ngs in advance, the drastic dividend
change had a significant impact on option prices. Call prices were helped by
the dividend cut (or anticipated dividend cut) and put prices were hurt.
The break in the pattern didn’t stop there. The dividend policy remained
$0.10 for five quarters until it rose to $0.12 in September 2010, then to
$0.14 in December 2010, then to $0.15 in June 2011. These irregular
changes in the historically predictable dividend policy made it tougher for
traders to attain accurate valuations. If the incremental changes were bigger,
the problem would have been even greater.
Good and Bad Dates with Models
Using an incorrect date for the ex-date in option pricing can lead to
unfavorable results. If the ex-dividend date is not known because it has yet
to be declared, it must be estimated and adjusted as need be after it is
formally announced. Traders note past dividend history and estimate the
expected dividend stream accordingly. Once the dividend is declared, the
ex-date is known and can be entered properly into the pricing model. Not
executing due diligence to find correct known ex-dates can lead to trouble.
Using a bad date in the model can yield dubious theoretical values that can
be misleading or worse—especially around the expiration.
Say a call is trading at 2.30 the day before the ex-date of a $0.25
dividend, which happens to be thirty days before expiration. The next day,
of course, the stock may have moved higher or lower. Assume for
illustrative purposes, to compare apples to apples as it were, that the stock is
trading at the same price—in this case, $76.
If the trader is using the correct date in the model, the option value will
adjust to take into account the effect of the dividend expiring, or reaching
its ex-date, when the number of days to expiration left changes from 30 to
29. The call trading postdividend will be worth more relative to the same
stock price. If the dividend date the trader is using in the model is wrong,
say one day later than it should be, the dividend will still be an input of the
theoretical value. The calculated value will be too low. It will be wrong.
Exhibit 8.1 compares the values of a 30-day call on the ex-date given the
right and the wrong dividend.
EXHIBIT 8.1 Comparison of 30-day call values
At the same stock price of $76 per share, the call is worth $0.13 more
after the dividend is taken out of the valuation. Barring any changes in
implied volatility (IV) or the interest rate, the market prices of the options
should reflect this change. A trader using an ex-date in the model that is
farther in the future than the actual ex-date will still have the dividend as
part of the generated theoretical value. With the ex-date just one day later,
the call would be worth 2.27. The difference in option value is due to the
effect of theta—in this case, $0.03.
With a bad date, the value of 2.27 would likely be significantly below
market price, causing the market value of the option to look more expensive
than it actually is. If the trader did not know the date was wrong, he would
need to raise IV to make the theoretical value match the market. This option
has a vega of 0.08, which translates into a difference of about two IV points
for the theoretical values 2.43 and 2.27. The trader would perceive the call
to be trading at an IV two points higher than the market indicates.
Dividend Size
It’s not just the date but also the size of the dividend that matters. When
companies change the amount of the dividend, options prices follow in step.
In 2004, when Microsoft (MSFT) paid a special dividend of $3 per share,
there were unexpected winners and losers in the Microsoft options. Traders
who were long calls or short puts were adversely affected by this change in
dividend policy. Traders with short calls or long puts benefited. With long-
term options, even less anomalous changes in the size of the dividend can
have dramatic effects on options values.
Let’s study an example of how an unexpected rise in the quarterly
dividend of a stock affects a long call position. Extremely Yellow Zebra
Corp. (XYZ) has been paying a quarterly dividend of $0.10. After a steady
rise in stock price to $61 per share, XYZ declares a dividend payment of
$0.50. It is expected that the company will continue to pay $0.50 per
quarter. A trader, James, owns the 528-day 60-strike calls, which were
trading at 9.80 before the dividend increase was announced.
Exhibit 8.2 compares the values of the long-term call using a $0.10
quarterly dividend and using a $0.50 quarterly dividend.
EXHIBIT 8.2 Effect of change in quarterly dividend on call value.
This $0.40 dividend increase will have a big effect on James’s calls. With
528 days until expiration, there will be six dividends involved. Because
James is long the calls, he loses 1.52 per option. If, however, he were short
the calls, 1.52 would be his profit on each option.
Put traders are affected as well. Another trader, Marty, is long the 60-
strike XYZ puts. Before the dividend announcement, Marty was running his
values with a $0.10 dividend, giving his puts a value of 5.42. Exhibit 8.3
compares the values of the puts with a $0.10 quarterly dividend and with a
$0.50 quarterly dividend.
EXHIBIT 8.3 Effect of change in quarterly dividend on put value.
When the dividend increase is announced, Marty will benefit. His puts
will rise because of the higher dividend by $0.66 (all other parameters held
constant). His long-term puts with six quarters of future expected dividends
will benefit more than short-term XYZ puts of the same strike would. Of
course, if he were short the puts, he would lose this amount.
The dividend inputs to a pricing model are best guesses until the dates
and amounts are announced by the company. How does one find dividend
information? Regularly monitoring the news and press releases on the
companies one trades is a good way to stay up to date on dividend
information, as well as other company news. Dividend announ


