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JULY 2005 Volume 1, No.

A better way to sell volatility


with long straddles PERSPECTIVE on naked puts

STRATEGY LAB: Trading employment reports with short strangles

risk with spreads

the best option


Long straddles: The importance of buying time . . . . . . . . . .16 Profiting from long straddles is largely a matter of time management. By Jim Graham Taking a peak at naked puts . . . . . . . . . . . .20 Learn how to save money by using naked puts as an alternative to long stock positions. By Mark Vakkur, M.D. Options Strategy Lab . . . . . . . . . . . . . . .24 Employment report strangle. Options Basics The volatility index (VIX) . . . . . . . . . . . . . . .28 The background of the VIX.

Contributors . . . . . . . . . . . . . . . . . . . . . . . . . .4 Letters . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .6
Options News Options exchanges jockeying after NYSE-Arca deal . . . . . . . . . . . . . . . . . . . .8 The New York Stock Exchange-Archipelago merger could cause some changes in the options and futures markets. By Jim Kharouf Trading Strategies Option butterflies: A safer way to sell volatility . . . . . . . . . . . .10 Learn how and when to use the butterfly spread. By Keith Schap Controlling risk with spreads . . . . . . . . . . .30 Spreads 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 . . . . . . . . . . . . . .34 How 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

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Editor-in-chief: Mark Etzkorn metzkorn@optionstradermag.com Managing editor: Molly Flynn mflynn@optionstradermag.com Associate editor: Carlise Peterson cpeterson@optionstradermag.com Associate editor: David Bukey dbukey@optionstradermag.com Contributing editor: Jeff Ponczak jponczak@optionstradermag.com Editorial assistant and Webmaster: Kesha Green kgreen@optionstradermag.com Art director: Laura Coyle lcoyle@optionstradermag.com President: Phil Dorman pdorman@optionstradermag.com Publisher, Ad sales East Coast and Midwest: Bob Dorman bdorman@optionstradermag.com Ad sales West Coast and Southwest only: Allison Ellis aellis@optionstradermag.com Classified ad sales: Mark Seger mseger@optionstradermag.com

Keith Schap, formerly senior editor at Futures magazine and senior technical marketing writer at the Chicago Board of Trade, is currently a freelance writer specializing in risk management and trading strategies. He is the author of numerous articles and several books on these subjects, including the recently published The Complete Guide to Spread Trading (McGraw-Hill).

Jim Graham is the product manager for OptionVue Systems and a registered investment advisor for OptionVue Research.

Steve Lentz is executive vice president of OptionVue Research and is the chief trader for the companys CTA-managed futures program called the Swing 500. Peter Stolcers (www.oneoption.com) is a trader for Last Atlantis Capital, a proprietary trading firm. Prior to that he was a senior vice president of Terra Nova Trading LLC in Chicago and vice president of sales at ED & F Man International. Stolcers is an experienced options trader, with more than a dozen years of success. He can be reached at pstolcers@brokersxpress.com. Brian Overby (www.brianoverby.com) is a trader and instructor who has given more than 1,000 seminars worldwide on options trading. He has been in the financial industry since 1992 and previously worked for OptionsXpress, Schwab, the CBOE, and Knight Trading Group. He can be reached at brian@brianoverby.com. Mark Vakkur, M.D. (mvakkur@hotmail.com, www.vakkur.com) is a stock and options trader and a psychiatrist in private practice in Atlanta.

Volume 1, Issue 4. Options Trader is published monthly by TechInfo, Inc., 150 S. Wacker Drive, Suite 880, Chicago, IL 60606. Copyright 2005 TechInfo, Inc. All rights reserved. Information in this publication may not be stored or reproduced in any form without written permission from the publisher. The information in Options Trader magazine is intended for educational purposes only. It is not meant to recommend, promote or in any way imply the effectiveness of any trading system, strategy or approach. Traders are advised to 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 not guarantee future results.

Jim Kharouf is a business writer and editor with more than 10 years of experience covering stocks, futures, and options worldwide. He has written extensively on equities, indices, commodities, currencies, and bonds in the U.S., Europe, and Asia. Kharouf has covered international derivatives exchanges, money managers, and traders for a variety of publications.



VIX rub
ongratulations on the new magazine what an undertaking! I have been enjoying the real, in-depth, options material, but Im sure it has been a daunting undertaking with lots of long hours. Ive noticed there have been several references to the CBOE Volatility Index (VIX). The VIX gets a lot of coverage, as options traders rely heavily on it as a market barometer as well as a strategy indicator. However, [in the June issue], the description of how it is calculated is outdated which can be especially troublesome in a publication at the level of Options Trader. The article Market insurance poli-

The eyes have (had) it

cies by William McLean in the June issue states ...the CBOE Volatility Index, which reflects the implied volatility of at-the-money OEX options. It should read the CBOE Volatility Index (VIX) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. It looks like the description that McLean used refers to the original methodology for calculating VIX. That methodology was changed in 2003, and today the VIX is based on all atthe-money plus out-of-the money S&P 500 (SPX) calls and puts with 30 days to maturity. I just wanted to let you know as Im sure VIX will be mentioned again at some point. Lynne Howard-Reed CBOE Public Relations Editors reply: The story mentioned above was adapted from previously published Active Trader articles that were written before the VIX was changed. These articles should have been updated with the new calculation when published in Options Trader. We apologize for any confusion. However, the premises of the articles are still valid, despite the differences in VIX calculation. Active Trader magazine covered the update of the VIX in 2003-2004, and you can also click here for a description of the revised index.

hank you for your excellent publication. Im delighted with the informative content but Im curious about the layout. Are you expecting us to print it out? Perhaps you are, and that would be the reason why you are still formatting the content in portrait orientation, with multiple text columns per page. However, Id wager that most people receiving the magazine would prefer not to print it out, but would rather view a landscape orientation on their screens. Would you consider switching the orientation to make it more screen-reader friendly? Phil Greenwood

We get arguments from both sides of the fence. People who print it send suggestions for improvement, and we also hear from people with opinions similar to yours. Rest assured, we are taking into account all reader feedback and will do whatever we can to give people the most user friendly magazine possible.

Forex options
would like to know where I could go to read up on forex options, in particular what the different strategies are called vs. regular options. Are spreads called 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 June issue of Options Trader explains the terminology and illustrates different strategies.


More mergers?

Options exchanges jockeying after NYSE-Arca deal

The cross pollination of stocks, futures, and options is one of the attractions of consolidation.

prils New York Stock Exchange-Archipelago merger and the Nasdaq buyout of Instinet made a predictably big splash in the stock market (see Big deals raise big questions, Active Trader, August 2005). But the two blockbuster deals could trigger some major waves in the U.S. options and futures markets as well. The NYSE-Arca deal will produce a European-type business model that features not only electronic stock trading, but also an electronic options exchange (and perhaps futures) under the same roof. The deal includes the Pacific Exchange (PCX), which is finalizing its agreement to be acquired by Arca. Among the six U.S. options exchanges, the PCX ranks fifth in terms of total volume with a market share of about 8 percent. Arca was already raising eyebrows when it announced the deal to buy the PCX in January. With the NYSE behind it, industry executives say it could provide a major boost to the PCX by bundling stocks and options contracts on the Arca electronic trading platform. By most estimates, integrating the PCX into the new NYSE-Arca platform will take about a year. That provides a window for the other five exchanges to make adjustments of their own, and many of them are on the move. The Chicago Board Options Exchange (CBOE) has been looking at demutualizing, or changing from a memberowned exchange to a for-profit shareholder model. In June, the exchange hired an investment bank to examine demutualization, which is often a precursor to an initial public offering. In the meantime, CBOE chairman and CEO Bill Brodsky says the exchange will continue doing what were doing. In other words, the exchange will stay focused on making enhancements to its CBOE hybrid system, which includes adding remote market makers and more complex order functionality, such as new spread capabilities. Other options exchanges say they, too, are focused on executing their own plans, not on what the NYSE is doing. The International Securities Exchange (ISE), which went public

in March and raised $70 million, continues to build on its stock index options trading. Exchange executives also have said the growth strategy heading forward involves partnering with a European exchange or liquidity provider that could provide a bridge or connection in terms of order flow.

More consolidation to come?

That hasnt stopped industry participants from speculating the ISE will become a key player in the expected fusion across U.S. exchanges. I think what youll see is consolidation among the futures and options exchanges, says John Margolis, senior vice president of Hyperfeed, an order-routing technology firm based in Chicago. I was not surprised to see the Nasdaq-Instinet deal, but also I think a Nasdaq-ISE deal would make more sense. That would be a fantastic move. In June, the Philadelphia Stock Exchange (PHLX), which has long been looking for a buyer or partner, teamed up with Merrill Lynch and Citadel Derivatives Group, with each taking a 10percent stake in the exchange. Depending on various performance targets, Merrill Lynch and Citadel could each take an additional 9.9-percent stake. This investment by Merrill Lynch and Citadel in the PHLX is truly a turning point in the evolution of the Exchange, PHLX chairman and CEO Meyer Sandy Frucher said in a statement. Our market model will benefit enormously by the commitment from Merrill Lynch, one of the largest and most respected broker dealers in the world, and of Citadel, one of the largest and most successful participants in the global cash and derivatives markets. The American Stock Exchange (AMEX), meanwhile, is pushing ahead with its hybrid system called ANTE, and executives say they have no plans to change strategy. To me, you cant alter your business model, says Neil Wyckoff, chairman and CEO of AMEX. If youre defensive you cant differentiate yourself. You just have to put your best product out there and try to attract the order flow. The Boston Options Exchange (BOX) is following a similar

path of keeping an eye on its own initiatives. The exchange is owned by a group of large institutions that created it in part to be distinct from other options markets not to consolidate with them. Will Easley, BOX managing director, says its goals include transitioning from a start-up to a full-functioning exchange. Easley said the BOX is increasing its messaging capacity twoor three-fold and introducing more complex functionality to its system. As the industry continues to buzz about consolidation among stock and futures exchanges, Easley does not anticipate participating.

industry executives said they would love to see the CME, CBOT, and CBOE combine forces in some way. Meanwhile, other futures exchanges are pushing toward IPOs, including the New York Mercantile Exchange and the Intercontinental Exchange. Although those exchanges are commodities-based institutions, derivatives exchanges are currently attractive because of their profit margins. Given the growing attention to commodities by virtually all trading participants, it would not be a surprise to see securities and commodities exchanges tie the knot.

