the same exposure is always abetter choice, but the exposure of the vertical is not exactly the same as that of the long call. The most obvious trade-off is the fact that profit is limited. For smaller moves—up to the price of the short strike—vertical spreads tend to be better trades than outright call purchases. Beyond the strike? Not so much.
But time is atrade-off, too. There have been countless times that Ihave talked with new traders who bought acall because they thought the stock was going up. They were right and still lost money. As the adage goes, timing is everything. The more time that passes, the more advantageous the lower-theta vertical spread becomes. When held until expiration, avertical spread can be abetter trade than an outright call in terms of percentage profit.
In the previous example, when Apple is at $391 with 40 days until expiration, the 395 call is worth 14.60 and the spread is worth 4.40. If Apple were to rise to be trading at $405 at expiration, the call rises to be worth 10, for aloss of 4.60 on the 14.60 debit paid. The spread also is worth 10. It yields again of about 127 percent on the initial $4.40 per share debit.
But look at this same trade if the move occurs before expiration. If Apple rallies to $405 after only acouple weeks, the outcome is much different. With four weeks still left until expiration, the 395 call is worth 19.85 with the underlying at $405. That’sa 36 percent gain on the 14.60. The spread is worth 5.70. That’sa 30 percent gain. The vertical spread must be held until expiration to reap the full benefits, which it accomplishes through erosion of the short option.
The long-call-only play (with asignificantly larger negative theta) is punished severely by time passing. The long call benefits more from aquick move in the underlying. And of course, if the stock were to rise to aprice greater than $405, in ashort amount of time—the best of both worlds for the outright call—the outright long 395 call would be emphatically superior to the spread.
Bear Call Spread
The next type of vertical spread is called abear call spread
. Abear call spread is ashort call combined with along call that has ahigher strike price. Both calls are on the same underlying and share the same expiration month. In this case, the call being sold is the option of higher value. This call spread results in anet credit when the trade is put on and, therefore, is called acredit spread.
The bull call spread and the bear call spread are two sides of the same coin. The difference is that with the bull call spread, one is buying the call spread, and with the bear call spread, one is selling the call spread. An example of abear call spread can be shown using the same trade used earlier.
Here we are selling one AAPL February (40-day) 395 call at 14.60 and buying the 405 call at 10.20. We are selling the 395–405 call at $4.40 per share, or $440.
Exhibit 9.4
is an at-expiration diagram of the trade.
EXHIBIT 9.4
Apple bear call spread.
The same three at-expiration outcomes are possible here as with the bull call spread: the stock can be above both strikes, between both strikes, or below both strikes. If the stock is below both strikes at expiration, both calls will expire worthless. The rights and obligations cease to exist. In this case, the entire credit of $440 is profit.
If AAPL is between the two strike prices at expiration, the 395-strike call will be in-the-money. The short call will get assigned and result in ashort stock position at expiration. The break-even price falls at $399.40—the short strike plus the $4.40 net premium. This is the price at which the stock will effectively be sold if assignment occurs.
If Apple is above both strikes at expiration, it means both calls are in-the-money. Stock is sold at $395 because of assignment and bought back at $405 through exercise. This leads to aloss of $10 per share on the negative scalp. Factoring in the $4.40-per-share credit makes the net loss only $5.60 per share with AAPL above $405 at February expiration.
Just as the at-expiration diagram is the same but reversed, the greeks for this call spread will be similar to those in the bull call spread example except for the positive and negative signs. See
Exhibit 9.5
.
EXHIBIT 9.5
Apple 395–405 bear call spread.
Acredit spread is commonly traded as an income-generating strategy. The idea is simple: sell the option closer-to-the-money and buy the more out-of-the-money (OTM) option—that is, sell volatility—and profit from nonmovement (above acertain point). In this example, with Apple at $391, aneutral to slightly bearish trader would think about selling this spread at 4.40 in hopes that the stock will remain below $395 until expiration. The best-case scenario is that the stock is below $395 at expiration and both options expire, resulting in a $4.40-per-share profit.
The strategy profits as long as Apple is under its break-even price, $399.40, at expiration. But this is not so much abearish strategy


in below $395 until expiration. The best-case scenario is that the stock is below $395 at expiration and both options expire, resulting in a $4.40-per-share profit.
The strategy profits as long as Apple is under its break-even price, $399.40, at expiration. But this is not so much abearish strategy as it is anonbullish strategy. The maximum gain with acredit spread is the premium received, in this case $4.40 per share. Traders who thought AAPL was going to decline sharply would short it or buy aput. If they thought it would rise sharply, they’duse another strategy.
From agreek perspective, when the trade is executed it’svery close to its highest theta price point—the 395 short strike price. This position theoretically collects $0.90 aday with Apple at around $395. As time passes, that theta rises. The key is that the stock remains at around $395 until the short option is just about worthless. The name of the game is sit and wait.
Although the delta is negative, traders trading this spread to generate income want the spread to expire worthless so they can pocket the $4.40 per share. If Apple declines, profits will be made on delta, and theta profits will be foregone later. All that matters is the break-even point. Essentially, the idea is to sell anaked call with amaximum potential loss. Sell the 395s and buy the 405s for protection.
If the underlying decreases enough in the short term and significant profits from delta materialize, it is logical to consider closing the spread early. But it often makes more sense to close part of the spread. Consider that the 405-strike call is farther out-of-the-money and will lose its value before the 395 call.
Say that after two weeks abig downward move occurs. Apple is trading at $325 ashare; the 405s are 0.05 bid at 0.10, and the 395s are 0.50 bid at 0.55. At this point, the lion’sshare of the profits can be taken early. Atrader can do so by closing only the 395 calls. Closing the 395s to eliminate the risk of negative delta and gamma makes sense. But does it make sense to close the 405s for 0.05? Usually not. Recouping this residual value accomplishes little. It makes more sense to leave them in your position in case the stock rebounds. If the stock proves it can move down $70; it can certainly move up $70. Because the majority of the profits were taken on the 395 calls, holding on to the 405s is like getting paid to own calls. In scenarios where abig move occurs and most of the profits can be taken early, it’soften best to hold the long calls, just in case. It’sawin-win situation.
Credit and Debit Spread Similarities
The credit call spread and the debit call spread appear to be exactly opposite in every respect. Many novice traders perceive credit spreads to be fundamentally different from debit spreads. That is not necessarily so. Closer study reveals that these two are not so different after all.
What if Apple’sstock price was higher when the trade was put on? What if the stock was at $405? First, the spread would have had more value. The 395 and 405 calls would both be worth more. Atrader could have sold the spread for a $5.65-per-share credit. The at-expiration diagram would look almost the same. See
Exhibit 9.6
.
EXHIBIT 9.6
Apple bear call spread initiated with Apple at $405.
Because the net premium is much higher in this example, the maximum gain is more—it is $5.65 per share. The breakeven is $400.65. The price points on the at-expiration diagram, however, have nothing to do with the greeks. The analytics from
Exhibit 9.5
are the same either way.
The motivation for atrader selling this call spread, which has both options in-the-money, is different from that for the typical income generator. When the spread is sold in this context, the trader is buying volatility. Long gamma, long vega, negative theta. The trader here has atrade more like the one in the bull call spread example—except that instead of needing arally, the trader needs arout. The only difference is that the bull call spread has abullish delta, and the bear call spread has abearish delta.
Bear Put Spread
There is another way to take abearish stance with vertical spreads: the bear put spread. Abear put spread is along put plus ashort put that has alower strike price. Both puts are on the same underlying and share the same expiration month. This spread, however, is adebit spread because the more expensive option is being purchased.
Imagine that astock has had agood run-up in price. The chart shows asteady march higher over the past couple of months. Astudy of technical analysis, though, shows that the run-up may be pausing for breath. An oscillator, such as slow stochastics, in combination with the relative strength index (RSI), indicates that the stock is overbought. At the same time, the average directional movement index (ADX) confirms that the uptrend is slowing.
For traders looking for asmall pullback, abear put spread can be an excellent strategy. The goal is to see the stock drift down to the

