options trader 0705

BUTTERFLY SPREADS:A better way to sell volatility

JULY 2005Volume 1, No. 4

• BUYING TIMEwith long straddles

• OPTIONSSTRATEGY LAB:Trading employment reports with short strangles

• A DIFFERENTPERSPECTIVEon naked puts

• HOW TO CONTROLrisk with spreads

• CHOOSINGthe best option

2 July 2005 • OPTIONS TRADER

Contributors . . . . . . . . . . . . . . . . . . . . . . . . . .4

Letters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6

Options NewsOptions exchanges jockeying after NYSE-Arca deal . . . . . . . . . . . . . . . . . . . .8The New York Stock Exchange-Archipelago merg-er could cause some changes in the options and futures markets.By Jim Kharouf

Trading StrategiesOption butterflies: A safer way to sell volatility . . . . . . . . . . . .10Learn how and when to use the butterfly spread.By Keith Schap

Long straddles: The importance of buying time . . . . . . . . . .16Profiting from long straddles is largely a matter of time management. By Jim Graham

Taking a peak at naked puts . . . . . . . . . . . .20Learn how to save money by using naked puts as an alternative to long stock positions.By Mark Vakkur, M.D.

Options Strategy Lab . . . . . . . . . . . . . . .24Employment report strangle.

Options BasicsThe volatility index (VIX) . . . . . . . . . . . . . . .28The background of the VIX.

Controlling risk with spreads . . . . . . . . . . .30Spreads can be a more appealing, lower-risk way to trade options than simply buying or selling puts or calls outright. By Brian Overby

Choosing the best option . . . . . . . . . . . . . .34How to find options that work well with swing trades.By Peter Stolcers

Options Resources . . . . . . . . . . . . . . . . . .36

Options Expiration Calendar . . . . . . . .37

Options Diary . . . . . . . . . . . . . . . . . . . . . . .38

Key Concepts and Definitions . . . . . . .40

Have a question about something you’ve seen in Options Trader?Submit your editorial queries or comments to [email protected].

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CONTENTS

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Volume 1, Issue 4. Options Trader is published monthly by TechInfo, Inc., 150 S. Wacker Drive, Suite 880, Chicago, IL 60606. Copyright © 2005TechInfo, Inc. All rights reserved. Information in this publication may not bestored or reproduced in any form without written permission from the publisher.

The information in Options Trader magazine is intended for educational pur-poses only. It is not meant to recommend, promote or in any way imply theeffectiveness of any trading system, strategy or approach. Traders are advisedto do their own research and testing to determine the validity of a trading idea.Trading and investing carry a high level of risk. Past performance does notguarantee future results.

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A publication of Active Trader®

CONTRIBUTORS


CONTRIBUTORS

�Keith Schap, formerly senior editor at Futures mag-azine and senior technical marketing writer at theChicago Board of Trade, is currently a freelance writerspecializing in risk management and trading strategies.He is the author of numerous articles and several bookson these subjects, including the recently published TheComplete Guide to Spread Trading (McGraw-Hill).

� Jim Graham is the product man-ager for OptionVue Systems and a reg-istered investment advisor forOptionVue Research.

� Steve Lentz is executive vice president ofOptionVue Research and is the chief trader for the com-pany’s CTA-managed futures program called the Swing500.

� Peter Stolcers (www.oneoption.com) is a traderfor Last Atlantis Capital, a proprietary trading firm. Priorto that he was a senior vice president of Terra NovaTrading LLC in Chicago and vice president of sales at ED& F Man International. Stolcers is an experienced optionstrader, with more than a dozen years of success. He canbe reached at [email protected].

�Brian Overby (www.brianoverby.com) is a trader andinstructor who has given more than 1,000 seminars world-wide on options trading. He has been in the financialindustry since 1992 and previously worked forOptionsXpress, Schwab, the CBOE, and Knight TradingGroup. He can be reached at [email protected].

� Mark Vakkur, M.D. ([email protected],www.vakkur.com) is a stock and options trader and a psy-chiatrist in private practice in Atlanta.

�Jim Kharouf is a business writer and editor withmore than 10 years of experience covering stocks, futures,and options worldwide. He has written extensively onequities, indices, commodities, currencies, and bonds inthe U.S., Europe, and Asia. Kharouf has covered interna-tional derivatives exchanges, money managers, andtraders for a variety of publications.













http://www.oneoption.com


http://www.brianoverby.com



http://www.vakkur.com

http://www.dcmoneyshow.com

Iwould like to know where I could go to read up on forex options, in partic-ular what the different strategies are called vs. regular options. Are spreadscalled “spreads” in forex? For example, can you place a bull call spread in

forex — that is, can you buy and sell two call options at the same time?

— D. Shaw

Spot forex options are a breed apart, actually. The article “Forex options” in the Juneissue of Options Trader explains the terminology and illustrates different strategies.

The eyes have(had) it

T hank you for your excel-lent publication. I’mdelighted with the inform-

ative content but I’m curious aboutthe layout. Are you expecting us toprint it out? Perhaps you are, andthat would be the reason why youare still formatting the content inportrait orientation, with multipletext columns per page. However, I’dwager that most people receivingthe magazine would prefer not toprint it out, but would rather view alandscape orientation on theirscreens. Would you considerswitching the orientation to make itmore screen-reader friendly?

— Phil Greenwood

We get arguments from bothsides of the fence. People whoprint it send suggestions forimprovement, and we also hearfrom people with opinions similar toyours.

Rest assured, we are taking intoaccount all reader feedback andwill do whatever we can to givepeople the most user friendly mag-azine possible.


LETTERS

VIX rub

C ongratulations on the newmagazine — what anundertaking! I have been

enjoying the real, in-depth, optionsmaterial, but I’m sure it has been adaunting undertaking with lots oflong hours.

I’ve noticed there have been severalreferences to the CBOE VolatilityIndex (VIX). The VIX gets a lot of cov-erage, as options traders rely heavilyon it as a market barometer as well asa strategy indicator. However, [in theJune issue], the description of how it iscalculated is outdated — which can beespecially troublesome in a publica-tion at the level of Options Trader.

The article “Market insurance poli-

cies” by William McLean in the Juneissue states “...the CBOE VolatilityIndex, which reflects the impliedvolatility of at-the-money OEXoptions.” It should read “the CBOEVolatility Index (VIX) is a key measureof market expectations of near-termvolatility conveyed by S&P 500 stockindex option prices.”

It looks like the description thatMcLean used refers to the originalmethodology for calculating VIX. Thatmethodology was changed in 2003,and today the VIX is based on all at-the-money plus out-of-the money S&P500 (SPX) calls and puts with 30 daysto maturity.

I just wanted to let you know — asI’m sure VIX will be mentioned againat some point.

— Lynne Howard-ReedCBOE Public Relations

Editor’s reply: The story mentionedabove was adapted from previously pub-lished Active Trader articles that werewritten before the VIX was changed. Thesearticles should have been updated with thenew calculation when published inOptions Trader. We apologize for anyconfusion. However, the premises of thearticles are still valid, despite the differ-ences in VIX calculation.

Active Trader magazine covered theupdate of the VIX in 2003-2004, and youcan also click here for a description of therevised index.

Forex options

http://www.optionstradermag.com/backissues.htm




http://www.cboe.com/spdr


OPTIONS NEWS

More mergers?

Options exchanges jockeying after NYSE-Arca dealThe cross pollination of stocks, futures, and options is one of the attractions of consolidation.

BY JIM KHAROUF

April’s New York Stock Exchange-Archipelagomerger and the Nasdaq buyout of Instinetmade a predictably big splash in the stock mar-ket (see “Big deals raise big questions,” Active

Trader, August 2005). But the two blockbuster deals couldtrigger some major waves in the U.S. options and futuresmarkets as well.

The NYSE-Arca deal will produce a European-type busi-ness model that features not only electronic stock trading,but also an electronic options exchange(and perhaps futures) under the sameroof. The deal includes the PacificExchange (PCX), which is finalizing itsagreement to be acquired by Arca.

Among the six U.S. options exchanges,the PCX ranks fifth in terms of total vol-ume with a market share of about 8 per-cent.

Arca was already raising eyebrowswhen it announced the deal to buy thePCX in January. With the NYSE behind it,industry executives say it could provide amajor boost to the PCX by bundlingstocks and options contracts on the Arcaelectronic trading platform. By most esti-mates, integrating the PCX into the newNYSE-Arca platform will take about ayear. That provides a window for theother five exchanges to make adjust-ments of their own, and many of them are on the move.

The Chicago Board Options Exchange (CBOE) has beenlooking at demutualizing, or changing from a member-owned exchange to a for-profit shareholder model. In June,the exchange hired an investment bank to examine demu-tualization, which is often a precursor to an initial publicoffering.

In the meantime, CBOE chairman and CEO Bill Brodskysays the exchange “will continue doing what we’re doing.”In other words, the exchange will stay focused on makingenhancements to its CBOE hybrid system, which includesadding remote market makers and more complex orderfunctionality, such as new spread capabilities.

Other options exchanges say they, too, are focused on exe-cuting their own plans, not on what the NYSE is doing. TheInternational Securities Exchange (ISE), which went public

in March and raised $70 million, continues to build on itsstock index options trading. Exchange executives also havesaid the growth strategy heading forward involves partner-ing with a European exchange or liquidity provider thatcould provide a bridge or connection in terms of order flow.

More consolidation to come?That hasn’t stopped industry participants from speculatingthe ISE will become a key player in the expected fusion

across U.S. exchanges.“I think what you’ll see is consolidation

among the futures and options ex-changes,” says John Margolis, senior vicepresident of Hyperfeed, an order-routingtechnology firm based in Chicago. “I wasnot surprised to see the Nasdaq-Instinetdeal, but also I think a Nasdaq-ISE dealwould make more sense. That would be afantastic move.”

In June, the Philadelphia StockExchange (PHLX), which has long beenlooking for a buyer or partner, teamed upwith Merrill Lynch and CitadelDerivatives Group, with each taking a 10-percent stake in the exchange. Dependingon various performance targets, MerrillLynch and Citadel could each take anadditional 9.9-percent stake.

“This investment by Merrill Lynch andCitadel in the PHLX is truly a turning point in the evolutionof the Exchange,” PHLX chairman and CEO Meyer“Sandy” Frucher said in a statement. “Our market modelwill benefit enormously by the commitment from MerrillLynch, one of the largest and most respected broker dealersin the world, and of Citadel, one of the largest and mostsuccessful participants in the global cash and derivativesmarkets.”

The American Stock Exchange (AMEX), meanwhile, ispushing ahead with its hybrid system called ANTE, andexecutives say they have no plans to change strategy.

“To me, you can’t alter your business model,” says NeilWyckoff, chairman and CEO of AMEX. “If you’re defensiveyou can’t differentiate yourself. You just have to put yourbest product out there and try to attract the order flow.”

The Boston Options Exchange (BOX) is following a similar

OPTIONS TRADER • July 2005 9

path of keeping an eye on its own ini-tiatives. The exchange is owned by agroup of large institutions that created itin part to be distinct from other optionsmarkets — not to consolidate withthem. Will Easley, BOX managing direc-tor, says it’s goals include transitioningfrom a start-up to a full-functioningexchange. Easley said the BOX isincreasing its messaging capacity two-or three-fold and introducing morecomplex functionality to its system.