Of
course, if he were short the puts, he would lose this amount.
The dividend inputs to a pricing model are best guesses until the dates
and amounts are announced by the company. How does one find dividend
information? Regularly monitoring the news and press releases on the
companies one trades is a good way to stay up to date on dividend
information, as well as other company news. Dividend announcements are
widely disseminated by the major news services. Most companies also have
an investor-relations phone number and section on their web sites where
dividend information can be found.
PART II
Spreads
CHAPTER 9
Vertical Spreads
Risk—it is the focal point around which all trading revolves. It may seem as
if profit should be occupying this seat, as most important to trading options,
but without risk, there would be no profit! As traders, we must always look
for ways to mitigate, eliminate, preempt, and simply avoid as much risk as
possible in our pursuit of success without diluting opportunity. Risk must be
controlled. Trading vertical spreads takes us one step further in this quest.
The basic strategies discussed in Chapters 4 and 5 have strengths when
compared with pure linear trading in the equity markets. But they have
weaknesses, too. Consider the covered call, one of the most popular option
strategies.
A covered call is best used as an augmentation to an investment plan. It
can be used to generate income on an investment holding, as an entrance
strategy into a stock, or as an exit strategy out of a stock. But from a trading
perspective, one can often find better ways to trade such a forecast.
If the forecast on a stock is neutral to moderately bullish, accepting the
risk of stock ownership is often unwise. There is always the chance that the
stock could collapse. In many cases, this is an unreasonable risk to assume.
To some extent, we can make the same case for the long call, short put,
naked call, and the like. In certain scenarios, each of these basic strategies is
accompanied with unwanted risks that serve no beneficial purpose to the
trader but can potentially cause harm. In many situations, a vertical spread
is a better alternative to these basic spreads. Vertical spreads allow a trader
to limit potential directional risk, limit theta and vega risk, free up margin,
and generally manage capital more efficiently.
Vertical Spreads
Vertical spreads involve buying one option and selling another. Both are on
the same underlying and expire the same month, and both are either calls or
puts. The difference is in the strike prices of the two options. One is higher
than the other, hence the name vertical spread . There are four vertical
spreads: bull call spread, bear call spread, bear put spread, and bull put
spread. These four spreads can be sliced and diced into categories a number
of ways: call spreads and put spreads, bull spreads and bear spreads, debit
spreads and credit spreads. There is overlap among the four verticals in how
and when they are used. The end of this chapter will discuss how the
spreads are interrelated.
Bull Call Spread
A bull call spread is a long call combined with a short call that has a higher
strike price. Both calls are on the same underlying and share the same
expiration month. Because the purchased call has a lower strike price, it
costs more than the call being sold. Establishing the trade results in a debit
to the trader’s account. Because of this debit, it’s called a debit spread.
Below is an example of a bull call spread on Apple Inc. (AAPL):
In this example, Apple is trading around $391. With 40 days until
February expiration, the trader buys the 395–405 call spread for a net debit
of $4.40, or $440 in actual cash. Or one could simply say the trader paid
$4.40 for the 395–405 call.
Consider the possible outcomes if the spread is held until expiration.
Exhibit 9.1 shows an at-expiration diagram of the bull call spread.
EXHIBIT 9.1 AAPL bull call spread.
Before discussing the greeks, consider the bull call spread from an at-
expiration perspective. Unlike the long call, which has two possible
outcomes at expiration—above or below the strike—this spread has three
possibilities: below both strikes, between the strikes, or above both strikes.
In this example, if Apple is below $395 at expiration, both calls expire
worthless. The rights and obligations of the options are gone, as is the cash
spent on the trade. In this case, the entire debit of $4.40 is lost.
If Apple is between the strikes at expiration, the 405-strike call expires
worthless. The trader is long stock at an effective price of $399.40. This is
the $395-strike price at which the stock would be purchased if the call is
exercised, plus the $4.40 premium spent on the spread. The break-even
price of the trade is $399.40. If Apple is above $399.40 at expiration, the
trade is profitable; below $399.40, it is a loser. The aptly named bull call
spread requires the stock to rise to reach its profit potential. But unlike an
outright long call, profits are capped with the spread.
If Apple is above $405 at expiration, both calls are in-the-money (ITM).
If the 395-strike calls are exercised, the trader buys 100 shares of Apple at
$395 and these shares, in turn, would be sold at $405 when the 405-strike
calls are assigned, for a $10 gain per share. Subtract from that $10 the $4.40
debit spent on the trade and the net profit is $5.60 per share.
There are some other differences between the 395–405 call spread and the
outright purchase of the 395 call. The absolute risk is lower. To buy the
395-strike call costs 14.60, versus 4.40 for the spread—a big difference.
Because the debit is lower, the margin for the spread is lower at most
option-friendly brokers, as well.
If we dig a little deeper, we find some other differences between the bull
call spread and the outright call. Long options are haunted by the specter of
time. Because the spread involves both a long and a short option, the time-
decay risk is lower

eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf


, versus 4.40 for the spread—a big difference.
Because the debit is lower, the margin for the spread is lower at most
option-friendly brokers, as well.
If we dig a little deeper, we find some other differences between the bull
call spread and the outright call. Long options are haunted by the specter of
time. Because the spread involves both a long and a short option, the time-
decay risk is lower than that associated with owning an option outright.
Implied volatility (IV) risk is lower, too. Exhibit 9.2 compares the greeks of
the long 395 call with those of the 395–405 call spread.
EXHIBIT 9.2 Apple call versus bull call spread (Apple @ $391).
395 Call395–405 Call
Delta 0.484 0.100
Gamma0.00970.0001
Theta −0.208−0.014
Vega 0.513 0.020
The positive deltas indicate that both positions are bullish, but the outright
call has a higher delta. Some of the 395 call’s directional sensitivity is lost
when the 405 call is sold to make a spread. The negative delta of the 405
call somewhat offsets the positive delta of the 395 call. The spread delta is
only about 20 percent of the outright call’s delta. But for a trader wanting to
focus on trading direction, the smaller delta can be a small sacrifice for the
benefit of significantly reduced theta and vega. Theta spread’s risk is about
7 percent that of the outright. The spread’s vega risk is also less than 4
percent that of the outright 395 call. With the bull call spread, a trader can
spread off much of the exposure to the unwanted risks and maintain a
disproportionately higher greeks in the wanted exposure (delta).
These relationships change as the underlying moves higher. Remember,
at-the-money (ATM) options have the greatest sensitivity to theta and vega.
With Apple sitting at around the long strike, gamma and vega have their
greatest positive value, and theta has its most negative value. Exhibit 9.3
shows the spread greeks given other underlying prices.
EXHIBIT 9.3 AAPL 395–405 bull call spread.
As the stock moves higher toward the 405 strike, the 395 call begins to
move away from being at-the-money, and the 405 call moves toward being
at-the-money. The at-the-money is the dominant strike when it comes to the
characteristics of the spread greeks. Note the greeks position when the
underlying is directly between the two strike prices: The long call has
ceased to be the dominant influence on these metrics. Both calls influence
the analytics pretty evenly. The time-decay risk has been entirely spread off.
The volatility risk is mostly spread off. Gamma remains a minimal concern.
When the greeks of the two calls balance each other, the result is a
directional play.
As AAPL continues to move closer to the 405-strike, it becomes the at-
the-money option, with the dominant greeks. The gamma, theta, and vega
of the 405 call outweigh those of the ITM 395 call. Vega is more negative.
Positive theta now benefits the trade. The net gamma of the spread has
turned negative. Because of the negative gamma, the delta has become
smaller than it was when the stock was at $400. This means that the benefit
of subsequent upward moves in the stock begins to wane. Recall that there
is a maximum profit threshold with a vertical spread. As the stock rises
beyond $405, negative gamma makes the delta smaller and time decay
becomes less beneficial. But at this point, the delta has done its work for the
trader who bought this spread when the stock was trading around $395. The
average delta on a move in the stock from $395 to $405 is about 0.10 in this
case.
When the stock is at the 405 strike, the characteristics of the trade are
much different than they are when the stock is at the 395 strike. Instead of
needing movement upward in the direction of the delta to combat the time
decay of the long calls, the position can now sit tight at the short strike and
reap the benefits of option decay. The key with this spread, and with all
vertical spreads, is that the stock needs to move in the direction of the delta
to the short strike.
Strengths and Limitations
There are many instances when a bull call spread is superior to other bullish
strategies, such as a long call, and there are times when it isn’t. Traders
must consider both price and time.
A bull call spread will always be cheaper than the outright call purchase.
That’s because the cost of the long-call portion of the spread is partially
offset by the premium of the higher-strike short call. Spending less for the
same exposure is always a better 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 a trade-off, too. There have been countless times that I have
talked with new traders who bought a call 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, a vertical
spread can be a better 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 a loss of 4.60 on the 14.60 debit paid. The spread also is worth
10. It yields a gain 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 a couple 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’s a 36 percent gain on the 14.60. The spread is
worth 5.70. That’s a 30 percent gain. The vertical spread must be he