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e strength index (RSI), indicates that the stock is overbought. At the same time, the average directional movement index (ADX) confirms that the uptrend is slowing.
For traders looking for asmall pullback, abear put spread can be an excellent strategy. The goal is to see the stock drift down to the short strike. So, like the other members of the vertical spread family, strike selection is important.
Let’slook at an example of ExxonMobil (XOM). After the stock has rallied over atwo-month period to $80.55, atrader believes there will be ashort-term temporary pullback to $75. Instead of buying the June 80 puts for 1.75, the trader can buy the 75–80 put spread of the same month for 1.30 because the 75 put can be sold for 0.45.
1
In this example, the June put has 40 days until expiration.
Exhibit 9.7
illustrates the payout at expiration.
EXHIBIT 9.7
ExxonMobil bear put spread.
If the trader is wrong and ExxonMobil is still above 80 at expiry, both puts expire and the 1.30 premium is lost. If ExxonMobil is between the two strikes, the 80 puts are ITM, resulting in an exercise, and the 75 puts are OTM and expire. The net effect is short stock at an effective price of $78.70. The effective sale price is found by taking the price at which the short stock is established when the puts are exercised—$80—minus the net 1.30 paid for the spread. This is the spread’sbreakeven at expiration.
If the trader is right and ExxonMobil is below both strikes at expiration, both puts are ITM, and the result is a 3.70 profit and no position. Why a 3.70 profit? The 80 puts are exercised, making the trader short at $80, and the 75 puts are assigned, so the short is bought back at $75 for apositive stock scalp of $5. Including the 1.30 debit for the spread in the profit and loss (P&(L)), the net profit is $3.70 per share when the stock is below both strikes at expiration.
This is abearish trade. But is the bear put spread necessarily abetter trade than buying an outright ATM put? No. The at-expiration diagram makes this clear. Profits are limited to $3.70 per share. This is an important difference. But because in this particular example, the trader expects the stock to retrace only to around $75, the benefits of lower cost and lower theta and vega risk can be well worth the trade-off of limited profit. The trader’sobjectives are met more efficiently by buying the spread. The goal is to profit from the delta move down from $80 to $75.
Exhibit 9.8
shows the differences between the greeks of the outright put and the spread when the trade is put on with ExxonMobil at $80.55.
EXHIBIT 9.8
ExxonMobil put vs. bear put spread (ExxonMobil @ $80.55).
80 Put
75–80 Put
Delta
−0.445
−0.300
Gamma
+0.080
+0.041
Theta
−0.018
−0.006
Vega
+0.110
+0.046
As in the call-spread examples discussed previously, the spread delta is smaller than the outright put’s. It appears ironic that the spread with the smaller delta is abetter trade in this situation, considering that the intent is to profit from direction. But it is the relative differences in the greeks besides delta that make the spread worthwhile given the trader’sgoal. Gamma, theta, and vega are proportionately much smaller than the delta in the spread than in the outright put. While the spread’sdelta is two thirds that of the put, its gamma is half, its theta one third, and its vega around 42 percent of the put’s.
Retracements such as the one called for by the trader in this example can happen fast, sometimes over the course of aweek or two. It’snot necessarily bad if this move occurs quickly. If ExxonMobil drops by $5 right away, the short delta will make the position profitable.
Exhibit 9.9
shows how the spread position changes as the stock declines from $80 to $75.
EXHIBIT 9.9
75–80 bear put spread as ExxonMobil declines.
The delta of this trade remains negative throughout the stock’sdescent to $75. Assuming the $5 drop occurs in one day, adelta averaging around −0.36 means about a 1.80 profit, or $180 per spread, for the $5 move (0.36 times $5 times 100). This is still afar cry from the spread’s $3.70 potential profit. Although the stock is at $75, the maximum profit potential has yet to be reached, and it won’tbe until expiration. How does the rest of the profit materialize? Time decay.
The price the trader wants the stock to reach is $75, but the assumption here is that the move happens very fast. The trade went from being along-volatility play—long gamma and vega—to ashort-vol play: short gamma and vega. The trader wanted movement when the stock was at $80 and wants no movement when the stock is at $75. When the trade changes characteristics by moving from one strike to another, the trader has to reconsider the stock’soutlook. The question is: if Ididn’thave this position on, would Iwant it now?
The trader has achoice to make: take the $180 profit—which represents a 138 percent profit on the 1.30 debit—or wait for theta to do its thing. The trader looking for aretracement would likely be inclined


sider the stock’soutlook. The question is: if Ididn’thave this position on, would Iwant it now?
The trader has achoice to make: take the $180 profit—which represents a 138 percent profit on the 1.30 debit—or wait for theta to do its thing. The trader looking for aretracement would likely be inclined to take aprofit on the trade. Nobody ever went broke taking aprofit. But if the trader thinks the stock will sit tight for the remaining time until expiration, he will be happy with this income-generating position.
Although the trade in the last, overly simplistic example did not reap its full at-expiration potential, it was by no means abad trade. Holding the spread until expiration is not likely to be part of atrader’splan. Buying the 80 put outright may be abetter play if the trader is expecting afast move. It would have abigger delta than the spread. Debit and credit spreads can be used as either income generators or as delta plays. When they’re used as delta plays, however, time must be factored in.
Bull Put Spread
The last of the four vertical spreads is abull put spread. Abull put spread is ashort put with one strike and along put with alower strike. Both puts are on the same underlying and in the same expiration cycle. Abull put spread is acredit spread because the more expensive option is being sold, resulting in anet credit when the position is established. Using the same options as in the bear put example:
With ExxonMobil at $80.55, the June 80 puts are sold for 1.75 and the June 75 puts are bought at 0.45. The trade is done for acredit of 1.30.
Exhibit 9.10
shows the payout of this spread if it is held until expiration.
EXHIBIT 9.10
ExxonMobil bull put spread.
The sale of this spread generates a 1.30 net credit, which is represented by the maximum profit to the right of the 80 strike. With ExxonMobil above $80 per share at expiration, both options expire OTM and the premium is all profit. Between the two strike prices, the 80 put expires in the money. If the ITM put is still held at expiration, it will be assigned. Upon assignment, the put becomes long stock, profiting with each tick higher up to $80, or losing with each tick lower to $75. If the 80 put is assigned, the effective price of the long stock will be $78.70. The assignment will “hit your sheets” as abuy at $80, but the 1.30 credit lowers the effective net cost to $78.70.
If the stock is below $75 at option expiration, both puts will be ITM. This is the worst case scenario, because the higher-struck put was sold. At expiration, the 80 puts would be assigned, the 75 puts exercised. That’sanegative scalp of $5 on the resulting stock. The initial credit lessens the pain by 1.30. The maximum possible loss with ExxonMobil below both strikes at expiration is $3.70 per spread.
The spread in this example is the flip side of the bear put spread of the previous example. Instead of buying the spread, as with the bear put, the spread in this case is sold.
Exhibit 9.11
shows the analytics for the bull put spread.
EXHIBIT 9.11
Greeks for ExxonMobil 75–80 bull put spread.
Instead of having ashort delta, as with the bear spread, the bull spread is long delta. There is negative theta with positive gamma and vega as XOM approaches the long strike—the 75s, in this case. There is also positive theta with negative gamma and vega around the short strike—the 80s.
Exhibit 9.11
shows the characteristics that define the vertical spread. If one didn’tknow which particular options were being traded here, this could almost be atable of greeks for either a 75–80 bull put spread or a 75–80 bull call spread.
Like the other three verticals, this spread can be adelta play or atheta play. Abullish trader may sell the spread if both puts are in-the-money. Imagine that XOM is trading at around $75. The spread will have apositive 0.364 delta, positive gamma, and negative theta. The spread as awhole is adecaying asset. It needs the underlying to rally to combat time decay.
Abullish trader may also sell this spread if XOM is between the two strikes. In this case, with XOM at, say, $77, the delta is +0.388, and all other greeks are negligible. At this particular price point in the underlying, the trader has almost pure leveraged delta exposure. But this trade would be positioned for only asmall move, not much above $80. Aspeculator wanting to trade direction for asmall move while eliminating theta and vega risks achieves her objectives very well with avertical spread.
Abullish-to-neutral trader would be inclined to sell this spread if ExxonMobil were around $80 or higher. Day by day, the 1.30 premium would start to come in. With 40 days until expiration, theta would be small, only 0.004. But if the stock remained at $80, this ATM put would begin decaying faster and faster. The objective of trading this spread for aneutral trader is selling future realized volatility—selling gamma to earn theta. Atrader can also trade avertical spread to profit from IV.
Verticals and Volatility
The


. But if the stock remained at $80, this ATM put would begin decaying faster and faster. The objective of trading this spread for aneutral trader is selling future realized volatility—selling gamma to earn theta. Atrader can also trade avertical spread to profit from IV.
Verticals and Volatility
The IV component of avertical spread, although small compared with that of an outright call or put, is still important—especially for large traders with low margin and low commissions who can capitalize on small price changes efficiently. Whether it’sacall spread or aput spread, acredit spread or adebit spread, if the underlying is at the short option’sstrike, the spread will have anet negative vega. If the underlying is at the long option’sstrike, the spread will have positive vega. Because of this characteristic, there are three possible volatility plays with vertical spreads: speculating on IV changes when the underlying remains constant, profiting from IV changes resulting from movement of the underlying, and special volatility situations.
Vertical spreads offer alimited-risk way to speculate on volatility changes when the underlying remains fairly constant. But when the intent of avertical spread is to benefit from vega, one must always consider the delta—it’sthe bigger risk. Chapter 13 discusses ways to manage this risk by hedging with stock, astrategy called delta-neutral trading.
Non-delta-neutral traders may speculate on vol with vertical spreads by assuming some delta risk. Traders whose forecast is vega bearish will sell the option with the strike closest to where the underlying is trading—that is, the ATM option—and buy an OTM strike. Traders would lean with their directional bias by choosing either acall spread or aput spread. As risk managers, the traders balance the volatility stance being taken against the additional risk of delta. Again, in this scenario, delta can hurt much more than help.
In the ExxonMobil bull put spread example, the trader would sell the 80-strike put if ExxonMobil were around $80 ashare. In this case, if the stock didn’tmove as time passed, theta would benefit from historical volatility being’slow—that is, from little stock movement. At first, the benefit would be only 0.004 per day, speeding up as expiration nears. And if implied volatility decreased, the trader would profit 0.04 for every 1 percent decline in IV. Small directional moves upward help alittle. But in the long run, those profits are leveled off by the fact that theta gets smaller as the stock moves higher above $80—more profit on direction, less on time.
For the delta player, bull call spreads and bull put spreads have apotential added benefit that stems from the fact that IV tends to decrease as stocks rise and increase when stocks fall. This offers additional opportunity to the bull spread player. With the bull call spread or the bull put spread, the trader gains on positive delta with arally. Once the underlying comes close to the short option’sstrike, vega is negative. If IV declines, as might be anticipated, there is afurther benefit of vega profits on top of delta profits. If the underlying declines, the trader loses on delta. But the pain can potentially be slightly lessened by vega profits. Vega will get positive as the underlying approaches the long strike, which will benefit from the firming of IV that often occurs when the stock drops. But this dual benefit is paid for in the volatility skew. In most stocks or indexes, the lower strikes—the ones being bought in abull spread—have higher IVs than the higher strikes, which are being sold.
Then there are special market situations in which vertical spreads that benefit from volatility changes can be traded. Traders can trade vertical spreads to strategically position themselves for an expected volatility change. One example of such asituation is when astock is rumored to be atakeover target. Anatural instinct is to consider buying calls as an inexpensive speculation on ajump in price if the takeover is announced. Unfortunately, the IV of the call is often already bid up by others with the same idea who were quicker on the draw. Buying acall spread consisting of along ITM call and ashort OTM call can eliminate immediate vega risk and still provide wanted directional exposure.
Certainly, with this type of trade, the trader risks being wrong in terms of direction, time, and volatility. If and when atakeover bid is announced, it will likely be for aspecific price. In this event, the stock price is unlikely to rise above the announced takeover price until either the deal is consummated or asecond suitor steps in and offers ahigher price to buy the company. If the takeover is a “cash deal,” meaning the acquiring company is tendering cash to buy the shares, the stock will usually sit in avery tight range below the takeover price for along time. In this event, implied volatility will often drop to very low levels. Being short an ATM call when the stock rallies will