As the industry continues to buzzabout consolidation among stock andfutures exchanges, Easley does notanticipate participating.

“I think we’ll be observers,” he says.“I don’t see us being interested inacquiring anybody. As for beingacquired, we’re certainly not shoppingourselves around.”

Futures exchanges fair gameOptions markets are not the only insti-tutions potentially in play. The ChicagoMercantile Exchange (CME) has nodoubt been the most successful pub-licly traded exchange, from a stock per-formance standpoint. Its shares weretrading around $305 at the end of June,and it had also built its war chest ofworking capital to almost $740 millionat the end of the first quarter.

In late June, the CME made a bid forthe Chicago Board of Trade (CBOT),which is preparing for an IPO. But theCME could make a move into theequity options space as well. Some

industry executives said they wouldlove to see the CME, CBOT, and CBOEcombine forces in some way.

Meanwhile, other futures exchangesare pushing toward IPOs, includingthe New York Mercantile Exchangeand the Intercontinental Exchange.Although those exchanges are com-modities-based institutions, deriva-tives exchanges are currently attrac-tive because of their profit margins.Given the growing attention to com-modities by virtually all trading par-ticipants, it would not be a surprise tosee securities and commoditiesexchanges tie the knot.

The cross pollination of securitiesand derivatives is one of the attrac-tions of consolidation. No doubt NYSEofficials saw PCX as a good way to getback into the options business. Manyexpect the NYSE to create attractivenew stock and options products. Evenso, some industry watchers say the BigBoard won’t win market share byname alone.

“I think it’s a great idea for theNYSE group to explore other assetclasses, but it’s not a walk in the parkfor them to begin trading options,”says Jodi Burns, an analyst with Celentin New York. “They are going to haveto build an options business just likethe ISE or the Boston OptionsExchange did, which is basically start-ing from nothing.” �

For information on the author see p. 4.

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TRADING STRATEGIES

Option butterflies:A safer way to sell volatility

Long butterfly spreads allow you to profit from the time decay

of short options — but with the added benefit of providing

a “safety net” around your position.


O ption spreads oftenhave rather fancifulnames — butterfly,iron butterfly, condor,

and alligator, to name a few. All ofthese strategies are multi-leg spreadsand, to some traders, seem designedprimarily to generate fees for brokers.This isn’t entirely fair (nor entirelyunfair). There are times when one ofthese more complex spreads can be auseful trading tool.

For example, a long butterflyspread can offer a way to “sell volatil-ity” (i.e., profit from high and declin-ing volatility through short options)while removing the risk inherent in anaked option position.

The positionYou can structure a butterfly entirelyof puts or calls, or a mixture of both.This discussion will focus on butter-flies that consist solely of calls. Thestructure is the same using either putsor calls: You choose three strike pricesat equidistant intervals and buy oneeach of the highest and lowest strikeprice options and sell two of the mid-dle strike price options.

The middle, two-option part of thespread is the “body” of the butterfly,and the upper and lower options arethe “wings.” (Apparently, earlyoptions traders thought the strategy’s

continued on p. 12

Strategy Snapshot

Strategy: Butterfly spread (long).

Market bias: Non-directional.

Preferred When implied volatility is relatively high and you expect conditions: decreasing volatility through the life of the trade.

Preferred Enter trade during the period of greatest time decay timing: (the last three or four weeks before options expiration)

and unwind it at option expiration.

Components: Options with three different strike prices at equidistant intervals: Buy one each of the highest and lowest strike price options and sell two of the middle strike price options.

Rationale: To benefit from the short options’ decreasing volatility and accelerating time decay. You can use this strategy if you think the underlying market will be at or close to the middle strike price at expiration.

Maximum The premium collected from the two short options plus profit: any remaining value in the long options (occurs when the

underlying market settles at the strike price of the middle options at options expiration).

Maximum loss: The initial price paid for the spread.

This butterfly spread cost very little to put on, but its profit is also modest. Minussigns in the Initial and Ending columns indicate premiums paid (debit), whilepositive values indicate premiums collected (credits). Minus signs in the Resultcolumn indicate losses.

TABLE 1 — THE HIGHEST THIS BUTTERFLY CAN FLY

Initial Ending

Sept. 5-yr. T-note futures price 107-24/32 108-00

Days to July option expiration 21 0

Implied volatility 5.6% NA

Call Strike Price Price Delta Price Result (64ths) (64ths) (64ths)

Buy 1 July 107.5 call -45 0.57 32 -13

Sell 2 July 108 calls 58 0.43 0 58

Buy 1 July 108.5 call -18 0.30 0 -18

Butterfly net price -5 32 27

Butterfly $ net price -78.125 421.875

BY KEITH SCHAP


payout diagram looked like a butterfly.This requires about the same effort ofimagination as looking at the constel-lations in the night sky. You mayremember, as a child, saying, “That’s abear? Come on.”)

The rationale for putting on a butter-fly spread is that you think the underly-ing market will be at or close to the mid-dle strike price at expiration. Also, youexpect the options you sell to expire val-ueless, or very nearly so. This willenable you to keep most of the premiumyou collect when you initially sell them.Accordingly, you want to trade butter-flies during the period of maximumtime decay — the last three or fourweeks before expiration — and holdthese spreads until the options expire.

Butterflies are primarily volatilitytrades. The body of the trade is the pairof short options, and severe time decayis always an option seller’s friend. Yousell options when implied volatilitiesare trading above the long-term medi-an historical volatility level and youhave reason to believe the volatilitywill revert to this median level, or evendrop below it. All this leads to a keyprinciple for butterfly traders: Onlytrade butterflies when you are com-fortable being short volatility.

When you sell options, you canexpect large losses if the market movesvery far from the strike price. This iswhy you buy the wings of the butterfly.These two options limit the loss poten-tial of these spreads to the net pricepaid to put on the trade. When theunderlying instrument trades abovethe highest strike price or below thelowest, the long options gain enoughvalue to offset the losses of the shortoptions. In essence, a butterfly is ashort option position with a safety net.

Stings like a bee in a range-bound market It is difficult to trade a market stuck ina relatively narrow trading range.

Even with reduced transaction costs,this kind of environment can be expen-sive, and the rewards are seldom greatenough to compensate for the cost.Butterfly spreads are one way toapproach this kind of market.

Suppose you had noticed September2005 five-year T-note futures (FVU05)were trading at 107-24 and had beentrading in a relatively narrow range forsome weeks. The current price wasnear the bottom of the range, around107-16. A futures price between 109-14

and 109-18 marked the upper bound-ary of this range.

Your market analysis might havesuggested the nature of the recent eco-nomic news was a big contributor tothis range. The indicators for andagainst growth and for and against abuild-up of inflation might have beenso evenly balanced the market couldnot find reasons to motivate largemoves in either direction. Further,there may have been no reason tobelieve this situation would resolve

TRADING STRATEGIES continued

The trade can still profit if the underlying settles relatively close to the middlestrike price at options expiration.

TABLE 3 — A GOOD RESULT: FUTURES SETTLE 6/32 BELOW MIDDLE STRIKE

Initial Ending 2

Sept. 5-yr. T-note futures price 107-24/32 108-10/32




Buy 1 July 107.5 call -45 0.57 52 7

Sell 2 July 108.5 calls 36 0.30 0 36

Buy 1 July 109.5 call -5 0.12 0 -5



This butterfly spread is almost three times as expensive as the one in Table 1, but the extra cost pays off. The best possible result occurs when the futures pricesettles exactly at the spread’s middle strike price (108.5) at option expiration.

TABLE 2 — THE OPTIMUM RESULT: FUTURES SETTLE AT MIDDLE STRIKE

Initial Ending 1





Buy 1 July 107.5 call -45 0.57 128 83

Sell 2 July 108.5 calls 36 0.30 0 36

Buy 1 July 109.5 call -5 0.12 0 -5


Butterfly $ net price -218.75 1,781.25


itself in the next month or so.Apart from the price situation, you

might have found implied volatilitywas at 5.6 percent. With 21 days tooption expiration, five-year T-notefutures median historical volatility ismore like 4.7 percent; a 5.5-percentvolatility reading is at the 75th per-centile. Given this volatility context,the 5.6-percent implied volatility

seems high, which could make this agood time to short volatility.

Further, the price and volatility situ-ations might have suggested a calloption butterfly spread using July callson September five-year T-note futures.

The structuring of this spreadrequires care. People often say theylike to have the options they sell payfor the options they buy, but it’s possi-

ble to go overboard with this notion.One possibility is to buy one July 107.5call, sell two July 108 calls, and buyone July 108.5 call. This version of thebutterfly spread would have cost only5/64 or $78.125 per spread. You con-vert to dollars by dividing the pricefigures by 64 and multiplying by 1,000(e.g., -5 ÷ 64 = -0.078125 x 1,000 =-$78.125).

A butterfly spread achieves its max-imum earnings potential when theunderlying market settles exactly atthe middle strike price at option expi-ration. Table 1 shows how you canexpect this spread to perform giventhe assumption the futures contractwill settle exactly at 108-00 at optionexpiration. The “NA” for the endingvolatility indicates volatility is notapplicable at expiration because theoption will be worth its intrinsic valueor have zero value.

Note that minus signs in the Initialand Ending columns indicate debits(premiums paid) and positive valuesindicate credits (premiums collected).Minus signs in the Result column indi-cate losses. The results are simply thesums of the initial and ending optionprices, and the Butterfly net prices arethe sums of the relevant rows.

It is important to note that when youchoose strike prices that are too closetogether, you lower the butterfly’s costbut limit its earning potential. Table 1illustrates this. The most you can earnwith this butterfly is $421.875.

With this cautionary note as back-ground, consider a butterfly in whichyou again buy the July 107.5 call, butyou sell two July 108.5 calls and buyone July 109.5 call. This butterflywould cost almost three times as muchas the first one, given the same marketassumptions as before, but it might beworth it.

Tables 2 through 5 show how thisJuly five-year T-note call butterfly

continued on p. 14

The result here and in Table 3 show this butterfly spread’s performance is stillbetter than the result from Table 1, even though the futures settled a little abovethe middle strike price.

TABLE 4 — A GOOD RESULT: FUTURES SETTLE 6/32 ABOVE MIDDLE STRIKE

Initial Ending 3





Buy 1 July 107.5 call -45 0.57 76 31

Sell 2 July 108.5 calls 36 0.30 -24 12

Buy 1 July 109.5 call -5 0.12 0 -5



Even if the futures prices settles well above the higher (109.5) strike price, thegains of the two long calls will offset the losses of the two short calls and holdthe loss to the initial price paid for the spread (-$218.50). An outright sale of twoJuly 108.5 calls would have resulted in a loss 10 times as big.

TABLE 5 — THE SAFETY NET AT WORK:LOSS LIMITED TO PRICE PAID FOR SPREAD

Initial Ending 4





Buy 1 July 107.5 call -45 0.57 160 115

Sell 2 July 108.5 calls 36 0.30 -192 -156

Buy 1 July 109.5 call -5 0.12 32 27

Butterfly net price -14 0 -14

Butterfly $ net price -218.75 -218.75



might have performed given four dif-ferent outcomes at expiration. Ending1 (Table 2) shows the best possibleresult occurs when the futures pricesettles exactly on the middle strikeprice at option expiration.

