from the strike price in either direction, the higher the net value of the
options.
Above $70, the call has value. If the underlying is at $74.25 at expiration,
the put will expire worthless, but the call will be worth 4.25—the price
initially paid for the straddle. Above this break-even price, the trade is awinner, and the higher, the better. Below $70, the put has value. If the
underlying is at $65.75 at expiration, the call expires, and the put is worth
4.25. Below this breakeven, the straddle is awinner, and the lower, the
better.
Why It Works
In this basic example, if the underlying is beyond either of the break-even
points at expiration, the trade is awinner. The key to understanding this is
the fact that at expiration, the loss on one option is limited—it can only fall
to zero—but the profit potential on the other can be unlimited.
In practice, most active traders will not hold astraddle until expiration.
Even if the trade is not held to term, however, movement is still beneficial
—in fact, it is more beneficial, because time decay will not have depleted
all the extrinsic value of the options. Movement benefits the long straddle
because of positive gamma. But movement is arace against the clock—arace against theta. Theta is the cost of trading the long straddle. Only pay it
for as long as necessary. When the stock’svolatility appears poised to ebb,
exit the trade.
Exhibit 15.2 shows the P&(L) of the straddle both at expiration and at the
time the trade was made.

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EXHIBIT 15.2 Long straddle P&(L) at initiation and expiration.
Because this is ashort-term at-the-money (ATM) straddle, we will
assume for simplicity that it has adelta of zero. 1 When the trade is
consummated, movement can only help, as indicated by the dotted line on
the exhibit. This is the classic graphic representation of positive gamma—
the smiley face. When the stock moves higher, the call gains value at an
increasing rate while the put loses value at adecreasing rate. When the
stock moves lower, the put gains at an increasing rate while the call loses at
adecreasing rate. This is positive gamma.
This still may not be an entirely fair representation of how profits are
earned. The underlying is not required to move continuously in one
direction for traders to reap gamma profits. As described in Chapter 13,
traders can scalp gamma by buying and selling stock to offset long or short
deltas created by movement in the underlying. When traders scalp gamma,
they lock in profits as the stock price oscillates.
The potential for gamma scalping is an important motivation for straddle
buyers. Gamma scalping astraddle gives traders the chance to profit from astock that has dynamic price swings. It should be second nature to volatility
traders to understand that theta is the trade-off of gamma scalping.

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The Big V
Gamma and theta are not alone in the straddle buyer’sthoughts. Vega is amajor consideration for astraddle buyer, as well. In astraddle, there are two
long options of the same strike, which means double the vega risk of asingle-leg trade at that strike. With no short options in this spread, the
implied-volatility exposure is concentrated. For example, if the call has avega of 0.05, the put’svega at that same strike will also be about 0.05. This
means that buying one straddle gives the trader exposure of around 10 cents
per implied volatility (IV) point. If IV rises by one point, the trader makes
$10 per one-lot straddle, $20 for two points, and so on. If IV falls one point,
the trader loses $10 per straddle, $20 for two points, and so on. Traders who
want maximum positive exposure to volatility find it in long straddles.
This strategy is aprime example of the marriage of implied and realized
volatility. Traders who buy straddles because they are bullish on realized
volatility will also have bullish positions in implied volatility—like it or
not. With this in mind, traders must take care to buy gamma via astraddle
that it is not too expensive in terms of the implied volatility. Awinning
gamma trade can quickly become aloser because of implied volatility.
Likewise, traders buying straddles to speculate on an increase in implied
volatility must take the theta risk of the trade very seriously. Time can eat
away all atrade’svega profits and more. Realized and implied exposure go
hand in hand.
The relationship between gamma and vega depends on, among other
things, the time to expiration. Traders have some control over the amount of
gamma relative to the amount of vega by choosing which expiration month
to trade. The shorter the time until expiration, the higher the gammas and
the lower the vegas of ATM options. Gamma traders may be better served
by buying short-term contracts that coincide with the period of perceived
high stock volatility.
If the intent of the straddle is to profit from vega, the choice of the month
to trade depends on which month’svolatility is perceived to be too high or
too low. If, for example, the front-month IV looks low compared with
historical IV, current and historical realized volatility, and the expected
future volatility, but the back months’ IVs are higher and more in line with
these other metrics, there would be no point in buying the back-month

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Trading the Long Straddle
Option trading is all about optimizing the statistical chances of success. Along-straddle trade makes the most sense if traders think they can make
money on both implied volatility and gamma. Many traders make the
mistake of buying astraddle just before earnings are announced because
they anticipate abig move in the stock. Of course, stock-price action is only
half the story. The option premium can be extraordinarily expensive just
before earnings, because the stock move is priced into the options. This is
buying after the rush and before the crush. Although some traders are
successful specializing in trading earnings, this is ahard way to make
money.
Ideally, the best time to buy volatility is before the move is priced in—
that is, before everyone else does. This is conceptually the same as buying astock in anticipation of bullish news. Once news comes out, the stock
rallies, and it is often too late to participate in profits. The goal is to get in at
the beginning of the trend, not the end—the same goal as in trading
volatility.
As in analyzing astock, fundamental and technical tools exist for
analyzing volatility—namely, news and volatility charts. For fundamentals,
buy the rumor, sell the news applies to the rush and crush of implied
volatility. Previous chapters discussed fundamental events that affect
volatility; be prepared to act fast when volatility-changing situations present
themselves. With charts, the elementary concept of buy low, sell high is
obvious, yet profound. Review Chapter 14 for guidance on reading
volatility charts.
With all trading, getting in is easy. It’smanaging the position, deciding
when to hedge and when to get out that is the tricky part. This is especially
true with the long straddle. Straddles are intended to be actively managed.
Instead of waiting for abig linear move to evolve over time, traders can
take profits intermittently through gamma scalping. Furthermore, they hold
the trade only as long as gamma scalping appears to be apromising
opportunity.

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Legging Out
There are many ways to exiting astraddle. In the right circumstances,
legging out is the preferred method. Instead of buying and selling stock to
lock in profits and maintain delta neutrality, traders can reduce their
positions by selling off some of the calls or puts that are part of the straddle.
In this technique, when the underlying rises, traders sell as many calls as
needed to reduce the delta to zero. As the underlying falls, they sell enough
puts to reduce their position to zero delta. As the stock oscillates, they
whittle away at the position with each hedging transaction. This serves the
dual purpose of taking profits and reducing risk.
Atrader, Susan, has been studying Acme Brokerage Co. (ABC). Susan
has noticed that brokerage stocks have been fairly volatile in recent past.
Exhibit 15.3 shows an analysis of Acme’svolatility over the past 30 days.
EXHIBIT 15.3 Acme Brokerage Co. volatility.
Stock Price Realized VolatilityFront-Month Implied Volatility
30-day high $78.6630-day high 47%30-day high 55%
30-day low $66.9430-day low 36%30-day low 34%
Current px $74.80Current vol 36%Current vol 36%
During this period, Acme stock ranged more than $11 in price. In this
example, Acme’svolatility is afunction of interest rate concerns and other
macroeconomic issues affecting the brokerage industry as awhole. As the
stock price begins to level off in the latter half of the 30-day period, realized
volatility begins to ebb. The front month’s IV recedes toward recent lows as
well. At this point, both realized and implied volatility converge at 36
percent. Although volatility is at its low for the past month, it is still
relatively high for abrokerage stock under normal market conditions.
Susan does not believe that the volatility plaguing this stock is over. She
believes that an upcoming scheduled Federal Reserve Board announcement
will lead to more volatility. She perceives this to be avolatility-buying
opportunity. Effectively, she wants to buy volatility on the dip. Susan pays
5.75 for 20 July 75-strike straddles.
Exhibit 15.4 shows the analytics of this trade with four weeks until
expiration.

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EXHIBIT 15.4 Analytics for long 20 Acme Brokerage Co. 75-strike
straddles.
As with any trade, the risk is that the trader is wrong. The risk here is
indicated by the −2.07 theta and the +3.35 vega. Susan has to scalp an
average of at least $207 aday just to break even against the time decay. And
if IV continues to ebb down to alower, more historically normal, level, she
needs to scalp even more to make up for vega losses.
Effectively, Susan wants both realized and implied volatility to rise. She
paid 36 volatility for the straddle. She wants to be able to sell the options at
ahigher vol than 36. In the interim, she needs to cover her decay just to
break even. But in this case, she thinks the stock will be volatile enough to
cover decay and then some. If Acme moves at avolatility greater than 36,
her chances of scalping profitably are more favorable than if it moves at
less than 36 vol. The following is one possible scenario of what might have
happened over two weeks after the trade was made.
Week One
During the first week, the stock’svolatility tapered off abit more, but
implied volatility stayed firm. After some oscillation, the realized volatility
ended the week at 34 percent while IV remained at 36 percent. Susan was
able to scalp stock reasonably well, although she still didn’tcover her seven
days of theta. Her stock buys and sells netted again of $1,100. By the end
of week one, the straddle was 5.10 bid. If she had sold the straddle at the
market, she would have ended up losing $200.