over is a “cash deal,” meaning the acquiring company is tendering cash to buy the shares, the stock will usually sit in avery tight range below the takeover price for along time. In this event, implied volatility will often drop to very low levels. Being short an ATM call when the stock rallies will let the trader profit from collapsing IV through negative vega.
Say XYZ stock, trading at $52 ashare, is arumored takeover target at $60. When the rumors are first announced, the stock will likely rise, to say $55, with IV rising as well. Buying the 50–60 call spread will give atrader apositive delta and anegligible vega. If the rumors are realized and acash takeover deal is announced at $60, the trade gains on delta, and the spread will now have negative vega. The negative vega at the 60 strike gains on implied volatility declining, and the stock will sit close to $60, producing the benefits of positive theta. Win, win, win.
The Interrelations of Credit Spreads and Debit Spreads
Many traders Iknow specialize in certain niches. Sometimes this is because they find something they know well and are really good at. Sometimes it’sbecause they have become comfortable and don’thave the desire to try anything new. I’ve seen this strategy specialization sometimes with traders trading credit spreads and debit spreads. I’ve had serial credit spread traders tell me credit spreads are the best trades in the world, much better than debit spreads. Habitual debit spread traders have likewise said their chosen spread is the best. But credit spreads and debit spreads are not so different. In fact, one could argue that they are really the same thing.
Conventionally, credit-spread traders have the goal of generating income. The short option is usually ATM or OTM. The long option is more OTM. The traders profit from nonmovement via time decay. Debit-spread traders conventionally are delta-bet traders. They buy the ATM or just out-of-the-money option and look for movement away from or through the long strike to the short strike. The common themes between the two are that the underlying needs to end up around the short strike price and that time has to pass to get the most out of either spread.
With either spread, movement in the underlying may be required, depending on the relationship of the underlying price to the strike prices of the options. And certainly, with acredit spread or debit spread, if the underlying is at the short strike, that option will have the most premium. For the trade to reach the maximum profit, it will need to decay.
For many retail traders, debit spreads and credit spreads begin to look even more similar when margin is considered. Margin requirements can vary from firm to firm, but verticals in retail accounts at option-friendly brokerage firms are usually margined in such away that the maximum loss is required to be deposited to hold the position (this assumes Regulation Tmargining). For all intents and purposes, this can turn the trader’scash position from acredit into adebit. From acash perspective, all vertical spreads are spreads that require adebit under these margin requirements. Professional traders and retail traders who are subject to portfolio margining are subject to more liberal margin rules.
Although margin is an important concern, what we really care about as traders is risk versus reward. Acredit call spread and adebit put spread on the same underlying, with the same expiration month, sharing the same strike prices will also share the same theoretical risk profile. This is because call and put prices are bound together by put-call parity.
Building a Box
Two traders, Sam and Isabel, share ajoint account. They have each been studying Johnson & Johnson (JNJ), which is trading at around $63.35 per share. Sam and Isabel, however, cannot agree on direction. Sam thinks Johnson & Johnson will rise over the next five weeks, and Isabel believes it will decline during that period.
Sam decides to buy the January 62.50 −65 call spread (January has 38 days until expiration in this example). Sam can buy this spread for 1.28. His maximum risk is 1.28. This loss occurs if Johnson & Johnson is below $62.50 at expiration, leaving both calls OTM. His maximum gain is 1.22, realized if Johnson & Johnson is above $65 (65–62.50–1.28). With Johnson & Johnson at $63.35, Sam’sdelta is long 0.29 and his other greeks are about flat.
Isabel decides to buy the January 62.50–65 put spread for adebit of 1.22. Isabel’sbiggest potential loss is 1.22, incurred if Johnson & Johnson is above $65 ashare at expiration, leaving both puts OTM. Her maximum possible profit is 1.28, realized if the stock is below $62.50 at option expiration. With Johnson & Johnson at $63.35, Isabel has adelta that is short around 0.27 and is nearly flat gamma, theta, and vega.
Collectively, if both Sam and Isabel hold their trades until expiration, it’sazero-sum game. With Johnson & Johnson below $62.50, Sam loses his investment of 1.28, but Isabel prof


With Johnson & Johnson at $63.35, Isabel has adelta that is short around 0.27 and is nearly flat gamma, theta, and vega.
Collectively, if both Sam and Isabel hold their trades until expiration, it’sazero-sum game. With Johnson & Johnson below $62.50, Sam loses his investment of 1.28, but Isabel profits. She cancels out Sam’sloss by making 1.28. Above $65, Sam makes 1.22 while Isabel loses the same amount, canceling out Sam’sgains. Between the two strikes, Sam has gains on his 62.50 call and Isabel has gains on her 65 put. The gains on the two options will total 2.50, the combined total spent on the spreads—another draw.
EXHIBIT 9.12
Sam’slong call spread in Johnson & Johnson.
62.50–65 Call Spread
Delta
+0.290
Gamma
+0.001
Theta
−0.004
Vega
+0.006
EXHIBIT 9.13
Isabel’slong put spread in Johnson & Johnson.
62.50–65 Put Spread
Delta
−0.273
Gamma
−0.001
Theta
+0.005
Vega
−0.006
These two spreads were bought for acombined total of 2.50. The collective position, composed of the four legs of these two spreads, forms anew strategy altogether.
The two traders together have created abox. This box, which is empty of both profit and loss, is represented by greeks that almost entirely offset each other. Sam’spositive delta of 0.29 is mostly offset by Isabel’s −0.273 delta. Gamma, theta, and vega will mostly offset each other, too.
Chapter 6 described abox as long synthetic stock combined with short synthetic stock having adifferent strike price but the same expiration month. It can also be defined, however, as two vertical spreads: abull (bear) call spread plus abear (bull) put spread with the same strike prices and expiration month.
The value of abox equals the present value of the distance between the two strike prices (American-option models will also account for early exercise potential in the box’svalue). This 2.50 box, with 38 days until expiration at a 1 percent interest rate, has less than apenny of interest affecting its value. Boxes with more time until expiration will have ahigher interest rate component. If there was one year until expiration, the combined value of the two verticals would equal 2.475. This is simply the distance between the strikes minus interest (2.50–[2.50 × 0.01]).
Credit spreads are often made up of OTM options. Traders betting against astock rising through acertain price tend to sell OTM call spreads. For astock at $50 per share, they might sell the 55 calls and buy the 60 calls. But because of the synthetic relationship that verticals have with one another, the traders could buy an ITM put spread for the same exposure, after accounting for interest. The traders could buy the 60 puts and sell the 55 puts. An ITM call (put) spread is synthetically equal to an OTM put (call) spread.
Verticals and Beyond
Traders who want to take full advantage of all that options have to offer can do so strategically by trading spreads. Vertical spreads truncate directional risk compared with strategies like the covered call or single-legged option trades. They also reduce option-specific risk, as indicated by their lower gamma, theta, and vega. But lowering risk both in absolute terms and in the greeks has atrade-off compared with buying options: limited profit potential. This trade-off can be beneficial, depending on the trader’sforecast. Debit spreads and credit spreads can be traded interchangeably to achieve the same goals. When along (short) call spread is combined with along (short) put spread, the product is abox. Chapter 10 describes other ways vertical spreads can be combined to form positions that achieve different trading objectives.
Note
1
. Note that it is customary when discussing the purchase or sale of spreads to state the lower strike first, regardless of which is being bought or sold. In this case, the trader is buying the 75–80 put spread.