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To me, you cant alter your business model. You just have to put your best product out there and try to attract the order flow. Neil Wyckoff, chairman and CEO of AMEX
I think well be observers, he says. I dont see us being interested in acquiring anybody. As for being acquired, were certainly not shopping ourselves around. The cross pollination of securities and derivatives is one of the attractions of consolidation. No doubt NYSE officials saw PCX as a good way to get back into the options business. Many expect the NYSE to create attractive new stock and options products. Even so, some industry watchers say the Big Board wont win market share by name alone. I think its a great idea for the NYSE group to explore other asset classes, but its not a walk in the park for them to begin trading options, says Jodi Burns, an analyst with Celent in New York. They are going to have to build an options business just like the ISE or the Boston Options Exchange did, which is basically starting from nothing. For information on the author see p. 4.

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Futures exchanges fair game

Options markets are not the only institutions potentially in play. The Chicago Mercantile Exchange (CME) has no doubt been the most successful publicly traded exchange, from a stock performance standpoint. Its shares were trading around $305 at the end of June, and it had also built its war chest of working capital to almost $740 million at the end of the first quarter. In late June, the CME made a bid for the Chicago Board of Trade (CBOT), which is preparing for an IPO. But the CME could make a move into the equity options space as well. Some

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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.



TABLE 1 THE HIGHEST THIS BUTTERFLY CAN FLY This butterfly spread cost very little to put on, but its profit is also modest. Minus signs in the Initial and Ending columns indicate premiums paid (debit), while positive values indicate premiums collected (credits). Minus signs in the Result column indicate losses.


Initial Sept. 5-yr. T-note futures price Days to July option expiration Implied volatility Call Strike Price 107-24/32 21 5.6% Price (64ths) -45 58 -18 -5 -78.125 Delta 0.57 0.43 0.30

Ending 108-00 0 NA Price (64ths) 32 0 0 32 Result (64ths) -13 58 -18 27 421.875

ption spreads often have rather fanciful names butterfly, iron butterfly, condor, and alligator, to name a few. All of these strategies are multi-leg spreads and, to some traders, seem designed primarily to generate fees for brokers. This isnt entirely fair (nor entirely unfair). There are times when one of these more complex spreads can be a useful trading tool. For example, a long butterfly spread can offer a way to sell volatility (i.e., profit from high and declining volatility through short options) while removing the risk inherent in a naked option position.

Buy 1 July 107.5 call Sell 2 July 108 calls Buy 1 July 108.5 call Butterfly net price Butterfly $ net price

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.

The position
You can structure a butterfly entirely of puts or calls, or a mixture of both. This discussion will focus on butterflies that consist solely of calls. The structure is the same using either puts or calls: You choose three strike prices at equidistant intervals and buy one each of the highest and lowest strike price options and sell two of the middle strike price options. The middle, two-option part of the spread is the body of the butterfly, and the upper and lower options are the wings. (Apparently, early options traders thought the strategys
continued on p. 12





payout diagram looked like a butterfly. This requires about the same effort of imagination as looking at the constellations in the night sky. You may remember, as a child, saying, Thats a bear? Come on.) The rationale for putting on a butterfly spread is that you think the underlying market will be at or close to the middle strike price at expiration. Also, you expect the options you sell to expire valueless, or very nearly so. This will enable you to keep most of the premium you collect when you initially sell them. Accordingly, you want to trade butterflies during the period of maximum time decay the last three or four weeks before expiration and hold these spreads until the options expire. Butterflies are primarily volatility trades. The body of the trade is the pair of short options, and severe time decay is always an option sellers friend. You sell options when implied volatilities are trading above the long-term median historical volatility level and you have reason to believe the volatility will revert to this median level, or even drop below it. All this leads to a key principle for butterfly traders: Only trade butterflies when you are comfortable being short volatility. When you sell options, you can expect large losses if the market moves very far from the strike price. This is why you buy the wings of the butterfly. These two options limit the loss potential of these spreads to the net price paid to put on the trade. When the underlying instrument trades above the highest strike price or below the lowest, the long options gain enough value to offset the losses of the short options. In essence, a butterfly is a short option position with a safety net.

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 price settles exactly at the spreads middle strike price (108.5) at option expiration. Initial Sept. 5-yr. T-note futures price Days to July option expiration Implied volatility Call Strike Price Buy 1 July 107.5 call Sell 2 July 108.5 calls Buy 1 July 109.5 call Butterfly net price Butterfly $ net price 107-24/32 21 5.6% Price (64ths) -45 36 -5 -14 -218.75 Delta 0.57 0.30 0.12 Ending 1 108-16/32 0 NA Price (64ths) 128 0 0 128 Result (64ths) 83 36 -5 114 1,781.25

TABLE 3 A GOOD RESULT: FUTURES SETTLE 6/32 BELOW MIDDLE STRIKE The trade can still profit if the underlying settles relatively close to the middle strike price at options expiration. Initial Sept. 5-yr. T-note futures price Days to July option expiration Implied volatility Call Strike Price Buy 1 July 107.5 call Sell 2 July 108.5 calls Buy 1 July 109.5 call Butterfly net price Butterfly $ net price 107-24/32 21 5.6% Price (64ths) -45 36 -5 -14 -218.75 Delta 0.57 0.30 0.12 Ending 2 108-10/32 0 NA Price (64ths) 52 0 0 52 Result (64ths) 7 36 -5 38 593.75

Stings like a bee in a rangebound market

It is difficult to trade a market stuck in a relatively narrow trading range.

Even with reduced transaction costs, this kind of environment can be expensive, and the rewards are seldom great enough to compensate for the cost. Butterfly spreads are one way to approach this kind of market. Suppose you had noticed September 2005 five-year T-note futures (FVU05) were trading at 107-24 and had been trading in a relatively narrow range for some weeks. The current price was near the bottom of the range, around 107-16. A futures price between 109-14

and 109-18 marked the upper boundary of this range. Your market analysis might have suggested the nature of the recent economic news was a big contributor to this range. The indicators for and against growth and for and against a build-up of inflation might have been so evenly balanced the market could not find reasons to motivate large moves in either direction. Further, there may have been no reason to believe this situation would resolve

TABLE 4 A GOOD RESULT: FUTURES SETTLE 6/32 ABOVE MIDDLE STRIKE The result here and in Table 3 show this butterfly spreads performance is still better than the result from Table 1, even though the futures settled a little above the middle strike price. Initial Sept. 5-yr. T-note futures price Days to July option expiration Implied volatility Call Strike Price Buy 1 July 107.5 call Sell 2 July 108.5 calls Buy 1 July 109.5 call Butterfly net price Butterfly $ net price 107-24/32 21 5.6% Price (64ths) -45 36 -5 -14 -218.75 Delta 0.57 0.30 0.12 Ending 3 108-22/32 0 NA Price (64ths) 76 -24 0 52 Result (64ths) 31 12 -5 38 593.75

TABLE 5 THE SAFETY NET AT WORK: LOSS LIMITED TO PRICE PAID FOR SPREAD Even if the futures prices settles well above the higher (109.5) strike price, the gains of the two long calls will offset the losses of the two short calls and hold the loss to the initial price paid for the spread (-$218.50). An outright sale of two July 108.5 calls would have resulted in a loss 10 times as big. Initial Sept. 5-yr. T-note futures price Days to July option expiration Implied volatility Call Strike Price Buy 1 July 107.5 call Sell 2 July 108.5 calls Buy 1 July 109.5 call Butterfly net price Butterfly $ net price 107-24/32 21 5.6% Price (64ths) -45 36 -5 -14 -218.75 Delta 0.57 0.30 0.12 Ending 4 110-00/32 0 NA Price (64ths) 160 -192 32 0 Result (64ths) 115 -156 27 -14 -218.75

itself in the next month or so. Apart from the price situation, you might have found implied volatility was at 5.6 percent. With 21 days to option expiration, five-year T-note futures median historical volatility is more like 4.7 percent; a 5.5-percent volatility reading is at the 75th percentile. Given this volatility context, the 5.6-percent implied volatility

seems high, which could make this a good time to short volatility. Further, the price and volatility situations might have suggested a call option butterfly spread using July calls on September five-year T-note futures. The structuring of this spread requires care. People often say they like to have the options they sell pay for the options they buy, but its possi-

ble to go overboard with this notion. One possibility is to buy one July 107.5 call, sell two July 108 calls, and buy one July 108.5 call. This version of the butterfly spread would have cost only 5/64 or $78.125 per spread. You convert to dollars by dividing the price figures by 64 and multiplying by 1,000 (e.g., -5 64 = -0.078125 x 1,000 = -$78.125). A butterfly spread achieves its maximum earnings potential when the underlying market settles exactly at the middle strike price at option expiration. Table 1 shows how you can expect this spread to perform given the assumption the futures contract will settle exactly at 108-00 at option expiration. The NA for the ending volatility indicates volatility is not applicable at expiration because the option will be worth its intrinsic value or have zero value. Note that minus signs in the Initial and Ending columns indicate debits (premiums paid) and positive values indicate credits (premiums collected). Minus signs in the Result column indicate losses. The results are simply the sums of the initial and ending option prices, and the Butterfly net prices are the sums of the relevant rows. It is important to note that when you choose strike prices that are too close together, you lower the butterflys cost but limit its earning potential. Table 1 illustrates this. The most you can earn with this butterfly is $421.875. With this cautionary note as background, consider a butterfly in which you again buy the July 107.5 call, but you sell two July 108.5 calls and buy one July 109.5 call. This butterfly would cost almost three times as much as the first one, given the same market assumptions as before, but it might be worth it. Tables 2 through 5 show how this July five-year T-note call butterfly
continued on p. 14



might have performed given four different outcomes at expiration. Ending 1 (Table 2) shows the best possible result occurs when the futures price settles exactly on the middle strike price at option expiration. Endings 2 and 3 (Tables 3 and 4) indicate that when the futures price misses the target by a little in either direction, this butterfly spread will not perform nearly as well, although the results are still better than the one from Table 1. Finally, Ending 4 (Table 5) shows what happens if the futures prices set-