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Susan decided to hold her position. Toward the end of week two, there
would be the Federal Open Market Committee (FOMC) meeting.
Week Two
The beginning of the week saw IV rise as the event drew near. By the close
on Tuesday, implied volatility for the straddle was 40 percent. But realized
volatility continued its decline, which meant Susan was not able to scalp to
cover the theta of Saturday, Sunday, Monday, and Tuesday. But, the straddle
was now 5.20 bid, 0.10 higher than it had been on previous Friday. The
rising IV made up for most of the theta loss. At this point, Susan could have
sold her straddle to scratch her trade. She would have lost $1,100 on the
straddle [(5.20 − 5.75) × 20] but made $1,100 by scalping gamma in the
first week. Susan decided to wait and see what the Fed chairman had to say.
By week’send, the trade had proved to be profitable. After the FOMC
meeting, the stock shot up more than $4 and just as quickly fell. It
continued to bounce around abit for the rest of the week. Susan was able to
lock in $5,200 from stock scalps. After much gyration over this two-week
period, the price of Acme stock incidentally returned to around the same
price it had been at when Susan bought her straddle: $74.50. As might have
been expected after the announcement, implied volatility softened. By
Friday, IV had fallen to 30. Realized volatility was sharply higher as aresult
of the big moves during the week that were factored into the 30-day
calculation.
With seven more days of decay and alower implied volatility, the straddle
was 3.50 bid at midafternoon on Friday. Susan sold her 20-lot to close the
position. Her profit for week two was $2,000.
What went into Susan’sdecision to close her position? Susan had two
objectives: to profit from arise in implied volatility and to profit from arise

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in realized volatility. The rise in IV did indeed occur, but not immediately.
By Tuesday of the second week, vega profits were overshadowed by theta
losses.
Gamma was the saving grace with this trade. The bulk of the gain
occurred in week two when the Fed announcement was made. Once that
event passed, the prospects for covering theta looked less attractive. They
were further dimmed by the sharp drop in implied volatility from 40 to 30.
In this hypothetical scenario, the trade ended up profitable. This is not
always the case. Here the profit was chiefly produced by one or two high-
volatility days. Had the stock not been unusually volatile during this time,
the trade would have been acertain loser. Even though implied volatility
had risen four points by Tuesday of the second week, the trade did not yield
aprofit. The time decay of holding two options can make long straddles atough strategy to trade.

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Short Straddle
Definition : Selling one call and one put in the same option class, in the
same expiration cycle, and with the same strike price.
Just as buying astraddle is apure way to buy volatility, selling astraddle
is away to short it. When atrader’sforecast calls for lower implied and
realized volatility, astraddle generates the highest returns of all volatility-
selling strategies. Of course, with high reward necessarily comes high risk.
Ashort straddle is one of the riskiest positions to trade.
Let’slook at aone-month 70-strike straddle sold at 4.25.
The risk is easily represented graphically by means of a P&(L) diagram.
Exhibit 15.5 shows the risk and reward of this short straddle.
EXHIBIT 15.5 Short straddle P&(L) at initiation and expiration.
If the straddle is held until expiration and the underlying is trading below
the strike price, the short put is in-the-money (ITM). The lower the stock,
the greater the loss on the +1.00 delta from the put. The trade as awhole

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will be aloser if the underlying is below the lower of the two break-even
points—in this case $65.75. This point is found by subtracting the premium
received from the strike. Before expiration, negative gamma adversely
affects profits as the underlying falls. The lower the underlying is trading
below the strike price, the greater the drain on P&(L) due to the positive
delta of the short put.
It is the same proposition if the underlying is above $70 at expiration. But
in this case, it is the short call that would be in-the-money. The higher the
underlying price, the more the −1.00 delta adversely impacts P&(L). If at
expiration the underlying is above the higher breakeven, which in this case
is $74.25 (the strike plus the premium), the trade is aloser. The higher the
underlying, the worse off the trade. Before expiration, negative gamma
creates negative deltas as the underlying climbs above the strike, eating
away at the potential profit, which is the net premium received.
The best-case scenario is that the underlying is right at $70 at the closing
bell on expiration Friday. In this situation, neither option is ITM, meaning
that the 4.25 premium is all profit. In reaping the maximum profit, both
time and price play roles. If the position is closed before expiration, implied
volatility enters into the picture as well.
It’simportant to note that just because neither option is ITM if the
underlying is right at $70 at expiration, it doesn’tmean with certainty that
neither option will be assigned. Sometimes options that are ATM or even
out-of-the-money (OTM) get assigned. This can lead to apleasant or
unpleasant surprise the Monday morning following expiration. The risk of
not knowing whether or not you will be assigned—that is, whether or not
you have aposition in the underlying security—is arisk to be avoided. It is
the goal of every trader to remove unnecessary risk from the equation.
Buying the call and the put for 0.05 or 0.10 to close the position is asmall
price to pay when one considers the possibility of waking up Monday
morning to find aloss of hundreds of dollars per contract because aposition
you didn’teven know you owned had moved against you. Most traders
avoid this risk, referred to as pin risk, by closing short options before
expiration.

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Trading the Short Straddle
Ashort straddle is atrade for highly speculative traders who think asecurity
will trade within adefined range and that implied volatility is too high.
While along straddle needs to be actively traded, ashort straddle needs to
be actively monitored to guard against negative gamma. As adverse deltas
get bigger because of stock price movement, traders have to be on alert,
ready to neutralize directional risk by offsetting the delta with stock or by
legging out of the options. To be sure, with ashort straddle, every stock
trade locks in aloss with the intent of stemming future losses. The ideal
situation is that the straddle is held until expiration and expires with the
underlying right at $70 with no negative-gamma scalping.
Short-straddle traders must take alonger-term view of their positions than
long-straddle traders. Often with short straddles, it is ultimately time that
provides the payout. While long straddle traders would be inclined to watch
gamma and theta very closely to see how much movement is required to
cover each day’serosion, short straddlers are more inclined to focus on the
at-expiration diagram so as not to lose sight of the end game.
There are some situations that are exceptions to this long-term focus. For
example, when implied volatility gets to be extremely high for aparticular
option class relative to both the underlying stock’svolatility and the
historical implied volatility, one may want to sell astraddle to profit from afall in IV. This can lead to leveraged short-term profits if implied volatility
does, indeed, decline.
Because of the fact that there are two short options involved, these
straddles administer aconcentrated dose of negative vega. For those willing
to bet big on adecline in implied volatility, ashort straddle is an eager
croupier. These trades are delta neutral and double the vega of asingle-leg
trade. But they’re double the gamma, too. As with the long straddle,
realized and implied volatility levels are both important to watch.

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Short-Straddle Example
For this example, atrader, John, has been watching Federal XYZ Corp.
(XYZ) for ayear. During the 12 months that John has followed XYZ, its
front-month implied volatility has typically traded at around 20 percent, and
its realized volatility has fluctuated between 15 and 20 percent. The past 30
days, however, have been abit more volatile. Exhibit 15.6 shows XYZ’srecent volatility.
EXHIBIT 15.6 XYZ volatility.
Stock Price Realized VolatilityFront-Month Implied Volatility
30-day high $111.7130-day high 26%30-day high 30%
30-day low $102.0530-day low 21%30-day low 24%
Current px $104.75Current vol 22%Current vol 26%
The stock volatility has begun to ease, trading now at a 22 volatility
compared with the 30-day high of 26, but still not down to the usual 15-to-
20 range. The stock, in this scenario, has traded in achannel. It currently
lies in the lower half of its recent range. Although the current front-month
implied volatility is in the lower half of its 30-day range, it’shistorically
high compared with the 20 percent level that John has been used to seeing,
and it’sstill four points above the realized volatility. John believes that the
conditions that led to the recent surge in volatility are no longer present. His
forecast is for the stock volatility to continue to ease and for implied
volatility to continue its downtrend as well and revert to its long-term mean
over the next week or two. John sells 10 September 105 straddles at 5.40.
Exhibit 15.7 shows the greeks for this trade.
EXHIBIT 15.7 Greeks for short XYZ straddle.