CHAPTER 10
Wing Spreads
Condors and Butterflies
The “wing spread” family is aset of option strategies that is very popular, particularly among experienced traders. These strategies make it possible for speculators to accomplish something they could not possibly do by just trading stocks: They provide ameans to profit from atruly neutral market in asecurity. Stocks that don’tmove one iota can earn profits month after month for income-generating traders who trade these strategies.
These types of spreads have alot of moving parts and can be intimidating to newcomers. At their heart, though, they are rather straightforward break-even analysis trades that require little complex math to maintain. Asimple at-expiration diagram reveals in black and white the range in which the underlying stock must remain in order to have aprofitable position. However, applying the greeks and some of the mathematics discussed in previous chapters can help atrader understand these strategies on adeeper level and maximize the chance of success. This chapter will discuss condors and butterflies and how to put them into action most effectively.
Taking Flight
There are four primary wing spreads: the condor, the iron condor, the butterfly, and the iron butterfly. Each of these spreads involves trading multiple options with three or four strikes prices. We can take these spreads at face value, we can consider each option as an individual component of the spread, or we can view the spreads as being made up of two vertical spreads.
Condor
Acondor is afour-legged option strategy that enables atrader to capitalize on volatility—increased or decreased. Traders can trade long or short iron condors.
Long Condor
Long one call (put) with strike A; short one call (put) with ahigher strike, B; short one call (put) at strike C, which is higher than B; and long one call (put) at strike D, which is higher than C. The distance between strike price Aand Bis equal to the distance between strike Cand strike D. The options are all on the same security, in the same expiration cycle, and either all calls or all puts.
Long Condor Example
Buy 1 XYZ November 70 call (A)
Sell 1 XYZ November 75 call (B)
Sell 1 XYZ November 90 call (C)
Buy 1 XYZ November 95 call (D)
Short Condor
Short one call (put) with strike A; long one call (put) with ahigher strike, B; long one call (put) with astrike, C, that is higher than B; and short one call (put) with astrike, D, that is higher than C. The options must be on the same security, in the same expiration cycle, and either all calls or all puts. The differences in strike price between the vertical spread of strike prices Aand Band the strike prices of the vertical spread of strikes Cand Dare equal.
Short Condor Example
Sell 1 XYZ November 70 call (A)
Buy 1 XYZ November 75 call (B)
Buy 1 XYZ November 90 call (C)
Sell 1 XYZ November 95 call (D)
Iron Condor
An iron condor is similar to acondor, but with amix of both calls and puts. Essentially, the condor and iron condor are synthetically the same.
Short Iron Condor
Long one put with strike A; short one put with ahigher strike, B; short one call with an even higher strike, C; and long one call with astill higher strike, D. The options are on the same security and in the same expiration cycle. The put credit spread has the same distance between the strike prices as the call credit spread.
Short Iron Condor Example
Buy 1 XYZ November 70 put (A)
Sell 1 XYZ November 75 put (B)
Sell 1 XYZ November 90 call (C)
Buy 1 XYZ November 95 call (D)
Long Iron Condor
Short one put with strike A; long one put with ahigher strike, B; long one call with an even higher strike, C; and short one call with astill higher strike, D. The options are on the same security and in the same expiration cycle. The put debit spread (strikes Aand B) has the same distance between the strike prices as the call debit spread (strikes Cand D).
Long Iron Condor Example
Sell 1 XYZ November 70 put (A)
Buy 1 XYZ November 75 put (B)
Buy 1 XYZ November 90 call (C)
Sell 1 XYZ November 95 call (D)
Butterflies
Butterflies are wing spreads similar to condors, but there are only three strikes involved in the trade—not four.
Long Butterfly
Long one call (put) with strike A; short two calls (puts) with ahigher strike, B; and long one call (put) with an even higher strike, C. The options are on the same security, in the same expiration cycle, and are either all calls or all puts. The difference in price between strikes Aand Bequals that between strikes Band C.
Long Butterfly Example
Buy 1 XYZ December 50 call (A)
Sell 2 XYZ December 60 call (B)
Buy 1 XYZ December 70 call (C)
Short Butterfly
Short one call (put) with strike A; long two calls (puts) with ahigher strike, B; and short one call (put) with an even higher strike, C. The options are on the same security, in the same expiration cycle, and are either all calls or all puts. The vertical spread made up of the options with strike Aand strike Bhas the same distance between the st

eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00020.html


ls (puts) with ahigher strike, B; and short one call (put) with an even higher strike, C. The options are on the same security, in the same expiration cycle, and are either all calls or all puts. The vertical spread made up of the options with strike Aand strike Bhas the same distance between the strike prices of the vertical spread made up of the options with strike Band strike C.
Short Butterfly Example
Sell 1 XYZ December 50 call
Buy 2 XYZ December 60 call
Sell 1 XYZ December 70 call
Iron Butterflies
Much like the relationship of the condor to the iron condor, abutterfly has its synthetic equal as well: the iron butterfly.
Short Iron Butterfly
Long one put with strike A; short one put with ahigher strike, B; short one call with strike B; long one call with astrike higher than B, C. The options are on the same security and in the same expiration cycle. The distances between the strikes of the put spread and between the strikes of the call spread are equal.
Short Iron Butterfly Example
Buy 1 XYZ December 50 put (A)
Sell 1 XYZ December 60 put (B)
Sell 1 XYZ December 60 call (B)
Buy 1 XYZ December 70 call (C)
Long Iron Butterfly
Short one put with strike A; long one put with ahigher strike, B; long one call with strike B; short one call with astrike higher than B, C. The options are on the same security and in the same expiration cycle. The distances between the strikes of the put spread and between the strikes of the call spread are equal. The put debit spread has the same distance between the strike prices as the call debit spread.
Long Iron Butterfly Example
Sell 1 XYZ December 50 put
Buy 1 XYZ December 60 put
Buy 1 XYZ December 60 call
Sell 1 XYZ December 70 call
These spreads were defined in terms of both long and short for each strategy. Whether the spread is classified as long or short depends on whether it was established at acredit or adebit. Debit condors or butterflies are considered long spreads. And credit condors or butterflies are considered short spreads.
The words long and short mean little, though in terms of the spread as awhole. The important thing is which strikes have long options and which have short options. Acall debit spread is synthetically equal to aput credit spread on the same security, with the same expiration month and strike prices. That means along condor is synthetically equal to ashort iron condor, and along butterfly is synthetically equal to ashort iron butterfly, when the same strikes are used. Whichever position is constructed, the best-case scenario is to have debit spreads expire with both options in-the-money (ITM) and credit spreads expire with both options out-of-the-money (OTM).
Many retail traders prefer trading these spreads for the purpose of generating income. In this case, atrader would sell the guts, or middle strikes, and buy the wings, or outer strikes. When atrader is short the guts, low realized volatility is usually the objective. For long butterflies and short iron butterflies, the stock needs to be right at the middle strike for the maximum payout. For long condors and short iron condors, the stock needs to be between the short strikes at expiration for maximum payout. In both instances, the wings are bought to limit potential losses of the otherwise naked options.
Long Butterfly Example
Atrader, Kathleen, has been studying United Parcel Service (UPS), which is trading at around $70.65. She believes UPS will trade sideways until July expiration. Kathleen buys the July 65–70–75 butterfly for 2.00. She executes the following legs:
Kathleen looks at her trade as two vertical spreads, the 65–70 bull (debit) call spread and the 70–75 bear (credit) call spread. Intuitively, she would want UPS to be at or above $70 at expiration for her bull call spread to have maximum value. But she has the seemingly conflicting goal of also wanting UPS to be at or below $70 to get the most from her 70–75 bear call spread. The ideal price for the stock to be trading at expiration in this example is right at $70 per share—the best of both worlds. The at-expiration diagram,
Exhibit 10.1
, shows the profit or loss of all possible outcomes at expiration.
EXHIBIT 10.1
UPS 65–70–75 butterfly.
If the price of UPS shares declines below $65 at expiration, all these calls will expire. The entire 2.00 spent on the trade will be lost. If UPS is above $65 at expiration, the 65 call will be ITM and will be exercised. The call will profit like along position in 100 shares of the underlying. The maximum profit is reached if UPS is at $70 at expiration. Kathleen makes a 5.00 profit from $65 to $70 on her 65 calls. But because she paid 2.00 initially for the spread, her net profit at $70 is just 3.00. If UPS is above $70 ashare at expiration in this example, the two 70 calls will be assigned. The assignment of one call will offset the long stock acquired by the 65 calls being exercised. Assignment of the other call will create ashort position in the underlying. That short position loses as


3.00. If UPS is above $70 ashare at expiration in this example, the two 70 calls will be assigned. The assignment of one call will offset the long stock acquired by the 65 calls being exercised. Assignment of the other call will create ashort position in the underlying. That short position loses as UPS moves higher up to $75 ashare, eating away at the 3.00 profit. If UPS is above $75 at expiration, the 75 call can be exercised to buy back the short stock position that resulted from the 70’sbeing assigned. The loss on the short stock between $70 and $75 will cost Kathleen 5.00, stripping her of her 3.00 profit and giving her anet loss of 2.00 to boot. End result? Above $75 at expiration, she has no position in the underlying and loses 2.00.
Abutterfly is abreak-even analysis trade
. This name refers to the idea that the most important considerations in this strategy are the breakeven points. The at-expiration diagram,
Exhibit 10.2
, shows the break-even prices for this trade.
EXHIBIT 10.2
UPS 65–70–75 butterfly breakevens.
If the position is held until expiration and UPS is between $65 and $70 at that time, the 65 calls are exercised, resulting in long stock. The effective purchase price of that stock is $67. That’sthe strike price plus the cost of the spread; that’sthe lower break-even price. The other break-even is at $73. The net short position of 100 shares resulting from assignment of the 70 call loses more as the stock rises between $70 and $75. The entire 3.00 profit realized at the $70 share price is eroded when the stock reaches $73. Above $73, the trade produces aloss.
Kathleen’strading objective is to profit from UPS trading between $67 and $73 at expiration. The best-case scenario is that it declines only slightly from its price of $70.65 when the trade is established, to $70 per share.
Alternatives
Kathleen had other alternative positions she could have traded to meet her goals. An iron butterfly with the same strike prices would have shown about the same risk/reward picture, because the two positions are synthetically equivalent. But there may, in some cases, be aslight advantage to trading the iron butterfly over the long butterfly. The iron butterfly uses OTM put options instead of ITM calls, meaning the bid-ask spreads may be tighter. This means giving up less edge to the liquidity providers.
She could have also bought acondor or sold an iron condor. With condor-family spreads, there is alower maximum profit potential but awider range in which that maximum payout takes place. For example, Kathleen could have executed the following legs to establish an iron condor:
Essentially, Kathleen would be selling two credit spreads: the July 60–65 put spread for 0.30 and the July 75–80 call spread for 0.35.
Exhibit 10.3
shows the payout at expiration of the UPS July 60–65–75–80 iron condor.
EXHIBIT 10.3
UPS 60–65–75–80 iron condor.
Although the forecast and trading objectives may be similar to those for the butterfly, the payout diagram reveals some important differences. First, the maximum loss is significantly higher with acondor or iron condor. In this case, the maximum loss is 4.35. This unfortunate situation would occur if UPS were to drop to below $60 or rise above $80 by expiration. Below $60, the call spread expires, netting 0.35. But the put spread is ITM. Kathleen would lose anet of 4.70 on the put spread. The gain on the call spread combined with the loss on the put spread makes the trade aloser of 4.35 if the stock is below $60 at expiration. Above $80, the put spread is worthless, earning 0.30, but the call spread is aloser by 4.65. The gain on the put spread plus the loss on the call spread is anet loser of 4.35. Between $65 and $75, all options expire and the 0.65 credit is all profit.
So far, this looks like apretty lousy alternative to the butterfly. You can lose 4.35 but only make 0.65! Could there be any good reason for making this trade? Maybe. The difference is wiggle room. The breakevens are 2.65 wider in each direction with the iron condor.
Exhibit 10.4
shows these prices on the graph.
EXHIBIT 10.4
UPS 60–65–75–80 iron condor breakevens.
The lower threshold for profit occurs at $64.35 and the upper at $75.65. With condor/iron condors, there can be agreater chance of producing awinning trade because the range is wider than that of the butterfly. This benefit, however, has atrade-off of lower potential profit. There is
always
aparallel relationship of risk and reward. When risk increases so does reward, and vice versa. This way of thinking should now be ingrained in your DNA. The risk of failure is less, so the payout is less. Because the odds of winning are higher, atrader will accept lower payouts on the trade.
Keys to Success
No matter which trade is more suitable to Kathleen’srisk tolerance, the overall concept is the same: profit from little directional movement. Before Kathleen found astock on which to trade her spread, she will have sifted through myriad stocks to find those