tial $4.40 per share debit.
But look at this same trade if the move occurs before expiration. If Apple
rallies to $405 after only a couple 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’s a 36 percent gain on the 14.60. The spread is
worth 5.70. That’s a 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 a significantly larger negative theta) is
punished severely by time passing. The long call benefits more from a
quick move in the underlying. And of course, if the stock were to rise to a
price greater than $405, in a short 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 a bear call spread . A bear call
spread is a short call combined with a long call that has a higher 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 a net credit when the trade is put on and, therefore, is
called a credit 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 a bear 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 a short
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 a loss 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.
A credit 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 a certain point). In this example, with Apple at $391,
a neutral 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 a bearish strategy as it is a
nonbullish strategy. The maximum gain with a credit 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 a put. If they thought it would
rise sharply, they’d use another strategy.
From a greek perspective, when the trade is executed it’s very close to its
highest theta price point—the 395 short strike price. This position
theoretically collects $0.90 a day 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 a naked call with a maximum 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 a big downward move occurs. Apple is trading at
$325 a share; the 405s are 0.05 bid at 0.10, and the 395s are 0.50 bid at
0.55. At this point, the lion’s share of the profits can be taken early. A trader
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 ca


ma 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 a big move occurs and most of the profits can be taken
early, it’s often best to hold the long calls, just in case. It’s a win-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’s stock 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. A trader 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 a trader 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 a
trade more like the one in the bull call spread example—except that instead
of needing a rally, the trader needs a rout. The only difference is that the
bull call spread has a bullish delta, and the bear call spread has a bearish
delta.
Bear Put Spread
There is another way to take a bearish stance with vertical spreads: the bear
put spread. A bear put spread is a long put plus a short put that has a lower
strike price. Both puts are on the same underlying and share the same
expiration month. This spread, however, is a debit spread because the more
expensive option is being purchased.
Imagine that a stock has had a good run-up in price. The chart shows a
steady march higher over the past couple of months. A study 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 a small pullback, a bear 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’s look at an example of ExxonMobil (XOM). After the stock has
rallied over a two-month period to $80.55, a trader believes there will be a
short-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’s breakeven 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 a positive
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 a bearish trade. But is the bear put spread necessarily a better 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’s
objectives 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 Put75–80 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 a better 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’s goal.
Gamma, theta, and vega are proportionately much smaller than the delta in
the spread than in the outright put. While the spread’s delta is two thi


