ll 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,


e. 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 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 sh

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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 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)
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

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ll (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 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 sho


0 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 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


o 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, invest


s 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 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 l


e 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 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 da


or’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 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 decisio


gh 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 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 outloo


rom 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. Using calendar spreads as income generators is popular among retail and professional traders alike. The process involves buying a longer-term at-the-money option and selling a shorter-term at-the-money (ATM) option. The options must be either both calls or both puts. Because this transaction results in a net debit—the longer-term option being purchased has a higher premium than the shorter-term option being sold—this is referred to as buying the calendar.
The main intent of buying a calendar spread for income is to profit from the positive net theta of the position. Because the shorter-term ATM option decays at a faster rate than the longer-term ATM option, the net theta is positive. As for most income spreads, the ideal outcome occurs when the underlying is at the short strike (in this case, shared strike) when the shorter-term option expires. At this strike price, the long option has its highest value, while the short option expires without the trader’s getting assigned. As long as the underlying remains close to the strike price, the value of the spread rises as time passes, because the short option decreases in value faster than the long option.
For example, a trader, Richard, watches Bed Bath & Beyond Inc. (BBBY) on a regular basis. Richard believes that Bed Bath & Beyond will trade in a range around $57.50 a share (where it is trading now) over the next month. Richard buys the January–February 57.50 call calendar for 0.80. Assuming January has 25 days until expiration and February has 53 days, Richard will execute the following trade:
Richard’s best-case scenario occurs when the January calls expire at expiration and the February calls retain much of their value.
If Richard created an at-expiration P&(L) diagram for his position, he’d have trouble because of the staggered expiration months. A general representation would look something like
Exhibit 11.1
.
EXHIBIT 11.1
Bed Bath & Beyond January–February 57.50 calendar.
The only point on the diagram that is drawn with definitive accuracy is the maximum loss to the downside at expiration of the January call. The maximum loss if Bed Bath & Beyond falls low enough is 0.80—the debit paid for the spread. If Bed Bath & Beyond is below $57.50 at January expiration, the January 57.50 call expires worthless, and the February 57.50 call may or may not have residual value. If Bed Bath & Beyond declines enough, the February 57.50 call can lose all of its value, even with residual time until expiration. If the stock falls enough, the entire 0.80 debit would be a loss.
If Bed Bath & Beyond is above $57.50 at January expiration, the January 57.50 call will be trading at parity. It will be a negative-100-delta option, imitating short stock. If Bed Bath & Beyond is trading high enough, the February 57.50 call will become a positive-100-delta option trading at parity plus the interest calculated on the strike. The February deep-in-the-money option would imitate long stock. At a 2 percent interest rate, interest on the 57.50 strike is about 0.17. Therefore, Richard would essentially have a short stock position from $57.50 from the January 57.50 call and would be essentially long stock from $57.50 plus 0.28 from the February call. The maximum loss to the upside is about 0.63 (0.80 − 0.17).
The maximum loss if Bed Bath & Beyond is trading over $57.50 at expiration is only an estimate that assumes there is no time value and that interest and dividends remain constant. Ultimately, the maximum loss will be 0.80, the premium paid, if there is no time value or carry considerations.
The maximum profit is gained if Bed Bath & Beyond is at $57.50 at expiration. At

eBooks\Trading Options Greeks\Trading Options Greeks_ How Time, Volatility, and Other Pricing Factors Drive Profits (Bloomberg Financial).epub#section:text00021.html