ower payouts on the trade.
Keys to Success
No matter which trade is more suitable to Kathleen’srisk tolerance, the overall concept is the same: profit from little directional movement. Before Kathleen found astock on which to trade her spread, she will have sifted through myriad stocks to find those that she expects to trade in arange. She has afew tools in her trading toolbox to help her find good butterfly and condor candidates.
First, Kathleen can use technical analysis as aguide. This is arather straightforward litmus test: does the stock chart show atrending, volatile stock or aflat, nonvolatile stock? For the condor, aquick glance at the past few months will reveal whether the stock traded between $65 and $75. If it did, it might be agood iron condor candidate. Although this very simplistic approach is often enough for many traders, those who like lots of graphs and numbers can use their favorite analyses to confirm that the stock is trading in arange. Drawing trendlines can help traders to visualize the channel in which astock has been trading. Knowing support and resistance is also beneficial. The average directional movement index (ADX) or moving average converging/diverging (MACD) indicator can help to show if there is atrend present. If there is, the stock may not be agood candidate.
Second, Kathleen can use fundamentals. Kathleen wants stocks with nothing on their agendas. She wants to avoid stocks that have pending events that could cause their share price to move too much. Events to avoid are earnings releases and other major announcements that could have an impact on the stock price. For example, adrug stock that has been trading in arange because it is awaiting Food and Drug Administration (FDA) approval, which is expected to occur over the next month, is not agood candidate for this sort of trade.
The last thing to consider is whether the numbers make sense. Kathleen’siron condor risks 4.35 to make 0.65. Whether this sounds like agood trade depends on Kathleen’srisk tolerance and the general environment of UPS, the industry, and the market as awhole. In some environments, the 0.65/4.35 payout-to-risk ratio makes alot of sense. For other people, other stocks, and other environments, it doesn’t.
Greeks and Wing Spreads
Much of this chapter has been spent on how wing spreads perform if held until expiration, and little has been said of option greeks and their role in wing spreads. Greeks do come into play with butterflies and condors but not necessarily the same way they do with other types of option trades.
The vegas on these types of spreads are smaller than they are on many other types of strategies. For atypical nonprofessional trader, it’shard to trade implied volatility with condors or butterflies. The collective commissions on the four legs, as well as margin and capital considerations, put these out of reach for active trading. Professional traders and retail traders subject to portfolio margining are better equipped for volatility trading with these spreads.
The true strength of wing spreads, however, is in looking at them as break-even analysis trades much like vertical spreads. The trade is awinner if it is on the correct side of the break-even price. Wing spreads, however, are acombination of two vertical spreads, so there are two break-even prices. One of the verticals is guaranteed to be awinner. The stock can be either higher or lower at expiration—not both. In some cases, both verticals can be winners.
Consider an iron condor. Instead of reaping one premium from selling one OTM call credit spread, iron condor sellers double dip by additionally selling an OTM put credit spread. They collect adouble credit, but only one of the credit spreads can be aloser at expiration. The trader, however, does have to worry about both directions independently.
There are two ways for greeks and volatility analysis to help traders trade wing spreads. One of them involves using delta and theta as tools to trade adirectional spread. The other uses implied volatility in strike selection decisions.
Directional Butterflies
Trading abutterfly can be an excellent way to establish alow-cost, relatively low-risk directional trade when atrader has aspecific price target in mind. For example, atrader, Ross, has been studying Walgreen Co. (WAG) and believes it will rise from its current level of $33.50 to $36 per share over the next month. Ross buys abutterfly consisting of all OTM January calls with 31 days until expiration.
He executes the following legs:
As adirectional trade alternative, Ross could have bought just the January 35 call for 1.15. As acheaper alternative, he could have also bought the 35–36 bull call spread for 0.35. In fact, Ross actually does buy the 35–36 spread, but he also sells the January 36–37 call spread at 0.25 to reduce the cost of the bull call spread, investing only adime. The benefit of lower cost, however, comes with trade-offs.
Exhibit 10.5
compares the bull call spread with


call spread for 0.35. In fact, Ross actually does buy the 35–36 spread, but he also sells the January 36–37 call spread at 0.25 to reduce the cost of the bull call spread, investing only adime. The benefit of lower cost, however, comes with trade-offs.
Exhibit 10.5
compares the bull call spread with abullish butterfly.
EXHIBIT 10.5
Bull call spread vs. bull butterfly (Walgreen Co. at $33.50).
The butterfly has lower nominal risk—only 0.10 compared with 0.35 for the call spread. The maximum reward is higher in nominal terms, too—0.90 versus 0.65. The trade-off is what is given up. With both strategies, the goal is to have Walgreen Co. at $36 around expiration. But the bull call spread has more room for error to the upside. If the stock trades alot higher than expected, the butterfly can end up being alosing trade.
Given Ross’sexpectations in this example, this might be arisk he is willing to take. He doesn’texpect Walgreen Co. to close right at $36 on the expiration date. It could happen, but it’sunlikely. However, he’dhave to be wildly wrong to have the trade be aloser on the upside. It would be amuch larger move than expected for the stock to rise significantly above $36. If Ross strongly believes Walgreen Co. can be around $36 at expiration, the cost benefit of 0.10 vs. 0.35 may offset the upside risk above $37. As ageneral rule, directional butterflies work well in trending, low-volatility stocks.
When Ross monitors his butterfly, he will want to see the greeks for this position as well.
Exhibit 10.6
shows the trade’sanalytics with Walgreen Co. at $33.50.
EXHIBIT 10.6
Walgreen Co. 35–36–37 butterfly greeks (stock at $33.50, 31 days to expiration).
Delta
+0.008
Gamma
−0.004
Theta
+0.001
Vega
−0.001
When the trade is first put on, the delta is small—only +0.008. Gamma is slightly negative and theta is very slightly positive. This is important information if Walgreen Co.’sascent happens sooner than Ross planned. The trade will show just asmall profit if the stock jumps to $36 per share right away. Ross’stheoretical gain will be almost unnoticeable. At $36 per share, the position will have its highest theta, which will increase as expiration approaches. Ross will have to wait for time to pass to see the trade reach its full potential.
This example shows the interrelation between delta and theta. We know from an at-expiration analysis that if Walgreen Co. moves from $33.50 to $36, the butterfly’sprofit will be 0.90 (the spread of $1 minus the 0.10 initial debit). If we distribute the 0.90 profit over the 2.50 move from $33.50 to $36, the butterfly gains about 0.36 per dollar move in Walgreen Co. (0.90/(36 − 33.50). This implies adelta of about 0.36.
But the delta, with 31 days until expiration and Walgreen Co. at $33.50, is only 0.008, and because of negative gamma this delta will get even smaller as Walgreen Co. rises. Butterflies, like the vertical spreads of which they are composed, can profit from direction but are never purely directional trades. Time is always afactor. It is theta, working in tandem with delta, that contributes to profit or peril.
Abearish butterfly can be constructed as well. One would execute the trade with all OTM puts or all ITM calls. The concept is the same: sell the guts at the strike at which the stock is expected to be trading at expiration, and buy the wings for protection.
Constructing Trades to Maximize Profit
Many traders who focus on trading iron condors trade exchange-traded funds (ETFs) or indexes. Why? Diversification. Because indexes are made up of many stocks, they usually don’thave big gaps caused by surprise earnings announcements, takeovers, or other company-specific events. But it’snot just selecting the right underlying to trade that is the challenge. Atrader also needs to pick the right strike prices. Finding the right strike prices to trade can be something of an art, although science can help, as well.
Three Looks at the Condor
Strike selection is essential for asuccessful condor. If strikes are too close together or two far apart, the trade can become much less attractive.
Strikes Too Close
The QQQs are options on the ETFs that track the Nasdaq 100 (QQQ). They have strikes in $1 increments, giving traders alot to choose from. With QQQ trading at around $55.95, consider the 54–55–57–58 iron condor. In this example, with 31 days until expiration, the following legs can be executed:
In this trade, the maximum profit is 0.63. The maximum risk is 0.37. This isn’tabad profit-to-loss ratio. The break-even price on the downside is $54.37 and on the upside is $57.63. That’sa $3.26 range—atight space for amover like the QQQ to occupy in amonth. The ETF can drop about only 2.8 percent or rise 3 percent before the trade becomes aloser. No one needs any fancy math to show that this is likely alosing proposition in the long run. While choosing closer strikes can lead to higher premiums, the range can be so constricting that it asphyxiates the possibility of profit.
Strikes


