Trading Strategies Profit Making Techniques For Stock_10 pot

If the position is profitable, you are likely holding a bearish ratio spread, and holding the position can make sense.. If the position is unprofitable, you are likely holding a bullish

Ratio Spreads 241

If you have a bullish ratio call spread, then holding the position makes

sense The UI price has moved lower, but you are now looking for the ket to move in your direction Therefore, your position should begin toshow a profit if your market opinion is correct On the other hand, you willnot want to hold the position if you have a bearish ratio spread

mar-If you initiated a bearish ratio spread, then you should consider

liqui-dating the position.There is never any reason to hold a bearish position ifyou are bullish

The most aggressive approach would be to liquidate the short options

or buy more calls This would shift the position to a net long call position.Hopefully, you are adjusting the position because of newfound bullishness,not because you lost money due to a poor adjustment to the ratio because

of the higher prices If you are adjusting because you are now bullish, youmight have a slight profit in the trade because of the decay in the timepremium Thus, you will be shifting to a long call position with a profitthat, in effect, raises the break-even point One problem with this tactic isthat you likely initiated the original ratio spread with little time left beforeexpiration This means that you will be buying time premium when time isworking significantly against you

If you expect prices to remain about the same, you could:

1. Hold the position if profitable; or

2. Roll down if unprofitable

If the position is profitable, you are likely holding a bearish ratio

spread, and holding the position can make sense Holding the position will

mainly accomplish the goal of capturing the time premium on the shortoptions

If the position is unprofitable, you are likely holding a bullish ratio

spread, and rolling down to lower strike prices might help recover some

of the losses This is basically a tactic to try to maximize the time premiumthat you capture Thus, the short options should be at-the-money, whereasthe long options should be in-the-money

If you are bearish, you could:

1. Hold the position if initiated at a credit;

2. Roll down; or

3. Liquidate the long calls or sell more calls

If you are holding a bearish ratio spread, then holding the position

makes sense An expectation of lower prices will lead to greater profits Nomatter what market bias you have, consider holding the position wheneveryou have initiated the trade for a credit

242 OPTION STRATEGIES

If the position is unprofitable, you are likely holding a bullish ratio

spread, and rolling down to lower strike prices might help recover some

of the losses This is basically a tactic to try to maximize the time premiumthat you capture Thus, the short options should be at-the-money, whereasthe long options should be in-the-money

A more aggressive approach is to sell more calls or liquidate some long

calls.The ultimate version of this tactic is to liquidate all the long calls Youhave to be very confident of your bearish prognostication because of thegreater risk of a naked short call position However, the potential reward

is also much higher

Ratio Put Spreads If you are bullish, you could:

1. Hold the position if initiated at a credit; or

2. Liquidate the long puts or sell more puts

If you were able to initiate the ratio put spread at a credit, then you

can hold the position You have no up-side risk in a ratio put spread if

initiated for a credit As a result, you should continue to hold the sition If you have a bullish ratio put spread, then holding the positionwill give you additional time for prices to move back to the maximumprofit point

po-The most aggressive choice is to liquidate the long puts or sell more

short puts This will bring large profits if prices move higher, but it willhave very large losses if prices change direction and fall You must have afirm opinion about the expected rally

If you expect prices to remain about the same, you could:

1. Hold the position if profitable; or

2. Roll down if unprofitable

If the position is profitable, you are likely holding a bearish ratio

spread, and holding the position can make sense Holding the position will

mainly accomplish the goal of capturing the time premium on the shortoptions

If the position is unprofitable, you are likely holding a bullish ratio

spread Rolling down to lower strike prices might help recover some of

the losses This is basically a tactic to try to maximize the time premiumthat you capture Thus, the short options should be at-the-money, whereasthe long options should be in-the-money

Ratio Spreads 243

If you are bearish, you could:

1. Hold the position if profitable;

2. Liquidate the position;

3. Buy more puts or liquidate the short puts; or

4. Roll down if unprofitable

If the position is profitable, you are likely holding a bearish ratio

spread, and holding the position can make sense Holding the position will

mainly accomplish the goal of capturing the time premium on the shortoptions

If you are holding a bullish position, then the most flexible approach

is to liquidate the position You will then be able to select from a larger

variety of bearish positions to take

A more aggressive approach would be to buy more puts or liquidate

some of your short puts.The ultimate version of this tactic would be toliquidate all the short puts You would have to be very confident of yourbearish prognostication because of the somewhat greater risk of a long putposition However, the potential reward is also much higher