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


ack month means positive vega.
Managing an Income-Generating Calendar
Let’s say that instead of trading a one-lot calendar, Richard trades it 20 times. His trade in this case is
His total cash outlay is $1,600 ($80 times 20). The greeks for this trade, listed in
Exhibit 11.5
, are also 20 times the size of those in
Exhibit 11.3
.
EXHIBIT 11.5
20-Lot Bed Bath & Beyond January–February 57.50 call calendar.
Note that Richard has a +0.18 delta. This means he’s long the equivalent of about 18 shares of stock—still pretty flat. A gamma of −0.72 means that if Bed Bath & Beyond moves $1 higher, his delta will be starting to get short; and if it moves $1 lower he will be longer, long 90 deltas.
Richard can use the greeks to get a feel for how much the stock can move before negative gamma causes a loss. If Bed Bath & Beyond starts trending in either direction, Richard may need to react. His plan is to cover his deltas to continue the position.
Say that after one week Bed Bath & Beyond has dropped $1 to $56.50. Richard will have collected seven days of theta, which will have increased slightly from $18 per day to $20 per day. His average theta during that time is about $19, so Richard’s profit attributed to theta is about $133.
With a big-enough move in either direction, Richard’s delta will start working against him. Since he started with a delta of +0.18 on this 20-lot spread and a gamma of −0.72, one might think that his delta would increase to 0.90 with Bed Bath & Beyond a dollar lower (18 − [−0.072 × 1.00]). But because a week has passed, his delta would actually get somewhat more positive. The shorter-term call’s delta will get smaller (closer to zero) at a faster rate compared to the longer-term call because it has less time to expiration. Thus, the positive delta of the long-term option begins to outweigh the negative delta of the short-term option as time passes.
In this scenario, Richard would have almost broken even because what would be lost on stock price movement, is made up for by theta gains. Richard can sell about 100 shares of Bed Bath & Beyond to eliminate his immediate directional risk and stem further delta losses. The good news is that if Bed Bath & Beyond declines more after this hedge, the profit from the short stock offsets losses from the long delta. The bad news is that if BBBY rebounds, losses from the short stock offset gains from the long delta.
After Richard’s hedge trade is executed, his delta would be zero. His other greeks remain unchanged. The idea is that if Bed Bath & Beyond stays at its new price level of $56.50, he reaps the benefits of theta increasing with time from $18 per day. Richard is accepting the new price level and any profits or losses that have occurred so far. He simply adjusts his directional exposure to a zero delta.
Rolling and Earning a “Free” Call
Many traders who trade income-generating strategies are conservative. They are happy to sell low IV for the benefits afforded by low realized volatility. This is the problem-avoidance philosophy of trading. Due to risk aversion, it’s common to trade calendar spreads by buying the two-month option and selling the one-month option. This can allow traders to avoid buying the calendar in earnings months, and it also means a shorter time horizon, signifying less time for something unwanted to happen.
But there’s another school of thought among time-spread traders. There are some traders who prefer to buy a longer-term option—six months to a year—while selling a one-month option. Why? Because month after month, the trader can roll the short option to the next month. This is a simple tactic that is used by market makers and other professional traders as well as savvy retail traders. Here’s how it works.
XYZ stock is trading at $60 per share. A trader has a neutral outlook over the next six months and decides to buy a calendar. Assuming that July has 29 days until expiration and December has 180, the trader will take the following position:
The initial debit here is 2.55. The goal is basically the same as for any time spread: collect theta without negative gamma spoiling the party. There is another goal in these trades as well: to roll the spread.
At the end of month one, if the best-case scenario occurs and XYZ is sitting at $60 at July expiration, the July 60 call expires. The December 60 call will then be worth 3.60, assuming all else is held constant. The positive theta of the short July call gives full benefits as the option goes from 1.45 to zero. The lower negative theta of the December call doesn’t bite into profits quite as much as the theta of a short-term call would.
The profit after month one is 1.05. Profit is derived from the December call, worth 3.60 at July expiry, minus the 2.55 initial spread debit. This works out to about a 41 percent return. The profit is hardly as good as it would have been if a short-term, less expensive August 60 call were the long leg of this spread.
Rolling the Spread
The July–December