8 percent or rise 3 percent before the trade becomes aloser. No one needs any fancy math to show that this is likely alosing proposition in the long run. While choosing closer strikes can lead to higher premiums, the range can be so constricting that it asphyxiates the possibility of profit.
Strikes Too Far
Strikes too far apart can make for impractical trades as well.
Exhibit 10.7
shows an options chain for the Dow Jones Industrial Average Index (DJX). These prices are from around 2007 when implied volatility (IV) was historically low, making the OTM options fairly low priced. In this example, DJX is around $135.20 and there are 51 days until expiration.
EXHIBIT 10.7
Options chain for DJIA.
If the goal is to choose strikes that are far enough apart to be unlikely to come into play, atrader might be tempted to trade the 120–123–142–145 iron condor. With this wingspan, there is certainly agood chance of staying between those strikes—you could drive aproverbial truck through that range.
This would be agreat trade if it weren’tfor the prices one would have to accept to put it on. First, the 120 puts are offered at 0.25 and the 123 puts are 0.25 bid. This means that the put spread would be sold at zero! The maximum risk is 3.00, and the maximum gain is zero. Not areally good risk/reward. The 142–145 call spread isn’tmuch better: it can be sold for adime.
At the time, again alow-volatility period, many traders probably felt it was unlikely that the DJX will rise 5 percent in a 51-day period. Some traders may have considered trading asimilarly priced iron condor (though of course they’dhave to require some small credit for the risk). Alittle over ayear later the DJX was trading around 50 percent lower. Traders must always be vigilant of the possibility of volatility, even unexpected volatility and structure their risk/reward accordingly. Most traders would say the risk/reward of this trade isn’tworth it. Strikes too far apart have agreater chance of success, but the payoff just isn’tthere.
Strikes with High Probabilities of Success
So how does atrader find the happy medium of strikes close enough together to provide rich premiums but far enough apart to have agood chance of success? Certainly, there is something to be said for looking at the prices at which atrade can be done and having asubjective feel for whether the underlying is likely to move outside the range of the break-even prices. Alittle math, however, can help quantify this likelihood and aid in the decision-making process.
Recall that IV is read by many traders to be the market’sconsensus estimate of future realized volatility in terms of annualized standard deviation. While that is amouthful to say—or in this case, rather, an eyeful to read—when broken down it is not quite as intimidating as it sounds. Consider asimplified example in which an underlying security is trading at $100 ashare and the implied volatility of the at-the-money (ATM) options is 10 percent. That means, from astatistical perspective, that if the expected return for the stock is unchanged, the one-year standard deviations are at $90 and $110.
1
In this case, there is about a 68 percent chance of the stock trading between $90 and $110 one year from now. IV then is useful information to atrader who wants to quantify the chances of an iron condor’sexpiring profitable, but there are afew adjustments that need to be made.
First, because with an iron condor the idea is to profit from net short option premium, it usually makes more sense to sell shorter-term options to profit from higher rates of time decay. This entails trading condors composed of one- or two-month options. The IV needs to be deannualized and converted to represent the standard deviation of the underlying at expiration.
The first step is to compute the one-day standard deviation. This is found by dividing the implied volatility by the square root of the number of trading days in ayear, then multiplying by the square root of the number of trading days until expiration. The result is the standard deviation (σ) at the time of expiration stated as apercent. Next, multiply that percentage by the price of the underlying to get the standard deviation in absolute terms.
The formula
2
for calculating the shorter-term standard deviation is as follows:
This value will be added to or subtracted from the price of the underlying to get the price points at which the approximate standard deviations fall.
Consider an example using options on the Standard & Poor’s 500 Index (SPX). With 50 days until expiration, the SPX is at 1241 and the implied volatility is 23.2 percent. To find strike prices that are one standard deviation away from the current index price, we need to enter the values into the equation. We first need to know how many actual trading days are in the 50-day period. There are 35 business days during this particular 50-day period (there is one holiday and seven weekend days). We now have all the data we need to calculate


rrent index price, we need to enter the values into the equation. We first need to know how many actual trading days are in the 50-day period. There are 35 business days during this particular 50-day period (there is one holiday and seven weekend days). We now have all the data we need to calculate which strikes to sell.
The lower standard deviation is 1134.55 (1241 − 106.45) and the upper is 1347.45 (1241 + 106.45). This means there would be about a 68 percent chance of SPX ending up between 1134.55 and 1347.45 at expiration. In this example, to have about atwo-thirds chance of success, one would sell the 1135 puts and the 1350 calls as part of the iron condor.
Being Selective
There is about atwo-thirds chance of the underlying staying between the upper and lower standard deviation points and about aone-third chance it won’t. Reasonably good odds. But the maximum loss of an iron condor will be more than the maximum profit potential. In fact, the max-profit-to-max-loss ratio is usually less than 1 to 3. For every $1 that can be made, often $4 or $5 will be at risk.
The pricing model determines fair value of an option based on the implied volatility set by the market. Again, many traders consider IV to be the market’sconsensus estimate of future realized volatility. Assuming the market is generally right and options are efficiently priced, in the long run, future stock volatility should be about the same as the implied volatility from options prices. That means that if all of your options trades are executed at fair value, you are likely to break even in the long run. The caveat is that whether the options market is efficient or not, retail or institutional traders cannot generally execute trades at fair value. They have to sell the bid (sell below theoretical value) and buy the offer (buy above theoretical value). This gives the trade astatistical disadvantage, called giving up the edge, from an expected return perspective.
Even though you are more likely to win than to lose with each individual trade when strikes are sold at the one-standard-deviation point, the edge given up to the market in conjunction with the higher price tag on losers makes the trade astatistical loser in the long run. While this means for certain that the non-market-making trader is at aconstant disadvantage, trading condors and butterflies is no different from any other strategy. Giving up the edge is the plight of retail and institutional traders. To profit in the long run, atrader needs to beat the market, which requires careful planning, selectivity, and risk management.
Savvy traders trade iron condors with strikes one standard deviation away from the current stock price only when they think there is more than atwo-thirds chance of market neutrality. In other words, if you think the market will be less volatile than the prices in the options market imply, sell the iron condor or trade another such premium-selling strategy. As discussed above, this opinion should reflect sound judgment based on some combination of technical analysis, fundamental analysis, volatility analysis, feel, and subjectivity.
A Safe Landing for an Iron Condor
Although traders can’tcontrol what the market does, they can control how they react to the market. Assume atrader has done due diligence in studying astock and feels it is aqualified candidate for aneutral strategy. With the stock at $90, a 16.5 percent implied volatility, and 41 days until expiration, the standard deviation is about 5. The trader sells the following iron condor:
With the stock at $90, directly between the two short strikes, the trade is direction neutral. The maximum profit is equal to the total premium taken in, which in this case is $800. The maximum loss is $4,200. There is about atwo-thirds chance of retaining the $800 at expiration.
After one week, the overall market begins trending higher on unexpected bullish economic news. This stock follows suit and is now trading at $93, and concern is mounting that the rally will continue. The value of the spread now is about 1.10 per contract (we ignore slippage from trading on the bid-ask spreads of the four legs of the spread). This means the trade has lost $300 because it would cost $1,100 to buy back what the trader sold for atotal of $800.
One strategy for managing this trade looking forward is inaction. The philosophy is that sometimes these trades just don’twork out and you take your lumps. The philosophy is that the winners should outweigh the losers over the long term. For some of the more talented and successful traders with aproven track record, this may be aviable strategy, but there are more active options as well. Atrader can either close the spread or adjust it.
The two sets of data that must be considered in this decision are the prices of the individual options and the greeks for the trade.
Exhibit 10.8
shows the new data with the stock at $93.
EXHIBIT 10.8
Greeks for iron condor with stock at $93.
The trade is no longer


er close the spread or adjust it.
The two sets of data that must be considered in this decision are the prices of the individual options and the greeks for the trade.
Exhibit 10.8
shows the new data with the stock at $93.
EXHIBIT 10.8
Greeks for iron condor with stock at $93.
The trade is no longer neutral, as it was when the underlying was at $90. It now has adelta of −2.54, which is like being short 254 shares of the underlying. Although the more time that passes the better—as indicated by the +0.230 theta—delta is of the utmost concern. The trader has now found himself short amarket that he thinks may rally.
Closing the entire position is one alternative. To be sure, if you don’thave an opinion on the underlying, you shouldn’thave aposition. It’slike making abet on asporting event when you don’treally know who you think will win. The spread can also be dismantled piecemeal. First, the 85 puts are valued at $0.07 each. Buying these back is ano-brainer. In the event the stock does retrace, why have the positive delta of that leg working against you when you can eliminate the risk inexpensively now?
The 80 puts are worthless, offered at 0.05, presumably. There is no point in trying to sell these. If the market does turn around, they may benefit, resulting in an unexpected profit.
The 80 and 85 puts are the least of his worries, though. The concern is acontinuing rally. Clearly, the greater risk is in the 95–100 call spread. Closing the call spread for aloss eliminates the possibility of future losses and may be awise choice, especially if there is great uncertainty. Taking asmall loss now of only around $300 is abetter trade than risking atotal loss of $4,200 when you think there is astrong chance of that total loss occurring.
But if the trader is not merely concerned that the stock will rally but truly believes that there is agood chance it will, the most logical action is to position himself for that expected move. Although there are many ways to accomplish this, the simplest way is to buy to close the 95 calls to eliminate the position at that strike. This eliminates the short delta from the 95 calls, leading to anow-positive delta for the position as awhole. The new position after adjusting by buying the 85 puts and the 95 calls is shown in
Exhibit 10.9
.
EXHIBIT 10.9
Iron condor adjusted to strangle.
The result is along strangle: along call and along put of the same month with two different strikes. Strangles will be discussed in subsequent chapters. The 80 puts are far enough out-of-the-money to be fairly irrelevant. Effectively, the position is long ten 100-strike calls. This serves the purpose of changing the negative 2.54 delta into apositive 0.96 delta. The trader now has abullish position in the stock that he thinks will rally—amuch smarter position, given that forecast.
The Retail Trader versus the Pro
Iron condors are very popular trades among retail traders. These days one can hardly go to acocktail party and mention the word
options
without hearing someone tell astory about an iron condor on which he’smade abundle of money trading. Strangely, no one ever tells stories about trades in which he has lost abundle of money.
Two of the strengths of this strategy that attract retail traders are its limited risk and high probability of success. Another draw of this type of strategy is that the iron condor and the other wing spreads offer something truly unique to the retail trader: away to profit from stocks that don’tmove. In the stock-trading world, the only thing that can be traded is direction—that is, delta. The iron condor is an approachable way for anonprofessional to dabble in nonlinear trading. The iron condor does agood job in eliminating delta—unless, of course, the stock moves and gamma kicks in. It is efficient in helping income-generating retail traders accomplish their goals. And when aloss occurs, although it can be bigger than the potential profits, it is finite.
But professional option traders, who have access to lots of capital and have very low commissions and margin requirements, tend to focus their efforts in other directions: they tend to trade volatility. Although iron condors are well equipped for profiting from theta when the stock cooperates, it is also possible to trade implied volatility with this strategy.
The examples of iron condors, condors, iron butterflies, and butterflies presented in this chapter so far have for the most part been from the perspective of the neutral trader: selling the guts and buying the wings. Atrader focusing on vega in any of these strategies may do just the opposite—buy the guts and sell the wings—depending on whether the trader is bullish or bearish on volatility.
Say atrader, Joe, had abullish outlook on volatility in
Salesforce.com
(CRM). Joe could sell the following condor 100 times.
In this example, February is 59 days from expiration.
Exhibit 10.10
shows the analytics for this trade with CRM at $104.32.
EXHIBIT 10.10
Salesforce.com
cond


