Index
American-exercise options
Arbitrageurs
At-the-money (ATM)
Backspreads
Bear call spread
Bear put spread
Bernanke, Ben
Black, Fischer
Black-Scholes option-pricing model
Boxes
building
Bull call spread
strengths and limitations
Bull put spread
Butterflies
long
alternatives
example
short
iron
long
short
Buy-to-close order
Calendar spreads
buying
“free” call, rolling and earning
rolling the spread
income-generating, managing
strength of
trading volatility term structure
buying the front, selling the back
directional approach
double calendars
ITM or OTM
selling the front, buying the back
Calls
buying
covered
entering
exiting
long ATM
delta
gamma
rho
theta
tweaking greeks
vega
long ITM
long OTM
selling
Cash settlement
Chicago Board Options Exchange (CBOE) Volatility Index
®
Condors
iron
long
short
long
short
strikes
safe landing
selectiveness
too close
too far
with high probability of success
Contractual rights and obligations
open interest and volume
opening and closing
Options Clearing Corporation (OCC)
standardized contracts
exercise style
expiration month
option series, option class, and contract size
option type
premium
quantity
strike price
Credit call spread
Debit call spread
Delta
dynamic inputs
effect of stock price on
effect of time on
effect of volatility on
moneyness and
Delta-neutral trading
art and science
direction neutral vs. direction indifferent
gamma, theta, and volatility
gamma scalping
implied volatility, trading
selling
portfolio margining
realized volatility, trading
reasons for
smileys and frowns
Diagonal spreads
double
Dividends
basics
and early exercise
dividend plays
strange deltas
and option pricing
pricing model, inputting data into
dates, good and bad
dividend size
Estimation, imprecision of
European-exercise options
Exchange-traded fund (ETF) options
Exercise style
Expected volatility
CBOE Volatility Index®
implied
stock
Expiration month
Ford Motor Company
Fundamental analysis
Gamma
dynamic
scalping
Greeks
adjusting
defined
delta
dynamic inputs
effect of stock price on
effect of time on
effect of volatility on
moneyness and
gamma
dynamic
HAPI: Hope and Pray Index
managing trades
online, caveats with regard to
price vs. value
rho
counterintuitive results
effect of time on
put-call parity
strategies, choosing between
theta
effect of moneyness and stock price on
effects of volatility and time on
positive or negative
taking the day out
trading
vega
effect of implied volatility on
effect of moneyness on
effect of time on
implied volatility (IV) and
where to find
Greenspan, Alan
HOLDR options
Implied volatility (IV)
trading
selling
and vega
In-the-money (ITM)
Index options
Interest, open
Interest rate moves, pricing in
Intrinsic value
Jelly rolls
Long-Term Equity AnticiPation Securities® (LEAPS®)
Open interest
Option, definition of
Option class
Option prices, measuring incremental changes in factors affecting
Option series
Options Clearing Corporation (OCC)
Out-of-the-money (OTM)
Parity, definition of
Pin risk
borrowing and lending money
boxes
jelly rolls
Premium
Price discovery
Price vs. value
Pricing model, inputting data into
dates, good and bad
dividend size
“The Pricing of Options and Corporate Liabilities” (Black & Scholes)
Put-call parity
American exercise options
essentials
dividends
synthetic calls and puts, comparing
synthetic stock
strategies
theoretical value and interest rate
Puts
buying
cash-secured
long ATM
married
selling
Ratio spreads and complex spreads
delta-neutral positions, management by market makers
through longs to shorts
risk, hedging
trading flat
multiple-class risk
ratio spreads
backspreads
vertical
skew, trading
Realized volatility
trading
Reversion to the mean
Rho
counterintuitive results
effect of time on
and interest rates
in planning trades
interest rate moves, pricing in
LEAPS
put-call parity
and time
trading
Risk and opportunity, option-specific
finding the right risk
long ATM call
delta
gamma
rho
theta
tweaking greeks
vega
long ATM put
long ITM call
long OTM call
options and the fair game
volatility
buying and selling
direction neutral, direction biased, and direction indifferent
Scholes, Myron
Sell-to-open transaction
Skew
term structure
trading
vertical
Spreads
calendar
buying
“free” call, rolling and earning
income-generating, managing
strength of
trading volatility term structure
diagonal
double
ratio and complex
delta-neutral positions, management by market makers
multiple-class risk
ratio
skew, trading
vertical
bear call
bear put
box, building
bull call
bull put
credit and debit, interrelations of
credit and debit, similarities in
and volatility
wing
butterflies
condors
greeks and
keys to success
retail trader vs. pro
trades, constructing to maximize profit
Standard deviation
and historical volatility
Standard & Poor’s Depositary Receipts (SPDRs or Spiders)
Straddles
long
basic
trading
short
risks with
trading
synthetic
Strangles
long
example
short
premium
risk, limiting
Strategies and At-Expiration Diagrams
buy call
buy put
factors affecting