Notice in Table 5 the 156/64 loss on the short July 108.5 calls is 2-28 (or, sometimes, 228 in conventional fixedincome price notation). This would be a $2,437.50 loss if you had simply sold the two July 108.5 calls outright. The wings of the butterfly limit that loss to the initial price paid for the spread $218.75.

A word of caution
Never confuse cant lose much with cant lose. Option butterflies will not lose more than the initial cost of the spread, but there are situations, only

option expiration and held in place for three weeks will prove disappointing. Hold these trades to expiration because sharply rising implied volatility can harm these fragile creatures. This adds another wrinkle to butterfly trades. Most exchanges automatically exercise any options that expire in the money unless the option holder gives directions to the contrary. If you do not want to assume the long or short futures positions these options imply, you must be certain your broker knows this and passes word to the clearing house.

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.
tles well above the 109.5 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. Table 2 highlights the advantage of choosing strike prices that are at least slightly farther apart than those used in Table 1. This spread exhibits far greater earnings potential in dollar terms. Tables 3 and 4 illustrate another strong reason for preferring the revised version of the five-year T-note call butterfly: It is far more forgiving of results that are fairly wide of the forecast mark. In fact, this trade will outperform the Table 1 trade (in dollar terms) even if the futures price settles as far as 6/32 away from the 108-16 futures price target at option expiration. Clearly, the wider strike price intervals not only increase the spreads earning potential (in the case where the futures price is exactly on target), but they also significantly increase the price range in which you can earn a significant return.

one of which was illustrated, in which these losses will occur. Also, because these are essentially volatility trades, you should trade butterflies only when you are comfortable with the idea of being short volatility. Further, because the key element of these trades is the body of short options, you want as much time decay as possible. This makes butterflies appropriate during the last three or four weeks before option expiration. Butterflies put on with, say, 75 days to

However, when you observe these precautions, option butterflies make it possible to trade markets that might otherwise prove difficult. Although the positions structure limits its earning potential, the butterfly trade can generate healthy returns in the right circumstances, and its loss potential is modest enough that even the worst case 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 how these strategies can work in most of the commonly traded futures and options 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 a butterfly spread can reduce an unprofitable long puts risk and preserve potential profitability.



Long straddles:
The importance of buying time
Buying options has a bad reputation in some trading circles because youre 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.



he long straddle is a non-directional option strategy that can yield solid results with low risk. Its used when you expect a stock or futures contract to make a big price move but you dont 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 straddles value is very sensitive to changes in implied volatility (IV). Also, because a straddle consists of long options, its value erodes a little bit each day (the process known as time decay). After explaining how to construct a long straddle, well examine how to take into account the current volatility situation and the effects of time decay when planning a trade. Finally, well compare two straddles that use options from different expiration months to illustrate how buying more time can create a trade with a higher probability of success.

Constructing a long straddle

A long straddle is created by purchasing equal numbers of call and put options on the same underlying instrument and with the same strike price and expiration month. It makes sense to buy near-the-money options so a sharp price move has a better chance of increasing the positions value. A large price move will make one of the legs deep in the money, providing a gain by virtue of price movement alone. Also, an at-the-money straddle will be cheaper than a straddle whose strike price is not equal to the stock price because it consists of options whose values are composed solely of time value (i.e., neither option has any intrinsic value). Of course, you will not always find strike prices that are identical to the current stock price, but you want options that are as close as possible. Buying undervalued options helps put the odds further in

your favor. The trick is to determine when options are cheap. a graph, with each data point representing a weekly averOptions are undervalued when IV is low from a historical age. Figure 1 shows an example of a volatility chart for the perspective (that is, it is low compared to past IV readings), Biotech HOLDRS (BBH) that showed up as a likely straddle as well as low relative to historical, or statistical volatility candidate, which in early July had IV in the 1-percentile (SV), which is the actual volatility of the stock. Also, anoth- rank, meaning IV at this time was lower than 99 percent of er reason to buy at-the-money options is changes in IV will IV readings over the past six years. have a bigger impact on them with a few months left to expiThe volatility chart has two lines. The solid line is statisration. tical volatility (SV), which shows the actual volatility of the Long straddles actually give you two ways to FIGURE 1 STATISTICAL VS. IMPLIED VOLATILITY make money: Either the Volatility in the Biotech HOLDRS (BBH) was low overall, and implied volatility was even lower underlying stock can than statistical (historical) volatility, making BBH options a good candidate for a long straddle. make a big price move, or IV can increase. Because volatility changes have such a big impact on a straddles value, the next issue we will investigate is how to find straddle candidates with historically low IV levels, and how to measure the effect an IV increase has on an options value.

Putting volatility in your corner

Placing a long straddle on a stock with historically low IV can provide a considerable advantage. Every asset has quiet periods when its Source: OptionVue Systems (www.optionvue.com) options are cheap and volatile periods when its options are expensive. You should also be aware volatility stocks daily price changes. The dashed line is the average has an important tendency called reversion to the mean. IV, the volatility implied by BBH option prices. Not only After reaching extreme highs or lows, volatility tends to was IV currently at its lowest point since options began return to a more normal, average level. trading on BBH, but it was also considerably lower than SV The first thing to look for when searching for likely strad- (15 percentile rank), indicating the option prices are not dle candidates is the current IV compared to past IV. The even reflecting the actual volatility of the stock. best candidates for long straddles are in the 10th percentile A positions sensitivity to changes in IV is measured by of cheapness that is, 90 percent of the time the IV has Vega, which is one of the option Greeks (see Additional been higher than it is currently. This increases the odds IV research). For ease of use, Vega is usually shown as the will revert to a higher level, increasing the straddles value. gain or loss a position would experience because of a 1-perDifferent time periods can be used to calculate this per- cent IV increase. Long straddles always have positive Vega, centile; the past three years of volatility history is a good which is why they are popular for exploiting expected place to start. increases in IV. A long straddles Vega is highest when the One way to measure IV in this way is to average the IV stock price is identical to the options strike price. levels of both calls and puts and then plot those averages on continued on p. 18


The drawback of time

Options are a decaying asset, and as you get closer to expiration the rate of decay accelerates. The value of a straddles long calls and puts constantly declines because of time decay. As a result, to make a reasonable profit you need a price move and/or an IV increase that can overcome the time decay plus the initial purchase cost. Theta is used to measure a positions sensitivity to the

Choosing the best position

Many traders have difficulty understanding exactly how option spreads become profitable. For a long straddle to be profitable at expiration, the stock price must be sufficiently higher or lower than the options strike price to give either the call or put enough intrinsic value to offset the straddles original cost. But before expiration, you must take into account the simultaneous effect changes in the underlying stock price, implied volatility and time have FIGURE 2 LONG STRADDLE PROFIT PROFILE on each leg of the spread. The short-term straddle (blue line) has the potential to rack up a sizable profit as long as the For that reason, having underlying stock makes a big move in the next 30 days, but the long-term LEAPS straddle access to a program that (red line) can profit even if the stock remains nearly stagnant. allows you to analyze and graphically display the profit or loss of a potential option trade is very important. Lets compare how profitable two long straddles in the Biotech HOLDRS might be, one using the August 2004 options (with 54 days to expiration), and the other using the January 2007 LEAPS (more than two years to expiration). In early July, BBH was trading at 142.5, exactly halfway between the available strike prices of 140 and 145. Comparing the possible trades revealed using the 145 strike price had a higher expected return. Source: OptionVue Systems (www.optionvue.com) The following trade passing of time. It is usually expressed as the value a posi- examples used $5,000 as the maximum amount of capital to tion would lose in one day due to the effect of time alone. invest, in each case buying as many contracts as possible to Theta is always negative for a long straddle because the keep the amount invested in the trades as close as possible. options lose value as time passes. Time decay doesnt manifest itself immediately. A sixThe shorter-term straddle position is: month straddle does not decay much at first, and time Buy 5 August 145 calls (BBHHI) at $3.40 ($1,700) decay does not really begin to accelerate until the last Buy 5 August 145 puts (BBHTI) at $5.30 ($2,650) month or so before expiration. Total cost: $4,350 Because volatility trades take time to develop, make sure you give yourself enough time for IV to make the move you The longest-term LEAPS straddle is: expect. Look to use farther-out options, even LEAPS (LongBuy 1 January 2007 145 call (OEEAI) at $28.10 ($2,810) Term Equity AnticiPation Securities, which are options that Buy 1 January 2007 145 put (OEEMI) at $19.90 ($1,990) can expire several years in the future), when buying straddles Total cost: $4,800 to provide plenty of time for IV to revert to its average level.