Endings 2 and 3 (Tables 3 and 4)indicate that when the futures pricemisses the target by a little in eitherdirection, this butterfly spread will notperform nearly as well, although theresults are still better than the one fromTable 1.

Finally, Ending 4 (Table 5) showswhat happens if the futures prices set-

tles well above the 109.5 strike price:The gains of the two long calls will off-set the losses of the two short calls andlimit the loss to the initial price paid.This is the safety net at work.

Table 2 highlights the advantage ofchoosing strike prices that are at leastslightly farther apart than those usedin Table 1. This spread exhibits fargreater earnings potential in dollarterms.

Tables 3 and 4 illustrate anotherstrong reason for preferring therevised version of the five-year T-notecall butterfly: It is far more forgiving ofresults that are fairly wide of the fore-cast mark. In fact, this trade will out-perform the Table 1 trade (in dollarterms) even if the futures price settlesas far as 6/32 away from the 108-16futures price target at option expira-tion. Clearly, the wider strike priceintervals not only increase the spread’searning potential (in the case wherethe futures price is exactly on target),but they also significantly increase theprice range in which you can earn asignificant return.

Notice in Table 5 the 156/64 loss onthe short July 108.5 calls is 2-28 (or,sometimes, 2’28 in conventional fixed-income price notation). This would bea $2,437.50 loss if you had simply soldthe two July 108.5 calls outright. Thewings of the butterfly limit that loss tothe initial price paid for the spread —$218.75.

A word of cautionNever confuse “can’t lose much” with“can’t lose.” Option butterflies will notlose more than the initial cost of thespread, but there are situations, only

one of which was illustrated, in whichthese losses will occur.

Also, because these are essentiallyvolatility trades, you should trade but-terflies only when you are comfortablewith the idea of being short volatility.Further, because the key element ofthese trades is the body of shortoptions, you want as much time decayas possible. This makes butterfliesappropriate during the last three orfour weeks before option expiration.Butterflies put on with, say, 75 days to

option expiration and held in place forthree weeks will prove disappointing.

Hold these trades to expirationbecause sharply rising implied volatil-ity can harm these fragile creatures.This adds another wrinkle to butterflytrades. Most exchanges automaticallyexercise any options that expire in themoney unless the option holder givesdirections to the contrary. If you do notwant to assume the long or shortfutures positions these options imply,you must be certain your brokerknows this and passes word to theclearing house.

However, when you observe theseprecautions, option butterflies make itpossible to trade markets that mightotherwise prove difficult. Althoughthe position’s structure limits its earn-ing potential, the butterfly trade cangenerate healthy returns in the rightcircumstances, and its loss potential ismodest enough that even the worstcase will not be ruinous. �

For information on the author see p. 4.Questions or comments? Click here.

Related reading

The Complete Guide to Spread Trading by Keith Schap (McGraw-Hill,2005). Master the mechanics and logic of spread trading and learn howthese strategies can work in most of the commonly traded futures andoptions markets.

“Easing the pain: Option repair strategies,” by John Summa (Options Trader, May 2005).A look at how two option “repair” strategies — a bear put spread and abutterfly spread — can reduce an unprofitable long put’s risk and preservepotential profitability.

If the futures price settles well above the upper strike price, the gains of the two

long calls will offset the losses of the two short calls and limit the loss to the

initial price paid. This is the safety net at work.


mailto:[email protected]?subject=Butterflies

http://www.aosbroker.com


BY JIM GRAHAM

T he long straddle is a non-directional optionstrategy that can yield solid results with lowrisk. It’s used when you expect a stock orfutures contract to make a big price move but

you don’t know whether it will be up or down. Besides price, the other variables that affect the value of a

long straddle are volatility and time. A straddle’s value isvery sensitive to changes in implied volatility (IV). Also,because a straddle consists of long options, its value erodesa little bit each day (the process known as “time decay”).

After explaining how to construct a long straddle, we’llexamine how to take into account the current volatility sit-uation and the effects of time decay when planning a trade.Finally, we’ll compare two straddles that use options fromdifferent expiration months to illustrate how buying moretime can create a trade with a higher probability of success.

Constructing a long straddleA long straddle is created by purchasing equal numbers ofcall and put options on the same underlying instrumentand with the same strike price and expiration month. Itmakes sense to buy near-the-money options so a sharp pricemove has a better chance of increasing the position’s value.A large price move will make one of the legs deep in themoney, providing a gain by virtue of price movement alone.

Also, an at-the-money straddle will be cheaper than astraddle whose strike price is not equal to the stock pricebecause it consists of options whose values are composedsolely of time value (i.e., neither option has any intrinsicvalue). Of course, you will not always find strike prices thatare identical to the current stock price, but you want optionsthat are as close as possible.

Buying undervalued options helps put the odds further in

TRADING STRATEGIES

Long straddles:The importance of buying time

Buying options has a bad reputation

in some trading circles because

you’re always fighting time decay.

But knowing how to find options with

the best volatility characteristics and

tapping into LEAPS can allow you

to construct higher-probability long

straddles.


your favor. The trick is to determine when options are cheap.Options are undervalued when IV is low from a historicalperspective (that is, it is low compared to past IV readings),as well as low relative to historical, or statistical volatility(SV), which is the actual volatility of the stock. Also, anoth-er reason to buy at-the-money options is changes in IV willhave a bigger impact on them with a few months left to expi-ration.

Long straddles actuallygive you two ways tomake money: Either theunderlying stock canmake a big price move, orIV can increase. Becausevolatility changes havesuch a big impact on astraddle’s value, the nextissue we will investigateis how to find straddlecandidates with histori-cally low IV levels, andhow to measure the effectan IV increase has on anoption’s value.

Putting volatility inyour cornerPlacing a long straddleon a stock with histori-cally low IV can providea considerable advan-tage. Every asset hasquiet periods when itsoptions are cheap andvolatile periods when itsoptions are expensive. You should also be aware volatilityhas an important tendency called “reversion to the mean.”After reaching extreme highs or lows, volatility tends toreturn to a more “normal,” average level.

The first thing to look for when searching for likely strad-dle candidates is the current IV compared to past IV. Thebest candidates for long straddles are in the 10th percentileof cheapness — that is, 90 percent of the time the IV hasbeen higher than it is currently. This increases the odds IVwill revert to a higher level, increasing the straddle’s value.Different time periods can be used to calculate this per-centile; the past three years of volatility history is a goodplace to start.

One way to measure IV in this way is to average the IVlevels of both calls and puts and then plot those averages on

a graph, with each data point representing a weekly aver-age. Figure 1 shows an example of a volatility chart for theBiotech HOLDRS (BBH) that showed up as a likely straddlecandidate, which in early July had IV in the 1-percentilerank, meaning IV at this time was lower than 99 percent ofIV readings over the past six years.

The volatility chart has two lines. The solid line is statis-tical volatility (SV), which shows the actual volatility of the

stock’s daily price changes. The dashed line is the averageIV, the volatility implied by BBH option prices. Not onlywas IV currently at its lowest point since options begantrading on BBH, but it was also considerably lower than SV(15 percentile rank), indicating the option prices are noteven reflecting the actual volatility of the stock.

A position’s sensitivity to changes in IV is measured byVega, which is one of the option “Greeks” (see “Additionalresearch”). For ease of use, Vega is usually shown as thegain or loss a position would experience because of a 1-per-cent IV increase. Long straddles always have positive Vega,which is why they are popular for exploiting expectedincreases in IV. A long straddle’s Vega is highest when thestock price is identical to the options’ strike price.

continued on p. 18

Source: OptionVue Systems (www.optionvue.com)

Volatility in the Biotech HOLDRS (BBH) was low overall, and implied volatility was even lowerthan statistical (historical) volatility, making BBH options a good candidate for a long straddle.

FIGURE 1 — STATISTICAL VS. IMPLIED VOLATILITY



The drawback of timeOptions are a decaying asset, and as you get closer to expi-ration the rate of decay accelerates. The value of a straddle’slong calls and puts constantly declines because of timedecay. As a result, to make a reasonable profit you need aprice move and/or an IV increase that can overcome thetime decay plus the initial purchase cost.

Theta is used to measure a position’s sensitivity to the

passing of time. It is usually expressed as the value a posi-tion would lose in one day due to the effect of time alone.Theta is always negative for a long straddle because theoptions lose value as time passes.

Time decay doesn’t manifest itself immediately. A six-month straddle does not decay much at first, and timedecay does not really begin to accelerate until the lastmonth or so before expiration.

Because volatility trades take time to develop, make sureyou give yourself enough time for IV to make the move youexpect. Look to use farther-out options, even LEAPS (Long-Term Equity AnticiPation Securities, which are options thatcan expire several years in the future), when buying straddlesto provide plenty of time for IV to revert to its average level.

Choosing the best position Many traders have difficulty understanding exactly howoption spreads become profitable. For a long straddle to beprofitable at expiration, the stock price must be sufficientlyhigher or lower than the options’ strike price to give eitherthe call or put enough intrinsic value to offset the straddle’soriginal cost. But before expiration, you must take intoaccount the simultaneous effect changes in the underlying

stock price, impliedvolatility and time haveon each leg of the spread.For that reason, havingaccess to a program thatallows you to analyzeand graphically displaythe profit or loss of apotential option trade isvery important.

Let’s compare howprofitable two long strad-dles in the Biotech HOL-DRS might be, one usingthe August 2004 options(with 54 days to expira-tion), and the other usingthe January 2007 LEAPS(more than two years toexpiration). In early July,BBH was trading at 142.5,exactly halfway betweenthe available strike pricesof 140 and 145. Com-paring the possible tradesrevealed using the 145strike price had a higherexpected return.

The following tradeexamples used $5,000 as the maximum amount of capital toinvest, in each case buying as many contracts as possible tokeep the amount invested in the trades as close as possible.

The shorter-term straddle position is:Buy 5 August 145 calls (BBHHI) at $3.40 ($1,700)Buy 5 August 145 puts (BBHTI) at $5.30 ($2,650)Total cost: $4,350

The longest-term LEAPS straddle is:Buy 1 January 2007 145 call (OEEAI) at $28.10 ($2,810)Buy 1 January 2007 145 put (OEEMI) at $19.90 ($1,990)Total cost: $4,800



The short-term straddle (blue line) has the potential to rack up a sizable profit as long as theunderlying stock makes a big move in the next 30 days, but the long-term LEAPS straddle(red line) can profit even if the stock remains nearly stagnant.

FIGURE 2 — LONG STRADDLE PROFIT PROFILE



The straddle using the August options has a Vega of 215.2and a Theta of -37.5 when it is placed. The Vega/Theta ratiois 5.7, which means IV must rise 1 percent in only 5.7 daysjust for the position to remain at breakeven. The straddleusing the January 2007 LEAPS has a Vega of 139.9 and aTheta of -2.92, which translates to a Vega/Theta ratio of47.9, which means that IV only needs to increase 1 percentevery 47.9 days for the position to stay even. Of course, anyprice moves by the stock would also affect the positions’values.

