Option Spread Strategies

Mechanics and Real World Opportunities

Carley Garner 1-866-790-TRADE cgarner@decarleytrading.com www.DeCarleyTrading.com

AUTHOR, ANALYST, BROKER, COLUMNIST

There is substantial risk of loss in trading futures and options!

A CRASH COURSE IN THE BASICS

Options provide traders with options

Options are incredibly versatile Through a combination of long and short calls and puts it is possible to create various levels of risk, reward, and leverage

Call option

The right, but not the obligation, to buy a specific commodity at a specified price during a specified period of time. Bullish
The option to buy

Put option

The right, but not the obligation, to sell a specific commodity at a specified price during a specified period of time. Bearish
The option to sell

Two types of options

7

Option Premium
The price paid by the buyer to the seller for the right to buy or sell the underlying futures contract. Higher market volatility translates into higher option premiums More time to expiration equates to more valuable options Market demand can increase the value of options beyond what can be justified.

Buy low, sell high

Be a net buyer of options

Low volatility markets Markets that arent getting attention (low demand for options)

Be a net seller of options

High volatility markets Markets surrounded by hype (high demand for options)

Be fearful with others are greedy, and greedy when others are fearful. ~ Warren Buffet

Options on Futures

Underlying asset is leveraged No dividends range bound Standardized contracts, but not point values

Options on Stocks

Expiration of underlying asset

Favorable tax consequences, 60/40% blend between longterm and short-term gains Single profit/loss figure reported to IRS

Non-leveraged underlying If exercised/assigned can hold underlying indefinitely Dividends favor uptrend All stock options involve same calculations Unfavorable tax consequences, mostly short-term capital gains. Cumbersome task of reporting the results of each individual trade to the IRS

Not all options are created equal

10

Options on Futures

Readily available margin no minimum account size No interest charged on borrowed/margined funds Commission charged round turn Nearly 24-hour market access Direct and efficient speculation on underlying

Options on Stocks

Not All options are created equal

Must apply for margin account and meet minimum Most must pay broker interest (4 9%) Commission charged by ticket Market access only 10 hours per day (including pre-market and afterhours) Indirect speculation (ETFs)

11

THE LONG AND SHORT OF OPTIONS

12

Options are eroding assets

Each minute that passes reduces the value of any particular option

Buying an option is similar to buying a car and watching the value plummet as it is driven off of the lot
Time works against the buyer but in favor the seller
Options are eroding assets to buyers Options are eroding liabilities to sellers

13

Long Option Strategy

Limited Risk Unlimited Reward Eroding Asset Unfavorable Odds

Time is against you

Short Option Strategy

Unlimited Risk Limited Reward Eroding Liability Favorable Odds

Time is on your side Roughly 20% expire in-themoney

Similar to buying insurance, or lottery tickets

Approximately 80% expire worthless

Similar to selling insurance, or lottery tickets

Options are priced to lose

14

What is an option spread?

A spread is a combination of long or short options that together work towards a common goal
Often involves a primary long option, surrounded by short options to finance the trade The position is inherently hedged

Primary long option determines bullish (call) or bearish (put) As market goes up or down, some legs of spread will benefit and others will counter
15

Why option spread trading?

Spread traders enjoy the best of both worlds

Spread trading enables a reduction of market volatility relative to outright futures trading Option spreads can be created as a means of accomplishing various degrees of aggression in price speculation Spread traders can reduce their cost, and arguably their risk, through the sale of options around their primary long call or put
16

Why option spread trading?

Use the markets money to buy options not your own For every option purchased, sell at least one, but maybe two, in order to finance the trade This premise attempts to take advantage of the dismal odds facing long options

17

RATIO SPREADS

18

Ratio spreads

A ratio spread is one in which a trader simultaneously holds an unequal number of long and short positions.
Most common ratio is a 1 by 2, or two short options for each long with the short options sharing the same strike price

Front Spread Most typical, buying a close-to-the-money option and selling two equidistant out-of-the-money options Back Spread Selling a close-to-the-money option and buying two equidistant out-of-the-money options

Not a recommended strategy, profit only occurs in quiet market or in the case of a large move but a loss occurs with a moderate price move
19

No limit to the possibilities

Ratio spreads can be constructed in an infinite number of ways

May involve limited or unlimited profit potential Will always involve theoretically unlimited risk
More short options = More risk
One by threes, one by fours, etc. Not a recommended strategy Long option is expensive and offers little help in explosive market, better off selling less options
20

Using the markets money

The premise of a ratio spread is to finance a long option position with premium collected for short options
Assuming that more options than not expire worthless; the odds of success must be better for a spread in which two options are sold for every option purchased

21

Debit

Depending on the strike prices, months chosen and structure, ratio spreads can be filled at:
Credit

