Market Neutral Options Strategy Guide

Strategy Guide
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A guide to successful options trading
Copyright 2007 MarketNeutralOptions
Version 2
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MARKETNEUTRALOPTIONS ADVISORY SERVICE LEGAL NOTICE
DISCLAIMER AND WAIVE R OF CLAIMS

Please read through the following notice very carefully. Upon using any MarketNeutralOptions services or products, you are deemed to have agreed to this legal notice. Options involve risk and are not suitable for all investors. All investors who deal with options should read and understand the publication "Characteristics and Risks of Standardized Options." A copy of this publication can be obtained by clicking on this link: http://www.optionsclearing.com/publications/risks/riskchap1.jsp All examples cited in this e-book are hypothetical. You should not assume that the stocks and options pricing or profits from trades used as examples in this e-book will be in accordance with actual pricing or results in the market place. Commission costs will impact the outcome of all stock and option transactions and must be considered prior to entering into any transactions. The examples used in this e-book are not to be construed as a recommendation to purchase or sell any security or group of securities. MarketNeutralOptions is the copyright owner of all text and graphics contained in this publication. Copying, publishing or redistributing any material in any way without the written consent of MarketNeutralOptions is strictly prohibited. The owners, publishers, and agents of MarketNeutralOptions are not liable for any losses or damages, monetary or other that may result from the application of information contained within this publication. Within this publication, we publish materials that meet specific criteria representing characteristics associated with described trading strategies. Individual traders must use their own due diligence in analyzing featured options to determine if they represent a suitable opportunity. MarketNeutralOptions and any of their agents, affiliates, representatives, employees, principals, business associates or affiliates, partners or independent contractors are not responsible for any losses or profits that may result from the application of information contained within this publication. Past performance is not indicative of future results. Option trading involves substantial risk. You can lose money trading options. The past results posted on this site are meant to give you a reasonable idea of what you could have made or lost trading by following the MarketNeutralOptions strategy but are in no way an exact reflection of what you would have made or lost. Therefore, you should not rely on our past trade results as a perfect replication of what your returns or losses would have been by following our service. There are inherent risks involved in the stock market and these risks should be considered prior to any decision. The representatives of MarketNeutralOptions may or may not hold a position in any stocks listed at the time of publication and reserve the right to buy or sell any security, option, future or derivative product without notification. Nothing published by MarketNeutralOptions should be considered personalized investment advice. Although the MarketNeutralOptions team may answer your general customer service questions, they are not licensed under securities laws to address your particular investment situation. No communication by the MarketNeutralOptions team to you should be deemed as personalized investment advice.
Introduction
Thank you for choosing MarketNeutralOptions Advisory Service. Here at MarketNeutralOptions we strive to offer the best value and best customer service to our subscribers. Our advisory service is one of the most reasonably-priced services in the industry by pegging our subscription fee to our advisory performance. You pay for what you get, not what you were promised, and we profit together with you. This Strategy Guide will shed more light on the strategies that we use for our advisory service. Even if you are totally new to options trading, I hope this book will help you understand market-neutral strategies such as iron condors and double diagonals that we use in our advisory service regularly. I hope you will find this book useful in this never-ending journey to learn to be a better trader. Gary Ang Founder of MarketNeutralOptions
T able of Contents
Introduction to the Basics of Options Trading ........................... 1 What are options? .................................................................... 2 Moneyness of an Option .......................................................... 3 Leverage .................................................................................. 7 Basic Options Trading Strategies ........................................... 10 Basic Building Blocks ............................................................. 10 A Spread ................................................................................ 10 Vertical Spreads ..................................................................... 11 Calendar Spread .................................................................... 15 Iron Condor ............................................................................ 16
Break-Even Points ............................................................................................... 18 Capital Requirement ............................................................................................ 19 Expected Returns ................................................................................................ 20 Risk/Reward Ratio (R3) ....................................................................................... 22 Exit Strategy ......................................................................................................... 27
Double Diagonal..................................................................... 29
Roll ....................................................................................................................... 30 Capital Requirements .......................................................................................... 32 Characteristics of a Double Diagonal .................................................................. 32 Conclusion ........................................................................................................... 33
Appendix: An Introduction to the Greeks in Options Trading .. 34

The Delta ............................................................................................................. 34 Gamma ................................................................................................................ 36 Theta .................................................................................................................... 37 Vega ..................................................................................................................... 37
M A R K E T N E U T R A L O P T I O N S S T R A T E G Y G U I D E
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Introduction to the Basics of Options Trading

Never risk your hard-earned money on something you hardly understand. Not only have you risked losing your money, you may not even know why you lose.
t is extremely important that you have a firm understanding of the basics of options before you even start trading with your hard-earned money. Options have been labeled as highly risky and speculative by critics. But what these critics fail to understand is option itself is neither risky nor speculative. In fact, when used properly, option can be less risky than buying actual stocks. Option not only serves as a strategic investment vehicle, it can also be used to reduce risk with its hedging property. Option is only risky when you dont know what you are doing with it! Option trading is a skill that may take a long time to master. In fact, I personally think that education in option trading is never over. It is therefore critical that you fully understand how options work to take full advantage of option trading. Options are complex investment instruments that present traders unlimited style or strategies of trading. Whether you are a bull, a bear or market neutral, you can be sure to find a few strategies to suit your market view. Whether you are delta neutral, trading gamma or vega, you will be able to take advantage of what options offer. Before you learn complicated strategies such as the Iron Condor and Double Diagonal, it is imperative that you understand the basic building blocks of these strategies. At the end of this e-book, you should be able to understand how an Iron Condor and Double Diagonal work and how you can expect to make money from trading them.
1 www.MarketNeutralOptions.com Copyright 2007 MarketNeutralOptions
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What are options?

