Friday, December 12, 2008

Ratio Spread

Ratio spreads are neutral in the sense that you don't want the market to move much either way once you make the trade.

While call and put ratio spreads can be effective strategies when you are expecting relatively stable prices over the short term, they are not without risk. By definition, a ratio spread involves more short than long options. If the trade moves against you, the extra short option(s) expose you to unlimited risk.

(You might want to also review a call back spread, which is a ratio spread that involves more long than short options. As such, it is a limited risk, unlimited reward strategy.)
Put Ratio Spread

To create a put ratio spread, you would buy puts at a higher strike and sell a greater number of puts at a lower strike. Ideally, this trade will be initiated for a minimal debit or, if possible, a small credit. This way, if the stock jumps, you won't suffer much because all of the puts will expire worthless. However, if the stock plummets, you have unlimited risk to the downside because you will have sold more options than you bought. For maximum profitability, you want the stock price to stay at the strike price where you are short options.
Example

Using Merrill Lynch (MER), we can create a put ratio spread using in-the-money options. With MER Trading at $39.68 in May, you might sell three of the JUL 40 puts and buy one JUL 50 put.
MER trading @ $39.68
Buy 1 MER JUL 50 Put @ $10.60 $1,060
Sell 3 MER JUL 40 Put @ $2.40 ($720)
Cost/Proceeds $340

The profit/loss above does not factor in commissions, interest, or tax considerations.
Ratio Spread Chart Ratio Spread Graph

In this case, you would pay a $340 debit for putting on the trade. If the stock jumped above 60, you would only lose the $340 paid for the spread. However, the real money would be made if the stock stayed right around $40. Here, the short 40 puts would expire worthless and the long 50 put would be worth $10. The value of the 50 put, minus the initial $340 debit would bring the net profit up to $660.

A big move to the downside in this case would spell trouble. The downside breakeven point occurs when the stock price equals 36.70, below this point the risk of losses exceeds $7,000.

The Butterfly

The long butterfly spread is a three-leg strategy that is appropriate for a neutral forecast � when you expect the underlying stock price (or index level) to change very little over the life of the options. A butterfly can be implemented using either call or put options. For simplicity, the following explanation discusses the strategy using call options.

A long call butterfly spread consists of three legs with a total of four options: long one call with a lower strike, short two calls with a middle strike and long one call of a higher strike. All the calls have the same expiration, and the middle strike is halfway between the lower and the higher strikes. The position is considered "long" because it requires a net cash outlay to initiate.

When a butterfly spread is implemented properly, the potential gain is higher than the potential loss, but both the potential gain and loss will be limited.

The total cost of a long butterfly spread is calculated by multiplying the net debit (cost) of the strategy by the number of shares each contract represents. A butterfly will break-even at expiration if the price of the underlying is equal to one of two values. The first break-even value is calculated by adding the net debit to the lowest strike price. The second break-even value is calculated by subtracting the net debit from the highest strike price. The maximum profit potential of a long butterfly is calculated by subtracting the net debit from the difference between the middle and lower strike prices. The maximum risk is limited to the net debit paid for the position.

Butterfly spreads achieve their maxim profit potential at expiration if the price of the underlying is equal to the middle strike price. The maximum loss is realized when the price of the underlying is below the lowest strike or above the highest strike at expiration.

As with all advanced option strategies, butterfly spreads can be broken down into less complex components. The long call butterfly spread has two parts, a bull call spread and a bear call spread. The following example, which uses options on the Dow Jones Industrial Average (DJX), illustrates this point.
DJX trading @ $75.28
Buy 1 DJX 72 Call @ $6.10 x 100 $610 (wing)
Sell 2 DJX 75 Call @ $4.10 x 100 ($820) (butterfly body)
Buy 1 DJX 78 Call @ $2.60 x 100 $260 (wing)
Net Debit from Trade $50 ($870 - $820)

In this example the total cost of the butterfly is the net debit ($.50) x the number of shares per contract (100). This equals $50, not including commissions. Please note that this is a three-legged trade, and there will be a commission charged for each leg of the trade.

