and margin concerns. The more profitable ratio
spread will have a larger margin cost of carrying the position which is a real
consideration for most traders. The broken wing butterfly was less profitable, but
with the greatly reduced margin to carry the position, a trader can execute more
trades that usually more than make up for the lower profitability when compared
to the ratio spread.
As a result of margin, almost all traders will elect to do a form of the broken
wing butterfly, even if they think they are initiating a ratio spread, but then are
46
later forced to buy tails by their clearing house or brokerage house. Also, if you
do not plan to watch the market at least once every other day, and 3 glances of
30 second at the price of the underlying per day is really what should be
practiced. This is the minimum amount of time one should commit to making
sure that nothing weird happing in the markets could hurt them.
These are not time consumin2 trades to mana2e. One does not be ever have to
be vigilant of how the option prices are moving or how much the underlying is
moving on a minute by minute, hour by hour or day by day basis like many other
trades that must be constantly monitored. What you will be doing is just
checking to make sure the market is not crashing or bubbling up beyond even the
days we saw during the "Bubble of 2000". In other words, as long as a 2 or 3
standard deviation move is not under way, the position almost never has to be
worried about.
As a matter of fact there was nothing more boring on the trading floor than
having a large ratio spread in position that was tying up all your money in
margin. If all your capital is frozen in margin, there is very little one could trade,
thus you pretty much came to work everyday to sit on a stair of the pit and read
the newspaper.
Delta Analysis
Delta of April Position
The charts reveal that the net delta position of the short April ratio put spread is a
positive 7 deltas (0.07 is a 7 percent delta). The broken wing butterfly spread is
even more delta neutral with a delta of only 1 . positive delta. What this means to
the trader is that the position does not contain very much risk from an adverse
move in the markets. Consider that a delta of 1 (or 1 percent before the option' s
1 00 multiplier) i s negligible and in reality insignificant. Should the stock or
index move $ 1 (on a $ 1 00 underlying), the position will literally make or lose
only $ 1 . The markets could move 1 0% and you would make or lose $ 1 0. On
even a large size of 1 00 contracts you would make or lose only $ 1 00 on a 1 0%
market movement, which is by anyone ' s definition a fairly exorbitant move for 1
month.
Delta of March Position
The March chart indicates with a high degree of accuracy that the position that
was initiated the month before has seen little change in the overall market
direction risk (delta risk); however, what little change that was made was to our
benefit. The original positions saw a slight positive net delta once the spread was
on as a package. As the month progressed, the original positive delta position
became a slight negative delta position.
47
Ratio Spread Delta Change
The ratio spread began the month of March with a net delta position of positive
(7). It ended the month of March (as April became the front month) with a net
delta of ( 1 ) .
Broken Wing Delta Change
The broken wing butterfly (BWB) did a similar switch but to a lesser degree.
The BWB ' s delta started the beginning of the month as a positive delta of 1 , and
ended the month with negative (3) deltas.
This change in deltas from a net positive to a net negative is a benefit to the
trader in that the risk the trader considers himself exposed to is to the downside
(with this particular put ratiolbroken wing - had this been calls the reverse
benefit would likely take place). The fact that the position was initiated to the
downside is an indication that the trader had a neutral to bearish opinion of the
markets. Despite this bearish stance, a move too drastic and fast to the downside
without adjusting the position could result in a loss. The negative deltas will help
offset any loss should a dramatic move occur, and will add to the profits should a
decent and reasonable downside move come about. Thus, this change in deltas is
of great favor to the trader, and is just one more benefit of the ratio spread.
Gamma Analysis
Gamma April
Both the ratio spread and the broken wing butterfly have very small gamma
exposure. Recall that gamma can be defined as the unit of measure that
determines how much delta will change over a given amount of movement in the
underlying. The unit is generally described as a 1 point movement. Looking at
the April net gamma for the ratio position we have calculated at negative (1 ).
The broken wing has a net gamma of positive 1 . This is insignificant considering
how much a move it would take to have an appreciable affect on our delta.
"
48
Gamma March
After one month of having either spread on in position, the net gammas have not
changed in any significant manner. The fact that after one month of trading the
gamma has not significantly changed is not the result the individual gammas not
changing. Looking at the charts for comparison will reveal that the individual
gammas doubled as time approached expiration. The nature of this particular
trade has the distinct advantage, compared to other trades you have learned in
the past, of being well hedged by its design.
Theta
&
Vega Analysis
The same argument that has been discussed for delta and gamma apply for the
net theta and vega of these two trades. To cover this is unnecessary as the
numbers for theta are very similar to gamma, and the numbers for vega are very
similar to the delta numbers. Also, all the numbers are not too different from one
another as it is.
Why Do The Greeks Wo rk Out So Well?
The reason that these numbers keep balancing out, as some of y ou may have
guessed, is the normal distribution curve (Gaussian curve, bell curve, etc.). An
oversimplified explanation, but one that will be used for ease of comprehension,
is that the option being bought is usually about twice as high up on the normal
distribution curve as the option being sold. Selling twice as many options that is
Y2 the height of the option being purchased does a fairly good j ob of balancing
out the risk. With a put ratio, all the negative deltas acquired from the purchase
of a put will be offset by roughly an equal number of positive deltas acquired by
selling twice as many puts that have Y2 the delta of the other option.
This is huge, as the majority of people trading these products do not even realize
the phenomena at work here !
"Learn from the mistakes of others .
You wont live long enough to make them all yourself'
Jane Bryant Quinn
49
Bell C u rve for Delta , Gamma", Theta or Vega
1 00
Line " 8"'
o
stock Price
quick glance at the Gaussian curve will reveal the secrets of why the ratio and
BWB work out to be well hedged positions. Looking at line "A" and comparing
to line "B" tells a powerful story, even to those individuals who do not
understand the greeks. Line "B" is the option strike being sold in twice the
quantity of the options being purchased in line "A", and line "B" is half the
height (roughly) as that of line "A". We are quite certain that no other company,
until they steal a copy of our text, has a clue as to why this position works, and
as a result will steer their clients away from this (if they have even heard of it) in
favor of less reliable and more risky positions such as a vertical spread.
A
The Practical Use and Mechanics of Ratio Spreads
This section has been created so that the reader gets a thorough understanding of
the mechanics behind the spreads. In addition the text is very powerful in its
presentation so that you not only understand the trade; but, will have a tangible
grasp, a thorough understanding, and come to believe that you can do the trade
immediately after reading this. We have designed the text and criteria so that a
very real risk assessment can be made; a sense of confidence on being able to
manage the position regardless of what the market does; and actually have the
sense that he you are finding the best trade available. So, let's begin trying to
capture an excellent ratio spread or broken wing butterfly.
50
Before we begin the section of explaining the practical aspects of the ratio
spread, we will provide a chart of the OEX index detailing the prices of options
and greeks so that we have a constant source to use and derive information from.
The options are going to be quoted with 3 weeks until expiration and 7 weeks
until expiration for the back month. Also of importance is to inform you that the
numbers provided are factual, and that the OEX is on the extremely low end of
the volatility range (VIX for the examples is about 1 4.50.) The low volatility of
the option chain in this study is an excellent place to start learning the ratio
spread as these examples are about as low of a volatility trade that one will find.
As volatility increases, the amount one can spread the strike prices apart
increases and the premiums paid or received becomes more favorable.
51
Now that numbers are given by which one can begin lookingfor a trade, human
nature and curiosity begin to ask questions during the explanation of the trade
that follows. Be patient as the criteria leaves nothing to the imagination, and is
all inclusive. Most likely all the questions you are starting to hypothesize will be
answ.ered as well as questions that you were not aware that you should be
asking.
How Ratio Spreads React in Reality (as opposed to theoretically) to Price
A good understanding of how these spreads lose money and profit as the
underlying vacillates in all directions is crucial to understanding the criteria, and
to having a sense of comfort in holding onto the position when panic would
strike some. In the past I have heard from traders that they felt
uncomfortable executing trades even after a year of trading because of the
fear and uncertainty of the unknown. When the unknown is understood, it
ceases to provoke fear, and is replaced by confidence and courage to "jump into
a position" when others are panicking to get out.
Let 's Begin!
As an example of how the ratio spread works, we will use the OEX puts, even
though the process works the same way with calls .
Buying I contract of the 5 3 5 puts for ($0. 80)
Sellin� 2 contracts of the 520 puts at $0.40
Net Cost
=
=
=
($80) debit
$80 credit [$40 x 2
$0
=
$80]
Extracted from the OEX chart to highlight that which we are focusing on.
52
When one purchases the 5 3 5 put (line MI 7), the cost is $80 per contract ($0.80
per share x 1 00 shares per contract x 1 contract $ 80) . When selling the 520 put
(line M20) twice as often as the option purchased, one will receive $80 as a
credit from the sale ($0.40 per share x 1 00 shares per contract x 2 contracts
$80) . The resulting debit of $80 on the purchase has been completely offset by
an $80 credit from the sale of the 520 puts.
=
=
This spread has been initiated for what traders refer to as, "the spread was
placed for even-money". This phrasing of the trading being placed for even­
money is NOT to imply that the trade is incapable of having some theoretical
loss, but to let everyone know that the trade was placed without a credit or debit
occurnng.
Market Stays Flat No Time Passes
After a ratio spread is placed and no time elapses and the market does not move,
it is clear that nothing will happen to the value of the spread. The variables
affecting the price of options have not change, thus the option prices will not
change. Obviously this will not be the case should the market remain stable but
time begins to approach expiration, but this is covered in the next section.
-
On expiration day, should the index cash close at the same price as it currently is
trading ($565.00) then the 535 put will expire worthless as it is $40 OTM.
Obviously that would indicate that the 520 puts would expire worthless as welL
Because the spread was purchased for no outlay of capital, and since both
options expired worthless, the net result will be neither a profit nor a loss. As a
matter of fact, should the index close anywhere above the option purchased (535
put) the position will expire worthless.
If the options are placed where either one strike or both are ITM and the market
does not move by expiration, the position will close out for intrinsic value only.
This sometimes results in a huge profit if the market performs well and you
chose the correct strikes to play.
All stocks and a few indexes will expire into stock, so should any options be
ITM by at least $0.25 at expiration be prepared to take a stock positions going
into the weekend, or simply close out the entire position prior to the close of
trading that day. For some reason people have little problem remembering that
their equity position have to be closed out if there is a risk of stock being put to
you (long ITM call or a short ITM put) or taken (short ITM call or long ITM
put). The real stickler that many people forget about is the QQQQ index. This is
the Mini Nasdaq index and it is one of the most liquid indexes at this time. It is
not uncommon to see the bid-ask spread $0.05 wide and 4,000 contracts being
both bid for and offered. This is an excellent product for ratio spreads, but you
must remember that this does contain an exercise risk.
" .;
53
Also, many people take the knowledge in this text and apply it as a learning tool
for commodity and bond options. In addition the options on the Standard and
Poor's 500 index that are traded on the Chicago Mercantile Exchange (CME)
either expire into cash (primary months) or into S&P futures of serial months (all
other months other than December, March, June and September) . If you enj oy
trading options on the S&P 500 index that is traded on the Chicago Board
Options Exchange (CBOE), which is an excellent product to conduct these
spreads in, do not be fearful of ending up with the right product but on the wrong
exchange. If you want to trade the CME ' s options, you will have to go out of the
way to specify that exchange. It is almost impossible to end up with the wrong
product, but it was addressed here as some people do like trading this product.
Stock Market Runs Up Immediately - No Time Passes
When placing a ratio spread using puts, if the strikes are chosen carefully, the
trader ideally wants the market to sell off. Logic would thus have it that a run up
in the markets would likely result in a loss; however, this is NOT the case in
most cases unless the spread was initiated for a large debit. Should the trade have
been placed for a credit, the run in the market will in the worst case result in the
trade expiring and the trader keeping the proceeds from the sale of the ratio
spread in the form of a credit. Should the market close at expiration above the
put strikes contained in the spread, the net credit or debit received/paid
when the trade was placed will be the total return on the trade. But what
happens to the position should the market run up the minute the trade was
placed, and virtually no time elapsed? Obviously time decay is not an issue, but
the net profit and loss of the individual options results in what kind of
IMMEDIATE pro fit or loss?
One can go utilize an options pricing model run on a personal computer to
simulate the trade, but a more rapid and comforting method by which one can
estimate what will happen should the market move in a particular direction is
simply using the option chain to answer all of your questions and "what ifs".
IMPORTANT: (Increment Moves) The methodology by which we will use the
option chain to calculate the price of an option should the stock move instantly
only works easily when calculating moves by the same amount as that of the
strike price distances. This means that the best use of this formula is when the
trader is applying the following shortcut in move increments equal to the lowest
point distance between strikes. The OEX index has strike prices $5 apart, thus to
get an accurate picture of the future price of an option, one must determine or
think of movement in $5 increments. Obviously the markets very seldom move in
exactly $5 increments every day to make this a perfect tool; however, that which
it does not cover will be able to be interpolated.
54
I can say that after years of studying traders,
The best predictor of success is simply whether
the person is improving with time and experience .
- Charles Faulkner
Estimation of a Spread Price After an Immediate Movement Up
The dissected portion of the full option chain below will allow us to get a quick
value for what is likely to occur with regard to a change in price of the spread as
the index moves up.
A Study of the 535 Puts Only as the Index Advances
QUESTION:
If the 5 3 5 puts are currently trading at $0.80, what will they be trading at when
the stock index runs up by exactly $ 1 O?
Buying 1 contract of the 5 3 5 puts for ($0. 80)
Selling 2 contracts of the 520 puts at $0.40
Net Cost
=
=
=
($80) debit
$80 credit [$40 x 2
$0
=
$80]
Extracted from the OEX chart to highlight that which we are focusing on.
55
ANSWER:
1.
Line M 1 7, the 535 puts, i s currently $ 3 0 OTM as the index cash is
trading for $565.
2.
The 535 put is trading for $0.80 when it is $30 OTM ($565 current
price -$30 amount OTM = $535 strike bought).
3.
Should the index
$575.
4.
The 535 put will now be $40 out-of-the-money because the stock
moved $ 1 0 further from the option' s strike ($575 new index price 535
strike put purchase = $40).
run
up in value by $ 1 0, the index price will now be
-
5.
To find out what the option will be worth when it is $40 OTM, simply
find the option that is $40 OTM BEFORE the move occurred.
6.
The $525 put was $40 OTM when the index was at $565 ($565- $40
OTM = $525 strike that is $40 OTM).
7.
When the trade was initiated the 525 strike put (line M 1 9) was going
for $0.50. Because this put was exactly $40 OTM, the 535 put could
expect to be trading for $0.50 if it were to be $40 OTM.
CONCLUSION:
When trying to deteimine what an option will be trading for when it is at a
certain price in the future, you may use the formula as follows:
1.
S_, what would the --X- strike Call/Put be
With the underlying at $_
trading for if the underlying moved up/down by $...M.... dollars/points?
2.
Before the move, the � strike Cal1/Put was $-X... OTM.
3.
After the underlying moves up/down, the --X... strike Call/Put will be
trading $--L OTM.
4.
If you want to know what the ----X- strike Call1Put will be trading for
after the stock moves $ M , and is --L OTM, simply look at the
chart and see what the CURRENT option that is $--L OTM, and that
is what the option should be trading for after the move.
The price = $
Note :
?
Formula for Y:
CALL = (S - X)
PUT = (X - S)
Formula for A :
CALL = - (M) + Y
PUT = M + Y
M is positive when the market moves up and negative when it moves
down.
56
OEX Example
We can now plug our variables for the OEX ratio spread that we have been
discussing into the formula that we just established. The formula is probably not
needed by most people once they have gone through a few examples in the
process of determining the price of an option post market movement. Once the
trader gets comfortable moving up and down strike prices according to a rise or
decline in the underlying, it is very likely that the formula will seem like a huge
waste of time.
However, many reading this book will be more comfortable going through an
equation as "math doesn't lie". Many times after a prolonged period away from
trading you may fmd that going through the formula again will actually help you
refresh your memory as to how you were sliding around strikes without
formulas.
EXAMPLE :
From Our Previous OEX Example :
Question: "If the 535 puts are currently trading at $0.80, what will they
be trading at when the stock index runs up by exactly $10?"
Given: Stock is currently at $565 . 00
Expected move up: $ 1 0
Current Option Price $0.80
Put strike Bought: 535
=
Work in Formula:
1.
With the underlying at $ 565 , what would the 535 strike CalVPut be
trading for if the underlying moved up/down by $.iIL dollars/points?
2.
Before the move, the 535 strike Call/Put was $-.JJL OTM.
3.
After the underlying moves up/down, the 535 strike Call/Put will be
trading $..A!L OTM.
·
If you want to know what the 535 strike Call1Put will be trading for
after the stock moves $ +10 , and is 40 OTM, simply look at the
chart and see what the CURRENT option that is $ 40 OTM, and that
is what the option should be trading for after the move.
4.
The price
=
$
0.50
Formula for Y:
PUT
Formula for A:
PUT
?
=
=
(X - S)
-30
M+Y
$40
57
=
=
535 - 565
$ 1 0 + $30
Example Conclusion
The formula states that whatever the option that is $40 OTM is, that is what the
535 strike put will be trade for should the market run up $ 1 0 against us. Having
purchased the 5 3 5 put naked would give the trader a bearish stance towards the
market, and should the index run up instead of selling off, a loss could be
expected. The option started out initially $30 OTM when the underlying was
trading at $565 .00, but as the market runs up the option moves further OTM.
When the index stops its run up to $575.00, the put option is $40 OTM. Because
the $40 OTM option before the run up was the $525 put ($565 - $40 $525) our
$30 OTM (53 5 put) option should be trading for $0.50 (see line M I 9) when it is
.
$40 0TM.
=
CalculationlEstimation of Pricing a Spread After an Immediate Move Down
Should the revers� happen and the stock sell off in the anticipated direction the
opposite would happen. The sell of in the stock would allow the put to get closer
to being ITM. The option is getting closer to A TM or ITM, thus it is increasing
in value the further down the stock moves.
Rule: When trying to determine an estimate of what an option will be worth
after a given number of s trike movements there is one quick method of
determining the new price. Simply moving up and down strikes to figure out a
resulting price will become very simple with a little practice. Moving up and
down strikes to determine what an option will be worth after the stock moves a
certain number of strikes may lead to some confusion; however, the only thing to
remember is that as the stock moves up, puts get cheaper, and as the stock moves
down, the calls get cheaper.
The following applies:
Adjusting Strikes Rules:
Calls or Puts
Stock Moves Up - > Move Down in Strikes
Stock Moves Dn - - > Move Up in Strikes
-
A good little mind game to remember:
"Puts are opposite of calls, thus you move strikes in opposite directions."
In other words, if you are trying to determine what an option will be if the
market moves up in value, simply move down on strikes . Similarly, as the
market declines, trying to determine the value of an option is best done by
moving up strikes. You will move one strike increment up or down for every
strike increment the underlying moves up or down.
58
Some traders like to imagine that the strike prices slide up or down as the market
moves down or up respectively. Others like to slide the option chain and leave
the strike at the same place. To understand this, a visual example will best serve
in your learning of this concept. Using our original example:
"If the 535 puts are currently trading at $0.80, what will they
be trading at when the stock index runs up by exactly $10?"
59
We know that if the market increases in price from $565 to $575, the price of the
5 3 5 put is going to change from $0.80 to $0.50. The tables above illustrate how
one could look at these in two separate, but equivalent views.
1.
You could imagine as the stock slides up, the "OEX After $ 1 0 Up
Move" chart to the right slides up $ 1 0 as well. The bar at the strike
price of the put (or call) will remain in place as if it were nailed to the
wall.
2.