Trader pays more premium for long options than is collected for short Equal premium paid for long options as collected for short options

Trader collects more premium from short options than is paid for long

EVEN MONEY

Net premium
22

1 by 2 Call Spread

1 by 2 Put Spread

Buy close-to-the-money call Sell 2 out-of-the-money calls at the same strike price
Bullish One naked call Risk in being too right, market rallies Difficult to exit entire spread with desirable profit before expiration Open for adjustments

Buy close-to-the-money put Sell 2 out-of-the-money puts at the same strike price
Bearish One naked put Risk in being too right, market drops Difficult to exit entire spread with desirable profit before expiration Open for adjustments

Ratio spreads
23

1 x 2 ratio write

Unlimited Risk Limited Profit Potential Low out of pocket expense Large profit zone Best when executed in highly volatile market
Preferably the long option should be with the trend and the short options countertrend
This enables traders to collect top dollar for the short options, pushing the break-even point and risk farther from the market. Not recommended as a counter-trend strategy Can be used for free insurance
The trend is only your friend until it ends!

24

1 by 2 call spread

25

1 by 2 ratio call spread

26

Ratio Risk management

1 by 2 ratio spreads are challenging in volatile markets because the extrinsic value, or implied volatility, of the two short options can engulf profits on the long option.

Shouldnt be used if large move is expected Shouldnt be executed in quiet markets

27

Ratio Risk management

Traders establish where their risk lies by determining the breadth of the spread and the net premium paid

Constructing a narrow spread reduces the cost and shifts the first break even point favorably but shifts the second break even point unfavorably Accepting low premium for short options (low implied volatility) increases losses sustained in an exploding market
28

CONVERTING TO A BUTTERFLY

29

Iron Butterfly

A 1 by 2 ratio spread can be converted into an Iron Butterfly by simply purchasing an equidistant option to limit risk exposure.

Creates a limited risk debit spread Relatively small profit zone If spread held intact, difficult to liquidate with a respectable profit until near expiration

30

Call Fly

Buy 1 close-to-the-money call Sell 2 out-of-the-money calls at the same strike Buy 1 equidistant out-ofthe-money call
Bullish Range trade Limited risk (if held intact) Open for adjustments

Put Fly

Buy 1 close-to-the-money put Sell 2 out-of-the-money puts at the same strike Buy 1 equidistant out-ofthe-money put
Bearish Range trade Limited risk (if held intact) Open for adjustments

Iron Butterfly
31

Iron butterfly

32

DEBIT SPREADS AND VARIATIONS

33

Bull Call Spread

Buy close-to-the-money call Sell out-of-the-money call

Bullish Cost mitigated but still expensive

Bear Put Spread

Buy close-to-the-money put Sell out-of-the-money put

Bearish Cost mitigated but still expensive

Distant break even point

Distant break even point

Most Common Debit Spreads

34

Bull call and Bear Put spreads

Limited Risk Limited Reward Best used as counter trend strategy

Large out of pocket expense, creates a distant break even point and in many cases less than attractive odds of success

35

Financing the trade

36

Financing the trade

X $50

37

EXCHANGE CALCULATED RISK FOR BETTER ODDS

38

Why stop there?

A bull call spread trader could sell an additional call with a distant strike to reduce the cost of the primary position (long call) even more

This is often referred to as a Christmas Tree, and is a version of a ratio spread (same strike would be a 1x2 ratio write)

39

Swapping risk and reward

The goal of selling premium is to increase the odds of success by accomplishing two things

Shifting the break-even point closer-to-the-money Lowering the out of pocket expense of the trade (dont forget that more options than not expire worthless) The benefits are not without additional risk
Lower costs increases maximum profit Swapping lower cost and better odds for unlimited risk for being too right
40

Carefully choose risk point

You cant control the market, but you can control your risk points

When using short options to finance a primary long option, place strike and unlimited risk beyond pre-determined support and resistance areas! Make sure that you are collecting enough premium, net of commission, to make the risk worth the reward
41

Sell more premium to shift BE!