Basics of Calls and Puts. Readers who are already familiar with the basics of Calls and Puts may skip to the next section.
L
Main Points
A call (put) buyer has the right to buy (sell) the underlying at a fixed price. A call (put) seller has the obligation to sell (buy) the underlying at a fixed price. The strike price is the fixed price stated in the option. Options have expiry dates. American-style options can be exercised before or on expiration. European-style options can only be exercised on expiration. The price of an option is determined by many factors such as the price of the underlying, days left before expiration, interest rate and implied volatility.
earning to trade options can be one of the most challenging and rewarding endeavors in your investment education. Unlike stock, options are multi dimensional investment vehicles. The terminology used in options trading can be intimidating for most beginners and it is not surprising that many beginners give up on learning options because they simply find it too difficult. In the simplest terms, options are derivatives that derive their values from the value of an underlying. The underlying of a stock option is the stock itself; likewise, the underlying of an index option is the index. For example, an IBM option derives its value from the share price of IBM. Depending on the characteristics of the option, the value of the option may increase or decrease when the share price of IBM rises. Options are contracts to buy or sell an underlying at a specific price before or on a specific date. There are two types of options: calls and puts. Calls are contacts to buy an underlying at specific price before or on a specific date while puts are contracts to sell an underlying at a specific price before or on a specific date. The specific price to buy or sell the underlying is called the strike price. Since options are time-sensitive, the last day of an options validity is known as expiration date. The expiration date of most options falls on the third Friday of every month. Exceptions are index options such as the SPXthe symbol of the S&P 500 indexexpire on the third Thursday of every month and quarterly options that expire on the last trading day of the month. An American-style option can be exercised before or on the expiration day itself while a European-style option can only be exercised on the expiration day itself. Most of the stock options listed in the American markets are American-style. As mentioned earlier, options are multi dimensional investment vehicles whose prices are determined by factors such as price of the underlying, days to expiration, interest rate and implied volatility. For example, an IBM Feb 95 call option is a contract to buy 100 of IBM shares at the strike price of $95 before or on the third Friday of February. When you buy (go long) this call, you have the right to buy 100 shares of IBM at the strike price of $95 anytime
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before or on the third Friday of February regardless of how much IBM is worth. Even if IBM is trading at $120 in February, you can choose to exercise your long call and buy 100 shares of IBM at $95. However, if IBM were to trade at a price of $80, you will not want to exercise your long call to buy IBM at $95 since you can get it at a market price of $80. Similarly, an IBM Feb 95 put options is a contract to sell 100 shares of IBM at the strike price of $95 anytime before or on the third Friday of February. When you long this put, you have the right to sell 100 shares of IBM at the strike price of $95 anytime before or on the third Friday of February regardless how much is IBM trading at. If IBM is trading at $120 in February, you will not exercise your Feb 95 put because you will not want to sell IBM at $95 when you can sell at $120 in the open market. However, if IBM is trading at $90 in February, you may choose to exercise your long Feb 95 put to sell 100 shares of IBM at $95 when it is trading at $90 in the open market.
Moneyness of an Option
he value of an option may be difficult to model. There are a few option pricing models around; the most celebrated would most probably be the Black-Scholes model, which is a Nobel Prize winner. Fortunately, one does not have to be a Nobel Prize winner to understand the basics of options! The price of an option can be broadly divided into two main parts: its intrinsic value and its time value, sometimes called the extrinsic value.
Intrinsic value
Time value
Price of option
An IBM Feb 95 call option may cost $1.80 when IBM is trading at $96. Remember that owning an IBM Feb 95 call gives you the right to buy IBM at $95 no matter how much IBM is trading at. When IBM is trading at $96, your long IBM Feb 95 call will be worth at least $1 since it gives its owner the right to buy IBM at $95 when it is currently trading at $96. This $1 is the intrinsic value of the call option. But you may notice that the actual price of the call option almost always exceeds its intrinsic value. In our example, the call option cost $1.80 when it only has an intrinsic value of $1. The difference of $0.80 is known as the time value. An options time value is directly related to the number of days left to expiration. The more days the option has before expiration, the more time value is has. On expiration day, all options will have
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zero time value. When IBM is trading at $96, we say that the Feb 95 call option is in-the-money (ITM). Similarly, an IBM Feb 100 put will have a positive intrinsic value of $4 when IBM is trading at $96 because the put gives its owner the right to sell IBM at $100 even if IBM is trading at $96. An ITM option is an option with positive intrinsic value. If IBM were to be trading at $95, the Feb 95 call will not have any intrinsic value because nobody would care for a right to buy IBM at $95 when everyone can buy it at $95 in the open market. Likewise, a Feb 95 put will also not have any intrinsic value when IBM is trading at $95 since nobody will care for a right to sell IBM at $95 when everyone can sell it at $95. The Feb 95 call and put options are known as at-the-money (ATM) options. When an options intrinsic value is zero, i.e. the stock price is equal to the strike price, it is ATM. Now, lets say IBM is trading at $90, the Feb 95 call will have negative intrinsic value since nobody will be interested in the right to buy IBM at $95 when it is trading at $90. This Feb 95 call option is called an out-of-the-money (OTM) option. On the put side, a Feb 85 put will be OTM when IBM is trading at $90 since nobody will be interested to sell IBM at $85 when they can sell it at $90 in the open market. However, an ATM or OTM option will not be worthless until on expiration day because it will still have time value. On expiration day, all ATM and OTM options expire worthless.
Main Points
Price of an option is the sum of its intrinsic value and its time value. In-the-money (ITM) options are options with positive intrinsic value. At-the-money (ATM) options are options with zero intrinsic value. Out-of-the-money (OTM) options are options with negative intrinsic value. All options will have zero time value on expiration day. All ATM and OTM options will be worthless on expiration day.
Table 1: A typical option chain

Call Strike Price Put
ITM ITM ITM ATM OTM OTM OTM
87.5 90 92.5 95 97.5 100 102.5
OTM OTM OTM ATM ITM ITM ITM
This table shows the moneyness of Call and Put options when underlying is trading at $95
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A Call Example
Alvin bought a SPY Aug 131 call from Ben for $0.50 with 40 days to expiration. SPY is, say, currently at $130. Alvin would have thought or hoped that SPY would rise to above $131 within the next 40 days since he had the right to purchase the stock at $131 even if it happens to be trading at $135 in the next 40 days. On the contrary, when Ben sold the Aug 131 call to Alvin, he must have been bearish on the SPY and hope that SPY would be trading below $131 since he had the obligation to sell SPY at $131 to Alvin even in the event that SPY is trading at $135 within the next 40 days. Ben obviously would not want to sell Alvin SPY at $131 when it is trading at $135! As illustrated, buying a call is bullish and selling a call is bearish. Now, when expiration comes and SPY is trading at, say, $129, the 131 call would expire worthless since it is out of the money (OTM). What this means to Alvin is that he would have lost his entire investment of $0.50 since his investment is now worthless. For Ben, he would have profited the $0.50 since the option he sold to Alvin is now worthless. However, if SPY were to trade at $133 on expiration day, the 131 call would be worth $2 since Alvin can exercise the right to buy SPY at $131 when it is trading at $133 currently. This 131 call is said to be in-the-money (ITM). Alvin can choose to exercise the right to buy SPY at $131 and then subsequently sell it back to the open market at $133 to make a $1.50 profit ($2$0.50). Alternatively, he can choose to sell the option to another trader before the market closes. Alvin has the potential to make unlimited profit because the higher SPY goes before expiration, the more profit he makes with his long call. Now, Ben on the other side of the market would be sweating cold sweat. The 131 call he sold Alvin for $0.50 is now worth $2. Ben can choose to close out his short call position by buying back the call, now worth $2, from Alvin, and thus suffer a $1.50 loss. However, if Alvin were to exercise his long call before expiration, Ben would have to honor his obligation to sell SPY at $131 to Alvin. Ben would have to buy SPY at $133 from the open market and then sell it to Alvin to $131. He would have suffered $1.50 loss from either scenario. Unlike Alvin, who can only lose his entire investment of $0.50, Ben is exposed to unlimited risk. The higher SPY goes before expiration, the more Ben loses.
As illustrated, long call presents limited risk while short calls presents unlimited risk.
A Put Example
Alvin bought a SPY Aug 129 put from Ben for $0.50 with 40 days to expiration. SPY is, say, currently at $130. Alvin would have thought or hoped that SPY would fall to below $129 within the next 40 days since he had the right to sell the stock at $129 even if it happens to be trading at $125 in the next 40 days. On the contrary, when Ben sold the Aug 129 put to Alvin, he must have been bullish on the SPY and hope that SPY would be
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trading above $129 since he had the obligation to buy SPY at $129 to Alvin even in the event that SPY is trading at $125 within the next 40 days. Surely, Ben would dread the idea of having to buy SPY at $129 when it is trading at only $125. As illustrated, buying a put is bearish and selling a put is bullish. Now, when expiration comes and SPY is trading at, say, $131, the 129 put would expire worthless since it is out of the money (OTM). The right to sell SPY at $129 is worthless because nobody would want to sell SPY at $129 when they can sell it at $131 in the open market. What this means to Alvin is that he would have lost his entire investment of $0.50 since his investment is now worthless. For Ben, he would have profited the $0.50 since the option he sold to Alvin is now worthless. However, if SPY were to trade at $127 on expiration day, the 129 put would be worth $2 since Alvin can exercise the right to sell the SPY at $129 when it is trading at $127 currently. This 129 put is said to be in-the-money (ITM). Alvin can choose to exercise the right to sell SPY at $129 and then subsequently buy it back from the open market at $127 to cover his short stock position and make a $1.50 profit. Alternatively, he can choose to sell the 129 put option to another trader before the market closes. Alvin has the potential to make unlimited profit because the lower SPY goes before expiration, the more profit he makes with his long put. Main Points
An option controls 100 shares of the underlying. Buying a call is bullish while selling a call is bearish. Buying a put is bearish while selling a put is bullish. Long options present limited risk while short options present unlimited risk.
Now, Ben on the other side of the market would be watching the market nervously. The 129 put he sold Alvin for $0.50 is now worth $2. Ben can choose to close out his short put position by buying back the put, now worth $2, from Alvin, and thus suffer a $1.50 loss. However, if Alvin were to exercise his long put before expiration, Ben would have to honor his obligation to buy SPY at $129 from Alvin even though SPY is currently trading at $127. Ben would have to buy SPY at $129 from the Alvin and then sell it to the open market at $127 if he does not want to have any long stock position. He would have suffered $1.50 loss from either scenario. Unlike Alvin, who can only lose his entire investment of $0.50, Ben is exposed to unlimited risk. The lower SPY goes before expiration, the more Ben loses. As illustrated, long put presents limited risk while short put presents unlimited risk.
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Leverage
Using options as leverage to control stocks.
imilar to warrants, options offer leverage. With a small amount of upfront capital, an option buyer can control 100 shares of a more expensive stock. For example, Google (GOOG) is trading at $684.16 on 6 December 2007 (16 days to December expiration) and Table 2 shows the option chain for December expiration. Lets say you are bullish on GOOG. To buy 100 shares of GOOG, you will need about $68,416 [$684.16 X 100]. In the next 10 days, Google shares soar $100 to $784.16. You would have made $10,000 [$100 X 100] in profit. In percentage terms, you would have made about 14.62% returns on your investment. Not bad at all. Now, lets say you are an option trader and you are also bullish on GOOG. You look at the option chain (Table 2) and you decide to buy the Dec 680 Call for $25.20 apiece. You upfront investment will be $2,520. Remember that with GOOG currently trading at $684.16, your Dec 680 call has an intrinsic value of only $4.16. You are paying $21.04 for time value. In the next 10 days, GOOG shares soar $100 to $784.16. Based on a simple computer simulation, your Dec 680 call should be worth about $100. You would have profited $7,480 [($100 $25.20) X 100]. In percentage terms, you would have profited an amazing 296.83% returns on your investment!
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Table 2: Google option chain when Google is trading at $684.16.
Source: Screenshot taken from thinkorswim trading platform.
In both cases GOOG advances $100 in 10 days but the option trader seems to have a better deal. This is the power of leverage. Many people learn about options in this manner. Before you get all excited and start counting the number of days it will take for you to become a millionaire, let me get you back on earth by saying that youll probably have to be a psychic or fortune-teller, a very accurate one at that, in order to trade options successfully this way. Why? This is because you have to know that leverage, as amazing as it is, is a double-edged sword and it works both ways. Lets go back to our Google example and instead of advancing $100 in the next 10 days, GOOG declines $10. The stock trader would have suffered a loss of $1,000 [$10 X 100]. In percentage terms, the stock trader would have made a loss of 1.46%. However, based on a simple computer simulation, the options traders Dec 680 call option would be worth only $11.62. The options trader would have made a loss of $1,358 [($25.2 $11.62) X 100]. In percentage terms, the options trader would have made a loss of about 53.89%. Things will only get worse for the options trader who punted on the wrong side of the market. With GOOG trading at $674.16 after the $10 fall, his Dec 680 call option is now OTM with zero intrinsic value. Lets say GOOG remains at $674.16
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for the remaining days until December expiration, the Dec 680 call option will expire worthless and the option trader would have suffered a 100% loss on his investment. On the other hand, the stock trader can hold on to his GOOG shares and can wait forever for a rebound. Now, let me present you a third scenario. Lets say after the option trader bought his Dec 680 call option, GOOG remains at $684.16 until December expiration with no gains or losses. Remember that the Dec 680 call option has an intrinsic value of only $4.16. Come December expiration, this call will only be worth its intrinsic value of $4.16. The stock trader would not make any profit or loss because the stock did not gain or lose its value. In fact, the stock trader stands to receive any dividend paid by Google for as long as he holds on to his GOOG shares. The option trader will again be in an undesirable position. Even though GOOG did not gain or lose a single cent, the option trader sees his Dec 680 call option shrinks its value from $25.20 to $4.16 in a short 16 days. Now, even if GOOG were to advance $10 by December expiration, how will the option trader fare? Bear in mind that the option trader was bullish and he was right. By expiration, if GOOG is trading at $694.16, his Dec 680 call option will be worth only $14.16 [the initial intrinsic value of $4.16 plus the additional $10 as GOOG goes up by $10]. In fact, the option trader will only breakeven if GOOG were to advance by $21.04 to $705.20 [initial GOOG value of $684.16 plus time value of $21.04]. If GOOG were to trade at anything less than $705.20 on expiration, the option trader makes a loss. Many would agree with me that making money by buying calls and puts is not easy. Underlying goes against you, you lose. Underlying goes sideway, you lose again. Even if underlying goes in the direction that you speculated, you may still lose if the move isnt spectacular enough. Even though buying straight calls and puts is a difficult way to make money, many option traders are still doing it. This is because buying straight calls and puts is the easiest way to trade options. It does not help that many options trading courses out in the market are teaching new option traders this simple strategy. Their claims of making 300% profit on a single trade will lead many newbies to think that trading options is the fastest way to get rich. This is partly why most new options traders lose money despite spending a fortune on courses and seminars. Of course there are a handful of traders who manage to make a fortune by simply buying calls and puts but they are really the minority and it involves a different set of skills altogether.
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Basic Options Trading Strategies