rom the December call, worth 3.60 at July expiry, minus the 2.55 initial spread debit. This works out to about a 41 percent return. The profit is hardly as good as it would have been if a short-term, less expensive August 60 call were the long leg of this spread.
Rolling the Spread
The July–December spread is different from short-term spreads, however. When the Julys expire, the August options will have 29 days until expiration. If volatility is still the same, XYZ is still at $60, and the trader’s forecast is still neutral, the 29-day August 60 calls can be sold for 1.45. The trader can either wait until the Monday after July expiration and then sell the August 60s, or when the Julys are offered at 0.05 or 0.10, he can buy the Julys and sell the Augusts as a spread. In either case, it is called rolling the spread. When the August expires, he can sell the Septembers, and so on.
The goal is to get a credit month after month. At some point, the aggregate credit from the call sales each month is greater than the price initially paid for the long leg of the spread, thus eliminating the original net debit.
Exhibit 11.6
shows how the monthly credits from selling the one-month calls aggregate over time.
EXHIBIT 11.6
A “free” call.
After July has expired, 1.45 of premium is earned. After August expiration, the aggregate increases to 2.90. When the September calls, which have 36 days until expiration, are sold, another 1.60 is added to the total premium collected. Over three months—assuming the stock price, volatility, and the other inputs don’t change—this trader collects a total of 4.50. That’s 0.50 more than the price originally paid for the December 60 call leg of the spread.
At this point, he effectively owns the December call for free. Of course, this call isn’t really free; it’s earned. It’s paid for with risk and maybe a few sleepless nights. At this point, even if the stock and, consequently, the December call go to zero, the position is still a profitable trade because of the continued month-to-month rolling. This is now a no-lose situation.
When the long call of the spread has been paid for by rolling, there are three choices moving forward: sell it, hold it, or continue writing calls against it. If the trader’s opinion calls for the stock to decline, it’s logical to sell the December call and take the residual value as profit. In this case, over three months the trade will have produced 4.50 in premium from the sale of three consecutive one-month calls, which is more than the initial purchase price of the December call. At September expiration, the premium that will be received for selling the December call is all profit, plus 0.50, which is the aggregate premium minus the initial cost of the December call.
If the outlook is for the underlying to rise, it makes sense to hold the call. Any appreciation in the value of the call resulting from delta gains as the underlying moves higher is good—$0.50 plus whatever the call can be sold for.
If the forecast is for XYZ to remain neutral, it’s logical to continue selling the one-month call. Because the December call has been financed by the aggregate short call premiums already, additional premiums earned by writing calls are profit with “free” protection. As long as the short is closed at its expiration, the risk of loss is eliminated.
This is the general nature of rolling calls in a calendar spread. It’s a beautiful plan when it works! The problem is that it is incredibly unlikely that the stock will stay right at $60 per share for five months. It’s almost inevitable that it will move at some point. It’s like a game of Russian roulette. At some point it’s going to be a losing proposition—you just don’t know when. The benefit of rolling is that if the trade works out for a few months in a row, the long call is paid for and the risk of loss is covered by aggregate profits.
If we step outside this best-case theoretical world and consider what is really happening on a day-to-day basis, we can gain insight on how to manage this type of trade when things go wrong. Effectively, a long calendar is a typical gamma/theta trade. Negative gamma hurts. Positive theta helps.
If we knew which way the stock was going, we would simply buy or sell stock to adjust to get long or short deltas. But, unfortunately, we don’t. Our only tool is to hedge by buying or selling stock as mentioned above to flatten out when gamma causes the position delta to get more positive or negative.
1
The bottom line is that if the effect of gamma creates unwanted long deltas but the theta/gamma is still a desirable position, selling stock flattens out the delta. If the effect of gamma creates unwanted short deltas, buying stock flattens out the delta.
Trading Volatility Term Structure
There are other reasons for trading calendar spreads besides generating income from theta. If there is skew in the term structure of volatility, which was discussed in Chapter 3, a calendar spread is a way to trade vola