An expiration profit and loss graph for this strategy is displayed below.
Butterfly Chart Butterfly Graph

*The profit/loss above does not factor in commissions, interest, tax, or margin considerations.

This profit and loss graph allows us to easily see the break-even points, maximum profit and loss potential at expiration in dollar terms. The calculations are presented below.

The two break-even points occur when the underlying equals 72.50 and 77.50. On the graph these two points turn out to be where the profit and loss line crosses the x-axis.
First Break-even Point = Lowest Strike (72) + Net Debit (.50) = 72.50
Second Break-even Point = Highest Strike (78) - Net Debit (.50) = 77.50

The maximum profit can only be reached if the DJX is equal to the middle strike (75) on expiration. If the underlying equals 75 on expiration, the profit will be $250 less the commissions paid.
Maximum Profit = Middle Strike (75) - Lower Strike (72) - Net Debit (.50) = 2.50

$2.50 x Number of Shares per Contract (100) = $250 less commissions

The maximum loss, in this example, results if the DJX is below the lower strike (72) or above the higher strike (78) on expiration. If the underlying is less than 72 or greater than 78 the loss will be $50 plus the commissions paid.
Maximum Loss = Net Debit (.50)

$.50 x Number of Shares per Contract (100) = $50 plus commissions

By looking at the components of the total position, it is easy to see the two spreads that make up the butterfly.

Bull call spread: Long 1 of the November 72 calls & Short one of the November 75 calls

Bear call spread: Short one of the November 75 calls & Long 1 on the November 78 calls
Summary

A long butterfly spread is used by investors who forecast a narrow trading range for the underlying security, and who are not comfortable with the unlimited risk that is involved with being short a straddle. The long butterfly is a strategy that takes advantage of the time premium erosion of an option contract, but still allows the investor to have a limited and known risk.

Naked Call

Calendar spreads are also known as time or horizontal spreads because they involve options with different expiration months. In this case, "horizontal" refers to the fact that option months were originally listed on the board at the exchange from left to right. At the same time, strike prices were listed from top to bottom. For this reason, options with different strike prices and the same expiration are often referred to as vertical spreads.

In simplest terms, a long calendar spread involves buying an option with a longer expiration and selling an option with the same strike price and a shorter expiration. For example, imagine that Dell Computer (DELL) is trading for $45 per share. To initiate a calendar spread, you might sell the Dell June 45 calls and buy the July 45 calls.
DELL trading @ $45

June

July
Dell 45 Calls 4.50 6.50
Time to Expiration 2 months 3 months
Spread value: $2 (6.50 - 4.50)

Like most long positions, there is a cost to put on this trade. In this case, the cost is $2. For the time spread to work, the June option must lose its time premium faster than the July option. If the stock price remains relatively stable as the June expiration approaches, the value of the spread should increase. With only one month remaining before the June expiration, the option prices might look like this.
DELL trading @ $45

June

July
Dell 45 Calls 1.50 4.50
Time to Expiration 1 months 2 months
Spread value: $3 (4.50 - 1.50)

In this case, the position could be closed for a one-point profit by selling the July calls and buying back the June calls.

For long calendar spreads to work, the underlying stock price must remain relatively stable. Any swings in either direction will negatively impact the time value of both options causing the spread to lose value.

Calender Spread

Calendar spreads are also known as time or horizontal spreads because they involve options with different expiration months. In this case, "horizontal" refers to the fact that option months were originally listed on the board at the exchange from left to right. At the same time, strike prices were listed from top to bottom. For this reason, options with different strike prices and the same expiration are often referred to as vertical spreads.