The second method would be to take the before and after tables as the
same table, but slide the bar up when the market goes down, and down
when the market goes up. See the table below.
"You have to be smart to succeed at this busines s .
That shouldn ' t be surprising, but to many, i t is.
I suppose it' s because so many people look at the
Stock market like a big casino where some lucky
gamblers win. Not true . "
Peter J. Tanous
..
60
Here is the Same Example Using Calls (Not Puts)
"If the 575 calls are currently trading at $2.70, what will they
be trading at when the stock index runs !Ul by exactly $10?"
We will use the methodology in solving this equation as we did when we were
working on the put examples. First, the "Adjusting Strikes Rules" for you again.
Adjusting Strikes Rules :
Calls o r Puts
Stock Moves Up -> Move Down in Strikes
Stock Moves Dn - - > Move Up in Strikes
-
The table above shows that the movement up in the underlying price did not
need a different shift, though we are dealing with calls in this example. When the
index was at $565 .00 the trader elected to purchase the $575 calls ($ 1 0 OTM
$565 - $575 -$ 1 0) for $2.70. At time 2 , after the market made its run up $ 1 0
points to $575, the calls became exactly ATM options and were now trading for
$7.00.
=
=
61
Said another way - (time period 1 ) We purchased the $ 5 75 calls that were $ 1 0
OTM when the trade was initiated, as the index was at $565 . At the time we
made this initial purchase, the ATM options were the 565-strike calls, because
the index was at $565 . In addition, the ATM 565-strike calls were trading for
$7.00. The market later ran up (time period 2) to where the index was at $575,
thus the 575-strike calls were ATM. Now, if when we originally placed the trade
the 565-strike options were the ATM option, and they were trading for exactly
$7.00, then the $575 calls (when they are at-the-money) after the index runs up
in price will be trading for $7.00 as they will now be an ATM option.
Using the Formula to Calculate the Price of a Spread (Not Just One Option)
As an example we can determine what the price of the ratio spread would be
worth using this formula and breaking the trade into two separate pieces. After
each piece is calculated to determine the price after a movement in the
underlying, the pieces are summed to determine the post move total position
debit/credit.
By using the method in which the trader adjusts the table up to show what
happens after an upwardlbullish move in the underlying by $ 1 0, we see that the
call that we purchased for $2.70 has increased in value to $7.00. Notice that this
adjusting one way or the other is applicable for both the calls and the puts!
F or once a rule that does not need to be flipped when changing from calls to
puts.
But the examples that we have been working on have been with the use of a
single option. The ratio spread has not been used as of yet in explaining the
option price estimation, as two options are often confusing at first. We started
out with the "buy put" portion of the $535 - $520 (lines MI and MK
respectively) 1 by 2 ratio spread. We will now look at both pieces of the spread
simultaneously to see what o� total position/spread would be worth in the same
$ 1 0 advance in the underlying.
We can then determine what the price of the ratio spread would be worth using
this formula and breaking the trade into two separate pieces. After each piece is
calculated to determine the price after a movement in the underlying, the pieces
are summed to determine the post move total position debit/credit. Also, instead
of sliding the table that has one bar attached at the one strike we purchase,
we will have two bars attached for the two strikes of the spread.
The process of determining the price of the spread will easily become a one step
exercise after a little familiarity with looking at the positions. In the mean time
we will break the endeavor into the individual steps.
Step 1 . Get the new price of the options bought.
Step 2. Get the new price of the options sold.
Step 3 . Add the numbers determined in steps # 1 and #2.
62
We will continue to use the 535-520 ratio spread for this example. The ending
price of the OEX spread can be determined by breaking the position down into
the 3 steps found above.
Ques.tion:
"What is the ending price of the 535-520 ratio spread if
the OEX underlying runs up from $565.00 to $575.00?"
Step I : Get the new price of the options bought.
This was already done for us in the previous pages, starting on page 26. We
determined that the 535-strike put will move from an original price of $0.80 to
an ending price of $0.50 should the underlying move up $ 1 0. Thus, step # 1 is
done in that this step asks us to determine the price of the option bought, and we
determined that the answer was $0.50.
Step 2 : Get the new price o f the options sold.
Step #2 dictafes that we determine the ending price of the options sold after the
underlying makes it move. In this ratio spread example, the options sold are the
520-strike puts.
63
Using the same option chain tables from the previous put examples is all that is
required in determining the answer that we are looking for. In the Step # 1
example we locked the bar at the 5 35-strike put line and simply moved the table
up the exact amount of strikes that the underlying moved up. Because the
underlying moved up 2 full strikes ($ 1 0 on a $ strike increment index), we
moved the table up two strikes to see that the 5 3 5 put would now be trading like
it was the 525 put previous to the move.
However, we are now looking at the 520-strike put, so instead of locking the
535-strike option and moving the table up, we will lock the bar on the 520-strike
put and move the bar up. The 520 put has the bar locked down like a safety bar
on a roller coaster and then the index takes off. After the index gets to the top of
the track ($575), we get a measurement of where the bar is now.
The table on the left that depicts the price prior to the stock movement shows
that the 520-strike puts were trading at $0.40 when the trade was initiated. As
soon as the index ran up in value a new calculation shows that the 520-strike
puts are now acting like the 5 1 0 puts were before the run up.
Different Method of Explaining the Movement Calculation
Said another way, when the ratio spread was initiated the 520-stfike puts were
$45 OTM as the index was at $565. After the run up the 520-strike will no
longer be $45 OTM, but instead it is now $ 5 5 OTM. In order to get an
approximation of where the 520-strike option will be trading at when it is $55
OTM, we simply look to see what the option that is currently $55 OTM is
trading for. With the index at $565 (prior to the move) the $55 OTM option will
be the 5 1 0-strike price put, and it has a current value of $0.25.
We can now answer the question Step #2 asks us with regard to the ending price
of the options sold. We can say with a relative degree of accuracy that the 520strike puts will now be going for $0.25, which is a loss of $0. 1 5 from its starting
price of $0.40.
Now that we have the ending prices of both strike options, we can determine
what the spread is trading for by going to Step #3 below.
Step 3 : Add the numbers determined in steps
#1
and #2.
There are several different methods by which one may calculate what the spread
is worth after the expected move happens, with most now being able to take
Steps 1 & 2 and doing the math in your head; however, the example below will
very detailed example so that the reader may look at this trade' s cost calculation
in a way that they feel most comfortable with .
.,
64
Method One:
Take answers in steps 1 & 2 and sum them as follows :
($0.50)
Step # 1 ($0.50) x 1 contract
$0.50
Step #2 ($0.25 ) x 2 contracts
$0
Net price of spread after the move
=
=
=
=
=
Method Two :
Price
sell
Net
1
1
2
2
credit/debit
$ (0. 50) $ (0.50)
credit/debit
=
Net Cost
=
Conclusion: The interesting item about this spread is that the stance is a neutral
to bearish position, and yet we broke even with the market running up the
equivalent of about 200 DJIA points ! Try that with a vertical spread.
How Ratio Spreads React in Reality (as opposed to theoretically) to Time
Market Stays Flat, But Time Slowly Approaches Expiration
One of the most beautiful aspects of these trades is that even if the market does
not move, and you own out-of-the-money put ratios, a profit can often be
realized! This is just one reason that many floor traders embrace these trades.
You will see many awesome .reasons throughout the rest of this chapter on why
ratio spreads are considered "the only trade I want to do", by many of the
"educated" traders.
Time Until Expiration Approaches
Prior to expiration a profit will likely be made as time slowly approaches
expiration as the options sold lose value faster than the option protecting the
sales . As expiration approaches the normal distribution curve of time value
narrows as the likelihood that the market can reach the outside strike becomes
less probable. However, the option purchased is a lot closer to being ATM, thus
it will likely still have some reasonable probability of being able to be reached
by expiration, and thus it will retain some value.
Because the options sold are losing value, and can be bought back cheap, we will
make a profit on them. The other side of the coin is that the option purchased has
likely lost value as time dwindles, but because it still has some probability of
being reached by expiration, some time value will remain so that the option can
be sold for a small loss before it expires worthless. The net result is the greater
profit from the sale of the 2 further-out-of-the-money options will usually more
than offset the loss from the purchase of one closer-to-the-money option.
"
65
,
Many people would expect that the power behind this is theta. Because two
options we sold for every one option purchased, "The position must have theta
working in our favor as two short options rotting away more than the one long
option rotting away. " Actually this is not necessarily the case. However, if you
guessed theta was behind this, do not feel bad. Many long time and successful
traders who have placed these trades hundreds of times a year think the same
thing. The correct phenomena at work here is the normal distribution probability
curve. We will address this with an excellent example of how it the trade actual
works immediately after we see the practical numerical method of predicting
how much the spread will change due to time only.
Practical Example
As a practical example we back up the clock slowly in order to use our option
chain to explain the phenomena and give us proof that this actually works. We
can take a look at the April option chain that has 7 weeks to go, and forward the
clock by 4 weeks. Using two different expiration months to see how the spread
moves in an exact one month time frame will be a fantastic tool to determine
which strikes will lend themselves to the best spread. That will be covered in the
criteria chapter.
Remember: We are buying I contract and selling 2 contracts that are further
OTM.
Below are the tables for April and March puts. For continuity we will use the
same ratio put spread (535-520) that we have been using throughout this chapter.
In the charts below the 535-strike puts and the 520-strike puts have been
highlighted to stand out. There is no bar representing a shift in stock price
because we are addressing time only in this section.
Work: Below is a question that is used as a learning example and for the math
behind it. Though the first time through may be a tad difficult, once the concept
is grasped, you will most likely be very close to being able to make money in
ratios.
Question:
"What will the April 535 (buy 1 contract) - April 520 (sell 2 contracts)
spread be worth in exactly one month when there are only 3 weeks
remaining until April expiration?"
Time Period #1
Should we elect to purchase the April 535-520 put ratio spread when there is 7
weeks remaining until April expiration, the spread will be placed for a $0.60
credit. The table below shows that the April 535-strike puts can be purchased I
time for ($3 . 80), and the April 520-strike put can be sold 2 times at $2.20, which
comes to $4.40. With a ($3 .80 debit and a $4.40 credit, the net result is a $0.60
66
credit ($4.40 credit - $ 3 . 8 0 debit $0.60 credit). Thus, for every 1 contract of
spread ( 1 buy and 2 sells is considered 1 contract spread) a net $60 is taken in.
1 0 contracts is equal to a $600 credit.
=
I With 7 W eeks
Price
Code
A
540
$8.30
$6.80
$5.60
$4.60
A
5 15
5 10
505
$ 1.85
$ 1.60
$ 1.40
21
A 22
A 23
555
550
545
A
A
13
14
15
16
A
Math Work For Explanation Above
Work / Notes :
Time Period One
Buy 1 , April 5 3 5 - Put for ($3 . 80) ($3 80)
$440
Sell 2. April 520- Puts at $2.20
$60
Net Credit of Ratio =
($3 80) debit per spread
$220 per contract x 2 contracts
=
=
Time Period Two
=
$440
Work / Notes:
Buy 1 , March 5 3 5 - Put for ($0 . 80) ($80)
$ 80
Sell 2. March 520- Puts at $0.40
Net Credit of Ratio = $ 0
($ 80) debit per spread
$40 per contract x 2 contracts
=
=
67
=
$ 80
Time Period #2
A fair assumption can now be made by comparing the two tables on the previous
page. The table in time period number one illustrates that we initiated the spread
for a $0.60 credit. As time drifted by for four weeks, the spread collapsed as the
tails lost more value (for a profit) than the closer to ATM options (for a loss).
Even with 3 weeks remaining until expiration the spread could be taken off for
zero cost to close. As it was initiated for a credit and taken off for even-money, a
respectable profit was realized. Quite frankly, most traders would not likely take
this spread of at this point in time, as this is where the real money can now be
made.
As a matter of fact the ratio spread the following week will likely be able to be
taken off for a credit the other way! With 2 weeks until April expiration one
would likely see the 535-strike put trading for about $0.60, and the 520-strike
put trading for $0.20. Thus a $0.20 credit could be achieved in closing out the
position.
Time Until Expiration Equals 7 Weeks
BIS
Strike
cost
X's
Net
Time Until Expiration Equals 3 Weeks
BIS
Strike
cost
X's
Time Until Expiration Equals 2 Weeks
Net
BIS
Strike
cost
X's
Buy 1 535 - Put at $ (3.80) x 1 = $ (3.80)
Buy 1 535 - Put at $ (0.80) x 1 = $ (0.80)
Buy 1 535 - Put at $ (0.60) x 1 =
SelI 2 520 - Put at $ 2.20 x 2 = $ 4.40
Sel1 2 520 - Put at $ 0.40 x 2 = $
Sel1 2 520 - Put at $
-
Net Debit Credit = $ 0.60
0.80
-
Net Debit Credn
=
$
-
Net
$ (0.60)
0.20 x 2 = $
0.40
-
Net Debit Credit = $ (0.20)
Time Period #3
A remedial glance at the above table tells a rather exciting picture. The trade
placed 5 weeks earlier was il1itiated for a $0.60 credit. At time period· #3 (two
weeks prior to expiration) the spread that was initially placed for a credit can
now be taken off for a credit ! How many people have ever bought a spread for a
credit and then sold it for a credit, or vice versa? Actually, it is not to
uncommon to actually make a good deal of money on these positions, and the
longer one holds onto them the more sensitive they become to price fluctuations
on the underlying. We will go into that when we get into the criteria.
The Normal Distribution Graph and Ratios
The real phenomena behind this fascinating trading strategy, is again the bell
curve.
68
Sell 2
Buy 1
4 WEEKS U NTIL EXPIRATI ON
With four weeks to go until e1Cpiration
both the options bought and sold are
within range
of the index reaching it.
3 WEEKS U NTIL EXPIRATION
As o n e week of ti m e has passed, th e
option bought h a s not lost much time
value, but the options sold are getting
crushed and losing value rapidly.
2 WEEKS U NTIL EXPIRATION
Th e foUowing week the option bought i s
starting to lose some value more rapidly;
however,
the options sold are now
almost statistically insignificant.
· 1 WEEK UNTIL EXPIRATION
With one week remaining the options sold
are absolutely worthless, but the options
bought still can be sold to capture the last
of the ti me value before e1Cpiration.
EXPIRATION OPEN I N G BELL
Now that it is e1Cpiration day there is so litUe
to have a realistic
of being worth anything. The BeU
time left for either option
chance
Curve shows this mathematical story.
520 P
535 P
Combination of Ratio over Time and Market Movement
69
What We Already Learned About Price and Time
The last and most important item to grasp when looking at the ratio spreads and
making a determination if you will place this trade, is what happens to the spread
when both time and movement affect the price of the spread. In the previous
pages, we became familiar with how the price movement of the underlying
affects the price of a ratio spread, and how time loss affects the price of the
spread.
Combining Price and Time
Having a fairly good understanding of how these two variables come together
may be a bit difficult to grasp at first, but that is usually because an adequate
explanation using words in lieu of a classroom environment becomes wordy.
Setting Up the Ex,ample
To clearly explain how the two variables of price movement (delta) and time
change (theta) come into play, two tables from previous examples will be lined
up for a visual reference.
Spread Price Influenced ByMovemetl
OEXAI'ter $ilJ Up fibre
Spread� I� By fll1e
,..
.'; �
How to Look at the Above Option Chains Line Up by Price and Time
Once you get a tangible feel for how to put the option price changes as they
relate to movement of the index, and changes in time, you will simply need a
few pieces of criteria in order to be doing these on your own.
The process by which one goes about calculating what an option or spread will
be worth at some point in the future after the market has moved is a fairly
straight forward path that should be just a tad more complicated than either of
the variables individually. The steps can be easily taken as follows:
70
1.
Detennine which spread you are going t o initiate.
2.
Decide what kind of movement you are looking to see from the index.
3.
Calculate what strikes the spread will b e at.
4.
Once you know what the spread will be trading for, should the
underlying move in your expectation of the potential (we need not be
right to win ! ) movement, then go one month closer in to get an
indication what the spread will be trading for with a month of time
having gone by.
Step 1 : Detennine which spread you are going to initiate.
Throughout this chapter we have gone back and forth between primarily using
the OEX 5 35-520 put 1 -by-2 ratio. As we need to have a front month option
chain to utilize in estimating what an option will be trading one month from
now, we will use the April for our trade execution month. For purposes of this
example, we will continue to use the OEX 535-520 1 -by-2 ratio that we initiated
for the month of April.
Thus, the trade we will initiate is:
Buy 1 contract of the April 535 -strike put for ($3 . 80)
Se11 2 contracts of the April 520 - strike puts at $2.20 (2x' s)
Net Credit of
=
=
=
($3 . 8 0)
$4.40
$0.60
Step 2: Decide what kind of movement you are looking to see from the index.
We have not as of yet looked at one of these spreads to detennine what happens
as the stock sells off, as opposed to our examples always being bullish. It is time
to have the index move in the direction we would like, as you have already seen
that it is hard to lose money even when the index moves in the wrong direct.
For this example we will assume that the market is moving down $10 instead
of up $10. Recall that when the market ran up, the bar on the option chain
was stuck and the table moved up; however, this time the market is going
down. The bar on the option chain table will stay frozen, but the table will be
slid down 2 strikes ($ 10 movement) in order to get an expectation of what our
spread will be worth.
Step 3 : Calculate what strikes the spread will be at.
The market selling off will have the result of the put options being bought and
sold as part of the spread package getting closer and closer to being ATM.
Because the index is expected to fall $ 1 0, we will slide the option chain table
down 2 strikes or simply think about what is happening. Knowing that the
options should be going up in value as the market is selling of, if we see the
options getting cheaper we are adjusting the table the wrong way.
71
We can also simply say that the market started with the index trading at $565 ;
however, a $ 1 0 decline in the index value will result in the index ending up at
$ 5 5 5 . We have two strike prices that are incorporated with the spread position ­
the 5 3 5 and 520 strikes. Now that the index is at $ 5 5 5 , the 535-put we are long is
only $20 OTM. Prior to the index ' s fall, that particular option was $35 OTM.
Using the same argument of the 53 5-strike put getting closer-to-the-money, the
520-strike put will also be getting closer-to-the-money. That put is actually now
only $35 OTM, which is where the option we purchased was before the move.
What Strikes do The Puts Look Like Now?
•
Put Bought was the 5 3 5 put that was $35 OTM, but is now $20 OTM.
To get an approximation of what the put is worth, we will look at the
put that wa� $20 OTM before the stock slid, which was the 545 put.
We will use the 545 put to see what our option would be trading at if it
were $20 OTM.
•
•
Puts sold were the 520 puts that were $45 OTM before the index slid.
After the slide down by $ 1 0, the 520 puts would be $ 10 closer-to-the­
money than earlier. The puts that are $ 1 0 closer-to-the-money prior to
the slide were the 5 30-strike puts. We will use the 530 puts to see what
our options would be trading at if it were $ 1 0 closer to the index.
Thus, the strikes we need to look at to get an approximation of what the
spread is worth after the market decline $ 1 0 are:
o
o
Buy 1, 545-strike put
Sell 2, 530-strike puts
Step 4 : Once you know what the spread will be trading for should the
underlying move in your expected direction (we need not be right to win!)
movement, then go one month closer in to get an indication what the spread will
be trading for with a month of time having gone buy.
As we initiated the spread in April with 7 weeks left before expiration, the
March options naturally contain 3 weeks of time prior to their expiration. If you
want to know what the strikes above are trading at a month from now, simply
use the March option chain to determine how much time value has been lost over
the last month.
So to answer the question of Step #4, we will use the March option.
72
Wrapping it Up :
Step 1 : Buy the April 535-520 put l -by-2 for a $0.60 credit.
