Equity Collar
The equity collar or sometimes just collar is a popular strategy among institutional and floor
traders. It can also a great strategy for retail investors, although most are unfamiliar with it.
Equity collars involves long stock paired with a long put and short call to provide limited
upside profits in exchange for limited downside losses.
Equity collar example:
Assume an investor is long 1,000 shares of stock at $100. He is willing to sell the stock at
$105, but is also worried about the downside risk. He could sell the $105 calls, and use those
proceeds to finance the long $95 puts. These three positions, long stock, short call, and long
put make up an equity collar.
There is no reason this investor must sell the $105 call and buy the $95 put. Instead, he
could sell the $100 call and buy the $100 put, or sell the $110 call and buy the $100 put.
There are many ways to position the collar including out-of-the-money, at-the-money and inthe-money options. Each has a unique set of risks and rewards and we will look at many
variations.
First, notice a couple of things about the collar. The above investor was long stock and then
sold the $105 calls -- a covered call position. However, the risk of a covered call is to the
downside (please see our section on "Covered Calls" and "Synthetics" if you are not sure
why). So to reduce the downside risk, the investor used the proceeds from the sale of the
calls to buy the puts.
If the stock rises above $105, he will be forced to sell his stock for $105 per share regardless
of how high it goes. But if the stock falls, he can always elect to sell the shares for $95 per
share.
From a profit and loss standpoint, the collar looks like this:
We are assuming this investor paid $100 per share for the stock, sold the calls, and bought
the puts for a credit of $1. If the stock falls below $95, he will exercise the put and receive
$95 for a total profit of $96 after taking into account the $1 credit. Bear in mind that the
investor paid $100 for the stock, so this is still a $4 loss overall.
If the stock rises above $105, he will be assigned on the short calls and be forced to sell the
stock for $105. With the $1 credit, this yields a profit of $106 for any stock price above $105.
Because the investor paid $100 for the stock, a $6 profit is made for any stock price above
$105.
Sometimes it is easier to view the profit and loss diagram to take into account the cost of the
stock. We can view the above chart by subtracting out the $100 cost for the stock and see
the true profits and losses for all stock prices:
If you read our section on "Basic Spreads" and "Synthetics," you may have noticed the above
profit and loss diagram looks very much like a bull spread. In fact, the collar strategy is a
synthetic bull spread. Also, you may remember the three-sided position used by market
makers called a conversion. Because the strike prices are unequal in this example, this
strategy is sometimes called a split-price conversion.
If you're still not sure why it is the same as a bull spread, the following may help. Keep in
mind that a bull spread with the above positions would be long $95 call and short $105 call.
Collar = Long stock + long $95 put + short $105 call
Synthetically, the long $95 put = short stock + long $95 call
So replace the long $95 put with short stock and long $95 call as follows:
Collar = Long stock + (short stock + long $95 call) + short $105 call
The long and short stock cancel out and you're left with a long $95 call + short $105 call -- a
bull spread.
Collars for credits or debits?
There are many investors who believe the best strategy with collars is to execute them for
credits. After all, why not get paid to have the long put and short call position?
Investors who believe this are not understanding profit and losses with the total position. If
you execute a collar for a credit versus a debit with all else the same, you will open the doors
to a larger loss. Once you understand synthetics, you will see you are paying for the credit
synthetically by allowing a larger loss potential. This is not to say that it is not a good strategy
to execute for credits. Just be sure that you understand the total picture, and that it is in line
with your expectations on the stock. In other words, do not execute for credits if your bigger
concern is the downside risk of the stock.
Let's run through several examples to make sure you understand it.
Corning (GLW) is currently trading for $59-3/4 with the following option quotes for January
(approximately 2 months to expiration):
Calls
Jan $50
Jan $55
Jan $60
Jan $65
Jan $70
Bid
13 5/8
11
8 1/2
6 1/4
4 3/4
Puts
Ask
14 3/8
11 3/4
8 3/4
6 3/4
5 1/8
Bid
4
5 7/8
8 1/4
10 7/8
14 1/8
Ask
4 3/8
6 3/8
8 3/4
11 5/8
14 7/8
Same strike collars (Conversions)
Say an investor buys 1,000 shares and sells 10 $60 calls and buys 10 $60 puts -- a collar with
both strike prices the same. If you read our section on synthetic options, you will recognize
this strategy as a conversion.
The investor will pay $59-3/4 for the stock, receive $8-1/2 for the call (the bid) and pay $8-3/4
(the ask) for the put. The options (not counting commissions) cost 1/4 point. The most this
investor will gain on the stock is 1/4 of a point if the stock rises above $60 at expiration. But
because it cost 1/4 to establish the collar, there is no net gain from the position; it is effectively
locked at $60.
This investor is guaranteed to receive $60 at expiration in two months. If the stock is above
$60, he will be assigned on the short calls and receive $60; if it closes below $60, he will
exercise the puts and receive $60.
Notice that the investor's cost basis is also raised by 1/4 point. He paid $59-3/4 and paid 1/4
point for the options for a total of $60.
What does this cost? If interest rates are roughly 5%, then $60 * 5% * 2 months (2/12 year)=
1/2 point. So, strictly from a monetary standpoint, this collar is not a good strategy, as it will
cost you 1/2 point in lost interest. Basically, this investor is buying stock today for $60, and
guaranteeing the sale in two months at $60 for no money, as he will be losing out on interest
he could be earning if he just sold the stock today.
Now, this may be a good strategy for someone who is deferring a sale of stock. In the past,
this was done with a box position where the investor would short 1,000 shares against their
long 1,000 effectively locking in the current price, as did our collar trader above. Recent tax
law changes have effectively eliminated the box position as a tax advantaged trade. But we
can still execute it synthetically. Notice that the trader is long shares at an effective price of
$60. The short $60 call and long $60 put constitute a synthetic short position. So the investor
truly is long and short the same stock -- a box position. This is exactly why our trader will not
profit -- or lose -- anything from the above collar.
Collars for credits
Say our same investor, instead, chose to sell the $60 call for $8-1/2 but buy the $55 put for
$6-3/8. Now, he has a credit of $2-1/8 effectively, reducing the cost basis on the stock by this
amount to $57-5/8 ($59-3/4 - $2-1/8 = $57-5/8). Notice, though, that his "insurance" from the
put doesn't start until $55, so he can still lose $2-5/8 points (he pays $57-5/8 and sells for
$55) if he exercises these puts. This is what we were referring to when we said traders who
execute collars for credits wind up paying for it by additional downside risk.
The trader who executed the collar for a net zero had no downside risk, but when executed
for a credit, now has a $2-5/8 risk. This is exactly why the market will "pay" you credits for
this type of collar. Effectively this credit trader is assuming a "deductible" of $2-5/8. Notice
too that the market only paid him $2-1/8 for it. Again, the credit collars do not come for free.
This is a great strategy if the trader is very fearful of downside risk below $55 yet willing to sell
his stock for $60. He will profit by the $2-1/8 credit if the stock sits flat through expiration.
Collars for debits
Now let's assume the trader sells the $70 call for $4-3/4 and buys the $60 put for $8 3/4 for a
net debit of $4. Now the cost basis on the stock is raised from $59-3/4 to $63-3/4. In
exchange, he can sell his stock for $60 for a $3-3/4 loss, but may be forced to sell the stock
for $70 realizing a $6-1/4 profit.
This time, the trader is allowing a larger loss -- $3-3/4 instead of $2-5/8. Why did this happen
when he paid a debit to begin with? This is due to the fact that the $70 out-of-the-money call
was sold. The trader wants more profit if the stock rises, because all else being equal, all
investors would rather have more profit than not. The markets will effectively charge you for
that privilege.
Notice that no collar combination will prevent a loss! This is due to the fact that the markets
will not assume the risk for free. If you buy the stock at $59-3/4, no matter which combination
of short calls and long puts you choose, you must accept some downside risk after
accounting for the debits or credits from the collar. If you buy the $60 put for $8-3/4, you just
bumped your cost basis to $68-1/2. True, you are guaranteed to be able to sell your stock at
$60 but this leaves a loss of $8- 1/2 points. By selling calls against the long put position, it will
lessen the expense of the put, but never to the point of no loss. Even with the zero debit atthe-money collar we looked at earlier, the trader still lost on foregone interest and retained no
upside potential in the stock.
The only time a collar can lock in a profit is if the trader had purchased the stock previously at
a lower price, say, $50. With the above prices, he can now execute a number of collars to
guarantee a profit and still leave upside potential. But this still doesn't come for free either, as
the trader was holding the stock for some time and assuming all off the downside risk. Now
that the stock has moved in his favor, he may be able to lock in gains with a collar.
This is when collars are especially attractive. Consider using them when you have significant
profits especially if there is a big announcement such as earnings that may cause the stock to
plummet. The collar can still yield healthy upside potential while greatly reducing downside
risk.
Collar comparisons
The following chart shows four of many possible combinations of collars that could be
constructed from the above option quotes. There are two important things to notice: (1)
None of the collars prevent a loss, and (2) The higher the debit, the lower the loss and the
higher the reward. This confirms what we said earlier when it was noted that a trader who
places collars for credits is allowing for more downside risk. Notice in the chart how the trader
receiving the $6-5/8 credit has the lowest profit and highest loss. Again, this does not mean
that it is not a good strategy to execute for credits. Just be sure you understand that it does
not come for free.
Reverse equity collars
We mentioned earlier that equity collars are actually bull spreads. This allows the investor, in
most cases, to participate in additional upside in the stock as well as reduce the downside
exposure. What if the investor's main concern is the downside? Is there a way to hedge that
portion in exchange for the upside gains? Yes, and that is called a reverse equity collar.
In order to execute a reverse equity collar, one needs only to buy the higher strike put and sell
the lower strike call -- an in-the-money collar. Notice how, up until now, we have always
purchased the put with a lower strike, and sold a call with a higher strike. This will always net
a synthetic bull spread. If we execute the reverse, we end up with a synthetic bear spread.
Using the option quotes in the above box, let's assume a trader buys stock at $59-3/4, buys
the $65 put for $11-5/8, and sells the $55 call for $11 for a net debit of $5/8. The following
chart shows the profit and loss diagram for a reverse equity collar:
Notice how the chart favors the downside; that is, it becomees more profitable as the stock
falls, which is not the case with a regular collar.
Once again, this shows just how versatile options can be, and why all investors should take
the time to understand them.
Collars are fairly complex in that they require three positions. Most brokerage firms will
require level 1 option approval level to place a collar and they can be used in an Individual
Retirement Account (IRA). They are fairly simple to understand once you become familiar
with them, and a powerful hedging tool to add to your list of tactics.
Spreads
Bull and bear spreads
Spreads are strategies where the investor buys one option and sells another. There are
many different types of spreads, and we will look at most of the major strategies. Spreads get
their name because you are, in fact, spreading the risk when you enter into one of these
transactions. One of the positions, either the long or the short, acts as a hedge and either
makes the position cheaper or acts as protection from a runaway stock. We will look at this in
a lot of detail later. But for now, just understand that you are spreading the risk and this,
among other factors, is what makes spreads so popular and powerful.
In most situations, the trader is buying and selling an option in the same underlying stock or
index. For example, long MRVC $35 call and short MRVC $40 call. These are collectively
known as intra-market spreads because they are spreading within the same market. If you
are long MRVC $35 and short INTC $45, this is an inter-market spread. The intra-market
spreads are by far the most common and will be our only focus. Just be aware that you do
not have to be long and short the same underlying for it to be considered a spread.
Important note: A lot of references will be made regarding pricing relationships about
options. If you are not familiar with basic option pricing, you may want to read that section
first before continuing.
The four basic spreads
The most basic spreads are the bull spread and bear spread. Each can be accomplished by
using calls or puts for a total of four basic spreads. If you understand these four spreads, you
will add an invaluable tool to your arsenal of option strategies!
Bull spreads
As the name implies, bull spreads need an upward movement in the stock to be profitable.
The term bullish actually gets its name from the way a bull attacks; it lowers its horns and
then raises its head -- from low to high. Bull spreads can be placed with either calls or puts.
Bull spreads using calls
The bull spread using calls is one of the most common spreads. This strategy involves the
purchase of a lower strike call and the sale (equal number of contracts) of a higher strike call
with all other factors the same (i.e., same underlying stock or index and time to expiration).
For example, a trader may buy 10 MRVC Jan $35 calls and sell 10 MRVC Jan $40 calls. This
is sometimes referred to as a $35/$40 call bull spread.
Because the lower strike call will always be more expensive than the higher strike [1], this
trade will result in a net debit. In order to make up for this debit, the trader will need the stock
to move higher, hence the name bull spread. This spread is also known as a debit spread,
price spread or vertical spread. We'll show you how to remember these names later.
[1] Remember, calls give you the right to purchase stock. With all else constant, investors will prefer to pay less for a stock,
so they'll bid up the price of lower strike calls relative to the higher strikes. Again, please refer to our section on "Basic
Option Pricing" for more information.
In this case, the trader is said to be long the $35/$40 bull spread. Why? As with any position,
if you buy it, you are long; if you sell it, you are short. Because this trade resulted in a net
debit (the trader paid for it), the trader is long the spread.
In a call debit spread such as this one, the short call (the $55 strike) acts as a way to bring in
cash -- it reduces the cost basis of the long $50 strike. This is a great tool for option trading
as it can allow you to buy lots of time without having to pay a lot of money.
Example:
Say it is November, you are bullish on SCMR, trading around $64, and want to buy 10 June
$60 calls which are currently trading for $20-1/2. That trade will cost you $20,500 and could
expire worthless. Because of the high price, many people avoid buying time in options and
instead look at, say, a November $60 currently trading for $8. That call will cost you $8,000
for 10 contracts. Now, granted you can lose less money with the November contract;
however, you have a much higher probability of doing so. Is there a better way? Yes, and
the bull spread answers this problem for a lot of traders. Let's do a bull spread with SCMR
and see the difference:
Buy 10 SCMR Jun $60 = $20 1/2
Sell 10 SCMR Jun $65 = $18 1/4
Net cost
$ 2 1/4
Now, for only $2,250 expense, you will own 10 contracts but have all the way until June (8
months) to profit from it. Your tradeoff is that you will not profit above $65, but, that's not so
bad. If the stock does get above $65 at expiration, this trade will be worth $5 for $2-1/4 down,
or a profit of 122% or roughly 231% on an annualized basis. By using the spread tactic, you
reduce the time-decay of the position and put the odds on your side that you will, in fact, get a
very healthy profit.
Because options are so versatile, spreads can be versatile too. If you want more upside
potential, maybe sell the June $70 call instead:
Buy 10 SCMR Jun $60 = $20 1/2
Sell 10 SCMR Jun $70 = $16 7/8
Net cost
$3 5/8
Here you will pay $3,625 for 10 contracts. Yes, you now have more money at risk, but you
also get more reward in that you profit all the way to $70 instead of $65. The financial adage
"more risk, more reward" cannot be escaped, even in the options market. You can customtailor the spreads to exactly meet your needs. If the stock reaches $70 or higher at
expiration, this trader will make $10 points for $3-5/8 initial investment for a profit of 175%, or
358% annualized.
What does the position look like from a profit and loss standpoint? (Please see our section on
"Profit and Loss Diagrams" if you are not familiar with these diagrams.)
We can see that the most the trader can lose is the $3-5/8 -- the amount paid. The most the
spread can be worth is $10 points, so the max gain must be the difference or $6- 3/8. Where
is the break-even point? The trader needs to make back the $3-5/8 initially paid. If the stock
is trading for $63-5/8 at expiration, the long call will be worth exactly $3-5/8 and the short call
will be worthless; the break-even is therefore $63-5/8.
This trader will profit if the spread widens. In other words, he wants the spread to increase in
value so that it can be sold for a profit.
No matter how high the stock goes above $70, the most this trader will make is $6 3/8. The
bull spread has a limited downside as well as upside; the trader is trying to capture the 10point move between $60 and $70.
Bull spreads using puts
A bull spread with puts is a strategy where the trader buys a low strike put and sells a higher
strike put in equal quantities. Because a higher strike put will always be worth more (all else
constant)[2], this trade will result in a credit to the account.
[2] Put options give the owners the right to sell stock. With all else constant, investors prefer to sell for higher prices so they
will bid up the prices of higher strike puts relative to lower strike puts. Again, please refer to our section on "Basic Option
Pricing" for more information.
For example, a trader may buy 10 MRVC $40 puts and sell 10 MRVC $50 puts. This is also
called a $40/$50 put bull spread.
This spread is also known as a credit spread, vertical spread, or price spread.
This trader is said to be short the $40/$50 bull spread because of the resulting credit to the
account. This trader is hoping for the spread to "shrink" (as is any short seller) so that it may
be purchased back later at a profit. How will a bull spread using puts shrink? Only if the
stock moves up (actually, this spread can also profit by sitting still too; it just cannot move
down) hence the name bull spread.
Example:
Say you are bullish on MRVC trading at $39 1/2. You elect to do the following bull spread
with puts:
Buy 10 Apr $40 puts =
Sell 10 Apr $50 puts =
Net credit
$12 1/2
$16 1/4
$3 3/4
You will receive a credit of $3,750 to your account and will profit by this amount if the stock
closes above $50. If the stock is $50 or higher at expiration, both puts expire worthless and
the spread shrinks to zero -- exactly what you want it to do!
Let's look at the profit and loss diagram for the short $40/$50 bull (credit) spread.
It is easy to see, by looking at the chart, you will make $3- 3/4 maximum; that's assuming the
stock closes at $50 or higher on expiration. However, this $3-3/4 credit does not come for
free. In exchange, you must be willing to assume a downside risk of $6-1/4. Why?
Remember, the higher strike put is more valuable, and that is the one you sold. If the stock
falls, the higher strike put becomes more valuable to the owner and equally less valuable to
you! But, if the stock continues to fall below $40, then your long $40 put starts to become
valuable to you. So the spread can only be worth $10 at a maximum to the owner or negative
$10 to you, the seller. Because you brought in $3-3/4 for the initial trade, the most you can
lose is $10 - $2-3/4 = $6-1/4. Where is the break-even point? You took in $3-3/4 initially,
right? So the $50 put can go against you by this amount at expiration. So if the stock is
trading at $50 - $2-3/4 = $47-1/4 at expiration, then your short $50 put will be worth negative
$2-3/4 to you, and your long put will be worthless; you will just break even.
Notice also, that the above two profit and loss charts have exactly the same shape. This is
another way to identify a bull spread, as they will always have this similar shape.
Which is better -- the credit or debit spread?
There are a lot of people and books that claim there is no difference between the two types of
spreads. This is totally false. There is a big difference in the underlying assumptions,
depending on what they are, the call or put spread will be better suited.
We saw that, for the debit spread, the trader must have the stock move higher as the trader
must make up for the debit. The credit spread; however, does not need the stock to move; it
just cannot move down.
Example:
PWAV is currently $44-1/2. Let's compare the debit and credit spreads:
Debit Spread
Buy Dec $45 Call =
Sell Dec $50 Call =
Net debit
$6 7/8
$4 1/4
$2 5/8
Credit Spread
Buy Jun $40 Put =
Sell Jun $45 Put =
Net credit
$4 3/4
$6 3/4
$2
The trader using calls (debit spread) will pay $2-5/8 while one using the puts (credit spread)
will receive $2. If the stock sits still, the call trader will lose $2-5/8 while the put trader will
gain $1-1/2. How? If the stock is still $44- 1/2 at expiration, both calls will be worthless; the
long bull spread will lose the entire premium.
For the credit spread, if the stock is $44-1/2 at expiration, the short put will be worth -$1/2 and
the long put worthless. The credit spreader will take a loss of $1/2 from the short position, but
keep the $2 from the initial trade for a gain of $1- 1/2.
So is the credit spread the best? After all, in this example, it seems like you get the best of
both worlds. You get paid for the position, and you don't need the stock to move in order to
profit. Here's the catch, if you are wrong in your assumption about the direction of the stock
and it falls, the debit spread can only lose the amount of the debit or $2-5/8 while the credit
spread can lose $3.
The differences in the two types of spreads, either debit or credit, have to do with your
assumptions on how quickly the underlying stock will move (please see our section on deltas
and gammas for further details).
Cheap or chicken
You may have noticed something about the two spreads we have been discussing. The debit
trader is really only interested in purchasing the more valuable call. By entering the spread,
the trader can reduce the premium paid for this long position.
For the credit spreader, their goal is to short the more valuable strike and receive a premium;
however, the trader is now exposed to potentially unlimited losses. So by entering the
spread, they hedge themselves in case the stock moves the other way.
There is a somewhat comical, although valuable way of understanding the philosophies
between credit or debit spreads. We can say the debit spreader is "cheap" since they do not
want to pay a lot for the long call position by itself. Selling the higher strike reduces the price.
For the debit spreader, they are "chicken," as their goal is to short the more valuable strike.
But they are fearful of the unlimited downside risk, so buying another position gives them a
hedge.
So remember "cheap" or "chicken" to help identify the underlying philosophies!
Bear spreads
A bear spread, as the name implies, desires the stock or index to fall. The term bearish gets
its name from the way a bear attacks; it raises its paws and strikes down -- from high to low.
As with the bull spreads, bear spreads can be executed through calls or puts.
Bear spread using puts
This strategy involves the purchase of a high strike put and the sale of a lower strike put with
all other factors the same.