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ze profit
Standard deviation
and historical volatility
Standard & Poor’s Depositary Receipts (SPDRs or Spiders)
Straddles
long
basic
trading
short
risks with
trading
synthetic
Strangles
long
example
short
premium
risk, limiting
Strategies and At-Expiration Diagrams
buy call
buy put
factors affecting option prices, measuring incremental changes in
sell call
sell put
Strike price
Supply and demand
Synthetic stock
strategies
conversion
market makers
pin risk
reversal
Technical analysis
Teenie buyers
Teenie sellers
Theta
effect of moneyness and stock price on
effects of volatility and time on
positive or negative
risk
taking the day out
Time value
Trading strategies
Value
Vega
effect of implied volatility on
effect of moneyness on
effect of time on
implied volatility (IV) and
Vertical spreads
bear call
bear put
box, building
bull call
bull put
credit and debit
interrelations of
similarities in
and volatility
Volatility
buying and selling
teenie buyers
teenie sellers
calculating data
direction neutral, direction biased, and direction indifferent
expected
CBOE Volatility Index®
implied
stock
historical (HV)
standard deviation
implied (IV)
and direction
HV-IV divergence
inertia
relationship of HV and IV
selling
supply and demand
realized
trading
skew
term structure
vertical
vertical spreads and
Volatility charts, studying
patterns
implied and realized volatility rise
realized volatility falls, implied volatility falls
realized volatility falls, implied volatility remains constant
realized volatility falls, implied volatility rises
realized volatility remains constant, implied volatility falls
realized volatility remains constant, implied volatility remains constant
realized volatility remains constant, implied volatility rises
realized volatility rises, implied volatility falls
realized volatility rises, implied volatility remains constant
Volatility-selling strategies
profit potential
covered call
covered put
gamma-theta relationship
greeks and income generation
naked call
short naked puts
similarities
Would I Do It Now? Rule
Volume
Weeklys
SM
Wing spreads
butterflies
directional
long
short
iron
condors
iron
long
short
greeks and
keys to success
retail trader vs. pro
trades, constructing to maximize profit
Would I Do It Now? Rule


Open Interest and Volume
Traders use many types of market data to make trading decisions. Two
items that are often studied but sometimes misunderstood are volume and
open interest. Volume, as the name implies, is the total number of contracts
traded during a time period. Often, volume is stated on a one-day basis, but
could be stated per week, month, year, or otherwise. Once a new period
(day) begins, volume begins again at zero. Open interest is the number of
contracts that have been created and remain outstanding. Open interest is a
running total.
When an option is first listed, there are no open contracts. If Trader A
opens a long position in a newly listed option by buying a one-lot, or one
contract, from Trader B, who by selling is also opening a position, a
contract is created. One contract traded, so the volume is one. Since both
parties opened a position and one contract was created, the open interest in
this particular option is one contract as well. If, later that day, Trader B
closes his short position by buying one contract from Trader C, who had no
position to start with, the volume is now two contracts for that day, but open
interest is still one. Only one contract exists; it was traded twice. If the next
day, Trader C buys her contract back from Trader A, that day’s volume is
one and the open interest is now zero.