that the spread with the
smaller delta is a better 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’s goal.
Gamma, theta, and vega are proportionately much smaller than the delta in
the spread than in the outright put. While the spread’s delta 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 a week or two. It’s not
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’s descent to
$75. Assuming the $5 drop occurs in one day, a delta 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 a far 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’t be 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 a long-
volatility play—long gamma and vega—to a short-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’s outlook. The question is: if I didn’t have this position
on, would I want it now?
The trader has a choice 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 a retracement would likely be inclined to take a profit on
the trade. Nobody ever went broke taking a profit. 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 a bad trade. Holding the
spread until expiration is not likely to be part of a trader’s plan. Buying the
80 put outright may be a better play if the trader is expecting a fast move. It
would have a bigger 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 a bull put spread. A bull put spread is
a short put with one strike and a long put with a lower strike. Both puts are
on the same underlying and in the same expiration cycle. A bull put spread
is a credit spread because the more expensive option is being sold, resulting
in a net 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 a credit 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 a buy 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’s a
negative 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 a short 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’t know which particular options were being traded here, this could
almost be a table 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 a delta play or a theta
play. A bullish trader may sell the spread if both puts are in-the-money.
Imagine that XOM is trading at around $75. The spread will have a positive
0.364 delta, positive gamma, and negative theta. The spread as a whole is a
decaying asset. It needs the underlying to rally to combat time decay.
A bullish 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 gree


puts are in-the-money.
Imagine that XOM is trading at around $75. The spread will have a positive
0.364 delta, positive gamma, and negative theta. The spread as a whole is a
decaying asset. It needs the underlying to rally to combat time decay.
A bullish 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 a small move, not much above $80. A speculator
wanting to trade direction for a small move while eliminating theta and
vega risks achieves her objectives very well with a vertical spread.
A bullish-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 a neutral
trader is selling future realized volatility—selling gamma to earn theta. A
trader can also trade a vertical spread to profit from IV.
Verticals and Volatility
The IV component of a vertical 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’s a call spread or a put spread, a credit
spread or a debit spread, if the underlying is at the short option’s strike, the
spread will have a net negative vega. If the underlying is at the long
option’s strike, 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 a limited-risk way to speculate on volatility changes
when the underlying remains fairly constant. But when the intent of a
vertical spread is to benefit from vega, one must always consider the delta
—it’s the bigger risk. Chapter 13 discusses ways to manage this risk by
hedging with stock, a strategy 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 a call spread or a put 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 a share. In this case, if the stock
didn’t move as time passed, theta would benefit from historical volatility
being’s low—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 a little. 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 a potential
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 a rally. Once the underlying comes close to the
short option’s strike, vega is negative. If IV declines, as might be
anticipated, there is a further 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 a bull 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 a situation is when a stock is rumored to be a
takeover target. A natural instinct is to consider buying calls as an
inexpensive speculation on a jump 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 a call spread consisting of
a long ITM call and a short 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 a takeover bid is announced, it
will likely be for a specific price. In this event, the stock price is unlikely to
rise above the announced takeover price until either the deal is
consummated or a second suitor steps in and offers a higher 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 a very tight
range below the takeover price for a long time. In this event, implied
volatility will often drop to very low levels. Being short an ATM call when
th


l either the deal is
consummated or a second suitor steps in and offers a higher 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 a very tight
range below the takeover price for a long 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 a share, is a rumored 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 a trader
a positive delta and a negligible vega. If the rumors are realized and a cash
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 I know specialize in certain niches. Sometimes this is because
they find something they know well and are really good at. Sometimes it’s
because they have become comfortable and don’t have 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 a credit 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 a way that the maximum loss
is required to be deposited to hold the position (this assumes Regulation T
margining). For all intents and purposes, this can turn the trader’s cash
position from a credit into a debit. From a cash perspective, all vertical
spreads are spreads that require a debit 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. A credit call spread and a debit 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 a joint 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’s delta is long 0.29 and his other greeks are
about flat.
Isabel decides to buy the January 62.50–65 put spread for a debit of 1.22.
Isabel’s biggest potential loss is 1.22, incurred if Johnson & Johnson is
above $65 a share 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 a delta 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’s
a zero-sum game. With Johnson & Johnson below $62.50, Sam loses his
investment of 1.28, but Isabel profits. She cancels out Sam’s loss by making
1.28. Above $65, Sam makes 1.22 while Isabel loses the same amount,
canceling out Sam’s gains. 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’s long 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’s long 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 a combined total of 2.50. The
collective position, composed of the four legs of these two spreads, forms a
new strategy altogether.
The two traders together have created a box. This box, which is empty of
both profit and loss, is


