OPTIONS SPREADS  Options are a wasting asset. Who wants to buy a wasting asset?  But selling a wasting asset, now that’s a different story.  If options.

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Presentation transcript:

OPTIONS SPREADS

 Options are a wasting asset. Who wants to buy a wasting asset?  But selling a wasting asset, now that’s a different story.  If options are sold, not bought, and the market is relatively stable, profit can be made simply from the pure deterioration of the time premium of the short options.  Trading options for income is essentially about selling options and profiting from the evaporation of their time premium.

 When a short call is sold, the risk is theoretically unlimited on the upside and when a short put is sold the risk is theoretically as large as the underlying stock or index dropping to zero on the downside.  These positions are called naked calls or naked puts.  Brokers will margin naked options so heavily that the returns on these positions would not be worth the risk.

 If however the customer buys a long position to cap the unlimited risk, the broker will recognize that and margin the greatly reduced maximum risk.  Buying a long option further from the money in the same month as an otherwise naked short position is known as a “credit spread” because the premium received for the short is greater than the premium paid for the long.  The long options caps the risk by the amount of the strike separation between longs and short.  Credit spreads are directional trades, although profit is made in every scenario except a hard move against the credit spread.

 Capital consumed by credit spreads are calculated as follows: Number of Contracts X 100 X (i.e. the Strike separation between short option and long option) minus the Credit Received.

 Debit spreads are the mirror image of credit spreads—a long option which costs more money than the short option with which is paired in the same month. As the long option costs more than the short option, the term “debit” spread is used.  Debit spreads are cheaper than and similar to long calls or long puts but there is a cap on the upside profit of a debit spread.  Call credit spreads and put debit spreads at the same strikes have the exact same economics and accomplish the same purposes.

 A credit spread on the call side has virtually the same economic outcome as a debit spread at the exact same strikes on the put side.  A debit spread on the call side has virtually the same economic outcome as a credit spread on the put side at the exact same strikes.  Why?— “call—put parity”—the principle that time premium of same strikes on call side and put side are virtually the same.

 A short straddle is when you sell a call and a put at the same strike.  Remember the most time premium is ATM and thus a short straddle ATM has the most time premium of any position and the most time premium to burn off as it approaches expiration.  The expiration day profit range for slide 19 is : there is so much time premium evaporating from those ATM options that the market can move 42 points in either direction and the position would still show a profit.

 Take a look at Slide 7—it’s expanded to show the what would happen if a huge price move occurred before expiration. Your potential loss is infinity. That’s a lot of money.  Plus your broker will margin you so much that your return for such a transaction would be pitiful.  So how do we solve this?

 As with credit and debit spreads brokers typically “margin” clients by taking the worst case scenario loss on each position and encumbering that much capital in your account.  If the trader buys long options—in the case of a straddle the long options would be known as “wings” -- it puts a maximum on that worst case scenario and therefore the margin, making the capital level reasonable for a viable trade.

 The position now becomes an “iron butterfly”— once call credit spread and one put credit spread with wings farther out resulting in an overall cash credit to the account.  Note how the capital level drops almost 90% because of the wings.  That is because the worst case scenario is calculated as follows: (the long strike minus the short strike) X number of contract X 100 minus the credit received for the entire position

 (50 points between longs and shorts X 10 options contracts X 100)-credit of 31,770=$18,230.  You only margin one side or the other because the market can’t invade both credit spreads at the same time as they are “facing” in opposite directions.  Note that in this case the breakevens were not greatly reduced by adding wings but risk and capital were dropped by almost 90%.

 Butterflies can also be structured on the call side only or the put side only by using the principle that opposite side credit spreads and debits spreads at the same strike are virtually the same trade.  So the iron butterfly on screen 32 is virtually the same trade as the call side butterfly on screen 30 or the put side butterfly on screen 31.

 A strangle is a position that combines both a call and a put out of the money surrounding the market price at some distance.  Many of the most popular options strategies involve selling strangles and then buying wings further out of the money.  Time premium decays more slowly on strangles, and they have less income potential, but the profit ranges are generally wider than straddle-based trades.