In simplest terms, a long calendar spread involves buying an option with a longer expiration and selling an option with the same strike price and a shorter expiration. For example, imagine that Dell Computer (DELL) is trading for $45 per share. To initiate a calendar spread, you might sell the Dell June 45 calls and buy the July 45 calls.
DELL trading @ $45

June

July
Dell 45 Calls 4.50 6.50
Time to Expiration 2 months 3 months
Spread value: $2 (6.50 - 4.50)

Like most long positions, there is a cost to put on this trade. In this case, the cost is $2. For the time spread to work, the June option must lose its time premium faster than the July option. If the stock price remains relatively stable as the June expiration approaches, the value of the spread should increase. With only one month remaining before the June expiration, the option prices might look like this.
DELL trading @ $45

June

July
Dell 45 Calls 1.50 4.50
Time to Expiration 1 months 2 months
Spread value: $3 (4.50 - 1.50)

In this case, the position could be closed for a one-point profit by selling the July calls and buying back the June calls.

For long calendar spreads to work, the underlying stock price must remain relatively stable. Any swings in either direction will negatively impact the time value of both options causing the spread to lose value.

The Strangle

A Word on Strangles as Neutral Strategies

Although long and short strangles differ in their response to market movement, we have chosen to list both as neutral strategies. In a pure sense, the short strangle is a neutral strategy because it achieves maximum profit in a market that moves sideways. In contrast, the long strangle benefits from market movement in either direction. However, since a $10 move in either direction will have the same impact on profit, the trader doesn't necessarily have a preference which way the market moves. In this sense, the trader is neutral about market direction--as long as movement occurs.
Long Strangles

Long strangles are comparable to long straddles in that they profit from market movement in either direction. From a cash outlay standpoint, strangles are less risky than straddles because they are usually initiated with less expensive, near-the-money rather than at-the-money options.

Like long straddles, they have unlimited profit potential on both the upside and downside. For example, let's imagine that a particular stock is trading at $65 per share. The following chart shows where the near-the-money and at-the-money options are trading.

Stock @ $65
Strike Price Calls Puts
60 7 2.25
65 5.25 5
70 2.50 6.75

Calls and puts used in strangles have the same expiration.
Long Strangle
Buy 1 60 Put @ $2.25 $225
Buy 1 70 Call @ $2.50 $250

If we opted for the strangle, we could buy the 60 put for 2.25 and the 70 call for 2.50. Thus, our out-of-pocket cost-and maximum loss-would be 4.75 plus commissions. With the stock anywhere between $60 and $70, we would incur the maximum loss of $475 (4.75 x 100). Anywhere below $55 or above $75, the position will begin to show a profit.

Value at Expiration:
Stock Price Profit (Loss)
$50 $525
$55.25 $0
$60 ($475)
$65 ($475)
$70 ($475)
$74.75 $0
$80 $525

The profit/loss above does not factor in commissions, interest, or tax considerations.

The long strangle can also be created using in-the-money options. Using the example above, this would involve the following:
Long Strangle (less common alternative)

Buy one 60 call @ $7
Buy one 70 put @ $6 3/4

This is an interesting position for a number of reasons. First, it's guaranteed to have some value at expiration because at any price at least one of the options will have intrinsic value. More specifically, with the stock between $60 and $70, the position will be worth $10. Thus, the maximum loss will be 3.75 (13.75 - 10).

It's also worth noticing that the maximum loss using in-the-money options is lower (3.75 vs. 4.75) even though the out-of-pocket cost to initiate the position is much higher. The reason for this is that generally speaking, the time premium for in-the-money options is lower than it is for out-of-the money options. In the first example, neither the 70 call nor the 60 put had any intrinsic value with the stock at $65. Thus, the price of the options was primarily time premium.

In the second example, the 60 call and the 70 put each had $5 of intrinsic value with the stock at $65. When you subtract the intrinsic value from the total price of the options, you see that the time premium for these in-the-money options is lower than the time premium for options equidistant from the current stock price but out-of-the-money.

The Straddle

A Word on Straddles as Neutral Strategies

Although long and short straddles differ in their response to market movement, we have chosen to list both as neutral strategies. In a pure sense, the short straddle is a neutral strategy because it achieves maximum profit in a market that moves sideways. In contrast, the long straddle benefits from market movement in either direction. However, since a $10 move in either direction will have the same impact on profit, the trader doesn't necessarily have a preference which way the market moves. In this sense, the trader is neutral about market direction--as long as movement occurs.