Because you are buying the higher strike put, it will always be worth more and result in a
debit. In order for the trade to make money, the stock must fall -- hence the name bear
spread.
Let's say you are bearish on INTC; you think the price will fall. You could enter the following
spread:
Buy Apr $45 put =
Sell Apr $35 put =
Net debit
$6 1/2
$2 1/4
$4 1/4
This trader would be long the $45/40 bear spread. As before, this trader is long because a
premium is paid.
Let's run through the idea of the spread again. This trader is really interested in owning the
$45 strike because it is the most valuable of the two puts. However, he does not want to pay
$6-1/2. By entering the spread, he can own it for only $4-1/4. Using our "cheap or chicken"
method, this trader is "cheap." The tradeoff is that he can only profit to a fall of $35.
At expiration, if INTC is $45 or higher, this trader loses the entire premium of $4-1/4. If the
stock is $35 or below, the trader will make the full spread of $10 less the amount paid of $41/4 for a total profit of $5-3/4. In order to break even, the trader must be able to sell the long
position for $4-1/4, which means the stock will have to be this amount in-the-money or $403/4. As with any debit spread, this trader wants the spread to widen so that it may be sold for
a profit.
Let's take a look at these numbers on the profit and loss diagram:
The chart confirms what we figured out intuitively. Also notice that the bear spread profit and
loss diagram is opposite that of the bull diagrams above. The bear spread profits from a
downward move in the stock.
Bear spread using calls
This trader is really only interested in shorting (selling) the $45 call. However, because of the
unlimited risk to the upside, he buys a $55 call for protection. This follows the "chicken"
philosophy. Now it should be evident why the trader would spend the money to buy the $55
call.
For example, a trader could buy a $50 call and sell a $45. Because the lower strike will
always be more valuable, this trade will result in a credit.
Let's use INTC again but with calls instead.
Sell Apr $45 call =
Buy Apr $55 call=
Net credit
$8 1/8
$4 5/8
$3 1/2
At expiration, if INTC is below $45, both puts expire worthless and the trader will profit by the
$3-1/2 credit. If the stock is above $55, the trader will lose $10 on the spread, but will offset
this loss by the initial premium for a net loss of $6-1/2. In order to break even, the trader can
afford to have the lower strike call move $3-1/2 points against him for a closing stock price of
$48-1/2 at expiration. At this point, he will owe $3-1/2 for the short position, which exactly
offsets the original premium so he breaks even.
The following profit and loss diagram should confirm this:
Again, as expected, this bear spread has the same shape as the bear spread above. We see
that the maximum profit is in fact $3-1/2 and the maximum loss is $6-1/2.
Because this trader received a credit from the initial transaction, he wants the spread to
narrow so that it can be purchased back cheaper or expire worthless. Either way will result in
a profit.
A word of caution
One of the biggest mistakes investors make using spreads is to fail to understand the riskreward concept. This usually leads to unsuitable trades based on the investor's risk-reward
profile or outlook on the stock. Let's look at an example:
INTC is now trading for $44-7/8 with the following quotes for December available:
$35/$40 spread =;
$40/$45 spread =;
$45/$50 spread =
$55/$60 spread =
$4 1/4
$3 3/8
$2 1/2
$11/16
Novice investors will look at quotes such as these and think the $55/$60 spread is the best
because they pay only $11/16 and can make a maximum of $5 on the spread for a $4-5/16
profit. It certainly sounds better than paying $4-1/4 for the $35/$40 spread and only making
$3/4 profit.
The reason the $55/$60 spread is relatively cheap is because it is an out-of-the-money
spread; remember, the stock is trading at $44-7/8 so neither option is in-the-money. It is a
higher risk strategy, relative to the other spreads listed, so it should be trading for a cheaper
price and have a higher reward.
The $35/$40 spread is an in-the-money spread as both options have intrinsic value. This
spread will grow to a maximum of $5 without the stock moving -- just as long as the stock
does not fall below $40 by expiration. It is much less risky than the other two spreads so
should be trading for a higher price and have a lower reward.
When looking at profit and loss diagrams on spreads, you can immediately see the relative
risk in strategies. Take a look at the profit and loss diagrams for the four spreads listed
above:
You can see the $35/$40 spread in the upper left (red) has a large loss area and a low reward
area. As the spreads move more out-of-the-money, the profit and loss line shifts upward to
reflect a lower loss and higher reward. For example, look at the $55/$60 spread in the lower
right (orange). It has only an $11/16 loss but a $4-5/16 reward, which certainly sounds
appealing.
This is where the mistake is made. Again, most novice investors immediately jump to the
$55/$60, in this example, because of the amount of profit that can be made relative to the
amount invested. Remember, you cannot get around the risk-reward relationship! With the
$35/$40 spread, you will probably keep the $1/4 profit; with the $55/60 spread, you will
probably lose the $11/16.
It doesn't mean that either spread is right or wrong. Just be careful that you are picking the
correct one that matches your opinion of the move in the underlying stock.
One final note of caution: in the above example, we looked at a $35/$40 spread that cost $43/4 and could yield 1/4 profit. Even though you will probably keep the 1/4 point, be sure to
factor in commissions before entering into low yielding spreads such as this. The
commissions will, in many cases, lock you into a loss. Low profit spreads are common with
floor traders as they may only pay a couple of bucks in commissions and they are really
stacking the odds on their side that they will make a profit. For retail investors, you need to
be sure the commissions are not too high.
Spreads that lock you into a loss are entertainingly called alligator spreads -- as you will never
get out alive!
Bull and bear spreads -- how can I keep all these names
straight?
It can be confusing to remember which strategies are bullish and which are bearish,
especially if you are new to spreads. Fortunately, there is a really neat device that will help
you remember!
Whenever you BUY a LOW strike and SELL a HIGH strike, remember BLSH, which looks like
"Bullish" and you'll get the right answer. Of course, the reverse is true too. If you buy the
high strike and sell the low strike, it is a bearish strategy.
This method works for calls or puts so it can be very helpful.
Examples:
Buy $40 call and sell a $45 call.
You are buying the low strike and selling the high strike, so it is a bull spread.
Buy $120 put and sell $100 put.
You are buying the high strike and selling the low, so it is a bear spread.
Buy $40 put and sell $45 put.
You are buying the low strike and selling the high, so it is bullish.
Buy $50 call and sell the $40 call.
You are buying the high strike and selling the low for a bearish position.
Be careful with this method though. A lot of people remember the "BLSH" mnemonic but
often forget that it is in relation to the strike prices. It is very easy to look at the price of the
option and this is incorrect; in fact, it will get you the exact opposite answer!
Example:
Earlier we looked at the following trade:
Buy 10 SCMR Jun $60 = $20-1/2
Sell 10 SCMR Jun $65 = $18-1/4
It is easy for people to look at the prices of the options instead of the strikes. In this case,
they may think we are buying high ($20-1/2) and selling low ($18-1/4) and think it is a bearish
strategy -- exactly the opposite!
Just be careful and remember that the BLSH method works great -- for calls or puts -- if you
use it in relation to the strike prices.
How to remember the different kinds of spreads
There are many names for spreads, and some are used interchangeably. If you understand
where these names come from, it will help you to identify the type of trade. For example, you
may hear the following names for different spreads: price, time, vertical, horizontal, calendar,
time and diagonal just to name a few. So how do you remember them?
If you look at option quotes in your local paper, you will most likely see a similar grid with the
months across the top and the strikes down the side:
Now, look at the Jan $50 and Jan $60 highlighted in red. Depending on which one you buy
and sell, it could be either a bull or bear spread. Because it's also spread on the vertical axis,
it can be called a vertical spread or price spread , because it is the prices that are being
spread.
So all the bull and bear spreads that we've talked about are also vertical spreads or price
spreads.
If you spread horizontally such as the Mar $55 and Feb $55 in blue, then this is known as a
horizontal spread, calendar spread, or time spread because we are actually spreading time,
not price.
Lastly, if we spread time and price such as the Mar $65 and Feb $70 in green, what do you
think it's called? You've got it, that's a diagonal spread!
As always, if any of these spreads results in a net debit, the trader is said to be long the
spread and short if it results in a credit.
These are just the basics of spreads. There are many more strategies involving spreads listed
on our Web Site. We hope you take the time to learn more about them.
Deep-in-the-Money (DIM) Covered Calls
Many investors are aware of the covered call strategy; in fact, it is the first option strategy
most encounter. The strategy involves buying stock and then selling a call against it. This
position is considered covered, because no matter how high the stock moves, the trader will
always be able to deliver the stock in the event of an assignment from the short call. If the
stock rises, you may be forced to sell your stock, and if not, you keep the premium from the
option sale.
It can certainly be a great strategy for an investor who would hold the stock whether options
traded on it or not. In other words, as long as the investor is willing to assume the downside
risk of the stock, covered calls can provide income and provide small downside hedges.
Most traders entering covered call positions buy the stock and then sell a strike above the
current stock price. For example, they may buy stock at $50 and then sell a $55 or higher
strike call. Because these calls are out-of-the-money, they do not carry much time premium,
so they don't provide much of a downside hedge if the stock falls. Falling stock prices, not
rising as some think, are the risk of a covered call. Covered calls constructed with out-of-themoney calls are more of a revenue generating strategy than a risk reducing strategy.
Deep-in-the-money covered calls
We would like to introduce you to a variation of the covered call strategy, one that utilizes
deep-in-the-money calls. For example, a trader buys stock at $50 but sells a $40 strike call.
Now, I know some of you are thinking, "Wait a minute, why would I want to buy stock at $50
and give someone else the right to buy it for $40? That's a guaranteed loss!"
It is exactly this thinking that keeps most beginning option traders from using deep-in-themoney calls against stock. The piece of the puzzle they are missing is the time premium of
the call option. The $40 call in the above example may be selling for, say, $11. So even
though it appears you may be taking a 10-point loss at expiration, the call buyer is paying for
that up front. This $40 call has $10 intrinsic value and $1 point of time premium. It is the $1
time premium that the deep-in-the-money call writer is trying to capture. Deep-in-the-money
call writers intend to have the stock called.
If the option is trading at parity (all intrinsic value and no time premium), then deep-in-themoney calls certainly would not be a good strategy. For example, if the $40 call is trading for
exactly $10 (trading at parity), by entering the covered call position, you are buying the stock
for effectively $40 (buying stock at $50 and selling the call for $10), then selling your stock at
a later date for $40. Effectively, you are giving up the interest on $40 through option
expiration and paying two commissions to do so! Clearly, options trading at parity are not a
winning strategy for covered calls.
But as long as there is time premium on the deep-in-the-money call, the strategy changes.
Now the deep-in-the-money call writer is putting the odds on their side that they will get
assigned and be forced to sell the stock in exchange for the time premium.
What makes this strategy appealing is that you are, in most cases, receiving a high rate of
return and getting a huge downside hedge. You are getting the best of both worlds.
Now, don't get me wrong and think you will be overcompensated for the strategy. The
markets will price them according to the relative risks involved. But if you are using this
strategy on stock you like regardless, you will probably find this strategy to be one of the most
appealing, especially when you see the balance between returns and downside protection.
Example:
Extreme Networks (EXTR) is currently trading for $53 5/8. The December options with 16
days to expiration are quoted as follows:
Strike
Bid
Ask
Time
Premium
42 1/2
12 3/4
14
1 5/8
45
10 5/8
11 7/8
2
47 1/2
9 1/8
10 1/8
3
50
8 1/8
9 1/8
4 1/2
52 1/2
6 1/2
7 1/2
5 3/8
55
5 3/8
6 3/8
5 3/8
57 1/2
4 5/8
5 3/8
4 5/8
60
3 3/4
4 1/2
3 3/4
Say you buy the stock at $53-5/8 and sell a deep-in-the-money call such as the $45 strike.
The net cost to you is:
Buy stock = -$53 5/8
Sell $45 call = $10 5/8
Net cost
$43
Effectively you are buying stock at $43 and putting the odds heavily on your side that you will
sell it for $45. In fact, because the delta is currently 0.70, the markets are saying there is now
a 70% chance the sale will occur. If that happens, you earned 2 points (time premium) as
interest on a $43 investment for only 16 days of time. That's a simple return of 4.65%, an
annualized return of over 106%, and an effective compounded return of over 178%.
So far so good. Now let's look at the downside hedge. Because you received $10-5/8 for the
call, the stock can fall by this amount and you'd just be at break-even. With the stock trading
at $53-5/8, it could fall to $43 for nearly a 20% downside hedge!
If the stock is above $45 at expiration, you make an annualized rate of 178%; if it's down to
$45, you're at break-even. It's tough to beat, especially if it's a stock you don't mind holding,
and you're willing to assume the downside risk.
There are, of course, many ways to use the strategy. Maybe you're not so concerned with
the downside risk and want more upside return. You may elect to sell the $47-1/2 or $50
strikes instead. If you're more concerned with downside risk, you may go for sale of the $421/2 strike with $1-5/8 time premium.
You should now see the benefits of using deep-in-the-money calls compared to the usual outof-the-money calls used by most traders. Using the above quotes, many would be inclined to
sell the $60 calls. While that will yield a whopping 20.3% simple return and 6,397%
compounded return if the stock is above $60 at expiration, it only gives $3-3/4 points or 6.8%
downside hedge. Further, those returns are realized if the stock is above $60 -- there is a
huge chance that it will not be. The out-of-the-money call strategies are, for most investors,
disproportionately stacked with upside returns in relation to their downside hedge.
Why does this strategy work?
If you are still not clear as to why this strategy works, think about the following analogy:
Say you have a used car for sale for $20,000. A buyer comes to you with the following offer:
he will give you $15,000 now and the balance in 3 months. If you take the offer, you are
effectively loaning $5,000 to the buyer. Therefore, the only way you should accept the offer is
to take additional money (interest) above the $5,000 payment that he will owe you in 3months.
Notice the similarity with the deep-in-the-money covered call strategy above. The buyer (long
call position) is offering to buy your stock for $53-5/8. Instead of giving you the full amount up
front, he will pay you $10-5/8 now and the balance in 16 days effectively borrowing $43.
You are not taking a loss by purchasing stock at $53-5/8 and selling it for $45 any more than
you are taking a loss by giving someone the right to buy your $20,000 car for $5,000. In both
cases, the buyer is paying part of that future obligation now and paying you interest (time
premium on the option) to float the balance. If the interest rate is appealing to you, you will
take the offer.
Buy-writes
You can add a little edge to deep-in-the-money covered calls by entering the trade as a buywrite where both orders, the long stock and short call, are executed simultaneously. Because
market makers love combinations of stock, calls, and puts to get them into locked positions,
they will usually give you a break on the natural quote. For example, notice the spread on the
$45 calls above: $10-5/8 to $11-7/8 for a $1-1/4 spread. It is very feasible to enter an order to
buy the stock and sell the $45 call for a net debit of, say, $42-1/2. While this is only $1/2 point
better than the natural $43 debit we assumed earlier, look what it does to the returns! Now
you are buying stock at $42-1/2 and potentially selling it for $45. That's a 5.88% simple return
(compared to 4.65% earlier) and 261% effective annualized compounded rate (compared to
178%). What a difference a half point can make.
You do not need to necessarily look at volatile stocks for this strategy to work either. For
example, take General Electric (GE), which is considered to be one of the bluest of bluechips. The stock is trading for $48-7/8 and the January $43-3/8 strike is trading for $7 to $7-
1/4. If you sell the call for $7, that's $1-1/2 points of time premium for 51 days to expiration.
Chances are you will be assigned on the short call; if so, you effectively paid $41-7/8 (paid
$48-7/8 for stock and sold call for $7) and sold for $43-3/8 in 51 days. That's a simple return
of 3.58% or effective annualized compounded rate of 28.2%. Granted, not as impressive as
the returns we saw earlier but not as risky either. Your break-even point would be $41-7/8 for
a 14% downside hedge.
Two warnings
If you trade in small lots (say 100 to 300 shares), make sure the commissions do not eat
away your profits before entering the buy-write. To check, calculate the total net debit
including commission to enter the position and the total credit to sell it (called unwinding the
position). If you are trading in small lots (or being charged very high commissions), it will not
be uncommon to see the difference between your net credit from the sale and net debit from
the purchase be close to the same. If that's the case, it's definitely not worth doing. Make
sure there are significant dollars left over and that you feel that amount is worth the risk.
The second warning is to make sure you are not being compensated at only the risk-free
rate. The time premium on an option will approach the risk-free rate as you look deeper-inthe-money. For example, in the GE example above, we assumed the trader buys stock at
$41-7/8. So the trader is missing out on interest on $41-7/8 by entering the covered call. If
we assume a risk-free rate of roughly 6%, the cost of carry for this position is $41-7/8 * 6% *
51/360 = 0.355 or about 36 cents. Because the time premium of $1-1/2 is higher than 36
cents, this strategy will make financial sense as long as the commissions do not eat away the
profits. If enough strikes were available, you could keep looking further in-the-money and
eventually find one that is trading for exactly the cost of carry (if you are familiar with delta, it
will be where delta equals one). This will be true for all strikes below this strike too.
To enter a deep-in-the-money covered call with options that exactly pay the risk-free rate of
interest is to pay two commissions to enter the position yet earn the exact amount had you
just left the money in the risk-free money market. Why will the markets only reward you the
risk-free rate if you look deep enough into the calls? Because the deeper in-the-money you
go, the less risky the strategy becomes. At a certain strike and below, the markets will view
the deep-in-the-money covered position as nearly risk-free, and will only reward you the riskfree rate.
As a reminder, covered calls should really be attempted with stocks you would own
regardless. Remember, the downside risk is that the stock falls.
Covered calls can be a very rewarding strategy, especially when you get the risk-reward
ratios in proportion to your taste. If you feel the out-of-the-money covered positions you've
tried did not feel quite right, try deep-in-the-money calls for a revitalizing change.
Selling Options On Expiration Day
If you are an avid options trader, you may have noticed that in-the-money calls and puts will
often trade for less than the intrinsic amount (the difference between the stock price and the
strike) on, or near, expiration day. This is especially true for deep-in-the-money options. For
example, today is February 16th (option expiration day), and Juniper Networks (JNPR) is
trading for $83-5/8. You would think the Feb $70 call would be trading at parity -- exactly
intrinsic -- and be quoted at $13-5/8.
However, it is currently quoted at $12-3/8 on the bid. Many investors accept this as normal
functioning of the market and will sell their options to close below intrinsic value. For
example, say you hold 10 of the above JNPR Feb $70 calls and want to sell them. You could
sell at the bid and receive $12-3/8 * 10 * 100 = $12,375.
Is there a better way? Yes!
If you read our section on "Basic Option Pricing," you may recall that, in theory, an option
cannot trade for less than intrinsic. The theory says that if an option does trade below
intrinsic, arbitrageurs will sell the stock and buy the call for a guaranteed profit. This buying
and selling pressure will continue until intrinsic value is restored.
So how do you trade your in-the-money option that is trading below parity? The same way
the arbitrageurs would.
Instead of selling your call at the bid, simply place an order to sell the stock, then
immediately exercise the call option.
The stock is currently $83-11/16 on the bid. So you place an order to sell 1,000 shares at
$83-11/6. Now it doesn't matter if you have the stock or not. Why? Once the sell order is
executed, you simply submit exercise instructions to your broker and buy 1,000 shares at
$70. You received $83-11/16, but paid $70 to deliver the shares. Your proceeds are $1311/16 * 10 * 100 = $13,687, for a difference of $1,312! Now, your broker will charge you an
extra commission to sell the stock, but I think you can see it can be well worth it.
There is one important note to make here. There are people, brokers included, who will tell
you to "short" the stock, instead of a regular sell order, and then exercise the call. However,
shorting the stock subjects you to unnecessary risk and can be more costly. How? If you
short the stock you must have an uptick, and there is never a guarantee of this. So it is
possible you may never get the stock sold! In addition, if you short the stock, you will be
subjected to a 50% Reg T charge and may not earn interest on that amount while waiting for
settlement of the exercise (3 business days).
The regulations always allow you to sell shares (without it being a "short sale") that are not
held in your account. Many investors keep shares in safe deposit boxes and deliver the
shares within the three-day settlement period. This is perfectly acceptable. Now, it's possible
your firm does not allow shares to be sold that are not in the account. Sometimes the deepdiscount brokers have restrictions like this because they spend too much time chasing down
people to deliver the shares they promised to deliver, and do not generate the revenues to
make it worth their while. Further, it costs the firm money to file extensions in the event the
shares are not delivered. However, even if your firm requires the shares to be in the account
in order to be sold, let your broker know that your are immediately submitting exercise
instructions to purchase the shares. There is no reason they shouldn't allow it; the Options
Clearing Corporation (OCC) guarantees delivery of the shares at settlement.
Once you sell the stock, immediately submit exercise instructions. It is very important to
submit your exercise instructions on the same day, otherwise the sale of stock and purchase
from the option exercise will not have matching settlement dates. While this is not a major
problem (it's not going to cause you to lose the sale or anything), it's something your broker
does not want you to make a habit of. I won't go into the details, but as long as you submit
your exercise instructions on the same day you sell the stock, you will be fine.
What about put options? Assume the JNPR Feb $100 puts are trading for $15-7/8 on the
bid. If you sell 10 contracts, you'll receive $15,875. But with the stock trading at $83-3/4 on
the ask, we see they are below intrinsic and "should be" priced for $100 - $83-3/4 = $16-1/4.
If your put options are trading below intrinsic value, simply buy the stock, then
exercise your put.