Basic yet versatile strategies go a long way. Whether you are a bull, bear or neutral, you can be sure to find something you can use.
At MarketNeutralOptions, we believe that the best way to make money consistently by trading options is to let time decay work in our favor. If you havent understand the working principles behind market-neutral strategies or how positive theta works, please read our Introduction to Market-Neutral Options Strategies.
Basic Building Blocks A Spread

Long calls and puts offer leverage and limited risk. The most you can lose is your initial investment paid to buy the call or the put. However, if the market moves in your favor, you stand to be rewarded handsomely. Unlike short calls and puts, long calls and puts do not present unlimited risk to the buyer. However, that is not to say that long calls or puts are risk-free. The most obvious risk is time decay. Options are decaying assets: their value reduces as time goes by. If the underlying does not move, your long call or long put position may start to be worth less and less in value as time goes by. In fact, your long option positions run the risk of becoming worthless by expiration. You would have lost your entire investment should your long positions become worthless by expiration. Furthermore, long option positions are also subject to changes in volatility. The value of an option (call or put) is directly proportional to the change in volatility. The higher the volatility, the higher the value of long options and vice versa. This is because, in a volatile market, where there are large movements in either direction, there is a higher chance that your long options will end up ITM. Thus the higher prices reflect the higher probability that your long options may expire ITM.
Main Points
Most professional traders use a spread to offset the risk associated with a long or short position.
In fact, more often than not, a long call position may lose money even if the underlying is moving up. This is because the value of the option is decreasing due to time decay and a reduction in volatility. The move up is not enough to make up for the loss in time decay and volatility.
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Therefore, most professional traders use spread (a combination of long and short options) instead of simply long calls or puts. A spread involves the buying and selling of an option to offset some risk associated with the long or short position per se.
Vertical Spreads
Verticals are the most basic spread. It involves the buying and selling of a call or put with different strike price but in the same expiration month. Vertical spreads can be done for a debit (you pay) or a credit (you get paid). The reason why it is called vertical is because option prices are listed according to expiry month. Each month forms a column with strike prices one above another. When you buy and sell a call or a put in the same expiration month, you are looking at the prices in a vertical fashion. Thats why the name vertical spread.
Main Points
A debit spread involves buying a more expensive call (put) and selling a cheaper call (put). Therefore, you have to pay to initiate a debit spread. The maximum risk of a spread is limited. So is the profit. A bull call spread is bullish because you are using calls to be bullish. A bear put spread is bearish because you are using puts to be bearish.
Debit Spreads Debit call or put spread allows trader a long exposure. A debit call spread is also known as a bull call spread while a debit put spread is known as a bear put spread. Generally, when a spread is a net debit, you are said to be long the spread. Conversely, when a spread is a net credit, you are said to be short the spread. Bull Call Spread A bull call spread is long a lower strike call and short a higher strike call in the same expiration month. For example, you can go long SPY 130 Aug call and short a SPY 132 Aug call when SPY is trading at $129. Since the 130 call is near to the money, it will cost more than the 132 call that you sold. Therefore, the spread ends up a debit spread. When you put up a bull call spread, you are bullish and believe that SPY would trade higher than $130 before expiration. If SPY trades at $133 on expiration, your long 130 call would be worth $3 and your short 132 call would be worth $1. To avoid assignment and have the underlying delivered to you on Monday, you can close the trade by selling your long 130 call and buying back your short $132 call. You would have made $2 minus whatever debit you paid to initiate the trade. Even if SPY were to trade at $140 (yes, you were right to be bullish), you will still make only $2 minus the debit you paid. Your profit is limited to $2 minus the debit you paid even though you are right in your prediction.
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S E R V I C E
Maximum profit of a debit spread = difference between the strikes the initial debit paid. Maximum loss of a debit spread = the initial debit paid.
If you only bought the 130 call, you would have unlimited profit potential. If SPY were to be trading at $140, your 130 call will be worth $10 and youll profit that $10. Selling the 132 call to create the spread ensures that your profit is capped at $2 no matter how high SPY is trading. Why would anyone want to initiate a trade like that you may ask? The reason is simple: reduce risk. If you only go long your 130 call and SPY fails to rally and trades at $128, you would have lost your entire investment (the amount you paid for the 130 call). By selling the 132 call at the same time as you bought your 130 call, you reduce your risk since your short 132 call would bring in some credit, i.e. you actually pay less for your long 130 call because of the 132 call you sold. Since you paid less for the 130 call, you stand to lose less than if you were to go long 130 call only. The tradeoff is, of course, you limit your otherwise unlimited profit potential. Bear Put Spread A bear put spread is long a higher strike put and short a lower strike put in the same expiration month. For example, you can go long a SPY 129 Aug put and short a SPY 128 Aug put when SPY is trading at $130. Since your long 129 put is nearer to the money, it will be worth more than you short 128 put and therefore, your spread is a net debit. When you long a put spread, you are bearish and believe that SPY will trade below $129 by expiration. If SPY were to trade at $127 on expiration day, your long 129 put will be worth $2 and your short 128 put will be worth $1. You can close the trade by buying back your short 128 put for $1 and selling your long 129 put for $2 and pocket the difference. Your profit would be $2 minus the debit you paid to initiate the trade. If SPY trades above $129 on expiration day, both your short and long puts will expire worthless and youll lose your entire investment. A bear put spread (long/debit put spread) works the same way as a bull call spread (long/debit call spread) just opposite.
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Credit Spreads A credit spread allows a trader to have a short exposure. A credit call vertical spread is also known as a bear call spread while a credit put vertical spread is also known as a bull put spread. When your spread ends up a net credit, you are said to be short the spread.
Main Points
A credit spread involves selling a more expensive call (put) and buying a cheaper call (put). Therefore, you get paid when you initiate a credit spread. A bear call spread is bearish because you are using calls to be bearish. A bull put spread is bullish because you are using puts to be bullish.
Bear Call Spread A bear call spread is also known as a credit call vertical. It involves selling a lower strike call and buying a higher strike call. For example, SPY is trading at $130. To put up a credit call vertical is to sell 1 Aug 131 call and buy 1 Aug 132 call. Since your short 131 call is nearer to the money, it will be worth more than your long 132 call and therefore, you end up receiving a credit. When you put up a credit call spread, you are bearish and believe that SPY will expire below $131 on expiration day. If SPY were to trade below $131 on expiration day, both your long and short calls will expire worthless and you get to keep the credit you received for initiating the trade. However, if SPY were to be trading at $133 on expiration day, you short 131 call will be worth $2 and your long 132 call will be worth $1. To close the trade you will have to buy back your short 131 call at $2 and sell your long 132 call for $1. You will lose the $1 difference minus any credit that you received earlier. Say you received $0.30 credit for initiating this trade, your loss would be $1 $0.30 = $0.70.
Maximum profit of a credit spread = the initial credit collected. Maximum loss of a debit spread = the difference between the strikes the initial credit collected.
Bull Put Spread A bull put spread is also known as a credit put vertical. It is short a higher strike put and long a lower strike put. For example, SPY is trading at $130 and you are bullish on SPY. You set up a credit put spread by selling a 129 put and buying a 128 put. If SPY is trading above $129 on expiration day, both your short and long puts will expire worthless and you get to keep the credit you received for initiating the trade.
A D V I S O R Y
S E R V I C E
However, if SPY were to be trading at $127 on expiration day, your short 129 put will be worth $2 and your long 128 put will be worth $1. To close the trade youll have to buy back your short 129 put at $2 and sell you long 128 put for $1. Your loss will be limited to the difference between the strikes ($1) minus the credit you received. Similar to debit spreads, credit spreads offer limited risk as well as limited profit potential. For debit spreads, the selling of a higher strike call or lower strike put serves as a way to reduce risk by reducing the cost of buying the long call or put. It can be regarded as a discount for buying the call or the put. To have the discount youll have to limit you profit potential.
Main Points
A short call (put) without any long hedge is called a naked call (put). A naked call (put) presents unlimited risk and thus requires high margin to maintain the position.
Similarly, for credit spreads, the buying of a higher strike call or lower strike put is also to reduce risk. The long options serves as a hedge against you short options. Without the long option hedge, you will be simply short a call or a put (a naked call or a naked put). A naked call or put position is highly risky and requires exorbitant margin. As we discussed earlier, the seller of an option is exposed to unlimited risk should the market goes against your favor. By buying a higher strike call or lower strike put, you effectively limit you risk to the difference between the two strikes. It is important to know that a debit spread is theta (the Greek for time decay) negative and vega (the Greek for implied volatility) positive, meaning it loses money as time goes by and make money as implied volatility increases. A debit spread only makes money when the underlying moves in your favor or the implied volatility increases. Conversely, a credit spread is theta positive and vega negative: it makes money as time goes by and when implied volatility drops. A credit spread makes money as long as the underlying does not breach the short strike. On expiration, whether you get to keep 100% of the credit you received depends solely on the price of the underlying. If you are unfamiliar with the Greeks, please read the Appendix on Introduction to the Greeks in Options Trading on page 34. It is vital that you have a solid understanding of vertical spreads because they are the building blocks of market neutral strategies such as Iron Condor and Double Diagonal.
A D V I S O R Y
S E R V I C E
Calendar Spread
Main Points
A net debit position does not require any margin because the most you can lose is the debit you paid when you initiated the trade. On the other hand, a net credit position requires a margin to maintain the position because you collected a credit.