If the position is unprofitable, you are likely holding a bullish ratio

spread, and rolling down to lower strike prices might help recover some

of the losses This is basically a tactic to try to maximize the time premiumthat you capture Thus, the short options should be at-the-money, whereasthe long options should be in-the-money

Implied Volatility

Time Decay Gamma

Profit Potential Risk

Long

Straddles

Either Way a Lot

Increasing Helps

STRATEGY

The ratio calendar spread is a blending of ratio spreads and calendar

spreads It consists of selling nearby options and buying fewer of a ther option For example, you could sell 4 of the July 40 calls and buy 2 ofthe October 40 calls

far-The amount of bullishness or bearishness can be controlled by the ratio

of the long and short options A neutral spread can be constructed as adelta-neutral strategy and then kept neutral throughout the time period.Alternately, positions can be engineered that have a bullish or bearish bias.Ratio calendar spreads are good low-risk investments that can give asteady return They capture the higher time decay of the nearby option butmaintain the hedge of the far option In addition, ratio calendar spreadshave the potential for large gains after the nearby option expires because

of the still-existing long-term option (see Chapter 18 and Chapter 19)

245

246 OPTION STRATEGIES

RISK/REWARD

Unfortunately, there are no formulas to identify the risk and rewards

of ratio calendar spreads The strategy is too dynamic to reduce to mulas Much of the profit or loss is related to time decay of two different op-tions Thus, concepts such as break-evens are changing all the time How-ever, profits and losses can be estimated using a computer program thatsimulates time decay (The ramifications of time decay are addressed inChapter 18.)

for-DECISION STRUCTURE

Selection

First, determine your overall strategy There are two major strategies withratio calendar spreads: market bias or delta neutral The first strategy at-tempts to construct a ratio calendar spread that will profit through changes

in the price of the underlying instrument (UI) by adjusting the variousstrike prices and ratios of near to far options The second strategy looksmainly to capture the time premium of the nearby option but to retain thepossibility of large capital gains after the nearby option expires

If you have a market bias, use the deltas of the various options to

de-termine the correct market exposure Select a strike price that correspondswith your expected price scenario Preferably, you will initiate the trade at

a credit This will ensure a profit even if prices do not move However, there

is a trade-off In general, a large credit will occur only if you have shorted arelatively large number of options relative to the long side The greater theratio, the greater price risk if the position goes against you

For a delta-neutral strategy, set up the initial position with the total

delta of the nearby option position equal to the total delta of the far option

A main object of this trade is to capture the time premium of the nearby tion Therefore, you should be writing the at-the-money option Preferably,you will also be selling an option with a high implied volatility and buyingone with a low implied volatility

op-If the Price of the Underlying Instrument

Changes Significantly

With the delta-neutral strategy, you will adjust the longs and shorts to

maintain delta neutrality In addition, you can roll up or down to new

Ratio Calendar Spreads 247

strikes if the transaction costs are not prohibitive (that is, net gain in sellingtime premium is greater than transaction costs)

With a market bias strategy, you might want to liquidate the trade if

the UI price moves through the estimated eventual break-even point beforethe expiration of the nearby contract Assume you have a 2:1 ratio in Julyand October options Your ideal scenario would be a drop in price to belowthe strike price, with the nearby option expiring worthless, and then the UIprice moving strongly higher However, the UI price might move higherbefore the July expiration, necessitating a defensive liquidation Note howimportant your market outlook is You should definitely liquidate the posi-tion if you look for prices to continue higher before expiration A bearishoutlook suggests that you hold the original position (Chapter 18 and Chap-ter 19 will be helpful in understanding the potential follow-up tactics.)

C H A P T E R 21

Straddles and Strangles

STRATEGY

There are two types of straddles: long and short A long straddle is structed by being long both a call and a put A short straddle is constructed

con-by being short both a call and a put

Straddles are generally considered neutral strategies because the putand the call are usually both at-the-money options This means that the longstraddle will profit if the price of the underlying instrument (UI) movessignificantly in one direction or the other The short straddle will profit ifthe (UI) price stays in a narrow range Typically, straddles are put on withthe strike price being near the current UI price Long straddles are alwaysinitiated for a debit, while short straddles are always initiated at a credit.Figures 21.1 and 21.2 show option charts for straddles

A strangle is the most common combination other than a straddle This

is simply a straddle with different strike prices (See Figures 21.3 and 21.4for examples of option charts for strangles.) For example, a long straddlewould be long the $50 call and long a $50 put A long strangle would be longthe $60 call and long a $40 put