So you would pay $83-3/4 to buy the stock and receive $100 from the exercise of the put,
leaving you with the intrinsic amount of $16-1/4 or $16,250 -- a difference of $375 when
compared to the trader who just sold the puts at the bid price of $15-7/8. Again, the extra
commission will be well worth it.
In fact, years ago, there used to be an order called "exercise and cover" meaning that the
broker would sell the stock and cover the sale by exercising the call (or buy the stock and
exercise the put). With the increased liquidity in the options markets, this order has
disappeared although there are certainly times it could still be used.
Why will options trade below intrinsic? There are a number of reasons, but the overall reason
is that the market makers are having a difficult time spreading off the risk with the current
liquidity.
For example, as discussed earlier, the Feb $70 calls are trading for $12-3/8 but "should be"
trading for $13-5/8. This is strictly a result from having more seller than buyers. Everybody
wants to sell their calls and nobody wants to buy; the new equilibrium price is $12-3/8, which
is below the theoretical value.
You may be wondering why nobody is buying the calls and selling the stock to restore the
equilibrium. The answer is, they are. Market makers are buying at $12-3/8, then selling the
stock. However, there's just not enough volume or interest to bring it to equilibrium. In the
meantime, the stock continues to fall, so by the time they short the stock, they may be in for a
loss (even though market makers are immune to the "uptick" rule). With a bid at $12-3/8, they
feel that is worth the risk while awaiting executions.
What about retail investors? Why don't they join in and buy the call and sell the stock? They
can. However, they must purchase the call on the ask at $13-5/8 and sell the stock at the bid
of $83-5/8, leaving zero room for error! If you sell stock at $83-5/8 and buy the $70 call, you
will have a net credit of $13-5/8, which is exactly what it will cost you to buy the call.
Now, you may think to compete with the market makers and try to notch up the bid price a
bit. In other words, if you bid $12-5/8, you will now be the highest bidder and the quote will
move to $12-5/8 on the bid and $13-5/8 on the ask. If you purchase the call for $12-5/8, you
could certainly sell the stock and make money. But here's the catch: if you bid at $12-5/8,
the market makers will bid $12-3/4, giving them a call option for 1/8th! How? Market makers
would love to buy the call option below the "fair value" and hold an asset that will behave just
like the underlying stock. But if the stock falls, the market maker will sell it back to you at $125/8 and be out 1/8ths of a point. In other words, they will use your buy order as a guaranteed
stop order. If they buy it for $12-3/4 and it doesn't work out, they know they have a buyer at
$12-5/8 -- you! This is called "leaning on the book" and is a common practice among market
makers.
Just because the market is offering you a price below the fair value, this doesn't mean you
must accept it. Learn to correct for it and improve your option trading results!
Option Exam 7 - Week 7
1) Which best describes an equity collar?
a) Unlimited losses regardless of direction
b) Limited downside losses, limited upside returns
c) Limited upside returns, unlimited downside losses
d) Unlimited upside returns, limited downside losses
2) An equity collar is similar to a(n):
a) Bear spread
b) Bull spread
c) Ratio write
d) Condor spread
3) A reverse equity collar is similar to a(n):
a) Bear spread
b) Bull spread
c) Ratio write
d) Condor spread
4) Covered call strategies typically provide a very little downside hedge in the even the stock
falls. If this is a concern, you could use:
a) Deep-in-the-money covered calls
b) Out-of-the-money covered calls
c) At-the-money covered calls
5) An investor buys a stock trading for $100 and wants to write the $80 call for $21 1/4 with
three months of time. Assuming interest rates are 5%, the investor should write the call.
a) True
b) False
6) An investor has written a call against stock (covered call) and wants to get out of the
position by selling the stock and buying the call to close. However, he does not want to be
exposed to market movement. He can enter:
a) A buy-write
b) An unwind
c) A sell-write
d) A straddle
7) An investor buys a low strike call and sells a high strike call. This is a(n):
a) Bear spread
b) Bull spread
c) Ratio write
d) Condor spread
8) An investor buys a $50 call for $5 and sells the $60 call for $2. This is a(n):
a) Debit spread
b) Credit spread
c) Unwind
d) Sell-write
9) Using the same information in #8, what is the maximum the investor can lose per spread?
a) $2
b) $3
c) $4
d) $10
10) An investor buys a $55 call and sells a $50 call for a net credit of $3. The most this
investor can lose per spread is:
a) $2
b) $3
c) $4
) $5
11) An investor buys a $100 put and sells the $95 put. This is an example of a(n):
a) Bull spread
b) Bear spread
c) Condor spread
d) Ratio spread
12) An investor is considering two different bull spreads. With one he can pay $2 and possibly
make $10. The other he can pay $8 and possibly make $10. With the $2 spread is the better
deal because it allows for more profit.
a) True
b) False
Dividend Play
One of the more interesting strategies is known as a dividend play. It is ironic that it is nearly
risk-free yet entails a lot of uncertainty. It is uncertain because you are betting on the move of
the trader on the opposite side of your position.
The dividend play strategy is executed by purchasing stock and selling deep-in-the-money
calls prior to ex-date (the day the stock trades without the dividend). Doing so creates a
position where the trader will break even as a worst-case scenario, but may capture the
dividend if the long call position fails to exercise.
For example, say a stock is trading for $100 and is about to pay a $1 dividend. Also assume
that a $70 call is trading for $30 (trading at parity). A trader can buy the stock and sell the call
for a net debit of $70. On ex-date, the stock will fall by the amount of the dividend to $99
causing the deep-in-the-money call to fall to $29. The trader will lose $1 on the price of the
stock, but gain it back from the dividend. But the short call can be purchased back for $1
less. Overall, the trader profits by the amount of the dividend.
However, if the trader is assigned, he will receive $70 (the strike), which is the amount paid
originally, and break even. If not, he keeps the dividend.
The transactions are as follows:
Long Stock = -$100
Short $70 call = +$30
Net debit
$70
On ex-date, the account values are as follows:
Stock = +$99 (stock price reduced by amount of dividend)
Short $70 call = -$29 (call price falls $1 due to stock price reduced by dividend)
Dividend = +$1
Net credit $71
The trader can now sell the stock for $99 and buy back the short position for a total credit of
$70, which exactly offsets the original debit. In addition, he will keep the $1 dividend.
Look back to the original position and now assume the trader is, instead, assigned before exdate:
Original position:
Long Stock = +$100
Short $70 call = -$30
Net debit
$70
He will lose the stock from the assignment but also lose the $30 obligation because the call
has been assigned. In exchange, he will receive the $70 exercise price, which is exactly what
was paid originally.
Because of the low transaction costs, traders see it as a low risk, but potentially profitable
trade.
Variations with vertical spreads
There is a variation of the dividend play that uses vertical spreads. For example, say the
stock is $100 and the $65/$70 vertical spread (long $65 call and short $70 call) is trading for
$5 -- exactly the intrinsic amount.
It is possible for a market maker to attempt to purchase this spread at $5 even though there
appears to be no justification -- in most cases, you will pay $5 for the spread and sell it for $5,
but pay two commissions to do so.
So why would a market maker want to pay $5 for the spread? They may exercise the $65 call
and hope they are not assigned on the $70 call. By exercising the day before ex-date, they
will capture the dividend of the underlying. Of course, if assigned on the short $70 strike, they
will lose the gains and break even.
The transactions are as follows:
Long $65 call = -$35
Short $70 call = +$30
Net debit
$5
Trader exercises the $65 call and is now:
Exercise $65 call = -$65
Long stock =
+$100
Short $70 call =
-$30
Net credit
$5
Effectively, the trader has legged into a covered call position (long stock plus a short call).
Notice that the long $65 call was originally priced at $35. By using it to buy stock, he is now
long stock worth $100, but paid $65 for it -- a net value of $35. The market maker is simply
changing the form of the position and not the value.
On ex-date:
Long stock =
+$34(remember, the trader paid $65 for stock now worth $99)
Short $70 call = -$29
Dividend =
+$1
Net credit
+$6
The trader gains by the amount of the $1 dividend. But assume he is assigned instead:
Now he will lose the stock and receive $70 for it. In addition, he will lose the short call
obligation due to the assignment.
Receive $70 strike =
+$70
Paid $65 for the stock = -$65
Net credit
$5
Because the calls are both so deep-in-the-money, it is possible to execute the same strategy
with a short vertical as well (sell the $65 call and buy the $70 call). In a similar fashion, the
market maker will exercise the $70 in an attempt to capture the dividend and hope he is not
assigned on the $65. If he is assigned, he breaks even.
The market maker can take advantage of the strategy with any deep-in-the-money call
spread; he will exercise whichever call is long and hope he is not assigned on the other.
This strategy also explains why it is possible to see quotes such as bid $5 and ask $5 for
deep-in-the-money call spreads. The market makers, in these cases, are often trying to buy
or sell the spread for $5 in an attempt at a dividend play.
Remember, this strategy is only useful if you are paying very low commissions. We mention it
because it is useful for understanding why you may see your stock called the day before exdividend date.
Christmas Tree
A Christmas tree strategy is similar to a ratio spread. For calls, it involves the buying of one
strike and the sale of two higher strikes (for example, buy $50 call, sell a $55 call, sell a $60
call); for puts, a trader will purchase one strike and sell two lower strikes (for example, buy
$50 put, sell a $45 put, sell a $40 put). If you read our section on condor spreads, you may
recognize the strategy as a long condor spread without the upper protective wing (for calls) or
the lower protective wing (for puts).
The idea behind this strategy is that the trader lowers the cost basis of the long position by
selling two options against it, thereby accelerating the rate of return on investment. However,
unlike the ratio spread where multiple calls of a single higher strike are sold against the long
position, the trader instead sells multiple strikes. It is a lower risk, lower reward strategy
relative to the ratio spread.
Example:
A trader is bullish on a stock trading at $100 and wants to go long a Christmas tree. He will
buy the $100 call, sell the $105 call, and sell the $110 call for a net credit of $1. The profit
and loss diagram looks like this:
The trade is usually placed at a small credit and reaches maximum profit at the strike of either
short position. If the stock moves above the highest short call, $110 in this example, the
trader will start to lose profits and eventually end up with losses if the stock rises far enough.
The trader is effectively taking a little more conservative stance (although there is still the risk
of unlimited losses) relative to the ratio spreader.
Examples:
Corning (GLW) is currently trading for $59-3/4 with the following option quotes. Let's
compare a ratio spread with a Christmas tree and see how they differ. Investor A buys the
$60 call and sells two $65 calls.
Calls
Jan $50
Jan $55
Jan $60
Jan $65
Jan $70
Bid
13 5/8
11
8 1/2
6 1/4
4 3/4
Puts
Ask
14 3/8
11 3/4
8 3/4
6 3/4
5 1/8
Bid
4
5 7/8
8 1/4
10 7/8
14 1/8
Ask
4 3/8
6 3/8
8 3/4
11 5/8
14 7/8
This produces a credit of $3-3/4 as follows:
Buy $60 =
Sell 2 $65 =
Net credit
-$8 3/4
+$12 1/2
$3 3/4
Investor B enters a Christmas tree and buys the $60, sells the $65 and sells the $70 for a net
credit of $2-1/4 as follows:
Buy $60 = - $8 3/4
Sell $65 = +$6 1/4
Sell $70 = +$4 3/4
Net credit +$2 1/4
Notice the higher reward, $3-3/4 credit versus $2-1/4, with the ratio spread indicating the
higher risk.
From a profit and loss standpoint:
It is now easy to see the differences in the two strategies. The ratio spread has a higher
reward if the stock should fall or hit $65, the point of maximum profit for both strategies. If the
stock collapses, the ratio spread will keep the initial $3-3/4 credit while the Christmas tree will
keep $2-1/4. If the stock hits $65, the ratio spread makes an additional $5, the difference in
strikes, for a total profit of $8-3/4. Similarly, the Christmas tree will make $5 at a stock price
of $65 for a total of $7-1/4.
However, the ratio spread starts to lose profits for any stock price above $65, while the
Christmas tree does not start to lose them until $70 -- one strike higher.
At a stock price of $66-1/2, the two strategies are even; this is the point where the red line
crosses the blue line. Beyond $66-1/2, the Christmas tree strategy dominates the ratio
spread. This can be seen by the fact that the blue line (Christmas tree) is above the red line
(ratio spread) for all stock prices above $66-1/2. Likewise, the ratio spread wins for all stock
prices below $66- 1/2 and we can see that its profit and loss line is above the Christmas tree's
for all stock prices below this level.
The ratio spread will start heading into losses after the break-even $73-3/4, while the
Christmas tree will not start taking losses until the stock exceeds $77-1/4.
Christmas tree using puts
The Christmas tree with puts is used for the opposite reasons as above. Here, the trader is
bearish and wants to buy puts but sell two additional lower strikes to offset the cost.
Assume a trader is bearish on a stock trading at $100 and wants to go long a Christmas tree
using puts. He will buy the $100 put, sell the $95 put, and sell the $90 put for a net credit of
$1. The profit and loss diagram looks like this:
The trader will start to profit if the stock falls below $100. At a stock price of $95, he will reach
the maximum profit of $6 ($5 difference in strikes + $1 credit) and remain at this maximum
amount to a stock price of $90. Below $90, the trader starts to lose profits and will head into
losses below the break-even point of $84.
Examples:
Let's use the above option quotes again and compare a ratio spread with a Christmas tree.
Investor A again will enter a ratio spread and buy the $60 put and sell two $55 puts to finance
the purchase. His net credit is $3 as follows:
Buy $60 put = -$8 3/4
Sell 2 $55 = +$11 3/4
Net credit
$3
Investor B enters a Christmas tree and buys the $60 put, and sells the $55 and $50 puts for a
credit of $1 1/8:
Buy $60 put =
Sell $55 put =
Sell $50 put =
Net credit
-$8 3/4
+$5 7/8
+$4
$1 1/8
The profit and loss diagrams for the two strategies look like this:
Again, we see the ratio spread and Christmas tree make money if the stock falls below $100.
This should be the case, as both traders own the $100 put. However, Investor A with the ratio
spread will dominate as a higher credit was received from the initial trade ($3 versus $1-1/8).
This can be seen by the fact the red line is above the blue line through this range.
If the stock falls to $90, the ratio spread will reach maximum profit of $8 ($5 difference in
strike plus the initial $3 credit).
If the stock falls below $90, the ratio spread starts to lose profits; the Christmas tree will not
start to lose them until the stock falls below $85. The two trades are strategies that will be
equal at a stock price of $88.
Below $88, the Christmas tree dominates and we can see its profit and loss diagram is above
the ratio spreads throughout this range. The ratio spread will incur losses below the breakeven point of $82, while the Christmas tree's losses will occur below the break-even point of
$79.
The Christmas tree is a nice strategy for those wanting to utilize short positions to offset the
cost of long positions. They are a nice alternative for ratio spreads but still have unlimited
loss potential, so will require level 3 option approval from your broker. Christmas trees are a
lower risk, lower reward strategy relative to the ratio-spread counterpart.
If you like to enter ratio spreads, run through some numbers with the Christmas trees as well.
You may find you like the risk-reward structure much better.
Option Repair
If you have been buying stocks for any length of time, you have probably been in the situation
every investor dreads -- seeing your stock down twenty or more percent from your purchase
price.
Some of you may be thinking that will not happen to you because you use stop orders to
prevent such losses. Well, even if you use stop orders, large losses can occur between
trading days (known as gap downs). For example, a stock can close at $75 one night and
open the next day at $60. If you have a stop order in at $75, you will be filled at $60. If you
have a stop limit at $75, you will not be filled at all. In either case, the stop did not work as
expected and you're down!
Fortunately, with the use of options, we can sometimes get out of these precarious positions
with ease. To do so, you need to understand the option repair strategy.
Option repair strategy
This strategy is a very clever, yet simple strategy. Many investors would not think to do it,
which is what makes it a powerful tool to add to your list of strategies.
The repair strategy does have a couple of assumptions. First, you must be at least
moderately bullish on the stock over the short term. If you think the stock is heading south,
you are probably best selling at a loss or buying protective puts as a full or partial hedge.
Second, you are assumed to be trying to get out of the position by just breaking even (or
close to it). In other words, this strategy is not used as a high profit one; it is designed to get
you out of a bad situation for nearly break-even. So if you're in a losing stock situation and
thinking, "Just get me my money back and I'll walk away," then this may be the strategy for
you.
With the above assumptions, we can accomplish a break even with the repair strategy.
Here's how the strategy works:
Say you buy 1,000 shares of stock at $50 and it is now trading for $40 -- down 20%.
You think the stock will rise to $45 but not much past that; you must be somewhat bullish in
order for the strategy to work. The way to design a repair strategy under these assumptions
is to look for a ratio call spread you can write for free (if you are not familiar with these, please
see our section on "Ratio Spreads"). How do we do that? In our example, we may buy 10
$40 calls for $5 and write 20 $45 calls for $2-1/2.
Here are the transactions:
Buy 10 $40 calls for $5 =
-$5,000
Sell 20 $45 calls for $2-1/2 = $5,000
Net cost
$0
Notice that we bought 10 and sold 20 -- a ratio call spread. Normally, a ratio writer is
subjected to unlimited upside risk. However, because you already own shares, you can cover
10 of the short $45 calls with your stock and the remaining 10 contracts with the $40 call.
Effectively you are writing 10 $45 contracts as a covered call plus entering 10 $40/$45 bull
spreads. Because we can write a twice as many calls as we need to purchase, the long $40
calls cost us nothing!
In most cases, you will be limited to no more than a five-point difference in strikes. In other
words, this strategy will usually not work by buying the $40 and selling the $50 calls, because
that is a ten-point difference in strikes.
Now, if the stock does move to $45 at expiration, the long shares will be worth only $45 (the
short $45 calls will expire worthless). The $40/$45 bull spread will be worth $5 points for a
total of $50 points.
Here are the transactions in detail:
Transaction
Account Value
Buy the stock at $50
Stock falls to $40
Buy 10 $40 calls, Sell 20 $45 calls for $0
Stock rises from $40 to $45
$50,000
$40,000
$40,000
Long stock now worth $45,000
Long $35/$40 spread worth $5,000
Total account value = $50,000
In effect, we have leveraged the account for an upside move for no money down or additional
risk. Our trade-off is that we cap our upside returns. But if you are not long-term bullish, then
capping the upside in exchange for break-even may make perfect sense for a particular
situation.
In the example above, does the stock need to close at exactly $45 in order for the strategy to
work? No, it will work as long as the underlying stock rises to $45 or higher. Say the stock
rallies all the way back to $50 at expiration. Now your long stock is worth +$45 (remember,
you have a $45 covered call against the shares), and your long $40/$45 calls spread is worth
+$5 for a total of $50.
Any stock price above $45 at expiration will result in the total position being worth $50.
It is also helpful to look at the various option strikes and months, known as option chains, to
help make your decision as to which options to buy and sell. You can get these through most
brokerage firms or from the Chicago Board Options Exchange at http:/www.cboe.com.
The option repair strategy is yet another demonstration as to the versatility of options. We
have taken these "risky" assets and used them in a way to leverage our returns for no money
down. If you take the time to learn and understand these assets, you will greatly improve
your portfolio performance.
Ex-Dividend Dates
As you invest in stocks, you will encounter the words "ex-dividend date." This is a term that is
important to understand -- what it is and how it works. Ex-dividend dates govern who gets
dividends, split shares, spin-off shares, or any other form of payment or distribution from the
company.
Many option strategies depend on the payment of a dividend on the underlying stock and, if
you miss the payment, the strategy could be shot. Even if you are not using options, it helps
to understand ex-dividend dates if you wish to collect a dividend on a stock.
Many stocks pay dividends, which are simply distributions of cash given to shareholders. If a
stock pays a 10-cent dividend and you own 100 shares, you will receive 100 shares * 0.10 =
$10 from the company.
In fact, stock splits are really just dividends paid in the form of stock. If you have 100 shares
and they split 2:1, your account statement will show a 1-share dividend paid on your
statement. That just means that you received 1 share for each share owned. In this example,
you'd receive 100 shares * 1 share dividend = 100 shares, which when added to your original
100 shares equals 200 shares and is what you'd expect after a 2:1 split on 100 shares.
There's no question as to who gets the dividends (or split shares) if you've been the one
holding the stock all along. But what if you purchased the stock close to the time the dividend
is paid? Will you get it or will it be the person who sold the stock?
To answer that question, we need to know the ex-dividend date.
What Is the Ex-Dividend Date?
The ex-dividend date, also called the ex-date, is the date the stock trades without the
dividend. Just remember that "ex" means without, and you will not be prone to one of the
most common mistakes made by investors (and brokers too).
Let's say a stock is about to pay a dividend, and the ex-date is June 10. If you buy the stock
on June 10 or later, you will not get that upcoming dividend. Remember, ex means without. If
you buy the stock on the ex-date (or later), you are buying the stock without that dividend.
If you buy the stock before June 10, you will get the upcoming dividend when it is paid.
If you just focus on the ex-date and nothing else, it is very easy to determine who gets the
dividend and who does not.
More Examples:
1) ABC stock will pay a 5-cent dividend and the ex-date is August 18. You sell your shares on
August 18. Will you get the dividend?
Answer: Yes. The buyer of your shares purchased them on the ex-date. They purchased the
shares without the dividend, which means you are entitled to it.
2) Using the above example, what if you sold your shares on August 17 or before?