sh on volatility.
Say atrader, Joe, had abullish outlook on volatility in
Salesforce.com
(CRM). Joe could sell the following condor 100 times.
In this example, February is 59 days from expiration.
Exhibit 10.10
shows the analytics for this trade with CRM at $104.32.
EXHIBIT 10.10
Salesforce.com
condor (
Salesforce.com
at $104.32).
As expected with the underlying centered between the two middle strikes, delta and gamma are about flat. As
Salesforce.com
moves higher or lower, though, gamma and, consequently, delta will change. As the stock moves closer to either of the long strikes, gamma will become more positive, causing the delta to change favorably for Joe. Theta, however, is working against him with
Salesforce.com
at $104.32, costing $150 aday. In this instance, movement is good. Joe benefits from increased realized volatility. The best-case scenario would be if
Salesforce.com
moves through either of the long strikes to, or through, either of the short strikes.
The prime objective in this example, though, is to profit from arise in IV. The position has apositive vega. The position makes or loses $400 with every point change in implied volatility. Because of the proportion of theta risk to vega risk, this should be ashort-term play.
If Joe were looking for asmall rise in IV, say five points, the move would have to happen within 13 calendar days, given the vega and theta figures. The vega gain on arise of five vol points would be $2,000, and the theta loss over 13 calendar days would be $1,950. If there were stock movement associated with the IV increase, that delta/gamma gain would offset some of the havoc that theta wreaked on the option premiums. However, if Joe traded astrategy like acondor as avol play, he would likely expect abigger volatility move than the five points discussed here as well as expecting increased realized volatility.
Acondor bullish vol play works when you expect something to change astock’sprice action in the short term. Examples would be rumors of anew product’sbeing unveiled, aproduct recall, amanagement change, or some other shake-up that leads to greater uncertainty about the company’sfuture—good or bad. The goal is to profit from arise in IV, so the trade needs to be put on before the announcement occurs. The motto in option-volatility trading is “Buy the rumor; sell the news.” Usually, by the time the news is out, the increase in IV is already priced into option premiums. As uncertainty decreases, IV decreases as well.
Notes
1
. It is important to note that in the real world, interest and expectations for future stock-price movement come into play. For simplicity’ssake, they’ve been excluded here.
2
. This is an approximate formula for estimating standard deviation. Although it is mathematically only an approximation, it is the convention used by many option traders. It is atraders’ short cut.


CHAPTER 11
Calendar and Diagonal Spreads
Option selling is aniche that attracts many retail and professional traders because it’spossible to profit from the passage of time. Calendar and diagonal spreads are practical strategies to limit risk while profiting from time. But these spreads are unique in many ways. In order to be successful with them, it is important to understand their subtle qualities.
Calendar Spreads
Definition
: Acalendar spread, sometimes called atime spread
or ahorizontal spread
, is an option strategy that involves buying one option and selling another option with the same strike price but with adifferent expiration date.
At-expiration diagrams do acalendar-spread trader little good. Why? At the expiration of the short-dated option, the trader is left with another option that may have time value. To estimate what the position will be worth when the short-term option expires, the value of the long-term option must be analyzed using the greeks. This is true of the variants of the calendar—double calendars, diagonals, and double diagonals—as well. This chapter will show how to analyze strategies that involve options with different expirations and discuss how and when to use them.
Buying the Calendar
The calendar spread and all its variations are commonly associated with income-generating spreads. Using calendar spreads as income generators is popular among retail and professional traders alike. The process involves buying alonger-term at-the-money option and selling ashorter-term at-the-money (ATM) option. The options must be either both calls or both puts. Because this transaction results in anet debit—the longer-term option being purchased has ahigher premium than the shorter-term option being sold—this is referred to as buying the calendar.
The main intent of buying acalendar spread for income is to profit from the positive net theta of the position. Because the shorter-term ATM option decays at afaster rate than the longer-term ATM option, the net theta is positive. As for most income spreads, the ideal outcome occurs when the underlying is at the short strike (in this case, shared strike) when the shorter-term option expires. At this strike price, the long option has its highest value, while the short option expires without the trader’sgetting assigned. As long as the underlying remains close to the strike price, the value of the spread rises as time passes, because the short option decreases in value faster than the long option.
For example, atrader, Richard, watches Bed Bath & Beyond Inc. (BBBY) on aregular basis. Richard believes that Bed Bath & Beyond will trade in arange around $57.50 ashare (where it is trading now) over the next month. Richard buys the January–February 57.50 call calendar for 0.80. Assuming January has 25 days until expiration and February has 53 days, Richard will execute the following trade:
Richard’sbest-case scenario occurs when the January calls expire at expiration and the February calls retain much of their value.
If Richard created an at-expiration P&(L) diagram for his position, he’dhave trouble because of the staggered expiration months. Ageneral representation would look something like
Exhibit 11.1
.
EXHIBIT 11.1
Bed Bath & Beyond January–February 57.50 calendar.
The only point on the diagram that is drawn with definitive accuracy is the maximum loss to the downside at expiration of the January call. The maximum loss if Bed Bath & Beyond falls low enough is 0.80—the debit paid for the spread. If Bed Bath & Beyond is below $57.50 at January expiration, the January 57.50 call expires worthless, and the February 57.50 call may or may not have residual value. If Bed Bath & Beyond declines enough, the February 57.50 call can lose all of its value, even with residual time until expiration. If the stock falls enough, the entire 0.80 debit would be aloss.
If Bed Bath & Beyond is above $57.50 at January expiration, the January 57.50 call will be trading at parity. It will be anegative-100-delta option, imitating short stock. If Bed Bath & Beyond is trading high enough, the February 57.50 call will become apositive-100-delta option trading at parity plus the interest calculated on the strike. The February deep-in-the-money option would imitate long stock. At a 2 percent interest rate, interest on the 57.50 strike is about 0.17. Therefore, Richard would essentially have ashort stock position from $57.50 from the January 57.50 call and would be essentially long stock from $57.50 plus 0.28 from the February call. The maximum loss to the upside is about 0.63 (0.80 − 0.17).
The maximum loss if Bed Bath & Beyond is trading over $57.50 at expiration is only an estimate that assumes there is no time value and that interest and dividends remain constant. Ultimately, the maximum loss will be 0.80, the premium paid, if there is no time value or carry considerations.
The maximum profit is gained if Bed Bath & Beyond is at $57.50 at expiration. At this price, the February

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t assumes there is no time value and that interest and dividends remain constant. Ultimately, the maximum loss will be 0.80, the premium paid, if there is no time value or carry considerations.
The maximum profit is gained if Bed Bath & Beyond is at $57.50 at expiration. At this price, the February 57.50 call is worth the most it can be worth without having the January 57.50 call assigned and creating negative deltas to the upside. But how much precisely is the maximum profit? Richard would have to know what the February 57.50 call would be worth with Bed Bath & Beyond stock trading at $57.50 at February expiration before he can know the maximum profit potential. Although Richard can’tknow for sure at what price the calls will be trading, he can use apricing model to estimate the call’svalue.
Exhibit 11.2
shows analytics at January expiration.
EXHIBIT 11.2
Bed Bath & Beyond January–February 57.50 call calendar greeks at January expiration.
With an unchanged implied volatility of 23 percent, an interest rate of two percent, and no dividend payable before February expiration, the February 57.50 calls would be valued at 1.53 at January expiration. In this best-case scenario, therefore, the spread would go from 0.80, where Richard purchased it, to 1.53, for again of 91 percent. At January expiration, with Bed Bath & Beyond at $57.50, the January call would expire; thus, the spread is composed of just the February 57.50 call.
Let’snow go back in time and see how Richard figured this trade.
Exhibit 11.3
shows the position when the trade is established.
EXHIBIT 11.3
Bed Bath & Beyond January–February 57.50 call calendar.
Asmall and steady rise in the stock price with enough time to collect theta is the recipe for success in this trade. As time passes, delta will flatten out if Bed Bath & Beyond is still right at-the-money. The delta of the January call that Richard is short will move closer to exactly −0.50. The February call delta moves toward exactly +0.50.
Gamma and theta will both rise if Bed Bath & Beyond stays around the strike. As expiration approaches, there is greater risk if there is movement and greater reward if there is not.
Vega is positive because the long-term option with the higher vega is the long leg of the spread. When trading calendars for income, implied volatility (IV) must be considered as apossible threat. Because it is Richard’sobjective to profit from Bed Bath & Beyond being at $57.50 at expiration, he will try to avoid vega risk by checking that the implied volatility of the February call is in the lower third of the 12-month range. He will also determine if there are any impending events that could cause IV to change. The less likely IV is to drop, the better.
If there is an increase in IV, that may benefit the profitability of the trade. But arise in IV is not really adesired outcome for two reasons. First, arise in IV is often more pronounced in the front month than in the months farther out. If this happens, Richard can lose more on the short call than he makes on the long call. Second, arise in IV can indicate anxiety and therefore agreater possibility for movement in the underlying stock. Richard doesn’twant IV to rock the boat. “Buy low, stay low” is his credo.
Rho is positive also. Arise in interest rates benefits the position because the long-term call is helped by the rise more than the short call is hurt. With only aone-month difference between the two options, rho is very small. Overall, rho is inconsequential to this trade.
There is something curious to note about this trade: the gamma and the vega. Calendar spreads are the one type of trade where gamma can be negative while vega is positive, and vice versa. While it appears—at least on the surface—that Richard wants higher IV, he certainly wants low realized volatility.
Bed Bath & Beyond January–February 57.50 Put Calendar
Richard’sposition would be similar if he traded the January–February 57.50 put calendar rather than the call calendar.
Exhibit 11.4
shows the put calendar.
EXHIBIT 11.4
Bed Bath & Beyond January–February 57.50 put calendar.
The premium paid for the put spread is 0.75. Ahuge move in either direction means aloss. It is about the same gamma/theta trade as the 57.50 call calendar. At expiration, with Bed Bath & Beyond at $57.50 and IV unchanged, the value of the February put would be 1.45—a 93 percent gain. The position is almost exactly the same as the call calendar. The biggest difference is that the rho is negative, but that is immaterial to the trade. As with the call spread, being short the front-month option means negative gamma and positive theta; being long the back month means positive vega.
Managing an Income-Generating Calendar
Let’ssay that instead of trading aone-lot calendar, Richard trades it 20 times. His trade in this case is
His total cash outlay is $1,600 ($80 times 20). The greeks for this trade, listed in
Exhibit 11.5
, are also 20 times the size of those in
Exhibit 11.3
.
EXHIBIT 11.5
2


