14 The Greeks
20.2 PRECISION OPTIONS
Long straddleoptions are used when the market is near A and there is an expectation that the markets will start to move but there is uncertainty as to the direction. This is an especially good position to have if the market is quiet and then starts to zigzag sharply, signalling a potential eruption. Profit is open-ended in either direction. At expiration, break-even is at A, plus or minus the cost of the spread. However, the position is seldom held to expiration because of increasing decay levels with time. Loss is limited to the cost of the spread with maximum loss being incurred if the market is at A at expiration. Decay accelerates as the options approach expiration. For this reason, the position is adjusted to neutrality by frequent profit taking. It is normally taken off well before expiration.
Short straddleoptions are used if the market is near A and there is an expectation that the market is stagnating. Because the trader will be short options, the trader will reap profits as they decay, as long as the market remains near A. Profit is maximised if at expiration the market is at A and the loss potential is open-ended in either direction. The position must therefore be closely monitored and readjusted to neutrality if the market begins to drift away from A.
Because they are only short options, the trader will pick up time value decay at an increasing rate as expiration nears, maximised if the market is near A.
Long strangleoptions are used when the market is stagnant and the market is within or near A–B range. If the market explodes either way, the position will make money, but if the market continues to stagnate, then the position will lose less than with a long straddle. Profit is open-ended in either direction and break-evens are at A minus the cost of the spread and B plus the cost of the spread. However, the spread is not usually held to expiration. Loss is limited and in its most common version, loss is equal to net cost of the position. Maximum loss is incurred if, at expiration, the market is between A and B. Decay accelerates as the option
Figure 20.9
Figure 20.10
Figure 20.11
approaches expiration but not as rapidly as with long straddles. To avoid the largest part of decay, the position is normally taken off prior to expiration.
Short strangleoptions are used when the market is within or near A–B range and, though active, is quieting down. If the market goes into stagnation, the position makes money. If it continues to be active, there is a slightly less risk than with a short straddle. Maximum profit is realised if the market, at expiration, is between A and B.
Potential loss is open-ended. Although less risky than a short straddle, the position is not riskless. It got its name during the April 1978 IBM price swings, when a number of good traders holding this position were wiped out. Because the position is one of only short options, the trader will pick up time value decay at an increasing rate as expiration nears and is maximised if the market is within A–B range.
Long butterflyoptions are one of the few positions that may be entered into advantageously in a long-term options series. The rule of thumb is that a trader will enter into this option type when, with one month or more to go, cost of the spread is 10% or less of B–A (20% if a strike exists between A and B). Maximum profit occurs if the market is at B at expiration. That profit
Common Option Strategies 141
Figure 20.12
Figure 20.13
Figure 20.14
would be B–A-cost of doing the spread. This profit develops, almost totally, in the last month.
Maximum loss, in either direction, is the cost of the spread. This is a very conservative trade and break-evens are at A plus the cost of the spread and at C minus the cost of the spread. Decay is negligible until the final month, during which time the distinctive pattern of the butterfly forms. Maximum profit growth is at B. If the trader is away from the A–C range entering into the last month, the trader may want to liquidate the position.
Short butterfly options are used when the market is either below A or above C and the position is overpriced with one month or so left. Also, this option strategy can be used when there is only a few weeks left and the market is near B and there is an expectation of a move in either direction. Maximum profit is credit for which the option spread is put on. This occurs when the market, at expiration, is below A or above C, thus making all options in-the-money or all options out-of-the-money. Maximum loss occurs if the market is at B at expiration. The amount of the loss is B–A-credit received when setting up the position. Break-evens are at A plus initial credit and at C minus initial credit. Decay is negligible until the final month, during which time the distinctive pattern of the butterfly forms. Maximum loss is at B.
Long condoroptions are entered into in far-out months. It is worth twice the average of A–B–C and B–C–D butterflies because it has twice the profit area. Maximum profit is realised
Figure 20.15
Figure 20.16
if the market is between B and C at expiration. Break-evens are at A plus the cost of the condor and D minus the cost of the condor. Maximum loss occurs if the market is below A or above D at expiration. Decay is negligible until the final month, during which time the “super butterfly”
condor develops its characteristic shape. Maximum profits occur in B–C range.
Short condoroptions are normally entered into when the market, with less than one month to go, is between B and C but the trader thinks there is a good potential for a strong move outside of that range. Maximum profit will occur if the market is below A or above D at expiration.
Maximum loss will occur if the position is held to expiration and, at that time, the market is between B and C. Decay is negligible until the last month, during which time the distinctive condor pattern emerges. The loss accelerates via decay with the market between B and C.
Call ratio spreadoptions are usually entered into when the market is near A and the user ex- pects a slight rise in the market but also sees a potential for a sell-off. Maximum profit is realised if the market is at B at expiration. Loss is limited on the downside but is open-ended if the mar- ket rises. The rate of loss, if the market rises beyond B, is proportional to the number of excess shorts in the position. If the market is at B, profits from option decay accelerate the most rapidly with passage of time. At A, there is the greatest rate of loss accrual by decay of long positions.
Put ratio spreadoptions are usually entered into when the market is near B and there is an expectation that the market will fall slightly but also there is a potential for a sharp rise.
Maximum profits are realised if the market is at A at expiration. Loss is limited on the upside but is open-ended if the market falls. The rate of loss, if the market falls below A, is proportional to the number of excess shorts in the position. If the market is at A, profits from option decay accelerates the most rapidly with passage of time. At B, there is the greatest rate of loss accrual by decay of long positions.
Call ratio backspreadoptions are normally entered into when the market is near B and shows signs of increasing activity, with greater probability to the upside. For example, if the last major
Common Option Strategies 143
Figure 20.17
Figure 20.18
Figure 20.19
move was down, followed by stagnation. Profit is limited on the downside but open-ended in a rallying market. Maximum loss is realised if the market is at B at expiration. However, this loss is less than for the equivalent long straddle, the trade-off for sacrificing profit potential on the downside. If the market is at B, loss from decay will accelerate the most rapidly. Therefore, it is wise to exit early as the market is near B as you enter the last month. At A, there is the greatest rate of profit accrual by decay of short options.
Put ratio backspreadoptions are normally entered into when the market is near A and shows signs of increasing activity, with greater probability to the downside. For example, if the last major move was up, followed by stagnation. Profit is limited on the upside but open-ended in a collapsing market. Maximum loss is realised if the market is at A at expiration. This loss is less than for the equivalent long straddle, the trade-off for sacrificing profit potential on the upside. If the market is at A, loss from decay will accelerate the most rapidly. Therefore, the trader will want to exit early if the market is near A as the position enters the last month. At B, there is the greatest rate of profit accrual by decay of short options.
Figure 20.20
Figure 20.21