Answer: You will not get the dividend. The buyer of your shares is purchasing them before the
ex-date, which means they are entitled to it.
If you want to receive the upcoming dividend, you must purchase the shares before that exdate. Likewise, if you are selling your shares but want to receive the upcoming dividend, you
must sell those shares on or after the ex-date.
Hopefully you can see how straightforward dividends can be if you just concentrate on the exdate.
Why Is There So Much Confusion in Practice?
The reason for all the confusion is that when a dividend is announced, there are usually three
dates associated with it:



Record date
Ex-date
Payable date
Usually, companies only publish the record date and payable date in the newspaper. In many
cases, the companies will not even be able to tell you what the ex-date is, even if you call
investor relations, and we'll show you why shortly.
The only date that matters to the company is the record date. Before the company pays the
dividend, they look up a list of names of all investors who are owners of their stock as of the
record date and pay the dividends to those names. For example, XYZ may announce they will
pay a dividend to all shareholders of record as of March 15. If you own the stock as of this
date or before, you will get the upcoming dividend.
Here's where the confusion sets in for most investors...
In order to be the owner of record, the stock transaction must be settled by the record date.
Keep in mind there is currently a three-business day settlement period! If you want to be a
record holder as of March 15, you need to purchase it as of March 12 (assuming those are
business days with no holidays). If you purchase the stock on March 12, the stock transaction
will settle on March 15, and you will be owner of record as of March 15. Now you can see
where all the confusion comes from. It all has to do with the timing of the settlement period.
Back to the Ex-Date
Fortunately, the ex-date was created by brokerage firms to mathematically figure out the
purchase date that makes you owner by the record date. In the previous example, March 13
would be the ex-date. If you purchase on or before March 12, you will be owner of record by
March 15.
Corporations are not stockbrokers and they are not, in many cases, even aware of the threebusiness day settlement period. They only publish the record date. This is why most firms will
not even be able to tell you what the ex-date is.
Many investors believe if they purchase shares on or before the record date, they will get the
dividend. This is false! In the previous example we said March 13 was the ex-date. If you
purchase your shares on March 13, it will settle three business days later on March 16 -- one
day too late. The stock will not settle by March 15, and you will not get the dividend.
Hopefully you see how much easier it is if you just focus on the ex-date, which you may have
to call your broker to get. If you wish to focus on the record date, that's okay too, but just be
sure you are purchasing the stock far enough in advance to make settlement by the record
date.
Stock Splits
As mentioned, stock splits are really nothing more than dividends. If a stock is about to split
2:1 and you want to get the split shares, you can call your broker and ask for the ex-date,
which we'll assume is May 10 for this example. If you buy 100 shares before May 10, you will
end up with 200 shares. If you buy 100 shares on May 10 (or later), you will buy the shares at
the cheaper price but will not get the additional shares.
Does It Matter If I Get the Dividend?
In most cases, it doesn't even matter if you get the dividend or not. Many new to investing find
this hard to believe. After all, it certainly seems like you'd be better off buying the stock and
getting the dividend rather than not getting the dividend, right?
The reason there is not a difference is that the stock price is reduced by the amount of the
dividend (rounded up to the nearest 1/8) on the ex-date! For instance, say a stock closes at
$100 on March 19 and is scheduled to pay a $2 dividend with an ex-date of March 20. On
March 20, the stock will open at $98 unchanged to reflect the $2 dividend that was paid. The
reason the stock will show unchanged is because the drop in price from $100 to $98 was due
to the dividend and not changes in supply and demand for the stock.
Let's compare two investors: one who buys the stock before ex-date and another who buys it
on the ex-date. You will be convinced there is no difference.
The investor who buys before the ex-date will pay $100 for the stock and receive a $2
dividend. The stock, however, will trade for $98 on the ex-date, and the total value of the
position will still be $100 ($98 in stock and $2 in cash). This investor is down $2 in the value
of the stock, which is offset by the $2 dividend.
A second investor who buys the stock on the ex-date will only pay $98 for the position and not
receive the dividend. While they are not down $2 on the value of the stock, they did not
receive the dividend either. Both investors are holding stock worth $98, and neither investor is
down overall.
So it doesn't really matter mathematically whether you get the dividend or not (although there
could be tax benefits to one choice over the other).
Rules Violation: Selling Dividends
Many brokers take advantage of investors by touting an immediate return on your money by
purchasing stock just before the ex-date. Using the above example, a broker may call and
say, "If you buy this stock for $100, you will get an immediate 2% return on your money the
very next day." By now you should understand why this is not true.
If you buy the stock for $100, it will be worth $98 the next day, and you will have $2 in cash
for a total position value of $100, which is neither a gain nor a loss. If this were really an
immediate return of 2%, the position would be worth $102 the following day.
Further, buying the stock just to get the dividend is a bad idea for tax reasons. If you buy one
share of stock for $100, you are paying with after-tax dollars; you do not owe taxes on the
$100. However, if you buy the stock, the very next day your position is still worth $100, yet
you owe taxes on $2. Basically, the dividend represents an immediate taxable return of
capital (where previously there was none) and not a return on your money.
For these reasons, the NASD prohibits brokers from selling you stock solely for the reason of
getting the dividend. Obviously, if the broker thinks the stock is going to be much higher in the
next day or two and recommends buying it for that reason, that's okay. They just cannot sell
you the stock based solely on the immediate return of the dividend. If they do, they are guilty
of "selling dividends" and in violation of NASD rule 2830, which states:
NASD Rule 2830 (e): No member shall, in recommending the purchase of investment
company securities, state or imply that the purchase of such securities shortly before an exdividend date is advantageous to the purchaser, unless there are specific, clearly described
tax or other advantages to the purchaser, and no member shall represent that distributions of
long-term capital gains by an investment company are or should be viewed as part of the
income yield from an investment in such company's securities.
While some option strategies rely on payments of dividends (please see "Dividend Play" in
this week's courses), keep in mind that you will never receive dividends from holding options.
If you own a call option and wish to receive a dividend, you must exercise the call option and
take delivery of the underlying stock before the record date.
A Real Life Example
The following is an excerpt from a Business Wire news article:
FAIRFIELD, Conn. -- (BUSINESS WIRE) -- Dec. 14, 2001 -- The Board of Directors of GE
today raised the Company's quarterly dividend 13% to $0.18 per outstanding share of its
common stock and increased its share repurchase program to $30 billion from $22 billion.
"GE has paid a dividend every year since 1899," said GE Chairman and CEO Jeff Immelt.
"Today's increases, in both our dividend and our share repurchase program, signal our
confidence in our ability to extend this track record of returning value to shareowners."
The dividend increase, from $0.16 per share, marks the 26th consecutive year in which GE
has increased its dividend. The dividend is payable January 25, 2002, to shareowners of
record on December 31, 2001. The ex-dividend date is Thursday, December 27.
Questions:
1) If you buy 100 shares of GE on December 27, will you get the dividend?
2) What is the last day you could purchase the stock and get the dividend? If you buy 100
shares, how much money will you receive? When will you receive it?
3) Why do you suppose there are four days between the ex-date and the record date?
Answers:
1) No. December 27 is the ex-date, and you will not get the dividend if you buy on or after this
date.
2) The last date you could purchase shares to get the dividend is December 26. If you have
100 shares, you will receive 100 * 0.18 = $18.
3) Notice that the ex-date is Thursday. This means that the last day to buy the stock and get
the dividend is Wednesday. If you buy on Wednesday, the stock will settle three business
days later on Monday, December 31, which the article shows as the record date.
Using Options to Take Delivery
If you wish to take delivery of the stock in order to get the dividend, you should wait as long as
possible (please see our course in week 1 on "Early Exercise" for reasons why you should
wait as long as possible) and exercise the call option the day before the ex-date. You must
exercise the option the day before the ex-date because options take one day to settle, which
will be on the ex-date. At that time, the stock will be delivered in three business days with your
name as owner of record. As always, if there are any questions, you should contact your
broker before entering the trade.
In cases where you are trying to capture a dividend (or avoid one), focus on the ex-date, and
there will be no unwanted surprises!
Naked Put Alternatives
Spreads as an alternative to naked puts
This section probably belongs under "Basic Spreads," but it is so powerful we feel it qualifies
as its own strategy. It is one that is highly overlooked, even by the most seasoned investor.
If you ever use the strategy of naked puts, you will want to reconsider once you see the
difference a spread can make!
Naked put strategy
As a review, recall that the strategy of selling naked puts is actually neutral to bullish. If the
stock sits still or rises, the trader will profit by the amount of the initial credit. However, many
traders add a twist to this strategy and use it as a way to purchase stock. They sell puts on
stocks they do not mind owning if the put is assigned. Because of this, they feel it is a winwin strategy. If the stock rises, they keep the premium; if it falls, they got paid to buy a stock
they wanted to buy anyway.
It is these investors we want to target in this section. We'll show you an alternative strategy
for selling naked puts.
In fact, this strategy is especially useful for investors who wish to sell naked puts (which
requires level 3 option approval) but only have approval to enter spreads (level 2). This
strategy allows you to effectively sell naked puts in a level 2 account!
Using far-out-of-the-money spreads
Assume you are willing to buy 1,000 shares of Intel (INTC) currently trading around $42-1/2.
Instead, you elect to sell a naked put, and the Jan $40 put is trading for $3. If you sell 10
contracts at $3, you bring in a credit of $3,000 and keep this amount regardless of what
happens to the stock. If the stock should fall below $40, the strike, you may be required to
purchase it at $40 if the long position decides to exercise. From a profit and loss standpoint
your max gains and losses are as follows:
Maximum gain: $3,000
Maximum loss: $37,000
The most you can make is $3,000, but the risk is that you may be forced to buy stock at $40,
which theoretically, could be worthless. You offset this $40 loss with the initial credit for a
max loss of $37,000.
Now I know some of you are saying that Intel will never go to zero, so the argument is invalid.
Well, it's probably true that it won't go to zero, at least anytime soon, so that may not be a
probable risk. It is, nonetheless, the worst that can happen from a naked put, and that's how
we have to base our decisions. Besides, there are many newer companies that can go very
close to zero even though they were high-fliers at one time, so the risk is very real.
Microstrategy (MSTR) rose from $7 to over $300 within a year -- only to return to $3 for the
longest time. Currently, it is trading around $16- 1/2. If you sold the $300 puts, believe me, it
felt like worthless stock no matter how much you received for the put. Iomega (IOM) went
from $3 to over $100 in a short time and back to $3 even quicker. Egghead.com (EGGS) fell
from $55 to the current price of $1-1/2. There are numerous examples, so please do not
discount the maximum loss zone.
Back to the example. Let's now compare a trader who enters a spread order. He will sell the
$40 put for $3 but simultaneously buy a far-out-of-the-money put, say a Jan $25, trading for
$1/4. Because these are simultaneous orders, it's very likely to get a better fill between the
two prices, but we will ignore that for now.
From a profit and loss standpoint:
Maximum gain: $2,750
Maximum loss: $12,250
This trader will take in a credit of $2,750 instead of the $3,000 the naked put trader received.
This is because the spread trader will use $1/4 ($250) of his proceeds to buy the $25 strike
put. In doing so, he now eliminates 25 points of risk to the downside. His maximum loss is
only $12,250 versus $37,000 for the naked put.
The result is this: The naked put trader increased his returns by only 1/4 point in return for
accepting an additional $24,750 potential loss ($37,000 versus $12,250). That is a very
expensive 1/4 point.
Naked puts are a great strategy, especially if you are selling against stocks you would like to
buy regardless. However, when things go bad, they can really go bad. This is the real risk of
naked put writing. Using spreads can eliminate this risk cheaply.
Comparing the two profit and loss diagrams:
We see the two traders are virtually identical for all stock prices down to $25. In fact, they are
only separated by 1/4 point, which was the difference in initial proceeds. However, if things
go bad and INTC falls below $25, the spread trader will be very happy to have the long $25
put as insurance.
Which profit and loss diagram looks more appealing to you? Would you pay 1/4 point for it?
In addition, most brokerage firms will charge you the lesser of the full spread requirement
(difference in strikes less the credit) or the naked requirement. So you will never be worse
off, from a margin standpoint, with the spread order. Granted, it will cost you an extra
commission, but in most cases, this will be well worth it.
Using far-out-of-the-money spreads as an alternative to naked puts is a form of catastrophe
insurance. The trader in the above example is "insured" for all prices below $25. Again, it is
unlikely for Intel to fall below this point, which is why the markets are pricing the $25 put at
$1/4. However, when using any form of insurance, it is wise to buy insurance on high-severity
and low-probability events, and that's exactly what a far-out-of-the-money put spread does for
you; it insures against low-probability catastrophes.
Take a look at the following charts to see just how big and fast a catastrophe can happen!
Headline: Lilly shares fall more than 31% as ruling speeds generic prozac
(8/09/00)
Headline: Apple computer falls more than 52% on 4th-quarter earnings estimates
(9/28/00)
Headline: Priceline.com down 42% on 3rd-quarter estimates (9/27/00)
Headline: Xerox down 26% as sales decline and 3rd-quarter loss expected
Headline: Eastman Kodak falls 25% on profit warning
(9/26/00)
(10/03/00)
Headline: Intel falls 22% on 3rd quarter revenue warning (9/22/00)
Headline: Lucent shares fall 23% on 4th quarter earnings
(10/10/00)
Hopefully you will see far-out-of-the-money put spreads as an enhanced alternative to naked
put selling. Many investors have gone broke selling naked puts on "good" companies.
However, good companies do not always report good news as the above charts
demonstrate. It is during these times the value of the far-out-of-the-money spread strategy
will be realized.
Ratio Spreads
Ratio spreads are a very powerful strategy and can be done with calls or puts. In theory, they
are probably the perfect trade as they provide for buying the valuable options and selling off
higher amounts of the "worthless" options to finance the long position. But they do come with
great risks to the tune of unlimited losses at an accelerated rate if the stock moves above the
strike of the short position.
The mirror image of the ratio spread is the backspread. If you place a ratio spread, the trader
on the other side has a backspread.
Call ratio spreads
A call ratio spread consists of buying a lower strike call and then selling a higher number of
contracts of a higher strike price.
Example:
A trader is bullish on MRVC currently trading $37-3/4. The trader thinks the stock will go
above $40 by December but not above $50. A ratio spread, under these circumstances, may
be a perfect strategy:
Buy 10 Dec $40 calls = $5 1/4
Sell 20 Dec $50 calls = $2 1/4
Net debit
$3/4
We have arbitrarily chosen the ratio of 10 and 20 (buying 10 and selling 20). The trader could
have bought 10 and sold 11, or bought 50 and sold 150, or any other ratio among the infinite
combinations. We will see shortly why a trader will choose one ratio over another.
First, we need to understand how we arrived at a net debit of $3/4 in the above trade.
There are two fairly easy ways to figure this out, and whichever one works for you is fine. The
first and probably best way to understand the ratio spread is to break the trade up into the
smallest component parts. To do this, we need to find the highest number that is common to
the 10 calls we're buying and the 20 we're selling (in math terms, the greatest common
factor).
The highest number, in this case, is 10; there is no number higher than 10 that can go into
both 10 and 20 evenly. If we divide the buy 10 and sell 20 calls by our greatest common
factor, we arrive with buy 1 call and sell 2, a basic unit. The trader in the above example is
just executing this basic spread 10 times.
In other words, he could call his broker and say, "Buy 1 and sell 2, Buy 1 and sell 2, Buy 1
and sell 2..." The trader could repeat this order 10 times and, in the end, would have
purchased 10 and sold 20.
In trader's jargon, this person executed 10 1 by 2 spreads which is usually written as 10 (1 x 2) spreads.
Examples:
If a trader:
buys 7 and sells 21: This is 7 (1 x -3) spreads
buys 3 and sells 7: This is 1 (3 x -7) spread
buys 16 and sells 24: This is 8 (2 x -3) spreads
Now that we know the basic unit is 1 by 2, let's look at the above trade again. Effectively the
trader has done this:
Buy 1 Dec $40 calls = $5 1/4
Sell 2 Dec $50 calls = $2 1/4
The trader purchases 1 for $5-1/4 and sells 2 for a total of 2 * $2 1/4 = $4-1/2. They paid $51/4 and received $4-1/2 for a net debit of $3/4.
The second method may be a little easier:
Buy 10 $40 calls for $5 1/4 =
Sell 20 $50 calls for $2 1/4 =
Net debit
-$5,250
+$4,500
$750
The trader buys 10 calls for a total of $5,250 and sells 20 for a total of $4,500. The net
difference is $750. Because he is trading 10 spreads (yes, you still have to be able to break it
down into component parts!), we need to divide $750 by 1,000 (because 10 contracts
represent 1,000 shares) for a net debit of $3/4 per spread.
Important note: It is very important to understand how to calculate these figures if you are
executing a ratio spread, because it is a complex strategy and will require level 3 option
approval. If your broker calculates this incorrectly, they may hold you either partially or fully
liable for the trade. Why? Because on the options application you will have to check the box
designating "excellent" knowledge to get level 3, and they may hold you to this.
Now we know the trader is trying to execute 10 (1 x -2) spreads for a net debit of $3/4. The
total debit from his account will be 1,000 * $3/4 = $750.
Can the market maker fill only part of the trade?
Yes, but not just arbitrarily. Because the minimum spread, in this example, is 1 by 2, the floor
trader could give your broker a confirmation of buy 1 sell 2, buy 2 sell 4, buy 3 sell 6, and so
on up to the total of buy 10 and sell 20. They could not, for example, return a confirm of buy 2
sell 20. It will always have to be a multiple of the basic unit, which is 1 by 2 for this trade.
An "all-or-none" restriction will prevent partial fills but are generally inadvisable, as option
quotes are good for a minimum of 20 contracts. If you put an "all-or-none" restriction on the
order, it is possible to get no execution, and you cannot hold the floor to time and sales. So
use "all-or-none" orders sparingly and it's probably best to never use all-or-none's for orders
of 20 contracts or less.
Let's assume our trader gets filled on all 10 (1 x -2) spreads and spends $750 to do so. What
does the position look like from a profit and loss standpoint? (If you are unsure how to read
these charts, please see our section under "Profit and Loss Diagrams.")
We see that the trader will lose the entire $3/4 per spread, or $750, if the stock is below $40
at expiration. The trader will maximize profits at $50, the strike price of the short position.
What will be the max profit? The maximum this spread can be worth is $10, the difference in
strikes; however, the trader paid $3/4, so the max profit will be $10 - $3/4 = $9 1/4.
It is easy to see where the danger is with the ratio spread; there is unlimited upside risk. The
trader will start to lose profit with the stock above $50 at expiration, and will break-even at
$40-3/4 and $59-1/4. The downside break-even is simple to figure; the trader paid $3/4 for
the position, so he must make this up. If the stock is at $40-3/4 at expiration, the long call
position will be worth $3/4 and the short position will expire worthless, so the trader will break
even.
It can be a little tough to figure the break-even on the upside, so we'll spend some time here.
For all the math people, one easy way to figure it is to understand that the slope will be
negative one due to the 1:2 ratio of the spread. With a slope of negative one, the stock must
move 9-1/4 points (the max profit) to the right of $50 (the stock price at max profit), which puts
you at a stock price of $59-1/4. This method does require a solid understanding of graphs
and slopes so do not use it if this does not make sense to you. I only mention for those who
do understand mathematical slopes, as it is easy to calculate in your head if you do. As an
example, if the trader entered a $40/$50 1 by 3 ratio spread for a net debit of $3/4, the breakeven point to the upside would occur at twice the rate; a slope of negative 2. Now, instead of
moving 9-1/4 points to the right, the stock will only have to move half this distance or $4-5/8
for a break-even price of $54-5/8.
To be on the safe side, especially if you are new to ratio spreads, the following method will be
the best, but does require basic skills in algebra. Start by understanding that the definition of
break-even is where revenues equal expenses, so:
If we let S represent the stock price at expiration,
Our profits will be (S - $40), because we will have intrinsic value of this amount on the long
position. Our expenses will be 2* (S - $50) - $3/4. This is because we sold two contracts for
every one purchased and they will have S - $50 for value which is a liability to us. In addition,
we spent $3/4 for the trade, which is also an expense. Now put the two equations equal to
each other and solve:
S - $40 = 2 * (S - $50) - $3/4
S - $40 = 2S - $100 - $3/4
After collecting all like terms to one side, we see S = $59-1/4.
If you understand nothing about the break-even point to the upside, at least understand this:
there is unlimited risk to the upside in a call ratio spread! The larger the ratio, the more
accelerated the losses become.
Why enter a call ratio spread?
This is a popular tool among floor traders and there are good reasons it is well liked. The
basic reason is this: it allows the trader to buy the "good" option cheaply by financing it with
the "junk" option -- the one he feels will never have intrinsic value. By doing so, the return on
investment is radically magnified.
Example:
Assume our trader above was bullish and just bought 10 calls of the $40 strike with two
months to expiration. He would have paid $5-1/4 per contract or $5,250. Let's also assume
the stock closes at $50 -- our trader's expectation -- at expiration. This position would be
worth 10 points on 10 contracts for a total of $10,000; however, the trader will net $4,750 after
costs. The return on investment is roughly 90-1/2% or 4,675% annualized!