Figure 2 shows what the two trades would look like 30days from purchase with a projected IV increase of 5 per-cent during this time. It is clear that if you want to swing forthe fences and hope a large price move occurs relatively

quickly, you should use the shorter-term options becauseyou actually have the chance, although small, of doublingyour money in a short time period. However, just to breakeven in 30 days — even with a 5-percent IV increase help-ing out, the stock would have to move down to $137.80 orup to $150.60. In other words, to do better than the LEAPSstraddle, BBH would have to drop at least $6.19 or increase$10.51 in the next 30 days.

In contrast, notice the longer-term LEAPS straddle wouldbe profitable across the range of stock prices as long as IVincreased 5 percent. In fact, if the stock bounced around butended up right where it started at $142.50, you would stillmake a 15-percent return (177 percent annualized), com-pared to a 30-percent loss using the shorter-term options.That shows just how important buying time can be in deter-mining your probability of placing a successful trade.

Deciding when to close a long straddle is subjective. If amove in the underlying stock has created a gain, one legwill now be worth much more than the other. The dominantleg will then be much more sensitive to changes in theunderlying stock price. You should then determine ifvolatility has returned to more normal levels, and considerclosing the position if it has.

Buying fairly valued options isn’t a bad thingThe argument many traders make against buying options isthat time decay is against you, but there is nothing wrongwith buying an option that is fairly valued. Despite thedrawback of time decay, the underlying market is in con-stant motion. In fact, time is precisely what gives the under-

lying stock or future its freedom to move. You simply needto evaluate whether the underlying instrument can moveenough to make a long straddle profitable.

Identifying stocks with inexpensive options puts theodds further in your favor. Volatility traders often createpositions using short-term options, expecting volatility torevert quickly to its mean. However, experience suggeststhat’s a difficult expectation to meet. It can happen, butcheap options often stay cheap for quite a while. When buy-ing long straddles, it’s a good idea to consider using thelongest-dated options available with decent liquidity.

Keep in mind the value of a straddle with more days untilexpiration will not change in value as much as one withfewer days left when the stock price moves up or down.The best straddle for taking advantage of changes in IV isnot going to be the best one to capitalize on quick moves inthe stock price.

Creating positions with which you are comfortable andunderstanding how to balance likely price moves againstTheta and Vega are things you need to consider when trad-ing straddles. There are no sure things in option trading,but understanding how a straddle works allows you to putthe odds in your favor when using this strategy.�

For information on the author see p. 4.Questions or comments? Click here. A version of this article previously appeared in Active Trader.

Additional research

To find definitions for many of the concepts and terms inthis article, see the Key Concepts and Definitions page.

To purchase and download other option-related articles,visit our online store at www.activetradermag. com/pur-chase_articles.htm.

The best candidates for long straddles are in the 10th percentile or lower of

cheapness — that is, 90 percent or more of the time the implied volatility has

been higher than it is currently.

http://www.activetradermag.com/purchase_articles.htm

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M ost traders, especially risk-averse traders,are familiar with the strategy of sellingcall options on a stock they already own.This strategy — covered call writing —

creates income while limiting both the reward and risk of along stock position. It is primarily used on stocks aboutwhich a trader is neutral to moderately bullish. Another lesscommon option strategy that achieves the same goals isselling a put.

In fact, selling a “naked” put (i.e., a put that is not backedby a position in the underlying security) is mathematicallyidentical to selling a covered call. In most cases, though, awould-be covered call writer would be better off selling anaked put than buying a stock outright because the putposition has a lower margin requirement and potentiallylower commissions (if the put expires worthless).

Despite these advantages, selling puts is not nearly aspopular a strategy as selling covered calls. However, by fol-lowing some simple rules that dictate which stocks or mar-kets to focus on and which options to trade (as well as whenand how many to trade), you can limit the risk of naked putsales and develop a strategy for taking consistent profits out

of the market.Understanding the characteristics of put options and

their relationship to the underlying market sets the stage forthis strategy, the simplest example of which is to sell at-the-money puts on a stock you expect to rise a little, but not a lot.

Put characteristicsThe price (or premium) of any option consists of two basiccomponents: intrinsic value and time value. Intrinsic value isthe difference between an option’s strike price and the cur-rent price of the underlying market. Only options that arein-the-money (ITM) have intrinsic value. (See “Key conceptsand Definitions,” for information on these and other optionterms.)

Time value reflects the amount of time remaining untilexpiration and can be thought of as an uncertainty factor —the dollar amount a put seller demands to give you theright to sell a stock or index at the strike price. Another wayto look at it is that it is the dollar amount the put sellerdemands to assume exposure to the long stock or futuresposition that may result if he or she is assigned.

All else being equal, the greater the volatility of theunderlying market, the greater anoption’s time value. Of course, allthings are never equal, which is whatmakes option trading so challenging.Interest rates, dividends and pendingnews or rumors can all affect the priceof an option.

Adding the intrinsic value to timevalue gives you the total option price.For example, with Microsoft (MSFT)trading at 69, assume a MSFT July 70put with three weeks until expiration istrading for $3. This represents $1 ofintrinsic value (70 - 69), and $2 of timevalue. As expiration nears, the option’s

TRADING STRATEGIES

Taking a peak at naked puts

Selling put options when you don’t own the underlying market is often portrayed as risky —

even reckless — trading. However, under certain circumstances, shorting puts can be a limited-risk

strategy that behaves the same way as selling a covered call — with potentially lower costs.

BY MARK VAKKUR, M.D.

Unlike the outright stock purchase, the naked put sale requires no initial capitaloutlay (debit), limits downside risk and frees up capital that can earn interest.

Naked put: Sell one Stock purchase: Buy 100 MSFT 70 put for $3. shares of MSFT @ $69.

Initial debit: $0 $6,900 plus commissions.

Initial credit: $300 minus commissions. $0

Interest earned $20 (@ 3.5% per annum two-year $0(on uninvested cash): T-note rate, times one month).

Net anticipated $320 credit, minus commissions. -$6,900 debit, plus cash flow: commissions.

TABLE 1 — PUT UP OR SHUT UP

time value will waste away, decaying most rapidly inthe final weeks before expiration.

Death, taxes and…There are very few guarantees in the market, but this isone: By expiration, the time value of an option will bezero.

This does not mean you are guaranteed a profit on anoption you sold short, only that you will get to keep thatpart of the option premium made up of time value. Inshort, when you sell an option, you will profit if the timepremium and intrinsic value at the time of sale exceed theoption’s intrinsic value at expiration.

The downside is that in exchange for collecting thetime premium, you assume the risk the underlying mar-ket will move against you. However, when you sell aput, this dollar risk is less than if you bought the under-lying market outright, as will be explained shortly.

If the market moves against you (i.e., declines) whenyou sell short a put, you may be forced to buy the stockif an option buyer exercises his or her put. This is calledassignment, and will only occur if the option is in-the-money. However, if you are financially — and psychologi-cally — prepared to buy the stock anyway (which youshould be if you are selling puts), this is hardly a disaster.Because you collected premium when you sold the put, youhave effectively purchased the stock at a discount to whatyou would have paid had you bought it outright.

Measuring upTo see how a naked put sale measures up against a stock pur-chase, consider the MSFT example discussed earlier. SayMSFT closes at 61 on expiration, and assume you have notbeen assigned (forced to buy) the stock prior to expiration.The 70 put has an intrinsic value of $9 (70 - 61). Because thetime value must be zero at expiration, $9 is the most theoption will be worth.

If you had sold the option for $3 when MSFT was at 69,you lost money on the trade. You keep the $3 premium, butlose the cost ($9) to buy back the option, for a net loss of $6before commissions.

In reality, the option would most likely be exercised, andthe Monday after option expiration you would own 100

shares of MSFT at $70 a share. However, the end result is thesame. You could immediately liquidate the position, sellingMSFT at $61 and losing $9 on the trade, but keeping the $3premium for a net loss of $6.

By comparison, had you bought MSFT stock outright at$69, you would now be looking at an $8 loss, because youdidn’t collect $3 in time value when you bought yourshares.

Addressing the criticsThe criticism of selling naked calls is that they have theo-retically unlimited risk. However, as long as you do not sellmore puts than the number of shares you are willing to pur-chase (e.g., sell five puts if you would be comfortable buy-ing 500 shares) and you follow certain trade guidelines,naked put selling entails finite risk — in fact, less than thatof an outright stock position, as the previous exampleshowed.

“Put-selling guidelines” summarizes the rules for sellingnaked put options effectively. These rules essentially are meth-ods for selecting the stocks and the market conditions that will

continued on p. 22


Of the three scenarios (stock higher/lower/unchanged at expiration), the naked put sale fares worse than the outright stockpurchase only when the underlying stock rallies significantly.

MSFT price Stock Naked put advantage/ at expiration: Naked put: purchase: disadvantage:

74 (+$5) +$320 profit $600 profit -$280

69 +$220 profit, minus commissions. (Will be forced to buy $0 profit/loss +$220(unchanged) MSFT at $70, a -$100 loss, offset against the $320 collected.)

64 (-$5) -$280 loss, minus commissions. (Will be forced to buy MSFT -$500 loss +$220at $70, a -$600 loss, offset against the $320 collected.)

TABLE 2 — BETTER TO GO NAKED?

Price of Microsoft at expiration

Put seller is better off at prices of about 72 or below

60 62 64 66 68 70 72 74 76 78 80

Profit/loss of put sale vs. stock purchase$1,500

$1,000

$500

$0

$-500

$-1,000

Sell put Buy stock

A comparison of buying 100 shares of MSFT at $69 vs. sellinga $70 put for $3. The naked put strategy caps profits if thestock rallies, but it also reduces downside risk if it movesagainst you. Its profit-loss profile is identical to that of the cov-ered call strategy.

FIGURE 1 — NAKED PUT VS. LONG STOCK


limit your risk on these trades. Doing so increases the odds ofsafely benefiting from the income naked put selling offers.

Consider this worst-case scenario: The most you couldlose selling a MSFT 70 put for $3 when MSFT is at $69would be $6,700 (plus commissions) — and that would beonly if MSFT went to zero by the third Friday of nextmonth. Yes, it could happen, but even if MSFT went bank-rupt, it would likely take more than a month.

The maximum loss on the outright stock position is $6,900,$200 more than the put position. However, if MSFT goesnowhere, the put seller pockets a $200 profit and can repeatthe cycle next month. The stockholder, on the other hand,gets paid nothing for waiting. Table 1 compares these trades.

Because MSFT can only do one of three things (go up, godown, or end flat), Table 2 illustrates the possible outcomes.

As Table 2 summarizes, if MSFT is at or below $70 atexpiration, you would be better off selling the put (vs. buy-ing the stock). Creating a table that shows all possible tradeoutcomes for every price of MSFT at expiration will greatlyenhance your understanding of options.

Figure 1 graphically compares the profit-loss profiles of anaked put vs. a stock purchase. It shows you would be bet-ter off buying the stock only if it soared above $72. The dol-lar advantage of selling a put at prices below $72 equals thetime premium collected (the total premium minus theintrinsic value), in this case $2 ($3 - $1). The $20 interest


A dhering to the following rules can reduce of the riskof selling naked puts.