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The Options Clearing Corporation
Remember when Wimpy would tell Popeye, “I’ll gladly pay you Tuesday
for a hamburger today.” Did Popeye ever get paid for those burgers? In a
contract, it’s very important for each party to hold up his end of the bargain
—especially when there is money at stake. How does a trader know the
party on the other side of an option contract will in fact do that? That’s
where the Options Clearing Corporation (OCC) comes into play.
The OCC ultimately guarantees every options trade. In 2010, that was
almost 3.9 billion listed-options contracts. The OCC accomplishes this
through many clearing members. Here’s how it works: When Trader X buys
an option through a broker, the broker submits the trade information to its
clearing firm. The trader on the other side of this transaction, Trader Y, who
is probably a market maker, submits the trade to his clearing firm. The two
clearing firms (one representing Trader X’s buy, the other representing
Trader Y’s sell) each submit the trade information to the OCC, which
“matches up” the trade.
If Trader Y buys back the option to close the position, how does that
affect Trader X if he wants to exercise it? It doesn’t. The OCC, acting as an
intermediary, assigns one of its clearing members with a customer that is
short the option in question to deliver the stock to Trader X’s clearing firm,
which in turn delivers the stock to Trader X. The clearing member then
assigns one of its customers who is short the option. The clearing member
will assign the trader either randomly or first in, first out. Effectively, the
OCC is the ultimate counterparty to both the exercise and the assignment.

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Corporation. Then, in August 2000, Ford offered shareholders a choice of
converting their shares into (a) new shares of Ford plus $20 cash per share,
(b) new Ford stock plus fractional shares with an aggregate value of $20, or
(c) new Ford stock plus a combination of more new Ford stock and cash.
There were three classes of options listed on Ford after both of these
changes: F represented 100 shares of the new Ford stock; XFO represented
100 shares of Ford plus $20 per share ($2,000) plus cash in lieu of $1.24;
and FOD represented 100 shares of new Ford, 13 shares of Visteon, and
$2,001.24.
Sometimes these changes can get complicated. If there is ever a question
as to what the underlying is for an option class, the authority is the OCC. A
lot of time, money, and stress can be saved by calling the OCC at 888-
OPTIONS and clarifying the matter.
Expiration Month
Options expire on the Saturday following the third Friday of the stated
month, which in this case is December. The final trading day for an option
is commonly the day before expiration—here, the third Friday of
December. There are usually at least four months listed for trading on an
option class. There may be a total of six months if Long-Term Equity
AnticiPation Securities® or LEAPS® are listed on the class. LEAPS can have
one year to about two-and-a-half years until expiration. Some underlyings
have one-week options called WeeklysSM listed on them.
Strike Price
The price at which the option holder owns the right to buy or to sell the
underlying is called the strike price, or exercise price. In this example, the
holder owns the right to buy the stock at $170 per share. There is method to
the madness regarding how strike prices are listed. Strike prices are
generally listed in $1, $2.50, $5, or $10 increments, depending on the value
of the strikes and the liquidity of the options.
The relationship of the strike price to the stock price is important in
pricing options. For calls, if the stock price is above the strike price, the call
is in-the-money (ITM). If the stock and the strike prices are close, the call is

eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:33


at-the-money (ATM). If the stock price is below the strike price the call is
out-of-the-money (OTM). This relationship is just the opposite for puts. If
the stock price is below the strike price, the put is in-the-money. If the stock
price and the strike price are about the same, the put is at-the-money. And,
if the stock price is above the put strike, it is out-of-the-money.
Option Type
There are two types of options: calls and puts. Calls give the holder the
right to buy the underlying and the writer the obligation to sell the
underlying. Puts give the holder the right to sell the underlying and the
writer the obligation to buy the underlying.
Premium
The price of an option is called its premium. The premium of this option is
$5. Like stock prices, option premiums are stated in dollars and cents per
share. Since the option represents 100 shares of IBM, the buyer of this
option will pay $500 when the transaction occurs. Certain types of spreads
may be quoted in fractions of a penny.
An option’s premium is made up of two parts: intrinsic value and time
value. Intrinsic value is the amount by which the option is in-the-money.
For example, if IBM stock were trading at 171.30, this 170-strike call
would be in-the-money by 1.30. It has 1.30 of intrinsic value. The
remaining 3.70 of its $5 premium would be time value.
Options that are out-of-the-money have no intrinsic value. Their values
consist only of time premium. Sometimes options have no time value left.
Options that consist of only intrinsic value are trading at what traders call
parity . Time value is sometimes called premium over parity .
Exercise Style
One contract specification that is not specifically shown here is the exercise
style. There are two main exercise styles: American and European.
American-exercise options can be exercised, and therefore assigned,
anytime after the contract is entered into until either the trader closes the

eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:34


EXHIBIT 1.3 Naked Target call.
If TGT is trading below the exercise price of 50, the call will expire
worthless. Sam keeps the 1.45 premium, and the obligation to sell the stock
ceases to exist. If Target is trading above the strike price, the call will be in-
the-money. The higher the stock is above the strike price, the more intrinsic
value the call will have. As a seller, Sam wants the call to have little or no
intrinsic value at expiration. If the stock is below the break-even price at
expiration, Sam will still have a profit. Here, the break-even price is $51.45
—the strike price plus the call premium. Above the break-even, Sam has a
loss. Since stock prices can rise to infinity (although, for the record, I have
never seen this happen), the naked call position has unlimited risk of loss.
Because a short stock position may be created, a naked call position must
be done in a margin account. For retail traders, many brokerage firms
require different levels of approval for different types of option strategies.
Because the naked call position has unlimited risk, establishing it will
generally require the highest level of approval—and a high margin
requirement.
Another tactical consideration is what Sam’s objective was when he
entered the trade. His goal was to profit from the stock’s being below $50

eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:46


during this two-month period—not to short the stock. Because equity
options are American exercise and can be exercised/assigned any time from
the moment the call is sold until expiration, a short stock position cannot
always be avoided. If assigned, the short stock position will extend Sam’s
period of risk—because stock doesn’t expire. Here, he will pay one
commission shorting the stock when assignment occurs and one more when
he buys back the unwanted position. Many traders choose to close the naked
call position before expiration rather than risk assignment.
It is important to understand the fundamental difference between buying
calls and selling calls. Buying a call option offers limited risk and unlimited
reward. Selling a naked call option, however, has limited reward—the call
premium—and unlimited risk. This naked call position is not so much
bearish as not bullish . If Sam thought the stock was going to zero, he
would have chosen a different strategy.
Now consider a covered call example:
Buy 100 shares TGT at $49.42
Sell 1 TGT October 50 call at 1.45
Unlimited and risk are two words that don’t sit well together with many
traders. For that reason, traders often prefer to sell calls as part of a spread.
But since spreads are strategies that involve multiple components, they have
different risk characteristics from an outright option. Perhaps the most
commonly used call-selling spread strategy is the covered call (sometimes
called a covered write or a buy-write ). While selling a call naked is a way
to take advantage of a “not bullish” forecast, the covered call achieves a
different set of objectives.
After studying Target Corporation, another trader, Isabel, has a neutral to
slightly bullish forecast. With Target at $49.42, she believes the stock will
be range-bound between $47 and $51.50 over the next two months, ending
with October expiration. Isabel buys 100 shares of Target at $49.42 and
sells 1 TGT October 50 call at 1.45. The implications for the covered-call
strategy are twofold: Isabel must be content to own the stock at current
levels, and—since she sold the right to buy the stock at $50, that is, a 50
call, to another party—she must be willing to sell the stock if the price rises
to or through $50 per share. Exhibit 1.4 shows how this covered call
performs if it is held until the call expires.

eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:47


EXHIBIT 1.4 Target covered call.
The solid kinked line represents the covered call position, and the thin,
straight dotted line represents owning the stock outright. At the expiration
of the call option, if Target is trading below $50 per share—the strike price
—the call expires and Isabel is left with a long position of 100 shares plus
$1.45 per share of expired-option premium. Below the strike, the buy-write
always outperforms simply owning the stock by the amount of the
premium. The call premium provides limited downside protection; the stock
Isabel owns can decline $1.45 in value to $47.97 before the trade is a loser.
In the unlikely event the stock collapses and becomes worthless, this
limited downside protection is not so comforting. Ultimately, Isabel has
$47.97 per share at risk.
The trade-off comes if Target is above $50 at expiration. Here, assignment
will likely occur, in which case the stock will be sold. The call can be
assigned before expiration, too, causing the stock to be called away early.
Because the covered call involves this obligation to sell the sock at the
strike price, upside potential is limited. In this case, Isabel’s profit potential
is $2.03. The stock can rise from $49.42 to $50—a $0.58 profit—plus $1.45
of option premium.
Isabel does not want the stock to decline too much. Below $47.97, the
trade is a loser. If the stock rises too much, the stock is sold prematurely and

eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:48


is found by subtracting the premium paid, 2.30, from the strike price, 139.
This is the point at which the position breaks even. If SPY is below $136.70
at expiration, Isabel has a profit. Profits will increase on a tick-for-tick
basis, with downward movements in SPY down to zero. The long put has
limited risk and substantial reward potential.
An alternative for Isabel is to short the ETF at the current price of
$140.35. But a short position in the underlying may not be as attractive to
her as a long put. The margin requirements for short stock are significantly
higher than for a long put. Put buyers must post only the premium of the put
—that is the most that can be lost, after all.
The margin requirement for short stock reflects unlimited loss potential.
Margin requirements aside, risk is a very real consideration for a trader
deciding between shorting stock and buying a put. If the trader expects high
volatility, he or she may be more inclined to limit upside risk while
leveraging downside profit potential by buying a put. In general, traders buy
options when they expect volatility to increase and sell them when they
expect volatility to decrease. This will be a common theme throughout this
book.
Consider a protective put example:
This is an example of a situation in which volatility is expected to
increase.
Own 100 shares SPY at 140.35
Buy 1 SPY May139 put at 2.30
Although Isabel bought a put because she was bearish on the Spiders, a
different trader, Kathleen, may buy a put for a different reason—she’s
bullish but concerned about increasing volatility. In this example, Kathleen
has owned 100 shares of Spiders for some time. SPY is currently at
$140.35. She is bullish on the market but has concerns about volatility over
the next two or three months. She wants to protect her investment. Kathleen
buys 1 SPY May 139 put at 2.30. (If Kathleen bought the shares of SPY and
the put at the same time, as a spread, the position would be called a married
put.)
Kathleen is buying the right to sell the shares she owns at $139.
Effectively, it is an insurance policy on this asset. Exhibit 1.7 shows the risk
profile of this new position.

eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:54


EXHIBIT 1.7 SPY protective put.
The solid kinked line is the protective put (put and stock), and the thin
dotted line is the outright position in SPY alone, without the put. The most
Kathleen stands to lose with the protective put is $3.65 per share. SPY can
decline from $140.35 to $139, creating a loss of $1.35, plus the $2.30
premium spent on the put. If the stock does not fall and the insuring put
hence does not come into play, the cost of the put must be recouped to
justify its expense. The break-even point is $142.65.
This position implies that Kathleen is still bullish on the Spiders. When
traders believe a stock or ETF is going to decline, they sell the shares.
Instead, Kathleen sacrifices 1.6 percent of her investment up front by
purchasing the put for $2.30. She defers the sale of SPY until the period of
perceived risk ends. Her motivation is not to sell the ETF; it is to hedge
volatility.
Once the anticipated volatility is no longer a concern, Kathleen has a
choice to make. She can let the option run its course, holding it to
expiration, at which point it will either expire or be exercised; or she can
sell the option before expiration. If the option is out-of-the-money, it may
have residual time value prior to expiration that can be recouped. If it is in-
the-money, it will have intrinsic value and maybe time value as well. In this
situation, Kathleen can look at this spread as two trades—one that has

eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:55


Vega
Over the past decade or so, computers have revolutionized option trading.
Options traded through an online broker are filled faster than you can say,
“Oops! I meant to click on puts.” Now trading is facilitated almost entirely
online by professional and retail traders alike. Market and trading
information is disseminated worldwide in subseconds, making markets all
the more efficient. And the tools now available to the common retail trader
are very powerful as well. Many online brokers and other web sites offer
high-powered tools like screeners, which allow traders to sift through
thousands of options to find those that fit certain parameters.
Using a screener to find ATM calls on same-priced stocks—say, stocks
trading at $40 a share—can yield a result worth talking about here. One $40
stock can have a 40-strike call trading at around 0.50, while a different $40
stock can have a 40 call with the same time to expiration trading at more
like 2.00. Why? The model doesn’t know the name of the company, what
industry it’s in, or what its price-to-earnings ratio is. It is a mathematical
equation with six inputs. If five of the inputs—the stock price, strike price,
time to expiration, interest rate, and dividends—are identical for two
different options but they’re trading at different prices, the difference must
be the sixth variable, which is volatility.

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Implied Volatility (IV) and Vega
The volatility component of option values is called implied volatility (IV).
(For more on implied volatility and how it relates to vega, see Chapter 3.)
IV is a percentage, although in practice the percent sign is often omitted.
This is the value entered into a pricing model, in conjunction with the other
variables, that returns the option’s theoretical value. The higher the
volatility input, the higher the theoretical value, holding all other variables
constant. The IV level can change and often does—sometimes dramatically.
When IV rises or falls, option prices rise and fall in line with it. But by how
much?
The relationship between changes in IV and changes in an option’s value
is measured by the option’s vega. Vega is the rate of change of an option’s
theoretical value relative to a change in implied volatility . Specifically, if
the IV rises or declines by one percentage point, the theoretical value of the
option rises or declines by the amount of the option’s vega, respectively.
For example, if a call with a theoretical value of 1.82 has a vega of 0.06 and
IV rises one percentage point from, say, 17 percent to 18 percent, the new
theoretical value of the call will be 1.88—it would rise by 0.06, the amount
of the vega. If, conversely, the IV declines 1 percentage point, from 17
percent to 16 percent, the call value will drop to 1.76—that is, it would
decline by the vega.
A put with the same expiration month and the same strike on the same
underlying will have the same vega value as its corresponding call. In this
example, raising or lowering IV by one percentage point would cause the
corresponding put value to rise or decline by $0.06, just like the call.
An increase in IV and the consequent increase in option value helps the
P&(L) of long option positions and hurts short option positions. Buying a
call or a put establishes a long vega position. For short options, the opposite
is true. Rising IV adversely affects P&(L), whereas falling IV helps.
Shorting a call or put establishes a short vega position.

eBooks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).pdf#page:87


The Effect of Moneyness on Vega
Like the other greeks, vega is a snapshot that is a function of multiple facets
of determinants influencing option value. The stock price’s relationship to
the strike price is a major determining factor of an option’s vega. IV affects
only the time value portion of an option. Because ATM options have the
greatest amount of time value, they will naturally have higher vegas. ITM
and OTM options have lower vega values than those of the ATM options.
Exhibit 2.13 shows an example of 186-day options on AT&T Inc. (T),
their time value, and the corresponding vegas.
EXHIBIT 2.13 AT&T theos and vegas (T at $30, 186 days to Expry, 20%
IV).
Note that the 30-strike calls and puts have the highest time values. This
strike boasts the highest vega value, at 0.085. The lower the time premium,
the lower the vega—therefore, the less incremental IV changes affect the
option. Since higher-priced stocks have higher time premium (in absolute
terms, not necessarily in percentage terms) they will have higher vega.
Incidentally, if this were a $300 stock instead of a $30 stock, the 186-day
ATMs would have a 0.850 vega, if all other model inputs remain the same.