A calendar spread (sometime known as time spread) involves the selling a near month option and buying a far month option with the same strike. Similar to verticals, a long calendar is a net debit while a short calendar is a net credit. Specifically, a long call calendar spread could be long SPY Nov 130 call and short Oct 130 call. Since the Nov 130 call has more time value, itll be worth more and thus, you end up a net debit since you have to pay more than you receive. Likewise, a long put calendar could be set up by going long a SPY Nov 130 put and short an Oct 130 put. A long calendar requires no margin as the maximum you can lose is the debit you paid to initiate the trade. A long calendar, whether call or put, has its maximum value when the price of the underlying is at the strike price of the options. Conversely, it has its minimum value when the price of the underlying is far away from the strike price of the options. A calendar spread is theta positive and vega positive: it makes money as time passes and when implied volatility rises. A calendar spread works under the principle that options lose its value fastest in the last 30 days of their lifespan. For example, you believe that SPY is going to be trading at $130 for the next 30 days. You can set up a calendar spread by buying the Nov 130 call at $3 and selling the Oct 130 call for $2. Your net cost for this trade would be $3 $2 = $1 debit. This is the most you can lose with this trade. Now, if SPY is indeed trading at or near $130 on October expiration, your short Oct 130 call will have no more time value left while your long Nov 130 call will have roughly about a months time value left. You can then buy back your Oct 130 call and sell your Nov 130 call for about $2, which is the same price of your short Oct 130 call when you initiated the trade. You will collect $2 for this roll and would have made a $1 profit on this trade. In this example, you paid $1 for this trade and make a profit of $1. This trade makes a percentage profit of 100%! Although a calendar spread has defined risk, the most you can lose is the debit you paid, it is not possible to know exactly how much you can make from the roll until you really do it. However, you can roughly estimate the value of the roll by looking at the value of the options in the current month.
A D V I S O R Y
S E R V I C E
Iron Condor
An iron condor is made up of a credit call spread and a credit put spread. It is a defined-risk strategy and is theta positive. Remember that a credit call (put) spread makes money as long as the underlying does not breach the short call (put). For a credit call spread, as long as the price of the underlying stays below the short strike, both the long and short calls will expire worthless and thereby allowing the trader to keep the credit he received when he initiated the trade. As such, the risk profile of a credit call spread looks like this:
Profit
Long strike Short strike Loss Price
For a credit put spread, as long as the price of the underlying stays above the short strike, both the long and short puts will expire worthless and thereby allowing the trader to keep the credit he received when he initiated the trade. As such, the risk profile of a credit put spread looks like this:
Profit
Long strike Short strike Loss Price
A D V I S O R Y
S E R V I C E
Combining the two vertical spreads would result in an iron condor.
Profit Short put strike Short call strike
Price
Loss
Long put strike
Long call strike
The maximum potential profit or loss is determined when you enter the trade. You can easily calculate the break-even points the moment you put up the trade. For example, lets say SPY is currently trading at $130 and it is about 30 days to the next expiration date. You believe that SPY is going to stay within the range of $127 and $133 for the next 30 days. You enter a 125/127/133/135 SPY Iron Condor for $1.00 credit. Specifically, you short an OTM credit call and put spread, that is:
Main Points
An iron condor is made up of a credit call spread and a credit put spread. The maximum potential profit and loss can be determined when the trade is entered.
Sell 133 SPY call Buy 135 SPY call Sell 127 SPY put Buy 125 SPY put
Credit call spread Credit put spread
Profit $100 126 125 -$100 Loss 127 133 134 135 Price
A D V I S O R Y
S E R V I C E
As shown in the risk profile, if SPY were to trade between the profit range of $126 and $134, this Iron Condor is profitable. However, if SPY were to trade beyond $134 or below $126 on expiration day, this condor will be a loser.
Break-Even Points
Lets take a look at how the break-even points of $126 and $134 are calculated. For the put side, remember that we are short the 127 put and long the 125 put. As long as SPY does not breach our short 127 put, the two puts will expire worthless on expiration day. However, if SPY were to trade below $127 but above $125, our short 127 put with have some intrinsic value. The exact value will depends on the price of SPY on expiration day. The same is true for our 133/135 call spread on the other end. Now, since we collected $1.00 credit when we put up this trade, well still profit if our short options (127 put and 133 call) are worth less than $1.00 on expiration day. For example, if SPY were to trade at $126.50 on expiration day, our short 127 put will be worth $0.50. The right to sell SPY at $127 when SPY is trading at $126.50 is worth $0.50 on expiration day. We can simply buy back our short 127 put for $0.50 and let the rest expire worthless. We would have made ($1.00 $0.50 = $0.50) $0.50 profit from this trade. The same is true for the call side. If SPY were to trade at $133.60 on expiration, our short 133 call will be worth about $0.60. The right to buy SPY at $133 when it is trading at $133.60 will be worth about $0.60 on expiration day. Now, we can simply buy back our short 133 call at $0.60 and make a profit of $0.40 for this trade. Since we have collected $1.00 credit when we initiated the trade, well make a profit as long as our short options (127 put and 133 call) is worth less than $1.00 on expiration day. However, if SPY were to be trading at $126 on expiration day, our 127 put will be worth about $1.00. Well break-even if we cover our short 127 put for $1.00. Similarly, well also break-even if SPY were to trade at $134 on expiration day since well have to buy back our short 133 call for $1.00. This is how we calculate our break-even points for an Iron Condor.
A D V I S O R Y
S E R V I C E
In short, Lower Break-even point = short put strike net credit received Upper Break-even point = short call strike + net credit received
These break-even points also tell us the profit range. As long as the underlying stays within these two points, the Iron Condor is a winner!
Capital Requirement
Even though a short Iron Condor is done for a credit, we still need capital to put up this trade. As mentioned earlier when we discussed vertical spreads, our brokers will need us to maintain a margin for such a position albeit our risk is limited. Margin required = Difference between the strikes Net credit received. Similar to a vertical spread, the maximum we can lose is the difference of the short and long strike. Since we received a credit for initiating the trade, our maximum loss will be reduced by the amount we collected in the beginning. Going back to our previous example, if SPY is trading at $124 on expiration day, both our short 127 and long 125 puts will be ITM. Our short 127 put will be worth roughly about $3.00 while our long 125 put will be worth roughly about $1.00. To close our put position to avoid assignment, well have to buy back our short 127 put at $3.00 and sell our long 125 put for $1.00 incurring a loss of $2.00. However, since we collected $1.00 for initiating this Iron Condor, our loss is only $1.00. Since our maximum possible loss is $1.00, our margin requirement will be $100 per contract. Because an Iron Condor is made up of two vertical spreads, some less-informed brokers will require margin for both your call and put spreads. Option orientated brokers, however, know that you can only lose on one side and require margin for only one of the spreads. You seriously should consider changing to a better broker if your current broker requires you to margin both sides for an Iron Condor.
A D V I S O R Y
S E R V I C E
Expected Returns
Iron Condors when set up properly can generate consistent profit month after month no matter where the market goes. As shown in the previous example, our maximum profit for that Iron Condor is $100 per contract and our maximum loss is also $100 per contract. In essence, we are risking $100 to make $100; our risk/reward ratio is 1: 1. If the probability of SPY trading between $126 and $134 is more than 50%, we can expect positive expected returns. What this means is: if we were to put up this trade month after month, we are guaranteed to profit in the long run. Yes, guaranteed! I dont use the word guarantee freely, but in this example, the mathematics behind the trade guarantees that it will make money in the long run. More accurately, it has to do with high school statistics. In high school statistics, we learnt that expected value (mean) is equal to the sum of the payoffs multiplied by its own probability. This can be summarized by this formula:
E =
P( = )
Now, lets say the probability of SPY trading between $126 and $134 is 51% when we initiated the trade (as illustrated in the diagram below).
Profit $100 126 125 -$100 Loss 127 51% 133 134 135 Price
Our risk/reward can be easily summarized by this table:
A D V I S O R Y
S E R V I C E
Payoff Probability
+$100 0.51
-$100 0.49
Our expected returns can then be calculated this way: Expected returns = (0.51)($100) + (0.49)(-$100) = $2 What this means is that we expect to make a positive return of $2 per trade. Whenever we have a positive expected return we say that odds are in our favor. By the Law of Large Numbers, if we keep playing this game with these odds forever, we are guaranteed to make money. Think about it this way. If you and a friend were to play a game of tossing coins: if it turns up head you win $1, tail you lose $1 to him. How much do you expect to win? Well, the answer will depend on how many times you are going to play. If you are only going to play this game once, you may win or lose that $1 with equal probability. That is 100% profit or loss on your risk! That is a 1:1 risk/reward ratio. Now, lets say you are going to play 1,000 rounds of this game. How much do you expect to win or lose? You dont have to be a math genius to guess the answer isnt it? The answer is zero. You dont expect to win or lose because you are expected to lose 50% of the time. Even if you play this game infinite number of times, you and your friend will get nothing more than tired fingers! The more rounds you play, the closer you will get to zero. The Law of Large Numbers states that! This scenario can be easily simulated by a scientific calculator. Let us change the situation a little, lets say you start with $50 and your friend starts with $10 to play this game until someone becomes bankrupt. Who do you think will become a bankrupt first? The answer is doubtlessly your friend! Even though the two of you have equal probability to win from each other, simply because you started with significantly more money than him, he will become bankrupt before you! Let us dwell into this a little further. Now lets say the coin is rigged, I dont know how you can rig a coin but let us just say that the coin is rigged, and it will turn up head 51% of the time (now you have a 51% chance of winning $1 for each round). Nothing changes; you will still start with $50 and your friend
A D V I S O R Y
S E R V I C E
