13 Butterflies and condors: combining call spreads and put spreads 149Volatility, days until expiration, and butterflies and condors Likewise when volatilities are high, you can often
Trang 113 Butterflies and condors: combining call spreads and put spreads 145
Table 13.5 Marks and Spencer long April 320–330–340–350 put condor
M&S 310.00 320.00 322.25 330.00 340.00 347.75 350.00 360.00Spread debit –2.25 -
*Long at-the-money put condor
For stationary markets
Put condors, like call condors, can be placed at many different strikes, depending on your near-term outlook for the underlying If your out-look calls for a stationary market, but you wish to leave room for error
on the downside, you can substitute the long
at-the-money put condor for the at-at-the-money put
butterfly You might, for example, buy the above
April 360–350–340–330 put condor for a debit of
3.5 The downside profit potential of this spread is
3302
46810
0–2–4
Figure 13.5 Expiration profit/loss relating to Table 13.5
Put condors, can be placed at many different strikes, depending on your near-term outlook for the underlying
Trang 2146 Part 2 Options spreads
the same as the upside profit potential of the long April 340–350–360–370 call condor The profit/loss at expiration is summarised as follows:
Debit from long April 360 put: –16.25
Debit from long April 330 put: –3.75
Credit from short April 350 put: 10.25
Credit from short April 340 put: 6.25
–––––
Maximum profit: difference between highest two strikes minus spread debit: (360 – 350) – 3.5 = 6.5
Range of maximum profit: 350 – 340
Upper break-even level: highest strike minus spread debit:
360 – 3.5 = 356.5
Lower break-even level: lowest strike plus spread debit:
330 + 3.5 = 333.5
Profit range: 356.5 – 333.5 = 23
Maximum loss: cost of spread: 3.5
The risk/return ratio is again favourable at 3.5/6.5 = 0.54 for 1, or 1/1.85
By now you should be an expert at tabulating and graphing the expiration profit/loss levels of condors and butterflies
* Short at-the-money put condor
For volatile markets
Like the butterfly, the condor can be sold in order to profit from a tile or trending market Although this is more of a market-maker’s trade,
vola-you might consider trading it during volatile kets For example, you could sell the above April 360–350–340–330 put condor at 3.5 If Marks and Spencer closes above 360 or below 330 at expira-tion, you earn the credit from the spread In this case you are taking a slightly bullish position.The profit/loss figures are exactly the opposite of the above long put condor
mar-Like the butterfly, the
condor can be sold in
order to profit
from a volatile or
trending market
Trang 313 Butterflies and condors: combining call spreads and put spreads 147
* Short at-the-money call condor for volatile
markets
If instead your outlook is for volatile conditions and you are slightly ish, you might sell the April 340–350–360–370 call condor at 2.75 (Don’t be surprised if you earn your profit on the upside.) If at expiration Marks and Spencer closes below 340 or above 370, then you earn the credit from the spread Again, this is a market-maker’s trade, but you might learn about it to increase your market awareness Your profit/loss summary is as follows
bear-Credit from short April 340 call: 17.00
Credit from short April 370 call: 3.75
Debit from long April 350 call: –11.25
Debit from long April 360 call: –6.75
–––––
Maximum profit: spread credit: 2.75
Range of maximum profit: below 340 and above 370
Lower break-even level: lowest strike plus spread credit:
Price range of shares for potential loss: 367.25 – 342.75 = 24.5 points
The risk/return ratio is 7.25/2.75 = 2.64 to 1
*Butterflies and condors with non-adjacent
strikes
Butterflies are flexible spreads which can profit from a variety of trading ranges You can extend the profit range of a butterfly by extending the distance of the strikes If XYZ is at 100, and you
expect it to rally into a range of between 105 and
115, then you can buy the 100–110–120 call
but-terfly This spread costs more than the adjacent
strike, 105–110–115 call butterfly, but it has a
greater profit range
Butterflies are flexible spreads which can profit from a variety of trading ranges
Trang 4148 Part 2 Options spreads
Using the set of Marks and Spencer April options, you could pay 11.25 for the 350 call, sell two 370 calls at 3.75, and pay 1 for the 390 call, for a net debit of 4.75 Your profit range is then 354.75 to 385.25, or 30.5 points, or 8.7 per cent of the share’s value
Condors can also increase their profit ranges by increasing the distance
of the strikes This is especially feasible while that stock indexes and, as
a result, options premiums, are at high levels Consider the set of FTSE options below
June FTSE-100 options
June Future at 62504
106 days until expiry
ATM implied at 26 per cent
Strike 6225.0 6325.0 6425.0 6525.0 6625.0 6725.0 6825.0 6925.0Calls 359.5 303.0 253.5 205.0 165.0 131.0 102.5 80.0
If you discern that the path of least resistance is up, or if you’re simply bullish, you may wish to take a long call position in the UK market But if the thought of spending £2,000 to £3,000 for one options contract gives you pause, then you may instead consider financing your call purchase with a spread
For £470, the 6325–6525–6725–6925 call condor can be purchased out taking out a second mortgage The maximum profit is 200 – 47 = 153 ticks The break-even levels, at 6372 and 6878, provide a profit range of
with-506 points The risk/return for this spread is favourable, at 47/153 = 0.31.The trade-off with this spread is that if the FTSE rallies quickly, then the spread will show only a modest profit Like all butterflies and condors, this spread needs time decay to work for it