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to be more risk than usual of future volatility. The question remains: Is the
higher premium worth the risk?
The answer to this question is subjective. Part of the answer is based on
Stacie’s assessment of future volatility. Is the market right? The other part is
based on Stacie’s risk tolerance. Is she willing to endure the greater price
swings associated with the potentially higher volatility? This can mean
getting whipsawed, which is exiting a position after reaching a stop-loss
point only to see the market reverse itself. The would-be profitable trade is
closed for a loss. Higher volatility can also mean a higher likelihood of
getting assigned and acquiring an unwanted long stock position.
Cash-Secured Puts
There are some situations where higher implied volatility may be a
beneficial trade-off. What if Stacie’s motivation for shorting puts was
different? What if she would like to own the stock, just not at the current
market price? Stacie can sell ten 65 puts at 1.75 and deposit $63,250 in her
trading account to secure the purchase of 1,000 shares of Johnson &
Johnson if she gets assigned. The $63,250 is the $65 per share she will pay
for the stock if she gets assigned, minus the 1.75 premium she received for
the put × $100 × 10 contracts. Because the cash required to potentially
purchase the stock is secured by cash sitting ready in the account, this is
called a cash-secured put.
Her effective purchase price if assigned is $63.25—the same as her
breakeven at expiration. The idea with this trade is that if Johnson &
Johnson is anywhere under $65 per share at expiration, she will buy the
stock effectively at $63.25. If assigned, the time premium of the put allows
her to buy the stock at a discount compared with where it is priced when the
trade is established, $64. The higher the time premium—or the higher the
implied volatility—the bigger the discount.
This discount, however, is contingent on the stock not moving too much.
If it is above $65 at expiration she won’t get assigned and therefore can
only profit a maximum of 1.75 per contract. If the stock is below $63.25 at
expiration, the time premium no longer represents a discount, in fact, the
trade becomes a loser. In a way, Stacie is still selling volatility.

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Covered Call
The problem with selling a naked call is that it has unlimited exposure to
upside risk. Because of this, many traders simply avoid trading naked calls.
A more common, and some would argue safer, method of selling calls is to
sell them covered.
A covered call is when calls are sold and stock is purchased on a share-
for-share basis to cover the unlimited upside risk of the call. For each call
that is sold, 100 shares of the underlying security are bought. Because of the
addition of stock to this strategy, covered calls are traded with a different
motivation than naked calls.
There are clearly many similarities between these two strategies. The
main goal for both is to harvest the premium of the call. The theta for the
call is the same with or without the stock component. The gamma and vega
for the two strategies are the same as well. The only difference is the stock.
When stock is added to an option position, the net delta of the position is
the only thing affected. Stock has a delta of one, and all its other greeks are
zero.
The pivotal point for both positions is the strike price. That’s the point the
trader wants the stock to be above or below at expiration. With the naked
call, the maximum payout is reaped if the stock is below the strike at
expiration, and there is unlimited risk above the strike. With the covered
call, the maximum payout is reaped if the stock is above the strike at
expiration. If the stock is below the strike at expiration, the risk is
substantial—the stock can potentially go to zero.
Putting It on
There are a few important considerations with the covered call, both when
putting on, or entering, the position and when taking off, or exiting, the
trade. The risk/reward implications of implied volatility are important in the
trade-planning process. Do I want to get paid more to assume more
potential risk? More speculative traders like the higher premiums. More
conservative (investment-oriented) covered-call sellers like the low implied
risk of low-IV calls. Ultimately, a main focus of a covered call is the option

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premium. How fast can it go to zero without the movement hurting me? To
determine this, the trader must study both theta and delta.
The first step in the process is determining which month and strike call to
sell. In this example, Harley-Davidson Motor Company (HOG) is trading at
about $69 per share. A trader, Bill, is neutral to slightly bullish on Harley-
Davidson over the next three months. Exhibit 5.7 shows a selection of
available call options for Harley-Davidson with corresponding deltas and
thetas.
EXHIBIT 5.7 Harley-Davidson calls.
In this example, the May 70 calls have 85 days until expiration and are
2.80 bid. If Harley-Davidson remained at $69 until May expiration, the 2.80
premium would represent a 4 percent profit over this 85-day period (2.80 ÷
69). That’s an annualized return of about 17 percent ([0.04 / 85)] × 365).
Bill considers his alternatives. He can sell the April (57-day) 70 calls at
2.20 or the March (22-day) 70 calls at 0.85. Since there is a different
number of days until expiration, Bill needs to compare the trades on an
apples-to-apples basis. For this, he will look at theta and implied volatility.
Presumably, the March call has a theta advantage over the longer-term
choices. The March 70 has a theta of 0.032, while the April 70’s theta is
0.026 and the May 70’s is 0.022. Based on his assessment of theta, Bill
would have the inclination to sell the March. If he wants exposure for 90
days, when the March 70 call expires, he can roll into the April 70 call and
then the May 70 call (more on this in subsequent chapters). This way Bill
can continue to capitalize on the nonlinear rate of decay through May.
Next, Bill studies the IV term structure for the Harley-Davidson ATMs
and finds the March has about a 19.2 percent IV, the April has a 23.3

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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.