+0.006
EXHIBIT 9.13 Isabel’s long 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 a combined total of 2.50. The
collective position, composed of the four legs of these two spreads, forms a
new strategy altogether.
The two traders together have created a box. This box, which is empty of
both profit and loss, is represented by greeks that almost entirely offset each
other. Sam’s positive 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 a box as long synthetic stock combined with short
synthetic stock having a different strike price but the same expiration
month. It can also be defined, however, as two vertical spreads: a bull (bear)
call spread plus a bear (bull) put spread with the same strike prices and
expiration month.
The value of a box 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’s value). This 2.50 box, with 38 days until
expiration at a 1 percent interest rate, has less than a penny of interest
affecting its value. Boxes with more time until expiration will have a higher
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
a stock rising through a certain price tend to sell OTM call spreads. For a
stock 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 a trade-off compared with buying options: limited profit
potential. This trade-off can be beneficial, depending on the trader’s
forecast. Debit spreads and credit spreads can be traded interchangeably to
achieve the same goals. When a long (short) call spread is combined with a
long (short) put spread, the product is a box. 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 a set 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 a means to profit from a truly neutral market
in a security. Stocks that don’t move one iota can earn profits month after
month for income-generating traders who trade these strategies.
These types of spreads have a lot 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. A simple
at-expiration diagram reveals in black and white the range in which the
underlying stock must remain in order to have a profitable position.
However, applying the greeks and some of the mathematics discussed in
previous chapters can help a trader understand these strategies on a deeper
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
A condor is a four-legged option strategy that enables a trader 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 a higher 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
A and B is equal to the distance between strike C and 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 a higher strike, B;
long one call (put) with a strike, C, that is higher than B; and short one call
(put) with a strike, 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 A
and B and the strike prices of the vertical spread of strikes C and D are
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)


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 A
and B and the strike prices of the vertical spread of strikes C and D are
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 a condor, but with a mix 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 a higher strike, B; short one
call with an even higher strike, C; and long one call with a still 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 a higher strike, B; long one
call with an even higher strike, C; and short one call with a still higher
strike, D. The options are on the same security and in the same expiration
cycle. The put debit spread (strikes A and B) has the same distance between
the strike prices as the call debit spread (strikes C and 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 a higher 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 A and B equals that between
strikes B and 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 a higher 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 A and strike B
has the same distance between the strike prices of the vertical spread made
up of the options with strike B and 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, a butterfly has
its synthetic equal as well: the iron butterfly.
Short Iron Butterfly
Long one put with strike A; short one put with a higher strike, B; short one
call with strike B; long one call with a strike 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 a higher strike, B; long one
call with strike B; short one call with a strike 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 a credit or a debit. 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 a
whole. The important thing is which strikes have long options and which
have short options. A call debit spread is synthetically equal to a put credit
spread on the same security, with the same expiration month and strike
prices. That means a long condor is synthetically equal to a short iron
condor, and a long butterfly is synthetically equal to a short 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, a trader would sell the guts, or middle
strikes, and buy the wings, or outer strikes. When a trader 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
A trader, 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 exp


g 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 a long 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
a share 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 a short position in
the underlying. That short position loses as UPS moves higher up to $75 a
share, 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’s being 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 a
net loss of 2.00 to boot. End result? Above $75 at expiration, she has no
position in the underlying and loses 2.00.
A butterfly is a break-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’s the strike price plus the cost of
the spread; that’s the 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 a loss.
Kathleen’s trading 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 a slight 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 a condor or sold an iron condor. With condor-
family spreads, there is a lower maximum profit potential but a wider 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 a condor 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 a net of 4.70 on the put spread. The gain on the call
spread combined with the loss on the put spread makes the trade a loser 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 a loser by 4.65. The gain on
the put spread plus the loss on the call spread is a net loser of 4.35. Between
$65 and $75, all options expire and the 0.65 credit is all profit.
So far, this looks like a pretty 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 a greater chance of producing a
winning trade because the range is wider than that of the butterfly. This
benefit, however, has a trade-off of lower potential profit. There is always a
parallel 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 les