The straddle using the August options has a Vega of 215.2 and a Theta of -37.5 when it is placed. The Vega/Theta ratio is 5.7, which means IV must rise 1 percent in only 5.7 days just for the position to remain at breakeven. The straddle using the January 2007 LEAPS has a Vega of 139.9 and a Theta of -2.92, which translates to a Vega/Theta ratio of 47.9, which means that IV only needs to increase 1 percent every 47.9 days for the position to stay even. Of course, any price moves by the stock would also affect the positions values. Figure 2 shows what the two trades would look like 30 days from purchase with a projected IV increase of 5 percent during this time. It is clear that if you want to swing for the fences and hope a large price move occurs relatively

Deciding when to close a long straddle is subjective. If a move in the underlying stock has created a gain, one leg will now be worth much more than the other. The dominant leg will then be much more sensitive to changes in the underlying stock price. You should then determine if volatility has returned to more normal levels, and consider closing the position if it has.

Buying fairly valued options isnt a bad thing

The argument many traders make against buying options is that time decay is against you, but there is nothing wrong with buying an option that is fairly valued. Despite the drawback of time decay, the underlying market is in constant motion. In fact, time is precisely what gives the under-

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.
quickly, you should use the shorter-term options because you actually have the chance, although small, of doubling your money in a short time period. However, just to break even in 30 days even with a 5-percent IV increase helping out, the stock would have to move down to $137.80 or up to $150.60. In other words, to do better than the LEAPS straddle, 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 would be profitable across the range of stock prices as long as IV increased 5 percent. In fact, if the stock bounced around but ended up right where it started at $142.50, you would still make a 15-percent return (177 percent annualized), compared to a 30-percent loss using the shorter-term options. That shows just how important buying time can be in determining your probability of placing a successful trade. lying stock or future its freedom to move. You simply need to evaluate whether the underlying instrument can move enough to make a long straddle profitable. Identifying stocks with inexpensive options puts the odds further in your favor. Volatility traders often create positions using short-term options, expecting volatility to revert quickly to its mean. However, experience suggests thats a difficult expectation to meet. It can happen, but cheap options often stay cheap for quite a while. When buying long straddles, its a good idea to consider using the longest-dated options available with decent liquidity. Keep in mind the value of a straddle with more days until expiration will not change in value as much as one with fewer days left when the stock price moves up or down. The best straddle for taking advantage of changes in IV is not going to be the best one to capitalize on quick moves in the stock price. Creating positions with which you are comfortable and understanding how to balance likely price moves against Theta and Vega are things you need to consider when trading straddles. There are no sure things in option trading, but understanding how a straddle works allows you to put the 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 in this article, see the Key Concepts and Definitions page. To purchase and download other option-related articles, visit our online store at www.activetradermag. com/purchase_articles.htm.



Taking a peak at

naked puts
Selling put options when you dont 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.

ost traders, especially risk-averse traders, are familiar with the strategy of selling call options on a stock they already own. This strategy covered call writing creates income while limiting both the reward and risk of a long stock position. It is primarily used on stocks about which a trader is neutral to moderately bullish. Another less common option strategy that achieves the same goals is selling a put. In fact, selling a naked put (i.e., a put that is not backed by a position in the underlying security) is mathematically identical to selling a covered call. In most cases, though, a would-be covered call writer would be better off selling a naked put than buying a stock outright because the put position has a lower margin requirement and potentially lower commissions (if the put expires worthless). Despite these advantages, selling puts is not nearly as popular a strategy as selling covered calls. However, by following some simple rules that dictate which stocks or markets to focus on and which options to trade (as well as when and how many to trade), you can limit the risk of naked put sales 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 for this strategy, the simplest example of which is to sell at-themoney puts on a stock you expect to rise a little, but not a lot.

Put characteristics

The price (or premium) of any option consists of two basic components: intrinsic value and time value. Intrinsic value is the difference between an options strike price and the current price of the underlying market. Only options that are in-the-money (ITM) have intrinsic value. (See Key concepts and Definitions, for information on these and other option terms.) Time value reflects the amount of time remaining until expiration and can be thought of as an uncertainty factor the dollar amount a put seller demands to give you the right to sell a stock or index at the strike price. Another way to look at it is that it is the dollar amount the put seller demands to assume exposure to the long stock or futures position that may result if he or she is assigned. All else being equal, the greater the volatility of the underlying market, the greater an options time value. Of course, all TABLE 1 PUT UP OR SHUT UP things are never equal, which is what Unlike the outright stock purchase, the naked put sale requires no initial capital makes option trading so challenging. outlay (debit), limits downside risk and frees up capital that can earn interest. Interest rates, dividends and pending news or rumors can all affect the price Naked put: Sell one Stock purchase: Buy 100 of an option. MSFT 70 put for $3. shares of MSFT @ $69. Adding the intrinsic value to time Initial debit: $0 $6,900 plus commissions. value gives you the total option price. Initial credit: $300 minus commissions. $0 For example, with Microsoft (MSFT) trading at 69, assume a MSFT July 70 Interest earned $20 (@ 3.5% per annum two-year $0 (on uninvested cash): T-note rate, times one month). put with three weeks until expiration is trading for $3. This represents $1 of Net anticipated $320 credit, minus commissions. -$6,900 debit, plus intrinsic value (70 - 69), and $2 of time cash flow: commissions. value. As expiration nears, the options


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

FIGURE 1 NAKED PUT VS. LONG STOCK A comparison of buying 100 shares of MSFT at $69 vs. selling a $70 put for $3. The naked put strategy caps profits if the stock rallies, but it also reduces downside risk if it moves against you. Its profit-loss profile is identical to that of the covered call strategy.

Death, taxes and

There are very few guarantees in the market, but this is one: By expiration, the time value of an option will be zero. Profit/loss of put sale vs. stock purchase $1,500 This does not mean you are guaranteed a profit on an option you sold short, only that you will get to keep that $1,000 part of the option premium made up of time value. In short, when you sell an option, you will profit if the time $500 Put seller is better off at prices premium and intrinsic value at the time of sale exceed the of about 72 or below options intrinsic value at expiration. $0 60 62 64 66 68 70 72 74 76 78 80 The downside is that in exchange for collecting the $-500 time premium, you assume the risk the underlying market will move against you. However, when you sell a $-1,000 put, this dollar risk is less than if you bought the underPrice of Microsoft at expiration lying market outright, as will be explained shortly. Sell put Buy stock If the market moves against you (i.e., declines) when you sell short a put, you may be forced to buy the stock if an option buyer exercises his or her put. This is called assignment, and will only occur if the option is in-the- shares of MSFT at $70 a share. However, the end result is the money. However, if you are financially and psychologi- same. You could immediately liquidate the position, selling cally prepared to buy the stock anyway (which you MSFT at $61 and losing $9 on the trade, but keeping the $3 should be if you are selling puts), this is hardly a disaster. premium for a net loss of $6. By comparison, had you bought MSFT stock outright at Because you collected premium when you sold the put, you have effectively purchased the stock at a discount to what $69, you would now be looking at an $8 loss, because you didnt collect $3 in time value when you bought your you would have paid had you bought it outright. shares.

Measuring up
To see how a naked put sale measures up against a stock purchase, consider the MSFT example discussed earlier. Say MSFT closes at 61 on expiration, and assume you have not been assigned (forced to buy) the stock prior to expiration. The 70 put has an intrinsic value of $9 (70 - 61). Because the time value must be zero at expiration, $9 is the most the option 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, but lose the cost ($9) to buy back the option, for a net loss of $6 before commissions. In reality, the option would most likely be exercised, and the Monday after option expiration you would own 100
TABLE 2 BETTER TO GO NAKED? Of the three scenarios (stock higher/lower/unchanged at expiration), the naked put sale fares worse than the outright stock purchase only when the underlying stock rallies significantly. MSFT price at expiration: 74 (+$5) 69 (unchanged) 64 (-$5) Naked put: +$320 profit +$220 profit, minus commissions. (Will be forced to buy MSFT at $70, a -$100 loss, offset against the $320 collected.) -$280 loss, minus commissions. (Will be forced to buy MSFT at $70, a -$600 loss, offset against the $320 collected.) Stock purchase: $600 profit $0 profit/loss -$500 loss Naked put advantage/ disadvantage: -$280 +$220 +$220

Addressing the critics

The criticism of selling naked calls is that they have theoretically unlimited risk. However, as long as you do not sell more puts than the number of shares you are willing to purchase (e.g., sell five puts if you would be comfortable buying 500 shares) and you follow certain trade guidelines, naked put selling entails finite risk in fact, less than that of an outright stock position, as the previous example showed. Put-selling guidelines summarizes the rules for selling naked put options effectively. These rules essentially are methods for selecting the stocks and the market conditions that will
continued on p. 22




limit your risk on these trades. Doing so increases the odds of safely benefiting from the income naked put selling offers. Consider this worst-case scenario: The most you could lose selling a MSFT 70 put for $3 when MSFT is at $69 would be $6,700 (plus commissions) and that would be only if MSFT went to zero by the third Friday of next month. Yes, it could happen, but even if MSFT went bankrupt, 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 goes nowhere, the put seller pockets a $200 profit and can repeat the 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, go down, or end flat), Table 2 illustrates the possible outcomes. As Table 2 summarizes, if MSFT is at or below $70 at expiration, you would be better off selling the put (vs. buying the stock). Creating a table that shows all possible trade outcomes for every price of MSFT at expiration will greatly enhance your understanding of options. Figure 1 graphically compares the profit-loss profiles of a naked put vs. a stock purchase. It shows you would be better off buying the stock only if it soared above $72. The dollar advantage of selling a put at prices below $72 equals the time premium collected (the total premium minus the intrinsic value), in this case $2 ($3 - $1). The $20 interest