Now let's look at our trader who entered the ratio spread. Effectively, he is buying the 10 $40
strike contracts for only $3/4 of a point instead of the $5-1/4 of the long call trader. Of course,
this does not come for free, as the ratio trader is faced with unlimited risks to the upside; the
long trader would simply make more money as the stock moves higher. Assuming the
trader's assumption that the stock will not rise (or at least significantly) above $50, let's see
how the ratio spread fares:
Buy 10 Dec $40 calls =
Sell 20 Dec $50 calls =
Net debit
$5 1/4
$2 1/4
$3/4
Again, assuming the stock closes at $50, this trader will also make $10 points on the spread,
as the short $50 calls will expire worthless. The return on investment here is 1,233% or
561,865,400%
You can certainly see where the incentive is to trade ratios! Be careful, the market does not
allow for these returns for nothing. The ratio spreader took a proportionately higher risk to
capture that kind of profit.
Why would a trader enter a different ratio?
We have demonstrated the advantage of the ratio spread,which is magnified gains if you are
correct in your assumptions. If the trader feels really sure about his assumptions and is
willing to take the risk, he may decide to enter into a larger ratio. Let's run through the above
example again, but this time, assume the trader enters a 1:3 ratio spread.
Buy 10 Dec $40 calls = $5 1/4
Sell 30 Dec $50 calls = $2 1/4
Net Credit
$1 1/2
This trader actually gets a credit from the net transactions, effectively getting paid to take the
10 long $40 strike calls. Again, do not be fooled into thinking it comes for free!
How did we figure the credit? The trader bought 1 for - $5-1/4 and sold 3 for a total of + $63/4 for a net of $1-1/2 credit per spread.
We know he bought 10 (1 x -3) spreads for a total credit of $1,500. By the way, this is still
considered a buy even though a credit is received. This is because the trader wants the
spread to widen.
The profit and loss diagram looks like this:
It is now easy to see the differences. As the number of sells increases relative to the buys,
the profit and loss diagram will shift upward as in the 1:3 ratio (red) compared to the 1:2
(blue). That's the good part; the long position gradually becomes cheaper to own, and the
trader will receive a credit if enough of the short calls are sold. Now for the downside, as
more are sold, the downside break-even point approaches much more rapidly, which means
you head into losses at a faster rate.
For the 1:3 spread, the trader received a credit of $1-1/2 so there is no downside breakeven.
The trader will have a $1-1/2 profit even if the stock collapses. The maximum gain is the 10
points on the spread plus the $1-1/2 received, for a total of $11-1/2.
As for the upside break-even point, (for the math people again) we know the slope is negative
2, so the $11-1/2 maximum gain will fall at twice the rate or $5-3/4. So if the stock price is
$55 3/4 at expiration, this trader will be at break even.
Algebraically, our revenues at expiration are:
S-$40 + $1-1/2
And the expenses are:
3 * (S-$50)
Putting these two equal to each other:
S - $40 + $1-1/2 = 3 * (S-$50)
S - $40 + $1-1/2 = 3S - $150
2S = $111.50
S = $55-3/4
If you want to check it, assume the stock is at $55 3/4 at expiration. The long calls will be
worth +$15 3/4 (intrinsic value) and the short calls with be worth 3 * $5-3/4 = $17-1/4 which is
a liability because it is a short position. So, the trader has +$15- 3/4 and - $17-1/4 for a net
loss of $1-1/2 which exactly offsets the $1-1/2 credit received at the onset of the position.
The real risk to the trader is if the call ratio trader is if the stock makes a large move to the
upside, especially between trading sessions. For example, the trader in the above trade
could be holding the position with the stock now at $48. The next trading day, the stock
opens at $60 and continues trading higher. In this instance, the trader never has a chance to
get out of the position until large losses have occurred. Floor traders will generally close them
out long before the risk gets too great, and if the stock collapses, often end up with a credit
from the trade.
Ratio spreads with puts
Ratio spreads can be established with puts as well. A put ratio spread allows the investor to
play the downside for much less money then either a long position or regular spread position.
To establish a ratio spread with puts, the trader will buy one strike price and sell a higher
number of contracts of a lower strike price.
Assume a trader is bearish and we have the following quotes on MRVC:
Buy 10 Dec $40 puts = $7 1/2
Sell 20 Dec $30 puts = $2 3/8
Net debit
$2 3/4
The trader effectively buys 10 $40 strike puts for $2-3/4 instead of $7-1/2.
The profit and loss diagram looks like this:
We see, as expected, that the put ratio spread is exactly opposite the of the call ratio spread.
Here, that maximum gain is at the strike price of the short $30 put. At this point, the spread
will be worth $10 to the trader for a net of $7-1/4 after the $2-3/4 cost is subtracted. Below
$30, the trader starts to lose profits and hits break-even at $22-3/4. If the stock should fly to
the upside, the maximum the trader can lose is the original $2-3/4.
Ratio spreads are a wonderful tool for trading. The spreads can all be custom-tailored to suit
your specific needs and sentiment of the underlying stock. They can, depending on how
they're used, have substantial risks and will require the use of naked options approval
(usually level 3 for most firms) from your broker.
Practice doing "paper trades" if you're new to ratio spreads, as they will greatly improve your
understanding of options, strategies, and position management techniques.
Option Exam 8 - Week 8
1) A Christmas tree strategy is similar to a:
a) Straddle
b) Ratio spread
c) Buy-write
d) Sell-write
2) Which of the following is a Christmas tree?
a) Buy $100 call, sell 2 $105 calls
b) Buy $100 call, sell a $105 call, sell a $110 call
c) Buy $100 call, sell 2 $105 calls, buy a $110 call
d) Buy $100 call, sell a $105 call, buy a $110 put
3) A $50 call is quoting $8, the $55 call is $6, and the $60 call is $3. What is the net
debit/credit for a long Christmas tree?
a) Net debit $1
b) Net credit $1
c) Net debit $11
d) Net credit $11
4) A long Christmas tree has:
a) Unlimited upside risk
b) Limited upside risk
c) Unlimited downside risk
d) Limited downside and limited upside risk
5) Christmas trees are usually initiated for a(n):
a) Credit
b) Debit
c) Net zero
6) Compared to ratio spreads, Christmas trees are usually:
a) A higher risk, lower reward strategy
b) A higher risk, higher reward strategy
c) A lower risk, higher reward strategy
d) A lower risk, lower reward strategy
7) You wish to write a naked put. However, your broker is only able to get you approved for
spreads and not naked positions. You should:
a) Transfer the account
b) Consider far out-of-the-money credit spreads
c) Just stick to stocks
8) In order to execute an "option repair" strategy, you must be _____ on the underlying stock.
a) Bearish
b) At least mildly bullish
c) Neutral
9) An "option repair" strategy has:
a) Limited risk
b) Unlimited risk
10) When might you see the bid and ask for a spread the same price?
a) After ex-date
b) Prior to ex-date
Butterfly
As you become more involved in trading options, you will no doubt hear about a strategy
known as the "butterfly spread."
The butterfly spread is one of many strategies that belong to a family collectively known as
"wing spreads"; they get this name, as you will soon see, from the shape of their profit and
loss diagrams.
The butterfly spread is avidly written about in many options books, so it tends to attract
traders who want to venture into new strategies. But because the strategy involves three or
four separate commissions (and sometimes more depending on how the spread is
constructed) to open and the same number to close, it is very costly and typically not a good
strategy for the retail investor.
The butterfly spread is really designed for floor-traders to take advantage of pricing
discrepancies between spreads. While it is not an arbitrage play, it stacks the odds in their
favor, largely due to the fact they are not paying retail commissions.
The long butterfly spread
A basic butterfly spread involves three strike prices, which we shall generically call low,
medium, and high. For the long butterfly, the trader will buy 1 low strike, sell 2 medium
strikes, and buy 1 high strike all with the same expiration dates. The butterfly can be
executed with either calls or puts (or a combination). The high and low strikes must be the
same distance from the medium option.
Example:
A stock is trading at $100, and a trader wants to place a butterfly spread. The trader may buy
1 $95 call, sell 2 $100, calls and buy 1 $105 call. Notice how the high and low strikes are the
same distance, in this example $5, from the medium strike. This would be called a
$95/$100/$105 butterfly. Sometimes traders will just refer to the "body" of the butterfly and
call it simply a $100 butterfly.
The long butterfly spread is always executed in a 1-2-1 pattern -- buy 1, sell 2, buy 1. Of
course, you could elect to do multiple spreads in which case your pattern would be 2-4-2 or 36-3 or any other combination as long as the middle strike is always double the number of
contracts as either the high or low.
If you execute a 2-4-2 pattern, this is considered 2 butterfly spreads; a 3-6-3 is considered to
be 3 spreads.
Understanding the butterfly
There are many ways to view a butterfly spread. In fact, there are probably an infinite number
of ways to construct one although most investors who are faintly familiar with them will tell you
there are only two ways (either with calls or puts) and always three strikes. A trader can use
calls, puts, combinations of the two, and synthetic versions of each piece of the butterfly to
create the same profit and loss diagrams. All ways are equally correct as long as the profit
and loss diagrams look the same.
One of the easiest ways to view the long butterfly is as a combination of a long bull spread
and a long bear spread. For example, the trader in the above example went long 1 $95 call,
short 2 $100 calls, and long 1 $105 call. We can look at that trade in another way as follows:
Long $95 call
Short $100 call
This is the bull spread
Short $100 call
Long $105 call
This is the bear spread
We see the long bull and long bear spreads consist of exactly the same pieces as the
butterfly spread: long 1 $95, short 2 $100, long 1 $105.
If you understand the butterfly spread in this way, it will help to understand why it is so useful
to the floor traders.
Why floor traders love butterflies
Let's assume a stock is trading for $101 and we see the following quotes on some call
options:
Option
$95 call
$100 call
$105 call
Quote
$10
$8
$6
We know from basic option pricing that the $95 call should be more than the $100 and the
$100 more than the $105, and we see that they are. In addition, the differences in price do
not exceed the strikes, so no problems there (if you are unsure about these principles, please
see our section under "Basic Option Pricing").
However, after checking these basic relationships, market makers will additionally check
spreads and straddles for other possible mispricings.
Here is what they will look for: the $95/$100 bull spread becomes more valuable as the stock
rises. In fact, the maximum profit is achieved if the stock price is above $100 at expiration.
With the stock at $101, the bull spread, at this point, would be at maximum profit if the options
were to expire instantaneously.
Now let's look at the bear spread. The bear spread consists of the short $100 call and the
long $105 call. This spread will become more valuable as the stock falls; in fact, the
maximum profit here will occur if the stock is below $100 at expiration. The bear spread,
unlike the bull spread at this point, will be below maximum profit if the options expire
instantaneously.
So if you had to pick a spread to be the winner, which would it be? Obviously, it should be
the bull spread because it is theoretically worth more. But look at the quotes again -- we see
both spreads are prices at $2.
How? The bull spread consists of the long $95 and short $100 for a net debit of $2. The bear
spread consists of the short $100 and long $105 for a net credit of $2.
With the stock at $101, the market maker knows the bull spread should be more valuable
relative to the bear spread, so he'll buy the bull spread and sell the bear spread -- a butterfly
spread.
Notice that this does not guarantee a profit -- the stock could fall below $95 or rise above
$105 -- so is not an arbitrage play. It does, however, allow the market maker to take an unfair
advantage of a mispricing and put the odds on his side that the trade will, in fact, be
profitable. This is one of many trading situations known as a pseudo-arbitrage because it
does not guarantee a profit, but is traded solely from a theoretical mispricing viewpoint; it is an
arbitrage on theoretical odds.
What does a butterfly spread look like?
The profit and loss diagram for the above butterfly looks like this:
Notice how there is no loss area; the lowest this spread can go, in this example, is zero. This
is because it was constructed with the bull and bear spread priced the same, so there was no
cash outlay -- the market maker paid $2 for the bull spread and received $2 for the bear
spread. Realistically, there may be a slight debit, especially after commissions, so it may
actually look like this:
The point is that with a butterfly (assuming a very low debit or low commissions), you have
very little loss area but a high profit area albeit over a small range of stock prices. In a lot of
ways, it's like playing the lottery. The market makers are thinking they have little to lose but
much to gain. The maximum profit will be achieved at the strike price of the short, in this
case, $100.
If you use your imagination, the profit and loss diagram looks like the wings of a butterfly (I
told you to use your imagination!) -- hence the name butterfly spread.
Iron butterfly
Another way to view the spread is that it's the combination of a short straddle and long
strangle (please see our section on "Straddles and Strangles" for more information on these
strategies). If a trader executes a short straddle and long strangle, it is a special variation of
the butterfly known as an iron butterfly. The trader of an iron butterfly wants the stock to fall,
so the above profit and loss diagram is actually a short iron butterfly or long butterfly. The
short straddle is easy to see; it is the part that forms the upside down "V" in the diagram. The
long strangle just provides protection from further losses if the stock falls below $95 or rises
above $105. It is the long strangle that forms the protective "wings" to the left and right of the
diagram. If a butterfly spread is constructed in this manner, there will be four commissions to
open and four to close.
If you can ever execute a butterfly for a very low debit, you may want to consider it. If you can
ever execute it for a credit, do not pass it up, as this would be an arbitrage situation -- you
cannot lose!
Let's look at some real numbers and see why retail investors should think twice before
entering a butterfly spread.
Example:
MSFT is currently trading for $68-3/4 with the following option quotes available:
Dec $65 call = $6-1/2 ask
Dec $70 call = $3-3/8 bid
Dec $75 call = $1-3/4 ask
Let's trade the $65/$70/$75 butterfly and see what happens:
Long 1 $65 = -$6-1/2
Short 2 $70 = +$6-3/4
Long 1 $75 = -$1-3/4
Net debit
$1-1/2
Now, to make it more realistic, let's say you pay a commission of $100 for the three contracts,
which may be a conservative number. Now you must add $100 to the cost. Remember that
we are dealing with three different strikes, so there will be three separate commissions -- and
that's just to buy it.
Now our net debit is $2-1/2 and the maximum we can make is $5. Here's our profit and loss
diagram so far:
It already looks much different from the market maker's above. Notice just how much more
"loss" area there is in this diagram.
Now, our break-even points are $67-1/2 and $72-1/2. If the stock closes below $67-1/2 or
above $72-1/2, the trade will incur losses, and we haven't even considered the commissions
to get out.
Already it's a pretty narrow range in order to be profitable -- a five-point range between breakeven points. Let's assume the stock closes at exactly $70, which is the point of maximum
gain. We make $250 but have to pay another $100 in commissions for a total of $150.
Now, it still may not seem like such a bad deal, after all, $150 bucks is $150 bucks. But this
was assuming the stock closed at exactly $70. Just how much room do we have to work?
Taking the sell commissions into account, here's how the trade looks now:
The stock must close above $68-1/2 or below $71-1/2 in order to get anything. In order to get
the full $150, we need the stock at exactly $70. If you can call the stock closing prices within
this close of a range, you're probably better off selling naked calls, puts, or straddles.
The butterfly spread is an interesting combination strategy, which you will no doubt hear
about as you continue with your options trading. Over the past seven years, I have seen
many retail investors attempt butterfly spreads and did not see one -- not a single one -- make
a dime.
If you decide to try one, you may want to check with your broker regarding commissions and
break-even points.
My guess is that you will decide against it.
Condor
Condor, albatross, pterodactyl spreads
Once again, the traders have given some creative names to another class of wingspreads -strategies with profit and loss diagrams resembling wings. The condor, albatross and
pterodactyl spreads are all similar to the butterfly spread (please see "Butterfly Spreads" for
more information) except each of these strategies sells multiple strikes.
It should be noted that, like the butterfly, these spreads are really meant to be used as floor
trader tools for hedging and taking advantage of small pricing discrepancies that periodically
appear in the market. Because of the large number of strikes involved, the commissions
usually make these losing strategies for retail investors.
This does not mean that you should not take the time to understand them. They will increase
your knowledge of options and give insights into the versatility of options by showing how
strategies can be stacked on one another.
Condor spread
The condor spread is a strategy involving four strikes and can be made up of calls, puts or a
combination of both. The basic condor spreads are usually constructed with either calls or
puts.
To execute a basic condor spread, a trader needs four strikes, which we will call S1, S2, S3
and S4 with each strike being successively higher and having the same expiration. The
trader will be long S1, short S2, short S3, and long S4. For example, the trader may be long
the $100 call, short the $105 call, short the $110 call and long the $115 call. Notice how each
strike is successively higher. It is not necessary to have them separated by five points,
though. You could construct one with a long $100 call, short $110 call, short $120 call and
long $130 call -- as long as the strikes are evenly spaced. From a profit and loss standpoint,
the condor spread looks like this:
The trader will maximize profit between the two short strikes, $105 and $110 in this example.
For stock prices below $105 or above $110, the trader will start to lose profits and eventually
end up negative if the stock falls below $101 (low break-even point) or rises above $114 (the
high break-even point). Any stock price below $100 or above $115 produces the maximum
loss of $1 -- the cost of the spread.
Notice how the condor is similar to a butterfly where the trader buys a low strike, sells two
medium strikes, and buys one high strike. The condor is the same basic pattern except the
trader is splitting the two medium strikes of the butterfly into two separate strikes. This action
creates a wider profit area relative to the butterfly. The trader is hoping for a relatively stable
stock price. The following chart shows a comparison between the condor and butterfly:
Notice how the butterfly (blue) has a higher profit but, in return, gets into loss territory
quicker. The condor (red) has a lower, but wider, profit area and takes longer to head into
losses. The markets realize the condor is therefore more desirable and will bid its price up.
Again, market makers are probably the biggest users of condors as they pay very little in
commissions and can make it worth their while to pay four commissions to enter the condor
and four to exit.
Why do market makers use them?
To understand them, we need a refresher on butterflies. If you read our section on butterfly
spreads, you will recall that market makers are actually spreading spreads -- they buy the bull
spread and sell the bear spread. For example a basic call butterfly has this pattern:
Strike
Call butterfly
100
+1
105
-2
110
+1
115
120
125
In other words, the long butterfly trader is long the $100 call, short 2 $105 calls and long the
$110 call. If the stock is at $105-1/2, the $100/$105 bull spread (long $100, short $105)
should be more valuable than the $105/$110 bear spread (short $105 and long $110). If, for
some reason, the markets are pricing them equally, market makers will buy the bull spread
and sell the bear spread making them long the butterfly. For the same reasons traders buy
spreads (buy one call and sell another), traders will spread spreads, which is a butterfly.
With condors, market makers are actually laddering butterfly spreads; that is, they buy one
set of butterflies and buy a successively higher set of butterflies.
Strike
100 105 110 115 120 125
Call butterfly #1 +1
-2 +1
Call butterfly #2
+1
-2 +1
Net position
+1
-1 -1 +1 = condor spread
A trader may see a theoretical discrepancy between the $100/$105 bull and $105/$110 bear
spread and want to buy butterfly #1 above. In addition, there may be another discrepancy
between the $105/$110 bull and $110/$115 bear, so they may desire to purchase that one as
well. With one condor, all pricing discrepancies between the two butterflies are captured!
A short condor will be the mirror image of the long position and, consequently, have opposing
profits and losses. Using the same example above, to execute a short condor, the trader will
be short $100 call, long $105 call, long the $110 call, and short the $115 call. The short
condor looks like this:
With the short condor, the trader will make maximum profit if the stock makes a large move in
either direction. In this example, if the stock is below $109 or above $114, the break-even
points, the trader will keep the initial $1 credit. If the stock is between $100 and $115, the
position will start to lose profits, and eventually end up at a maximum loss of $4 if the stock is
between $105 and $110 -- the strikes of the two long positions.
Albatross spread
The basic long albatross is a strategy utilizing four strikes just as the condor. However, the
trader skips a strike in the middle. Using the earlier notation, a long condor trader will be long
S1, short S2, short S3, long S4, but skip a strike between S2 and S3. For example, a trader
who is long the $100 call, short $105, short $115, long $120 is long an albatross spread.
From a profit and loss standpoint, the long albatross looks like this:
It has a wider but lower profit zone relative to the condor. This reflects the relative risks of the
two strategies. All else equal, traders would prefer to have wider ranges of profit so will bid
this strategy higher relative to the condor. This can be seen if we overlay the two profit and
loss diagrams:
The trader will profit for any stock price above $102 and below $118, the break-even points.
Maximum profit will be realized for stock prices between $105 and $115. Similar to the
condor trader, a long albatross position is betting on a fairly stable stock price; however, the
albatross trader has more room for error.
As with the condor, the albatross is a continuation of the laddering of butterfly spreads. For
example, the following chart shows the trader who is long an albatross spread is effectively
long the $105, $110 and $115 butterflies.
Strike
100 105 110 115
Call butterfly #1 +1
-2 +1
Call butterfly #2
+1
-2 +1
Call butterfly #3
+1
-2
Net position
+1
-1
0
-1
120
125
+1
+1 = albatross spread
The short albatross, of course, will be the opposite of the long position. Here, the trader is
betting on a very large move, either up or down, in the underlying.
Pterodactyl spread
As you probably guessed, the pterodactyl spread is just a continuation of the albatross. It still
involves four strike prices but, this time, two strikes are skipped in the middle. A trader who is
long $100 call, short $105 call, short $120 call, and long $125 call is long a pterodactyl. The
profit and loss diagram looks like this:
The albatross trader has an even lower, but wider, range of profits compared to the
albatross. The trader, in this example, will be profitable for any stock price above $102 3/4 or
below $117-1/4, the break-even points. Maximum profit will be realized for stock prices
between $105 and $120.