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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)

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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)

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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

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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.

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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.

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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).

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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 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.

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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

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Diagonals
Definition : A diagonal spread is an option strategy that involves buying one
option and selling another option with a different strike price and with a
different expiration date. Diagonals are another strategy in the time spread
family.
Diagonals enable a trader to exploit opportunities similar to those
exploited by a calendar spread, but because the options in a diagonal spread
have two different strike prices, the trade is more focused on delta. The
name diagonal comes from the fact that the spread is a combination of a
horizontal spread (two different months) and a vertical spread (two different
strikes).
Say it’s 22 days until January expiration and 50 days until February
expiration. Apple Inc. (AAPL) is trading at $405.10. Apple has been in an
uptrend heading toward the peak of its six-month range, which is around
$420. A trader, John, believes that it will continue to rise and hit $420 again
by February expiration. Historical volatility is 28 percent. The February 400
calls are offered at a 32 implied volatility and the January 420 calls are bid
on a 29 implied volatility. John executes the following diagonal:
Exhibit 11.11 shows the analytics for this trade.
EXHIBIT 11.11 Apple January–February 400–420 call diagonal.

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From the presented data, is this a good trade? The answer to this question
is contingent on whether the position John is taking is congruent with his
view of direction and volatility and what the market tells him about these
elements.
John is bullish up to August expiration, and the stock in this example is in
an uptrend. Any rationale for bullishness may come from technical or
fundamental analysis, but techniques for picking direction, for the most
part, are beyond the scope of this book. Buying the lower strike in the
February option gives this trade a more positive delta than a straight
calendar spread would have. The trader’s delta is 0.255, or the equivalent of
about 25.5 shares of Apple. This reflects the trader’s directional view.
The volatility is not as easy to decipher. A specific volatility forecast was
not stated above, but there are a few relevant bits of information that should
be considered, whether or not the trader has a specific view on future
volatility. First, the historical volatility is 28 percent. That’s lower than
either the January or the February calls. That’s not ideal. In a perfect world,
it’s better to buy below historical and sell above. To that point, the February
option that John is buying has a higher volatility than the January he is
selling. Not so good either. Are these volatility observations deal breakers?

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EXHIBIT 15.4 Analytics for long 20 Acme Brokerage Co. 75-strike
straddles.
As with any trade, the risk is that the trader is wrong. The risk here is
indicated by the −2.07 theta and the +3.35 vega. Susan has to scalp an
average of at least $207 a day just to break even against the time decay. And
if IV continues to ebb down to a lower, more historically normal, level, she
needs to scalp even more to make up for vega losses.
Effectively, Susan wants both realized and implied volatility to rise. She
paid 36 volatility for the straddle. She wants to be able to sell the options at
a higher vol than 36. In the interim, she needs to cover her decay just to
break even. But in this case, she thinks the stock will be volatile enough to
cover decay and then some. If Acme moves at a volatility greater than 36,
her chances of scalping profitably are more favorable than if it moves at
less than 36 vol. The following is one possible scenario of what might have
happened over two weeks after the trade was made.
Week One
During the first week, the stock’s volatility tapered off a bit more, but
implied volatility stayed firm. After some oscillation, the realized volatility
ended the week at 34 percent while IV remained at 36 percent. Susan was
able to scalp stock reasonably well, although she still didn’t cover her seven
days of theta. Her stock buys and sells netted a gain of $1,100. By the end
of week one, the straddle was 5.10 bid. If she had sold the straddle at the
market, she would have ended up losing $200.

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

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

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

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

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

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

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

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

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

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

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

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