with $10, your friend will still become a bankrupt before you. The only difference is hell become a bankrupt FASTER! This is precisely how casinos make money! It is common knowledge that all the games in a casino are not fair gamesthe house always has a better chance of winning! Even if the games are fair, you will still go bankrupt first if you play infinite number of rounds because you start with a smaller capital vis-vis the casino! The unfair games simply make you bankrupt at a faster rate! This is known as the Gamblers Ruin. Of course, youve heard stories of people who won millions from casinos. Yes, these stories are true and casinos always pay up promptly. Casinos dont lose any money by paying the winners because they know for sure the winners will come back and play some more and because the more they play the more they lose, the casinos will make back their money. Even if the winners dont return to play some more, the casinos will have thousands of other punters to pay for the winnings. That is the reason casinos are open 24 hours a day, 7 days a week. It is to ensure that the Law of Large Numbers works. That said, Iron Condors with positive returns are extremely difficult to find. But they do exist.
Risk/Reward Ratio (R3)
Main Points
Risk/Reward Ratio is known as R3.
At MarketNeutralOptions, we pay close attention to the very important Risk/Reward Ratio, which we term it R3 for short. You dont have to be a math genius to calculate this ratio. To put it simply, it is merely the number you get when you divide your risk by your reward potential. The purpose of this ratio is to let you have a good idea of the risk you are undertaking for the reward that you can get.
R3 =
Total Risk Total Potential Reward
It should not be too difficult to tell that the higher the R3, the higher the risk you are undertaking and therefore, the lower the R3, the lower the risk you are undertaking.
A D V I S O R Y
S E R V I C E
Do note that the R3 is most useful for trades with defined risk and profit. It will not be useful to use the R3 on a long call, which has unlimited profit potential, or a short put, which has unlimited risk.
Main Points
MarketNeutralOptions Advisory Service trades mainly 2 types of iron condor: high R3 iron condors and low R3 iron condors. When R3 is less than or equal to 2, it is a low R3 iron condor. When R3 is more than 2, it is a high R3 iron condor.
There are two types of iron condors that we trade here at MarketNeutralOptions. The High R3 and Low R3 iron condors. When an iron condor has a R3 of less than or equal to 2, it is a Low R3 iron condor. When an iron condor has a R3 of more than 2, it is considered a High R3 iron condor. High R3 Iron Condor For example, we can set up an iron condor with a profitable probability of 90% (see illustration below), maximum profit potential of $10 and maximum loss of $90. In this case, well be risking $90 to make $10. Therefore, the R3 for this 90 iron condor is 10 = 9. This R3 of 9 tells us immediately that were risking $9 for every $1 we make. As you can see from the P&L chart below, high R3 iron condors will almost always come with high probability of success. However, this is not a wise iron condor because we are risking too much to make too little.
Profit $10 Price
-$90 Loss
90%
At MarketNeutralOptions, we dont normally trade iron condors with a R3 of more than 5. Most of the time our high R3 iron condors have a R3 of between 3 and 4.5.
A D V I S O R Y
S E R V I C E
A typical iron condor with a R3 of 3 to 4.5 will have a P&L chart that looks like the one shown below (Chart 1).
Chart 1: RUT iron condor P&L. Main Points
We usually initiate high R3 iron condors about 30 to 40 days before expiration. We always try to aim for a probability of at least 68% for high R3 iron condors. High R3 iron condors have high risk but also high probability of success.
As you can see from chart 1, this is a 10-point wide iron condor trade on RUT for $2.30 credit. The maximum risk for this iron condor is $1,000 per position. Because we took in $230 in credit, our maximum risk for this iron condor is 770 reduced by $230 to $770. This iron condor has a R3 of 230 = 3.35. For high R3 iron condors, we usually aim for at least 68% probability of success. At 68%, we are aiming for one standard deviation range. We normally try to initiate such iron condors 30 to 40 days before expiration. It is a wellknown fact that options decay the fastest during their last 30 days. If we were to initiate such an iron condor with less than 30 days to expiration, it is very likely that well get a higher R3 if we want a probability of at least 68%. From the P&L chart above, you can see that we are risking $770 to make $230 with a probability of success of 71.34%. This gives us a negative expected value of $56.60 [($230 X 0.7134) ($770 X 0.2866)]. What this means is that we are losing $56.60 for every position we put up. Before you start thinking that its foolish to enter such a trade, you may wish to know that our high R3 iron condors such as this example provide the most consistent returns.
A D V I S O R Y
S E R V I C E
Although the probability theory paints a gloomy picture of this iron condor, the trick is in managing it! For high R3 iron condors, we have to be ever vigilant to major moves in the underlying. Because we are risking a lot more than we can profit, all it takes is to suffer a maximum loss to wipe out 3 or 4 winning months! If we were to practice a fire-and-forget strategy with such iron condors, we will be helplessly governed by the probability theory and be a guaranteed loser in the long run. The way to defy the mathematics is to introduce human intervention. By this I mean adjustments. The key lies in this: never ever suffer the maximum risk! Yes, thats it! Thats the great secret behind the consistent returns that weve been enjoying year in and year out. The devil is, as usual, in the details.
Main Points
Never suffer the maximum loss for high R3 iron condors. Always trade high R3 iron condors using index options or index-tracking EFT options. Be ready to adjust when the underlying gets too close to your short options.
First of all, it should be clear that the biggest enemy of a high R3 iron condor is major movement. This is why well normally avoid doing high R3 iron condor with stock options. In fact, at MarketNeutralOptions, we only use index options or index-tracking ETF options for our iron condors. This is because an index represents a basket of stocks and is less likely to gap. Individual stock options have the tendency to gap up or down when the company announces their earnings. Index options and index-tracking ETF options do gap sometimes but it is rare and less spectacular when compared with stock options. After we put up a high R3 iron condor, the next most important thing to do is to set up your defense. Think of your short options as your base camps and the current price as your enemy. As your enemy (current price) moves closer to your base camps, you would want to do something to prevent the enemy from overrunning your base camps! A high R3 iron condor is usually dead if your short Call or Put gets ITM. The idea is not to allow the short options to get ITM (not to allow the enemy to overrun your base camps) at all cost! To protect your base camps, we need to set up a perimeter that will provide a kind of advance warning. For those Tom Clancy fans, its like setting up a sentry or having an AWACS (Airborne Warning and Control System)! Lets use the previous example or the RUT iron condor (Chart 1). You can see from the P&L chart that we are shorting 860 Call and the 700 Put when the RUT is trading at about 778. We will normally go at least 3% of the current price away from our short options. In this case, 3% of 778 is about 23.34, therefore well set up our fences at 30 points away from our short strikes.
A D V I S O R Y
S E R V I C E
What this means is that were going to set a mental stop at 830 *860 30] and 730 [700 + 30]. When the RUT trades above 830 or below 730, it means that the enemy is getting too close for comfort. Well have to reassess the trade to decide the next course of action. Whether well adjust or close up the wing that is in danger all depends on the existing market conditions. Remember, our main objective is to prevent the enemy from overrunning our base camps (our short options become ITM). The way for high R3 iron condor to work in the long run is to be pro-active in managing the position. It is usually too late to adjust if the underlying trades pass your short options because you are risking a lot more than what you can make. Low R3 Iron Condor As mentioned earlier, by low R3 iron condor we are referring to an iron condor with a R3 of 1 to 2. Lets take a look at a typical low R3 iron condor (see Chart 2).
Chart 2: IWM iron condor P&L.
A D V I S O R Y
S E R V I C E
Main Points
A low R3 iron condor has lower risk but also lower probability of success. We should always aim for about 50% probability of success.
As you can see from the chart, this is a 2-point wide iron condor and thus, our maximum risk is $200 per position. But because we collected $0.93 credit ($93), our maximum risk will be reduced to $107. What this means is we are 107 risking $107 to make $93, which will give us a R3 of 1.15 [ 93 ]. From the chart we can also see that this iron condor has a 50.40% chance of being successful. Low R3 iron condors are less risky because we are risking about the same as what we can potentially make. However, this lower risk brings about a lower probability of success. How nice if we can have low risk and high probability at the same time! Well, there is always a tradeoff. Otherwise who would want to take our trade at the opposite end? Market-makers are not stupid you know! For this kind of low R3 iron condors, we expect and should aim for a probability of about 50%. The higher the R3, the higher the probability of success should be.
Main Points
Try not to adjust a low R3 iron condor. A low R3 iron condor can be initiated about 20 to 35 days before expiration. Use price as a guide to decide when to close the trade.
The difference between a low R3 and a high R3 iron condor lies mainly in the way we manage them. We normally initiate a low R3 iron condor about 20 to 35 days from expiration. When implied volatility (IV) is high, we can set up such an iron condor with only 20-odd days left to expiration. For low R3 iron condors, we normally avoid adjustments since any adjustment will most probably increase the risk. We can normally be more patient with low R3 iron condors. There is no need to set up defense for this kind of iron condors because we are not looking for signs to adjust. In fact, the way to deal with this kind of iron condor is use its price. Using the example from chart 2, when we initiated the trade, the iron condor was trading at $0.93. Well close up this trade when it starts to trade 40% to 50% more than what it was. In this case, well close up the trade when this iron condor is worth more than $1.30. Again the key is not to suffer the maximum loss. However, it can be very frustrating when the underlying falls back into the profitable range after you close the trade because it hits your stop.
Exit Strategy
When set up properly, it is best to leave the iron condors alone and let the positive theta do its magic.
A D V I S O R Y
S E R V I C E
It is possible to leave the condors to expire worthless if the underlying is far from the short strikes. However, it would be wise to close up the trade once it is trading at $0.20 or $0.30. Especially for high R3 iron condors, lock in your profit whenever you can. No point risking a winning trade to try to gain another $0.20 or $0.30! Usually it will be wise to close out the entire position in the last 10 days before expiration. You would have pocketed most of the profit if you can close it for $0.20 or less. In fact, when the market is trading low and your call spread is cheap, you can close up the call spread first and then close up your put side when the market bounces back up. Exiting this way will not incur higher margin. However, this exiting style may reduce your profit substantially when not done properly.
A D V I S O R Y
S E R V I C E
Double Diagonal
The set up of a double diagonal consists of shorting a call and put option in a near month and long a call and put option in a far month with different strikes. One can think of a diagonal spread as a combination of a vertical and calendar spread.
A typical vertical spread A typical calendar spread A typical diagonal spread
Call Aug 135 134 133 132 131