Step 2: The index is to move down by $ 1 0, or 2 strikes.
Step 3 : If the index does move down 2 strikes, the options we obtained in step # 1
will resemble the options at the 5 4 5 and 530 strike.
Step 4: With one month of time decay have taken its toll, we will move from the
April chain to look at March options.
Thus, the spread we purchased was the April 53 5-520 put l -by-2. With one
month having gone by, and the index having sold off $ 1 0, the spread we own
will resemble the March 545-530 1 "-by-2 ratio spread.
What Was the Profit or Loss?
Since we own the April spread that will now be trading like the March 545-530
l -by-2 ratio spread, we may observe the option chain to see what has occurred.
Also, as we have originally sold the ratio spread, to close it out we will reverse
to procedure and buy the spread back. A quick warning: the spread will look to
good to be true. This is just how these trades work, and that is why traders on the
floor do them all the time.
Prices ofthe March Options:
March 545-strike put
March 5 3 0-strike put
=
=
(line M 1 5 of option chain)
(line M 1 8 of option chain).
$ 1 . 80
$0.65
Table below illustrates the prices we got into the spread for (left side of table),
and the prices that we could get out of it at one month later (right side of table).
line M 1 5
2
Net
credit/debit
1III....
Iii
lllliiiIi
il
....
iiI
....
line M1 8
=
=
Conclusion of Ratio Adjusted for Price and Time
The above table indicates on the left side that we initially got into the spread for
a $0.60 credit. The right side of the table illustrates that we can get out of the
trade one month later (and $ 1 0 lower in index price) for a $0.50 credit.
YES, THAT IS HOW THESE TRADES OFTEN WORK!
73
[page intentionally blank]
74
Broken Wing Butterfly Spreads
(BWB)
Entry Criteria
www .RandomWalkTradipg.com
75
Broken Wing Butterfly Spreads and Ratio Spread
Entry Criteria
Introduction
This section provides the reader with specific criteria and actual methodologies
used by many floor traders to grind out a living doing these particular trades.
This is the real tradin� secret of the floor. Most of the gamblers, scalpers,
speculators, etc. on the trading floor eventually fall into a long series of bad
trades, and are then forced to leave the floor. But wouldn't you rather have
consistent profits month after month, than a home run every 5-7 months, and
losing months the rest of the time? If you are looking for a low risk strategy that
gives consistent returns, this strategy is hard to beat.
The very successful and disciplined traders continue to improve their level of
knowledge as they are usually more mature and realistic about the prospects of
their future should they simply speculate for a living. Some of the improvements
include combing trades by using their own set of criteria. Once continued and
repeated success with a certain strategy develops, many traders will simply
employ those types of trades, and are not embarrassed to have a simple one, two
or three strategy repertoire from which they never deviate.
What Circumstances Are These Trades Good For?
Virtually any market condition makes an excellent environment!
The ratios or broken wing butterfly spreads can be traded with a long or short
term time frame until expiration; high volatility or low volatility; calls or puts;
bullish, bearish, or neutral stance. Really the only time that these trades can be
dangerous is during the every 2-7 year event of a dramatic market sell off over
1 5% in a couple of months. Even then, it is rare that markets gap up or down
more than 5%, which would allow an adjustment if you felt it was needed.
Random Walk, LLC. spent a considerable amount of time honing the available
strategies down to just a few select trades that should consistently make money
over the long run. This is not to say you will never lose money in this strategy,
but we feel it' s fair to say this is one of a handful of strategies that is most
suitable for you.
Considerations That Make This a Good Trade
There are 4 maj or factors involved in selecting a great ratio spread or broken
wing butterfly spread. As with most things in life there is always a trade off with
what you want and what you can live with. Selection of a ratio has the same type
of trade-offs. You would like to get a $ 3 . 5 0 credit to put the trade on, but then
you will be taking on an exorbitant amount of risk. You would like it to expire
the next day, as that gives you the greatest chance of determining where the
index will close (as opposed to 2 months away), but then the premiums and
strike spreads will not be good.
76
What you end up with when you have a great ratio spread is an even balance of
all variables affeCting the trade. These include :
Trade Offs in Selecting a Great Ratio Spread
a.
b.
c.
d.
Premiums - The larger the credit or the smaller the debit the better.
Strike Distance - The larger the distance between strikes the better.
Distance From Being ATM.
Time Until Expiration.
Step 1 : Select an underlying to trade.
Criteria
Unless you have a particular index that you like to trade all of the time, a
good place to start looking for trades is in the OEX (S&P 1 00) index.
(If you are undercapitalized, you will be forced to use the MNX, DJX, or QQQQ
index options. So scratch OEX out and use one of those after learning this material.)
Indexes
Utilizing one of the index products available is the favorable instrument to be
used for this strategy. There are several reasons for this.
1.
The distance between strikes as a percentage of the index i s usually
favorable for the trader to get one of these trades on for little or no
capital outlay.
2.
The vast diversification of equities in an index dampens out the a­
systematic risk (company specific risk) from allowing the
underlying to move too great a distance in any given period. In
other words, the fact that there are so many stocks that make up an
index, even should one company go out of business in a day, the
index ' s extreme movement will be smoothed in comparison to
having a position in that particular stock. As a matter of fact,
reading on further in this chapter will show that the mathematical
probabilities of the indexes getting into a dangerous area is slim
provided one uses the methodologies in this chapter correctly.
On the next page are two ratio spreads comparing that of an equity and an index
that both have two weeks prior to the end of their expiration cycle. The table
sums up well why traders prefer to do this type of strategy using index options as
opposed to equity options.
77
$ 29.00
Apri l
Stock Price =
1
Buy
-2
Sell
N et Cost
$ ( 1 85 .00 )
$
1 30 .00
Stike % OTM
5.2%
$
$ 568.45
Stock Price =
1
Buy
-2
Sell
N et Cost
$
(55 .00)
$
60.00
A valid argument could be made to begin looking for the ratio spread in any of
the indexes; however, one must start somewhere. Because of the trade otIs being
made in determining which index one should start with in the evaluation process,
the OEX is an excellent compromise between the benefits and drawbacks of all
of the indexes available.
OEX Strike Increments - the distance between strikes is very small on a
percentage basis, thus we can get a very precise analysis on the movement
needed to maximize the trade ' s potential and limit its downside risk. As of this
writing the OEX index contains strike prices $5 apart. This $5 distance between
strikes on a $565 index represents 9/ 1 0 of 1 % movement on the underlying
between strikes
OEX LiQuidity - Despite what some brokers may tell their clients about the
OEX American exercise index, it still contains tighter markets between bid ask, and its liquidity is greatly larger than the XEO (European Exercise Index) .
Many brokers steer their clients away from this product as it is difficult to
explain to uneducated clients how to determine if the OEX has an early exercise
possibility that day.
OEX / OYTI Ratio Spread Strike Distances The table above compares the
best ratio spread that can be found roughly 5 % OTM in both the Stock OVTI and
the OEX Index. Notice how the distance between strikes on OVTI is $2.50
(27 .50 - 25 .00 2.50); whereas, the distance between the strikes on the OEX
spread are $20 apart (540 - 520 20).
-
=
=
This indicates that the maximum one can make on the OVTI spread is $2.50 plus
the credit/minus the debit. The spread can not be purchased without a $0.55 debit
occurring. Thus, the maximum the spread can make for the owner is $ 1 .95
[$2.50 - $0.55 (debit) $ 1 . 95 ] .
=
78
The OEX spread has strike prices $20 apart, so the most that can be made per
share on 1 spread is the distance between the strikes plus the credit/minus the
debit. That means the owner of this spread could make up to $20.05 ($20
distance between the strikes + $0.05 credit $20.05).
=
Stock
As mentioned in the chapter explaining how these spreads function, we will
seldom do a ratio spread in an equity. Either you can get good prices, but the
stock will be too volatile; or you will have an adequate volatility, but the
premiums will not be sufficient in order to get good pricing. Combine the above
arguments with that fact that equities have a greater likelihood of getting cut
down to almost zero, or moving up 1 00% in a month, and one will find that
index options provide a better platform by which to use these trades as consistent
revenue producers (as opposed to gambles).
This is not to imply that traders will never find it interesting to initiate a few
ratio spreads in stocks from time to time; however if ratios or broken winged
butterfly (BWB) spreads are placed the trader is well aware of the additional risk
being taken on when compared to a similar index spread.
Indexes
Utilizing one of the many index products available is the favorable instrument(s)
to be used for this $trategy. There are several reasons for this. This will be
discussed shortly.
Step 2 : Decide if you are bullish, bearish or neutral on the market.
Criteria
Bullish Start with the calls.
Bearish = Start with the puts.
Neutral Start with the puts, or puts and calls combined.
No Opinion = Use puts only.
=
=
Bullish - Start With the Calls - These trades are directional in the sense that
should the stock make a move up the direction of the OTM strikes that you used
when you initiated the trade, a profit is likely to result, and very little loss is at
risk provided the trades are managed correctly.
Bearish - Start With the Puts - Recall that these trades are directional in the
sense that should the stock make a move (down) in the direction of the OTM
strikes that you used when you initiated the trade, a profit is likely to result, and
very little loss is at risk provided the trades are managed correctly.
·t
79
Neutral - Start With the Puts or "Strangle" the Index. The trader can also vary
the distance between the strike purchased and the strike sold further apart with
OTM puts as opposed to OTM calls. The greater the distance between the
strikes, the greater the profits that can be actualized and more protection one has.
Thus, if given a choice between more money and less risk (puts) compared to
less money and more risk (calls), the decision is easy - use puts.
Neutral - It is also not uncommon for many traders to place these trades on both
sides of the market when they do not have a strong opinion as to market
direction. The rationale behind the "ratio strangle" is that the two pieces of the
trade (call ratio and put ratio) double the chance of the trader making some
money if the market moves in a reasonable manner. If the market runs up, the
call ratio will provide a profit, and the put ratio can be sold out, or left to expire
worthless. The opposite happens should the market sell off. If the markets
remain very stable, the spreads will likely make a small amount of money, but
not have the room for an extremely large profit to occur.
OEX Option Chain
80
Going back to a previous page where the statement was made, " . . . the trader can
also vary the distance between the strike purchased and the strike sold further
apart with OTMputs as opposed to OTM calls. " Using the option chain provided
above we will compare the ratio call spread to the ratio put spread.
Criteria
We like to place the trades where they are done for about even-money with the
strikes as far apart as they can get without having to pay a debit for the spread!
In the comparison of the OVTI stock and the OEX index, a set of prices was
plucked from the option chain on the day of this writing, thus the prices will be
different that the prices in the box above. There is a trade off one has to make in
'
the distance between the strikes (safety) and the price of an even-money trade
(cost).
For the rest of the section on criteria, we will use only the
option chain above, unless stated otherwise.
Call vs. Put Ratio Spread for Even-Money OEX Comparison
Puts
The best ratio spread that can be purchased for even-money in the puts is the 535
- 520 put ratio of buying one 5 3 5 put for ($0. 8 0), and then selling two 5 2 0 puts
at $0.40 ($0.40 x 2 contracts = $0.80). The ($0. 80) debit on the put purchase is
offset by the credit on the put sale. Trying to fmd a better ratio spread than this is
not easy. Moving the strikes around j ointly, keeping the same $ 1 5 distance
between strikes does not produce any better trades. Also, trying to widen out the
distance between the strikes to $20 apart does not reveal any spreads that would
fit for even-money. Any further distance added between the strikes will result in
the trade costing the trader a debit.
Calls
Using the identical method of scanning for the best strikes and distances is
disappointing with the OEX calls. Simply start with the ATM calls and split the
strikes of buying and selling apart by $5 (to start with as we will see in the
criteria). You will notice that there are only two spreads where even-money
trades can be purchased $5 apart. One has the choice between the following:
Trade #1
Trade #2
Buy 1 , 5 8 5 -Call for ($0 . 8 5 ) x l ct. = ($0 . 8 5 )
Sell 2. 5 90-Ca11s at $0.50 x 2 ct. = $ 1 .00
Buy 1 , 5 90-Calls for ($0. 50) x 1
Sell 2. 595-Calls at $0.30 x
Net credit
=
Net credit
$0. 1 5
81
=
=
=
($0. 50)
$0 . 60
$0. 1 0
Therefore, when we apply our goal of placing a trade for even money or better
we see the put strike prices being $ 1 5 apart (allowing a potential $ 1 5 profit) and
only a $5 difference in the call strike prices (allowing of a $5 potential profit).
Which profit potential would you like to have?
Step 3 : Select the month(s).
When to Place the Trade
Which time period will be the best to use in selecting a ratio spread or broken
wing butterfly is complex, as there are several factors that come into play, such
as time until expiration, underlying volatility, if the market looks like it is
making a bottom or top, etc. As no one can predict the future the best time to
place a ratio spread is right now . TODAY ! Provided nothing weird happens in
the market, waiting until tomorrow is proven to be costly in premiums received
at the strike prices being used.
Which Month to Use
We will use this step of criteria as a starting point that we will come back to
later. We have to start somewhere, thus we will use the below information to
start our search. That is not to say this step is going to result in the best strike
being selected, but it is simply used to find a starting point.
Note : As volatility moves around and the skew of the volatility between strikes
expands and contracts, the distance betw een strike prices, the premiums
paid/received, and the distance away from being ATM will all fluctuate. Do not
feel like this step is leaving you in a position of guessing as this is simply a
starting point. Until we examine more information, it is impossible to know the
best strike at this point, but we will determine it shortly.
FRONT MONTH
5 Weeks to 3 Weeks Until Expiration
[3 to 5 Weeks]
Some traders consider this the perfect time to enter into a trade when using ratio
spreads to trade, and a lot of arguments can be made that it is the ideal time to
trade these spreads as it is a nice balance between time to expiration (the less the
better) and premium and strike selection (the more the better).
More Than 1 Week But Lest Than 3 Weeks
[I to 3 Weeks]
If the front month has less than 3 weeks to expiration, look approximately 3-6%
.
OTM in an index, (if using stocks you will likely have very little to chose from).
See if there is any ratio in the OEX puts in that general area that can be
purchased for even-money with the strike prices $ 1 5 or more apart.
82
Less Than One Week Remaining
[0-1 Week]
If the front month has less than 1 week remaining until expiration, then use the
same method above; however you may have to move the spread much closer to
ATM, and/or closing the strikes down tighter (say $ 1 0 apart instead of $ 1 5).
Front Month With Only a Few Days Remaining.
[0-4 Days]
(For very aggressive traders only. Must watch the trade all day long.)
If the front month only has a few days remaining, you can still elect to place this
trade, however the risk is now going to be awkward. A great deal of money can
be made with ratio spreads that have only a few days remaining. The only
downside to these trades is that if the market makes a huge move, you will have
to stay on top of things, and adjust or close the position the moment it appears
that the trade could become a liability.
Depending on the market conditions, there will be times where the VIX is high
enough to see the possibility of initiating a ratio spread $ 1 0-$ 1 5 with only a few
days remaining to expiration; however, under almost every other situation (other
than VIX above 40%), getting a ratio spread on for even money is difficult even
for $5 ratios (in the OEX), provided you are placing the trade ATM or OTM.
ITM spreads can be found for even-money; however, to place an ITM spread is
not advisable with this strategy, especially when getting into the last week of
trading.
BACK MONTH - Using the Second Month Out
Using the second month out is going be important in the criteria as we might go
through the entire criteria without finding a good trade if we only looked at the
front month. This would leave the trader with the feeling that a ratio could not be
found that month or at that time. Simply not true.
By simultaneously plugging �he front and back month into the remaining steps
we have 2 different trades to choose from. Sometimes it will be advantageous to
go with the front month spread and sometimes the second month out will provide
the risk-reward characteristics that the trader finds most appealing.
Bottom Line : The best time to start is now, and we will compare the two
months for the best trade.
Step 4: Detennine with which strikes to begin.
Criteria
Start with the ATM options and go OTM until it is apparent that going any
further out cannot be done I by 2 for even money. If the index is at $ 1 02 (DJX),
then start with the 1 02 strike. We will start with the front month, and then go to
the second month.
83
A. Start with the ATM options and go OTM until it is apparent that going
any further out of the money will not allow a 1 by 2 spread to be done
for even money.
B.
Start with the strikes about 5% OTM and get a few ratios in that general
area that are closer and further away from ATM. This is the method that
I use; however, I have looked at tens of thousands of ratios over the
years. I also sometimes create more work for myself by starting it in
this way, but it was a discipline I started to ensure that I did not choose
the wrong strike prices.
84
Step 5 : Calculate the cost of a small ATM Ratio spread.
Criteria
Calculate the price of buying I ATM option, and then selling 2 contracts of the
next strike further OTM (either calls or puts as determined in step 2) options.
The net premium is the credit or debit of the spread sale on I unit I -by-2 equals
one spread.
Stop when the strikes bought are 9% OTM in the front month.
Stop when the strikes bought are 12% OTM in the back month options.
Part One
What is the ATM option trading for?
Assume that you are purchasing I contract of the ATM option (call or put
depending on what decision was made at step 2). If you we bullish, buy the
ATM call.
Following the material that was used earlier to illustrate how the ratio and
broken wing butterfly worked; we will use the OEX option chain above.
Furthermore, we will assume a bearish stance, as that is what has been used to
illustrate the mechanics so far.
This step ' s criteria states that we start with an ATM option, which in this
example was the 565-strike put for the month of March.
e.g. Buy I , March 565-strike put
=
$7.00 (line M l l )
Part Two
What are 2 of the next further OTM options trading for?
Then calculate how much you would receive by selling 2 contracts of the next
OTM strike option. Again, if you were bullish, you would go one strike higher in
price and assume you sold 2 contacts. With a bearish stance using puts, you
would go one strike lower and assume you sold 2 contracts.
e.g. Sell 2, March 560-strike puts at $5 .20 (line M I 2)
Part Three
What was the net debit/credit of the spread?
If the spread was done for a debit, then this is most likely the maximum width of
the ratio spreads that one could do on this index/stock.
Net Credit/Debit
Buy 1 , March 565-strike put for $7 .00 x 1 contract
Sell 2. March 5 60-strike puts at $5 .20 x 2 contracts
Net Debit / Credit of the Ratio Spread
=
85
=
=
=
($7 .00) debit
$ 1 0.40 credit
$3 .40 credit
If the spread was done for a credit, then skip further OTM to the next set of
strike prices and see if a credit could still be received. You will repeat this step
until you can't receive a credit anymore.
First Spread Analyzed =
Buy 1 ct. of the 565 puts, sell 2 cts . of the 560 puts
Second Spread Analyzed =
Buy 1 ct. of the 560 puts, sell 2 cts. of the 5 5 5 puts
Third Spread Analyzed =
Buy 1 ct. of the 555 puts, sell 2 cts. of the 550 puts
Etc.
=
____
=
____
=
____
Reviewing the tables above allows us to visually see what is going on with the
price of the ratio spreads as we walk down (with puts or up with calls) the option
chain. It is not until the option chain ends at the 495-490 put ratio does a credit
end, and the spreads would be done for even money.
86
Buy 1 , 495-strike put for ($0 . 1 0)
Sell 2. 490-strike puts at $0.05
Ratio Spread done for even-money
The thing about this ratio spread that is $70 OTM ($565 - $495 $70) is that it
is well over 9% OTM. This certainly provides a lot of downside protection;
however, the odds of this spread working out favorably are remote. It is just too
far OTM per our criteria.
=
One will always be buying one option and selling two at the adj acent strike
further OTM. When adhering to Step 5 , if we were using the DJX at 1 08 , for
example with calls, we would buy 1 , 1 1 0 call - sell 2 , 1 1 1 calls.