 As with straddles, adding wings to strangles cuts the risk and controls the margin, reducing capital levels and increasing returns.  Wings in connection with strangles are typically added in the front month (for  “ iron condors”) and in the back month (for “double diagonals”).

 Time spreads, also known as calendar spreads involve selling a front month call or put and selling the same back month option, normally at or near the money.  Profit is made on time spreads because the front month time premium completely evaporates at expiration while the back month time premium evaporates more slowly and still retains much of its value on the expiration date of the front month short.

 Look at the time premium of the short and long options of the calendar spread on slide 39.  Note the time premium of those same options on slide 40. Both burned off time premium (theta doing its thing) but the short option burned off faster. That relative difference in theta is why time spreads can be profitable.

 An options Implied Volatility (IV or MIV) is the one standard deviation probability that a stock or index will close in exactly one year in a range plus or minus the IV.  So for example if IBM is trading at 145 and the 145 January 2010 call has an IV of 18, the market is pricing in a one standard deviation probability that IBM will close in January of 2011 in a range between 127 and 163 ( i.e. plus or minus its IV of 18)

 Calculating IVs less than a year out can be important when setting up spreads so that you can feel more comfortable that a spread will be profitable during your trade period as the probability of the market price staying within the profit range of the spread is satisfactory.  The formula is as follows: (Square root of #days to expiration/365)* (MIV of ATM call)* ( Market Price of the Stock)= the 1 SD range of the stock during trade in either direction.  So, to calculate the 45 day one standard deviation range of IBM in the previous example, the formula is as follows: (Square root of 45 /365) times (.18) times 145= So the market is pricing in a 68% probability that IBM will close between and in 45 days.

 Single Calls  Single Puts  Credit Spreads  Debit Spreads  Straddles  Strangles  Time Spreads  Now let’s go make some money!

 Select seven different vehicles of your choice—they can be a stock, an index or an ETF.  Iron Condor: For one of them, go 60 days out and sell a 10 lot iron condor with the delta of the short strikes set at approximately 10 on both sides with wings the next strike out. In your own words, explain why the “net requirement” is at the value shown by optionvue. Also, advance backtrader to one day before expiration and note the P and L of the position and the greeks.  Double Diagonal: For another vehicle, go 45 days out and sell a 10 lot double diagonal with the delta of the short strike set at approximately one standard deviation 38 days into the trade on both sides with wings two strikes strike out the next month out. In your own words, explain why the “net requirement” is at the value shown by Optionvue. Also, advance backtrader to one day before expiration and note the P and L of the position and the greeks.  Iron Butterfly: For another vehicle, go 30 days out and sell a 10 lot ATM iron butterfly with the wings set at one standard deviation 23 days into the trade. In your own words, explain why the “net requirement” is at the value shown by Optionvue. Also, advance backtrader to one day before expiration and note the P and L of the position and the greeks.  Butterfly : For another vehicle, go 30 days out and sell a 10 lot ATM butterfly with the wings set at one standard deviation 17 days into the trade. In your own words, explain why the “net requirement” is at the value shown by Optionvue. Also, advance backtrader to one day before expiration and note the P and L of the position and the greeks.

 Calendar Spread: For another vehicle, go 40 days out and sell a 10 lot ATM call side calendar spread. In your own words, explain why the “net requirement” is at the value shown by Optionvue.. Also, advance backtrader to one day before expiration and note the P and L of the position and the greeks.  Credit Spread: For another vehicle, go 35 days out and sell a 10 lot put credit spread one standard deviation out of the money. In your own words, explain why the “net requirement” is at the value shown by Optionvue.. Also, advance backtrader to one day before expiration and note the P and L of the position and the greeks.  Debit Spread: : For the final vehicle, go 20 days out and buy a 10 lot ATM put debit spread. In your own words, explain why the “net requirement” is at the value shown by Optionvue.. Also, advance backtrader to one day before expiration and note the P and L of the position and the greeks.