As shown in the following chart, the pterodactyl spread is a laddering of four butterfly spreads:
Strike
100
Call butterfly #1 +1
Call butterfly #2
Call butterfly #3
Call butterfly #4
Net position
+1
105
-2
+1
-1
110 115 120 125
+1
-2 +1
+1
-2 +1
+1
-2 +1
0
0
-1 +1 = pterodactyl spread
Notice in the following chart how each spread -- the condor, albatross, and pterodactyl -reflects the relative risks of each position. The strategy with the highest profit potential will be
the cheapest one to purchase. Sometimes new traders find this confusing and think the
highest profit strategies should be the most expensive, as those are the ones everybody
wants and will bid the price higher. This is incorrect, as the highest profit strategies are also
the riskiest. In order to make them worth the risk, the market must reduce the price.
Think of it this way: if all spreads were priced equally, which would you prefer? Obviously, the
pterodactyl as it has the widest area for profit. So traders will bid up the price of the
pterodactyl relative to the others. The same process will occur for the albatross and the
condor. No matter how sophisticated you become with option trading, you will never be able
to avoid the risk-reward relationships.
Spreads are great trading tools and you should take the time to become familiar with these
advanced combinations. In most cases, these are better suited for market makers but that
doesn't mean they cannot be used at the retail level. If you plan to use one, be sure to
evaluate your break-even points and maximum gains and losses taking commissions into
account.
Calendar Spread
A calendar spread is any spread where the trader buys a particular month, and then sells the
same strike of a different month. For example, a trader may buy a March $50 strike and sell a
January $50. Notice that the trader is spreading months, hence the name calendar spread.
Also, because months represent time, these are equally known as time spreads or horizontal
spreads.
If the trade results in a net debit, the trader is said to be long the calendar spread; if it results
in a net credit, then he is short the spread.
With a calendar spread, the trader is expecting the stock to sit flat -- this trade is
actually a play on time-decay and volatility as opposed to direction.
Many traders have trouble understanding why you want the stock to sit still, so let's go
through the reasoning. Say a trader buys the above trade -- long March $50 for $10 and
short Jan $7 for a net debit of $3. Because the trader is long the spread, he will want the
spread to widen so that he may close it for a profit.
Now, if the stock sits still, as we approach January expiration, what will happen to the
spread? Both options will lose money as time goes by, but the short January option will lose
far more than the long March option. The January will be nearly worthless, while the March
will still have significant time remaining. For instance, the January option may be trading for
$1/2 while the March, with over two months remaining, may be worth $7. The trader paid $3
and can close it for a net credit of $6-1/2 for a $3- 1/2 gain.
Let's say the stock nosedives and is trading for $20. Now, both options will be virtually
nothing. You may see the January for $1/16 and the March for $1/8, but the point is: the
trader will close out the spread for next to nothing for a loss of about $3. If the stock
collapses, the spread will also collapse toward zero.
What if the stock rallies and is trading way up? If the options are very deep-in-the-money,
regardless of the time remaining, they will converge on intrinsic value. You will see a small
difference in the March $50 calls just to reflect an additional two months cost-of-carry, but the
difference will be negligible.
We may see the Jan $50 trading for $30-1/2 and the Mar $50 for $31 but, again, the spread
has narrowed to 1/2 point so the trader will incur a $2-1/2 loss.
From a profit and loss standpoint, the long calendar spread looks like this:
It should be evident that a long calendar spread wants the stock to sit still. Conversely, a
short calendar spread will want the stock to move, either up or down by a large amount as
shown by the profit and loss diagram below:
Many traders make the big mistake of entering into a calendar spread when bullish on the
stock. If they are lucky enough to get the direction correct, they are greatly disappointed to
see the spread collapse.
If you are bullish or bearish on a particular stock and entering into a calendar spread, you
want to be short the spread -- you want the spread to narrow. In other words, if you short the
spread, you will receive a credit. If the stock moves way up or way down, the spread will
narrow and you can purchase it back for a profit.
If you are expecting the stock to sit still, you want to be long the spread. You will spend
money to do so but the spread will widen if you are correct and the stock is relatively quiet.
Calendar spreads add a whole new dimension for most traders; that is, a limited risk way to
profit from a stock doing nothing. Granted, short calls, short puts and covered calls can make
money from a neutral outlook on the stock as well. However, their risk with an adverse move
in the underlying is often too big for many investors. Calendar spreads can be a great way to
profit from a neutral outlook while greatly limiting your risk.
Option Exam 9 - Week 9
1) Assume you are looking at $50, $55 and $60 strike call options. How would you construct a
butterfly spread?
a) Buy a $50, sell a $55, buy a $60
b) Buy a $50, buy 2 $55, sell a $60
c) Sell a $50, sell a $55, buy a $60
d) Buy a $50, sell 2 $55, buy a $60
2) The butterfly can be viewed as the combination of a(n):
a) Bull spread and condor spread
b) Bull spread and bear spread
c) Bear spread and condor spread
d) None of the above
3) The owner of an at-the-money butterfly spread (middle strike equal to the stock price)
wants the underlying stock to:
a) Move sharply upward
b) Move slowly upward
c) Fall sharply
d) Sit still
4) A trader enters a $50/$55/$60 butterfly. The maximum value this spread can ever be worth
is:
a) $5
b) $10
c) $60
d) None of the above
5) If you can ever enter a butterfly spread for a net credit you should:
a) Never do it as it is a sure loser
b) Always do it as you can never lose
c) Not enough information as butterfly spreads are always executed for credits
6) The butterfly spread is generally a great strategy for retail customers.
a) True
b) False
7) Compared to the butterfly spread, the condor is a higher risk, higher reward spread.
a) True
b) False
8) The owner of a calendar spread wants the spread to:
a) Narrow
b) Widen
c) Stay the same
9) The owner of a calendar spread wants the underlying stock to:
a) Stay the same
b) Rise
c) Fall
10) Which of the following is a calendar spread?
a) Buy the March $50 and sell the January $40
b) Buy the March $50 and sell the January $50
c) Buy the March $50 and sell the April $55
d) Buy the March $50 and buy the April $50
Backspread
The backspread is similar to a ratio spread, except that it has unlimited profit instead of
unlimited loss on the profit and loss diagram. It is the mirror image of the ratio spread. In
fact, the backspread is often called a long ratio spread.
Call backspread
A call backspread involves the sale of a low strike price call and the purchase of a higher
number of contracts at a higher price. For example, a trader may sell 10 $50 calls and buy 20
$60 calls, also known as a $50/$60 backspread.
The profit and loss diagram for a call backspread looks like this:
Assume the trader sells 10 $50 calls for $10 and buys 20 $60 calls for $3. This trade can be
broken down to 10 (-1/2) spreads (please see our section on "Ratio Spreads" for more
information). In other words, the trader sold one call and bought two calls, but did this ten
times. For every call sold at $10, two were purchased at $3 for a total of $6. Therefore, the
above trade was executed for a net credit of $4 (received $10 but paid $6). Depending upon
prices and ratios used, backspreads may be entered for either debits or credits.
For any stock price below $50, the trader will keep the net credit of $4, as both calls will
expire worthless. If the stock moves above $50, the trader will head into loss territory
because he is short these calls. However, if the stock continues upward, the $60 calls will
come to the rescue and stop the losses. The maximum loss will occur at $60 where the
trader will lose ten points (the difference in strikes) less the credit of $4, for a maximum loss of
$6. Because there are two $60 calls for every short $50, the trader will start to make gains
above $60. In order to make up for the $6 loss, the stock must rise to $66 to reach breakeven. The downside break-even can be found in two ways: One, the trader must make up
the $6 loss from the low point of $60; Or, he can sustain a loss of $4 (the initial credit) above
$50. Either way you choose, you will see the downside break-even is $54.
Notice that if the trader had purchased the 10 $50 calls and sold 20 $60 calls, he would have
a ratio spread. Ratio spreads and backspreads are opposites. The following is a profit and
loss diagram comparing the two spreads:
Why enter a call backspread?
If a trader is bullish on a stock yet fears a market turndown, then both sides of the market can
be played with a backspread. The trader will capture all upside profits yet have a credit (or
less of a loss if entered as a debit) if the stock should fall. Typically, novice traders will enter
long straddles to play the upside and downside. However, with long straddles, the breakeven points become very wide due to the fact that premiums are paid for both the call and put
and must be made up. With the backspread, a trader can custom-tailor his bias in the stock
and create better risk-reward ratios. The trader using a call backspread is more bullish, but
fears a downturn. He will not profit as much as a long straddle trader, but does not have as
much at risk either.
Backspreads are another great example of just how versatile options can be.
Put backspread
Backspreads can be used with put options too. To enter a put backspread, the trader will sell
a high strike put and buy a higher number of a lower strike put. For example, a trader may
sell 10 $60 puts and buy 20 $50 puts.
The profit and loss diagram for a put backspread looks like this:
Assume the trader sells the $60 puts for $10 and buys the $50 puts for $3. As above, this
spread can be broken down into 10 (-1/2) spreads. This means that for every one put that
was sold, two were purchased. The trader receives $10 from the sale of the $60, but pays $6
for the two $50 puts for a net credit of $4. If the stock should rise, the trader is left with a
credit, as both puts will expire worthless. If the stock falls below $60, the trader heads into
loss territory, as he is short these puts. If the stock continues to fall to $50, the losses stop
and gains will start, as he is long two of the $50 puts for every one of the $60 puts that are
short.
So for any stock price below $50, the trader starts to gain. At $50, the trader is down $10 (the
difference in strikes), but received $4 from the initial trade for a net loss of $6. Because this
$6 must be made up, the break-even will be $6 points below the $50 strike or $44. If the
stock falls below $44, the trader will start to show profits. Where is the upside break-even?
The trader will need to make up the $6 from the max loss point at $50 to the upside; equally,
he can sustain a $4 loss (the initial credit) below $60. Either way of looking at it will yield an
upside break-even of $56.
With puts, traders are betting more on the downside, but they fear the upside risk. A put
backspread allows them to capture both possibilities while favoring the position to the
downside.
Intel backspread example
Let's run through an actual example using Intel (INTC), which is currently trading around $41.
The option quotes are as follows:
Dec $40 Call = Bid:$3-1/2
Dec $45 Call = Bid:$1-3/8
Ask: $3-3/4
Ask: $1-3/4
Assume a trader wants to place a $40/$45 backspread and sells the $40 call for $3-1/2 and
buys 2 $45 calls for $1-3/4 each or $3-1/2 for a net debit of zero shown by:
Short 1 $40 call =
long 2 $45 calls at $1 3/4 each =
Net debit
-$3 1/2
+$3 1/2
$0
Here is what the profit and loss diagram will look like for the above trade:
The trader will make nothing if the stock falls, and lose $5 if the stock closes at $45. If the
stock is above $45, the trader will start to recover losses and eventually break even at $50.
Any stock price above $50 will yield a profit. Note the break-even points of $40 and $50. If
the stock closes between these two points, the trader ends up with a loss.
Remember we said the trade opposite the backspread is the ratio spread? Well, the floor
trader who executes the above backspread will have the ratio spread (assuming the trades
are not matched with other orders or positions). The floor trader's profit and loss diagram will
look like this:
Backspreads are great tools; especially for active traders. They generally require level 2
option approval (ratio spreads require level 3). Many traders shy away from ratio and
backspreads because of the initial complexity in understanding them. However, with a little
work, you can quickly find the maximum gain and loss points as well as the break-evens.
They are a wonderful tool for option traders, so you should take the time to understand them if
you want advance to a higher level of trading!
Box Spread
There are many tools that market-makers use to hedge risks, either partially or fully. One of
the most powerful tools is called a box spread. While this particular strategy is not widely
used by retail investors, it is very useful in determining if your vertical spread is priced fairly.
Another important use of the box spread is for investors who place spread orders (please see
our section on spreads if you are not familiar with these.) They often ask, "Do you think I can
get filled at such-and-such a price?" If you understand the box spread, you will be able to
immediately determine if there is any room for the market makers to work with your order.
If you are a user of spread orders, understanding box spreads will be a very helpful tool!
The box spread
A box spread is a relatively simple strategy. To enter into a long box position, all you need to
do is buy the bull spread and buy the bear spread with the same strikes and all other factors
the same (if you are unsure about bull and bear spreads, please see our section on "Basic
Spreads.")
For example, say a stock is trading at $50. A trader could buy the Jan $50 call and sell the
Jan $55 call (bull spread), and also buy the Jan $55 put and sell the Jan $50 put (bear
spread.)
This trade will result in a debit for both spreads. What is interesting about this position is that
it is now guaranteed to be worth $5 (the difference in strikes) at expiration (keep in mind this
is a theoretical price, and in the real world of trading, the bid-ask spreads will probably make
the value slightly less than $5 at expiration).
How? Think about this: No matter where the stock closes, either the $50 call or the $55
put will be in-the-money. Because these are the two long positions of the box spread, the
trader who buys the box spread is guaranteed to have a position worth $5 at expiration.
Let's run through some examples if you are still not sure:
If the stock closes at $53, the long $50 call will be worth $3 and the long $55 put will be worth
$2 for a total of $5. The short $55 call and short $50 put will expire worthless (if you are not
sure why these prices must hold, please see our section under "Basic Option Pricing").
If the stock closes at $51, the $50 call will be worth $1, and the $55 put will be worth $4 for a
total of $5. Again, the two short positions expire worthless.
What if the stock closes outside the ranges of $50 and $55?
If the stock closes at, say, $30, the $55 put will be worth $25 and both calls will expire
worthless. However, the short $50 put now has value. In fact, it will be worth $20, which is
an obligation because the trader is short. So the total value of the position is +$25 - $20 =
$5.
You can't get around it. No matter where the stock closes, the position will be worth the
difference in strikes, in this case, $5.
Question:
Okay, here's one for you to try. What will be the value of the above box spread is the stock is
trading for $100 at expiration? How would you show it? (Answers at the end.)
Pricing a box spread
Now that we know the mechanics of the box spread, how can we use it to help with our
trading?
It is now October 31 and say you are interested in SCMR, which is currently $58-3/8, with the
following quotes available for options:
Dec $55 Call
Dec $65 Call
BID
$12-7/8
$8-7/8
ASK
$13-7/8
$9-5/8
Dec $55 Put
Dec $65 Put
$8-3/4
$14-3/4
$9-1/2
$15-3/4
Let's say you are bullish on SCMR and want to place a $55/$65 bull spread:
Buy Dec $55 Calls = $13-7/8
Sell Dec $65 Calls = $ 8-7/8
Net debit
$ 5
Is this being priced fairly? Is it likely we will get filled if we put a net debit of $4-3/4?
In order to answer these questions, let's look at the other side of the box spread:
Buy Dec $65 Puts = $15-3/4
Sell Dec $55 Puts = $ 8-3/4
Net debit
$ 7
Now, you will pay $5 for the bull spread and $7 for the bear spread for a total debit of $12,
which is guaranteed to fall to a value of $10 at expiration! So with the current bid/ask
spreads, this box is not being priced fairly. In fact, this is most often the case and the primary
reason the box spread is not a popular tool for retail investors.
Let's see what the market makers are trying to do. Remember, the bid represents what they
are willing to pay, and the ask what they are willing to sell. So, from the market-makers
perspective, here is how the box spread looks:
Buy Dec $55 Calls =
Sell Dec $65 Calls =
Net debit
$12-7/8
$ 9-5/8
$ 3-1/4
Buy Dec $65 Puts =
Sell Dec $55 Puts =
Net debit
$14-3/4
$ 9-1/2
$ 5-1/4
The market makers want to complete the box spread for a total of $8 1/2 points, which is
guaranteed to grow to a value of $10.
On the surface, it appears to be a pretty good deal. Let's see just how good it is.
Remember, it is October 31 and we are looking at December options, which will expire in 45
days. That actually works out to be 17.6% simple interest, or a whopping 267% annualized
rate of return -- which certainly beats the guaranteed rates on T-bills.
So to answer the second question: yes there is certainly a lot of room to work with on the bull
spread.
Let's go a step further. Just how much room is there? One useful method is to start with
what the spread "should" cost. If the spread is guaranteed, it should earn the risk-free rate
(roughly 6%). So the value of $10 guaranteed in 45 days is about $9.93, which is roughly
$1.17 above the $8-3/4 price the market makers are trying to pay.
In a case like this, it is very feasible to get 1/2 point or maybe more off of this spread.
Please remember, any limit order, no matter how close to the market, is not guaranteed to fill,
so, if you really need to get into or out of a trade, use caution in applying this method. This
pricing method is a great tool for analyzing the potential for all traders who like to use limit
orders.
Uses of the box spread
Why would a market maker enter into a box spread? The box spread is effectively a way for
market makers to borrow or lend money. If a market maker sells a box spread, they are
effectively borrowing money. They receive a credit and must pay back the value of the box at
expiration. Similarly, if they buy a box spread, they are loaning money. They will pay money
but receive a guaranteed return at expiration.
Of course, the market makers will price the boxes in their favor and either buy it below or sell
it above the theoretical fair value.
For example, say a $90/$100 box is priced at $9. If the $90/$100 put spread is priced at $4,
the $90/$100 call spread should be worth $5. However, the market maker may bid $4-3/4
and ask $5-1/4 for the call spread. This way, regardless of whether he buys or sells the call
spread, he is either borrowing at less than (or loaning for a higher rate of) current risk-free
rates by completing the box. For instance, if he buys the call spread for $4-3/4, he will buy
the put spread for $4 and thus pay only $8-3/4 for a box position worth $9, and effectively
loan money for higher than the risk-free rate. Likewise, if he sells the bull spread for $5-1/4,
he will sell the bear spread for $4 thereby completing the box for $9-1/4. Now the market
maker has sold a box worth $9 for $9-1/4 and effectively borrowed money for less than the
risk-free rate.
Other views of the box spread
We said earlier that a long box spread could be viewed as a long bull spread matched with a
long bear spread. There are two other ways to view boxes, and depending on your situation,
one or the other may be more helpful.
One way to see it as a conversion at one strike and a reversal at another. For example, if a
trader is short stock at $50, long $50 calls and short the $50 puts, he has a reversal at $50. If
he subsequently buys stock at $60 with long $60 puts and short $60 calls, he has a $60
conversion.
Notice that the long and short stock positions cancel out, leaving the trader with long $50 calls
and short $50 puts (synthetic long position) with long $60 puts and short $60 calls (synthetic
short position).
$50 reversal
Short 1,000 shares at $50
$60 conversion
Long 1,000 shares at $60
Long 10 $50 calls
Short 10 $50 puts
Long 10 $60 puts
Short 10 $60 calls
The long and short stock positions cancel each other out (shown in red). The remaining
positions are a synthetic long position (blue) at $50 and a synthetic short position (black) at
$60. Notice the embedded bull and bear spreads (long $50 call and short $60 call, long $60
put and short $50 put).
Of course, a long position matched with a short position cancels each other. This holds true
whether it's actual stock or synthetic versions. The trader who is synthetic long at $50 and
synthetic short at $60 has effectively purchased stock at $50 and sold at $60. Bear in mind
this is not as good as it seems, as the trader was also short stock at $50 and long at $60.
The profits or losses come for the total reversal and conversion prices.
If you trade spreads, take the time to really understand box positions, as it will make all the
difference in the world in your understanding of spread pricing. Once you have a handle on
that, you will be able to make more knowledgeable decisions as to which limits to use with
your orders.
Answers:
What will be the value of the above box spread if the stock is trading for $100 at expiration?
How would you show it?
The question was referring to the $50/$55 box spread. The value of the box spread must be
worth $5 -- the difference in strikes -- at expiration. To prove it, if the stock is trading at $100,
the long $50 call will be worth $50 and the short $55 call (which is an obligation) will be worth
$45. Both puts, the $50 and $55, will expire worthless because they are out-of-the-money.
So the total value to the trader will be +$50 - $45 = $5
Option Exam 10 - Week 10
1) Call backspreads exhibit unlimited profit potential for the holder.
a) True
b) False
2) Call backspreads have unlimited downside risk if the stock falls.
a) True
b) False
3) Which of the following is a call backspread?
a) Sell $50 call, buy 2 $55 calls
b) Sell $50 call, sell $55 call
c) Buy $50 call, sell 2 $55 calls
d) Buy $50 call, sell $55 call
4) Put backspreads have unlimited risk if the stock rises.
a) True
b) False
5) A call ratio spread has unlimited risk if the stock rises.
a) True
b) False
6) A put ratio spread has unlimited risk if the stock rises.
a) True
b) False
7) Consider these two ratio spreads:
(1) Buy $50 call and sell 2 $55 calls
(2) Buy $50 call, sell 3 $55 calls
a) The first ratio spread is riskier than the second
b) The second ratio spread is riskier than the first
c) Both are equally risky
d) Neither have any risk
8) A trader places a ratio-spread order to buy 10 $50 calls and sell 20 $55 calls as a limit
order. Can the market maker fill the order as buy 8 $50 calls and sell 14 $55 calls?
a) Yes
b) No
9) Box spreads are a way for market makers to borrow and lend money.
a) True
b) False
10) Box spreads can be used by retail investors to see if vertical spreads are priced fairly.
a) True
b) False
Synthetic Options
The name sure sounds intimidating, but synthetic options are fairly easy to understand and
are truly a fascinating and useful part of options trading. Understanding synthetic positions
will allow you to effectively do things many traders will tell you cannot be done, such as
shorting stock on a downtick (or even when no stock is available), buying calls or selling
naked puts in an IRA, buying stock for virtually no money, and a host of other imaginative
strategies. Further, understanding synthetics will give you great insights into option pricing.