If you find that by going down 9% OTM on a stock or index that there is a strike
(or more than one) in which a credit is received, then this may be the best strike
distance to use; However, we will continue on to step #6 simply to rule out
another trade existing with wider strike prices for about the same money and less
risk. It is not at all uncommon to see this, so do not feel like it is a fruitless
endeavor; however, if you do not find any examples of a potentially better
spread, then going out and trying to widen the strikes even further will almost
never be worth the effort.
Having gone through criteria #5 revealed that at every strike within the criteria
range « 9%) there could be a ratio spread for even-money or better (a credit).
When one sees ratio spreads where money can be taken in during the sale one
may get the inclination to simply take in a large credit. The 555-550 ratio spread
sold can bring in $ 1 .20 in premiums if sold. Don't stop there !
Step 6 : Calculate the cost of a medium width ATM ratio spread.
Criteria
Calculate the price of buying 1 ATM option, and then selling 2 contracts of the
options an additional strike further OTM. In other words, the strike bought will
have a strike separating the strike sold. The net premium is the credit or debit of
the spread sale on I unit I -by-2 equals one spread.
Stop when the strikes bought are 9% OTM in the front month.
Stop when the strikes bought are 120/0 OTM in the back month options.
We want to continue widening out the strikes, one strike price increment at a
time, to see if a decent credit or break-even trade is available with the strike
prices skipping a strike as in leapfrog. In other words, we will look to see what
kind a trade we can create by skipping a strike, and turning the spread into $ 1 0
wide.
87
Step 6 Medium Spread
Two Strikes Wide
Step 5 Small Spread
One Strike Wide
Strike One
Strike Two
=
=
Buy 1 , 5 6 5 put.
Sell 2 , 5 60 puts
Strike One
Strike Two
Strike Three
=
=
=
Buy 1 , 565 put
--- � -- , 5 60 put
Sell 2 , 5 5 5 put
=
Skip Over
The table below will give the reader a visual representation of the pricing and
movement of the strike prices to create a more risk averse spread when
compared to the first one in step 5 criteria.
March Option Chain:
STEP #3
SIS Cts. Strike CIP Price
B
S
88
1
2
555
545
P
P
$3.60
$1 .80
Net Cost
$ (3.60)
$ 3.60
Step 7 : Calculate the cost of a large width ATM ratio spread.
Steps 5, 6, 7, etc. will continue on forever until the credits stop being achieved,
as this is the area of greatest concern to us. It just so happens that the area in
which the spreads are widened to the point of an even-money trade being
established is usually the area in which the best trade off of risk vs. reward can
be found.
Step 5 Small Spread
One Strikes Wide
Step 6 Medium Spread
Two Strikes Wide
Buy 1 , 5 6 5 put.
Sell 2, 5 60 puts
Buy 1 , 565 put
5 60 put
Sell 2, 5 5 5 put
=
Step 7 Large Spread
Three Strikes Wide
Skip
Buy 1 , 565 put
5 60 put
5 5 5 put
Sell 2, 5 50 put
=
=
Skip
Skip
In Step 6 , we saw that some trades could have been done for even or a credit,
even though we also saw one for a debit, we have nothing to lose by continuing
with the process by going the next strike further apart in the separation of strike
prices. It is at this point though, if nothing around even money is found, then we
will quit looking for more trades and go onto the next step.
STEP # 1
SIS Cts. Strike CIP Price
B
S
1
2
565
550
P
P
$ 7.00
$2.40
Net Cost
$ (7.00)
$ 4.80
STEP #2
••••••• �':���))
:.I.II�����...
=
89
It is not until we take this stepping down process of the $ 1 5 wide ratio spreads
down to the 535-strike (Step #6) that we find a spread that can be initiated for
even money. This is the spread we will do ifwe use the front month.
STEP # 4
B/S Cts. Strike CIP Price
B
S
1
2
545
530
P
P
$ 1 .80
$0.65
STEP #5
What can one expect to see when looking for ratios?
The first thing many people think about is, "What is a good distance to see the
strike prices splitting." In other words, if there were 3 weeks until expiration
and the OEX put ratios could only be split one strike apart, would this be a · good
trade?
90
Expected Range of Ratio and Broken Wing Butterfly Trades
The boxes below will serve as a good baseline to determine how wide a ratio
spread or BWB should be under normal market conditions. The numbers are
considered good to exceptional strike price distances for markets that are trading
in an extremely low volatility to moderate volatility (anything under a 3 0-3 5 %
VIX measurement).
Under most situations a patient individual should be able to keep the distances
apart by the stated amount. There will be times, however, when one might have
to split strikes or move a strike in further in order to get the trade on. These
situations are relatively rare, but do occur. During these periods of exceptions
one should expect to at least take in some premium credits (as opposed to doing
the trade for even-money).
During periods of high volatility, one should be able to spread the strikes further
apart to put on a ratio or BWB for even. A normal spread will actually even go
for a good credit.
ex.
ex.
ex.
Remember that these are guidelines to provide feel to the novice for where
things are generally trading. The more important step is to move the trade you
chose, even if it doesn't comply with the above chart, around in a way that one
can expect or predict certain outcomes for any given price in the underlying.
91
Skew
The reason for the deficiencies in range between strikes on an index call ratio
spread when compared to a put ratio spread can be described by skew.
Prior to 1 98 7 ' s stock market crash, options use to trade on a constant volatility
throughout the range of strike prices. Every option in a particular month would
trade on the exact same volatility, and a perceived arbitrage advantage was
implied to exist for those who would buy a cheap volatility option to hedge
against the sale of a high volatility option. The thinking was that if all variables
could be kept in a constant inert status until expiration, the options would all
expire of time value and. the edge would be realized.
After the market crashed 23 % in a single day the OCC, brokerage houses, and
clearing firms began to look at risk and possible stock movement in a different
strike. No longer did traders on the floor have to demonstrate financial liquidity
should the market sell off a small reasonable amount, but floor traders were
being held responsible to remain liquid should the market fall 2 standard
deviation and/or 20%. As a result an artificial demand for far OTM puts was
created, and traders were now forced to j ack up the price of puts in order to get
some in inventory. What was considered worthless prior to the crash was now
considered "possible" even if it were not likely to happen again in our lifetime.
Because of the demand without a source of supply, options that should be
offered at $0.05 were now being bid up to $0.20 to $0.30. When measured in
volatility, the further OTM options were now trading on a higher mathematical
volatility than the ATM options. Now a skew was developing on puts as you
went further OTM.
To offset the higher cost of insurance, traders would offset their risk by selling
calls that they normally had no interest in selling, thus volatility would decline in
the measure value of calls.
What you see on the next page is the net result of the demand for OTM puts and
the forcing calls sales to offset the put purchased. Because the options no longer
trade on the same volatility throughout the option chain a skew was now in
effect.
92
30
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oS 20
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OEX strikes, 565 ATM
Put Skew
This skew affects the ratios in that the options being sold on the put ratio spread
will be on a higher volatility than the options being purchased at a higher strike
price. You may be buying a put on a 23 volatility, but you are selling twice as
many puts on a 24, 25, or 25 volatility. This is the reason why put ratios spreads
can usually be done further apart than call ratio spreads.
Call Skew
The reverse is true for call ratio spreads. With the sale of a call ratio spread, the
trader is purchasing a call closer to being ATM. These closer to ATM calls are
on a slightly higher volatility than the further OTM calls that you will be selling,
thus from a volatility stand point only, the trade has a slight edge going against
you.
not worry about the slight edge of the ratio spread going against you as the
only real negative effect of this is that the strike price distances apart will be less
than if the volatility was not skewed, or was skewed up.
Do
93
Step 8 : Find the spread in the next month out.
Find the same spread (using the same strike prices) the next month out for
comparison purposes and the selection process.
If you evaluated March, you now look at April.
If you started with June, you now look at July.
The table below is the calculation of the OEX 5 3 5-520 strike ratio spreads for
the next month out from the month that we have been evaluating so far. We were
using the March OEX option chain for our calculations, thus we will now be
reviewing April option prices with the same $ 1 5 distance between strikes.
April OEX Option Chain
94
When the trader finds the front month option spread that meets the criteria, he
should then proceed to see what the same spread is trading for the next month
out. In the previous step we saw that the most favorable risk-reward balanced
trade, based on the "even-money" method of trade selection, was the March 5 3 05 1 5 strike ratio spread for even-money.
Same Trade One Month Further Out Results
The exact same spread that is trading with one month more time is going for a
$0.60 credit. What this says is that if a trade was initiated today in the month of
April, and exactly one month of time went by without any variable changing
(time value, stock price, interest rates, etc . ) we could expect the trade we placed
today to be worth $0.
If today is 7 weeks until April expiration, we could sell the ratio spread and
receive a $0.60 premium. If nothing happens for' one month, the April options
with 7 weeks will only have 3 weeks remaining until expiration. Thus, the March
options that are trading with exactly three weeks until expiration are the price
that the April options will be in one month. Concluding this argument we can
state that the spread in April sold today will be trading for even-money in 4
weeks time. Is this good? Let' s continue on to find out.
Step . 9 : Determine the range of the underlying if it moved 5
-
6%.
Using the OEX index as an example for this step, we saw earlier that the
underlying cash value was $565.00. We can plug this number into the above
equation to calculate how much the index would net move should the underlying
move by +/- 5%.
�
$565.00 Underlying Price X 0.05 (50/0 in decimal form) = $28.25
Rounding off this number approximates $30, or 6-strike prices up and down
based on the given information of the OEX strike prices trade $ 5 apart.
$28.25 Underlying Range / $5 Strike Increments = 5.70 strikes (round to 6)
Step 1 0 : Calculate the spread's value after the underlying moves.
Determine the value of the spreads for the two months (calculated in the
previous steps) should the spread' s underlying move in an amount of up to 5%.
With the back month options one knows what the movement combined with a
month' s of time decay is worth, because it will look like the first month ' s price
adjusted for movement.
95
IMPORTANT:
This is the critical step in determining which spread is going to be the best
balance between credits/debits, profit potential, and risk protection.
Most traders will eventually be able to simply "eyeball" the expected values of
the ratio spreads with a little practice. In fact, most traders will be able to simply
move their fingers around the option chain to determine what a spread' s value
will be worth should the underlying and/or time until expiration change.
For those new to the process, and not feeling 1 00% comfortable with the
numbers they calculate being accurate, a table has been provided that shows
what the spread' s value for each month will be after a I strike move until a 5-6%
range (both up and down) has been calculated.
Put Portion of the Option Chain for Consideration
96
The table on the previous page contains all of the information needed to
determine which spread will give the trade the best risk v. reward trade-off. On
the following pages, there will be various tables that were developed to make the
understanding of the thinking process behind the trade easier to grasp. It has
been said that a picture speaks 1 ,000 words, and you find that it is certainly true
in this case.
The tables will show the various probabilities of the index making a 5%+ move
within the period of time prior to expiration. Below those probabilities will be
the profit/loss that will be realized should the stock move to that area of the Bell
curve.
A method of approximating these probability numbers is to simply go to your
broker site and have it display the deltas for each of the options in the option
chain. The delta of the option at the long strike will b e a very close
approximation of the likelihood of the option getting to ATM.
(NOTE: ProbabilHes Are Based On The Index Reaching The Strike Sold).
MARCH OPTION CHAIN
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
....
_
Probability of Underlying Reaching the Strike Sold
97
(NOTE: Probabililes Are Based On The Index Reaching The Strike Sold).
APRIL OPTION CHAIN
50%
45%
40%
35%
30%
25%
20%
15%
10%
5%
0%
Probability of Under�ing Reaching the Strike Sold
1
570
545
550
=:.:l:1
545
540
535
530
$ 12.40 $ 10.00 $ 8.30 $ 6.80 $ 5.60 $ 4.60
$ 5.60 $ 4.60 $ 3.80 $ 3.1 0 $ 2.60
i�
---iliiiii..
il $ 6BO
530
515
2
3
4
5
$ 575 $ 580 $ 585 $
525
510
520
505
515
500
510
495
$ 3.10 $ 2.60 $2.20 $ 1.85 $ 1.60 $ 1 .40
1 .85 $ 1 .60 $ 1 .40 $ 1 .20 $ 1.00 $ 0.80
The previous two illustrations contain the March and April spread profitlloss
graphs with a normal distIibution curve above that shows the reader the
likelihood of the particular profitlloss of occurring.
IMPORTANT: The table on the next page combines the two tables, above
overlapping one another. In addition, the net PIL was inserting at the bottom.
The beautiful thing about the table below is that the arrangement of the data
allows the reader to make a quick visual decision on which of the spreads is the
best. One simply makes an informed and calculated decision of which profit/loss
you can feel comfortable with based on the probabilities of it coming to fruition.
98
535
540
545
5 50
555
560
565
570
575
580
585
590 '
(NOTE: Probabililes Are Based On The Index Reaching The Strike Sold).
MARCH v. APRIL O PTION CHAI N
50%
45%
40%
35%
30"'"'
25%
20"'"'
15%
10%
5%
0"'"'
Probability of Underlying Reaching the Strike Sold
! MARCH NET PIL VS. MOVEMENT ! $ 2.20 $ 1.60 S 1.20 $ 0.80
$
0.50 $ 0.20 _ $ 0.05
! APRIL NET P/L VS. MOVEMENT ! $ (0.60) $ (0.60) $(0.30) $(0.20) $ .
$ .
_$
.
$
$.
$.
0.05 $ 0.10 !
$0.05 $ 0.20 S 0.40 !
Step 1 1 : Compare and contrast the various price possibilities that the spread
may go to;
Now that we have determined what the spread will likely be trading for after
various amounts of movement we can compare the various possible outcomes
and decide which month to trade and if the trade is worth doing.
What you are looking for is the largest range of potential profits
WITHOUT time being a consideration.
Note: One must remember that the table above was made to determine what
happens as a function of price movement only. Should any other variable
change, especially time until expiration, the spread will act differently. And by
different it is meant that the spread will likely perform better for the trader than
if time had not changed.
The PIL clip dissected from the table above.
! MARCH NET P/L VS. MOVEMENT ! $ 2.20 $ 1 .60 $ 1 .20 $ 0.80 S 0.50 $ 0.20 _ S 0.05
I APRIL NET P/L VS. MOVEMENT 1 $ (0.60) $ (0.60) $(0.30) $ (0.20) $ .
$ .
_$
. _ $.
$ 0.05 $ 0.10 !
$ .
$0.05 $ 0.20 $ 0.40 I
Without going into anything else than what has been shown here, we will now
make the determination if this is a spread worth doing.
99
Step 1 2 : Determine if the front or the back month spread is better.
Comparison of $15 March (1 month) vs. $20 April (2 month) Ratio Spread
Apples and Apples - Same Month and Same Strike Comparison
Going through the criteria for the March (front month) ratio spread we found the
best spread was the 535-520 ($ 1 5 points apart) spread. We then went to April
(back month) and looked at the same strike spread (535-520), but with one more
month of trading time until expiration. We determined that the March spread
could be sold for even money [($. 80) debit on the 5 3 5 put $ .40 x 2 contract
credit on the 520 puts
$0 debit/credit] . We then look at the April 2 month
spread and see that that spread would be done for a $0.60 credit [($3 . 80) 5 3 5 put
- $2.20 x2 520 put credit $0.60 c redit] .
-
=
=
As much as the $0.60 credit appears appealing to the trader, one has to note that
we are comparing the same strike ratio spreads over two different months.
However, is this a fair comparison?
Using our criteria for finding the best ratio spread for any given month, a $0.60
credit in a certain trade would dictate that we look at a wider spread. In other
words, having gone through the criteria in finding the optimal April ratio spread
to execute we noticed that the $ 1 5 wide ratio (535-520) resulted in a $0.60
credit. Having received this size of a credit the criteria would dictate that we
would go through the selection process again, but this time widen the trade out
one strike more, which would be looking for a $20 spread.
Having previously looked at the 5 3 5-520 spread and found the $0.60 credit, we
will now widen the spread 1 strike further apart and analyze different $20
spreads. If the purchase of the 53 5 strike still works out to be the best option to
buy, then we will be selling the 5 1 5 strike puts to finish the ratio spread.
Obviously if the ratio spreads $20 wide turned out to be trading for too large of a
debit (more than $0. 1 0 -$0.30 after we took having to buy a tail into account),
we would stay with the original $ 1 5 spread.
We see that the wider April trade (535-5 1 5) is trading for about even money,
thus it would make sense to trade the wider trade as it still meets our criteria, but
also provides more protection and profit potential.
Original Comparison
New Comparison
Mm
April
March
April
Buy 1 , 5 3 5 put (0.80)
Buy 1 , 5 3 5 put (3 . 80)
Buy 1, 535 put (.80)
Buy 1, 535 put (3.80)
S!.:ll 2, 520 pms 4Q;K2
S!.:ll 2, 52Q 12m:! 2.2Qx2
Sell 2. S2D PUg .40x2
S!;lU Z. SIS put 1 .2DIZ
Net $0
Net $0
Net $0.60
1 00
Net $0
Granny Smith v. Golden Delicious - Two Months and Two Different Strikes
In the previous paragraphs we noticed that the comparison of two different
months using the same strike prices was not necessarily the best trade as the
April (back month) spread. We could widen the strikes and have a better trade.
The table below illustrates visually what the difference between the two different
trades look like once the April spread is widened out. You will notice that the
first column is the $20 wide April (back month) spread. The second column is
the $ 1 5 March (front month) spread. I have also added a third column of what
the $20 April (back month) spread would look if one month of time elapsed from
right now. The reason I added the third column is that we could not use the
March option profit and loss results to determine what the April would be in one
month because we are using two different strikes.
In the previous example when comparing a front and back month $ 1 5 ratio
spread, we could easily interpolate what the back month spread would be worth
in one month by simply using the front month chain. However, as we are
comparing a March 53 5-520 spread ($ 1 5) to an April 535-5 1 5 ($20) spread,
simply moving over to the earlier month profit and loss results would give us
misleading information. The table below indicates net profit or loss at certain
strikes, not the pricing of the spread.
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101
What Does the Table Tell Us?
The table was created so that one could intelligently and obj ectively compare the
best ratio spread for the front and back month to determine which spread would
better serve our interest. The 1 month April portion (column 3) of the trade table
was �dded so that those who chose to use the April spread over the March would
have a reasonable estimate of what the trade would be going for a month after it
was initiated had you remained in the trade for that length of time. For the most
part, you will not use column 3 in your decision making process of which trade
is better (March or April) as there is no way to predict that the underlying will
remain stable for one month.
Important
An important item to point out again is that we have no idea if we will even have
the trade on by the end of the day that we initiate the trade. We have chosen to
select the best possible trade out of all possible combinations based on what
would happen if the stock moved immediately, and that is why we determine
prices by sliding up and down strikes. We do know that with all variables other
than time remaining relatively constant, that whatever trade is selected for
execution will only get better over time.
Which Month and Strike is Better?
1 . What the trader of this spread is going to initially focus on is what can be lost.
March
Analyzing the March option profit and loss scenarios for this up 6 and down 8
strike range, we see that there is no place in which the trade will lose money.
Certainly, if the index goes down far enough the trade will eventually become a
loser; however, in this example it would keep increasing in value as we go down
8 strike prices (roughly 7%).
April
Analyzing the April trade reveals that no loss occurs to the downside on this
trade; however there are a couple of strikes in which a loss would occur on an
increased move of the underlying. Thinking this through, reveals that if the trade
is initiated for zero cost, the loss in the spread value as the market runs up is not
a concern (when using puts). If the market stayed at a higher price that when the
trade was initiated, we would not close out the position for a loss, but would
rather simply let the spread expire worthless in which case we would get our
money back. To summarize, on the surface the April spread' s loss risk looks
greater than that of the March spread, but because we would close out and take
the loss, it is not a real consideration.