1. Only sell puts on stocks you would want to own.Never sell a put just because it has a fat premium. Ask your-self, “If I had to buy the stock tomorrow, would I be happy own-ing it?“ If the answer is no, don’t sell the put.

2. Never sell so many puts that if you were assigned,you wouldn’t have enough money to purchase the stock.For example, if you have a $100,000 margin account and youare uncomfortable being more than 100 percent exposed toequities, do not sell more puts than would require $100,000 tocover if assigned.

To determine the dollar amount required to meet an assign-ment, simply multiply the strike price of each put contract yousell by 100 (the number of shares each option contract repre-sents). For example, if you were selling puts on a stock tradingat $100, do not sell more than 10 at-the-money puts, eleven 90puts, twelve 80 puts, etc.

Beware: It is tempting, especially after a few successfulcycles of put selling, to sell more puts to boost income. But ifyou are using 300 percent or 400 percent leverage, you couldget badly hurt. Put selling got a bad name after the Crash of1987 mainly because it was abused by traders who sold farout-of-the-money puts that represented much more moneythan they had in their accounts. They assumed the marketwould never fall below the strike prices of the puts they sold.They were wrong. When the market crashed, they were forcedto borrow large sums of money to meet margin calls. Neverassume a put is so far out-of-the-money that you won’t getassigned!

3. Sell puts expiring in one to three months. The risk ofselling close-to-expiration puts is lower for every dollar of pre-mium received. Selling options as close to expiration as possi-ble exploits the period of maximum time decay and creates thehighest annualized returns.

4. Annualize the option time premium you collect. Forexample, if you sell a 100 put for 6.50 on XYZ Technologies,

which is trading at 95, you’ve collected $1.50 of time premium(the intrinsic value is 100-95 = 5). That works out to 20 percentannualized. More conservatively, convert option time premiumto time premium per month (to compare closer-to-option expi-rations with those expiring later). The time premium is usuallyfattest for at-the-money options, and diminishes as you go fur-ther in- or out-of-the-money.

5. Only sell options that offer at least 1.5 percent timevalue per month. To express a put premium as a percentage,divide it by the option’s strike price. It is not uncommon to beable to pocket 4 to 5 percent a month for slightly out-of-the-money put options on volatile stocks. Options on lower-pricedstocks — e.g., those trading below $20 — are not alwayspriced as efficiently as higher-priced stocks, so look to theseissues for great deals. (However, remember Guideline #1:Never sell an option just because the premium is high.)

6. If you are very bullish on a stock, and really want toown it, sell in-the-money puts. This exposes you to greaterrisk, but also to more upside potential.

7. If you are more conservative and just want to collecttime premium, sell out-of-the-money puts. You will collectless premium, but have more downside protection.

8. Consider selling a put on a stock (or index) you think isa good long-term buy just after it has suffered a dramaticdecline. Put premiums often soar to extreme levels in these situ-ations, allowing you to pocket the premium or buy the stock at asignificant discount. Selling puts at these points requires tremen-dous courage, but is safer than buying the stock outright becauseof the buffer provided by the premium you collect.

9. For best results, repeat the option-selling processevery month. A mediocre strategy followed mechanically isalmost always superior to a brilliant one followed intermittently.To achieve anywhere close to the annualized returns possiblefrom put selling, you must participate on as regular a basis asyour risk tolerance and buying power allow.

10. If assigned, consider reversing immediately and sell-ing a call against your newly purchased stock. This keepsthe wasting power of options working in your favor.

Put-selling guidelines

shown in Table 1 is the result of having $6,900 (that wouldotherwise be used to buy the stock) at work in Treasurybonds or bills.

The trade-offThe risk of selling puts is always less than the risk of buy-ing an equivalent number of shares of the stock; however, inexchange for this decreased risk, you are capping your max-imum profit. If this sounds familiar, it’s because it’s thesame description as a covered call.

The returns outlined here may seem rather tame untilyou consider a few factors.

The probability of an asset closing unchanged or slightlychanged in a given month is much greater than the proba-bility of it moving much higher. Therefore, you exchange alow-probability, high-profit trade for a high-probability, low-profit trade. Selling gives you an edge on the outright stockpurchase because it results in a smoother equity curve.

If you collect only 1.5 percent of time premium a month,you will be adding 20 percent (12*0.015 compounded)annually to your portfolio. If you collect 3 percent a month(the approximate value of a 25 percent implied volatility at-the-money call option expiring in a month), you will gross42.6 percent a year. This is the return if the stock goesnowhere. If it goes up, you do even better.

A more conservative choice — for the right traderContrary to popular opinion, selling a naked put is a low-risk way to increase income and perhaps acquire a stock ata discount — as long as you are comfortable with the possi-bility of owning the underlying stock. Traders who aren’tshould consider other techniques.

Put selling is especially profitable after severe marketdeclines, when put premiums can soar. You are trading thepotentially unlimited but low-probability gain of an out-right stock position for the high-probability, limited gain ofthe naked put. Even if your bullish market interpretation isincorrect and the stock declines, you will still be better offthan a stock buyer because your net price (strike priceminus the premium collected) will be lower than the priceof the stock on the day you sold the option.

When you sell a naked put you are short a wasting asset— one that naturally loses value as time passes. Because ofthis edge, you can botch your stock analysis, have less-than-perfect market timing, and still end up ahead. Over time,the odds are in your favor.�


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OPTIONS STRATEGY LAB


System concept: Last month’sOption Strategy Lab analyzed theprofitability of a one-day straddleusing options on the 10-year T-notefutures contract at the close on theday before the monthly employmentreport and unwinding the trade atthe announcement day’s close.

This strategy lost money in twoof every three trades and was prof-itable overall from March 2004 toMay 2005 (15 months) because itbought options when the T-notes’implied volatility was high and soldthem after IV dropped as the reporthit the Street. Price moves in theunderlying 10-year T-note futuresweren’t large enough to offset theoptions’ lost value because of theirdeclining implied volatility.

The analysis that follows focuseson another options strategy — theshort strangle, which involves selling an out-of-the-moneycall and an out-of-the-money put in the same expirationmonth — to attempt to profit from an expected drop inimplied volatility on monthly employment reportannouncement days.

Figure 1 shows a daily chart of the 10-year T-note futureswith arrows marking employment announcement days overthe past 14 months. Notice the periods immediately follow-ing each release: The contract often traded in a tight channelfor several days or more, which means selling options maybe a more profitable way to trade the employment reportbecause out-of-the-money options would often expireworthless.

Instead of buying a straddle the day before the employ-ment report release, what if you sold an option strangle atthe close on announcement day?

Although this short spread is designed to take advantageof a quiet market, its potential gain is limited to the premiumcollected from the short options, while its potential risk istheoretically unlimited. Overnight price gaps can be espe-cially devastating to a short strangle position.

Trade rules:1. Sell one out-of-the-money call and one out-of-the-money put in the nearest option expiration month at theclose on the Friday of the monthly employment reportrelease. Try to position the options’ strikes at least onestandard deviation away from the underlying’s closingprice, but use discretion if the premiums for thoseoptions are too small. If this occurs, sell an option one

strike closer to the money. Sell both options at the lastprice quoted.

2. Liquidate the entire position and wait until the nextmonth’s release date if the underlying futures touchesone of the short strikes. Otherwise, let the strangle expireworthless.

Figure 2 shows a risk profile of a strangle placed onMarch 5, 2004: Short one April 117 call at 7/64ths and shortone 113 put at 9/64ths for a total credit of $250. The verticalline shows the 10-year T-note futures closing price (115’14),and the two horizontal bars below it represent the futures’one- (purple) and two-standard-deviation (green) moves,based on the volatility and time projections.

The figure’s shaded area shows the first standard devia-tion move, which covers 68 percent of the probable prices ofthe underlying over the next 22 days and also representswhere we would remain in the trade. The probability calcu-lator available in many options analysis programs can giveyou these numbers quickly.

Test data: The revised system was tested on nearest-month options of the 10-year T-note futures contract.

Test period: Initial test — March 2004 to May 2005; sec-ond test — January 2001 to May 2005. The strategies weretested using OptionVue’s BackTester module. (Commissionsand slippage are not included.)

Employment report strangle

The 10-year T-note futures tend to be quite volatile when the monthly employmentreport is released (see arrows), but the contract often trades in a narrow rangefollowing this event. Selling options to collect premiums during these “quiet” timesmight be a profitable strategy.

FIGURE 1 — EMPLOYMENT ANNOUNCEMENT DAYS

Ten-year T-note (TY), 60 days

March April May June July Aug. Sept. Oct. Nov. Dec. Jan. Feb. March April2004 2005

118

116

114

112

110

108

106

104


continued on p. 26




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Test results: The Strategy Summary shows the shortstrangle gained ground during the same 15-month period inwhich the original long straddle was unprofitable. Eight ofthe fifteen months were profitable, and the spread gained$640.68 since March 2004. Also, the average winner ($359.38)was substantially higher than the average loser ($169.64). This approach shows more promise, but a 15-month sample

is too small to draw significant conclusions. To expand ouremployment report test, we looked back to Jan. 1, 2001 andtraded a one-lot strangle each month. The second StrategySummary table shows its total profit was $3,078.24 over thepast 53 months. Each trade required roughly $500 to initiateand resulted in an average gain of $58.08.

The approach was profitable 58 percent of the time, andits average winner ($262.10) was just abit higher than its average loser($229.40), which suggests the idea isworth consideration.

However, the strategy had an initialdrawdown of almost $1,200 in 2001, andsix of the first nine months were losers,so this trade is not for the faint of heart.But the strategy’s winning percentagehas been 64 percent since October 2001.

Bottom line: As the old market sayinggoes, “If it’s obvious, it’s obviously nottrue.” Although it’s difficult to find a trad-able edge for a predictable event, the shortstrangle tested here (or one similar to it)clearly deserves attention. Before you con-sider implementing this strategy, be sureto include commissions and examine theexact price you are likely to receive to takeinto account any possible slippage.

— Steve Lentz and Jim Graham of OptionVue

STRATEGY SUMMARY (SINCE MARCH 2004)

Net gain ($): 640.68No. of trades: 15No. of winning trades: 8No. of losing trades: 7Win/loss (%): 53Avg. trade ($): 42.71Largest winning trade ($): 359.38Largest losing trade ($): -281.25Avg. profit (winners) $: 228.52Avg. loss (losers) $: -169.64Ratio avg. win/avg. loss: 1.35Avg. hold time (winners) days: 19Avg. hold time (losers) days: 9Max. consec. win/loss: 4 / 5

STRATEGY SUMMARY (SINCE JANUARY 2001)

Net gain ($): 3,078.24No. of trades: 53No. of winning trades: 31No. of losing trades: 22Win/loss (%): 58Avg. trade ($): 58.08Largest winning trade ($): 546.88Largest losing trade ($): -484.37Avg. profit (winners) $: 262.10Avg. loss (losers) $: -229.40Ratio avg. win/avg. loss: 1.14Avg. hold time (winners) days: 19Avg. hold time (losers) days: 10Max. consec. win/loss: 6 / 5

LEGEND: Net gain — Gain at end of test period, less commission. No. trades — Number of trades generated by the system. No. of win-ning trades — Number of winners generated by the system. No. of losing trades — Number of losers generated by the system. Win/loss(%) — The percentage of trades that were profitable. Avg. trade — The average profit for all trades. Largest winning trade —biggest indi-vidual profit generated by the system. Largest losing trade — biggest individual loss generated by the system. Avg. profit (winners) —The average profit for winning trades. Avg. loss (losers) — The average loss for losing trades. Ratio avg. win/ avg. loss — Average win-ner divided by average loser. Avg. hold time (winners and losers) — The holding period for all trades (in days). Max consec. win/loss —The maximum number of consecutive winning and losing trades.