t deltas, buying stock flattens out the delta.
Trading Volatility Term Structure
There are other reasons for trading calendar spreads besides generating income from theta. If there is skew in the term structure of volatility, which was discussed in Chapter 3, a calendar spread is a way to trade volatility. The tactic is to buy the “cheap” month and sell the “expensive” month.
Selling the Front, Buying the Back
If for a particular stock, the February ATM calls are trading at 50 volatility and the May ATM calls are trading at 35 volatility, a vol-calendar trader would buy the Mays and sell the Februarys. Sounds simple, right? The devil is in the details. We’ll look at an example and then discuss some common pitfalls with vol-trading calendars.
George has been studying the implied volatility of a $164.15 stock. George notices that front-month volatility has been higher than that of the other months for a couple of weeks. There is nothing in the news to indicate immediate risk of extraordinary movement occurring in this example.
George sees that he can sell the 22-day July 165 calls at a 45 percent IV and buy the 85-day September 165 calls at a 38 percent IV. George would like to buy the calendar spread, because he believes the July ATM volatility will drop down to around 38, where the September is trading. If he puts on this trade, he will establish the following position:
What are George’s risks? Because he would be selling the short-term ATM option, negative gamma could be a problem. The greeks for this trade, shown in
Exhibit 11.7
, confirm this. The negative gamma means each dollar of stock price movement causes an adverse change of about 0.09 to delta. The spread’s delta becomes shorter when the stock rises and longer when the stock falls. Because the position’s delta is long 0.369 from the start, some price appreciation may be welcomed in the short term. The stock advance will yield profits but at a diminishing rate, as negative gamma reduces the delta.
EXHIBIT 11.7
10-lot July–September 165 call calendar.
But just looking at the net position greeks doesn’t tell the whole story. It is important to appreciate the fact that long calendar spreads such as this have long vegas. In this case, the vega is +1.522. But what does this number really mean? This vega figure means that if IV rises or falls in both the July and the September calls by the same amount, the spread makes or loses $152 per vol point.
George’s plan, however, is to see the July’s volatility decline to converge with the September’s. He hopes the volatilities of the two months will move independently of each other. To better gauge his risk, he needs to look at the vega of each option. With the stock at $164.15 the vegas are as follows:
If George is right and July volatility declines 8 points, from 46 to 38, he will make $1,283 ($1.604 × 100 × 8).
There are a couple of things that can go awry. First, instead of the volatilities converging, they can diverge further. Implied volatility is a slave to the whims of the market. If the July IV continues to rise while the September IV stays the same, George loses $160 per vol point.
The second thing that can go wrong is the September IV declining along with the July IV. This can lead George into trouble, too. It depends the extent to which the September volatility declines. In this example, the vega of the September leg is about twice that of the July leg. That means that if the July volatility loses eight points while the September volatility declines four points, profits from the July calls will be negated by losses from the September calls. If the September volatility falls even more, the trade is a loser.
IV is a common cause of time-spread failure for market makers. When i in the front month rises, the volatility of the back-months sometimes does as well. When this happens, it’s often because market makers who sold front-month options to retail or institutional buyers buy the back-month options to hedge their short-gamma risk. If the market maker buys enough back-month options, he or she will accumulate positive vega. But when the market sells the front-month volatility back to the market makers, the back months drop, too, because market makers no longer need the back months for a hedge.
Traders should study historical implied volatility to avoid this pitfall. As is always the case with long vega strategies, there is a risk of a decline in IV. Buying long-term options with implied volatility in the lower third of the 12-month IV range helps improve the chances of success, since the volatility being bought is historically cheap.
This can be tricky, however. If a trader looks back on a chart of IV for an option class and sees that over the past six months it has ranged between 20 and 30 but nine months ago it spiked up to, say, 55, there must be a reason. This solitary spike could be just an anomaly. To eliminate the noise from volatility charts, it helps to filter the data. News stories from that ti