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The goal here is for implied volatility to fall to around 20. If it does, John
makes $1,254 (6 vol points × 2.09 vega). He also thinks theta gains will
outpace gamma losses. The following is atwo-week examination of one
possible outcome for John’strade.
Week One
The first week in this example was aprofitable one, but it came with
challenges. John paid for his winnings with afew sleepless nights. On the
Monday following his entry into the trade, the stock rose to $106. While
John collected aweekend’sworth of time decay, the $1.25 jump in stock
price ate into some of those profits and naturally made him uneasy about
the future.
At this point, John was sitting on aprofit, but his position delta began to
grow negative, to around −1.22 [(–1.18 × 1.25) + 0.26]. For a $104.75
stock, amove of $1.25—or just over 1 percent—is not out of the ordinary,
but it put John on his guard. He decided to wait and see what happened
before hedging.
The following day, the rally continued. The stock was at $107.30 by
noon. His delta was around −3. In the face of an increasingly negative delta,
John weighed his alternatives: He could buy back some of his calls to offset
his delta, which would have the added benefit of reducing his gamma as
well. He could buy stock to flatten out. Lastly, he could simply do nothing
and wait. John felt the stock was overbought and might retrace. He also still
believed volatility would fall. He decided to be patient and enter astop
order to buy all of his deltas at $107.50 in case the stock continued trending
up. The XYZ shares closed at $107.45 that day.
This time inaction proved to be the best action. The stock did retrace.
Week one ended with Federal XYZ back down around $105.50. The IV of
the straddle was at 23. The straddle finished up week one offered at $4.10.
Week Two
The future was looking bright at the start of week two until Wednesday.
Wednesday morning saw XYZ gap open to $109. When you have ashort
straddle, a $3.50 gap move in the underlying tends to instantly give you a

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sinking feeling in the pit of your stomach. But the damage was truly not that
bad. The offer in the straddle was 4.75, so the position was still awinner if
John bought it back at this point.
Gamma/delta hurt. Theta helped. Acharacteristic that enters into this
trade is volatility’schanging as aresult of movement in the stock price.
Despite the fact that the stock gapped $3.50 higher, implied volatility fell by
1 percent, to 22. This volatility reaction to the underlying’srise in price is
very common in many equity and index options. John decided to close the
trade. Nobody ever went broke taking aprofit.
The trade in this example was profitable. Of course, this will not always
be the case. Sometimes short straddles will be losers—sometimes big ones.
Big moves and rising implied volatility can be perilous to short straddles
and their writers. If the XYZ stock in the previous example had gapped up
to $115—which is not an unreasonable possibility—John’strade would
have been ugly.

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Synthetic Straddles
Straddles are the pet strategy of certain professional traders who specialize
in trading volatility. In fact, in the mind of many of these traders, astraddle
is all there is. Any single-legged trade can be turned into astraddle
synthetically simply by adding stock.
Chapter 6 discussed put-call parity and showed that, for all intents and
purposes, aput is acall and acall is aput. For the most part, the greeks of
the options in the put-call pair are essentially the same. The delta is the only
real difference. And, of course, that can be easily corrected. As amatter of
perspective, one can make the case that buying two calls is essentially the
same as buying acall and aput, once stock enters into the equation.
Take anon-dividend-paying stock trading at $40 ashare. With 60 days
until expiration, a 25 volatility, and a 4 percent interest rate, the greeks of
the 40-strike calls and puts of the straddle are as follows:
Essentially, the same position can be created by buying one leg of the
spread synthetically. For example, in addition to buying one 40 call, another
40 call can be purchased along with shorting 100 shares of stock to create a
40 put synthetically.

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Combined, the long call and the synthetic long put (long call plus short
stock) creates asynthetic straddle. Along synthetic straddle could have
similarly been constructed with along put and along synthetic call (long
put plus long stock). Furthermore, ashort synthetic straddle could be
created by selling an option with its synthetic pair.
Notice the similarities between the greeks of the two positions. The
synthetic straddle functions about the same as aconventional straddle.
Because the delta and gamma are nearly the same, the up-and-down risk is
nearly the same. Time and volatility likewise affect the two trades about the
same. The only real difference is that the synthetic straddle might require abit more cash up front, because it requires buying or shorting the stock. In
practice, straddles will typically be traded in accounts with retail portfolio
margining or professional margin requirements (which can be similar to
retail portfolio margining). So the cost of the long stock or margin for short
stock is comparatively small.

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Long Strangle
Definition : Buying one call and one put in the same option class, in the
same expiration cycle, but with different strike prices. Typical long
strangles involve an OTM call and an OTM put. Astrangle in which an
ITM call and an ITM put are purchased is called along guts strangle.
Along strangle is similar to along straddle in many ways. They both
require buying acall and aput on the same class in the same expiration
month. They are both buying volatility. There are, however, some functional
differences. These differences stem from the fact that the options have
different strike prices.
Because there is distance between the strike prices, from an at-expiration
perspective, the underlying must move more for the trade to show aprofit.
Exhibit 15.8 illustrates the payout of options as part of along strangle on
a $70 stock. The graph is much like that of Exhibit 15.1 , which shows the
payout of along straddle. But the net cost here is only 1.00, compared with
4.25 for the straddle with the same time and volatility inputs. The cost is
lower because this trade consists of OTM options instead of ATM options.
The breakdown is as follows:

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EXHIBIT 15.8 Long strangle at-expiration diagram.
The underlying has abit farther to go by expiration for the trade to have
value. If the underlying is above $75 at expiration, the call is ITM and has
value. If the underlying is below $65 at expiration, the put is ITM and has
value. If the underlying is between the two strike prices at expiration both
options expire and the 1.00 premium is lost.
An important difference between astraddle and astrangle is that if astrangle is held until expiration, its break-even points are farther apart than
those of acomparable straddle. The 70-strike straddle in Exhibit 15.1 had alower breakeven of $65.75 and an upper break-even of $74.25. The
comparable strangle in this example has break-even prices of $64 and $76.
But what if the strangle is not held until expiration? Then the trade’sgreeks must be analyzed. Intuitively, two OTM options (or ITM ones, for
that matter) will have lower gamma, theta, and vega than two comparable
ATM options. This has atwo-handed implication when comparing straddles
and strangles.
On the one hand, from arealized volatility perspective, lower gamma
means the underlying must move more than it would have to for astraddle
to produce the same dollar gain per spread, even intraday. But on the other
hand, lower theta means the underlying doesn’thave to move as much to
cover decay. Alower nominal profit but ahigher percentage profit is
generally reaped by strangles as compared with straddles.

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Long-Strangle Example
Let’sreturn to Susan, who earlier in this chapter bought astraddle on Acme
Brokerage Co. (ABC). Acme currently trades at $74.80 ashare with current
realized volatility at 36 percent. The stock’svolatility range for the past
month was between 36 and 47. The implied volatility of the four-week
options is 36 percent. The range over the past month for the IV of the front
month has been between 34 and 55.
As in the long-straddle example earlier in this chapter, there is agreat deal
of uncertainty in brokerage stocks revolving around interest rates, credit-
default problems, and other economic issues. An FOMC meeting is
expected in about one week’stime about whose possible actions analysts’
estimates vary greatly, from acut of 50 basis points to no cut at all. Add apending earnings release to the docket, and Susan thinks Acme may move
quite abit.
In this case, however, instead of buying the 75-strike straddle, Susan pays
2.35 for 20 one-month 70–80 strangles. Exhibit 15.9 compares the greeks of
the long ATM straddle with those of the long strangle.
EXHIBIT 15.9 Long straddle versus long strangle.
The cost of the strangle, at 2.35, is about 40 percent of the cost of the
straddle. Of course, with two long options in each trade, both have positive
gamma and vega and negative theta, but the exposure to each metric is less
with the strangle. Assuming the same stock-price action, astrangle would

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enjoy profits from movement and losses from lack of movement that were
similar to those of astraddle—just nominally less extreme.
For example, if Acme stock rallies $5, from $74.80 to $79.80, the gamma
of the 75 straddle will grow the delta favorably, generating again of 1.50,
or about 25 percent. The 70–80 strangle will make 1.15 from the curvature
of the delta–almost a 50 percent gain.
With the straddle and especially the strangle, there is one more detail to
factor in when considering potential P&L: IV changes due to stock price
movement. IV is likely to fall as the stock rallies and rise as the stock
declines. The profits of both the long straddle and the long strangle would
likely be adversely affected by IV changes as the stock rose toward $79.80.
And because the stock would be moving away from the straddle strike and
toward one of the strangle strikes, the vegas would tend to become more
similar for the two trades. The straddle in this example would have avega
of 2.66, while the strangle’svega would be 2.67 with the underlying at
$79.80 per share.