Put-selling guidelines
dhering to the following rules can reduce of the risk of 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 yourself, If I had to buy the stock tomorrow, would I be happy owning it? If the answer is no, dont sell the put. 2. Never sell so many puts that if you were assigned, you wouldnt have enough money to purchase the stock. For example, if you have a $100,000 margin account and you are uncomfortable being more than 100 percent exposed to equities, do not sell more puts than would require $100,000 to cover if assigned. To determine the dollar amount required to meet an assignment, simply multiply the strike price of each put contract you sell by 100 (the number of shares each option contract represents). For example, if you were selling puts on a stock trading at $100, do not sell more than 10 at-the-money puts, eleven 90 puts, twelve 80 puts, etc. Beware: It is tempting, especially after a few successful cycles of put selling, to sell more puts to boost income. But if you are using 300 percent or 400 percent leverage, you could get badly hurt. Put selling got a bad name after the Crash of 1987 mainly because it was abused by traders who sold far out-of-the-money puts that represented much more money than they had in their accounts. They assumed the market would never fall below the strike prices of the puts they sold. They were wrong. When the market crashed, they were forced to borrow large sums of money to meet margin calls. Never assume a put is so far out-of-the-money that you wont get assigned! 3. Sell puts expiring in one to three months. The risk of selling close-to-expiration puts is lower for every dollar of premium received. Selling options as close to expiration as possible exploits the period of maximum time decay and creates the highest annualized returns. 4. Annualize the option time premium you collect. For example, if you sell a 100 put for 6.50 on XYZ Technologies,

which is trading at 95, youve collected $1.50 of time premium (the intrinsic value is 100-95 = 5). That works out to 20 percent annualized. More conservatively, convert option time premium to time premium per month (to compare closer-to-option expirations with those expiring later). The time premium is usually fattest for at-the-money options, and diminishes as you go further in- or out-of-the-money. 5. Only sell options that offer at least 1.5 percent time value per month. To express a put premium as a percentage, divide it by the options strike price. It is not uncommon to be able to pocket 4 to 5 percent a month for slightly out-of-themoney put options on volatile stocks. Options on lower-priced stocks e.g., those trading below $20 are not always priced as efficiently as higher-priced stocks, so look to these issues 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 to own it, sell in-the-money puts. This exposes you to greater risk, but also to more upside potential. 7. If you are more conservative and just want to collect time premium, sell out-of-the-money puts. You will collect less premium, but have more downside protection. 8. Consider selling a put on a stock (or index) you think is a good long-term buy just after it has suffered a dramatic decline. Put premiums often soar to extreme levels in these situations, allowing you to pocket the premium or buy the stock at a significant discount. Selling puts at these points requires tremendous courage, but is safer than buying the stock outright because of the buffer provided by the premium you collect. 9. For best results, repeat the option-selling process every month. A mediocre strategy followed mechanically is almost always superior to a brilliant one followed intermittently. To achieve anywhere close to the annualized returns possible from put selling, you must participate on as regular a basis as your risk tolerance and buying power allow. 10. If assigned, consider reversing immediately and selling a call against your newly purchased stock. This keeps the wasting power of options working in your favor.



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

A more conservative choice for the right trader

Contrary to popular opinion, selling a naked put is a lowrisk way to increase income and perhaps acquire a stock at a discount as long as you are comfortable with the possibility of owning the underlying stock. Traders who arent should consider other techniques. Put selling is especially profitable after severe market declines, when put premiums can soar. You are trading the potentially unlimited but low-probability gain of an outright stock position for the high-probability, limited gain of the naked put. Even if your bullish market interpretation is incorrect and the stock declines, you will still be better off than a stock buyer because your net price (strike price minus the premium collected) will be lower than the price of 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 of this edge, you can botch your stock analysis, have less-thanperfect market timing, and still end up ahead. Over time, the odds are in your favor.
For information on the author see p. 4. Questions or comments? Click here. A version of this article previously appeared in Active Trader.

The trade-off
The risk of selling puts is always less than the risk of buying an equivalent number of shares of the stock; however, in exchange for this decreased risk, you are capping your maximum profit. If this sounds familiar, its because its the same description as a covered call. The returns outlined here may seem rather tame until you consider a few factors. The probability of an asset closing unchanged or slightly changed in a given month is much greater than the probability of it moving much higher. Therefore, you exchange a low-probability, high-profit trade for a high-probability, lowprofit trade. Selling gives you an edge on the outright stock purchase 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 atthe-money call option expiring in a month), you will gross 42.6 percent a year. This is the return if the stock goes nowhere. If it goes up, you do even better.


Employment report strangle

System concept: Last months The 10-year T-note futures tend to be quite volatile when the monthly employment Option Strategy Lab analyzed the report is released (see arrows), but the contract often trades in a narrow range profitability of a one-day straddle following this event. Selling options to collect premiums during these quiet times using options on the 10-year T-note might be a profitable strategy. futures contract at the close on the day before the monthly employment Ten-year T-note (TY), 60 days 118 report and unwinding the trade at the announcement days close. 116 This strategy lost money in two 114 of every three trades and was profitable overall from March 2004 to 112 May 2005 (15 months) because it bought options when the T-notes 110 implied volatility was high and sold them after IV dropped as the report 108 hit the Street. Price moves in the 106 underlying 10-year T-note futures werent large enough to offset the 104 options lost value because of their March April May June July Aug. Sept. Oct. Nov. Dec. Jan. Feb. March April declining implied volatility. 2004 2005 Source: OptionVue Systems (www.optionvue.com) The analysis that follows focuses on another options strategy the strike closer to the money. Sell both options at the last short strangle, which involves selling an out-of-the-money price quoted. call and an out-of-the-money put in the same expiration month to attempt to profit from an expected drop in 2. Liquidate the entire position and wait until the next implied volatility on monthly employment report months release date if the underlying futures touches announcement days. one of the short strikes. Otherwise, let the strangle expire Figure 1 shows a daily chart of the 10-year T-note futures worthless. with arrows marking employment announcement days over the past 14 months. Notice the periods immediately followFigure 2 shows a risk profile of a strangle placed on ing each release: The contract often traded in a tight channel for several days or more, which means selling options may March 5, 2004: Short one April 117 call at 7/64ths and short be a more profitable way to trade the employment report one 113 put at 9/64ths for a total credit of $250. The vertical because out-of-the-money options would often expire line shows the 10-year T-note futures closing price (11514), and the two horizontal bars below it represent the futures worthless. Instead of buying a straddle the day before the employ- one- (purple) and two-standard-deviation (green) moves, ment report release, what if you sold an option strangle at based on the volatility and time projections. The figures shaded area shows the first standard deviathe close on announcement day? Although this short spread is designed to take advantage tion move, which covers 68 percent of the probable prices of of a quiet market, its potential gain is limited to the premium the underlying over the next 22 days and also represents collected from the short options, while its potential risk is where we would remain in the trade. The probability calcutheoretically unlimited. Overnight price gaps can be espe- lator available in many options analysis programs can give you these numbers quickly. cially devastating to a short strangle position. Trade rules: 1. Sell one out-of-the-money call and one out-of-themoney put in the nearest option expiration month at the close on the Friday of the monthly employment report release. Try to position the options strikes at least one standard deviation away from the underlyings closing price, but use discretion if the premiums for those options are too small. If this occurs, sell an option one


Test data: The revised system was tested on nearestmonth options of the 10-year T-note futures contract. Test period: Initial test March 2004 to May 2005; second test January 2001 to May 2005. The strategies were tested using OptionVues BackTester module. (Commissions and slippage are not included.)
continued on p. 26



is too small to draw significant conclusions. To expand our employment report test, we looked back to Jan. 1, 2001 and traded a one-lot strangle each month. The second Strategy Summary table shows its total profit was $3,078.24 over the past 53 months. Each trade required roughly $500 to initiate and resulted in an average gain of $58.08. The approach was profitable 58 percent of the time, and its average winner ($262.10) was just a bit higher than its average loser FIGURE 2 SHORT STRANGLE RISK PROFILE ($229.40), which suggests the idea is Each short strangle was built with out-of-the-money puts and calls and held until worth consideration. expiration, unless the 10-year T-note futures hit either strike, which were placed However, the strategy had an initial one standard deviation away from the close on jobs announcement days. drawdown of almost $1,200 in 2001, and six of the first nine months were losers, so this trade is not for the faint of heart. But the strategys winning percentage has been 64 percent since October 2001. Bottom line: As the old market saying goes, If its obvious, its obviously not true. Although its difficult to find a tradable edge for a predictable event, the short strangle tested here (or one similar to it) clearly deserves attention. Before you consider implementing this strategy, be sure to include commissions and examine the exact price you are likely to receive to take into account any possible slippage.
Source: OptionVue Systems (www.optionvue.com)

Test results: The Strategy Summary shows the short strangle gained ground during the same 15-month period in which the original long straddle was unprofitable. Eight of the 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

Steve Lentz and Jim Graham of OptionVue



Net gain ($): No. of trades: No. of winning trades: No. of losing trades: Win/loss (%): Avg. trade ($): Largest winning trade ($): Largest losing trade ($): Avg. profit (winners) $: Avg. loss (losers) $: Ratio avg. win/avg. loss: Avg. hold time (winners) days: Avg. hold time (losers) days: Max. consec. win/loss:

640.68 15 8 7 53 42.71 359.38 -281.25 228.52 -169.64 1.35 19 9 4/5

Net gain ($): No. of trades: No. of winning trades: No. of losing trades: Win/loss (%): Avg. trade ($): Largest winning trade ($): Largest losing trade ($): Avg. profit (winners) $: Avg. loss (losers) $: Ratio avg. win/avg. loss: Avg. hold time (winners) days: Avg. hold time (losers) days: Max. consec. win/loss:

3,078.24 53 31 22 58 58.08 546.88 -484.37 262.10 -229.40 1.14 19 10 6/5

LEGEND: Net gain Gain at end of test period, less commission. No. trades Number of trades generated by the system. No. of winning 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 individual 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 winner 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 youd like to see tested, please send the trading and money-management rules to Advisor@OptionVue.com.