You will understand how options are created, and why the market makers are quoting the
puts and calls the way they are.
In order to understand these mysterious sounding options, you need to understand one of the
most fundamental concepts of option pricing known as put-call parity.
Put-call parity
Put-call parity is a relationship showing that call and put prices are very dependent on one
another, and not just arbitrarily chosen. In order to understand the put-call parity equation
better, it's best to show how orders are filled on the floor of the exchange. Here's an example
of how it works:
Say you want to buy 10 calls to open of the ABC $50 strike (with 1 year to expiration) at
market. ABC stock is also trading at $50.
When this buy order is received on the floor, the market maker must become the seller so that
the transaction can be completed. This means the market maker must be willing to be short a
call. Now, while you may be totally comfortable in speculating by buying 10 calls, the market
maker may not be so eager to be on the short side. The reason is this: Market makers are in
the business to take 1/8th's or 1/4th's of a point on a large number of trades; they are not
really too interested in holding open speculative positions over long periods of time -especially short calls that have unlimited upside risk!
How does the market maker create a short call?
If the market maker is to be short a one-year call, his risk will be that the stock goes higher.
So, in order to protect himself from this risk, he will purchase 1,000 shares. No matter how
high the stock moves, he will always be able to deliver 1,000 shares of stock (represented by
the 10 calls) at expiration.
However, now there is a new risk; the stock may fall. So to protect himself from this, he will
buy a $50 put with one year to expiration.
Now our market maker is now long 1,000 shares of stock, long 10 $50 put options and short
10 $50 call options. Because he is short 10 calls, he can now fill your order to be long 10
calls. But what price should he charge?
Here is what's interesting about this position: The market maker is now fully hedged
(protected) against any stock price movement at expiration. This means he cannot lose on
the position! How? Well, the stock price can do one of three things between now and
expiration of the call:It can stay the same, go up or go down. If the stock stays exactly at $50,
the call and put expire worthless and the market maker's position is worth exactly $50,000,
which is the amount he originally paid for the stock. If the stock closes above $50, the long
put will expire worthless and the market maker will get assigned on the short call and lose the
stock; however, he will be paid the $50 strike and receive exactly $50,000. Likewise, if the
stock closes below $50 at expiration, the short call will expire worthless and the market maker
will exercise his put and receive $50,000.
With the long stock at $50, long $50 put and short $50 call, the market maker is now
guaranteed to receive $50,000 in one year. It is kind of ironic by using these speculative
derivatives of puts and calls we can actually create a risk-free portfolio!
Now, if any financial asset is guaranteed to be worth a certain amount in the future, then its
value today must be worth the present value discounted at the risk-free rate of interest.
PRESENT VALUE/FUTURE VALUE are "time value of money" concepts used throughout the
financial industry to describe the value of assets at different points in time. The concept of
time value says that a dollar today is worth more than a dollar tomorrow because the dollar
today can be invested and earn interest. For example, if you deposit $100 into an account
that pays 5% interest, you will have $100 (1+5%) = $105 in the future. So the future value of
$100 today is $105 if interest rates are 5%.
Similarly, if someone owes you $105 one year from now and interest rates are 5%, then you
should be willing to accept $105/(1+5%) = $100 today. In other words, it should make no
difference to you by waiting one year and receiving $105 or collecting $100 today. The
reason is that you can take the $100 today, invest it at 5% for one year, and still have your
$105 a year from now. So the present value of $105 one year from now is $100 (if rates are
5%). To calculate the present value, we simply take the future value of the asset and divide it
by 1 + risk-free interest rate.
The market maker is guaranteed to receive $50,000 in one year regardless of the stock price.
So the present value of $50,000 in one year is $50,000 / (1.05) = $47,619 today. The market
maker should pay $47,619 today for these three assets -- the stock, long put and short call
positions. Why? If he pays $47,619 and receives $50,000 in one year, his return on
investment will be 5%, which is exactly the interest rate he should receive for a risk-free
investment.
The market maker will spend $50,000 for the 1,000 shares of stock trading at $50. Let's also
assume he pays $5 for the put. Now he will spend an additional $5,000 for the put for a total
cash outlay of $55,000. We already figured that the fair price for this package of three assets
should be worth $47,619 yet he's paying $55,000 for it.
The market maker has overpaid by $55,000 - $47,619 = $7,381, so he will need to bring in a
credit for this amount. How can the market maker receive a credit of $7,381? Easy -- he will
fill your order on the 10 $50 calls for roughly $7-3/8. Doing so, he will receive the necessary
credit to make his -$55,000 cash outlay equal to -$47,619. Of course, the market maker will
try to make an 1/8 or 1/4 point profit, so the order would probably be filled around $7-1/2.
To summarize, the market maker's initial position looks like this:
Buy 1000 shares at $50 =
-$50,000
Buy 10 $50 puts at $5 =
-$5,000
Sells 10 $50 calls at $7 3/8 = +$7,375
Equals
-$47,625 cash outlay by market maker.
This is guaranteed to grow to a value of $50,000 in one year ($47,625 * 1.05 = $50,000)
because of the full hedge provided by the 3-sided position.
This three-sided position (long stock + long put + short call) established by the market maker
is called a conversion. If he does the reverse (i.e. short stock + short puts + long calls) then it
is called a reversal or reverse conversion.
The put-call parity equation
We have shown that the market maker's three-sided position (conversion) is guaranteed to be
worth the present value of the exercise price. Remember, he was short $50 calls and long
$50 puts; the stock must either be above or below this price at expiration, resulting in a cash
inflow of $50 -- the exercise price. Because he's guaranteed this strike price, the long stock +
long put + short call position must be worth the present value of the exercise price. We can
rewrite this using S for stock price, P for put price, C for call price, and E for exercise price as
follows:
S + P - C = Present Value E
And therein lies the magic of synthetic options!
Notice the notation with the plus and minus signs. The long put position is denoted by a "+"
sign and the short call is denoted by "-". This will be important to remember later.
To make things a little easier to understand, we know the present value of E (the right side of
the equation) is guaranteed to grow to E so it behaves like a risk-free investment -- a T-bill (or
Treasury bill, treasury note or treasury bond). We can therefore rewrite the above equation
as:
S + P - C = T-bill
With some very basic algebra, we can create many interesting positions. We will take it slow
with lots of examples, so hang in there!
This equation is known as put-call parity. If you know the value of a call option, you can
immediately figure out the value of the put.
One small adjustment
Before we can continue with some examples, there is one note we need to make with an
example. Let's say we are interested in seeing what a long stock + long put position are
equal to. Using the equation, S + P - C = T-bill, how can we get the S + P (the pieces we are
interested in) by themselves? Algebraically, we need to get the C to the other side of the
equal sign; we need to add C to both sides. Now we have S + P = C + T-bill.
What does this mean? It means that someone holding long stock and a long put in a portfolio
(the left side of the equation) will have exactly the same portfolio balance at option expiration
as another person holding a call plus a T-bill (the right side of the equation).
Let's see if it holds true:
Assume we are interested in 1-year options and interest rates are 5%:
Investor A holds stock at $50 and a $50 put (left side of the equation)
Investor B holds a $50 call and a T-bill (right side of equation)
Investor B will pay $50,000/(1.05) = $47,619 for the T-bill.
At expiration:
Portfolio A
Stock price
Stock
35
40
45
50
55
60
65
70
75
80
85
35
40
45
50
55
60
65
70
75
80
85
Total
$50 put Value At
Expiration
50
15
50
10
50
5
50
0
55
0
60
0
65
0
70
0
75
0
80
0
85
0
Portfolio B
T-bill
$50 Call
50
50
50
50
50
50
50
50
50
50
50
0
0
0
0
5
10
15
20
25
30
35
Total
Value At
Expiration
50
50
50
50
55
60
65
70
75
80
85
Regardless of where the stock closes, investor A will be worth exactly the same as investor B;
there are no differences in the two portfolios. Why does this happen? Portfolio A can never
fall below $50 -- the strike of the put. However, if the stock rises, investor A will participate
fully. Portfolio B must grow to a value of $50 because that is the T-bill portion and is
guaranteed. Portfolio B, like A, can never have a value below $50. If the stock rises, investor
B's call will start to increase in value by the same amount as the increase in stock in A's
portfolio so both A and B receive all of the upside potential in the stock.
Portfolio B is said to be the synthetic equivalent of portfolio A. Also A can be said to
be the synthetic equivalent of B.
So, a synthetic equivalent -- or synthetic -- is any position that has exactly the same profit and
loss, at expiration, as another position using different instruments.
Now here's the one small adjustment I was referring to at the beginning of this section. By
definition, synthetic positions only track the changes in portfolios and not the total value. For
example, in the above example with investor A and B, the total value of B's portfolio is the
same as A's. To have the synthetic equivalent, we only need to look at the changes. If B just
held the $50 call option and not the T-bill, he would exactly reflect the changes in A's portfolio.
For example, if A buys the stock for $50 and it falls to $40, A can exercise the put and receive
$50 -- so A starts with a value of $50 and ends with $50 and therefore has no change.
Portfolio B would also reflect no change as well. The $50 call will expire with a value of zero.
If the stock is trading at $60 at expiration, portfolio A will be worth $60, from $50, reflecting a
change of $10. Portfolio B will also change by $10, as the $50 call will now be worth $10.
The whole point of all this is that, with the original equation S + P - C = T-bill, we can ignore
the T-bill on the right hand side; it accounts for total value and not the changes in portfolio
value.
Now our equation is even easier! All you need to know is:
S+P-C=?
And you can figure out any synthetic position!
Synthetic positions
Now that you have the necessary equation, let's work through lots of examples to get the
hang of synthetic options.
For starters, remember that we said the above is equal to a T-bill? Well, if you are long stock
+ long put + short call you are said to be holding a synthetic T-bill; the positions will behave
exactly the same at expiration.
Synthetic long call
Using the equation, S + P - C = ?, we are in a position to find out. We are trying to find out
the synthetic value of a long call, so we need to get a +C (remember, we are using "+" to
denote a long position) on one side of the equation. If we add C to both sides and we get: S
+ P = C, and there's the answer; long stock and long put (left side of the equation) will behave
just like a long call (right side). Therefore, if you hold long stock and a long put, you have a
synthetic call position.
Let's check the profit and loss diagrams to see if we're correct:
We can easily see there is no difference between long stock + long $50 put purchased at $5
(left chart) and long $50 call purchased at $5. The person holding the long stock and long put
raised the cost basis of their stock from $50 to $55, that's why their break-even point is now
$55. However, they still participate in all of the upside movement of the stock. What if the
stock falls? The investor is protected for all prices below $50, which is the strike of the put.
The worst that can happen is for the stock to fall to zero. This investor will exercise the put
and receive $50 effectively only losing on the $5 they paid for the put; therefore the maximum
loss is $5.
For the call holder (right chart), they paid $5 so their maximum loss is also $5 but they too
participate in all of the upside of the stock. The stock will have to be $55 at expiration in order
for the call holder to break even.
It should now be apparent that call owners get downside protection as well as a put holders;
the call keeps you from losing value in the stock because you are not holding the stock!
So how do you own calls in an IRA? Now you should know. Use the synthetic equivalent and
buy the stock and put. Your return on investment will be much lower than the person who
buys the call because of the difference in capital required to purchase the stock, but the two
positions will behave the same way at expiration.
Synthetic long stock
Without looking ahead, see if you can use the equation S + P - C = ? and solve it for long
stock.
Because we have +S on the left side already, let's move the C and P to the other side. To do
this we need to add C and subtract P from both sides. If you did it correctly you should find
that S = C - P. Now you know that a trader holding a long call and short put (right side of
equation) are actually holding synthetic stock (left side).
Looking at the profit and loss diagrams for each:
We see there is no difference in the two positions. The long stock purchased at $50 (left
chart) will gain and lose point-for-point to the upside as well as the downside. The same
holds true for the long $50 call and short $50 put (right chart). The $50 call will gain point-forpoint at expiration while the short put will become a liability (loss) point-for-point if the stock
should fall.
So synthetic stock is long call plus a short put. What would synthetic short stock be? Just the
opposite, long put and short calls. This is great to know for all traders involved in short
selling. Now you know how it is possible to short stock without an uptick or when stock is not
even available for shorting -- use synthetics and buy the put and sell the call.
How much will it cost to short synthetic stock? Theoretically you should receive a credit. This
can be shown by the original equation S + P - C = Present value of E. If we rearrange so that
C - P = S - Present value E we see that, if S and E are equal (in other words, at-the-money),
then S - Present value E must be a positive number. In order for C - P to be positive, C must
be more expensive than P. Because you are buying puts and shorting calls, you should get a
slight credit. Realistically though, because of bid-ask spreads and commissions, it will
probably cost you a slight debit.
Synthetic covered call
Hopefully you are getting the hang of this, but we'll do one more to be sure. What is a
synthetic covered call? We know a covered call is long stock plus a short call, so it would be
represented by S - C in our equation. Looking at the equation S + P - C = ?, we need to get S
and -C on one side. In order to do that, we can just subtract P from both sides and get S - C
= -P. A covered call position is synthetically equivalent to a short put.
As expected, the profit and loss diagrams are the same. For the covered call position (left
chart), the investor buys stock at $50 and sells a $50 call for $5, effectively giving the stock a
cost basis of $45, which is the break-even point. If the stock rallies, the investor will be forced
to sell it for $50 regardless of how high the stock moves. The short put (right chart) is at risk
for all stock prices below $50, which is offset by the $5 premium received, which gives a
break-even point of $45.
How can an investor sell puts in an IRA? Using synthetics, one can buy stock and sell calls,
which is exactly the same thing from a profit and loss standpoint.
It is a little ironic that most brokerage firms require level 3 option approval to short puts yet
require only level 0 to enter covered call positions. Synthetically, they are exactly the same
thing. If you wouldn't short a put on a particular stock, you shouldn't enter into the covered
call either.
Incidentally, if you do enter a into a covered call position, you should see the benefit of
entering the order as a buy-write (please see our section under "Buy-writes" for more
information). Doing so gives the market maker two of the three sides necessary to complete
a reversal. This gives the market maker a guaranteed trade so they are very eager to get
them filled. Most of the time, you will receive a better fill than the natural at the time the trade
is placed.
Practicing with synthetics
It is a good idea to practice with the synthetic relationships of any trade you are thinking of
entering. Doing so will help you understand synthetics as well as give you additional insights
into the way the trade will behave at expiration.
As a guide, remember that there are three pieces to the puzzle: Stock, calls and puts. The
synthetic of any one of the pieces will always be some combination, either long or short, of
the remaining two. For example, a synthetic call will be some combination of stock and puts.
Synthetic stock will be a combination of calls and puts.
Once you become proficient with synthetics, you will certainly become a better options trader!
Systematic Writing
The strategy called "systematic put writing" or sometimes just "systematic writing" is a hedged
variation of naked, or uncovered, put writing. This strategy will be appealing to investors
ranging from conservative to speculative. If you like writing naked puts, this strategy will be of
great interest to you. If you think you would never attempt it, you may change your mind!
Before we start, we should clarify some misconceptions about naked put writing. When you
sell a put, you are effectively acting as an insurance company by entering into an agreement
to potentially buy stock at a fixed price over a given amount of time. For this protection, the
buyer will pay you a premium. It's a mutually beneficial relationship; you are willing to insure
their stock and they are willing to pay for the peace of mind.
Many investors shy away from naked puts because of the large downside risk, to a stock
price of zero, if the stock should fall. But these same investors are usually willing to buy stock
and hold it. Let's see what the real risk is.
Example:
Say we have two investors, A and B. A only buys stock and B only sells naked puts. In the
eyes of many investors, A is conservative, and B is a loose cannon that speculates with
options.
A and B each have $50,000 in their accounts.
XYZ stock is selling for $50 per share. A buys 1,000 shares but B sells 10 $50 puts, with 3
months of time, for $8. Investor A now has $50,000 worth of stock and no cash while B has
$58,000 cash ($50,000 cash + $8,000 from sale of put) and no stock. What happens at
expiration?
If the stock is down, say $30, A's account will be worth $30,000 but B's will be worth $38,000.
Why? Because B started with $58,000 but is forced to buy stock 3 months later for $50,000
due to the option assignment. He will pay $50,000 but receive stock worth $30,000. His
transactions are:
Portfolio value at start:
Pays for option assignment:
Receives stock:
Net account value:
+$58,000
-$50,000
+$30,000
+$38,000
In fact, B's total account value will always dominate A's for all stock prices at $58 ($50 strike
price plus $8 premium for the put) or below. Any stock price above $58 at expiration, B's
account will be worth $58,000 and no more. From a profit and loss standpoint, the two
accounts look like this at expiration:
Investor B's account dominates A's for all prices below $58. His tradeoff for this privilege is
that he does not participate in any upside potential of the stock if it moves above $50.
Investor B is giving up upside potential in exchange for a downside hedge. In addition, B has
deferred his payment for buying the stock by three months in exchange for the premium. So,
B actually appears conservative compared to A, the long stock position!
If you read our sections on "Profit and Loss Diagrams" and "Synthetic Options," you will
understand that a naked put is really nothing more than a covered call in disguise. They are
synthetic equivalents.
So, the point of all this is to understand that naked put writing really isn't as speculative or
dangerous as some would think. This is assuming you are writing puts on stock you
would buy regardless, not because the premiums are high!
Hopefully you are now not as reluctant to write naked puts. If so, continue reading about how
systematic writing may benefit you.
The systematic writing strategy
This strategy is appealing in a number of ways. It allows investors to sell naked puts but adds
a couple of new dimensions. First, it allows the investor to dollar cost average into the stock.
Second, it allows for the sale of a covered straddle thereby giving the investor one more
additional option premium to further reduce the downside risk.
The systematic writing recipe:
Step 1:Start by writing puts on half the amount of shares in which you are willing to buy (for
example, if you are willing to buy 1,000 shares, write 5 puts).
Note: Repeat step 1 until you are assigned. Again, it is very important to use this strategy
only for stocks you would be willing to buy at the strike price regardless.
Step 2:Once you are assigned in step 1, write covered straddles (sell a call and sell a put). In
this example, the investor will write 5 calls and 5 puts. The position is considered covered,
because the investor can always deliver the shares if assigned on the short calls.
Step 3:If the investor gets assigned from the calls in step 2, start with step 1 again. If
assigned on the puts again, write covered calls against the entire position.
Example:
Let's use our two investors above, A and B, and see how they would fare using naked puts
versus systematic writing.
Investor A is now convinced that naked put writing may not be so bad. He likes the stock and
would be willing to buy 1,000 shares so he sells 10 $50 puts for $8. The time to expiration is
a matter of preference, but all else equal, investors are usually better selling shorter-term
options.
Step 1 for systematic writing
Investor B uses the systematic strategy. He will write puts on one-half of the position, to
represent the 500 shares he's willing to purchase. So he writes only 5 of the contracts for $8.
At expiration, the stock is trading for $35. While A is at least hedged by the amount of the
original premium, he's not willing to buy any more stock because he is now long 1,000 shares
-- his original limit -- from the assignment. His cost basis is $42 per share ($50 for the stock
less $8 for put premium). He must sit and be patient for the stock to rally. While it is possible
for A to write calls at this point, if the stock is down far enough, this strategy may not be
sufficient, as there may be no premium in a $45 strike that would be necessary to bring him to
a profit if called away.
Step 2 for systematic writing
Because B is using the systematic principle, he bought only 500 shares from the put
assignment. Now he enters the second step of the strategy: writing covered straddles.
Investor B will now write 5 $35 puts (assume they are $5) and 5 $35 calls (assume they are
$6).
Investor B will bring in an additional $2,500 for the puts and $3,000 for the calls.
At this point, two only two things can happen for the stock: It will either be above or below
$35 at expiration. If the stock is above $35 (the strike price) at expiration, B will have his
shares called away due to the short call option. But that's okay, as we will see shortly that his
average cost is only $33, and he will make 2 points profit. But, let's assume the stock is down
again to $30. Investor B will buy his second lot of 500 shares at a price of $35, the strike of
the short put.
Investor A's cost basis is $50 for the stock, less $8 for the put, for a total of $42. Investor B's
cost basis is effectively $42-1/2 for the purchase of stock alone (500 shares at $50 and 500
shares at $35). But in addition, B took in $4,000 for the original put sale, and $5,500 for the
covered straddle (500 * $5 for the puts and 500 * $6 for the calls). The total proceeds from
the options is $9,500, for a total cost basis of $33,000 or $33 per share for investor B.
Now, investor A has a cost basis of $42, and B has one of $33 with the stock trading at $30.
Notice the large difference in cost basis between the two investors. The majority of the
difference in costs is due to B being able to average into the stock. He bought 500 shares at
$50 and 500 at $35 with 3 option premiums along the way to boot.
Step 3 for systematic writing
The third step for the systematic writing would require B to write 10 calls (covered call
position) against his 1,000 shares. The market is at $30 and his average cost is $33. Say he
can sell 10 $30 calls trading at $5 to bring his cost basis to $28 per share. If he gets
assigned, he will sell 1,000 shares at $30. If not, he will continue to write calls against the
entire position until called out. At that point, he will look to start with step 1 again in the
strategy.