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Short Strangle
Definition : Selling one call and one put in the same option class, in the
same expiration cycle, but with different strike prices. Typically, an OTM
call and an OTM put are sold. Astrangle in which an ITM call and an ITM
put are sold is called ashort guts strangle.
Ashort strangle is avolatility-selling strategy, like the short straddle. But
with the short strangle, the strikes are farther apart, leaving more room for
error. With these types of strategies, movement is the enemy. Wiggle room
is the important difference between the short-strangle and short-straddle
strategies. Of course, the trade-off for ahigher chance of success is lower
option premium.
Exhibit 15.10 shows the at-expiration diagram of ashort strangle sold at
1.00, using the same options as in the diagram for the long strangle.
EXHIBIT 15.10 Short strangle at-expiration diagram.
Note that if the underlying is between the two strike prices, the maximum
gain of 1.00 is harvested. With the stock below $65 at expiration, the short
put is ITM, with a +1.00 delta. If the stock price is below the lower
breakeven of $64 (the put strike minus the premium), the trade is aloser.
The lower the stock, the bigger the loss. If the underlying is above $75, the

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short call is ITM, with a −1.00 delta. If the stock is above the upper
breakeven of $76 (the call strike plus the premium), the trade is aloser. The
higher the stock, the bigger the loss.
Intuitively, the signs of the greeks of this strangle should be similar to
those of ashort straddle—negative gamma and vega, positive theta. That
means that increased realized volatility hurts. Rising IV hurts. And time
heals all wounds—unless, of course, the wounds caused by gamma are
greater than the net premium received.
This brings us to an important philosophical perspective that emphasizes
the differences between long straddles and strangles and their short
counterparts. Losses from rising vega are temporary; the time value of all
options will be zero at expiration. But gamma losses can be permanent and
profound. These short strategies have limited profit potential and unlimited
loss potential. Although short-term profits (or losses) can result from IV
changes, the real goal here is to capture theta.

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Short-Strangle Example
Let’srevisit John, a Federal XYZ (XYZ) trader. XYZ is at $104.75 in this
example, with an implied volatility of 26 percent and astock volatility of
22. Both implied and realized volatility are higher than has been typical
during the past twelve months. John wants to sell volatility. In this example,
he believes the stock price will remain in afairly tight range, causing
realized volatility to revert to its normal level, in this case between 15 and
20 percent.
He does everything possible to ensure success. This includes scanning the
news headlines on XYZ and its financials for areason not to sell volatility.
Playing devil’sadvocate with oneself can uncover unforeseen yet valid
reasons to avoid making bad trades. John also notes the recent price range,
which has been between $111.71 and $102.05 over the past month. Once
John commits to an outlook on the stock, he wants to set himself up for
maximum gain if he’sright and, for that matter, to maximize his chances of
being right. In this case, he decides to sell astrangle to give himself as
much margin for error as possible. He sells 10 three-week 100–110
strangles at 1.80.
Exhibit 15.11 compares the greeks of this strangle with those of the 105
straddle.
EXHIBIT 15.11 Short straddle vs. short strangle.
As expected, the strangle’sgreeks are comparable to the straddle’sbut of
less magnitude. If John’sintention were to capture adrop in IV, he’dbe

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better off selling the bigger vega of the straddle. Here, though, he wants to
see the premium at zero at expiration, so the strangle serves his purposes
better. What he is most concerned about are the breakevens—in this case,
98.20 and 111.8. The straddle has closer break-even points, of $99.60 and
$110.40.
Despite the fact that in this case, John is not really trading the greeks or
IV per se, they still play an important role in his trade. First, he can use
theta to plan the best strangle to trade. In this case, he sells the three-week
strangle because it has the highest theta of the available months. The second
month strangle has a −0.71 theta, and the third month has a −0.58 theta.
With strangles, because the options are OTM, this disparity in theta among
the tradable months may not always be the case. But for this trade, if he is
still bearish on realized volatility after expiration, John can sell the next
month when these options expire.
Certainly, he will monitor his risk by watching delta and gamma. These
are his best measures of directional exposure. He will consider implied
volatility in the decision-making process, too. An implied volatility
significantly higher than the realized volatility can be ared flag that the
market expects something to happen, but there’sabigger payoff if there is
no significant volatility. An IV significantly lower than the realized can
indicate the risk of selling options too cheaply: the premium received is not
high enough, based on how much the stock has been moving. Ideally, the
IV should be above the realized volatility by between 2 and 20 percent,
perhaps more for highly speculative traders.

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Backspreads
Definition : An option strategy consisting of more long options than short
options having the same expiration month. Typically, the trader is long calls
(or puts) in one series of options and short afewer number of calls (or puts)
in another series with the same expiration month in the same option class.
Some traders, such as market makers, refer generically to any delta-neutral
long-gamma position as abackspread.
Shades of Gray
In its simplest form, trading abackspread is trading aone-by-two call or put
spread and holding it until expiration in hopes that the underlying stock’sprice will make abig move, particularly in the more favorable direction.
But holding abackspread to expiration as described has its challenges. Let’slook at ahypothetical example of abackspread held to term and its at-
expiration diagram.
With the stock at $71 and one month until March expiration:
In this example, there is acredit of 3.20 from the sale of the 70 call and adebit of 1.10 for each of the two 75 calls. This yields atotal net credit of
1.00 (3.20 − 1.10 − 1.10). Let’sconsider how this trade performs if it is held
until expiration.
If the stock falls below $70 at expiration, all the calls expire and the 1.00
credit is all profit. If the stock is between $70 and $75 at expiration, the 70
call is in-the-money (ITM) and the −1.00 delta starts racking up losses
above the breakeven of $71 (the strike plus the credit). At $75 ashare this
trade suffers its maximum potential loss of $4. If the stock is above $75 at
expiration, the 75 calls are ITM. The net delta of +1.00, resulting from the
+2.00 deltas of the 75 calls along with the −1.00 delta of the 70 call, makes
money as the stock rises. To the upside, the trade is profitable once the
stock is at ahigh enough price for the gain on the two 75 calls to make up

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for the loss on the 70 call. In this case, the breakeven is $79 (the $4
maximum potential loss plus the strike price of 75).
While it’sgood to understand this at-expiration view of this trade, this
diagram is abit misleading. What does the trader of this spread want to
have happen? If the trader is bearish, he could find abetter way to trade his
view than this, which limits his gains to 1.00—he could buy aput. If the
trader believes the stock will make avolatile move in either direction, the
backspread offers adecidedly limited opportunity to the downside. Astraddle or strangle might be abetter choice. And if the trader is bullish, he
would have to be very bullish for this trade to make sense. The underlying
needs to rise above $79 just to break even. If instead he just bought 2 of the
75 calls for 1.10, the maximum risk would be 2.20 instead of 4, the
breakeven would be $77.20 instead of $79, and profits at expiration would
rack up twice as fast above the breakeven, since the trader is net long two
calls instead of one. Why would atrader ever choose to trade abackspread?
EXHIBIT 16.1 Backspread at expiration.
The backspread is acomplex spread that can be fully appreciated only
when one has athorough knowledge of options. Instead of waiting patiently
until expiration, an experienced backspreader is more likely to gamma scalp
intermittent opportunities. This requires trading alarge enough position to
make scalping worthwhile. It also requires appropriate margining (either
professional-level margin requirements or retail portfolio margining). For