.,
1 02
2. The trader is to focus on which trade can make more money.
March
When analyzing the two spreads to see which is the better in view of profit
potential, one should not forget to look at every strike on the way down and up.
People tend to get myopic and only focus on the maximum profit of each
individual trade instead of comparing how the two spreads reach in relation to
one another on the way down.
In the example of the March trade illustrated above, we notice that the trade is
better than the April when viewed after an 8 strike move down in the underlying.
The March trade will incur a profit of $3.60 when the market falls 7%, but the
April trade will only be trading for $ 1 . 60 . But is this true for 1 , 2, 3 . . . . , 8 strikes
down?
April
The interesting thing about this trade is that the April spread will always behave
worse than the March in this particular example. Do not assume that this
relationship is always going to favor the front month spread, even though it will
most of the time.
Conclusion
In the example above, we see that viewing the trade from both the profit and loss
perspective reveals that we would want to do the March trade as it has no point
of loss, and every strike up and down is more profitable when compared to the
April trade. This particular example leaves us with the absolute conclusion that
we will want to trade the March (front month) spread even though the April
spread appears to be less risky in the view that the strikes are wider apart.
Exception to the Above Rule
There is one exception to the rule that if the front month spread is better that you
would surely want to place the trade in the front month. When comparing the
two months to determine the better trade, one may elect to purchase the further
out spread if there is very little appreciable difference in profits and losses and
you are of the strong belief that the markets will move very gently in the desired
direction.
Suppose that you were of the opinion that the markets were going to gently sell
of (if a put position was initiated) over the course of a month. If you did place
the March trade, one may not get a decent strike selection in place after it was
time to take off the March options and put on the ApriL
1 03
As a trader initiates the March 535-520 spread and the market sells off slowly
over a few weeks from 565 to 545, the March spread will be taken off and now a
new April position will be placed. However, starting over with the criteria
selection process now that April is in the front month will force us to place the
trade at lower strikes than were initially traded.
New Trade 5% OTM
When the OEX is at $545
Original Trade 5 % OTM
When the OEX was at $565
Original OEX Price $565
Multiplied by 5 Percent
Equals Net Dollar Move
New OEX Price $565
Multiplied by 5 Percent
Equals Net Dollar Move
$565
X 0.05
$28.25
=
$545
X 0.05
$27.25
=
A specific underlying price point that was 5% OTM (the 535 strike) when the
original trade was initiated, will now have a much different strike spread on after
the new trade has been initiated as the market had sold off during the first
spread' s existence. The market sold off $20 while the original trade was on
($565 staring price $545 ending price $20 move to the downside), thus a new
trade placed roughly 5% OTM will have the first strike (the purchase) at the 5 1 5
strike area.
-
=
April Spread Considerations
Looking at the above P/L strip reveals that the April 535-520 ratio spread may
not be favorable to people with no opinion on the market other than they feel the
market is stagnant.
April Profits by Time Change Without Movement
Should the underlying remain stable throughout the next 4 weeks, and by that I
mean the underlying can fluctuate but is back to the original starting price of
$565 4 weeks later, the spread after time has bled (from 7 weeks to 3 weeks) will
have gone from being placed with a $0.60 credit to trading for even-money. This
will result in a profit of $0.60 being made in 4 weeks; however it comes with a
price. For the sole reason that the market did not have a net change for 4 weeks,
a $0.60 profit was realized.
April Profits After Stock Movement w/o Time Change
A less favorable picture is painted when one looks at the above table and realizes
that any movement of >$ 1 0 will result in a loss beginning to occur. As a result of
the extra option sold, the spread will have a loss that may be temporary
depending on time and movement.
For example, looking at ONLY the April portion of the trade reveals some
interesting things about the performance of the ratio spreads. If a two strike
movement in the underlying occurs to the upside, as small profit will
immediately be made; whereas, if a two strike movement in the underlying
occurs to the downside, an immediate loss begins to occur.
1 04
April Ratio Spread After a Movement and Time Until Expiration
April options after a move to the downside have shown to be losing for a brief
period of time. But does this small loss stay in effect as time goes buy? Say that
a trader went out and sold the $535-520 ratio spread in April for a $0.60 credit.
Suddenly, the market immediately drops to $535 from $565 (a loss of $30). The
chart above shows that the spread we sold at a $0.60 credit has gone to being
able to sell it now for a $ 1 .20 credit. What that means is that if we had waited a
short period of time longer before we sold the ratio spread, we could have
received $ 1 .20 instead of $0.60, thus we gave up or lost $0.60 of potential profit.
If we were forced to close out the position and buy it back, we would have to
.
pay $ 1 .20 debit, thus we lost $0.60.
If we do nothing with the trade for 4 weeks after we sell the spread and then
watch as the mark�t sells off $30 to $535, AND we hold on and the market does
nothing for 4 weeks, we will be fine.
What the charts illustrate are as follows :
1 . Market is at $565 and we sell the April 53 5-520 ratio spread for a $0.60
credit.
2.
Market then sells off $30 points immediately to $535, and the spread is
now going for $ 1 .20, thus we lost $0.60.
3.
We wait one month after event #2 , and come back to see where the
spread is trading now that a month has gone by and only 3 weeks
remain until expiration.
4.
We look at the March table under the heading of the underlying trading
at $535, and see that the spread is now trading for a $2.20 credit to take
it om
April (Back Month) Conclusion
What we see is if the spread is initiated and the stock moves against you, the
spread will immediately take a small loss. However, most of the time the loss is
only temporary, and if you can hold off for a while, it usually comes back. If it
doesn't come back, we will see what to do in the maintenance and closing
criteria section.
1 05
March (Front Month) Conclusion
We saw in the above argument that selling the ratio spread in April allowed us to
take in $0.60 credit. If the market remained stable or went up, we would make a
little money; however, if the market went down a bit, we would likely lose a
little money (at least temporarily). We would not get the loss back without time
going by or a move back up in the underlying. It was still a decent trade, and one
that had a good risk/reward ratio when compared to most other types of trades
(verticals, time spreads, etc.), but would trading the front month option instead
of the second month options give us a better risk/reward ratio?
Looking at the PNL clip (page 99) of prices of the underlying for a 5% move in
either direction shows no area of loss. It would be very difficult to argue that the
front month spread is not the better trade. Certainly there is a loss potential if the
market crashes dramatically for and extended period of time, but that is
addressed in the Closing out and Maintenance chapter next. Yes, there is a
downside to this trade. If the market were to run up quickly, the spread ' s
individual option prices would get crushed, and the spread would likely expire
worthless. Though no · money would be made when the market runs up, no
money (other than commissions) would be lost either. Not a bad trade
PROVIDED you follow the criteria.
Conclusion:
Though the back mon.th ratio spread is not a bad trade, the front month is better.
The front month spread, in our opinion, is much superior in that there is no room
for loss within a 5% range in the underlying, and the profit potential is much
greater than that of the back month. The correct trade in this scenario would be
to place the back month trade on the shelf, and execute the front month trade.
What happens one week later?
This hypothetical trade is not so hypothetical in that real option prices were
taken for the example. Let's assume that a week after the start of the chapter the
market has sold off.
Front Month
The price the spread we initiated in the front month for even-money is as
follows:
Original Trade
Three Weeks Out
Trade 1 Week Later
Two Weeks Out
Long 1 , March 5 3 5 p for ($0.80)
Short 2. March 5 20 p at
$0 .40
Net Credit = $0
1 06
Long 1 , March 5 3 5 p for ($ 1 .90)
Short 2. March 520 p at
$0. 60
Net Credit = + $0.70
Back Month
The price the spread we initiated in the back month for a $0.60 credit is as follows:
Original Trade
Three Weeks Out
Trade 1 Week Later
Two Weeks Out
Long 1 , April 5 3 5 P for ($3 . 80)
Short 2. April 520 p at $2.20
Net Credit
+$0.60
Long 1 , April 5 3 5 p for ($6.40)
Short 2. April 520 P at $ 3 . 60
Net Credit
+$0.80
=
=
Summary of One Week After Trade Was Placed
One week after the trade was placed, and the OEX cash value moved from
$565 . 00 to $552. 80, we saw that the back month spread lost value as the credit
we received went to' a larger credit. The front month trade, the better one to
execute, was placed for even money, so we did not get paid to put the trade on.
Yet, after the market sold of, we made money on the front month spread, and
lost small on the back month spread. The phenomena of the front month being
the better is often the case, but is by no means a rule, thus we always evaluate
the spread with both the front and back month spreads being calculated.
Step 1 3 : Compare other indexes.
After you have calculated which of the ratio spreads is the better, it would be
advisable to do either of the following:
a.
Go into the other indexes and compare the spreads to one another with
similar properties (distance from ATM, credit, etc.)
b.
Skip this step if you warit to stay in this particular product as many
people will stay with one index only as they feel they can get a mastery
of the product better. Most of the floor traders the author knows
specialized in just one name, and did quite well.
a. An example
Compare what results we found in calculating the important aspects of the OEX
to another index such as the DJX. We will keep all the variables such as time
until expiration, distance between the strikes as % of the stock, the distance the
first strike is from the index, etc .
MARCH OEX 535·520
RATIO
BIS Quant. Month Strike Price
Buy 1
March 535 $(0.80)
Sell 2
March 520 $ 0.40
BlS Quant.
March
Buy 1
March
Sell 2
Net Credit/Debit =
Net Credit/Debit =
Index Cash Value
1 07
=
Summary
Comparing the two different trades above we will make the assumption that both
trades will have the same profit and loss amount throughout the entire spectrum
of possible closing prices. In addition, all other variables are very close to one
another, thus these are basically the same trade.
Even more accurate is that the top 3 0 stocks of the Dow are the 3 0 larges stocks
in the OEX index, which accounts for over a 97% correlation of movement to
one another. Yet, the DJX spread is trading in such a manner that it can be
initiated for a $0.30 credit, whereas the OEX spread can only be put on for even­
"
money. Again, all things being equal, the DJX would be the better trade in thi s
scenano.
b. Skip this step .
As stated above, many people feel branching out into too many different names
becomes counter productive, and then they are trading scared and confused as
opposed to relaxed, confident and looking for opportunities. Stay in just a few
names !
Most floor traders only trade one or two names, and will not get into anything
else as it is a distraction. For most people, skipping this step (all of # 1 3),
especially at first, is the best thing that they can do for themselves. Certainly you
may miss a slightly better trade when getting into the position; however, if you
are too overwhelmed to manage all the trades correctly, then the cost of getting
out at the wrong time, while scared and confused, will cost much more than the
small opportunity loss.
Step 1 4 : Ratio Spread versus Broken Wing Butterfly (BWB)
Criteria
Determine if you would like to do the trade as it is, or would you like to turn it
into a broken-wing butterfly by purchasing the "tails." The ratio provides the
trade with less out-of-pocket money and bigger credit than the BWB; however,
the BWB has much less risk and greatly reduced margin requirements.
The Floor Trader
Most traders on the floors of the various exchanges who did these type of trades
usually did not buy the "tails" to convert it into a BWB, or they bought the tails
and did not know it. Traders are cheap people.
The tails that are purchased by traders to convert the ratio into a BWB are often
called "worthless options " by the traders even though there is still a long period
of time until expiration. They feel that the tails are usually so far OTM that the
odds of them ever being worth anything are pretty small. As such, they will only
1 08
buy these "worthless options" if forced to because their clearing firm is insisting
on them cutting back on their risk exposure.
The Public
The average home trader, whether they are doing it full time or not, is considered
to be grouped in with the masses, by floor traders, whether that analogy is valid
or not. The margin requirements on the general public ' s orders can be even
stricter, and depending on one ' s capitalization (size of account), it may be
absolutely necessary to purchase the tails to free up capital.
Ratio v. BWB Margin
Recall from the previous chapter that the margin on a naked sale of an option is
Y2 the value of the underlying in addition to the premiums received. Having to
put up Y2 the value of the OEX when it is trading at $565 "per share" equates to
$260.00 ($520 strike sold / 2 $260) per share of margin required (in addition to
the option premiums). Since each option controls 1 00 share equivalents, it is not
uncommon to have a brokerage firm want $26,000 per naked sale for margin. In
this instance, buying the OTM puts for protection, no matter how far OTM will
provide substantial margin relief.
=
Some relief will be provided by the long put spread purchased (Buy 1 53 5-520
put spread). Since the spread purchased is $ 1 5 between strikes, one could make
up to $ 1 5 per share on this portion of the trade, which would bring our margin
down even further to $505 per share * Y2 the index value, or $252 .50. (Or
$25,250 per spread in margin).
Total Margined Ratio Spread Requirement For Our Stock Example
($4,500)
Y2 Maximum Loss Potential of Put Sale
$ 1 80
+ Premiums Received from Put Sale
($4,320)
Total Maximum Loss PotentiallMargin
=
=
=
However, by purchasing a put tail for every ratio initiated will result in a margin
reduction to a normal butterfly, plus the extra distance between strikes.
BWB Margin
Width of Spread Purchased Width of spread sold (using center strike as both
sale side of each spread) - debitl+credit Margin Per Share.
-
=
BWB Margin Formula
[Spread Sold Width] - [Spread Purchased Width] - + [-Debit! + Credit]
BWB Margin
,�.
1 09
=
Margin Comparison of 535-520 Ratio to a 535-520-495 BWB
Ratio Spread
Buy 1 , 5 3 5 put (wing)
Sell 2, 520 puts (body)
Broken Win� Butterfly
Buy 1 5 3 5 put (wing)
Se11 2, 520 put (body)
Buy 1 , 495 put (wing)
Formula (Ratio):
% value of stock from strike sold - put spread width +/- $0 option premo
[ Y2 -x 520] - $ 1 5 +/- $0 option premiums.
$260 - 1 5 +/- $0
$245 per share margin of this ratio
=
=
=
=
Formula (BWB):
[Spread Sold Width ] - [Spread Purchased Width] - + [-Debit! + Credit]
BWB Margin
$25 - $ 1 5 +/- $0 BWB Margin
=
=
$ 1 0 per share BWB margin
Step 1 5 : Converting a Ratio Spread into a Broken Wing Butterfly (BWB)
Criteria
Determine which "tail" call or put you are going to purchase if you wish to turn
the position into a BWB in order to reduce margin requirements and reduce risk.
This is not as difficult as one may at first surmise. The primary reasons for
turning your ratio spread into a broken wing butterfly are:
1.
Margin Reduction
2.
Risk Reduction
Reason 1 Margin Reduction
Almost exclusively, the reason floor traders turn their ratio spreads into a broken
wing butterfly spread is to reduce the cost of margin being allocated, used or
frozen. Even with a lot of capital and risk based margin, the ratio can tie up some
serious amounts of capital relatively quickly.
-
The example above showed that the Ratio margin was $245 per share in margin
($245 per share x 1 00 shares per contract
$24,500, and it will still tie up
$ 1 2,250 if you get the better margin rate of 25% (instead of 50%) the value of
the underlying. The BWB margin was $ 1 0 per share which equates to $ 1 ,000 per
spread. What this means to a floor trader is that he can do many more contracts
of the BWB with a given amount of money, than he could do with ratio spreads.
The hedged position above allowed the trader to do between 1 2 and 25 times the
=
1 10
amount of ratio spreads because the cut off of potential loss has been quantified
more than the full value of the underlying (with puts) or infinity (with calls).
Reason 2 Risk Reduction
This is much less of a determining factor for floor traders than it is for the public,
but many brokerage firms will not allow a ratio in the index without the full
underlying value. Certainly the $ 1 0 margin requirement for the BWB is also
coincidently (or not so coincidently) the maximum loss that one could incur on
the position. Reality will show that the 'garbage' put will very seldom provide
any real protection in the indexes , but can once in a while save a fortune in a
certain equity.
-
If the ratio was placed in the corre"Ct manner, and it is being watched according
to the closing out criteria in the next chapter, the extra protection afforded by the
"tail" will seldom be a factor, unless you simply stop monitoring the position at a
time when the market went crazy. But to put things in perspective, during the
bear market sell off and 9- 1 1 -0 1 , almost all front month index ratio spreads
initially made money when the markets opened up. Those that didn' t, usually
broke even and gave the trader an opportunity to "roll-down." (see next chapter)
What if you think the market will move fast and in great proportion toward
anticipated direction?
the
a.
Don't do the trade in that direction unless you can stay on top of the
markets until your temporary insanity subsides. Don ' t do ratios with
puts if you are expecting a huge down move. Don't do ratios with c alls
if you are expecting a huge up move.
b.
Do not do a ratio spread, but rather a broken wing butterfly (BWB) to
help offset the risk if you are going to put the ratio on in the anticipated
direction.
c.
Find the trade-off between cost versus protection that each of the
different tails would provide.
111
Put portion of OEX Option Chain
Buy
Sell
Protection Costs and Trade-offs
There will be a trade-off with the cost of the position' s protection versus risk and
margin reduction. The important thing to do is not get impulsive and simply buy
a far OTM put to clean things up . Deciding on which put to purchase for said
protection is no where near as critical to success as the previous steps are;
however, if the market does not move in your anticipated direction, then
whatever you pay for the protection is wasted money.
The Risk Above a 'Textbook' Butterfly
In the above example we determined that the front month (March) 535-520 put
ratio that was trading for even-money was the best spread. The distance between
strike is $ 1 5 ($53 5 - $520 $ 1 5). To clean up the risk perfectly by turning the
position into a textbook butterfly spread, one would purchase the $ 1 5 further
OTM puts that the puts sold ($520 puts) . For this position to be butterflied-off
exactly, we would go out and purchase the 505-strike puts (520 strike sold - $ 1 5
next incremental amount down 505 strike). The 505-strike puts, though adding
to get our position down to a no risk situation, are expensive.
=
=
If one moves the puts down to the 490-strike, the cost of margin relief and
protection declines, but so does the risk reduction. Instead of paying ($0.20) for
the 505-strike put, the trader will now be buying an option at the 490-strike that
is trading for ($0.05).
1 12
Yes the risk to the trader has increased, as well as the margin on the trade;
however, the cost has been cut by 75%. It may not seem like much money, but
these things add up very quickly. Also if you chose the best ratio spread to start
with and keep on top of things, the garbage puts purchased will likely never be a
money saver or money maker anyway.
Given the option chain above, your choices are as follows:
1 13
8NB wrm ADDrraw... PUTS PURCmSBl AT
SIS <mam.
Moot
�
CIP
brat
THE !D5-srmKE
�t
Reading the tables above reveal that as one slides down the option chain with
puts (up with calls), the cost of protection gets cheaper, as one would expect, but
the margin increases.
Conclusion:
The best put to purchase when turning a ratio spread into a BWB is the one that
is cheapest, but still affords enough margin relief so that you may still be able to
place the trade under your current capital amount. Thus :
a.
If you can afford not to buy the tail, then do not purchase it.
b.
If you can afford not to buy the tail, but would like to do more contracts
than your equity balance allows, then continue to "d".
c.
I f you have to purchase the tail or else you will b e unable to place the
trade at all, then continue to "d".
d.
Once you have dec�ded that for whatever reason you wantlhave to buy
the tail for protection andlor margin relief, then find the closest to A TM
strike put that is trading for $0.05 (the back month tails will be more
expensive), and focus on this strike.
a.
If you buy this tail in the exact s ame quantity as the options
purchased in the ratio, will this solve your financial and risk
constraints. If so, this it the tail for you.
b.
If not,
you will have to go to the next strike higher and repeat
the above step.
c.
e.
Continue going closer to ATM until there is a tail that solves
the problem for you. Once you find the tail that solves your
margin requirements, then that is the option to purchase.