If you have a strategy you’d like to see tested, please send the trading and money-management rules to [email protected].

Each short strangle was built with out-of-the-money puts and calls and held untilexpiration, unless the 10-year T-note futures hit either strike, which were placedone standard deviation away from the close on jobs announcement days.

FIGURE 2 — SHORT STRANGLE RISK PROFILE


OPTIONS STRATEGY LAB continued



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T he VIX measures theimplied volatility of S&P500 index options tradedon the Chicago Board

Option Exchange (CBOE). The indexreflects the market expectation of near-term (i.e., 30-day) volatility. The VIXhas been around since 1990, but under-went a major transformation in late2003. It is a commonly referencedgauge of the stock market’s “fearlevel.”

When the Chicago Board OptionsExchange (CBOE) overhauled itsvolatility index (VIX) in September2003, it changed it from a volatilitymeasurement based on the S&P 100(OEX) to one based on the S&P 500(SPX).

The old VIX formula used the Black-Scholes pricing model that looked ateight near-term at-the-money OEXoptions (calls and puts). The new VIXis derived from near-term at-the-money SPX options as well as out-of-the-money puts and calls (so the indexreflects the full range of volatility).

The new calculation derives the VIXfrom the prices of options themselvesrather than from a formula. The CBOEalso applied the new calculationmethod to the CBOE NDX VolatilityIndex (VXN), which reflects the volatil-ity of the Nasdaq 100 index.

The exchange still publishes theoriginal VIX calculation, which can befound under the ticker symbol VXO.Future articles will explore the VIX’srole as a market barometer and how itcan be used as a trade indicator.�

For more information about the VIXcalculation visit www.cboe.com/cfe/products/vixprimer/About.aspx.

OPTIONS BASICS

The volatility index (VIX)The VIX provides an estimate

of the expected market volatility

on a short-term time horizon.

CBOE volatility index (VIX), daily

CBOE volatility index, original (VXO), daily

April May June

18

17

16

15

14

13

12

11

17

16

15

14

13

12

11

The current incarnation of the CBOE volatility index (VIX, top) is derived fromthe prices of S&P 500 (SPX) options. The old VIX (VXO, bottom), which theCBOE still calculates, was extrapolated from the S&P 100 index (OEX) usingthe Black-Scholes option pricing model. The two indices appear similar, but theyhave important differences. The CBOE also calculates a comparable index —the VXN — using the prices of Nasdaq 100 options.

FIGURE 1 — THE VIX

Source: TradeStation

http://www.cboe.com/cfe/products/vixprimer/About.aspx

http://www.cboe.com/cfe/products/vixprimer/About.aspx

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B esides the movement of the underlying stock,two other obstacles of trading options are ero-sion of time premium and fluctuations in theoption’s implied volatility. Traders can use

option spreads, which are positions containing both long andshort options, to combat these problems.

Spreads are generally less susceptible to the effects oftime decay and implied volatility fluctuations compared tooutright long option positions. Another benefit of spreadingis reduced risk: The premium received from the shortoption offsets some of the cost of the long option.

The kind of spread we will discuss here is called a bullcall spread, which is created by simul-taneously buying one call and selling asecond, higher strike call with thesame expiration.

Suppose XYZ stock is trading at 52and a trader enters the following posi-tion (both options have 30 days untilexpiration):

Buy one XYZ 50 call @ 3.50. Net debit: -$350

Sell one XYZ 55 call @ 1.25. Net credit: +$125

Total net debit: -$225

By virtue of buying the call option,the trader is bullish — he or she antic-ipates XYZ’s price will go up some-time in the next 30 days. With the saleof the 55 call, though, the traderbelieves XYZ will not trade muchhigher than 55.

The sale of the call creates the obli-gation to sell stock at 55. This obliga-tion will limit the profit potential of the50 call. However, if XYZ drops in price,the credit from the sale will reduce theposition’s potential loss.

This is the bull call spread in a nutshell: a bullish (but nottoo bullish) position that balances limited profit potentialwith limited risk.

Next, let’s look at how this position helps alleviate theeffects of time decay.

It’s about timeTo the option buyer, the passage of time is similar to the effectsof the sun’s rays on an ice cube. Each hour that passes causessome of a long option’s value to “melt away.” Conversely,time decay is beneficial to short option positions. Because thespread trader is both a buyer and a seller of options, time

OPTIONS BASICS

Controlling riskwith spreads

Tired of fighting time decay and volatility fluctuations? Here’s a look at an option spread trade that was

a much lower-risk alternative to an outright purchase.

The implied volatility in the Pharmacia options increased significantly in July 2002, an indication that the options market saw uncertainty in the price ofthe stock.

Source: optionsXpress

80

70

60

50

40

30

20

48

46

44

42

40

38

36

34

32

30

Vol

atili

ty %

Sto

ck p

rice

Pharmacia Corp. (PHA), four-month chart

Stock price 30-day implied volatility

June 3 July 1 August 1 Sept. 3 Sept. 27

FIGURE 1 — IMPLIED VOLATILITY

BY BRIAN OVERBY


decay helps one leg of the spread and hurts the other.The biggest difference between a spread and an outright

purchase is when the trader wants the underlying positionto reach a certain price. In the case of an outright optionpurchase the trader wants the underlying position to reachthe target price as soon as possible, thereby minimizing theeffect time decay has on premium.

By contrast, because a spread reaches its maximum prof-it potential when the short option has little or no time valueremaining, the preferred time window for a spread is with-in a week of expiration. (For a discussion on time decay andoption valuation, as well as an options glossary, see “A mat-ter of time” on p. 90.)

However, time premium erosion is not the only concernwhen trading this type of position.

VolatilityImplied volatility fluctuations also altera spread. Although change in anoption’s premium is often the result ofmovement in the price of the underly-ing market, it can also be caused by thechanges in the option’s implied volatil-ity, independent of fluctuation in theunderlying stock. (We are more con-cerned with implied volatility than his-torical volatility because the former isderived from the option’s premium andreflects a consensus estimate from themarketplace of what the volatility of theunderlying stock will be in the future;the latter is simply a measure of theunderlying’s past volatility.)

Option implied volatility (IV), inmany instances, moves for the samereason the price of the underlying stockmoves — news, an imminent earningsreport, takeover rumors, etc.

However, sometimes the underlyingstock will not move at all for weeks(and the option’s historical volatility isat a low point), but the IV will increase significantly. Thisusually occurs around an earnings report or a similar event,when there is a great deal of uncertainty about the futureprice of the underlying stock.

Volatility-triggered changes in option premium may bedramatic and can be quite damaging to traders who havebought or sold a call. Again, though, spreading helps alle-viate this problem. While a decrease in implied volatilityhurts a long option, it helps a short option. Likewise, anincrease in implied volatility works against a short optionbut benefits a long option.

This is perhaps the biggest benefit of trading spreads.Although the risk of time erosion is something that can beplanned for and managed, volatility can often turn a prof-

itable outright option trade into a loser without warning.

How it worksThe following trade example shows how a spread tradefared better than an outright option purchase.

In July 2002, takeover rumors were stirring about phar-maceutical company Pharmacia (PHA). Because of the sto-ries, the at-the-money August 40 call option had an impliedvolatility of approximately 74 percent — almost twice theimplied volatility of the preceding few weeks (see Figure 1).Options implied volatility can be found at many options-related Web sites and is included in a number of higher-level options analysis programs.

An IV reading of 74 percent is not in and of itself “high.”A reading should be considered high or low relative to thetypical volatility over a given period. For example, a sud-den increase in IV compared to the typical IV of the past few

weeks can indicate volatility is reaching an extreme.Pharmacia was trading around 40 (see Figure 2), and the

August 40 call, which had 29 days until expiration, wastrading at $3.45. However, the following August 35-45 bullcall spread could have been purchased for $3.70:

Bull call spread:Buy one PHA Aug 35 call @ 5.60. Net debit: -$560Sell one PHA Aug 45 call @ 1.90. Net credit: +$190Total net debit: -$370

Outright long call:Buy one PHA Aug 40 call @ 3.45. Net debit: -$345

continued on p. 32

A big run-up in the price of Pharmacia stock caused the implied volatility of thecall option to almost double (see Figure 1). Placing a bull call spread trade inPharmacia options resulted in a bigger profit than purchasing the call.

Source: eSignal

47.0046.0045.0044.0043.0042.0041.0040.0039.0038.0037.0036.0035.0034.0033.0032.0031.0030.00

50M40M30M20M10M

Pharmacia (PHA), daily

Volume

10 11 12 15 16 17 18 19 22 23 24 25 26 29 30 31 1 2 5 6 7 8July 2002 August 2002

FIGURE 2 — PHARMACIA FACES TAKEOVER RUMORS


OPTIONS BASICS continued

Different option spreads allow you to take advantage of different kinds of market behavior and accommodate different marketperspectives. All bullish and bearish put or call spreads consist of options with the same expiration date.

TABLE 1 — MULTIPLE OPTIONS

STRATEGY WHEN TO USE IMPLEMENTATION

Bull call spread When you are moderately bullish Buy a call and sell a call with a higher strike price about the underlying market (same expiration)

Bull put spread When you are moderately bullish Sell a put and buy a put with a lower strike price about the underlying market (same expiration)

Bear call spread When you are moderately bearish Sell a call and buy a call with a higher strike price about the underlying market (same expiration)

Bear put spread When you are moderately bearish Buy a put and sell a put with a lower strike price about the underlying market (same expiration)

As it turned out, Pfizer bought Pharmacia and theimplied volatility returned to its typical level in the last fewdays before expiration. At that point, the stock price was44.70, and the August 40 call was trading at 4.90. The callcould have been sold for a profit of more than 40 percent(4.90 – 3.45 = 1.45), not counting commissions.

However, because the stock traded near the 45 strikeprice close to the expiration date, the maximum profit forthe spread was almost achieved. When the stock was trad-ing at 44.70, the value of the spread was 9.50:

Sell to close one PHA Aug 35 call @ 9.90. Net credit: +$990Buy to close one PHA Aug 45 call @ .40. Net debit: -$40Total net credit: $950

Because the spread cost 3.70 to open, closing it out wouldhave resulted in a net profit of 5.80. This represents a returnof 157 percent, less commission (and remember, the com-mission on a spread is more than on an outright transaction).

The two strategies — outright call purchase and bull callspread — have nearly the same risk ($3.40 for the spread,$3.70 for the outright purchase), but the long bull callspread would have yielded a much higher percentagereturn on dollars invested. That the risk was nearly identi-cal makes this an apples-to-apples comparison.