Long Straddles

Have you ever had the feeling that a stock was about to make a big move, but you weren't sure which way? For stockholders, this is exactly the kind of scenario that creates ulcers. For option traders, these feelings in the stomach are the butterflies of opportunity. By simultaneously buying the same number of puts and calls at the current stock price, option traders can capitalize on large moves in either direction.

Here's how this works. Let's imagine a stock is trading around $80 per share. To prepare for a big move in either direction, you would buy both the 80 calls and the 80 puts. If the stock drops to $50 by expiration, the puts will be worth $30 and the calls will be worth $0. If the stock gaps up to $110, the calls will be worth $30 and the puts will be worth $0.

The greatest risk in this case is that the stock remains at $80 where both options expire worthless.

Here's what the trade might look like:

Long Straddle
Buy 1 80 Call @ $7.50 $750
Buy 1 80 Put @ $7.00 $700

At these prices, every straddle will cost about 14.50. Since you are buying two options, a call and a put, you might get a slightly better price than the offer for each individual option. But, to keep it simple, we'll assume the prices listed above are the best available for the straddle. The 14.50 or $1,450 you pay for the straddle will also be the most you can lose if the price remains close to $80. Since the position profits from big moves in either direction, it has both an up- and a downside breakeven point calculated as follows:

Upside breakeven: Straddle Strike + Cost of Straddle

80 + 14.5 = 94.5

Downside breakeven: Straddle Strike - Cost of Straddle

80 - 14.5 = 65.5

Given this, the position will show a profit as long as the stock moves above 94.5 or below 65.5. Between those prices, the position will show a range of losses with the maximum lost right at the strike price where neither option has any value.

* The profit/loss above does not factor in commissions, interest, or tax considerations.

The Collar

To protect an existing stock position, some traders will put on a position known as a collar. The collar is also known as a fence or cylinder.

Protecting a Long Stock Position

When the stock position is long, the collar is created by combining covered calls and protective puts. From a profitability standpoint, the collar behaves just like a bull spread. The upside potential is limited beyond the strike price of the short call while the downside is protected by the long put.

Example

Suppose you purchased 100 shares of Network Appliance (NTAP) at $12.84 in May and would like a way to protect your downside with little or no cost. You would create a collar by buying one JUL 10 Put at $0.60 and selling one JUL 15 Call at $0.80.

The long stock behaves the same as any long stock position--it gains when the stock goes up and it loses when the stock drops. However, the maximum profit is achieved when the stock is at $15. Above 15, the profit on the stock is exactly offset by the loss on the call option that was sold. On the downside, the maximum loss occurs with the stock at or below $10. Below $10, the profit from the put offsets the loss from the stock.

NTAP trading @ $12.84
Buy 100 NTAP @ $12.84 $1,284
Buy 1 NTAP JUL 10 Put @ $0.80 $60
Sell 1 NTAP JUL 15 Call @ $0.80 ($80)
Cost of Trade $1,264

The collar strategy is best used for investors looking for a conservative strategy that can offer a reasonable rate of return with managed risk and potential tax advantages. The key to implementing the collar strategy is selecting the appropriate put and call combination that allows for profit while still protecting the downside risk. Many investors will roll the puts and calls in the collar strategy each month and lock in a 3-5% monthly return. By rolling, you would buy back the short calls and sell new calls for a later month and perhaps different strike price, and do the same with the puts. Hence adjusting the collar based on the movement in the stock price. There may be tax benefits associated with long term capital gains on the stock in the collar strategy versus short term capital gains in a pure option strategy. Consult your tax advisor for more details.

Collar Chart Collar Graph

In addition to retail investors, many senior executives at publicly traded companies use collars as a way to protect their personal wealth that might be heavily concentrated in their company's stock. By collaring their stock, an executive can insure the value of his/her stock without paying huge premiums for put insurance.

Important

Before using Universal Broker's spread and combination one-step trading screens, options spread traders MUST understand the additional risks associated with this type of trading.

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