"
When executing the ratio spread, depending on which brokerage firm
you are using, you will have to have the tail already purchased, or place
the entire three different pieces of the trade simultaneously. Stated
differently, the option tails purchased may be the deal breaker if you
don't have enough capital to place the trade without having the tails.
F or you to enter into the trade, the brokerage firm is not going to take
..
1 14
your word for it that you are going to eventually reduce your margin
exposure, and you will have to either buy the tail first (so that it is taken
into account immediately) or you will have to place the trade as a
package.
f.
You now have the necessary ingredients to fmish the analysis of the
trade, you can now execute it.
IMPORTANT NOTE :
If you are very low in capitalization, or you want to leverage your money as
large as you are able, then you may want to switch indexes. The above example
was started with the OEX, but we saw earlier in this chapter what this trade
looks like using the DJX index instead. Remember that the DJX is roughly 1 /5
the size of the OEX, and your margins when using this product will be also. The
problem with the DJX though, is the trade will have narrower strike distances
($3 in our above DJX example compared to $ 1 5 with the OEX), thus you
maximum profit will be diminished accordingly.
1 15
[page intentionally blank]
1 16
Broken Wing Butterfly Spreads
(BWB)
Exit Criteria
www .RandomWalkTra4ing.com
1 17
Maintenance and Closing Strategies with Exit Criteria
Introduction
Possibly the best thing about ratio spreads and broken wing butterfly trades is the
maintenance and closing out of the spread. That is not to say that there will not
be instances where looking back and hindsight doesn't force you to cringe
because, "If I had only done that . . . " creeps into the mind. The nagging second
guessing and thoughts of what could have been are torture to most traders.
The beauty of the trade is that one can, with greater ease, know the best time to
take the trade off during that relative time period. A vertical spread that is taken
off can then instantly become more profitable, and one is likely to think, "If only
I had waited another 20 minutes . . . " Or even worse, you may elect to keep a
vertical spread on trying to get more money, and the next thing you know, the
market reverses direction and what took 4 days to make is gone in 4 minutes.
With ratios, one can more easily judge when they are likely to have made the
most amount of money, and have some degree of expectation what would
happen if they waited longer. Couple that with a very good degree of estimation
about the stop loss and profit goal areas of the spread, and you have a position
that is hard to beat.
This is why we are so adamant about this trade being a part of every trader' s tool
box, and if we ever managed capital for very wealthy individuals (as has been
discussed) we thought that this was the way to go with a large portion of the
capital allocation. Other strategies just don' t offer the profit potential, likelihood
of success, and risk reduction �hat this strategy does.
Benefits of RatiolBWB Closing and Maintenance Strategies
1.
Predictability in determining when the most amount o f money has been
made for the time frame being looked at.
2.
Very easy trades t o leave alone should you not b e able t o look at the
markets on a certain day.
3.
Should the market reverse direction, you are protected, and you can
figure out where the best place to adjust the position is without losing
out on opportunity or giving back profit.
4.
Have a very liberal area where the market can go and still be a safe
trade. You will not be forced out of many of these trades before you
have a chance to make money.
S.
One can easily determine the best stop loss and profit goal, without
assigning it some arbitrary number. One of the downsides of certain
trades is people feel that the stop loss and profit goal is some arbitrary
number, and once they adhere to it, hindsight shows that the number
should have been different.
118
Exit Criteria
Step 1 : Go back to the entrance criteria work you did and either bring back the
sheet that you used to calculate the profit and loss results as the stock went
through a +1- 5% range, or if you did the work in your head, then bring back the
option chain.
Exit Criteria # 1
Get the P/L results calculated on the Criteria Page o f Previous Chapter.
Recall the chart from the chapter on entry criteria:
I MARCH NET P/L VS. MOVEMENT I $"2.20 $ 1.60 $ 1. 20 $ 0.80 $ 0.50 $ 0.20 _ $ 0.05
I APRIL NET P/L VS. MOVEMENT 1 $(0.60) $ (0.60) $(0.30) $(0.20) $ .
$ .
_$
.
$ 0.05 $ 0.10 I
$.
$ .
$0.05 $ 0.20 $ 0.40 I
The great news is that this work was already done in a previous step when
entering into the trade. If you prepare correctly, the exit criteria involved in this
trade will be the easiest of all strategies that you have learned so far.
Step 2 : After you have entered into your trade, it is time to establish a profit
goal and a stop lossl rolling down area.
Exit Criteria #2
Establish your points of exit if you are right, (the market moves too much in
your anticipated direction) or if you are wrong. Use the PIL clip above to
determine this point.
This is done by:
Scan through the PIL chain for how often the underlying moves in a 5% range
up, or down. Look for the areas that start incurring a loss should the underlying
reach that price immediately as measured by the numbers in the PILI clip.
The easiest method of determining where one wants to exit these trades involves
going back to the criteria work constructed in finding the trade in the first place.
The nice thing about the entrance criteria is it takes just one extra second to
determine at what point the trade is no longer acceptable from a risk v. reward
perspective.
One can determine the point where the trade is likely to start losing money in
advance of the underlying getting there. How nice is it to have a trade that is not
going to force you to exit before a profit can be made, but also lets you know
about where it is time to exit to avoid a loss !
..
1 19
Front Month
U sing the clip we imported from the entrance criteria we see that there really is
no place within a 5% up or a 5 % down move where we lose money with the
March options.
! MARCH NET P/L VS. MOVEMENT ! $ 2.20 $ 1 .60 $ 1.20 $ O.SO $ 0.50 $ 0.20 _ $ 0.05
! APRIL NET P/L VS. MOVEMENT ! $ (0.60) $ (0.60) $ (0.30) $ (0.20) $ .
$ .
_$
.
$ 0.05
$.
$.
S
0.10 I
$0.05 $ 0.20 $ 0.40 I
Because of this, we would make the determination that we are safe with regard
to the front month in almost all circumstances.
Back Month
Looking at the back month PIL movement as the underlying moves, we notice
that no money is lost to the upside as measured by a 5 % move. On the downside
we do not lose money until the underlying declines 2 strike prices ($ 1 0 in the
OEX).
Step 3 : Front Month And Back Month Maintenance/Closing: IMPORTANT !
Exit Criteria #3
The only major difference between front and back month ratio spreads is back
month spreads can be rolled further ITM or OTM and closer to expiration,
whereas the only adjustment a front month option is available for (other than
closing out) is to roll further ITM or OTM. Thus take your loss points found in
#2 and record them below.
Front Month Upside Loss Point:
Back Month Upside Loss Point:
____
Downside Loss Point:
Downside Loss Point:
____
----
Example:
Front Month Upside Loss Point:_NONE_ Downside Loss Point:_NONE
Back Month Upside Loss Point: _NONE_ Downside Loss Point:_$550_
The points above are all that we are going to concern ourselves with.
ASSUMPTION
We are going to go by the assumption that we are speaking of either month or
the front month unless specified to the contrary.
The front and back months closing criteria will be exactly the same for most of
the text. There are a couple small changes to adjust for when dealing with a
position with more than 4 weeks until expiration, as opposed to the front month;
however, we will be using the criteria from this point on to talk about both
months simultaneously.
120
Front Month
Facts : Index is starting at $565 with 3 weeks until Expiration (VIX is 20%) :
•
Probability that the index will go through the BIE price established in
the criteria <2%
•
Probability the index will move enough to make a $ 1 .00 or more 2 1 %
•
Probability of a loss on expiration < 2%
•
Probability of a loss at prior ate or prior to) expiration if tail is
purchased < 1 %
=
=
=
=
Back Month
Facts: Index is starting at $565 with 7 weeks until Expiration (VIX is 20%) :
•
Probability that the index will go through the BIE price established in
the criteria <5%
•
Probability the index will move enough to make $ 1 . 00 or more 24.7%
•
Probability of a loss on expiration < 2%
=
=
=
Note: Percentages are calculated using a generally accepted option pricing
model with volatility centered at 20%, the index trading at $565, and the strike
being the 535-520 ratio spread. Interest rates are set at about 1 . 50%, and time
before expiration is outlined above.
Step 4 : Watch the Markets a Few Times Per Day if Possible.
Exit Criteria #4
You will want to watch the markets a few times per day to ensure that the
underlying has not moved in a direction that can hurt your position. If it is
moving toward a point that could cause a financial loss , then continue on to step
#5 . All you are really checking for here is that the underlying is not moving so
much that an adjustment needs to be made. Other than that, everything is calm
and smooth sailing.
As long as the underlying is not moving, then you are actually in a favorable
position as the trade will become more profitable as time approaches expiration.
What you are looking to check is not the price of the options, but the price of the
underlying. You want to make sure that the underlying is not moving in the
direction where a loss could occur. Now keep in mind that usually a loss will
occur at some point in the direction that you want to the underlying to move. So
don't panic if the market is moving in the anticipated direction, it is usually a
good thing.
121
Step 5 : How often to Recalculate Profit and Loss Points
Note: Unless the market is moving a great deal (say over 2% a day),
the guidelines below will be sufficient to monitor the position.
Exit Criteria #5
3 Weeks or More Until Expiration
Only need to re-evaluate profit and loss areas after a week of time elapses, or
should the stock move by an amount of Y2 or more in the direction to the point
where a loss begins to occur. Fridays are the best day for this as it gives one time
over the weekend to let the position run around in their subconscious.
Less Than 3 Weeks Until Expiration
2-3 weeks recalculate twice a week (Tuesday and Friday are good times), or if
the underlying moves more than Y2 the amount needed for a loss to incur.
1-2 weeks recalculate three - four times a week (Monday, Wednesday and
Friday are good times), or if the underlying moves more than Y2 the amount
needed for a loss to incur.
0-1 week recalculate every day. This should not be a big problem to do at this
point in time, and this is where a huge profit could be realized. It is also the point
where if you have a profit, you may want to take the trade off in case the market
moves in the wrong direction. Remember that if the options are OTM, they will
all expire worthless, which means your current profit will evaporate.
Weeks or More Until Expiration
Should the position have not been adjusted for 1 week (provided at least 3 weeks
remain until expiration?) and the underlying not moved by half the distance or
more to the loss point calculated above, then get around to calculating the new
profit and loss exit points now that a week of time has elapsed.
3
However, should the market move in the direction of a loss point by half the
amount that it will need to move for a loss to begin to occur, then you will
proceed to step #6 immediately.
Less Than 3 Weeks Until Expiration
Should the position have not been adjusted for 1 week (provided less than three
weeks remain until expiration) and the underlying not moved by half the
distance or more to the loss point calculated above, then you will immediately
proceed to step #6.
However, should the market move in the direction of a loss point by half the
amount that it will need to move for a loss to occur, then you will proceed to step
#6 Immediately.
'.
122
Step 6 : This is the Time to Re-evaluate the P/L of the ratiolBWB adj usti ng for
the stock movement and time lapse that has occurred.
Exit Criteria #6
Simply go back to the same method of calculating the profit and loss points of
the spread that you went through when you initiated the trade.
Use a Blank Work Form for Pricing Out Profit and Loss Positions :
See Steps #9
&
10 of the Entrance Criteria Chapter.
Put Option Chain From Entrance Criteria:
Buy
Sell
Blank worksheets to use for calculating the price of what a Ratio or BWB will
change to after a move in the underlying are on the next page.
123
1 24
Step 7 : After the re-evaluation from step 6 is calculated, make a note of the
new prices in which the spread will start to lose money. This will be the new
point to monitor in the same fashion as steps 4 through 6.
Exit Criteria #7
Determine the new profit and Loss Range and then:
Keep Repeating the Cycle of Steps 4 through 6 until :
3. Underlying moves >50% in the direction of a loss would incur. OR
4. Less than 7 trading days are left. OR
5. The spread is trading for $1 more than it was placed for, and/or greater
than 1 0% of the maximum value of the spread.
Step 8 : Once an event in step 7 occurs, some action may be necessary.
Front Month Spreads
If the market is moving and a loss looks like it will occur, you will have to do
one of the following:
a.
b.
c.
Take the trade off.
Roll the trade down.
Butterfly the position off.
The criteria for front month spreads are almost exactly the same as the back
month spreads with the exception of "sweating the position out." You will recall
that ratio spread in the front month usually has more room to breathe as a
function of the underlying' s movement, than does the back month spread.
The front month options have so much more room to breathe that for there to be
a point where you are sweating the position out and staring at a loss, it is usually
because the underlying is getting dangerously close to passing through a
breakeven point. This is a danger sign that can't be ignored. Should this happen,
you will either close the position out immediately (usually at a large profit), roll
the spread further OTM, or butterfly the position off as described in the back
month options.
Back Month Spreads
Should a move occur in the back month spread that could endanger the position
should the market continue to move further is the same- direction, one of two
things will have to be done. Either the trade will have to be closed out, or rolled
further OTM to prevent a loss from occurring. An exception to this would be if
the loss that was to begin to occur was acceptable to the trader. In extreme
situations, butterfly the spread may be necessary.
125
a.
Exit the trade for B/E. If the trade was placed correctly according to
the criteria, and the underlying did not move too close to the area of
anticipated loss, taking the trade off for BIE or a small profit/loss
should be relatively easy to accomplish. Many people will do this action
and wait until the underlying stabilizes . We are of the belief that no one
can predict the future, and as such, waiting for a movement to stop or
occur is somewhat presumptuous of the trader.
We recommend going to step "b", unless the market has you feeling
totally uneasy. Going to the next step is the best scenario, as you will
be getting into a trade that is about the same distance from A TM as the
original trade was; however, if you are fearful of the market conditions,
let your gut feeling take you out. Very seldom does trading in fear ever
work out in your favor, thus you are better off closing out a position
that would be profitable, than holding onto one that causes you to later
panic and waste a lot of capital.
b.
Roll the trade further OTM. This is usually the best thing to do when
the original trade is going against you. Remember that the reason the
trade is going against you is also that the market is going in your
direction of profit. The only reason that you are looking to lose money
is that it is going too far in said direction. For that reason, closing out
the trade in j eopardy is the smart thing to do, followed by entering into
another similar trade.
Provided not too much time elapsed from the time you placed the
original trade to the time you decided to roll down, the new position
will likely be as far OTM from the current underlying prices as the
original one was OTM at the time the trade was placed.
In the April example above, we saw that the OEX move to the
downside would result in a small loss of ($0.20) should the market
decline to $550 from $565 . This represents about 300 Dow points in a
month which is not unreasonable to assume could occur. By taking this
trade off after a few strike prices, and then rolling the spread down,
more room was provided. If we moved the spread down when the OEX
cash was at $555 ($ 1 0 points lower than the starting price) for about
even money, the spread $ 1 0 further OTM than the original trade (this
$ 1 0 point move further OTM represents the amount the index moved
and has to be adjusted for). Thus we would now initiate a trade where
we closed out the 53 5-520 ratio spread, and enter into a trade where we
would now be in the $525- 5 1 0 ratio spread.
The good news is that if the move did not occur immediately, rolling
the position may not even be an issue because the normal distribution
curve has already collapsed somewhat, thus the spread' s area of danger
126
doesn't really have any danger anymore. For example, if it took two
weeks for the underlying to get to the area that we thought would be
dangerous, a quick glance at the current prices and how they are trading
today (as opposed to what they were like when we initiated the trade)
might reveal that no rolling is necessary. The area that was a concern
has disappeared over time.
Rolling Down Example:
Original Trade OEX
Buy 1 , 5 3 5 put
Sell 2 , 520 puts
-
-
c.
=
$565
Market Falls $ 1 0
Move Strike Down $ 1 0
Move Strike Down $ 1 0
New Trade OEX $ 5 5 5
Buy 1 , 5 25 put
Sell 2 , 5 1 0 puts
-
-
Be patient if the anticipated loss is acceptable. Some people will
elect to be patient with the trade which is not all bad provided you do
not let it get away from you. In other words, by having the back month
ratio spread on, the table shows that we begin to lose money if the
market makes an immediate move down by $ 1 5 to the $550 area.
When the index reaches the $550 area an anticipated loss of $0.20 per
share will result. Many people, especially those who are accustomed to
losing big money on other types of trades , when they lose a little money
have the patience to wait it out. Don't confuse waiting things out with
getting stubborn. The point of waiting things out is the fact that time is
working on your side. We can look at the front month table and see that
if the index stays at the same price for a month, then the ($0.20) loss we
took on initially has change to a profit over time. When the index is at
$555 with three weeks to go until expiration, the spread will be trading
for about an $0. 80 profit. Provided that the market is not going crazy,
and you are not reaching a point of panic, and the area that the index is
currently at would NOT be a loss if 1 month of time went by, you may
elect to stay in this trade.
Both methods are acceptable, except for a difference in opinion and risk
tolerance. No way is better except in hindsight. But do not choose one
way over the other if it does not conform to your personality traits.
d.
The last tool you have at your disposal is the tail. If you are overly
concerned, but do not want to take the trade off as it is working out, you
can always butterfly the spread off. As we started the trade with the
$53 5-520 spread, the definition butterfly would be to purchase the 505strike puts. However, as the index is moving down, you may be better
off going a couple strikes down to buy a cheaper put to give yourself
the comfort of knowing "worst case scenario. "
1 27
Important Note : The moment one uses the butterfly method to 'tourniquet off ' a
position to prevent bleeding, the first thing that comes across their mind is that
they now are long a butterfly, but short a vertical spread inside of it. Many
traders will then proj ect out to expiration and say to themselves, "What if the
mark,et closes through all the strikes on expiration. . . I could be out a lot of
money. "
Yes, i f you hold o n and d o nothing until expiration, and the index is closing
through all the strikes , you could lose a lot of money. However, you are not
�oin� to do this. Once the position is butterflied off, you will re-evaluate what
the trade will look like after a month of time elapses as that is how you will take
the trade off. Doing nothing until expiration is not how this is played. I would
guess that looking at the trade at the same place in the distant future, but not at
expiration, would show that you would likely have a good profit. To let that
profit evaporate is not the plan.
Step 9: If step 8 does not occur - When to Close
a.
h.
Market running in wrong direction.
Profit being made, but not at least 5 0% of the maximum profit.
Criteria for #9
If the spread does not run into trouble and the market is just si tting still, or
running in the wrong direction, you will either leave the position on or roll the
position closer to ATM. If it is moving in the correct direction, but the criteria
above is not telling you to exit the trade yet, then you will want to exit the trade .
when the profits stop coming it, or there is too great of a risk of giving back
profits.
a.
If the market is runnin� in the wron� direction. the trade should not
be causing any discomfort unless you placed the trade and it cost you
money (a debit) to initiate. As the market going in the wrong direction
will simply force the options to lose value, the worst that could happen
is that the position expires OTM and worthless. Now, as frustrating as it
is to have a position expire with no chance of a profit to be made, one
should be looking at the glass as half full, not half empty. Had this been
a vertical spread, you would have lost money if the market went in the
wrong direction.
There are going to be many months where you place a call ratio on, and
the market declines, or you place a put ratio on, and the market runs up.
Should you try to repair this strategy or attempt to move the spread into
an area where a moderate correction back to the original direction you
had placed, that is fine and even advisable.
,<
128
The Index Moves in the Wrong Direction
Should the market make a quick directional move in the wrong
direction shortly after the trade was initiated, you can simply move the
spread back to the original distance from the original OTM position. If
the OEX ran up $30 soon after you put the spread on, the cash will now
be trading for $595 (as it started at $565).
Index Moves and the Strikes Have Shifted
This will have caused the ratio spread to move $30 further OTM than
the original position of $30 OTM ($565 cash starting price + $30 run up
$595 ending cash price), or now a total of $ 6 0
in index cash price
OTM ($595 end cash price - $535 ratio spread' s long put strike
$60
OTM currently).