Main Points
A double diagonal is a combination of a vertical and calendar spread. A double diagonal can be initiated for a debit, credit or even money. Volatility skew between front month options and back month options should be as flat as possible.
Call Aug Long Short 135 134 133 132 131 135 134 133 132 131 Sep 135 134 133 132 131 Aug
Call Sep 135 134 Long 133 132 131
Short
Long
Short
For example, lets say SPY is trading at $130, a call diagonal spread could be initiated by selling the Aug 132 call and buying the Sep 134 call. Do the equivalent for the put side (sell Aug 128 put and buy Sep 126 put) and you have a double diagonal! A double diagonal can be initiated for a debit or a credit. A properly set up double diagonal should involve either a small debit or credit of not more than $0.30 per trade. In this example, the short 132 call serves as a hedge for the long 134 call. The credit received from the short 132 call is being used to offset the price of buying the long 134 call. Depending on the implied volatility at the moment, this can be done for a small debit, for free or even a small credit. There is a strong temptation to search for skews in implied volatility between the near month and far month options to get a credit. In fact, some options coaching programs out there specifically teach their students to look for such skews! However, it must be emphasized that the rise in the implied volatility in the front month also heightens the possibility of a large price movement in one direction or the other. Always believe that the market makers are as well informed as you if not better informed. The spike in IV for the front month options is there for a reason. Especially for individual stock options, it could be some imminent bad news or some takeover bid by rival companies that are
A D V I S O R Y
S E R V I C E
not made public yet and thus the fear associated with it. It is generally a good idea to avoid large implied volatility skews. When we set up a double diagonal, we would want to have a flat implied volatility skew between the front and back months. Of course that is not always possible but we try to have it as flat as possible.
Roll
Main Points
The roll turns a double diagonal into an iron condor. Roll a double diagonal when the short options have very little time value left.
How does a double diagonal make money? The answer to that lies in the ability to roll the double diagonal into an iron condor. Lets say SPY is trading at $130 and we initiated a double diagonal by selling an Aug 132 call and an Aug 128 put and buying a Sep 134 call and a Sep 126 put for $0.10 credit. We can get a credit for this trade because the options we sold are nearer to the money (worth more) than the ones we bought even though the ones we bought have more time value. About 10 days before August expiration, lets say SPY is still trading at $130, our short options (132 call and 128 put) will be worth very little since they are not ITM and there is little time value left. We can now buy back our short Aug 132 call and Aug 128 put for a small debit (since they are worth very little now) and sell Sep 132 call and Sep 128 put. Since the September options have roughly about a months time value, theyll be worth a lot more than their August counterparts. By making this roll, we will receive more credit for the position. After the roll, we are now short Sep 132 call and Sep 128 put and long Sep 134 call and Sep 126 put. We are now short an iron condor! Why dont we simply put up an Iron Condor? When we put up an iron condor, much of the credit from the sale of the short options goes to purchasing the long options. For a double diagonal, we are basically setting up our iron condor a full month ahead. Think about it as we are setting up a September iron condor by buying the September long options first. We then sell the August options to finance our purchase of the long options for our September iron condor. This way, we
A D V I S O R Y
S E R V I C E
Main Points
An iron condor that was a result of a double diagonal roll is almost always a better priced iron condor that is impossible to attain by simply putting up the same iron condor trade.
can purchase our long options for our September Iron Condor at a very low price, in some cases, maybe even free! When we roll our double diagonal into a full iron condor, the amount of credit we get will not be reduced by the need to purchase the long options. At the point of rolling, the credit we get for the September iron condor is usually unattainable by simply shorting the same Iron Condor at that time. What this means is that well get an iron condor for September for a very good price. It is generally not advisable to put up an iron condor more than 40 days away. Although we are, in effect, setting up a September iron condor even before August expiration, we are not taking a paramount risk for this trade. This is because we will not suffer our maximum loss at least until September expiration. Our long options will always be worth some value before September expiration. Even things goes horribly wrong, we can choose to close the trade before we roll and we lose the small debit we paid to initiate the trade. If we received a small credit for initiating the trade, we may even come out totally unharmed after commissions. However, do note that in extreme market conditions, there may be an extreme spike in IV for the front month, and we may incur losses more than the debit we paid to initiate the trade to close up the trade. This is rare but not impossible. Although a double diagonal is long vega (makes money when IV goes up), a more extreme spike in IV for the front month as compared to the back month will be detrimental to the position. This is because the spike in IV may cause the value of the front month (short) options to increase more than the back month (long) options. When to roll? It is generally advisable to roll the short front month options in the last 10 days of their lifespan. This is when they are the cheapest if they are not ITM or near the money. When you can buy back the short options for $0.15 or $0.10, it is a good time to roll. At the point of rolling, if the underlying is trading very near your short strikes, you may want to consider rolling up your call strikes or rolling down your put strikes since it will still be quite some time for the next expiration to come. Shorting an Iron Condor when the price of the underlying is so near the short strikes is often not a good idea. Alternatively, you may choose to close up the entire trade for a small gain, a small loss or even-money. This is the cool part about double diagonal, even if you are dead wrong, you wont suffer a huge loss. You may even have a small gain!
A D V I S O R Y
S E R V I C E
Capital Requirements
Similar to an iron condor, a double diagonal requires margin. Unlike an iron condor, whereby the maximum profit and loss is known at the moment of initiating the trade, a double diagonals maximum profit potential can only be estimated at the moment of initiation. The maximum profit of a double diagonal will be known only at the point of rolling. As such, the margin requirement of a double diagonal will be the maximum you can lose from this trade, that is, the difference between the strikes. For our previous example, we initiated a double diagonal by selling the Aug 132 call and Aug 128 put and buying the Sep 134 call and Sep 126 put for $0.10 credit, our margin requirement will be (134 132 0.10 = 1.90) $190. Margin required = Difference between the strikes Net credit received. Margin required = Difference between the strikes + Net debit paid.
Characteristics of a Double Diagonal
Like the iron condor, a double diagonal is market neutral and theta positive. Both strategies make money when the market trades within a range and as time passes. A double diagonal is vega positive before the roll and vega negative after the roll. What this means is that a double diagonal increases in value before the roll when implied volatility rises and loses value after the roll when implied volatility rises. A properly set up double diagonal should have a delta close to zero. You can adjust the actual delta value by adjusting the distance between your short strikes and the current price. For example, SPY is trading at $130 and you think that SPY is going down. You want to have a directional bias in your double diagonal. You can do so by moving your short call closer to $130 and your short put further from $130 to generate more negative delta. If you have a directional bias, a double diagonal is generally not a suitable strategy to deploy. A double diagonal and iron condor are best suited for market neutral stance. Verticals will be more appropriate for directional plays.
A D V I S O R Y
S E R V I C E
Conclusion
Many people tend to ask: which is better? Iron Condor or Double Diagonal? Neither is better than the other, they are just different. When you use them depends on market conditions. The best way to really learn them is to trade them. Enter the trade, watch how it makes money and try to do it again and again. Your learning journey will be much less tedious if you have someone guiding you. I sincerely hope that this e-book has in one way or another benefited you in learning Iron Condor and Double Diagonal. Options trading is a never-ending journey. I wont claim to know everything about options trading but I do know this much to be able to share with you. MarketNeutralOptions is glad to be able to play a small part in your journey to financial freedom.
A D V I S O R Y
S E R V I C E
Appendix: An Introduction to the Greeks in Options Trading
raders enter the market with two main preoccupations: risk and reward. While it is usually easy to determine the reward in monetary sense, it is generally more difficult to determine the risk involve in each trade.
Unlike stock, options are multi-dimensional investment vehicles. The value of an option is determined by many different factors that are constantly changing. For example, an options value is determined by the current price of its underlying, its strike price, the time left to expiration, volatility, dividend and interest rates. An option trader is therefore exposed to multi-dimensional risks. A successful option trader is a good risk manager as many would say. It is thus critical that an option trader can identify his risks at a glance. Mathematical equations have been developed to help identifying these risks. They are the Greeks in options trading. The Greeks are essentially mathematical outputs of the option-pricing model.
The Delta
The delta measures the rate of change of the price of the option relative to the price of the underlying. A long position has positive delta while a short position has negative delta. This implies that positive delta positions make money when the stock price goes up while negative delta positions make money when the stock price goes down. When you buy a call with +0.8 delta, you will be long 80 delta since 1 call contract represents 100 shares of stock. Therefore, when you buy 2 call contracts, you will be long 160 delta. When you are long (positive) 80 delta, it means that your position will make (in theory) $0.80 for every $1 the stock advances. It also means that your position will lose (again in theory) $0.80 for every $1 the stock falls. It basically behaves like 80% of the stock. When you buy a put, you will be short (negative) delta and your position makes money when the stock falls. If the stock rises when you are short delta, your position loses money.
A D V I S O R Y
S E R V I C E
Long Delta = Make money when stock price goes up (Bullish position) Short Delta = Make money when stock price goes down (Bearish position) Since buying (long) a call generates positive delta, selling (short) a call generates negative delta, which implies that when you sell a call, you want the stock to go down. Similarly, since buying a put generates negative delta, selling a put generates positive delta (you want the stock to go up). Depending on the strike price of the option and the current stock price, the delta of an option can take a value of between -1.0 to +1.0. An option with a delta of +1.0 behaves exactly like the stock since its price increases by $1 for every $1 increase in the stock price. A deep in-the-money (ITM) option will have a delta of close to +1.0. For example, SPY is currently trading at 130.80. A current month SPY 100 call option will therefore be deep (ITM) with 3 weeks to expiration. This SPY 100 call will thus have a delta of close to +1.0. If SPY were to advance by $1, the price of the 100 call will also advance by $1 to reflect the increase in its intrinsic value. On the other hand, far out-of-the-money (OTM) options will have a delta value of close to 0 since a $1 move will not have a great effect on its intrinsic value. For example, SPY is currently trading at 130.80. A current month SPY 200 call option will therefore be far OTM with 3 weeks to expiration. If SPY were to advance by $1, it is unlikely that the price of the 200 call will increase at all since it is so far OTM. Buying a share of the stock always generates +1.0 delta and selling a share of the stock always generates -1.0 delta. Some professional traders like to use delta as a proxy to the probability of the option expires ITM. Different traders have different opinions as to how accurate or inaccurate that is. Remember that delta is only a theoretical approximation of your risk exposure to market movements. The value of your positions depends on many other constantly changing factors. But the delta offers, in a glance, your position risk to market movements.
A D V I S O R Y
S E R V I C E
In summary, the delta represents the directional risk of your positions.