ption class and sees that over the past six months it has ranged between 20 and 30 but nine months ago it spiked up to, say, 55, there must be a reason. This solitary spike could be just an anomaly. To eliminate the noise from volatility charts, it helps to filter the data. News stories from that time period and historical stock charts will usually tell the story of why volatility spiked. Often, it is a one-time event that led to the spike. Is it reasonable to include this unique situation when trying to get a feel for the typical range of implied volatility? Usually not. This is a judgment call that needs to be made on a case-by-case basis. The ultimate objective of this exercise is to determine: “Is volatility cheap or expensive?”
Buying the Front, Selling the Back
All trading is based on the principle of “buy low, sell high”—even volatility trading. With time spreads, we can do both at once, but we are not limited to selling the front and buying the back. When short-term options are trading at a lower IV than long-term ones, there may be an opportunity to sell the calendar. If the IV of the front month is 17 and the back-month IV is 25, for example, it could be a wise trade to buy the front and sell the back. But selling time spreads in this manner comes with its own unique set of risks.
First, a short calendar’s greeks are the opposite of those of a long calendar. This trade has negative theta with positive gamma. A sideways market hurts this position as negative theta does its damage. Each day of carrying the position is paid for with time decay.
The short calendar is also a short-vega trade. At face value, this implies that a drop in IV leads to profit and that the higher the IV sold in the back month, the better. As with buying a calendar, there are some caveats to this logic.
If there is an across-the-board decline in IV, the net short vega will lead to a profit. But an across-the-board drop in volatility, in this case, is probably not a realistic expectation. The front month tends to be more sensitive to volatility. It is a common occurrence for the front month to be “cheap” while the back month is “expensive.”
The volatilities of the different months can move independently, as they can when one buys a time spread. There are a couple of scenarios that might lead to the back-month volatility’s being higher than the front month. One is high complacency in the short term. When the market collectively sells options in expectation of lackluster trading, it generally prefers to sell the short-term options. Why? Higher theta. Because the trade has less time until expiration, the trade has a shorter period of risk. Because of this, selling pressure can push down IV in the front-month options more than in the back. Again, the front month is more sensitive to changes in implied volatility.
Because volatility has peaks and troughs, this can be a smart time to sell a calendar. The focus here is in seeing the “cheap” front month rise back up to normal levels, not so much in seeing the “expensive” back month fall. This trade is certainly not without risk. If the market doesn’t move, the negative theta of the short calendar leads to a slow, painful death for calendar sellers.
Another scenario in which the back-month volatility can trade higher than the front is when the market expects higher movement after the expiration of the short-term option but before the expiration of the long-term option. Situations such as the expectation of the resolution of a lawsuit, a product announcement, or some other one-time event down the road are opportunities for the market to expect such movement. This strategy focuses on the back-month vol coming back down to normal levels, not on the front-month vol rising. This can be a more speculative situation for a volatility trade, and more can go wrong.
The biggest volatility risk in selling a time spread is that what goes up can continue to go up. The volatility disparity here is created by hedgers and speculators favoring long-term options, hence pushing up the volatility, in anticipation of a big future stock move. As the likely date of the anticipated event draws near, more buyers can be attracted to the market, driving up IV even further. Realized volatility can remain low as investors and traders lie in wait. This scenario is doubly dangerous when volatility rises and the stock doesn’t move. A trader can lose on negative theta and lose on negative vega.
A Directional Approach
Calendar spreads are often purchased when the outlook for the underlying is neutral. Sell the short-term ATM option; buy the long-term ATM option; collect theta. But with negative gamma, these trades are never really neutral. The delta is constantly changing, becoming more positive or negative. It’s like a rubber band: at times being stretched in either direction but always demanding a pull back to the strike. When the strike price being traded is not ATM, calendar spreads can be strategically traded as dir