=
=
Index Goes Back to the Original Starting Price
Simply buy back the 535-520 ratio spread for about the cost of entrance,
and now purchase the 565-550 ratio spread. The great thing about
rolling this up is that after a quick run up, it is not uncommon for a
stock or index to go back to the starting point to test the area. Now the
trade will be on in the prefect position should that happen.
b.
profit is being made. but not at least 500;9 of the maximum profit.
The tricky part of these trades is to know when to take them off should
the spread be increasing in value as a result of the market moving in the
right direction, and! or as a function of time elapsing. There are a
couple of tricks and hints we have that will help you maximize the
profit potential over the long run, but only hindsight will tell the trader
what should have been done in that particular situation.
A
Use an estimated move formula to determine the amount that the stock
can move between now and expiration. The formula for a one direction
and one standard deviation move is :
EM
=
�
(UP
*
IV * Sgrt DUE)
Sqrt 252
Where:
UP Underlying Price
IV Implied Volatility
Sqrt DUE Square root of Days Until Expiration
Sqrt 252 Square root of days market is open in a year.
=
=
=
=
With the example we have been using throughout the text, we can
assume that the OEX cash is at $565. There are 2 1 days (3 weeks) until
expiration, and an implied volatility of 20%.
1 29
Plugging these numbers into the equation for EM we find:
EM =
Y2
EM
Yz ($565 * 0.20 * Sqrt 2 1 )
Sqrt 252
EM
EM
=
=
=
(UP
*
IV * Sqrt DUE)
Sqrt 252
Yz ($565 * 0.20 * 4 . 5 8)
1 5.87
2 5 8. 77 / 1 5 . 8 7
EM = $16.30
What this means is we can expect that 34% of the time the market will
move within the boundaries of $ 1 6.30 (or about 3 strikes in this case) in
our anticipated direction, and 34% of the time it will be within the
boundaries of $ 1 6.30 in the wrong direction. This is an important
statistical number that the markets like to follow. It means that 68% of
the time the market will be within a $ 1 6. 3 0 move up or down between
now and expjration.
Now the EM number is the whole range we can expect 68% of the time,
but as we know prices of the market tend to vacillate. As such, if we
analyze what this position would look like 3 strikes in either direction,
and make an assumption that anything greater than that is unlikely, we
have a pretty good gauge to use in determining the possible prices we
could expect between now and expiration.
If you can live with the number that is going against you, should the
market move in the wrong direction in exchange for how much is to be
made if it moves in the right direction, then those are your parameters.
Over the long run, this is the best method of pushing you luck and
trying to get more from the trade than you currently have.
Strikes
-3
-2
-1
0
1
2
3
Index MO\tes
-$1 5. 00
-$1 0. 00
-$5.00
AlM
$5. 00
$10.00
$1 5.00
Ratio Price
$4.90
$3. 30
$2. 00
$1 .20
$0. 90
$0. 70
$0. 60
Profit I Loss
$3.70
$2. 1 0
$0.80
$0.00
-$0.30
-$0.50
·$0.60
From Current Price
I m portant: Recall that a + 1 and - 1 strike move has the same odds of occurring .
The same is true for +2 and -2, as well as +3 and -3 strike moves.
130
Using the profit and loss box on the previous page to measure what
happens to the spread as the market moves through a series of strike
prices reveals something really interesting. Recall that the market has
the same mathematical likelihood of going up as it does going down by
1 strike increment. Because the ratio spread in our example dealt with
puts, we wanted to see the market decline in price. We see that if the
market does decline in price by 1 strike, we will make an additional
$0.80 to what we have already made; however, if the market runs in the
other direction by 1 strike, then we will give back $0.30 of our profits.
Taking this to the EM extreme of 3 strikes, if the market does decline
by 3 strikes prices (and the trend is your friend) an additional $3 . 70 will
be made; whereas, if the market reverses and moves up 3 strikes, you
will give back $0.60 (of the $ 1 .20) starting profit in the trade.
If you can live with this, which you should have no problem doing, for
the same exact mathematical likelihood of the market going down 3
strikes you have the market being able to go up three strikes. Should
this 3 strike (or 2 strike, or 1 strike) move occur, you have either made
an additional $ 3 . 70, or lost ($0. 60). You will have 6.33 : 1 odds in your
favor.
Step 1 0 : Lastly, if the market has less than one week until expiration, it may
be time to take the trade off.
Criteria for # 1 0
With less than one week o f time until expiration, you will have to decide if you
are happy with the profit and take it, or leave the trade on.
Remember that the calculations we have been using are for an instant move
based on the prices of the options are currently trading for, but at expiration all
time value goes away.
This is where things get a bit tricky, and it is a hindsight type of situation;
however, one easy rule can help you decide.
Rule: If the spread has not begun to open up, then leave it on, because if it
begins to open with less than a week, you will have a likely home run. However,
if you have so much profit in the trade that you would be upset if you gave it
back, then take the trade off. Or, the last thing you may elect to do is put a one
strike and one day stop in on the trade. You want the underlying to move down,
but if it moves up by one strike, or by the end of the day nothing has happened,
then take the trade off.
13 1
The guidelines above are what have been shown to provide the best long term
risk v. reward scenarios for this type of trade. The lesson here is to help you
make your own decisions of what you feel you are comfortable with, and
experience will be a good teaching tool. There will likely be a time when you
want to tweak the criteria a tad to conform to your personality and stomach for
risk versus desire for profit. Just remember that changing the rules in the middle
of a trade is called "letting your losses run, and taking your profits (in most
cases)," so don't get caught up in having the trend be your enemy, and the wrong
direction being your friend. That is the general public ' s domain.
132
Risk
Spreads
(Aggressive)
Ratio
www .RandomWalkTrading.com
133
Aggressive Risk Ratio Spreads
For those individuals wanting to supercharge this trade into a more powerful
strategy knowing in advance that they will also be incurring slightly more risk,
the strikes the criteria chose in the normal ratio spread or BWB can be adjusted
slightly.
Normal Ratio Spread
In the text book example of a ratio spread using our criteria, the strikes were
chosen based on two starting strategies. The first was to use strikes as far apart
as could be achieved from one another for close to a zero cost debit or credit.
The second portion of finding a plain vanilla ratio spread to was analyze what
the spread' s profit or. loss would be should the market move the underlying in
either direction. If these two concepts were initiated correctly, it was often
possible to find a spread where no significant loss would occur under any
realistic situation, and if one were to occur, you would know ahead of time
where the underlying could move to before concern was necessary.
The downside to this normal ratio spread was that if the market moved in the
wrong direction, by a significant amount (up when puts were being used, . or
down when calls where being used) , then no profit was usually made.
Risk Ratio Spread
A risk ratio spread will be the same trade as a normal ratio spread; however, we
will move the strike prices closer together in order to take in a credit when
placing the trade. This will, however, increase the risk of the trade.
As the strike prices are moved closer together we will incur more risk in two
separate, yet interrelated ways.
•
•
The first way in which we will incur more risk is by having a worse
breakeven point at expiration.
The second reason for us incurring more risk is that prior to expiration,
a severe and rapid move in our hoped for direction will result in the
spread losing money more rapidly that the same move had the strikes
been further apart.
1 34
Index Options
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135
Index Option s
The Collins Dictionary defmes an index a s " a system by which changes in the
value of something can be compared or measured". A stock index is a numerical
measure of the value of a collection of stocks. The Options Exchange Index
(OEX), for example, is an index that tracks a collection of 1 00 of the largest
capitalization-weighted stocks from a variety of market industries.
The most familiar index is that of the Dow Jones Industrial Averages (DJIA).
When hearing that the "Dow" was up 1 90 points on a given day, one
immediately gets a flavor for how the overall markets traded on that day. That
does not mean that every stock in that particular index was up; however, the
overall net effect of the combined total of stocks that were up. Microsoft may
have been up while Johnson & Johnson was down; yet, the value of the
collection of stocks was up as a whole.
There are currently a wide variety of equity and commodity indexes. One would
have little problem finding an index that matches up with a market segment he
was looking to study or measure.
Why Index Options?
Indexes are used to gauge the overall trend of a market, hedge existing positions,
arbitrage inefficiencies in a market place, and as a vehicle for trading in itself.
Traders often use the Nasdaq Market or the Dow Jones to get a "feel" for the
overall breadth of the market, and the impact that this will have on their
individual stocks. Indexes are also used to hedge a position or portfolio of stocks
as this can be done very efficiently with one-stop shopping. Program traders use
price discrepancies between the value of a collection of stocks (basket) in the
form of futures, synthetic futures, or other instruments, and that of the actual
stocks. Also, a large portion of professional traders use indexes as a vehicle from
which to earn a living. The only product that is traded by these individuals is a
desired index, believing that it is often easier to predict the overall trend of a
market that it is to pick an individual stock knowing that there stock could go
down even though the overall market direction is up (or vice versa).
Many of the benefits of indexes and index options are the following:
•
More liquidity.
•
Elimination of pin-risk (in most cases).
•
Less market movement needed to profit from many strategies.
•
Elimination of a-systematic risk.
•
Cash settlement (in most indexes).
•
Tighter bid-ask spreads.
136
o
More Liquidity
The average open interest and daily volume of most index options greatly
exceeds that of even the most actively traded stock options. Names like IBM,
Coca-Cola, Microsoft, and Apple cannot compete with an average index when
ease of entering and exiting an option position is compared. It is not uncommon
to see open interest in a SPX (Standard and Poor ' s 500 Index) strike to have over
50,000 contracts open.
o
Elimination of Pin Risk
Most indexes are cash settled, so concerns about having a short option position
assigned at inopportune times are of little concern (except with that of the OEX
index) . The fear of having an option position close ATM of expiration day is
also not a worry as it will simply expire for its intrinsic value. With equity
options, one is often uncertain as to what ones position will be on the Monday
following expiration when a short ATM option is in position. This often results
in a surprise come Monday morning when an unexpected stock position is
noticed. The risk of pin risk with indexes is almost always a non-factor. Before
trading an index, though, be certain as to what the contract specifications are s o
a s to b e forewarned about any potential for pin risk.
o
Less Market Movement Needed to Maximize
a
Profit
Most indexes trade at much higher prices than a stock (other than Berkshire
Hathaway); yet, they still offer strike prices in $ 1 and $5 increments. The tight
strike prices for a large index offer the trader the potential to initiate a strategic
trade designed to maximize profitability with only a slight movement of the
underlying. Below is a brief comparison of the SPX index that is hypothetically
trading at $ 1 503 with that of a stock trading for $28. In both underlying a
vertical call spread was placed where the trader bought the spread for $ 1 to make
a $4 profit. You will be advised to compare the percentage movement necessary
for each trade to hit the point of maximum profitability.
SPX Cash Price
=
Stock QWM = $28
$1503
Purchase the 1 505 call for $9
Sell the 1 5 1 0 call at $8
Net Spread Debit $ 1
Purchase the $30 call for $3
Sell the $35 call at $2
Net Spread Debit $ 1
Point of Maximum Profit > 1 5 1 0
Dollar Movement Needed + $7
Percentage Move Needed .47%
Point of Maximum Profit >$3 5
Dollar Movement Needed + $7
Percentage Move Needed 25%
=
=
=
=
=
=
=
=
137
Less than a Yz% move is needed in the index underlying at expiration to make
the maximum gain on the vertical spread, whereas a 25% move in needed in the
QWM stock on expiration to make the maximum on the vertical. The index
move needed in the SPX to make the maximum on the vertical spread is
equivalent to about 47 DJIA points if the Dow were at 1 0,000.
o
Elimination of A-Systematic Risk.
When discussing the risk of the markets, there are two separate risks to be
analyzed - systematic and a-systematic risk.
Systematic Risk can be defined as the overall risk to the markets as a whole. War,
interest rates, political events all contributes to the directions of the markets (and
indexes) as a whole, thus they will affect all companies stocks prices.
A-systematic risk is company specific risk. It is the risk an individual company
incurs by conducting it business. Airlines have specific a-systematic risk with
fuel costs. If aviation fuel skyrockets up 75% because of some manufacturing
costs associated with the production of fuel, an airline may have horrible
earnings one period that is specific to that industry. The high aviation fuel costs
will have little if any affect on Microsoft ' s earnings, thus it will not affect that
stock' s price.
Systematic risk is the only risk of the two risks one takes on when trading with
an index. The benefit of this is that one will not be right on the overall direction
of the market, but chose the wrong instrument to play the market direction with.
By using the OEX options to get long for a market run to the upside, one will not
have the misfortune of choosing the wrong equity (IBM) as the vehicle by which
to play the market from the long side. By definition, if the market is up in that
index, that index is up.
o
Cash Settlement (In Most Cases)
Most indexes are settled into cash when exercised or assigned. This cash
settlement feature eliminates the risk associated with taking on a stock position
when the OCC exercises a trader' s long ITM option, or when a trader is assigned
on a short option. Cash settled indexes convert the option into the indexes cash
intrinsic value. The money is then washed into the trader' s account and the
position is then forgotten about. An example of a cash settled option is illustrated
below with SPX (European exercise) ITM calls on expiration.
138
SPX Cash Settlement Value
Long 1 ( one), SPX 1 480 Call
Expiration Day
Intrinsic Value of the Call
Money Deposited Into Account
Stock Transfer
=
=
=
=
=
=
o
$ 1 48 8 . 3 8
$8.38
Today
$8.38
$ 8 3 8.00 ($8 . 3 8 X 1 00 multiplier)
None
Tighter Bid-Ask Prices Than Equity Options
Because of the high liquidity in the indexes, traders often have less bid-ask
slippage to forfeit when entering into a trade. It is not uncommon to see index
options that are trading at $ 1 0 trade in $0. 1 0 to $0.30 increments; yet, an illiquid
equity option that is trading for $ 1 to have up to $0.50 to $0.75 bid ask price
spreads. This is significant as giving up $0.50 on a $ 1 0 option is a mere 2Y2%
forfeiture of the bid-ask spread, but $0.50 bid-ask forfeiture on a $ 1 option is
50% of the option price.
Each individual index has its ' own characteristics and settlement procedures that
must be reviewed before getting involved in the product. Indexes and options on
indexes can convert into cash, futures , stock, actual product, etc. For this reason
it is imperative to know what product you are trading when trading it, even if an
'
equity index can be viewed as just one large stock and trades as such,
OEX (Options Exchange Index) as an Example
The OEX is an index on the Standard and Poor' s 1 00 Index, and is traded on the
Chicago Board Options Exchange. It is the world' s most actively traded index
option pit and is cash settled. Its expiration falls in line with that of equity
options, on the third Friday of the month. It is an American traded index, thus
there is an early exercise feature that has unique features that allow for arbitrage
opportunities. As it is an extremely liquid pit, options can be bought and sold
without having to give up a large amount of bid-ask (slippage) . The OEX has a
one hundred multiplier, thus every option trades in a multiple of $ 1 00 of its
trading price.
C ash Settlement Feature
The Options Exchange Index option is a cash settled one in which the options
when exercised are converted into cash based on the calculation of the OEX
index cash price at the close of that business day. For example, the owner of the
OEX 570-strike call holds the call until expiration day. The index settlement
price on expiration, based on the closing price of every stock in that index,
settles at 5 80.87. The owner of the call (one contract) can expect the option to be
worth $ 1 ,087, and that amount of cash be placed in his trading account. This
works because the option will close with $ 1 0.87 of intrinsic value ($5 80.87,
closing price
570, the strike price
$ 1 0. 8 7 intrinsic value) and has a 1 00
multiplier.
-
=
139
Thus the math looks as follows :
$ 1 0 . 87
$ 1 00
$ 1 ,087.00
Intrinsic Value
Multiplier
Dollar Value of Option on Expiration
Had the owner of the option paid $ 1 for the option, he would have netted a profit
of $987.00 before commissions, as the cost of one option contract trading at $ 1
is $ 1 00 ($ 1 , cost of the option X 1 00 multiplier $ 1 00 option dollar value).
=
Every penny change in the value of the index cash can be thought of as changing
the value of one option by one dollar. Had the cash settled at $580.88 (instead of
$580. 87) in the above example, the holder of the 5 70 calls would have actualized
an additional dollar of profit as the cash placed in his account would have been
$$ 1 ,088 .00 ($ 1 0. 8 8 intrinsic value multiplied by 1 00 equals $ 1 ,088.00).
1 40
Appendix
www .RandomWalkTrading.com
141
Terminology
Acquisition
The process of one company acqumng control of another
company by accumulating the shares of the later.
ADR
"American Depository Receipt." A certificate interest in a
foreign stock that is traded in the over the counter market. It is
traded in U.S . dollar denominations and settles like any other
security.
Alpha
The measure of volatility of a particular company with no
consideration for the volatility of the market as a whole. When
a company has a high alpha, it is expected to have high
volatility that is independent of the overall market' s volatility.
American
Refers to an option that ' s expiration allows for exercising prior
to the expiration date.
AMEX
"American Stock Exchange." A New York stock exchange
established to provide for free, open markets.
Appreciation
The increase in value of an investment. Usually used
describing securities and real estate.
Arbitrage
The simultaneous purchase and sale of two like contracts in
two different markets in order to achieve a near risk�less profit.
Ask
The lowest price that anyone is willing to sell something.
Because we are the only owners of the above $200,000 home,
we have set the ask price. If we reduce the price, then the new
price is the ask price. The stock market works the same way.
Asset
A fmancial resource owned (or controlled) by some entity that
is used for the purpose of acquiring appreciation.
m
Asset Allocation The act of moving assets from one investment source to
another in order to maximize gain and control risk exposure.
At-The-Market
An order given to a broker instructing him to buy or sell a
particular investment vehicle (usually stock) at the best
available price without delay.
At-The-Money
An option is at-the-money (ATM) if the stock price and the
strike price are identical.
142
Averaging
Popularly known as "dollar cost averaging". It is a method
investing in which one buys (or sells) an investment
regularly time intervals. Individuals also use averaging
acquire (or sell) and investment in price increments (in stead
time increments).
Balance Sheet
A financial statement that shows an entity' s ownership
interests in certain investment vehicles on a particular date.
Corporations use balance sheets to illustrate the fmancial
strength of the company.
Basis Point
The minimum unit of an interest rate yield. Usually measured
in one one-hundredths of one percent.
Bearish
Refers to having a position or opinion that reflects a belief that
the market is going to go down in value.
Bear Market
A market in which the overall trend is to the down side.
Analysts usually desc ribe a bear market in terms of a market in
which the overall value of said market has decline by at lease
20%. The overall volatility of the current NASDAQ market
has forced many analysts to rethink their criteria.
Beta
The measure of expected volatility of a partiCUlar stock in
comparison to the market as a whole. As stock that has a beta
of 1 is expected to move, on a percentage basis, in unison with
the overall market. Thus, if the market is up 20% in a year, one
could expect a stock with a beta of 1 to be up about 20% that
year.
Bid
The highest price that anyone is willing to pay for something.
If you were trying to sell your home for $200,000 and
someone came in with a bid of $ 1 75,000, this is the highest
price that someone is currently willing to pay for the home.
Should another buyer come in with a contract for $ 1 85 ,000,
this is now the highest price someone is willing to pay. This
new price of $ 1 85,000 has become the bid.
Black-Scholes
A pricing model used to calculate an option' s worth based on
the current market conditions and how those conditions relate
to the probability of the option having value at expiration.
Blue Chip
A company who ' s stock is widely accepted as being on an
upper tier to other stocks. It usually has a strong record of
paying dividends and good earnings. (e.g. IBM)
143
of
in
to
of
Bond
A debt instrument in which the buyer is to receive his principal
back at maturity, and interest periodically throughout the
duration of the bond ' s life . The seller of the bond receives the
monies and must pay back the money at maturity, as well as
interest for using the monies. Bonds are usually issued by
governments, municipalities, and corporations.