th condor/iron condors, there can be a greater chance of producing a
winning trade because the range is wider than that of the butterfly. This
benefit, however, has a trade-off of lower potential profit. There is always a
parallel 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, a trader will accept lower payouts on the trade.
Keys to Success
No matter which trade is more suitable to Kathleen’s risk tolerance, the
overall concept is the same: profit from little directional movement. Before
Kathleen found a stock on which to trade her spread, she will have sifted
through myriad stocks to find those that she expects to trade in a range. She
has a few tools in her trading toolbox to help her find good butterfly and
condor candidates.
First, Kathleen can use technical analysis as a guide. This is a rather
straightforward litmus test: does the stock chart show a trending, volatile
stock or a flat, nonvolatile stock? For the condor, a quick glance at the past
few months will reveal whether the stock traded between $65 and $75. If it
did, it might be a good 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 a range. Drawing trendlines can help traders to visualize the
channel in which a stock 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 a trend present. If there is, the stock may not be a good 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, a drug stock that has been trading
in a range because it is awaiting Food and Drug Administration (FDA)
approval, which is expected to occur over the next month, is not a good
candidate for this sort of trade.
The last thing to consider is whether the numbers make sense. Kathleen’s
iron condor risks 4.35 to make 0.65. Whether this sounds like a good trade
depends on Kathleen’s risk tolerance and the general environment of UPS,
the industry, and the market as a whole. In some environments, the
0.65/4.35 payout-to-risk ratio makes a lot 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 a typical nonprofessional trader, it’s hard 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 a winner
if it is on the correct side of the break-even price. Wing spreads, however,
are a combination of two vertical spreads, so there are two break-even
prices. One of the verticals is guaranteed to be a winner. 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 a double credit, but only one
of the credit spreads can be a loser 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 a
directional spread. The other uses implied volatility in strike selection
decisions.
Directional Butterflies
Trading a butterfly can be an excellent way to establish a low-cost,
relatively low-risk directional trade when a trader has a specific price target
in mind. For example, a trader, 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 a butterfly consisting of all OTM
January calls with 31 days until expiration.
He executes the following legs:
As a directional trade alternative, Ross could have bought just the January
35 call for 1.15. As a cheaper 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 a dime. The benefit of lower cost,
however, comes with trade-offs. Exhibit 10.5 compares the bull call spread
with a bullish 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 a lot higher than


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 a lot higher than
expected, the butterfly can end up being a losing trade.
Given Ross’s expectations in this example, this might be a risk he is
willing to take. He doesn’t expect Walgreen Co. to close right at $36 on the
expiration date. It could happen, but it’s unlikely. However, he’d have to be
wildly wrong to have the trade be a loser on the upside. It would be a much
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 a
general 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’s analytics 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.’s ascent happens sooner than Ross planned.
The trade will show just a small profit if the stock jumps to $36 per share
right away. Ross’s theoretical 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’s profit 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 a delta 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 a factor. It is theta, working in tandem with delta, that
contributes to profit or peril.
A bearish 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’t have big gaps caused by surprise
earnings announcements, takeovers, or other company-specific events. But
it’s not just selecting the right underlying to trade that is the challenge. A
trader 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 a successful 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 a lot 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’t a bad profit-to-loss ratio. The break-even price on the downside is
$54.37 and on the upside is $57.63. That’s a $3.26 range—a tight space for
a mover like the QQQ to occupy in a month. The ETF can drop about only
2.8 percent or rise 3 percent before the trade becomes a loser. No one needs
any fancy math to show that this is likely a losing 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, a trader might be tempted to trade the 120–123–142–145
iron condor. With this wingspan, there is certainly a good chance of staying
between those strikes—you could drive a proverbial truck through that
range.
This would be a great trade if it weren’t for 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 a really good
risk/reward. The 142–145 call spread isn’t much better: it can be sold for a
dime.
At the time, again a low-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 a similarly priced iron condor (though
of course they’d have to require some s