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example, this 1:2 contract backspread has adelta of −0.02 and agamma of
+0.05. Fewer than 10 deltas could be scalped if the stock moves up and
down by one point. It becomes amore practical trade as the position size
increases. Of course, more practical doesn’tnecessarily guarantee it will be
more profitable. The market must cooperate!
Backspread Example
Let’ssay a 20:40 contract backspread is traded. (Note : In trader lingo this is
still called aone-by-two; it is just traded 20 times.) The spread price is still
1.00 credit per contract; in this case, that’s $2,000. But with this type of
trade, the spread price is not the best measure of risk or reward, as it is with
some other kinds of spreads. Risk and reward are best measured by delta,
gamma, theta, and vega. Exhibit 16.2 shows this trade’sgreeks.
EXHIBIT 16.2 Greeks for 20:40 backspread with the underlying at $71.
Backspreads are volatility plays. This spread has a +1.07 vega with the
stock at $71. It is, therefore, abullish implied volatility (IV) play. The IV of
the long calls, the 75s, is 30 percent, and that of the 70s is 32 percent. Much
as with any other volatility trade, traders would compare current implied
volatility with realized volatility and the implied volatility of recent past
and consider any catalysts that might affect stock volatility. The objective is
to buy an IV that is lower than the expected future stock volatility, based on
all available data. The focus of traders of this backspread is not the dollar
credit earned. They are more interested in buying a 30 volatility—that’sthe
focus.
But the 75 calls’ IV is not the only volatility figure to consider. The short
options, the 70s, have implied volatility of 32 percent. Because of their

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lower strike, the IV is naturally higher for the 70 calls. This is vertical skew
and is described in Chapter 3. The phenomenon of lower strikes in the same
option class and with the same expiration month having higher IV is very
common, although it is not always the case.
Backspreads usually involve trading vertical skew. In this spread, traders
are buying a 30 volatility and selling a 32 volatility. In trading the skew, the
traders are capturing two volatility points of what some traders would call
edge by buying the lower volatility and selling the higher.
Based on the greeks in Exhibit 16.2 , the goal of this trade appears fairly
straightforward: to profit from gamma scalping and rising IV. But, sadly,
what appears to be straightforward is not. Exhibit 16.3 shows the greeks of
this trade at various underlying stock prices.
EXHIBIT 16.3 70–75 backspread greeks at various stock prices.
Notice how the greeks change with the stock price. As the stock price
moves lower through the short strike, the 70 strike calls become the more
relevant options, outweighing the influence of the 75s. Gamma and vega
become negative, and theta becomes positive. If the stock price falls low
enough, this backspread becomes avery different position than it was with
the stock price at $71. Instead of profiting from higher implied and realized
volatility, the spread needs alower level of both to profit.
This has important implications. First, gamma traders must approach the
backspread alittle differently than they would most spreads. The
backspread traders must keep in mind the dynamic greeks of the position.
With atrade like along straddle, in which there are no short options, traders
scalping gamma simply buy to cover short deltas as the stock falls and sell
to cover long deltas as the stock rises. The only risks are that the stock may
not move enough to cover theta or that the traders may cover deltas too
soon to maximize profits.

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With the backspread, the changing gamma adds one more element of risk.
In this example, buying stock to flatten out delta as the stock falls can
sometimes be apremature move. Traders who buy stock may end up with
more long deltas than they bargained for if the stock falls into negative-
gamma territory.
Exhibit 16.3 shows that with the stock at $68, the delta for this trade is
−2.50. If the traders buy 250 shares at $68, they will be delta neutral. If the
stock subsequently falls to $62 ashare, instead of being short 1.46 deltas, as
the figure indicates, they will be long 1.04 because of the 250 shares they
bought. These long deltas start to hurt as the stock continues lower.
Backspreaders must therefore anticipate stock movements to avoid
overhedging. The traders in this example may decide to lean short if the
stock shows signs of weakness.
Leaning short means that if the delta is −2.50 at $68 ashare, the traders
may decide to underhedge by buying just 100 or 200 shares. If the stock
continues to fall and negative gamma kicks in, this gives the traders some
cushion to the downside. The short delta of the position moves closer to
being flat as the stock falls. Because there is along strike and ashort strike
in this delta-neutral position, trading ratio spreads is like trading along and
ashort volatility position at the same time. Trading backspreads is not an
exact science. The stock has just as good achance of rising as it does of
falling, and if it does rise and the traders have underhedged at $68, they will
not participate in all the gains they would have if they had fully hedged by
buying 250 shares of stock. If trading were easy, everyone would do it!
Backspreaders must also be conscious of the volatility of each leg of the
spread. There is an inherent advantage in this example to buying the lower
volatility of the 75 calls and selling the higher volatility of the 70 calls. But
there is also implied risk. Equity prices and IV tend to have an inverse
relationship. When stock prices fall—especially if the drop happens quickly
—IV will often rise. When stock prices rise, IV often falls.
In this backspread example, as the stock price falls to or through the short
strike, vega becomes negative in the face of apotentially rising IV. As the
stock price rises into positive vega turf, there is the risk of IV’sdeclining. Adynamic volatility forecast should be part of abackspread-trading plan. One
of the volatility questions traders face in this example is whether the two-

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Ratio Vertical Spreads
Definition : An option strategy consisting of more short options than long
options having the same expiration month. Typically, the trader is short calls
(or puts) in one series of options and long afewer number of calls (or puts)
in another series in the same expiration month on the same option class.
Aratio vertical spread, like abackspread, involves options struck at two
different prices—one long strike and one short. That means that it is avolatility strategy that may be long or short gamma or vega depending on
where the underlying price is at the time. The ratio vertical spread is
effectively the opposite of abackspread. Let’sstudy aratio vertical using
the same options as those used in the backspread example.
With the stock at $71 and one month until March expiration:
In this case, we are buying one ITM call and selling two OTM calls. The
relationship of the stock price to the strike price is not relevant to whether
this spread is considered aratio vertical spread. Certainly, all these options
could be ITM or OTM at the time the trade is initiated. It is also not
important whether the trade is done for adebit or acredit. If the stock price,
time to expiration, volatility, or number of contracts in the ratio were
different, this could just as easily been acredit ratio vertical.
Exhibit 16.4 illustrates the payout of this strategy if both legs of the 1:2
contract are still open at expiration.

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EXHIBIT 16.4 Short ratio spread at expiration.
This strategy is amirror image of the backspread discussed previously in
this chapter. With limited risk to the downside, the maximum loss to the
trade is the initial debit of 1 if the stock is below $70 at expiration and all
the calls expire. There is amaximum profit potential of 4 if the stock is at
the short strike at expiration. There is unlimited loss potential, since ashort
net delta is created on the upside, as one short 75 call is covered by the long
70 call, and one is naked. The breakevens are at $71 and $79.
Low Volatility
With the stock at $71, gamma and vega are both negative. Just as the
backspread was along volatility play at this underlying price, this ratio
vertical is ashort-vol play here. As in trading ashort straddle, the name of
the game is low volatility—meaning both implied and realized.
This strategy may require some gamma hedging. But as with other short
volatility delta-neutral trades, the fewer the negative scalps, the greater the
potential profit. Delta covering should be implemented in situations where
it looks as if the stock will trend deep into negative-gamma territory.
Murphy’s Law of trading dictates that delta covering will likely be wrong at
least as often as it is right.

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Ratio Vertical Example
Let’sexamine atrade of 20 contracts by 40 contracts. Exhibit 16.5 shows
the greeks for this ratio vertical.
EXHIBIT 16.5 Short ratio vertical spread greeks.
Before we get down to the nitty-gritty of the mechanics and management
of this trade—the how—let’sfirst look at the motivations for putting the
trade on—the why. For the cost of 1.00 per spread, this trader gets aleveraged position if the stock rises moderately. The profits max out with
the stock at the short-strike target price—$75—at expiration.
Another possible profit engine is IV. Because of negative vega, there is
the chance of taking aquick profit if IV falls in the interim. But short-term
losses are possible, too. IV can rise, or negative gamma can hurt the trader.
Ultimately, having naked calls makes this trade not very bullish. Abig
move north can really hurt.
Basically, this is adelta-neutral-type short-volatility play that wins the
most if the stock is at $75 at expiration. One would think about making this
trade if the mechanics fit the forecast. If this trader were amore bullish than
indicated by the profit and loss diagram, amore-balanced bull call spread
would be abetter strategy, eliminating the unlimited upside risk. If upside
risk were acceptable, this trader could get more aggressive by trading the
spread one-by-three. That would result in acredit of 0.05 per spread. There
would then be no ultimate risk below $70 but rather a 0.05 gain. With
double the naked calls, however, there would be double punishment if the
stock rallied strongly beyond the upside breakeven.
Ultimately, mastering options is not about mastering specific strategies.
It’sabout having athorough enough understanding of the instrument to be