Gamma
The gamma is sometimes known as the curvature of an option. It is the rate of change of the delta relative to the stock price. If you think of delta as the first derivative, then gamma is the second derivative. You get long gamma when you long (buy) options whether they are calls or puts and you get short gamma when you short (sell) options whether they are calls or puts. Gamma is the highest for the near-term at-the-money (ATM) options. One good way of interpreting gamma is that long gamma manufactures deltas in the direction the stock is moving. That is why long delta positions get more positive delta when the stock rises and short delta positions get more negative delta when you are long gamma. For example, say you are long 100 delta (+100 delta) and long 50 gamma (+50 gamma). If the stock advances by $1, your long 100 delta tells you that your positions make $1 while your long 50 gamma tells you that your delta value will increase by 50. On the other hand, say you are short 100 delta and long 50 gamma. Now, the stock falls by $1. Your short 100 delta tells you that your positions make $1 while your long 50 gamma tells you that your delta value will decrease by 50. In short, long gamma adds on to your delta value when the market moves in your favor. Long delta will get more positive delta while short delta will get more negative delta. Short (negative) gamma does the opposite. When you are long delta and short gamma, your delta reduces when the stock moves in your favor and vice versa.
Stock price Delta Gamma
Up Down Up Down Up Down Up Down
+ (gets more + delta: delta increases) + (gets more delta: delta decreases) (gets more + delta: delta increases) (gets more delta: delta decreases) + (gets more delta: delta decreases) + (gets more + delta: delta decreases) (gets more delta: delta increases) (gets more + delta: delta decreases)
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+ + + +
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A D V I S O R Y
S E R V I C E
In short, a small gamma, positive or negative, wont change your delta much. However, a large gamma, positive or negative, can change your delta by a great magnitude and should be closely monitored.
Theta
The theta, also known as time decay factor, is the rate at which an option loses value as time passes. It is expressed in dollar value. Long options, calls or puts, have negative theta since long calls and puts lose time value as time passes. Short options, calls or puts, on the other hand, have positive theta since short options positions make money as time passes. Negative theta means you lose money as time passes while positive theta means you make money as time passes. Since long options generates long gamma and have negative theta and short options generates short gamma and have positive theta, theta and gamma are inversely proportionate. When your gamma is big and positive, your theta will be big and negative and vice versa. In general, theta tells you how much your positions cost you per day when you have negative theta. Conversely, it tells you how much your positions are generating per day when you are positive theta.
Vega
Vega is not a Greek letter. It has to be because vega will be easier to remember to represent volatility because of the same first letter. Greek or not, vega measures the rate of change of the price of an option for a 1 unit change in volatility. Long options, calls and puts, have positive vega and make money when implied volatility rises. On the other hand, short options, calls and puts, have negative vega and make money when implied volatility falls. Implied volatilities rise and fall, sometimes in great magnitude. It is often called the fear index. When there is great fear in the market, implied volatilities tend to rise and when there is complacency in the market, implied volatilities tend to subside. The more time there is to expiration, the higher the vega is for an option. Similar to gamma and theta, vega is highest for at-the-money (ATM) options. Therefore, ATM options are most sensitive to implied volatility fluctuations.