Other spreads, other factorsTraders can establish many types of spreads depending ontheir opinion of the market. The bull call spread, bear callspread, bull put spread and bear put spread are the mostcommon (see Table 1). These are all similar in structure —one option is bought and one option is sold — with the dif-ferences being whether puts or calls are used, which strikeprice (i.e., higher or lower) is purchased and which is sold.

The main distinction between the different types ofspreads is whether they are executed for a credit or a debit.Credit spreads will usually have a margin requirement, butwill initially add money to your trading account; debitspreads only require that you have the cash to pay for thenet purchase.

In regard to call credit spreads (bear call spreads), the shortoption will have the lower strike of the two options; with putcredit spreads (bull put spreads), the short option will havethe higher strike of the two options. The amount of premiumyou want to receive on the trade will determine if you wantto sell an in-the-money or an out-of-the-money option.

Selling in-the-money options can mean a higher reward ifyou are correct, but it also means it will take a larger movein the underlying stock price to achieve that reward.

To receive the maximum profit on a credit spread, both ofthe options have to be out of the money at expiration.Because of this, the more common option to sell in a creditspread is an out-of-the-money option. If the option is ini-tially out-of-the-money and stays that way, the trade will beprofitable at expiration.

In regard to call debit spreads (bull call spreads), thelong option will have the lower strike of the two options;with put debit spreads (bear put spreads), the long optionwill have the higher strike of the two options. When plac-ing a debit spread it is more common to initially purchasein-the-money options and sell out-of-the-money options.To make the maximum profit on the strategy, both theoptions need to be in the money at expiration. By selling anout-of-the-money option, the spread trader is speculatingthe underlying position will move enough for the soldoption to become in the money by expiration.

Practical considerationsSpreads must be traded from a margin account, and theymay have additional margin requirements. No spreadworks in every market situation, and traders need to under-stand the compromises inherent in each type.

If traders who usually buy options are willing to acceptthe trade-off of limited profit potential, spreads can greatlyreduce the exposure to time premium erosion and marketvolatility.�


mailto:[email protected]?subject=Overby

http://www.activetradermag.com


BY PETER STOLCERS

In today’s market, an overnightstock position can cause insom-nia and devastating losses.Swing traders who typically

hold positions for two or three daysshould consider buying options topotentially limit their risk. Finding the“right” option to trade plays a large rolein the success of this approach. Optionsmay or may not be a suitable tradingstrategy for you. You must balance theopportunities of options trading withthe corresponding risks involved.

In-the-money options allow tradersto construct leveraged stock positions.Suppose stock XYZ presented a buyingopportunity at its current price of 66and you thought it had a chance to hit

70 over the next few days. Your searchfor an appropriate option should beginwith the first series of front-month, in-the-money calls, which in this case is theApril 65 strike price. Since theseoptions are only $1 in-the-money, theywill carry a fair amount of time premi-um. These options have an intrinsicvalue of $1, yet they are offered at $2.35(Figure 1). Hence, they have $1.35 oftime premium.

If the options have more than aweek until expiration and are tradingwithin 50 cents of their intrinsic value,they present an opportunity becausethey are a low-cost, limited-riskapproach that controls the shares ofthe underlying stock without beingexposed to time premium decay. If theoptions have more time premium than50 cents, you may need to go one strikefurther in-the-money, in this case tothe $60 strike. Those options are

offered at $6.40, 40 cents over theirintrinsic value (Figure 1). Theseoptions meet our needs. Our goal is tobuy an option with little or no timevalue that will probably increasepoint-for-point with the underlyingstock as it goes up. An option tradingat its intrinsic value will not beexposed to time premium decay or adrop in implied volatility.

The reason for purchasing an in-the-money call trading at close to parity issimple — unlimited upside potentialand limited downside, although alloption strategies involve risk. This is asurrogate stock position with less risksince you can only lose what you paidfor the option if you buy one optioncontract for every 100 shares of stockyou intend to purchase. This is animportant point. Many traders willincrease their leverage by tradingmore options. Why? Because they can.

More is better, right? Wrong! Ifyou do this you are changingthe nature of the trade andyou might be taking on morerisk than trading the underly-ing stock. Stay the course andkeep the size of the positionequivalent to the potentialstock trade.

Timing the trade and selecting the strikeTo find options that are trad-ing close to parity, we need tofocus on the front monthbecause those options don’tcarry as much time value. Thefact that they may expire in aweek or two is of little conse-quence. Remember, youentered the trade because youthink the stock will make amove in the next few days;accordingly, you should be out

OPTIONS BASICS

Choosing the best optionTrading options can minimize your risk — if you know what to look for. Here are some guidelines

for finding the option that best suits the needs of a particular trade.

With XYZ stock trading at 66, the April 65 call was priced at 2.35. However, becausethe April 60 call, priced at 6.40, is more in-the-money, we choose it instead.

FIGURE 1

Source: RealTick® by Townsend Analytics, Ltd.


of the trade before expiration becomesa factor, provided there remains a mar-ket for the option.

Front-month options that are onlyone or two strikes in-the-money gener-ally have good volume. This normallynarrows the bid-ask spread and maymake it easier to get in and out of thetrade. Remember, option volume israrely as high as it is for the underlyingstock, and slippage will probably begreater with options. The extra eighthor quarter getting in or out is the priceyou pay to utilize this strategy.

Let’s now discuss the behavior of thisposition. Let’s say we were able to buythe XYZ 60 calls for $6.40 (40 cents overintrinsic value). These options havevalue because they are in-the-money.Remember, the call gives us the right,but not the obligation, to buy the stockat the strike price of $60. If we exercisedthe $60 calls and sold the stock in theopen market at $66, we would generate$6 from the transaction.

Don’t confuse this with a profit of $6.If we bought the options for $6.40, wewould actually lose 40 cents by per-forming this exercise. The point here isto reveal the concept of intrinsic valueand its impact on option pricing. Thisrelationship causes these options tousually move point for point with theunderlying stock. This is exemplifiedby the delta of the option. In this case,the delta is 1.00 because the option willincrease $1 for each $1 increase in theprice of the stock.

Contained riskIf the stock goes up to $70 as originallyanticipated, the option should be worthabout $10. (Again, the option positionwill mimic the stock position as itmoves higher.) Let’s take a look at howit will behave if the stock moves lower.

Earlier, we pointed out that this is asurrogate stock position. The objectiveis to reduce our overnight risk andmaintain our upside potential. Ifovernight news hits the stock and itopens $10 lower the next day, we have$6.40 at risk. With the stock at $56, the$60 calls are now out-of-the moneyand we stand to lose everything wehad in the position.

While this is certainly not what we

wanted, we would have lost $10 if wewere long the stock. Consider the possi-bility that the stock only dropped $6 thenext morning and the options were at-the-money. If the options still have timeuntil expiration, they might be tradingfor $1 or more. Normally, deep in-themoney (one strike or more) options ini-tially lose point-for-point during anadverse move. However, as theyapproach the strike price, they general-ly implode with implied volatility andmay lose value at a slower rate.

Other considerationsIf the options carry a lot of time valueand you have to go three to four strikesin-the-money to find an option that isclose to trading at parity, it probablymeans the underlying stock is veryvolatile. In general, the deeper in-the-money you go, the greater your risk.You may have to pay $20 or more for theoptions. Chances are they are less liquidand have wider bid-ask spreads, addingto your slippage. Be very careful inthese situations; it is generally good toavoid them altogether. Some traderswould argue that this potential scenarioonly strengthens the case for using theaforementioned strategy, since the posi-tion reduces overnight risk.

This strategy also works using putsinstead of carrying a short position. Infact, buying in-the-money puts hasadditional advantages over shortingthe stock outright. You don’t have towait for an uptick to buy the puts, youdon’t have to borrow the stock andcheck for availability, and you don’t runthe risk of a “buy-in” (when the stock isno longer available for shorting and thetrader is forced to buy back the shares).As with the call strategy, there are risksinvolved with purchasing puts.

A position in an in-the-money calloption that is more than two weeksfrom expiration and is trading within ahalf-point of parity will usually gainpoint-for-point with the underlyingstock as it moves with you, but (at acertain level) may lose less when thestock moves against you. The risk islimited to what you paid for the optionposition. If you trade one option con-tract for each 100 shares of stock youoriginally planned to trade, your risk

will be reduced. Increased slippageand the possibility of no market are thepotential associated risks of using thestrategy. Because options are not as liq-uid as the stock, it may cost an addi-tional 25 cents or more to get in andout of the trade. Both opening andclosing transactions are subject to com-mission charges and the above strate-gy may entail significant amounts ofbuying and selling. Commissionsshould be a factor in deciding whetherthis is an appropriate strategy for you.

The following guidelines can helpyou select the appropriate options forputting on a trade with equal potentialas and lower risk than an equivalentstock position:

1. Buy an in-the-money option.2. Use front-month options if there

are more than two weeks untilexpiration.

3. Determine the time-value component.

4. If there is more than one point of intrinsic premium, go one strikefurther in-the-money.

5. Continue the process until you find an option trading at or near parity.

6. Look for options with daily volume greater than 100 contracts.

Other points: Options that are deepin-the-money may have wide bid-askspreads, which could increase slip-page. If the anticipated move has notmaterialized in five days, get out. Ifyou hold the option position overnight,your risk is the price of the option.

For information on the author see p. 4.Questions or comments? Click here. A version of this article previously appearedin Active Trader magazine.

You should discuss tax treatment of the possi-ble options strategies with your tax advisorsprior to undertaking such transactions.Exercise, opening and closing transactions aresubject to commission charges. Prior to buyingor selling an option, a person must receive acopy of Characteristics and Risks ofStandardized Options. Copies of this docu-ment are available from the Options ClearingCorp.; 440 S. LaSalle Street, 24th floor;Chicago, IL; 60605.

�

mailto:[email protected]?subject=Stolcers

OPTIONS RESOURCES


Option Screening:Finding Profitable Trades

with Lawrence CavanaghMarketplace BooksDVD$99

Lawrence Cavanagh teachesoptions traders how to employ avariety of spread techniques.The DVD provides advice onshort-term bull and bear spreads, using standarddeviation to forecast the probability of trade success,calendar spreads, using long and short option statis-tics as indicators, and diagonal and back spreads.

Prophet.net has announced several membershipenhancements. Gold memberships will includeStreaming Time-and-Sales data for stocks, futures,and options, and Gold members will be able to chartup to 120 days of intraday history. Premium memberscan keep more Watch Lists and unlimited savedcharts. Additionally, Prophet.Net has moved to a high-bandwidth data pipeline hosted by Savvis.

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By Jeffrey Owen Katz, Ph.D., and Donna L. McCormickMcGraw-Hill, 2005Hardback, 437 pages$70

Katz and McCormick detailconditions where standardoption pricing models provideinaccurate price estimates, andthen explain how to build new,non-standard models that com-pensate for those flaws. Thebook’s examples compare thereal-market distribution ofprice changes to the populartheoretical distribution modelssuch as Black-Scholes.