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flexible enough to tailor aposition around aforecast. It’sabout minimizing
the unwanted risks and optimizing exposure to the intended risks. Still,
there always exists atrade-off in that where there is the potential for profit,
there is the possibility of loss—you can always be wrong.
Recalling the at-expiration diagram and examining the greeks, the best-
case scenario is intuitive: the stock at $75 at expiration. The biggest theta
would be right at that strike. But that strike price is also the center of the
biggest negative gamma. It is important to guard against upward movement
into negative delta territory, as well as movement lower where the position
has aslightly positive delta. Exhibit 16.6 shows what happens to the greeks
of this trade as the stock price moves.
EXHIBIT 16.6 Ratio vertical spread at various prices for the underlying.
As the stock begins to rise from $71 ashare, negative deltas grow fast in
the short term. Careful trend monitoring is necessary to guard against arally. The key, however, is not in knowing what will happen but in skillfully
hedging against the unknown. The talented option trader is adisciplined
risk manager, not aclairvoyant.
One of the risks that the trader willingly accepted when placing this trade
was short gamma. But when the stock moves and deltas are created,
decisions have to be made. Did the catalyst(s)—if any—that contributed to
the rise in stock price change the outlook for volatility? If not, the decision
is simply whether or not to hedge by buying stock. However, if it appears
that volatility is on the rise, it is not just adelta decision. Atrader may
consider buying some of the short options back to reduce volatility
exposure.
In this example, if the stock rises and it’sfeared that volatility may
increase, agood choice may be to buy back some of the short 75-strike
calls. This has the advantage of reducing delta (buy enough deltas to flatten

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How Market Makers Manage
Delta-Neutral Positions
While market makers are not position traders per se, they are expert
position managers. For the most part, market makers make their living by
buying the bid and selling the offer. In general, they don’tact; they react.
Most of their trades are initiated by taking the other side of what other
people want to do and then managing the risk of the positions they
accumulate.
The business of amarket maker is much like that of acasino. Acasino
takes the other side of people’sbets and, in the long run, has astatistical
(theoretical) edge. For market makers, because theoretical value resides in
the middle of the bid and the ask, these accommodating trades lead to atheoretical profit—that is, the market maker buys below theoretical value
and sells above. Actual profit—cold, hard cash you can take to the bank—
is, however, dependent on sound management of the positions that are
accumulated.
My career as amarket maker was on the floor of the Chicago Board
Options Exchange (CBOE) from 1998 to 2005. Because, over all, the trades
Imade had atheoretical edge, Ihoped to trade as many contracts as
possible on my markets without getting too long or too short in any option
series or any of my greeks.
As aresult of reacting to order flow, market makers can accumulate alarge number of open option series for each class they trade, resulting in asingle position. For example, Exhibit 16.7 shows aposition Ihad in Ford
Motor Co. (F) options as amarket maker.
EXHIBIT 16.7 Market-maker position in Ford Motor Co. options.

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options to me at prices Iwanted to buy them—my bid—and buying options
from me at prices Iwanted to sell them—my offer. Upon making an option
trade, Ineeded to hedge directional risk immediately. Iusually did so by
offsetting my option trades by taking the opposite delta position in the stock
—especially on big-delta trades. Through this process of providing liquidity
to the market, Ibuilt up option-centric risk.
To manage this risk Ineeded to watch my other greeks. To be sure, trying
to draw a P&Ldiagram of this position would be afruitless endeavor.
Exhibit 16.8 shows the risk of this trade in its most distilled form.
EXHIBIT 16.8 Analytics for market-maker position in Ford Motor Co.
(stock at $15.72).
Delta +1,075
Gamma−10,191
Theta +1,708
Vega +7,171
Rho −33,137
The +1,075 delta shows comparatively small directional risk relative to
the −10,191 gamma. Much of the daily task of position management would
be to carefully guard against movement by delta hedging when necessary to
earn the $1,708 per day theta.
Much of the negative gamma/positive theta comes from the combined
1,006 short January 15 calls and puts. (Note that because this position is
traded delta neutral, the net long or short options at each strike is what
matters, not whether the options are calls or puts. Remember that in delta-
neutral trading, aput is acall, and acall is aput.) The positive vega stems
from the fact that the position is long 1,927 January 2003 20-strike options.
Although this position has alot going on, it can be broken down many
ways. Having long LEAPS options and short front-month options gives this
position the feel of atime spread. One way to think of where most of the
gamma risk is coming from is to bear in mind that the 15 strike is
synthetically short 503 straddles (1,006 options ÷ two). But this position
overall is not like astraddle. There are more strikes involved—alot more.
There is more short gamma to the downside if the price of Ford falls toward
$12.50. To the upside, the 17.50 strike is long acombined total of 439
options. Looking at just the 15 and 17.50 strikes, we can see something that

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Trading Flat
Most market makers like to trade flat—that is, profit from the bid-ask
spread and strive to lower exposure to direction, time, volatility, and interest
as much as possible. But market makers are at the mercy of customer
orders, or paper, as it’sknown in the industry. If someone sells, say, the
March 75 calls to amarket maker at the bid, the best-case scenario is that
moments later someone else buys the same number of the same calls—the
March 75s, in this case—from that same market maker at the offer. This is
locking in aprofit.
Unfortunately, this scenario seldom plays out this way. In my seven years
as amarket maker, Ican count on one hand the number of times the option
gods smiled upon me in such away as to allow me to immediately scalp an
option. Sometimes, the same option will not trade again for aweek or
longer. Very low-volume options trade “by appointment only.” Amarket
maker trading illiquid options may hold the position until it expires, having
no chance to get out at areasonable price, often taking aloss on the trade.
More typically, if amarket maker buys an option, he must sell adifferent
option to lessen the overall position risk. The skills these traders master are
to lower bids and offers on options when they are long gamma and/or vega
and to raise bids and offers on options when they are short gamma and/or
vega. This raising and lowering of markets is done to manage risk.
Effectively, this is your standard high school economics supply-and-
demand curves in living color. When the market demands (buys) all the
options that are supplied (offered) at acertain price, the price rises. When
the market supplies (sells) all the options demanded (bid) at aprice level,
the price falls. The catalyst of supply and demand is the market maker and
his risk tolerance. But instead of the supply and demand for individual
options, it is supply and demand for gamma, theta, and vega. This is trading
option greeks.

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Hedging the Risk
Delta is the easiest risk for floor traders to eliminate quickly. It becomes
second nature for veteran floor traders to immediately hedge nearly every
trade with the underlying. Remember, these liquidity providers are in the
business of buying option bids and selling option offers, not speculating on
direction.
The next hurdle is to trade out of the option-centric risk. This means that
if the market maker is long gamma, he needs to sell options; if he’sshort
gamma, he needs to buy some. Same with theta and vega. Market makers
move their bids and offers to avoid being saddled with too much gamma,
theta, and vega risk. Experienced floor traders are good at managing option
risk by not biting off more than they can chew. They strive to never buy or
sell more options than they can spread off by selling or buying other
options. This breed of trader specializes in trading the spread and managing
risk, not in predicting the future. They’re market makers, not market takers.

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Trading Skew
There are some trading strategies for which market makers have anatural
propensity that stems from their daily activity of maintaining their
positions. While money managers who manage equity funds get to know
the fundamentals of the stocks they trade very well, options market makers
know the volatility of the option classes they trade. When they adjust their
markets in reacting to order flow, it’s, mechanically, implied volatility that
they are raising or lowering to change theoretical values. They watch this
figure very carefully and trade its subtle changes.
Acharacteristic of options that many market makers and some other
active professional traders observe and trade is the volatility skew. Savvy
traders watch the implied volatility of the strikes above the at-the-money
(ATM)—referred to as calls , for simplicity—compared with the strikes
below the ATM, referred to as puts . In most stocks, there typically exists a
“normal” volatility skew inherent to options on that stock. When this skew
gets out of line, there may be an opportunity.
Say for aparticular option class, the call that is 10 percent OTM typically
trades about four volatility points lower than the put that is 10 percent
OTM. For example, for a $50 stock, the 55 calls are trading at a 21 IV and
the 45 puts are trading at a 25 volatility. If the 45 puts become bid higher,
say, nine points above where the calls are offered—for instance, the puts are
bid at 32 volatility bid while the calls are offered at 23 vol—atrader can
speculate on the skew reverting back to its normal relationship by selling
the puts, buying the calls, and hedging the delta by selling the right amount
of stock.
This position—long acall, short aput with adifferent strike, and short
stock on adelta-neutral ratio—is called arisk reversal. The motive for risk
reversals is to capture vega as the skew realigns itself. But there are many
risk factors that require careful attention.
First, as in other positions consisting of both long and short strikes, the
gamma, theta, and vega of the position will vary from positive to negative
depending on the price of the underlying. Risk-reversal traders must be