Market Neutral Options Strategy Guide

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Strategy Guide

A guide to successful options trading

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DISCLAIMER AND WAIVE R OF CLAIMS

Appendix: An Introduction to the Greeks in Options Trading .. 34

Introduction to the Basics of Options Trading

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What are options?

Table 1: A typical option chain

ITM ITM ITM ATM OTM OTM OTM

87.5 90 92.5 95 97.5 100 102.5

OTM OTM OTM ATM ITM ITM ITM

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Table 2: Google option chain when Google is trading at $684.16.

Source: Screenshot taken from thinkorswim trading platform.

Basic Options Trading Strategies

Basic Building Blocks A Spread

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Long strike Short strike Loss Price

Long strike Short strike Loss Price

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Combining the two vertical spreads would result in an iron condor.

Profit Short put strike Short call strike

Long put strike

Long call strike

Credit call spread Credit put spread

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Our risk/reward can be easily summarized by this table:

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Total Risk Total Potential Reward

Profit $10 Price

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Source: Screenshot taken from thinkorswim trading platform.

Source: Screenshot taken from thinkorswim trading platform.

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Call Aug 135 134 133 132 131

Call Sep 135 134 Long 133 132 131

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Appendix: An Introduction to the Greeks in Options Trading

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In summary, the delta represents the directional risk of your positions.

Up Down Up Down Up Down Up Down

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