The analysis of strangles is essentially identical to that of straddles.Therefore, the rest of this chapter just refers to straddles, unless there aredifferences worth mentioning between straddles and strangles

Note also that bullish and bearish straddles and strangles can be structed For example, a bullish long straddle would have the strike pricesbelow the current UI price, thus maximizing the profits on the bull sidebut increasing the chances of losses if prices move lower A bullish short

con-249

40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60

FIGURE 21.2 Short Straddle

2 1 0

Price of Underlying Instrument

40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60

FIGURE 21.3 Long Strangle

Straddles and Strangles 251

40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60

FIGURE 21.4 Short Strangle

straddle would be constructed by selecting strike prices above the current

UI price Prices would have to rise to within the two break-even pointsbefore you would profit

RISK/REWARD

Maximum Profit

Long Straddle For the long straddle, maximum profit is unlimited.Once one of the break-even points is breached, the profit will be equal, dol-lar for dollar, the amount that the UI is above or below the break-even at ex-piration Thus, you will want the UI price to trend strongly in one direction

Short Straddle For the short straddle, maximum profit is the netcredit This will occur at the strike price Thus, you will want the UI price

to stagnate near the strike price of the straddle

$60, plus the net debit, $6, gives an up-side break-even of $66 The strikeprice, $60, minus the net debit, $6, gives a down-side break-even of $54.For another example, suppose Intel is trading at 1201/4 and you buythe November 120 call and the November 120 put for 101/4 each The netcredit is 201/2 The up-side break-even on a short straddle is 1401/2—thestrike price, 120, plus the net credit, 201/2 The down-side break-even is

991/2—the strike price, 120, minus the net credit, 201/2

Maximum Risk

A long straddle has a limited risk of just the debit paid for the straddle Nofurther losses can occur The maximum risk occurs at the strike price ofthe straddle

The dollar risk on a short straddle is unlimited Once the UI pricebreaches the break-even points, the loss will be dollar for dollar the amountthat the UI price is above or below the break-even at expiration

DECISION STRUCTURE

Selection

Long Straddle You will buy a straddle when:

r You look for a strong price movement in one direction, but you do notknow for sure what direction it will be

r You are expecting implied volatility to increase.

The whole purpose of a long straddle is to look for increased ity You want large price movements This is often the best strategy to usewhen you expect the UI price to make a big move

volatil-Straddles and Strangles 253

Unfortunately, there is a tendency for the most volatile instruments

to have the most expensive straddles The market marks up the price of

the straddle whenever it expects an increase in volatility For example, the

price of the straddle will typically rise just before an important ment, such as an earnings report or an important economic report Theprice of the straddle then often drops sharply after the report is releasedbecause the uncertainty is gone The converse of this also tends to be true.Cheap straddles usually occur when the market is dull and expected to staythat way

announce-Profits in buying straddles come from predicting an increase in eitheractual or implied volatility The quick method of evaluating the profit po-tential of a long straddle is to compare the price range suggested by the im-plied volatility with your expected price range You might consider buyingthe straddle if your expected price range is greater than the range implied

by the implied volatility

For example, Widgetron might be trading at $50 with the options at animplied volatility at 10 percent This suggests that the range in the futurewill be between $45 and $55, or 10 percent lower and higher than $50 Youmight think that the earnings report coming out will propel the stock to

$60 but that an earnings disappointment may hammer the stock to $40.The purchase of the straddle, therefore, may make good sense

A second way to look at the straddle is to compare the implied volatilitywith the recent past of the historical and implied volatility

Figure 21.5 shows, in bold, the implied volatility of the nearestTreasury-bond futures contract at-the-money option and, in dashed, the ac-tual volatility over the previous six weeks It is clear that these sometimesdeviate substantially, creating opportunities for profit

Notice how the implied volatility is low compared to previous readings.Implied volatility tends to move up and down within a wide range Thepurchase of a straddle near the low end of the range can, with patience, be

a profitable strategy In this case, you will be looking for implied volatilitiesthat are at the low end of their recent and expected range It is much moredifficult to buy straddles that have implied volatilities in the middle or highend of the range The odds are not with you Therefore, you must have astrong opinion about the prospects of a near-term strong-price movement.Typically, straddles are bought on options that have a long time to ex-piration Long-dated options have the highest sensitivity to volatility, orvega, and, therefore, will have the greatest price movement due to changes

in implied volatility Time decay is typically the enemy of any holder oflong options This is another reason for you to mainly focus on long-datedoptions when buying straddles

The only possible exception would be to speculate on a sudden ment caused by a specific news item In this case, you will want the highest