is 3.00, and the maximum gain is zero. Not a really good
risk/reward. The 142–145 call spread isn’t much better: it can be sold for a
dime.
At the time, again a low-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 a similarly priced iron condor (though
of course they’d have to require some small credit for the risk). A little over
a year 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’t worth it. Strikes too far apart have a greater
chance of success, but the payoff just isn’t there.
Strikes with High Probabilities of Success
So how does a trader find the happy medium of strikes close enough
together to provide rich premiums but far enough apart to have a good
chance of success? Certainly, there is something to be said for looking at
the prices at which a trade can be done and having a subjective feel for
whether the underlying is likely to move outside the range of the break-
even prices. A little 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’s consensus
estimate of future realized volatility in terms of annualized standard
deviation. While that is a mouthful to say—or in this case, rather, an eyeful
to read—when broken down it is not quite as intimidating as it sounds.
Consider a simplified example in which an underlying security is trading at
$100 a share and the implied volatility of the at-the-money (ATM) options
is 10 percent. That means, from a statistical 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 a trader who wants to quantify the chances of an iron
condor’s expiring profitable, but there are a few 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 a year, 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 a percent. 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 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 a two-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 a two-thirds chance of the underlying staying between the
upper and lower standard deviation points and about a one-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’s consensus 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 a statistical 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 a statistical loser in the long run. While this means for
certain that the non-market-making trader is at a constant 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, a tra


dge
given up to the market in conjunction with the higher price tag on losers
makes the trade a statistical loser in the long run. While this means for
certain that the non-market-making trader is at a constant 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, a trader 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 a two-
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’t control what the market does, they can control how
they react to the market. Assume a trader has done due diligence in studying
a stock and feels it is a qualified candidate for a neutral 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
a two-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 a
total of $800.
One strategy for managing this trade looking forward is inaction. The
philosophy is that sometimes these trades just don’t work 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 a proven track record, this may be a viable strategy, but there are more
active options as well. A trader 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 neutral, as it was when the underlying was at $90.
It now has a delta 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 a market that he thinks may rally.
Closing the entire position is one alternative. To be sure, if you don’t have
an opinion on the underlying, you shouldn’t have a position. It’s like
making a bet on a sporting event when you don’t really 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 a no-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 a
continuing rally. Clearly, the greater risk is in the 95–100 call spread.
Closing the call spread for a loss eliminates the possibility of future losses
and may be a wise choice, especially if there is great uncertainty. Taking a
small loss now of only around $300 is a better trade than risking a total loss
of $4,200 when you think there is a strong 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 a good 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 a now-positive delta for the position as a whole. 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 a long strangle: a long call and a long 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 a positive 0.96 delta.
The trader now has a bullish position in the stock that he thinks will rally—
a much 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 a cocktail party and mention the word options without
hearing someone tell a story about an iron condor on which he’s made a
bundle of money trading. Strangely, no one ever tells stories about trades in
which he has lost a bundle 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


a cocktail party and mention the word options without
hearing someone tell a story about an iron condor on which he’s made a
bundle of money trading. Strangely, no one ever tells stories about trades in
which he has lost a bundle 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: a way to profit from stocks that don’t move.
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 a nonprofessional
to dabble in nonlinear trading. The iron condor does a good 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 a loss 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. A
trader 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 a trader, Joe, had a bullish 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 a day. 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 a rise in IV.
The position has a positive 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 a short-term play.
If Joe were looking for a small 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 a rise 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 a strategy like a condor as a vol play, he would likely expect a bigger
volatility move than the five points discussed here as well as expecting
increased realized volatility.
A condor bullish vol play works when you expect something to change a
stock’s price action in the short term. Examples would be rumors of a new
product’s being unveiled, a product recall, a management change, or some
other shake-up that leads to greater uncertainty about the company’s future
—good or bad. The goal is to profit from a rise 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’s sake,
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 a traders’ short cut.
CHAPTER 11
Calendar and Diagonal Spreads
Option selling is a niche that attracts many retail and professional traders
because it’s possible 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 : A calendar spread, sometimes called a time spread or a
horizontal spread , is an option strategy that involves buying one option and
selling another option with the same strike price but with a different
expiration date.
At-expiration diagrams do a calendar-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.