ally neutral. The delta is constantly changing, becoming more positive or negative. It’s like a rubber band: at times being stretched in either direction but always demanding a pull back to the strike. When the strike price being traded is not ATM, calendar spreads can be strategically traded as directional plays.
Buying a calendar, whether using calls or puts, where the strike price is above the current stock price is a bullish strategy. With calls, the positive delta of the long-term out-of-the-money (OTM) call will be greater than the negative delta of the short-term OTM call. For puts, the positive delta of the short-term in-the-money (ITM) put will be greater than the negative delta of the long-term ITM put.
Just the opposite applies if the strike price is below the current stock price. The negative delta of the short-term ITM call is greater than the positive delta of the long-term ITM call. The negative delta of the long-term OTM put is greater than the positive delta of the short-term OTM put.
When the position starts out with either a positive or negative delta, movement in the direction of the delta is necessary for the trade to be profitable. Negative gamma is also an important strategic consideration. Stock-price movement is needed, but not too much.
Buying calendar spreads is like playing outfield in a baseball game. To catch a fly ball, an outfielder must focus on both distance and timing. He must gauge how far the ball will be hit and how long it will take to get there. With calendars, the distance is the strike price—that’s where the stock needs to be—and the time is the expiration day of the short month’s option: that’s when it needs to be at the target price.
For example, with Wal-Mart (WMT) at $48.50, a trader, Pete, is looking for a rise to about $50 over the next five or six weeks. Pete buys the August–September call calendar. In this example, August has 39 days until expiration and September has 74 days.
Exactly what does 50 cents buy Pete? The stock price sitting below the strike price means a net positive delta. This long time spread also has positive theta and vega. Gamma is negative.
Exhibit 11.8
shows the specifics.
EXHIBIT 11.8
10-lot Wal-Mart August–September 50 call calendar.
The delta of this trade, while positive, is relatively small with 39 days left until August expiration. It’s not rational to expect a quick profit if the stock advances faster than expected. But ultimately, a rise in stock price is the goal. In this example, Wal-Mart needs to rise to $50, and timing is everything. It needs to be at that price in 39 days. In the interim, a move too big and too fast in either direction hurts the trade because of negative gamma. Starting with Wal-Mart at $48.50, delta/gamma problems are worse to the downside.
Exhibit 11.9
shows the effects of stock price on delta, gamma, and theta.
EXHIBIT 11.9
Stock price movement and greeks.
If Wal-Mart moves lower, the delta gets more positive, racking up losses at a higher rate. To add to Pete’s woes, theta becomes less of a benefit as the stock drifts lower. At $47 a share, theta is about flat. With Wal-Mart trading even lower than $47, the positive theta of the August call is overshadowed by the negative theta of the September. Theta can become negative, causing the position to lose value as time passes.
A big move to the upside doesn’t help either. If Wal-Mart rises just a bit, the −0.323 gamma only lessens the benefit of the 0.563 delta. But above $50, negative gamma begins to cause the delta to become increasingly negative. Theta begins to wither away at higher stock prices as well.
The place to be is right at $50. The delta is flat and theta is highest. As long as Wal-Mart finds its way up to this price by the third Friday of August, life is good for Pete.
The In-or-Out Crowd
Pete could just as well have traded the Aug–Sep 50 put calendar in this situation. If he’d been bearish, he could have traded either the Aug–Sep 45 call spread or the Aug–Sep 45 put spread. Whether bullish or bearish, as mentioned earlier, the call calendar and the put calendar both function about the same. When deciding which to use, the important consideration is that one of them will be in-the-money and the other will be OTM. Whether you have an ITM spread or an OTM spread has potential implications for the success of the trade.
The bid-ask spreads tend to be wider for higher-delta, ITM options. Because of this, it can be more expensive to enter into an ITM calendar. Why? Trading options with wider markets requires conceding more edge. Take the following options series:
By buying the May 50 calls at 3.20, a trader gives up 0.10 of theoretical edge (3.20 is 0.10 higher than the theoretical value). Buying the put at 1.00 means buying only 0.05 over theoretical.
Because a calendar is a two-legged spread, the double edge given up by trading the wider markets of two in-the-money options can make the out-of-the-money spread a more attractive trade. The issue of wi