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The volatility index (VIX)

The VIX provides an estimate of the expected market volatility on a short-term time horizon.
FIGURE 1 THE VIX The current incarnation of the CBOE volatility index (VIX, top) is derived from the prices of S&P 500 (SPX) options. The old VIX (VXO, bottom), which the CBOE still calculates, was extrapolated from the S&P 100 index (OEX) using the Black-Scholes option pricing model. The two indices appear similar, but they have important differences. The CBOE also calculates a comparable index the VXN using the prices of Nasdaq 100 options.
CBOE volatility index (VIX), daily 18

he VIX measures the implied volatility of S&P 500 index options traded on the Chicago Board Option Exchange (CBOE). The index reflects the market expectation of nearterm (i.e., 30-day) volatility. The VIX has been around since 1990, but underwent a major transformation in late 2003. It is a commonly referenced gauge of the stock markets fear level. When the Chicago Board Options Exchange (CBOE) overhauled its volatility index (VIX) in September 2003, it changed it from a volatility measurement based on the S&P 100 (OEX) to one based on the S&P 500 (SPX). The old VIX formula used the BlackScholes pricing model that looked at eight near-term at-the-money OEX options (calls and puts). The new VIX is derived from near-term at-themoney SPX options as well as out-ofthe-money puts and calls (so the index reflects the full range of volatility). The new calculation derives the VIX from the prices of options themselves rather than from a formula. The CBOE also applied the new calculation method to the CBOE NDX Volatility Index (VXN), which reflects the volatility of the Nasdaq 100 index. The exchange still publishes the original VIX calculation, which can be found under the ticker symbol VXO. Future articles will explore the VIXs role as a market barometer and how it can be used as a trade indicator. For more information about the VIX calculation visit www.cboe.com/ cfe/products/vixprimer/About.aspx.







11 CBOE volatility index, original (VXO), daily 17







April Source: TradeStation





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Controlling risk with spreads

Tired of fighting time decay and volatility fluctuations? Heres a look at an option spread trade that was a much lower-risk alternative to an outright purchase.

esides the movement of the underlying stock, This is the bull call spread in a nutshell: a bullish (but not two other obstacles of trading options are ero- too bullish) position that balances limited profit potential sion of time premium and fluctuations in the with limited risk. options implied volatility. Traders can use Next, lets look at how this position helps alleviate the option spreads, which are positions containing both long and effects of time decay. short options, to combat these problems. Spreads are generally less susceptible to the effects of Its about time time decay and implied volatility fluctuations compared to To the option buyer, the passage of time is similar to the effects outright long option positions. Another benefit of spreading of the suns rays on an ice cube. Each hour that passes causes is reduced risk: The premium received from the short some of a long options value to melt away. Conversely, option offsets some of the cost of the long option. time decay is beneficial to short option positions. Because the The kind of spread we will discuss here is called a bull spread trader is both a buyer and a seller of options, time call spread, which is created by simultaneously buying one call and selling a FIGURE 1 IMPLIED VOLATILITY second, higher strike call with the The implied volatility in the Pharmacia options increased significantly in same expiration. July 2002, an indication that the options market saw uncertainty in the price of Suppose XYZ stock is trading at 52 the stock. and a trader enters the following position (both options have 30 days until Pharmacia Corp. (PHA), four-month chart expiration): Buy one XYZ 50 call @ 3.50. Net debit: -$350 Sell one XYZ 55 call @ 1.25. Net credit: +$125 Total net debit: -$225
Stock price 48 46 70 44 42 40 50 38 36 34 30 32 30
June 3 July 1 August 1 Sept. 3


60 Volatility %

By virtue of buying the call option, the trader is bullish he or she anticipates XYZs price will go up sometime in the next 30 days. With the sale of the 55 call, though, the trader believes XYZ will not trade much higher than 55. The sale of the call creates the obligation to sell stock at 55. This obligation will limit the profit potential of the 50 call. However, if XYZ drops in price, the credit from the sale will reduce the positions potential loss.


Sept. 27

Stock price Source: optionsXpress

30-day implied volatility


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 position to reach a certain price. In the case of an outright option purchase the trader wants the underlying position to reach the target price as soon as possible, thereby minimizing the effect time decay has on premium. By contrast, because a spread reaches its maximum profit potential when the short option has little or no time value remaining, the preferred time window for a spread is within a week of expiration. (For a discussion on time decay and option valuation, as well as an options glossary, see A matter of time on p. 90.) However, time premium erosion is not the only concern when trading this type of position.

itable outright option trade into a loser without warning.

How it works
The following trade example shows how a spread trade fared better than an outright option purchase. In July 2002, takeover rumors were stirring about pharmaceutical company Pharmacia (PHA). Because of the stories, the at-the-money August 40 call option had an implied volatility of approximately 74 percent almost twice the implied volatility of the preceding few weeks (see Figure 1). Options implied volatility can be found at many optionsrelated Web sites and is included in a number of higherlevel 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 the typical volatility over a given period. For example, a sudden increase in IV compared to the typical IV of the past few


Implied volatility fluctuations also alter a spread. Although change in an FIGURE 2 PHARMACIA FACES TAKEOVER RUMORS options premium is often the result of movement in the price of the underlyA big run-up in the price of Pharmacia stock caused the implied volatility of the call option to almost double (see Figure 1). Placing a bull call spread trade in ing market, it can also be caused by the Pharmacia options resulted in a bigger profit than purchasing the call. changes in the options implied volatility, independent of fluctuation in the 47.00 Pharmacia (PHA), daily underlying stock. (We are more con46.00 45.00 cerned with implied volatility than his44.00 43.00 torical volatility because the former is 42.00 41.00 derived from the options premium and 40.00 39.00 reflects a consensus estimate from the 38.00 37.00 marketplace of what the volatility of the 36.00 35.00 underlying stock will be in the future; 34.00 33.00 the latter is simply a measure of the 32.00 31.00 underlyings past volatility.) 30.00 Option implied volatility (IV), in 50M Volume many instances, moves for the same 40M 30M reason the price of the underlying stock 20M 10M moves news, an imminent earnings 10 11 12 15 16 17 18 19 22 23 24 25 26 29 30 31 1 2 5 6 7 8 report, takeover rumors, etc. July 2002 August 2002 However, sometimes the underlying Source: eSignal stock will not move at all for weeks (and the options historical volatility is at a low point), but the IV will increase significantly. This weeks can indicate volatility is reaching an extreme. Pharmacia was trading around 40 (see Figure 2), and the usually occurs around an earnings report or a similar event, when there is a great deal of uncertainty about the future August 40 call, which had 29 days until expiration, was trading at $3.45. However, the following August 35-45 bull price of the underlying stock. Volatility-triggered changes in option premium may be call spread could have been purchased for $3.70: dramatic and can be quite damaging to traders who have Bull call spread: bought or sold a call. Again, though, spreading helps alleBuy one PHA Aug 35 call @ 5.60. Net debit: -$560 viate this problem. While a decrease in implied volatility Sell one PHA Aug 45 call @ 1.90. Net credit: +$190 hurts a long option, it helps a short option. Likewise, an Total net debit: -$370 increase in implied volatility works against a short option but benefits a long option. Outright long call: This is perhaps the biggest benefit of trading spreads. Buy one PHA Aug 40 call @ 3.45. Net debit: -$345 Although the risk of time erosion is something that can be planned for and managed, volatility can often turn a profcontinued on p. 32


TABLE 1 MULTIPLE OPTIONS Different option spreads allow you to take advantage of different kinds of market behavior and accommodate different market perspectives. All bullish and bearish put or call spreads consist of options with the same expiration date. STRATEGY Bull call spread Bull put spread Bear call spread Bear put spread WHEN TO USE When you are moderately bullish about the underlying market When you are moderately bullish about the underlying market When you are moderately bearish about the underlying market When you are moderately bearish about the underlying market IMPLEMENTATION Buy a call and sell a call with a higher strike price (same expiration) Sell a put and buy a put with a lower strike price (same expiration) Sell a call and buy a call with a higher strike price (same expiration) Buy a put and sell a put with a lower strike price (same expiration)

As it turned out, Pfizer bought Pharmacia and the implied volatility returned to its typical level in the last few days before expiration. At that point, the stock price was 44.70, and the August 40 call was trading at 4.90. The call could 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 strike price close to the expiration date, the maximum profit for the spread was almost achieved. When the stock was trading at 44.70, the value of the spread was 9.50: Sell to close one PHA Aug 35 call @ 9.90. Net credit: +$990 Buy to close one PHA Aug 45 call @ .40. Net debit: -$40 Total net credit: $950 Because the spread cost 3.70 to open, closing it out would have resulted in a net profit of 5.80. This represents a return of 157 percent, less commission (and remember, the commission on a spread is more than on an outright transaction). The two strategies outright call purchase and bull call spread have nearly the same risk ($3.40 for the spread, $3.70 for the outright purchase), but the long bull call spread would have yielded a much higher percentage return on dollars invested. That the risk was nearly identical makes this an apples-to-apples comparison.