ncome-Generating Calendar
Let’ssay that instead of trading aone-lot calendar, Richard trades it 20 times. His trade in this case is
His total cash outlay is $1,600 ($80 times 20). The greeks for this trade, listed in
Exhibit 11.5
, are also 20 times the size of those in
Exhibit 11.3
.
EXHIBIT 11.5
20-Lot Bed Bath & Beyond January–February 57.50 call calendar.
Note that Richard has a +0.18 delta. This means he’slong the equivalent of about 18 shares of stock—still pretty flat. Agamma of −0.72 means that if Bed Bath & Beyond moves $1 higher, his delta will be starting to get short; and if it moves $1 lower he will be longer, long 90 deltas.
Richard can use the greeks to get afeel for how much the stock can move before negative gamma causes aloss. If Bed Bath & Beyond starts trending in either direction, Richard may need to react. His plan is to cover his deltas to continue the position.
Say that after one week Bed Bath & Beyond has dropped $1 to $56.50. Richard will have collected seven days of theta, which will have increased slightly from $18 per day to $20 per day. His average theta during that time is about $19, so Richard’sprofit attributed to theta is about $133.
With abig-enough move in either direction, Richard’sdelta will start working against him. Since he started with adelta of +0.18 on this 20-lot spread and agamma of −0.72, one might think that his delta would increase to 0.90 with Bed Bath & Beyond adollar lower (18 − [−0.072 × 1.00]). But because aweek has passed, his delta would actually get somewhat more positive. The shorter-term call’sdelta will get smaller (closer to zero) at afaster rate compared to the longer-term call because it has less time to expiration. Thus, the positive delta of the long-term option begins to outweigh the negative delta of the short-term option as time passes.
In this scenario, Richard would have almost broken even because what would be lost on stock price movement, is made up for by theta gains. Richard can sell about 100 shares of Bed Bath & Beyond to eliminate his immediate directional risk and stem further delta losses. The good news is that if Bed Bath & Beyond declines more after this hedge, the profit from the short stock offsets losses from the long delta. The bad news is that if BBBY rebounds, losses from the short stock offset gains from the long delta.
After Richard’shedge trade is executed, his delta would be zero. His other greeks remain unchanged. The idea is that if Bed Bath & Beyond stays at its new price level of $56.50, he reaps the benefits of theta increasing with time from $18 per day. Richard is accepting the new price level and any profits or losses that have occurred so far. He simply adjusts his directional exposure to azero delta.
Rolling and Earning a “Free” Call
Many traders who trade income-generating strategies are conservative. They are happy to sell low IV for the benefits afforded by low realized volatility. This is the problem-avoidance philosophy of trading. Due to risk aversion, it’scommon to trade calendar spreads by buying the two-month option and selling the one-month option. This can allow traders to avoid buying the calendar in earnings months, and it also means ashorter time horizon, signifying less time for something unwanted to happen.
But there’sanother school of thought among time-spread traders. There are some traders who prefer to buy alonger-term option—six months to ayear—while selling aone-month option. Why? Because month after month, the trader can roll the short option to the next month. This is asimple tactic that is used by market makers and other professional traders as well as savvy retail traders. Here’show it works.
XYZ stock is trading at $60 per share. Atrader has aneutral outlook over the next six months and decides to buy acalendar. Assuming that July has 29 days until expiration and December has 180, the trader will take the following position:
The initial debit here is 2.55. The goal is basically the same as for any time spread: collect theta without negative gamma spoiling the party. There is another goal in these trades as well: to roll the spread.
At the end of month one, if the best-case scenario occurs and XYZ is sitting at $60 at July expiration, the July 60 call expires. The December 60 call will then be worth 3.60, assuming all else is held constant. The positive theta of the short July call gives full benefits as the option goes from 1.45 to zero. The lower negative theta of the December call doesn’tbite into profits quite as much as the theta of ashort-term call would.
The profit after month one is 1.05. Profit is derived from the December call, worth 3.60 at July expiry, minus the 2.55 initial spread debit. This works out to about a 41 percent return. The profit is hardly as good as it would have been if ashort-term, less expensive August 60 call were the long leg of this spread.
Rolling the Spread
The July–December spread is different from short-term spreads, however. When the Julys expir


pread debit. This works out to about a 41 percent return. The profit is hardly as good as it would have been if ashort-term, less expensive August 60 call were the long leg of this spread.
Rolling the Spread
The July–December spread is different from short-term spreads, however. When the Julys expire, the August options will have 29 days until expiration. If volatility is still the same, XYZ is still at $60, and the trader’sforecast is still neutral, the 29-day August 60 calls can be sold for 1.45. The trader can either wait until the Monday after July expiration and then sell the August 60s, or when the Julys are offered at 0.05 or 0.10, he can buy the Julys and sell the Augusts as aspread. In either case, it is called rolling the spread. When the August expires, he can sell the Septembers, and so on.
The goal is to get acredit month after month. At some point, the aggregate credit from the call sales each month is greater than the price initially paid for the long leg of the spread, thus eliminating the original net debit.
Exhibit 11.6
shows how the monthly credits from selling the one-month calls aggregate over time.
EXHIBIT 11.6
A “free” call.
After July has expired, 1.45 of premium is earned. After August expiration, the aggregate increases to 2.90. When the September calls, which have 36 days until expiration, are sold, another 1.60 is added to the total premium collected. Over three months—assuming the stock price, volatility, and the other inputs don’tchange—this trader collects atotal of 4.50. That’s 0.50 more than the price originally paid for the December 60 call leg of the spread.
At this point, he effectively owns the December call for free. Of course, this call isn’treally free; it’searned. It’spaid for with risk and maybe afew sleepless nights. At this point, even if the stock and, consequently, the December call go to zero, the position is still aprofitable trade because of the continued month-to-month rolling. This is now ano-lose situation.
When the long call of the spread has been paid for by rolling, there are three choices moving forward: sell it, hold it, or continue writing calls against it. If the trader’sopinion calls for the stock to decline, it’slogical to sell the December call and take the residual value as profit. In this case, over three months the trade will have produced 4.50 in premium from the sale of three consecutive one-month calls, which is more than the initial purchase price of the December call. At September expiration, the premium that will be received for selling the December call is all profit, plus 0.50, which is the aggregate premium minus the initial cost of the December call.
If the outlook is for the underlying to rise, it makes sense to hold the call. Any appreciation in the value of the call resulting from delta gains as the underlying moves higher is good—$0.50 plus whatever the call can be sold for.
If the forecast is for XYZ to remain neutral, it’slogical to continue selling the one-month call. Because the December call has been financed by the aggregate short call premiums already, additional premiums earned by writing calls are profit with “free” protection. As long as the short is closed at its expiration, the risk of loss is eliminated.
This is the general nature of rolling calls in acalendar spread. It’sabeautiful plan when it works! The problem is that it is incredibly unlikely that the stock will stay right at $60 per share for five months. It’salmost inevitable that it will move at some point. It’slike agame of Russian roulette. At some point it’sgoing to be alosing proposition—you just don’tknow when. The benefit of rolling is that if the trade works out for afew months in arow, the long call is paid for and the risk of loss is covered by aggregate profits.
If we step outside this best-case theoretical world and consider what is really happening on aday-to-day basis, we can gain insight on how to manage this type of trade when things go wrong. Effectively, along calendar is atypical gamma/theta trade. Negative gamma hurts. Positive theta helps.
If we knew which way the stock was going, we would simply buy or sell stock to adjust to get long or short deltas. But, unfortunately, we don’t. Our only tool is to hedge by buying or selling stock as mentioned above to flatten out when gamma causes the position delta to get more positive or negative.
1
The bottom line is that if the effect of gamma creates unwanted long deltas but the theta/gamma is still adesirable position, selling stock flattens out the delta. If the effect of gamma creates unwanted short deltas, buying stock flattens out the delta.
Trading Volatility Term Structure
There are other reasons for trading calendar spreads besides generating income from theta. If there is skew in the term structure of volatility, which was discussed in Chapter 3, acalendar spread is away to trade volatility. The tactic is to buy the “cheap” month and sell the “expensive” month.
Selling the Front, Buying t