Notice too that, although a two-point profit may not seem like such a big deal, the stock has
fallen 34% from $50 to $33. There is not much an investor who paid $50 for the stock can do
at this point. But our systematic writer is able to potentially capture a two-point profit despite
the fall.
Using the strategy
This is an outstanding strategy for naked put writers; especially for stocks you expect to be
volatile. The average cost basis on your stock will be greatly reduced if you are assigned on
the short put written at the time of the covered straddle.
The strategy is very versatile. Investor B, in the above example, could have written calls and
puts with different strike prices (called a strangle or combo) for step 2 instead of the covered
straddle. Investors can select different time frames or strikes to meet their needs. You can
even mix and match some of the steps. For example, if you are very bullish on the stock, you
may elect to enter step 2 initially. This way you own half the shares you are willing to
purchase and have a short put to provide a small hedge. Now, if the stock runs to the upside,
at least you have some shares to fully participate in the rally unlike the investor who starts
with step 1 and only writes puts on half the position.
Again, it should be emphasized that naked put writing can actually be viewed as a
conservative strategy if you are writing puts on stock you would be willing to buy at the strike
price regardless. If, however, you are writing puts on stocks solely for a high premium that is
present and would rather not own the stock, be aware that this is an extremely speculative
position and you should invest accordingly.
Hopefully this strategy adds some interesting insights as to how valuable options can be for
conservative and speculative investors alike.
Jelly Rolls
Breakfast menu? No, it's an actual options strategy. There doesn't appear to be any
particular reason for the name, although rumor has it that market makers on the floor of the
Chicago Board Options Exchange (CBOE) created it.
Jelly rolls are primarily used by market makers, but are a great tool for retail investors to
evaluate the fair price between calendar spreads in the same way that box spreads can be
used to evaluate vertical spreads.
While you may never enter a jelly roll, they are crucial to understand if you are placing
calendar spreads -- spreads where you buy and sell calls or puts of the same strike, but at
different expiration months.
Jelly rolls
There are many ways to view and understand the jelly roll strategy, but it is probably easiest
to view from the market makers perspective. If you read our section on synthetics, you will
recall that market makers like to enter conversions and reversals -- three sided positions -involving stock, calls and puts.
Conversions (long stock, long puts and short calls) and reversals (short stock, short puts and
long calls) are ways for market makers to lock in profits, so they are always looking for orders
that allow them to create these positions.
Say a market maker has the following reversal for January expiration:
Short 1,000 shares at $50
Long 10 $50 calls
Short 10 $50 puts
And also has the following conversion for March expiration:
Long 1,000 shares at $50
Long 10 $50 puts
Short 10 $50 calls
This is a jelly roll -- a conversion in one month and a reversal in another.
Notice the market maker is short 1,000 shares in the reversal and long 1,000 shares in the
conversion -- a net zero position. This leaves him with long calls and short puts (synthetic
long position) in January, and long puts and short calls (synthetic short position) in March as
follows:
January reversal
March conversion
Short 1,000 shares at $50
Long 1,000 shares at $50
Long 10 $50 calls
Short 10 $50 puts
Long 10 $50 puts
Short 10 $50 calls
The long and short stock positions cancel each other (shown in red). The remaining positions
are a synthetic long position (blue) in January and a synthetic short position (black) in March.
One way to interpret the January synthetic is that the market maker will buy stock for $50 at
expiration. How? If the stock is above $50, he can exercise the call and pay $50; if it's below
$50, he will be assigned on the puts and be forced to buy stock at $50. Similarly in March he
must sell stock for $50. If the stock is above $50, he will be assigned on the short calls and
be forced to sell stock at $50; if the stock is below $50, will exercise the $50 puts and receive
that amount for the sale.
The market maker is therefore left with a position that forces him to buy stock for $50 in
January and sell it for $50 in March. What is the cost? It should be evident that the market
maker is not losing any principal as he's buying and selling at $50; however, he is missing out
on the interest he could have earned during the three months had he not been forced to
purchase the stock in January. Assuming the risk-free rate of interest is 6% and exactly three
months to expiration, the cost is $50 * 3/12 months * 6% = $3/4.
Therefore, the difference in cost between the synthetic long position in January and synthetic
short position in March should be about $3/4. If the January synthetic costs $10, the March
synthetic should cost $10-3/4.
If the stock pays a dividend, this must be subtracted from the position as well, because it
represents a cash inflow. If the above stock pays a 1/4-point dividend in March, the spread
value would be reduced by 1/4 point from $10-3/4 to $10-1/2.
Calendar spreads
We can also view the synthetic long and short positions as calendar spreads:
January
Short 10 $50 puts +
Long 10 $50 call
+
= Long synthetic stock
March
Long 10 $50 puts = Long calendar spread
Short 10 $50 calls = Short calendar spread
=Short synthetic stock
If we view the positions vertically, we see the market maker has a long synthetic stock
position in January and short synthetic stock position in March. This is the way we were
viewing the positions earlier. However, we can also view them horizontally and say he is long
a put calendar spread (long Mar $50 puts and short Jan $50 puts) and short a call calendar
spread (short Mar $50 calls and long Jan $50 calls).
An equally valid way, then, to view the jelly roll is the difference between two calendar
spreads (also called time or horizontal spreads).
If you trade calendar spreads, here's where the jelly roll can help!
Example:
Intel (INTC) is currently trading for $36-7/8 with the following quotes:
Calls
Month/Strike
Jan $35
Apr $35
Bid
5-3/8
7-1/4
Ask
5-3/4
7-5/8
Puts
Bid
3-1/8
4-1/4
Ask
3-1/4
4-5/8
Say you are interested in the following long calendar spread: Long April $35 calls and short
January $35 calls. The natural quote is currently $2-1/4 debit:
Buy Apr $35 calls = $7-5/8
Sell Jan $35 calls = $5-3/8
Net debit
$2-1/4
Because there is a net payment (debit), this is a long calendar spread.
Traders often ask if this is a fair price. Is there room to negotiate? If so, how much?
To answer these questions, let's look at the value of the synthetic long and short stock
positions from the retail investor's side. An investor buying a synthetic long position will pay
the asking price and sell at the bid price. As a guide, these numbers are highlighted below:
red is a debit and blue is a credit.
Calls
Month/Strike
Jan $35
Apr $35
Bid
5-3/8
7-1/4
Ask
5-3/4
7-5/8
Puts
Bid
3-1/8
4-1/4
Ask
3-1/4
4-5/8
The retail investor can create the January synthetic long and April synthetic short for: +7 1/4 $5 3/4 + $3 1/8 - $4 5/8 = $0. So a retail investor will receive zero credit for the trade. How
much should it be worth theoretically? There are approximately 135 days to expiration, so the
cost of carry is roughly $35 * 135/360 * 6% = 0.79 cents.
In addition, any dividends received must be subtracted. Intel is currently paying 2 cents per
share. The dividend is expected during the life of the jelly roll, so the cost is reduced from 79
cents to about 77 cents[*]. Most of the time dividends are not a big concern, especially for
tech companies. But in cases where the dividends are sizeable, be sure to factor it into the
cost.
[*]Technically, the credit will be reduced by the present value of the dividend. This is because the investor must wait to
receive the dividend. However, since most dividends are small as well as the time between buying and selling the stock,
most traders will just subtract off the full amount of the dividend as a very close estimate.
The trade should be worth a credit of 77 cents, but the retail investor receives zero. The
spread is clearly not priced fairly at the bid and ask prices for the retail investor.
How about from the market makers' perspective? Using the same color coded notation as
before, the market maker can create the synthetic January $35 long position by buying the
Jan $35 call at the bid and selling the Jan $35 put at the ask. He can also create the
synthetic short April position by purchasing the Apr $35 put on the bid and selling the Apr $35
call at the ask as shown in the chart below:
Calls
Month/Strike
Jan $35
Apr $35
Bid
5-3/8
7-1/4
Ask
5-3/4
7-5/8
Puts
Bid
3-1/8
4-1/4
Ask
3-1/4
4-5/8
The synthetic positions will create a net credit of: -$5-3/8 + $7-5/8 - $4-1/4 + $3-1/4 = + $11/4.
We said earlier the fair price of the package should be about 77 cents; however, the retail
investor receives nothing, and the market maker wants $1-1/4.
Notice a key point here. The market maker is able to construct the synthetic long and short
positions with the color coded trades above. If you recall from the beginning, we were
assuming you were interested in the calendar spread consisting of long April $35 calls, and
short January $35 calls. You would pay the asking price on the April $35 calls and sell for the
bid price on the January $35 calls -- exactly two of the pieces the market maker needs to
construct his synthetic positions!
The market maker can offset your trade by buying an April $35 put at $4-1/4 and selling the
January $35 put at $3-1/4 (remember, market makers buy at the bid and sell at the ask). In
other words, because you want to be long the calendar spread, the market maker must be
short the same spread in order to fill the order. To offset the short call calendar spread, he
will execute a long put calendar spread.
Because neither party -- neither you nor the market maker -- wants to execute the trade for
less than 77 cents, it appears you have about 48 cents with which to work. The market maker
wants $1-1/4, but theoretically should only receive 77 cents for a difference of 48 cents. You
probably won't be able to shave the full 48 cents off the price, but 1/4 point certainly looks
reasonable. So the calendar spread we described earlier:
Buy Apr $35 calls = $7-5/8
Sell Jan $35 calls = $5-3/8
could probably be filled for a net debit of $2 instead of the $2-1/4 natural.
Now, 1/4 point may not seem like much, but on a relative basis, it's about 11% better than the
$2-1/4 debit most traders would be tempted to place.
This is the essence of great options trading -- becoming a little bit better on each trade. It's
the little changes that make big differences on profits.
STRATEGIES
Wrangles
The wrangle is a complex position usually used by market makers for reasons we will see
later. It consists of a long ratio spread with calls and a long ratio spread with puts. Long ratio
spreads are also known as backspreads. A long call ratio spread is established by selling a
lower strike call and purchasing two (or more) higher strike calls. Likewise, a long put ratio
spread entails selling a higher strike put and then purchasing two (or more) lower strike puts.
Let's look at the individual pieces and then put them together. The profit and loss diagram for
a long call ratio spread looks like this:
The profit and loss for the long put ratio spread looks like this:
If we put these two profit and loss diagrams together we get the wrangle:
If you read our section on the strategy of "strangles," you may recognize the above profit and
loss diagram as identical. However, the wrangle, unlike the strangle, will not be exposed to
the same time decay if the stock stands still. It's my guess that the wrangle gets its name from
the fact that it is a ratioed strangle (which sounds like wrangle).
It may be difficult to see why the above profit and loss diagram results from two long ratio
spreads but let's break down the two component positions using $50 and $55 strikes and see
if we can make sense of it.
The basic long call ratio spread is:
Sell 1 $50 call
Buy 2 $60 calls
The basic long put ratio spread is:
Sell 1 $60 put
Buy 2 $50 puts
There are many ways to dissect this position but probably the easiest is to look at just the
short positions: sell 1 $50 call and sell 1 $60 put. These two options, by themselves, are a
short in-the-money strangle also called a "guts." The reason it is an in-the-money strangle is
because the put has a higher strike thereby guaranteeing this position to be down at least $10
(the difference in strikes) at expiration. Don't let the guaranteed value bother you because we
haven't even talked about price yet; the markets will have to pay you more than $10 for it. We
will use the proceeds from this short strangle to purchase two $50 puts and two $60 calls,
which is a long out-of-the-money strangle. Because we are long more contracts than short,
this position must become profitable as the market moves either up or down. In other words,
we are net long calls and puts so must make money if the market explodes to either the
upside or downside.
Another way to look at this net long contract position is to look at just the calls. If we are long
two $60 calls and short 1 $50 call, the effectively we are net long one $60 call. The sale of
the one $50 call reduced our purchase price a bit and lessens the risk if the stock should fall.
That's why the chart goes up on the right "wing" (showing profit) if the stock should move
beyond $60; we are net long 1 $60 call.
A similar argument can be made for the puts.
Is this position better than a strangle? It depends on your outlook on the stock and tolerances
for risk. Remember, there are no superior strategies as they all come with their own unique
sets of risks and rewards (Please see course "Best Strategy" under week 1). The wrangle
has less risk if the stock stands still but will also take longer to become profitable if the stock
does move. That's because the short positions are competing with the deltas of the long
positions -- something known as gamma risk.
The benefit of the short strangle is offset by its sluggish responsiveness to moves in the
underlying stock. Which is better depends on you and the circumstances at the time of the
trade.
While wrangles are generally used by market makers (after all, there are four commissions
just to establish the long position!), this doesn't mean it's not useful for retail investors to
understand. One scenario is that you enter into a backspread (long ratio spread) at one time
and hedge at a later time by legging into a wrangle.
But probably more important is the wrangle shows, once again, the versatility that options
provide and why they are so necessary to understand if you want to compete in today's
markets. By finding different combinations of calls and puts, you can completely change the
risk-reward characteristics to match your needs and that is something that cannot be done
with stocks alone.
Synthetic Short
If you read the section on synthetics, you should have a handle on how they work. Now we'll
show you how powerful they can be.
Shorting stock
Before we talk about synthetic short stock, let's go through the basic short sale.
A popular strategy among bearish investors is shorting stock. When you short stock, you are
selling it first and then buying it back later at hopefully a lower price. Short sellers are
attempting to sell high and buy low -- just in the reverse order of bullish investors.
In order to sell stock you don't own, you must borrow it from another investor. While this may
sound complicated, it is a seamless transaction and usually takes a matter of seconds to
execute.
Notice how the short stock position is exactly opposite the long position:
This means the investor who is short stock has unlimited upside liability. As the stock moves
higher, the short position increases its losses.
Uptick
There is one catch with selling stock short; the sale must be done on an uptick or a zero-plus
tick. What is an uptick? Say a stock is quoted bid $25 and offered at $25-1/2 with the last
trade at $25. If the next trade is higher than the last trade of $25, that new trade is an uptick.
If the trade is lower, it is a downtick.
When you look at the last trade of a stock, you will usually see a "+" or "-" sign to the side (or
on some systems, an up or down arrow). The "+" indicates and uptick and the "-" a downtick.
Using the above example, if the next trade is $25-1/4, you will see the last trade reported as
+$25-1/4. If the following trade is back to $25, you will see -$25.
If the next trade is $25-1/4, again, you will see +$25. What if the following trade is also $251/4? That is called a zero-plus tick indicating that the last change was an uptick but the
recent prices are unchanged.
The uptick rule was created to prevent investors from selling into a sharp downtrend, thereby
nearly guaranteeing a profit. The rule is of little significance to the investor other than it must
be met. There is nothing the trader needs to do other than place the order -- either it will fill or
it won't.
Because of the uptick rule, it is possible for a short sale to not execute even if it is a
market order!
We've seen there are two main obstacles to overcome when shorting stock: shares must be
located to be borrowed and the sale must occur on an uptick.
Locating shares
Although it is fairly uncommon, it is possible for shares to not be available for shorting.
Around April of 1999, there was a four-month period where Amazon.com (AMZN) was starting
to fall after being on a record climb to the upside (shown in red circle below). Prior to that,
investors saw it fall from nearly $100 to just above $40 (blue circle). So once it started falling
again in late April, investors were eager to sell it short hoping it would fall back to $40.
But many investors were unable to capitalize on the situation, as there was a two-week period
or so where no shares were available to short!
Most investors would let the situation pass as an unfortunate market technicality, and miss
out on a potentially terrific trading opportunity.
But if these same investors understood synthetic options, they would have participated fully
on the short side. Better yet, they would avoid the uptick rule.
Synthetic short stock
If you read our section on synthetics, you will recall the equation for synthetic options is Stock
+ Put - Call = ? Because we want to find out the synthetic equivalent of short stock, we need
to get short stock (minus stock) by itself in the equation. If we subtract stock from both sides,
we get Put - Call = - Stock and there's the answer: Long put + short call = short stock.
Basically what investors are doing with synthetic short sales is buying puts, and that gives
them the right to sell the stock so, will appreciate as the stock falls -- just like a short stock
position. However, puts can be very expensive especially under the conditions in the chart
above. So in order to pay for the puts, investors will sell calls and use the proceeds to buy
the puts. If the stock is trading for $100, the trader should theoretically receive a credit from
the trade. But due to bid-ask spread and commissions, the synthetic short sale will usually
result in a slight debit.
From a profit and loss standpoint, the synthetic short position looks like this:
We can see that is looks exactly like our short stock position shown earlier; at expiration, the
investor gains point-for-point if the stock falls, and loses point-for-point if it rises. The
synthetic position, at expiration, is behaving exactly like short stock.
It is important to remember that options do not behave like stock until expiration unless they
are very deep-in-the-money. So if a trader executes a synthetic short at a strike of $100, the
profit and loss diagram will not have the above shape until expiration. If a trader wishes to
have the options behave more like stock, he should consider buying an in-the-money put and
selling and in-the-money call.
What's great about the synthetic short is that it does not need an uptick to execute. You
simply place your order to buy the put and sell the call. Of course, it is usually suggested
these two trades be placed simultaneously to prevent execution or risk -- the risk of an
unfavorable market move while you are executing two separate orders.
Bear in mind that the short call position is naked. This means you will generally need level-3
option approval and, in addition, will have an option requirement in order to hold the naked
call position. Be sure to check with your broker if you are unsure as to how that works. The
requirement is not a huge offset for the synthetic position compared to short stock; the short
stock position will be charged with a 50% Reg T requirement, which is not applicable to the
synthetic.
Bullet strategy
There is an interesting strategy known as a "bullet" where investors can actually intensify the
fall of a stock and increase the odds that they will make money. Here's how it works, Say a
stock is in a rapid decline. You'd like to short it, but you're concerned there may not be an
uptick. However, if you buy a put, the market maker will be forced to short the stock and buy
a call to create the long put position for you. Market makers are not subject to the uptick rule;
they can just hit the bid and execute a short sale.
One strategy is to buy deep-in-the-money puts, which force market makers to hedge nearly
dollar-for-dollar and short an equal number of shares. For example, say a stock is trading for
$100 and falling sharply. If you buy a deep-in-the-money put such as a $130 (or wherever
delta is near 1), the market maker will sell nearly 100 shares for each put, thereby putting
more downward pressure on the underlying. Because you hold a deep-in-the-money put, it
will appreciate nearly dollar-for-dollar with each point fall in the underlying.
To exacerbate the fall further, you can enter the deep-in-the-money synthetic short position by
selling the calls, too. Now the market maker will be forced to short the stock again nearly
point-for-point. So if you buy 10 puts and sell 10 calls (both deep-in-the-money), the market
maker will be forced to short nearly 2,000 shares without an uptick.
Semifutures
There is a related strategy that has a little less risk called a semifuture. The strategy can be
used as a long or short position. If you want a synthetic short position with a little less risk,
you can split the strike prices, such as buy the $50 put and sell the $55 call. The more
distance you put between the strikes the less upside risk there is. From a profit and loss
standpoint, the short semifuture position looks like this:
You can see that the flat area between $50 and $55 creates less risk to the upside. In other
words, with synthetic stock at $50, the trader is exposed to losses for any stock price above
$50. With the semifuture, the trader is not exposed to losses until the stock is above $55.
The semifuture strategy can be split further. For example, the trader may buy the $45 put and
sell the $55 call. Now there will be less risk to the upside, but also less profit to the downside
as shown in the following chart:
Market downturns can be fast and furious, which is what attracts speculators to short sales.
Many investors recognize potential situations, but are unable to capitalize on them due to
market restrictions. If you understand synthetics, you can overcome many restrictions and
profit from your outlook on the market.
Option Exam 11 - Week 11
1) A position of long stock plus long put is synthetically the same as a:
a) Long put
b) Long call
c) Short call
d) Short put
2) Synthetic equivalents have the same ____ as the asset being replicated:
a) Profit and loss shape
b) Cost
c) Profit
d) Return on investment
3) Short stock plus a long call is synthetically the same as:
a) Short put
b) Short call
c) Long put
d) Long call
4) A trader wants to execute a short sale in a rapidly falling market. There have been no
upticks so he cannot get the trade executed. However, he can get it executed by entering a
synthetic short by:
a) Buying a call and selling a put
b) Buying a put and selling a call
c) Buying a call and buying a put
d) Selling a call and selling a put
5) A jelly roll is a(n):
a) Synthetic long in one month and a synthetic short in another
b) Synthetic short and synthetic long in the same month
c) Synthetic short in one month and a long position in another
d) Synthetic short in one month and a short position in another
6) Synthetic short stock positions have:
a) Limited upside risk
b) Unlimited downside risk
c) Unlimited upside and downside risk
d) Unlimited upside risk
7) Jelly rolls can be used to determine if _____ are being priced fairly.
a) Box spreads
b) Vertical spreads
c) Calendar spreads
d) Synthetic calls
8) Systematic writing is a three-step method of writing naked puts over time. Once you are
assigned on puts written in the first step, the next step is to sell:
a) Covered straddles
b) Naked straddles
c) Spreads
d) Box spreads
9) If you are interested in purchasing 400 shares of a stock and want to use a systematic
writing strategy, what is the first step?
a) Sell 4 straddles
b) Sell 4 puts
c) Sell 2 puts
d) Buy 200 shares
10) What is the last step in a systematic writing strategy?
a) Selling puts
b) Selling calls
c) Buying puts
d) Selling straddles