In regard to call credit spreads (bear call spreads), the short option will have the lower strike of the two options; with put credit spreads (bull put spreads), the short option will have the higher strike of the two options. The amount of premium you want to receive on the trade will determine if you want to sell an in-the-money or an out-of-the-money option. Selling in-the-money options can mean a higher reward if you are correct, but it also means it will take a larger move in the underlying stock price to achieve that reward. To receive the maximum profit on a credit spread, both of the options have to be out of the money at expiration. Because of this, the more common option to sell in a credit spread is an out-of-the-money option. If the option is initially out-of-the-money and stays that way, the trade will be profitable at expiration. In regard to call debit spreads (bull call spreads), the long option will have the lower strike of the two options; with put debit spreads (bear put spreads), the long option will have the higher strike of the two options. When placing a debit spread it is more common to initially purchase in-the-money options and sell out-of-the-money options. To make the maximum profit on the strategy, both the options need to be in the money at expiration. By selling an out-of-the-money option, the spread trader is speculating the underlying position will move enough for the sold option to become in the money by expiration.

Other spreads, other factors

Traders can establish many types of spreads depending on their opinion of the market. The bull call spread, bear call spread, bull put spread and bear put spread are the most common (see Table 1). These are all similar in structure one option is bought and one option is sold with the differences being whether puts or calls are used, which strike price (i.e., higher or lower) is purchased and which is sold. The main distinction between the different types of spreads is whether they are executed for a credit or a debit. Credit spreads will usually have a margin requirement, but will initially add money to your trading account; debit spreads only require that you have the cash to pay for the net purchase.

Practical considerations
Spreads must be traded from a margin account, and they may have additional margin requirements. No spread works in every market situation, and traders need to understand the compromises inherent in each type. If traders who usually buy options are willing to accept the trade-off of limited profit potential, spreads can greatly reduce the exposure to time premium erosion and market volatility.
For information on the author see p. 4. Questions or comments? Click here. A version of this article previously appeared in Active Trader.


Choosing the best option

Trading 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.
offered at $6.40, 40 cents over their intrinsic value (Figure 1). These options meet our needs. Our goal is to buy an option with little or no time value that will probably increase point-for-point with the underlying n todays market, an overnight stock as it goes up. An option trading stock position can cause insomat its intrinsic value will not be nia and devastating losses. exposed to time premium decay or a Swing traders who typically drop in implied volatility. hold positions for two or three days The reason for purchasing an in-theshould consider buying options to money call trading at close to parity is potentially limit their risk. Finding the simple unlimited upside potential right option to trade plays a large role and limited downside, although all in the success of this approach. Options option strategies involve risk. This is a may or may not be a suitable trading surrogate stock position with less risk strategy for you. You must balance the since you can only lose what you paid opportunities of options trading with for the option if you buy one option the corresponding risks involved. contract for every 100 shares of stock In-the-money options allow traders you intend to purchase. This is an to construct leveraged stock positions. important point. Many traders will Suppose stock XYZ presented a buying increase their leverage by trading opportunity at its current price of 66 more options. Why? Because they can. and you thought it had a chance to hit More is better, right? Wrong! If you do this you are changing FIGURE 1 the nature of the trade and With XYZ stock trading at 66, the April 65 call was priced at 2.35. However, because you might be taking on more the April 60 call, priced at 6.40, is more in-the-money, we choose it instead. risk than trading the underlying stock. Stay the course and keep the size of the position equivalent to the potential stock trade.


70 over the next few days. Your search for an appropriate option should begin with the first series of front-month, inthe-money calls, which in this case is the April 65 strike price. Since these options are only $1 in-the-money, they will carry a fair amount of time premium. These options have an intrinsic value of $1, yet they are offered at $2.35 (Figure 1). Hence, they have $1.35 of time premium. If the options have more than a week until expiration and are trading within 50 cents of their intrinsic value, they present an opportunity because they are a low-cost, limited-risk approach that controls the shares of the underlying stock without being exposed to time premium decay. If the options have more time premium than 50 cents, you may need to go one strike further in-the-money, in this case to the $60 strike. Those options are

Timing the trade and selecting the strike

To find options that are trading close to parity, we need to focus on the front month because those options dont carry as much time value. The fact that they may expire in a week or two is of little consequence. Remember, you entered the trade because you think the stock will make a move in the next few days; accordingly, you should be out

Source: RealTick by Townsend Analytics, Ltd.


of the trade before expiration becomes a factor, provided there remains a market for the option. Front-month options that are only one or two strikes in-the-money generally have good volume. This normally narrows the bid-ask spread and may make it easier to get in and out of the trade. Remember, option volume is rarely as high as it is for the underlying stock, and slippage will probably be greater with options. The extra eighth or quarter getting in or out is the price you pay to utilize this strategy. Lets now discuss the behavior of this position. Lets say we were able to buy the XYZ 60 calls for $6.40 (40 cents over intrinsic value). These options have value because they are in-the-money. Remember, the call gives us the right, but not the obligation, to buy the stock at the strike price of $60. If we exercised the $60 calls and sold the stock in the open market at $66, we would generate $6 from the transaction. Dont confuse this with a profit of $6. If we bought the options for $6.40, we would actually lose 40 cents by performing this exercise. The point here is to reveal the concept of intrinsic value and its impact on option pricing. This relationship causes these options to usually move point for point with the underlying stock. This is exemplified by the delta of the option. In this case, the delta is 1.00 because the option will increase $1 for each $1 increase in the price of the stock.

wanted, we would have lost $10 if we were long the stock. Consider the possibility that the stock only dropped $6 the next morning and the options were atthe-money. If the options still have time until expiration, they might be trading for $1 or more. Normally, deep in-the money (one strike or more) options initially lose point-for-point during an adverse move. However, as they approach the strike price, they generally implode with implied volatility and may lose value at a slower rate.

Other considerations
If the options carry a lot of time value and you have to go three to four strikes in-the-money to find an option that is close to trading at parity, it probably means the underlying stock is very volatile. In general, the deeper in-themoney you go, the greater your risk. You may have to pay $20 or more for the options. Chances are they are less liquid and have wider bid-ask spreads, adding to your slippage. Be very careful in these situations; it is generally good to avoid them altogether. Some traders would argue that this potential scenario only strengthens the case for using the aforementioned strategy, since the position reduces overnight risk. This strategy also works using puts instead of carrying a short position. In fact, buying in-the-money puts has additional advantages over shorting the stock outright. You dont have to wait for an uptick to buy the puts, you dont have to borrow the stock and check for availability, and you dont run the risk of a buy-in (when the stock is no longer available for shorting and the trader is forced to buy back the shares). As with the call strategy, there are risks involved with purchasing puts. A position in an in-the-money call option that is more than two weeks from expiration and is trading within a half-point of parity will usually gain point-for-point with the underlying stock as it moves with you, but (at a certain level) may lose less when the stock moves against you. The risk is limited to what you paid for the option position. If you trade one option contract for each 100 shares of stock you originally planned to trade, your risk

will be reduced. Increased slippage and the possibility of no market are the potential associated risks of using the strategy. Because options are not as liquid as the stock, it may cost an additional 25 cents or more to get in and out of the trade. Both opening and closing transactions are subject to commission charges and the above strategy may entail significant amounts of buying and selling. Commissions should be a factor in deciding whether this is an appropriate strategy for you. The following guidelines can help you select the appropriate options for putting on a trade with equal potential as and lower risk than an equivalent stock position: 1. Buy an in-the-money option. 2. Use front-month options if there are more than two weeks until expiration. 3. Determine the time-value component. 4. If there is more than one point of intrinsic premium, go one strike further 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 deep in-the-money may have wide bid-ask spreads, which could increase slippage. If the anticipated move has not materialized in five days, get out. If you 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 appeared in Active Trader magazine. You should discuss tax treatment of the possible options strategies with your tax advisors prior to undertaking such transactions. Exercise, opening and closing transactions are subject to commission charges. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies of this document are available from the Options Clearing Corp.; 440 S. LaSalle Street, 24th floor; Chicago, IL; 60605.

Contained risk
If the stock goes up to $70 as originally anticipated, the option should be worth about $10. (Again, the option position will mimic the stock position as it moves higher.) Lets take a look at how it will behave if the stock moves lower. Earlier, we pointed out that this is a surrogate stock position. The objective is to reduce our overnight risk and maintain our upside potential. If overnight news hits the stock and it opens $10 lower the next day, we have $6.40 at risk. With the stock at $56, the $60 calls are now out-of-the money and we stand to lose everything we had in the position. While this is certainly not what we

Option Screening: Finding Profitable Trades with Lawrence Cavanagh Marketplace Books DVD $99 Lawrence Cavanagh teaches options traders how to employ a variety of spread techniques. The DVD provides advice on short-term bull and bear spreads, using standard deviation to forecast the probability of trade success, calendar spreads, using long and short option statistics as indicators, and diagonal and back spreads. Prophet.net has announced several membership enhancements. Gold memberships will include Streaming Time-and-Sales data for stocks, futures, and options, and Gold members will be able to chart up to 120 days of intraday history. Premium members can keep more Watch Lists and unlimited saved charts. Additionally, Prophet.Net has moved to a highbandwidth data pipeline hosted by Savvis.