42

New cost of trade

Cost of spread = Premium paid Premium collected

9.25 cents ($462.50) = 36 (16.75 10) Bull call spread payout doesnt change, but reduced cost lowers break even point and provides a larger profit and profit zone.
New max loss if spread expires worthless Moderate margin on naked short $10.80 call

43

Increase profit potential

44

An alternative

Rather than selling an additional call, the bull call spread trader could have sold a put to finance the primary position.
Bull Call Spread financed with a short put, another version of a ratio spread Shifts unlimited risk to downside of market Increases the delta of the trade (aggression) Requires more margin

45

Bull Call Spread with a Naked Leg

46

Cost of the spread

Cost of spread = Premium paid Premium collected

9.125 cents ($456.25) = 36 (16.75 10.125)

Max loss if spread expires worthless, this occurs with the futures price between the strike of the primary long call and the short put Naked short put involves margin Bull call spread payout doesnt change, but reduced cost lowers break even point and provides a larger profit and profit zone.
47

Bull Call with a naked leg

48

AVOID COMMON PITFALLS

49

Stick with liquidity

Not all commodity option markets have ample liquidity for speculation Markets with attractive liquidity
Lumber Copper

Corn, soybeans, wheat Treasuries 10-year notes, 30-year bonds Stock indices S&P (Russell and NASDAQ questionable but decent bid/ask spreads)
50

Know the product

It is imperative that traders know the products they are trading

Market hours Venues (open outcry, electronic) Cash settle or futures exercise/assign (stock index quarterlies)

51

Consider open outcry execution

Most option markets offer two methods of execution

Open outcry Best for spread trading, in some markets or circumstances tighter bid/ask spreads Electronic Convenient and optimal in liquid markets and in supportive circumstances

During periods of event risk (Fed announcement, employment report, etc), the market makers often pull their bids and offers. This creates wide bid/ask spreads, for this reason it is important to have access to open outcry.
52

Open outcry execution often involves higher commission rates and incremental floor brokerage fees
This shouldnt be a deal-breaker
In most markets, if a floor broker can save you only 1 tick in your fill you have already covered the additional transaction costs The ability to place limit orders on option spreads might prevent you from being forced to accept prices on one leg of the spread once the other is filled
Creates a more controlled, efficient and monetarily favorable trading environment
53

Dont trip over pennies chasing dollars

Choosing the right brokerage

Access to open outcry options is a must

Even if your primary method of execution is electronic options, having the choice to use the alternative venue is critical Most broker/dealers and discount brokers do not have access to open outcry!
If you think that commission is expensive, try getting what you pay for.

54

Choosing the right brokerage

Discount brokerage firms cant afford to provide clients with margin leeway and are often quick to force liquidate shorts options and futures positions
In the spring of 2009, Fed announcement triggered 7 handle bond rally
Un-named discount broker force liquidated several clients that were short bond calls, many werent on a margin call, nor where they in danger of going negative The unnecessary liquidation likely causes hundreds to thousands of dollars in losses in effected accounts
If paid to the right brokerage, commission is an investment not an expense!

55

Dont blindly follow gurus

Dont believe everything that you hear or read

Even the experts can be wrong at times, so do your homework and use reasonable position sizing Your trades must be your decisions, otherwise premature panic liquidation or putting too much faith in someone else can cause emotional turmoil and potentially large losses.
56

Is the trend really your friend?

If the goal is to buy low and sell high, option traders might be better off counter trend trading

Markets in an up-trend to have expensive calls and cheap puts Markets in a down-trend often have overvalued puts and cheap calls

57

MARGIN AND OPTION TRADING

58

How short options are margined

Short option margin is calculated by a software program exclusively owned by the CME Group

SPAN Standard Portfolio Analysis of Risk

All positions in a trading account that are cleared on the same exchange are netted to find an overall risk and are margined accordingly
Therefore, margin on strangle is the same as one sided short option There is only risk of loss on call or put, not both

59

How short options are margined

Cash collected from short options is used toward margin

$10,000 starting balance + $2,000 short option premium = $12,000 account equity used toward margin
This method of margining benefits short option traders as they put positions on, but will work against them if margin trouble ensues

60

Managing margin

Short option traders should avoid overleveraging

50% margin to equity is ideal Explosions in volatility will result in premature liquidation in under capitalized accounts as premium and margin increases
An otherwise profitable trade might suffer a realized loss at the hands of a temporary price spike

61

Getting a margin call

Think of a margin call as a friendly reminder that you should lighten up, it isnt the end of the world

Buying back short options to alleviate a margin call is often counterproductive due to the way short option premium is accounted for
Lower the delta by adjusting the trade not exiting
Buying options with distant strike prices, or nearer expirations Buying or selling futures in the opposite direction of the short option

62

Conclusion

Options are versatile in regards to both risk and reward Trading options on futures involves several benefits over stock option speculation Traders can shift the odds of success in their favor through the use of short options Margin calls are a reminder to adjust the risk exposure but arent a reason to panic
63

AVAILABLE AT TRADERSLIBRARY.COM

Hidden behind the warm and fuzzy palaver is fierce intelligence and an aggressive stanceCommodity Options is a real wolf in sheeps clothing. - Phyllis Feinberg, The Investment Professional

64

Carley Garner 1-866-790-TRADE cgarner@decarleytrading.com www.DeCarleyTrading.com

65