Non-adjacent strike butterflies and condors are preferred alternatives in the OEX or SPX and SPY (SPDRS) as well They are sensible ways of reduc-ing premium exposure while minimising risk Some exchanges have reduced the tick size of these contracts in order to accommodate the indi-vidual investor, and to improve liquidity and price discovery
4 If and when the FTSE reaches this level again The point is to use butterflies and condors when options premiums are expensive
Trang 513 Butterflies and condors: combining call spreads and put spreads 149
Volatility, days until expiration, and butterflies
and condors
Likewise when volatilities are high, you can often find inexpensive cent strike butterflies and condors, such as in the above FTSE example This is because the underlying is trading in a wide range, and the prob-ability of it settling near a particular strike at expiration is small The same factors apply to these spreads when there are many days until expiration
adja-At times like these, it is preferable to trade butterflies and condors with non-adjacent strikes
The advantages
In this chapter we have covered butterflies and condors in depth The sons for this are twofold: when purchased, these spreads have low risk/return ratios; also, they can easily be opened and closed in one transac-tion They are therefore justifiable trading strategies under many market conditions It is worth learning how to use them
Trang 7The covered write, the calendar spread and the diagonal spread
The diagonal spread for trending markets
There are two additional spreads that profit from stationary markets The
covered write involves selling a call against a long underlying position,
and the calendar or time spread involves selling a near-term
at-the-money option, usually a call, and buying a further-term at-the-at-the-money option, again usually a call Both spreads profit from time decay
The covered write or the buy-write
If an investor owns or is long an underlying
con-tract, he may sell or write a call on it to earn
additional income This strategy is known as the
covered write and it is often used by long-term
holders of stocks that are temporarily
underper-forming It is often traded in bear markets
When the underlying is bought and the call is sold in the same tion, this spread is also known as the buy-write.
transac-For example, if you own XYZ at a price of 100, or hopefully less, you may sell one 105 call at 3 The maximum profit is the premium earned from the sale of the call plus the amount that the underlying appreciates to the strike price of the call Here, this would be 5 + 3 = 8 The downside break-even level is the price of the underlying at the time of the call sale less the call income Here, this would be 100 – 3 = 97
There are two risks:
When the underlying
is bought and the call
is sold in the same transaction, this spread
is also known as the
buy-write
Trang 8152 Part 2 Options spreads
This spread is best used by investors who have purchased the underlying
at significantly lower levels, who think that there is little or no upside potential, and who can tolerate short-term declines in the underlying.Consider Coca-Cola at 52.67; August options with 60 days until expiration:
At expiration, the maximum profit for your spread occurs at the strike price of the call There, you gain the price appreciation of the stock plus the full income from the call The maximum profit is calculated as the strike price minus the purchase price of the stock plus the income from the call, or (60 – 52.67) + 0.34 = 7.67
Above the call strike price, the profit from the stock is offset by the loss on the call, on a point for point basis The maxium profit is earned, no more,
no less The stock will be called away from you at expiration
The lower break-even level for your position is the price at which the call income equals the decline in the stock price This is calculated as the price of the stock minus the income from the call, or 52.67 – 0.34 = 52.33 Below this level the spread loses point for point with the stock
The expiration profit/loss for this covered write is summarised as follows.Maximum profit: strike price minus stock price, plus income from call: (60 – 52.67) + 0.34 = 7.67
The maximum profit occurs at or above the strike price of the call
Trang 914 The covered write, the calendar spread and the diagonal spread 153
Break-even level: stock price minus income from call: 52.67 – 0.34 = 52.33Maximum loss: full amount of stock price decline below break-even
level: 52.33
The expiration profit/loss is summarised in Table 14.1
Table 14.1 Coca-Cola covered write: with Coca-Cola at 52.67,
sell August 60 call at 0.34
Coca-Cola (below) 45.00 50.00 52.33 52.67 55.00 60.00 65.00Credit from
The expiration profit/loss is shown in Figure 14.1
246810
0–2–4–6–8–10
–12
42.5 45 47.5 50 52.5 55 57.5 60 62.5 65
Figure 14.1 Expiration profit/loss for Coca-Cola
Trang 10154 Part 2 Options spreads
Second, and more importantly, there is currently a lot of common advice which tells you to initiate buy-writes for tempting yields Well-meaning advisers usually tell you that you could pay 52.67 for Coca-Cola and sell the August 55 call at 1.45 Your annualised return would be 1.45/52.67 × 360/60 = 16.5% But this yield projects that the stock stays where it is for a year while you write more calls
True, if Coca-Cola rallies then you’ve made a bit, but then you’re making the classic mistake of trading on hope Instead, if Coca-Cola declines past 52.67 – 1.45 = 51.22 then you’re a loser This is why I don’t recommend the buy-write as an initiating trade
On the other hand, if you’ve inherited the stock from your father, who bought it for $20 or thereabouts, and we’re at the start of a bear market,
or maybe we’re in a bull market, and Coca-Cola is looking toppy, and you can’t afford to sell it because you’ll pay capital gains tax, then, in either of these cases you might consider writing a call