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When Delta Neutral Isn’t Direction
Indifferent
Many dynamic-volatility option positions, such as the risk reversal, have
vega risk from potential IV changes resulting from the stock’smoving. This
is indirectly adirectional risk. While having adelta-neutral position hedges
against the rather straightforward directional risk of the position delta, this
hidden risk of stock movement is left unhedged. In some circumstances, adelta-lean can help abate some of the vega risk of stock-price movement.
Say an option position has fairly flat greeks at the current stock price. Say
that given the way this particular position is set up, if the stock rises, the
position is still fairly flat, but if the stock falls, short lower-strike options
will lead to negative gamma and vega. One way to partially hedge this
position is to lean short deltas—that is, instead of maintaining atotally flat
delta, have aslightly short delta. That way, if the stock falls, the trade
profits some on the short stock to partially offset some of the anticipated
vega losses. The trade-off of this hedge is that if the stock rises, the trade
loses on the short delta.
Delta leans are more of an art than ascience and should be used as ahedge only by experienced vol traders. They should be one part of awell-
orchestrated plan to trade the delta, gamma, theta, and vega of aposition.
And, to be sure, adelta lean should be entered into amodel for simulation
purposes before executing the trade to study the up-and-down risk of the
position. If the lean reduces the overall risk of the position, it should be
implemented. But if it creates asituation where there is an anticipated loss
if the stock moves in either direction and there is little hope of profiting
from the other greeks, the lean is not the answer—closing the position is.

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Managing Multiple-Class Risk
Most traders hold option positions in more than one option class. As an
aside, Irecommend doing so, capital and experience permitting. In my
experience, having positions in multiple classes psychologically allows for
acertain level of detachment from each individual position. Most traders
can make better decisions if they don’thave all their eggs in one basket.
But holding aportfolio of option positions requires one more layer of risk
management. The trader is concerned about the delta, gamma, theta, vega,
and rho not only of each individual option class but also of the portfolio as awhole. The trader’sportfolio is actually one big position with alot of
moving parts. To keep it running like awell-oiled machine requires
monitoring and maintaining each part to make sure they are working
together. To have the individual trades work in harmony with one another, it
is important to keep awell-balanced series of strategies.
Option trading requires diversification, just like conventional linear stock
trading or investing. Diversification of the option portfolio is easily
measured by studying the portfolio greeks. By looking at the net greeks of
the portfolio, the trader can get some idea of exposure to overall risk in
terms of delta, gamma, theta, vega, and rho.

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CHAPTER 17
Putting the Greeks into Action
This book was intended to arm the reader with the knowledge of the greeks
needed to make better trading decisions. As the preface stated, this book is
not so much ahow-to guide as ahow-come tutorial. It is step one in athree-
step learning process:
Step One: Study . First, aspiring option traders must learn as much as
possible from books such as this one and from other sources, such as
articles, both in print and online, and from classes both in person and
online. After completing this book, the reader should have asolid base
of knowledge of the greeks.
Step Two: Paper Trade . Atruly deep understanding requires practice,
practice, and more practice! Fortunately, much of this practice can be
done without having real money on the line. Paper trading—or
simulated trading—in which one trades real markets but with fake
money is step two in the learning process. Ihighly recommend paper
trading to kick the tires on various types of strategies and to see how
they might work differently in reality than you thought they would in
theory.
Step Three: Showtime ! Even the most comprehensive academic study
or windfall success with paper profits doesn’tgive one atrue feel for
how options work in the real world. There are some lessons that must
be learned from the black and the blue. When there’sreal money on the
line, you will trade differently—at least in the beginning. It’shuman
nature to be cautious with wealth. This is not abad thing. But emotions
should not override sound judgment. Start small—one or two lots per
trade—until you can make rational decisions based on what you have
learned, keeping emotions in check.
This simple three-step process can take years of diligent work to get it
right. But relax. Getting rich quick is truly apoor motivation for trading
options. Option trading is abeautiful thing! It’sabout winning. It’sabout

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Example 1
Imagine atrader, Arlo, is studying the following chart of Agilent
Technologies Inc. (A). See Exhibit 17.1 .
EXHIBIT 17.1 Agilent Technologies Inc. daily candles.
Source : Chart courtesy of Livevol® Pro ( www.livevol.com )
The stock has been in an uptrend for six weeks or so. Close-to-close
volatility hasn’tincreased much. But intraday volatility has increased
greatly as indicated by the larger candles over the past 10 or so trading
sessions. Earnings is coming up in aweek in this example, however implied
volatility has not risen much. It is still “cheap” relative to historical
volatility and past implied volatility. Arlo is bullish. But how does he play
it? He needs to use what he knows about the greeks to guide his decision.
Arlo doesn’twant to hold the trade through earnings, so it will be ashort-
term trade. Thus, theta is not much of aconcern. The low-priced volatility
guides his strategy selection in terms of vega. Arlo certainly wouldn’twant
ashort-vega trade. Not with the prospect of implied volatility potential
rising going into earnings. In fact, he’dactually want abig positive vega
position. That rules out anaked/cash-secured put, put credit spread and the
likes.
He can probably rule out vertical spreads all together. He doesn’tneed to
spread off theta. He doesn’twant to spread off vega. Positive gamma is
attractive for this sort of trade. He wouldn’twant to spread that off either.
Plus, the inherent time component of spreads won’twork well here. As
discussed in Chapter 9, the bulk of vertical spreads profits (or losses) take
time to come to fruition. The deltas of acall spread are smaller than an
outright call. Profits would come from both delta and theta, if the stock rises
to the short strike and positive theta kicks in.

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Example 2
Atrader, Luke, is studying the following chart for United States Steel Corp.
(X). See Exhibit 17.2 .
EXHIBIT 17.2 United States Steel Corp. daily candles.
Source : Chart courtesy of Livevol® Pro ( www.livevol.com )
This stock is in asteady uptrend, which Luke thinks will continue.
Earnings are out and there are no other expected volatility events on the
horizon. Luke thinks that over the next few weeks, United States Steel can
go from its current price of around $31 ashare to about $34. Volatility is
midpriced in this example—not cheap, not expensive.
This scenario is different than the previous one. Luke plans to potentially
hold this trade for afew weeks. So, for Luke, theta is an important concern.
He cares somewhat about volatility, too. He doesn’tnecessarily want to be
long it in case it falls; he doesn’twant to be short it in case it rises. He’dlike to spread it off; the lower the vega, the better (positive or negative).
Luke really just wants delta play that he can hold for afew weeks without
all the other greeks getting in the way.
For this trade, Luke would likely want to trade adebit call spread with the
long call somewhat ITM and the short call at the $34 strike. This way, Luke
can start off with nearly no theta or vega. He’ll retain some delta, which
will enable the spread to profit if United States Steel rises and as it
approaches the 34 strike, positive theta will kick in.
This spread is superior to apure long call because of its optimized greeks.
It’ssuperior to an OTM bull put spread in its vega position and will likely
produce ahigher profit with the strikes structured as such too, as it would
have abigger delta.

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Managing Trades
Once the trade is on, the greeks come in handy for trade management. The
most important rule of trading is Know Thy Risk . Knowing your risk means
knowing the influences that expose your position to profit or peril in both
absolute and incremental terms. At-expiration diagrams reveal, in no
uncertain terms, what the bottom-line risk points are when the option
expires. These tools are especially helpful with simple short-option
strategies and some long-option strategies. Then traders need the greeks.
After all, that’swhat greeks are: measurements of option risk. The greeks
give insight into atrade’sexposure to the other pricing factors. Traders must
know the greeks of every trade they make. And they must always know the
net-portfolio greeks at all times. These pricing factors ultimately determine
the success or failure of each trade, each portfolio, and eventually each
trader.
Furthermore, always—and Ido mean always—traders must know their up
and down risk, that is, the directional risk of the market moving up or down
certain benchmark intervals. By definition, moves of three standard
deviations or more are very infrequent. But they happen. In this business
anything can happen. Take the “flash crash of 2010 in which the Dow Jones
Industrial Average plunged more than 1,000 points in “aflash.” In my
trading career, I’ve seen some surprises. Traders have to plan for the worst.
It’snot too hard to tell your significant other, “Sorry I’mlate, but Ihit
unexpected traffic. Ijust couldn’tplan for it.” But to say, “Sorry, Ilost our
life savings, and the kids’ college fund, and our house because the market
made an unexpected move. Icouldn’tplan for it,” won’tgo over so well.
The fact is, you can plan for it. And as an option trader, you have to. The
bottom line is, expect the unexpected because the unexpected will
sometimes happen. Traders must use the greeks and up and down risk,
instead of relying on other common indicators, such as the HAPI.