Broken Wing
A standard butterfly that has had the further OTM wing pulled
(cut and pasted) further away from ATM than the natural
sequential order of strikes dictates. A typical butterfly with a
stock at $ 1 00 may look as follows: Buy 1 1 00 call, Sell 2 1 05
calls, Buy 1 1 1 0 call. A broken wing may look as follows: Buy
1 1 00 call, Sell 2 1 05 calls, Buy 1 1 20 call. It is sometimes
abbreviated BWB for broken wing butterfly.
Broker
Brokers execute trades for the public. Because an exchange
membership is needed to consummate a transaction on an
exchange floor, most people cannot trade without going
through a broker. A broker is an individual who works for
himself or a large firm.
Broker-Dealer
An individual or firm who acts as an agent and as a principal.
Th� principal acts on its' own behalf when making investment
decisions.
Bullish
Refers to having a position or opinion that reflects
the market is going to go up in value.
Bull Market
Used to describe a market where the overall trend is up.
Buy-and-Hold
The strategy whereby an entity buys a particular investment
with no intention of selling in the near future. The average
investor often uses this strategy when allocating money in his
retirement account.
BWB
See broken wing butterfly.
Call Option
The right (not the obligation) to purchase a specified number
of shares (or commodities, bonds, etc.) at a specified price
prior to the option' s expiration date.
Capital Gain
The positive increase in value of money received from the sale
of an investment for a profit. It is calculated by taking the
difference between the purchase price and sale price of the
investment.
1 44
a
b.e lief that
Capital Loss
The negative change in value of money received from the sale
(or buy back) of an investment at a loss. It is calculated the
same as a capital gain.
Cash Equivalents A short-term highly liquid investment. T -Bills are often
thought of as cash equivalents.
Chapter 7
A bankruptcy condition in which the entity must liquidate
assets and is considered to be insolvent.
Chapter 1 1
A bankruptcy condition in which a court approved
reorganization of outstanding debt takes place. In the mean
time, the company is allowed to operate.
Charting
Another name for a form of market analysis known as
technical analysis.
Churning
The illegal act of trading excessively in a customer' s account
in order to elevate a broker' s commissions.
Closing Out
The process of offsetting a long or short position by reversing
out of it. It you bought a stock and closed it out, you sold the
stock.
Commission
The fees a brokerage house (or a broker) receives for executing
a trade for his customer.
Commodity
An inanimate obj ect or product used in commerce such as
gold, silver, grains, etc.
Common Stock
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Compounding
The process by which earned interest on an investment is
added to the principal to earn more interest.
CPI
"Consumer Price Index." An index used to measure the rate of
inflation. It measures a group of goods being purchased by
consumers to determine if cost of goods is going up.
Correction
A temporary downturn in the markets of 1 0% or more. Usually
after a maj or upward move has occurred.
Covered Call
A long stock position that is partially hedged with a short call
posItIon. This position mimics the profit and loss
characteristics of a short put. Also known as a buy-write.
portion of a company issued in legal paper.
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Cox-Rubenstein Similar to Black-Scholes, but calculated in a slightly different
manner.
Current Yield
The annual dividend rate divided by the cost of the underlying.
Stock ABC is trading for $25 and pays a $2 .50 per year
dividend, thus its ' current yield is 1 0% .
Cyclical Stocks
A stock whose price i s directly correlated with the economy's
business cycle. Steel and concrete businesses tend to do well
when the economy is doing well, as more people have
disposable income that can be used to build a new home.
Day Order
A type of order that is placed with a broker and is only valid
for that day. Typically, as orders, unless directly specified, are
day orders.
Day Trading
The process of purchasing and selling stock (bonds, futures ,
options, etc.) o n th e same day. Usually done at home o r at
"bucket shops", this is done with the intention of making a
profit on a daily basis. Statistically, very few people have
success day trading.
Debt-Equity
Ratio
A companies total liabilities divided by total shareholder
equity.
Derivative
financial instrument whose value is calculated off of another
instrument. Bond option prices are derived from the value of
the 3 0-year bond.
Discount Rate
The rate at which the Federal Reserve charges member banks
for money.
Diversification
The process of accumulating investment vehicles in different
categories of risk exposure, expecting that the overall all risk
of the entire portfolio will be less than the individual pieces.
Dividend
Proceeds a company pays to the shareholders from profits the
company earns. Dividends are usually announced prior to
payment and paid out on a regular basis provided the company
continues to earn a profit.
Dividend Yield
A measure of how much a company is paying in dividends as a
percentage of the price of the stock. Dividend yields are
calculated by dividing the annual dividend by the share price.
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EPS
"Earnings Per Share." A measure of a company' s profits . It is
calculated by taking the net profit after paying out preferred
stock payments, bond interest and taxes; and, then dividing
this by the number of shares of common stock that is
outstanding.
ERISA
"Employee Retirement Income Security Act." A law created in
1 974 for retirement plans that eased eligibility requirements,
and presented guidelines for managing pension fund assets.
Equity
Used synonymously with the word stock. An ownership
interest in a company.
European
Refers to an option that ' s expiration does not allow for an
exercise prior to the e xpiration date. The only way to exit out
of a European option prior to expiration is by closing it out.
Ex-Dividend
The last date by which someone wishing to purchase a stock
has rights to the upcoming dividend to be paid out. One must
own stock on (or prior) to the ex-dividend date to be entitled to
the dividend.
Expiration
The cut off date on which the right to exercise the option ends.
Options generally expire at the close of trading on the third
Friday of the named month. For example, July options will
expire on the third Friday of July. If that day is a holiday, then
the option will expire the third Thursday of the month.
Face Value
The principal amount of a bond issue.
Fed Funds Rate
An overnight interest rate that banks charge each other to
borrow money.
Fiduciary
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Fish
Slang for "the public." Used in a facetious manner to imply
that the average investor (non-professional) is uneducated
about avoiding risk. Thus, to make money off of their
mistakes/ignorance is "as easy as fishing".
Fixed Income
Investment
A term used to describe a variety of financial products that
pay a fixed amount of interest to the entity who purchased
said vehicle.
legal definition for an entity responsible for the wise use of
other people' s capital.
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Full Service
Broker
A brokerage firm that charges a premium to its ' clients for
advice, research and other services that the client does not
wish to do oneself, and c annot be found at a discount
brokerage house .
Futures Contract A legally binding agreement to buy o r sell a specified amount
of some commodity at a future time.
Garbage Option A garbage option is slang for an option that has a high
mathematical probability of expiring worthless. Typically one
is forced to buy garbage options to lower margin or risk.
GDP
"Gross Domestic Product." The total value of goods and
services in a nation' s economy during a one-year period.
Hedge
(n) A hedge is a position that has been out into place to protect
on from a possible downturn in value of another product or
instrument.
Income
Statement
Also known as a profit and loss statement (P&L statement)
that is used to summarize the profits and expenses of a
company during a given period of time.
Index
An instrument that measures a group of related investment
vehicles. There are indexes that measure the value of a group
of stocks, bonds, commodities, etc. Indexes are often used as
an investment vehicle, by which one can bet on a whole group
of instruments with one trade.
Inflation
general measure of goods and services in an economy used,
whereby the average cost of these goods and services is
mcreasmg.
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In-The-Money
An option is in-the-money (ITM) when it has intrinsic value.
Intrinsic Value
The value of an option after its time value has been removed.
IPO
"Initial Public Offering." The first time a corporation offers
shares in the company to public (non-employee) investors.
Junk bonds
High Yield bonds that have a credit rating of BB or less as
reported by a reputable independent firm such as Moody 's or
Standard and Poor 's. Generally thought of as having a higher
degree of risk than better rated bonds.
KCBOT
Kansas City Board of Trade
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Leading Indicator An economic measure that should, in theory, predict
advance when an economic cycle is changing direction.
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Leverage
Trades placed in position, which are held using a portion of
other people ' s money. Margin is a form of leverage, as well as
market maker margin.
Limit Order
An order that is placed with a specific price that the broker
cannot exceed in a negative manner. The broker can still fill
and order at a different price so long as it benefits the client.
Liquidity
The ability to enter or exit a position without having to give up
much in terms of bid or ask. Usually highly traded products are
liquid, as many buyers and sellers exist at the same time.
Load
The charge, commission, or fee a mutual fund charges one for
participating in the fund.
Long
Another name for owning something. If you are long a car, you
own an automobile.
Margin
The amount of money one needs to hold a position, minus the
money the individual uses of his own. Money that is borrowed
to hold a position.
Market Cap.
"Market Capitalization. "
The total dollar value of all
outstanding shares in a company.
It is calculated by
multiplying the share price by the total number of shares
outstanding.
Market-Maker
A member of the exchange floor who ' s sole purpose it to make
money from trading. This nam e is usually used on the Chicago
Board Options Exchange (CBOE). Market makers have the
responsibility of providing fair and orderly markets so that the
public is not at a disadvantage. The same function on the New
York Stock Exchange is termed "Specialist." Trader is another
name often mention when referring to someone functioning in
this capacity.
Market Order
An order instructing the broker to buy (or sell) an instrument at
the best available price and as quickly as possible.
Market Risk
A term used to describe a stocks risk relative to the risk of the
overall market. Market risk is often measured by beta.
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Maturity Date
The date in which a bond, draft, note, etc. is due and the buyer
is to be paid back his principal.
Money Market
Fund
A mutual fund that invests in short term cash equivalent
positions, usually government debt, and the interest is paid to
the owner of the fund.
Multiplier
A constant that each option has that is used to calculate its
dollar value. Equity options have a multiplier of 1 00. This
means that on option contract can be converted into a stock
position of 1 00 shares. One multiplies the price of the option
by its multiplier to determine the total cost of that particular
option. Stock IKL has a 3 5 -strike call that is trading for $2Yz.
To determine the cost of buying that option one time, you
mUltiply the cost of the option ($2 Yz) by its multiplier ( 1 00) to
get the total capital need ($250).
Municipal Bond
A
Mutual Fund
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Naked
Refers to the condition of being at risk. If one is not hedged,
spread-off, or protected, one is naked.
NASD
"National Association of Securities Dealers, Inc."
NASDAQ
"National Association of Securities Dealers Automated
Quotations System." A computerized quotation system that
disseminates price on roughly 5 ,000 of the most active over­
the-counter stocks.
NAV
"Net Asset Value." The fair market value of a mutual fund.
The price which mutual funds are quoted in the newspapers .
Net Change
The difference in price from the most recent quote and the
previous day ' s closing price. If a stock is quoted at $40 with a
net change of +$ 1 , the stock closed the night before at $39.
"New York Stock Exchange." An open outcry auction market
where stocks are bought and sold between professionals and
investors.
NYSE
tax-exempt debt instrument (i.e. bond) issued by a local
government body or state.
portfolio of stocks, bonds, convertible securities, etc. that is
managed by a professional with the intent of capital
appreciation for the investor. Most mutual funds are quoted on
a daily basis in a share equivalent quantity with the price of the
shares being quotes in terms of a NAV (Net Asset Value).
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NYSE Index
An index that measures the price of all stocks traded on the
New York Stock Exchange in a market-weighted mathematical
formula.
No Load
A fund that does not charge an up front fee to an individual
wishing to invest in said fund.
Open Order
An order that is held by a broker that has not been executed or
canceled as of that moment.
Option
An investment vehicle that give the holder the right to buy
(call) or sell (put) a particular investment vehicle at a pre­
selected price within a predetermined period of time (the
expiration).
OTM
An option is out-of-the-money (OTM) when it has no intrinsic
value.
OTC
"Over The Counter." A NASDAQ product that is traded on a
computer network, instead of open outcry.
Par Value
The face value of a security on the redemption date.
Parity
A condition in which an option is trading for exactly intrinsic
value prior to expiration. Another name for intrinsic value.
Penny Stock
An over the counter security that is trading for less than $5 and
usually is a new issue.
Portfolio
A collection or basket of investment products held by a single
entity and usually managed as one large product, stock, or
bond.
Preferred Stock
security that the company deems as superior to its common
stock. It pays a dividend in which the company is obligated to
pay before it can pay a dividend to the common shareholders.
It is deemed to be superior to common stock in rough times as
a company going through bankruptcy is forced to pay assets to
the preferred stock holders before the common stock holders.
Present Value
Today ' s value of a future payment that has been discounted by
an interest rate.
PIE Ratio
"Price-Earnings Ratio." A ratio that is calculated by dividing a
company' s share price by its earnings per share.
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Price Spread
The difference in price between the bid and the ask. The
difference between the bid price of $ 1 85,000 and the ask price
of $200,000 is $ 1 5 ,000. The price spread is $ 1 5 ,000.
Prim� Rate
The interest rate a chartered bank charges to its most credit
worthy borrowers.
Principal
The face value of a bond. The initial capital one uses to make
an investment.
Program Trading Computer Driven buying and selling of a basket of securities
while simultaneously taking the opposite direction position in
the futures, options or other like investment, with the objective
of profiting by inefficiencies between the two investments'
pnces.
Puts
An investment vehicle that allows the holder the right to sell
the underlying product at a specific price within a
predetermined amount of time.
Real Rate of
Return
Profit/return on an investment when adjusted for interest rates
and inflation.
Recession
Two or more consecutive quarters in which a downturn in
economic output occurs.
Retained
Earnings
The profits of a company after all dividends have been paid to
the investors.
Return
A profit that is usually expressed in percentage terms, from an
investment.
ROE
"Return On Equity." Net income divided by total equity or
investment equity.
Risk
The potential downside of an investment. The likelihood that
an investment may not perform as well as possible or
predicted.
Risk-Reward
The comparison of how much risk one has to undertake in
order to receive a certain potential return. When investing, one
ideally wants a high return with little risk, but often must
sacrifice some safety for a higher profit.
Seat
Another name for an exchange membership.
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Secondary
Market
The free market system that exists for investors to participate
in an investment (usually in securities) after the IPO.
Secondary
Offering
After an issuing company has sold a stock, it sometimes has a
redistribution of a large block of stock in what is known as the
Secondary Offering.
SEC
"Securities and Exchange Commission." A federal governing
body established in 1 934 to enforce the Securities Act of 1 93 3 ,
and to oversee the fairness o f the securities industry.
SEP
"Simplified Employee Pension Plan." A retirement vehicle
whereby the employee and the employer both contribute
monies for the benefit of the employee.
Securities
A generic term used to describe a wide array of investment
vehicles from bonds to stocks and mutual funds. Most
commonly associated with the term stock.
Short
Meaning that one has sold something that was not already
owned, usually with the intention of being able to buy it back
cheaper at a later date. Businesses sell products that have not
yet been produced, reducing their inventory problems. This is
done in the hopes that the cost of raw materials and labor for
manufacture will be less than the product was sold at.
Short Selling
The process" by which one sells a stock, bond, commodity, etc.
in anticipation of declining prices. Should the price of the
investment vehicle decline, the investor can profit by buying
back the instrument. The risk to the investor is that the price of
the vehicle could appreciate and the investor would be forced
to buy the instrument back at higher prices, and for a loss.
S&P
"Standard and Poor's." A company used to evaluate the credit
worthiness of a company, bond, or other debt instrument.
Known primarily for the S&P 5 00 index which is an index
used to measure the performance of the top 5 00 corporations in
America.
"Securities Investor Protection Corporation." A nonprofit
corporation established by Congress in 1 970 designed to
protect investor' s equities and cash positions from failure of a
member brokerage firm.
SIPC
Standard
Deviation
A statistical measure used to measure the difference between a
result and the expected result.
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Spread
The difference between the prices of the bid and the ask.
Stop Order
A protective order entered to either buy or sell an investment
vehicle at the market once the price has touched the order' s
specified price. Many stock traders use stop orders to sell out a
long stock position should the stock decline in value to a point
where the trader no longer views that security as an intelligent
investment.
Stop-Limit
An order just like a Stop Order, but also has a limit price of
how low the stock can be sold (or how high it can be bought).
Strike
The price that the option is converted into stock (cash, futures,
etc). Owning the 3 5 strike call gives the owner the right to buy
stock at $3 5 per share any time prior to expiration. Should the
stock be trading at $89 per share, the owner of the 3 5 calls can
buy stock at $35 any time that he wishes before expiration.
Tail
A tail is the slang term for the furthest OTM option in a spread
position. It is some times referred by a more pejorative term
"garbage" option.
Technical
Analysis
The study of price trends of an investment vehicle with the
intent of predicting ahead of time the way in which that
security should move. It is a way of studying the past in the
hopes of predicting the future. There is much controversy as to
whether or not technical analysis actually works.
Time Value
The value of an option determined by interest rates , time until
expiration, volatility, and distance from its strike price. When
subtracting intrinsic value out of an option, all that is left is its
time value.
Trade
An contractual agreement made between a willing buyer and a
willing seller.
Treasury Bill
Short-term debt instruments issued by the Federal Reserve that
trade in large dollar increments over $ 1 0,000.
Treasury Bond
Long-term debt instruments (over 1 0 years) issued by the U.S.
government to "roll over" its debt. Most treasury bonds pay a
coupon (interest payment) semi-annually and are callable.
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Treasury Notes
Medium term debt instruments that have a maturity between
one and ten years. Notes are discount instruments and do not
pay interest, nor are they callable.
Volatility
A measure of the anticipated price movement that a stock
could go through in a given period of time.
Volume
The total number of bonds, shares, futures, etc. that trade in a
specified period of time. Volume is usually measured on a
daily basis.
Yield
The return an investor receives on his investment.
Yield Curve
A graph that plots a curve to illustrate the difference in interest
rates as a function of time.
Zero Coupon
A bond that pays all of its interest at maturity; therefore, it is
not a coupon instrument.
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Types of Orders
All or None
An order instructing the broker to execute all of the contracts
specified or do nothing.
Day Order
An order that expires at the end of the day. Typically, all
orders unless specified to the contrary are day orders.
FOK
"Fill Or Kill." A type of order that is given to a broker in
which he has one try at executing the trade. Should the broker
not be able to immediately consummate the entire trade, then
the order is canceled.
GTC
"Good 'Til Canceled." An order given to a broker that instructs
him to keep the order open until it is canceled, or until it is
filled.
Limit
An order given that directs the broker to execute the trade at a
specific price or better. A trader who places an order to sell
stock IWM at $4 1 has given a limit order. The broker can sell
the stock only as low as $4 1 per share, but must get a better
price if the market will allow.
Market Order
An order that instructs the broker to exercise his fiduciary
responsibility by buying or selling an instrument at the best
possible pri�e at the earliest possible moment.
MIT
"Market If Touched." This is similar to a stop order, but can
be placed on either side of a market movement (either up or
down). Once the market touches the specified price it then
becomes a market order.
MOC
"Market On Close." This is an order that is to be executed at
the last possible moment of the day. The order can be placed at
any time during the day and will not be filled until the close.
Not Held
An order that instructs the broker to buy or sell an instrument
at the best possible price that he can; however, there is no
urgency in getting the trade completed. If the broker feels that
by waiting an hour he can get a better fill, then the broker has
discretion to do so. Not Held refers to the fact the broker is
Not Held Responsible should he have missed a better price
while trying to do better for you.
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OCO
"One Cancels The Other." This is a two (or more) piece order
in which one piece is canceled after another piece is filled. For
example, if a trader wanted to buy XYZ stock for $34 OR
IWM stock for $40 per share and did not care which one, the
trader could place an OCO order. Should one of the stocks get
purchased, then the order to buy the other one is canceled.
Stop Limit
Same as a stop order, but the stop price can not be filled below
a specified limit price. Also known as a stop loss order.
Stop Order
An order given to a broker that instructs him to close out an
existing position once the underlying hits a predetermined
price. Once it hits the price it then becomes a market order.
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