But only do it once or twice
And a story
Several years ago, I gave a lecture at a major London bank During the interval, a trader confided to me that they had recently done very well with a buy-write on shares He also stated that they were disappointed because the shares had rallied past the cut-off level, or the short call level, and that they had missed out on a good deal of profit
Knowing what they had done, I suggested that there were better ways of capturing the upside These are outlined in the examples at the end of Chapters 1 and 2, and they are called substitution trades
Trang 1114 The covered write, the calendar spread and the diagonal spread 155
If you really like the ‘stuff’ (as we called it at the Chicago Board of Trade),
and by this I mean soybeans, wheat, bonds, or whatever, then just buy it
with a sell stop order You don’t need options
On the other hand, if you have ever been stopped out two or three times
in one trade, then options are the way forward for you
How to manage the risk of the covered write
The covered write is best suited to long-term stock-holders who can ate a decline in the stock price below the current price
toler-There are two solutions to the upside risk Using the above spread, first note that with Coca-Cola at 52.67, the August 55 calls are priced at 1.45 Let’s assume that Coca-Cola immediately rallies $5, to 57.67 At this point, your short 60 calls will be worth approximately 1.45, and you may simply buy them back Your profit/loss is as follows:
Sale of 60 call: 0.34 credit
Purchase of 60 call: 1.45 debit
Profit on stock: 5 credit
With Coca-Cola at 57.67, the value of the 60 call will be, as we said, approximately 1.45 The 65 call will then be approximately 0.34 The 60–65 call spread will be approximately 1.45 – 0.34 = 1.11 You can then buy this spread, and by doing so, roll your short call to the 65 strike
The options summary is as follows:
Sale of 60 call: 0.34
Purchase of 60 call: –1.45
Sale of 65 call: 0.34
–––––
Total options debit: –0.77
Here, the profit equals the five points appreciation on the stock minus the total options debit, or 5 – 0.77 = 4.23
Trang 12156 Part 2 Options spreads
The total profit/loss summary at expiration is as follows:
Maximum profit: new strike price minus stock purchase price, minus debit from call position: (65 – 52.67) – 0.77 = 11.56
The maximum profit occurs at or above the strike price, 65, of the open August call
Break-even level: stock purchase price plus total options debit:
52.67 + 0.77 = 53.44 Note that this level is 1.11 points above the former break-even level, which was 52.44
Maximum loss: full amount of stock price decline below break-even level: 53.44
The risk here is that at the new price level, 57.67, Coca-Cola contains five points of downside loss potential for which you have received a credit of only 4.23 The potential return, of course, is improved
The expiration profit/loss is summarised in Table 14.2
Table 14.2 Expiration profit/loss for Coca-Cola
Coca-Cola (below) 45.00 47.50 50.00 52.67 53.44 60.00 62.50 65.00Total
A story and a bit of advice
With the covered write, it is important not to think in terms of the short call
as ‘downside protection’ Remember ’portfolio insurance’? A form of this
Trang 1314 The covered write, the calendar spread and the diagonal spread 157
now discredited strategy was a variation of the covered write During the 1980s portfolio insurance was sold to investors as a means of ‘downside pro-tection’, in other words, calls were written against a stock portfolio in order
to compensate for a price decline, and in the meantime, to earn income
Have you ever heard of an insurance policy that paid you to be insured?
On 19 October 1987, no amount of calls sold protected stockholders from the enormous loss of their assets’ values With options, the only form of full downside protection is the purchase of a put
The long calendar spread or long time spread
Calendar spreads in particular can be complicated, and their return tials can in many cases be duplicated by other stationary market spreads However, learning about them is an excellent way to improve your under-standing of options, and to improve your risk awareness
poten-Because an option’s decay accelerates with time it is possible to sell a term option and buy a further-term option at the same strike in order to profit from the different rates of decay The resulting position is termed either the long calendar spread or the long time spread Usually this
near-spread is traded with both options at-the-money For example, if XYZ is
at 100, you could sell one June 100 call and buy one September 100 call in the same transaction Apart from extraordinary circumstances, this spread
is done for a debit Your outlook should call for a stationary market with both options remaining at-the-money
This spread is best opened when the near-term option has between 60 to
30 days till expiration The time distance between the two options can vary A greater distance increases the cost of the spread, and reduces the hedge value of the further-term option, while a shorter distance reduces the difference in rates of decay, which in turn lowers the profit potential Optimally, there should be 30 to 90 days between options This spread should be closed before the near-term option expires
A preferable opportunity is when the relationship between the near-term implied volatility and the further-term volatility is at a discrepancy, i.e the near-term volatility is at a higher level than usual in comparison to the further-term volatility This often occurs when the underlying has reacted suddenly to an event that is of short-term significance, or perhaps when the longer-term significance of an event is not fully accounted for The underly-ing has moved to a level at which it is expected to remain for the near term