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The HAPI: The Hope and Pray
Index
So you bought acall spread. At the opening bell the next morning, you find
that the market for the underlying has moved lower—alot lower. You have
aloss on your hands. What do you do? Keep apositive attitude? Wear your
lucky shirt? Pray to the options gods? When traders finds themselves
hoping and praying—Iswear I’ll never do that again if Ican just get out of
this position!—it is probably time for them to take their losses and move on
to the next trade. The Hope and Pray Index is acontraindicator. Typically,
the higher it is, the worse the trade.
There are two numbers atrader can control: the entry price and the exit
price. All of the other flashing green and red numbers on the screen are out
of the trader’scontrol. Savvy traders observe what the market does and
make decisions on whether and when to enter aposition and when to exit.
Traders who think about their positions in terms of probability make better
decisions at both of these critical moments.
In entering atrade, traders must consider their forecast, their assessment
of the statistical likelihood of success, the potential payout and loss, and
their own tolerance for risk. Having considered these criteria helps the
traders stay the course and avoid knee-jerk reactions when the market
moves in the wrong direction. Trading is easy when positions make money.
It is how traders deal with adverse positions that separates good traders
from bad.
Good traders are good at losing money. They take losses quickly and let
profits run. Accepting, before entering the trade, the statistical nature of
trading can help traders trade their positions with less emotion. It then
becomes amatter of competent management of those positions based on
their knowledge of the factors affecting option values: the greeks. Learning
to think in terms of probability is among the most difficult challenges for anew options trader.

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Adjusting
Sometimes the position atrader starts off with is not the position he or she
should have at present. Sometimes positions need to be changed, or
adjusted, to reflect current market conditions. Adjusting is very important to
option traders. To be good at adjusting, traders need to use the greeks.
Imagine atrader makes the following trade in Halliburton Company
(HAL) when the stock is trading $36.85.
Sell 10 February 35–36–38–39 iron condors at 0.45
February has 10 days until expiration in this example. The greeks for this
trade are as follows:
Delta: −6.80
Gamma: −119.20
Theta: +21.90
Vega: −12.82
The trader has aneutral outlook, which can be inferred by the near-flat
delta. But what if the underlying stock begins to rise? Gamma starts kicking
in. The trader can end up with ashort-biased delta that loses exponentially
if the stock continues to climb. If Halliburton rises (or falls for that matter)
the trader needs to recalibrate his outlook. Surely, if the trader becomes
bullish based on recent market activity, he’dwant to close the trade. If the
trader is bearish, he’dprobably let the negative delta go in hopes of making
back what was lost from negative gamma. But what if the trader is still
neutral?
Aneutral trader needs aposition that has greeks which reflect that
outlook. The trader would want to get delta back towards zero. Further,
depending on how much the stock rises, theta could start to lose its benefit.
If Halliburton approaches one of the long strikes, theta could move toward
zero, negating the benefit of this sort of trade all together. If after the stock
rises, the trader is still neutral at the new underlying price level, he’dlikely
adjust to get delta and theta back to desired territory.
Acommon adjustment in this scenario is to roll the call-credit-spread legs
of the iron condor up to higher strikes. The trader would buy ten 38 calls

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and sell ten 39 calls to close the credit spread. Then the trader would buy 10
of the 39 calls as sell 10 of the 40 calls to establish an adjusted position that
is short a 10 lot of the February 35–36–39–40 iron condor.
This, of course, is just one possible adjustment atrader can make. But the
common theme among all adjustments is that the trader’sgreeks must
reflect the trader’soutlook. The position greeks best describe what the
position is—that is, how it profits or loses. When the market changes it
affects the dynamic greeks of aposition. If the market changes enough to
make atrader’sposition greeks no longer represent his outlook, the trader
must adjust the position (adjust the greeks) to put it back in line with
expectations.
In option trading there are an infinite number of uses for the greeks. From
finding trades, to planning execution, to managing and adjusting them, to
planning exits; the greeks are truly atrader’sbest resource. They help
traders see potential and actual position risk. They help traders project
potential and actual trade profitability too. Without the greeks, atrader is at
adisadvantage in every aspect of option trading. Use the greeks on each
and every trade, and exploit trades to their greatest potential.
Iwish you good luck !
For me, trading option greeks has been alabor of love through the good
trades and the bad. To succeed in the long run at greeks trading—or any
endeavor, for that matter—requires enjoying the process. Trading option
greeks can be both challenging and rewarding. And remember, although
option trading is highly statistical and intellectual in nature, alittle luck
never hurt! That said, good luck trading!

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long OTM
selling
Cash settlement Chicago Board Options Exchange (CBOE) Volatility
Index®
Condors
iron
long
short
long
short
strikes
safe landing selectiveness too close
too far
with high probability of success
Contractual rights and obligations open interest and volume opening and
closing Options Clearing Corporation (OCC) standardized contracts
exercise style expiration month option series, option class, and contract size
option type
premium
quantity
strike price
Credit call spread Debit call spread Delta
dynamic inputs effect of stock price on effect of time on effect of
volatility on moneyness and Delta-neutral trading art and science
direction neutral vs. direction indifferent gamma, theta, and volatility
gamma scalping implied volatility, trading selling
portfolio margining realized volatility, trading reasons for
smileys and frowns Diagonal spreads double
Dividends
basics
and early exercise dividend plays strange deltas
and option pricing pricing model, inputting data into dates, good and bad
dividend size

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Estimation, imprecision of European-exercise options Exchange-traded
fund (ETF) options Exercise style Expected volatility CBOE Volatility
Index®
implied
stock
Expiration month Ford Motor Company Fundamental analysis Gamma
dynamic
scalping
Greeks
adjusting
defined
delta
dynamic inputs effect of stock price on effect of time on effect of
volatility on moneyness and
gamma
dynamic
HAPI: Hope and Pray Index managing trades online, caveats with regard
to price vs. value rho
counterintuitive results effect of time on put-call parity
strategies, choosing between theta
effect of moneyness and stock price on effects of volatility and time
on positive or negative taking the day out
trading
vega
effect of implied volatility on effect of moneyness on effect of time
on implied volatility (IV) and
where to find Greenspan, Alan HOLDR options
Implied volatility (IV) trading
selling
and vega
In-the-money (ITM) Index options
Interest, open Interest rate moves, pricing in Intrinsic value Jelly rolls
Long-Term Equity AnticiPation Securities® (LEAPS®) Open interest
Option, definition of Option class

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Option prices, measuring incremental changes in factors affecting Option
series
Options Clearing Corporation (OCC) Out-of-the-money (OTM) Parity,
definition of Pin risk
borrowing and lending money boxes
jelly rolls
Premium
Price discovery Price vs. value Pricing model, inputting data into dates,
good and bad dividend size “The Pricing of Options and Corporate
Liabilities” (Black & Scholes) Put-call parity American exercise options
essentials
dividends
synthetic calls and puts, comparing
synthetic stock strategies
theoretical value and interest rate Puts
buying
cash-secured long ATM
married
selling
Ratio spreads and complex spreads delta-neutral positions, management
by market makers through longs to shorts risk, hedging trading flat
multiple-class risk ratio spreads backspreads
vertical
skew, trading Realized volatility trading
Reversion to the mean Rho
counterintuitive results effect of time on and interest rates in planning
trades interest rate moves, pricing in LEAPS
put-call parity and time
trading
Risk and opportunity, option-specific finding the right risk long ATM call
delta
gamma
rho
theta

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and volatility Volatility
buying and selling teenie buyers teenie sellers
calculating data direction neutral, direction biased, and direction
indifferent expected
CBOE Volatility Index®
implied
stock
historical (HV) standard deviation
implied (IV) and direction HV-IV divergence inertia
relationship of HV and IV
selling
supply and demand
realized
trading
skew
term structure vertical
vertical spreads and Volatility charts, studying patterns
implied and realized volatility rise realized volatility falls, implied
volatility falls realized volatility falls, implied volatility remains
constant realized volatility falls, implied volatility rises realized
volatility remains constant, implied volatility falls realized volatility
remains constant, implied volatility remains constant realized
volatility remains constant, implied volatility rises realized volatility
rises, implied volatility falls realized volatility rises, implied
volatility remains constant
Volatility-selling strategies profit potential covered call covered put
gamma-theta relationship greeks and income generation naked
call
short naked puts similarities Would I Do It Now? Rule

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