gher than the theoretical value). Buying the put at 1.00 means buying only 0.05 over theoretical.
Because a calendar is a two-legged spread, the double edge given up by trading the wider markets of two in-the-money options can make the out-of-the-money spread a more attractive trade. The issue of wider markets is compounded when rolling the spread. Giving up a nickel or a dime each month can add up, especially on nominally low-priced spreads. It can cut into a high percentage of profits.
Early assignment can complicate ITM calendars made up of American options, as dividends and interest can come into play. The short leg of the spread could get assigned before the expiration date as traders exercise calls to capture the dividend. Short ITM puts may get assigned early because of interest.
Although assignment is an undesirable outcome for most calendar spread traders, getting assigned on the short leg of the calendar spread may not necessarily create a significantly different trade. If a long put calendar, for example, has a short front-month put that is so deep in-the-money that it is likely to get assigned, it is trading close to a 100 delta. It is effectively a long stock position already. After assignment, when a long stock position is created, the resulting position is long stock with a deep ITM long put—a fairly delta-flat position.
Double Calendars
Definition
: A double calendar spread is the execution of two calendar spreads that have the same months in common but have two different strike prices.
Example
Sell 1 XYZ February 70 call
Buy 1 XYZ March 70 call
Sell 1 XYZ February 75 call
Buy 1 XYZ March 75 call
Double calendars can be traded for many reasons. They can be vega plays. If there is a volatility-time skew, a double calendar is a way to take a position without concentrating delta or gamma/theta risk at a single strike.
This spread can also be a gamma/theta play. In that case, there are two strikes, so there are two potential focal points to gravitate to (in the case of a long double calendar) or avoid (in the case of a short double calendar).
Selling the two back-month strikes and buying the front-month strikes leads to negative theta and positive gamma. The positive gamma creates favorable deltas when the underlying moves. Positive or negative deltas can be covered by trading the underlying stock. With positive gamma, profits can be racked up by buying the underlying to cover short deltas and subsequently selling the underlying to cover long deltas.
Buying the two back-month strikes and selling the front-month strikes creates negative gamma and positive theta, just as in a conventional calendar. But the underlying stock has two target price points to shoot for at expiration to achieve the maximum payout.
Often double calendars are traded as IV plays. Many times when they are traded as IV plays, traders trade the lower-strike spread as a put calendar and the higher-strike spread a call calendar. In that case, the spread is sometimes referred to as a
strangle swap
. Strangles are discussed in Chapter 15.
Two Courses of Action
Although there may be many motivations for trading a double calendar, there are only two courses of action: buy it or sell it. While, for example, the trader’s goal may be to capture theta, buying a double calendar comes with the baggage of the other greeks. Fully understanding the interrelationship of the greeks is essential to success. Option traders must take a holistic view of their positions.
Let’s look at an example of buying a double calendar. In this example, Minnesota Mining & Manufacturing (MMM) has been trading in a range between about $85 and $97 per share. The current price of Minnesota Mining & Manufacturing is $87.90. Economic data indicate no specific reasons to anticipate that Minnesota Mining & Manufacturing will deviate from its recent range over the next month—that is, there is nothing in the news, no earnings anticipated, and the overall market is stable. August IV is higher than October IV by one volatility point, and October implied volatility is in line with 30-day historical volatility. There are 38 days until August expiration, and 101 days until October expiration.
The Aug–Oct 85–90 double calendar can be traded at the following prices:
Much like a traditional calendar spread, the price points cannot be definitively plotted on a P&(L) diagram. What is known for certain is that at August expiration, the maximum loss is $3,200. While it’s comforting to know that there is limited loss, losing the entire premium that was paid for the spread is an outcome most traders would like to avoid. We also know the maximum gains occur at the strike prices; but not exactly what the maximum profit can be.
Exhibit 11.10
provides an alternative picture of the position that is useful in managing the trade on a day-to-day basis.
EXHIBIT 11.10
10-lot Minnesota Mining & Manufacturing Aug–Oct 85–90 double call calendar.
These numbers are a good representation of the posit