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MONTH

12 15LTD: All July equity options; July S&Poptions (CME); August Nasdaq options(CME); August Dow Jones options (CBOT);July lean hog options (CME); August orangejuice options (NYBOT)PPI for June

GLOBAL ECONOMIC CALENDAR

4Markets closed —Independence Day

5 6 7 8LTD: July currencies options(CME); July dollar indexoptions (CME); August sugarand coffee options (NYBOT)

Employment for June

21 22LTD: August T-bond options(CBOT); August corn,wheat, rice, oats, soybean,and soybean productsoptions (CBOT)

2319 20LTD: August platinumoptions (NYMEX)

The information on this page is subject to change. Options Trader is not responsible for the accuracy of calendar dates beyond press time.

Monday Tuesday Wednesday Thursday Friday Saturday

OPTIONS EXPIRATION CALENDAR JULY/AUGUST

18LTD: July GoldmanSachs CommodityIndex options(CME)

July 2005 • OPTIONS TRADER 37

1LTD: July porkbelly options(CME); Augustcocoa options(NYBOT); June milkoptions (CME)

11

9

Legend CBOT: Chicago Board of TradeCME: Chicago Mercantile ExchangeCPI: Consumer Price IndexFOMC: Federal Open Market CommitteeGDP: Gross Domestic Product

LTD: The final day a contract maytrade or be closed out before delivery ofthe underlying asset must occur. NYBOT: New York Board of TradeNYMEX: New York Mercantile ExchangePPI: Producer Price Index

26LTD: August natural gas,gasoline, and heating oiloptions (NYMEX); Augustaluminum, copper, silver,and gold options(NYMEX)

29GDP (advance) for Q2

ECI for June

2

13 14CPI for June

25 27 28 30

1 2 3 4 5LTD: August live cattleoptions (CME); Septembercocoa options (NYBOT);July milk options (CME)

Employment for July

6

8 9FOMC meeting

10 11 12LTD: August lean hogoptions (CME);September sugar andcoffee options(NYBOT)

13

TRADE

Date: Friday, May 20, 2005.

Position: Long strangle: Long 1 Australian dollarfutures July 77 call option at 0.35; long 1 July 75 put optionat 1.06

Reasons for trade/setup: Last month’s Options TradeJournal (Options Trader, June 2005, p. 35) described a longstrangle in Australian dollar futures options in anticipationof a breakout either above 78.48 or below 73.52 — the trad-ing range over the past six months. The Australian dollar’s(AD) statistical and implied volatilities were at 18-monthlows, and we expected them to rise from May 20 to July 9 —the July options’ expiration date.

A long strangle profits if the underlying security movessignificantly in either direction or if option implied volatili-ty soars. The Australian dollar was trading at 74.98 whenwe entered the trade on May 20 and climbed to 75.81 thefollowing week. This move back toward the middle of the

trading range wiped out 24 percent of the position’s value,but we held the strangle because there were still 43 days leftuntil expiration — plenty of time for the Aussie dollar tobreak out.

Initial stop: Exit the trade if Australian dollar futurestrade between 75.35 and 76.30 and implied volatility is flaton June 14 — halfway between its May 20 entry and July 9expiration dates. The stop represents a 50-percent loss,which seems unreasonable since the options still have 25days until expiration.

However, the strangle loses at least $18.44 per daybecause of time decay (see Trade Statistics), a daily loss thatwill increase as expiration approaches. Timing is critical —the Aussie dollar needs enough time to move higher (orlower), but we need to exit before time decay becomes toodifficult to overcome.

Initial target: We lowered our profit target to breakevenfrom 11 percent after the long strangle lost ground in thefirst week. Initially, we had planned to take profits whenthe Aussie dollar traded below 73.50 or above 78.25 by June14, but we narrowed this range to 74.07 and 78.04, respec-tively, which represented the trade’s June 14 breakevenpoints on May 27.

The targets are conservative, however, because neitheroriginal nor revised ones included an increase in impliedvolatility. If either of these thresholds were met and IV rosejust 1 percent by June 14, the strangle would gain roughly$100 (7 percent).

RESULT

Exit: Sell 1 July 77 call option at 0.34; sell 1 July 75 putoption at 0.33.

OPTIONS TRADE JOURNAL

TRADE STATISTICS


Date May 20, 2005 June 14, 2005Delta -22.83 4.93Gamma 29.68 39.47Theta -18.44 -25.18Vega 195.50 136.80

Average IV 10.0% 9.7%Calls IV 9.9% 9.7%Puts IV 10.1% 9.8%Probability of profit by expiration (July 9) 26% 9%Breakeven points 73.52 / 78.48 73.82 / 78.00

TRADE SUMMARY

Entry date 5/20/05

Underlying security ADU05

Position:Long 1 July 77 call ($): 0.35Long 1 July 75 put ($): 1.06Total position cost ($): 1.41Capital required ($): $1,480

Initial stop: If AD is trading between 75.35 and 76.30 with no increase

in IV — a 50-percent loss — by June 14, or twenty five

days before expiration (July 9).

Initial targets: Above 78.25 or below 73.50

Exit date: 6/14/05

Position:Offset 1 July 77 call ($): 0.34Offset 1 July 75 put ($): 0.33Total proceeds ($): 0.67Trade length (in days): 25 P/L: -0.74 (52.5%)LOP: n/aLOL: -0.77 (54.6%)

LOP — Largest open profit (maximum available profit during life-time of trade); LOL — largest open loss (maximum potential lossduring life of trade).

Long strangle fails to hit pay dirt



Reason for exit: Initial stophit.

Profit/loss: -0.74 (-52.5 per-cent).

Trade executed according to plan: Yes.

Lessons: The long stranglewas a bust — it lost groundfrom the beginning and neverrecovered as the Australiandollar futures traded between74.45 and 76.77 in late May andearly June.

Figure 1 shows Australiandollar futures with the longstrangle’s profitability “zones”(green and red areas, rightside). The Aussie dollar fell to afive-month low on June 1. Atthis point, the July 75 put roseto 1.21 from 1.06, but the 77 callfell to 0.15 from 0.35, whichkept the strangle from movinginto the money.

The underlying currencyclimbed 3.12 percent in thenext five days — a rally thatstalled in the middle of ourunprofitable zone. We exited atthe Australian dollar futures’June 14 close (76.01, blue line)after realizing that AD’s aver-age IV actually dropped sincewe placed the trade.

Figure 2 shows the longstrangle’s risk profile and plotsits profitability according toAD’s price on three dates:trade exit (June 14, orangeline), 13 days until expiration(June 27, dashed brown), andexpiration (July 9, solidbrown). The figure’s upper linerepresents the dilemma as weexited the trade: Not only did AD fail to break out of itsrange, but it traded in the middle of this area upon exit, pro-ducing a hefty loss.

However, daily time decay was actually the main reasonthe long strangle lost ground. It climbed to $25.18 from$18.44, which erased more than one-third of the trade’svalue by June 14 (see Trade Statistics); implied volatility

also fell to 9.7 from 10 percent. An expected sudden rise in implied volatility was unre-

alistic, and we overestimated the effect IV changes wouldhave. To overcome the negative effects of the Australiandollar’s sideways price action and time decay, impliedvolatility would have had to increase 5.5 percent — anunlikely scenario in less than a month.�

This long strangle remained unprofitable mainly because the expected moves (up ordown) in Australian dollar futures were unrealistic. However, time decay eroded at leasthalf the July option’s value.

FIGURE 2 — UNDERWATER STRANGLE

Source: OptionVue 5

Australian dollar futures closed at 76.01 on June 14, and our July options’ impliedvolatility didn’t increase as expected. This scenario triggered an exit, and the trade lost$740 (52.5 percent).

FIGURE 1 — STUCK IN A RANGE

Source: OptionVue 5

Price Chart — Australian Dollar (CME)

X1

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70Oct. Nov. Dec. 2005 Feb. Mar. Apr. May June July


American style: An option that can beexercised at any time until expiration.

Assign(ment): When an option seller(or “writer”) is obligated to assume a longposition (if he or she sold a put) or shortposition (if he or she sold a call) in theunderlying stock or futures contractbecause an option buyer exercised thesame option.

At the money (ATM): An option whosestrike price is identical (or very close)to the current underlying stock (orfutures) price.

Call option: An option that gives theowner the right, but not the obligation, tobuy a stock (or futures contract) at afixed price.

Deep (e.g., deep in-the-moneyoption or deep out-of-the moneyoption): Call options with strike pricethat are very far above the currentprice of the underlying asset and putoptions with strike prices that are veryfar below the current price of theunderlying asset.

Delta: The ratio of the movement inthe option price for every point move inthe stock price. An option with a deltaof .5 would move a half-point for every1-point move in the underlying stock;an option with a delta of 1.00 wouldmove 1 point for every 1-point move inthe underlying stock.

European style: An option that canonly be exercised at expiration, notbefore.

Exercise: To exchange an option for theunderlying instrument.

Expiration: The last day on which anoption can be exercised andexchanged for the underlying instru-ment (usually the last trading day orone day after).

Front month: The contract monthclosest to expiration.

In the money (ITM): A call option witha strike price below the price of theunderlying instrument, or a put optionwith a strike price above the underlyinginstrument’s price.

Intrinsic value: The differencebetween the strike price of an in-the-money option and the underlying assetprice. A call option with a strike price of22 has 2 points of intrinsic value if theunderlying market is trading at 24.

Out of the money (OTM): A call optionwith a strike price above the price ofthe underlying instrument, or a putoption with a strike price below theunderlying instrument’s price.

Parity: An option trading at its intrin-sic value.

Premium: The price of an option.

Put option: An option that gives the

owner the right, but not the obligation, tosell a stock (or futures contract) at a fixedprice.

Strike (“exercise”) price: The price atwhich an underlying stock isexchanged upon exercise of an option.

Time decay: The tendency of timevalue to decrease at an acceleratedrate as an option approaches expira-tion.

Time value: The amount of an option’svalue that is a function of the timeremaining until expiration.

Volatility: The level of price movementin a market. Historical (“statistical”)volatility measures the price fluctua-tions (usually calculated as the stan-dard deviation of closing prices) over acertain time period — e.g., the past 20days. Implied volatility is the currentmarket estimate of future volatility asreflected in the level of option premi-ums. The higher the implied volatility,the higher the option premium.

KEY CONCEPTS AND DEFINITIONS

Variance and standard deviation

Variance measures how spread out a group of values are — in other words,how much they vary. Mathematically, variance is the average squared “devi-ation” (or difference) of each number in the group from the group’s meanvalue, divided by the number of elements in the group. For example, for thenumbers 8, 9, and 10, the mean is 9 and the variance is:

{(8-9)2 + (9-9)2 + (10-9)2}/3 = (1 + 0 + 1)/3 = .667

Now look at the variance of a more widely distributed set of numbers: 2, 9,and 16:

{(2-9)2 + (9-9)2 + (16-9)2}/3 = (49 + 0 + 49)/3 = 32.67

The more varied prices, the higher their variance — the more widely dis-tributed they will be. The more varied a market’s price changes from day today (or week to week, etc.), the more volatile that market is.

A common application of variance in trading is standard deviation, whichis the square root of variance. The standard deviation of 8, 9, and 10 is: .667= .82; the standard deviation of 2, 9 and 16 is: 32.67 = 5.72.

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