Advanced Option Pricing Models: An Empirical Approach to Valuing Options By Jeffrey Owen Katz, Ph.D., and Donna L. McCormick McGraw-Hill, 2005 Hardback, 437 pages $70 Katz and McCormick detail conditions where standard option pricing models provide inaccurate price estimates, and then explain how to build new, non-standard models that compensate for those flaws. The books examples compare the real-market distribution of price changes to the popular theoretical distribution models such as Black-Scholes.

Three good tools for targeting customers . . .

Bob Dorman
Ad sales East Coast and Midwest bdorman@activetradermag.com (312) 775-5421

Allison Ellis
Ad sales West Coast and Southwest aellis@activetradermag.com (626) 497-9195

Mark Seger
Account Executive mseger@activetradermag.com (312) 377-9435




Monday Tuesday Wednesday Thursday Friday


CBOT: Chicago Board of Trade CME: Chicago Mercantile Exchange CPI: Consumer Price Index FOMC: Federal Open Market Committee GDP: Gross Domestic Product LTD: The final day a contract may trade or be closed out before delivery of the underlying asset must occur. NYBOT: New York Board of Trade NYMEX: New York Mercantile Exchange PPI: Producer Price Index

LTD: July pork belly options (CME); August cocoa options (NYBOT); June milk options (CME)

Markets closed Independence Day

LTD: July currencies options (CME); July dollar index options (CME); August sugar and coffee options (NYBOT) Employment for June




CPI for June

LTD: All July equity options; July S&P options (CME); August Nasdaq options (CME); August Dow Jones options (CBOT); July lean hog options (CME); August orange juice options (NYBOT) PPI for June

LTD: July Goldman Sachs Commodity Index options (CME)


LTD: August platinum options (NYMEX)


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



LTD: August natural gas, gasoline, and heating oil options (NYMEX); August aluminum, copper, silver, and gold options (NYMEX)



GDP (advance) for Q2 ECI for June


LTD: August live cattle options (CME); September cocoa options (NYBOT); July milk options (CME) Employment for July

FOMC meeting



LTD: August lean hog options (CME); September sugar and coffee options (NYBOT)


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




Long strangle fails to hit pay dirt

Date: Friday, May 20, 2005. Position: Long strangle: Long 1 Australian dollar futures July 77 call option at 0.35; long 1 July 75 put option at 1.06 Reasons for trade/setup: Last months Options Trade Journal (Options Trader, June 2005, p. 35) described a long strangle in Australian dollar futures options in anticipation of a breakout either above 78.48 or below 73.52 the trading range over the past six months. The Australian dollars (AD) statistical and implied volatilities were at 18-month lows, 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 moves significantly in either direction or if option implied volatility soars. The Australian dollar was trading at 74.98 when we entered the trade on May 20 and climbed to 75.81 the following week. This move back toward the middle of the TRADE SUMMARY Entry date Underlying security Position: Long 1 July 77 call ($): Long 1 July 75 put ($): Total position cost ($): Capital required ($): Initial stop: 5/20/05 ADU05 0.35 1.06 1.41 $1,480 trading range wiped out 24 percent of the positions value, but we held the strangle because there were still 43 days left until expiration plenty of time for the Aussie dollar to break out. Initial stop: Exit the trade if Australian dollar futures trade between 75.35 and 76.30 and implied volatility is flat on June 14 halfway between its May 20 entry and July 9 expiration dates. The stop represents a 50-percent loss, which seems unreasonable since the options still have 25 days until expiration. However, the strangle loses at least $18.44 per day because of time decay (see Trade Statistics), a daily loss that will increase as expiration approaches. Timing is critical the Aussie dollar needs enough time to move higher (or lower), but we need to exit before time decay becomes too difficult to overcome. Initial target: We lowered our profit target to breakeven from 11 percent after the long strangle lost ground in the first week. Initially, we had planned to take profits when the Aussie dollar traded below 73.50 or above 78.25 by June 14, but we narrowed this range to 74.07 and 78.04, respectively, which represented the trades June 14 breakeven points on May 27. The targets are conservative, however, because neither original nor revised ones included an increase in implied volatility. If either of these thresholds were met and IV rose just 1 percent by June 14, the strangle would gain roughly $100 (7 percent).

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). Above 78.25 or below 73.50 6/14/05 0.34 0.33 0.67 25 -0.74 (52.5%) n/a -0.77 (54.6%)

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

Initial targets: Exit date:

TRADE STATISTICS Date Delta Gamma Theta Vega May 20, 2005 -22.83 29.68 -18.44 195.50 June 14, 2005 4.93 39.47 -25.18 136.80 9.7% 9.7% 9.8% 9% 73.82 / 78.00

Position: Offset 1 July 77 call ($): Offset 1 July 75 put ($): Total proceeds ($): Trade length (in days): P/L: LOP: LOL:

LOP Largest open profit (maximum available profit during lifetime of trade); LOL largest open loss (maximum potential loss during life of trade).

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



Reason for exit: Initial stop hit. Profit/loss: -0.74 (-52.5 percent). Trade executed according to plan: Yes.

FIGURE 1 STUCK IN A RANGE Australian dollar futures closed at 76.01 on June 14, and our July options implied volatility didnt increase as expected. This scenario triggered an exit, and the trade lost $740 (52.5 percent).

80 79 78

Price Chart Australian Dollar (CME)

77 Lessons: The long strangle 76 was a bust it lost ground from the beginning and never 75 recovered as the Australian 74 dollar futures traded between 73 74.45 and 76.77 in late May and early June. 72 Figure 1 shows Australian 71 dollar futures with the long X1 70 strangles profitability zones Oct. Nov. Dec. 2005 Feb. Mar. Apr. May June July (green and red areas, right Source: OptionVue 5 side). The Aussie dollar fell to a five-month low on June 1. At this point, the July 75 put rose FIGURE 2 UNDERWATER STRANGLE to 1.21 from 1.06, but the 77 call This long strangle remained unprofitable mainly because the expected moves (up or fell to 0.15 from 0.35, which down) in Australian dollar futures were unrealistic. However, time decay eroded at least kept the strangle from moving half the July options value. into the money. The underlying currency climbed 3.12 percent in the next five days a rally that stalled in the middle of our unprofitable zone. We exited at the Australian dollar futures June 14 close (76.01, blue line) after realizing that ADs average IV actually dropped since we placed the trade. Figure 2 shows the long strangles risk profile and plots its profitability according to ADs price on three dates: trade exit (June 14, orange line), 13 days until expiration (June 27, dashed brown), and expiration (July 9, solid Source: OptionVue 5 brown). The figures upper line represents the dilemma as we exited the trade: Not only did AD fail to break out of its also fell to 9.7 from 10 percent. range, but it traded in the middle of this area upon exit, proAn expected sudden rise in implied volatility was unreducing a hefty loss. alistic, and we overestimated the effect IV changes would However, daily time decay was actually the main reason have. To overcome the negative effects of the Australian the long strangle lost ground. It climbed to $25.18 from dollars sideways price action and time decay, implied $18.44, which erased more than one-third of the trades volatility would have had to increase 5.5 percent an value by June 14 (see Trade Statistics); implied volatility unlikely scenario in less than a month.


American style: An option that can be exercised at any time until expiration. Assign(ment): When an option seller (or writer) is obligated to assume a long position (if he or she sold a put) or short position (if he or she sold a call) in the underlying stock or futures contract because an option buyer exercised the same option. At the money (ATM): An option whose strike price is identical (or very close) to the current underlying stock (or futures) price. Call option: An option that gives the owner the right, but not the obligation, to buy a stock (or futures contract) at a fixed price. Deep (e.g., deep in-the-money option or deep out-of-the money option): Call options with strike price that are very far above the current price of the underlying asset and put options with strike prices that are very far below the current price of the underlying asset. Delta: The ratio of the movement in the option price for every point move in the stock price. An option with a delta of .5 would move a half-point for every 1-point move in the underlying stock; an option with a delta of 1.00 would move 1 point for every 1-point move in the underlying stock. European style: An option that can only be exercised at expiration, not before. Exercise: To exchange an option for the underlying instrument. Expiration: The last day on which an option can be exercised and exchanged for the underlying instrument (usually the last trading day or one day after).

Front month: The contract month closest to expiration. In the money (ITM): A call option with a strike price below the price of the underlying instrument, or a put option with a strike price above the underlying instruments price. Intrinsic value: The difference between the strike price of an in-themoney option and the underlying asset price. A call option with a strike price of 22 has 2 points of intrinsic value if the underlying market is trading at 24. Out of the money (OTM): A call option with a strike price above the price of the underlying instrument, or a put option with a strike price below the underlying instruments price. Parity: An option trading at its intrinsic value. Premium: The price of an option. Put option: An option that gives the

owner the right, but not the obligation, to sell a stock (or futures contract) at a fixed price. Strike (exercise) price: The price at which an underlying stock is exchanged upon exercise of an option. Time decay: The tendency of time value to decrease at an accelerated rate as an option approaches expiration. Time value: The amount of an options value that is a function of the time remaining until expiration. Volatility: The level of price movement in a market. Historical (statistical) volatility measures the price fluctuations (usually calculated as the standard deviation of closing prices) over a certain time period e.g., the past 20 days. Implied volatility is the current market estimate of future volatility as reflected in the level of option premiums. The higher the implied volatility, the higher the option premium.

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 deviation (or difference) of each number in the group from the groups mean value, divided by the number of elements in the group. For example, for the numbers 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 distributed they will be. The more varied a markets price changes from day to day (or week to week, etc.), the more volatile that market is. A common application of variance in trading is standard deviation, which is 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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