How to not get ruined with Options - Part 3b of 4

In the previous post 3a, I explained simple strategies like cash covered put, rolling, selling covered calls, and bullish and bearish spreads (also called verticals).

Now let’s do some more advanced strategies, they can be quite interesting.

First, let’s quickly introduce the concept of a leg in options. It simply describes a specific combination of expiration / strike / call or put, said differently it groups the same options contract together. A long call or put is a single leg, whether you have 1 contract or 20, it has one kind of contract. A cash covered put, or a covered call have also a single leg. A vertical has 2 legs, one for the short strike, one for the long strike. It used to be that the trading fees were different depending on how many legs you had in your position, like a fixed price per leg plus the number of contracts, or $15 for exercise or assignment per leg regardless of how many contracts. In the past couple of years, the trading fees dropped quite a bit, so it does not seem to be happening anymore, but some brokers may still do that.

Calendars

A calendar is a 2 leg position. Both legs have the same strike, but they have different expiration dates. The closest expiration is a short position, the farthest position is a long position. It can be constructed with both calls and puts, and will have roughly the same cost either way. But if your strike is far from ATM, you should pick the variant that is OTM to avoid assignment on your short position.

Here is how a calendar looks like:

SELL -1 ABC 100 17 JUL 20 17.5 CALL @ 1.00

BUY +1 ABC 100 17 AUG 20 17.5 CALL @ 1.50

2 legs, both calls, strike of $17.50, you are shorting the July 17 contract, and long the August 20. Because Aug 20 is farther, it costs more than the July 17 contract. Total cost of that position is $50 per contract (($1.50 - $1.00) * 100 shares). This is your maximum risk. Despite having one short position, your long position has the same strike, and will be worth always more. Both values will move in tandem. This will be the case for both calls and puts. If your short position becomes somehow assigned because it is deep ITM, your long position will protect you, with a bit more extrinsic value.

Why would you take this position? As time passes, the short position will lose theta much faster than your long position. At the first expiration date (the one from your short position), if that’s OTM, then that short position expires worthless, and you are left with just a long position with extrinsic that now you can sell. If the share price and volatility stays the same, the short leg will go from $1.00 to $0, the long leg will go from $1.50 to $1.00. You paid $50 per position, you got $100, i.e. 100% profit in a month.

This position is positive theta and positive vega. You will benefit if the volatility increases (both legs will have their extrinsic values increase). However, if the volatility crashes, you may not make money, or even lose some. The long leg could drop from $1.50 to $0.50. You paid $50, you got $50. No gain. Worse, this position works best when the share is around the strike you picked. If the share moves up or down significantly, you’ll lose money (potentially your full $50). The profit curve looks like a gaussian curve, with the top at your strike price.

This position excels in two cases though:

• The short leg volatility is significantly higher than the long leg volatility. I will show in Part 4 how I took advantage of that.

• You want to buy some black swan event protection. You buy a deep OTM put calendar, because it is a very low probability event it will be very cheap, much cheaper than buying a straight put or bear spread. As the market drops, the share price is getting closer to your strike, so your calendar will naturally increase in value, and a market drop also means a significant volatility increase, so the calendar will go up in value even more. You will have to play with the numbers a bit to see if it makes sense. You will lose small sums every month that the market does not drop, though.

And did you notice that when you rolled your short puts or covered calls from month to month with the same strike, your trade was the same as selling a calendar?

Talking about rolls, you can also buy a much longer-term long position (like 6 months away, or even a year), and roll your short position each month, bringing you an additional premium. If the market complies, you can pay your 6 months options in 2-3 iterations of your monthly short, and maximize your profit.

Diagonals

Diagonals are a mix of calendars and verticals. You have a short position in the front month, and a long position in the back month while having 2 different strikes.

Here is how a diagonal looks like:

SELL -1 ABC 100 17 JUL 20 15.0 CALL @ 1.00

BUY +1 ABC 100 17 AUG 20 17.5 CALL @ 1.10

Diagonals can be tricky to set up, and you will have to play with the numbers a bit. It allows you to have a calendar-like position (but not exactly the same, the peak and profit/risk profile are different) at a lower cost. Notice in the example that the short position has a strike of $15, and the long position has a strike of $17.50. We pick these in a way that the cost of the short position is roughly the same as the cost of the long position (long position is farther so higher cost, but we pick a higher strike to lower its overall cost). Total cost is $0.10 per leg ($1.10 - $1.10). With this position, you will lose up to $250 in the worst-case scenario if the price shoots up (as both extrinsic values will go towards $0, and you will be left to pay for the strike difference between $15 and $17.50 - The extrinsic value of the short call will drop much faster than the long call though, so a $250 loss may not happen in practice). If the price in the short expiration is a bit below $15, you may earn $50 to $100 with the leftover extrinsic value of the long call.

Diagonals are usually positive theta, and vega neutral. Unlike for calendars, in general, the volatility change will not make a big difference in the position.

Something to note: When you roll your short puts, covered calls, or even calendars with a different strike, you are actually selling a diagonal.

Synthetic Share

Now let’s talk about a quite simple position, a synthetic share.

Did you notice that if you buy a call, and sell a short, you will have the same profit/risk as if you bought the shares?

ABC is trading at $33.05, here is a 2 leg version of a share with options:

SELL -1 ABC 100 17 JUL 20 33.0 PUT @ 1.80

BUY +1 ABC 100 17 JUL 20 33.0 CALL @ 1.85

Cost of this position is around $0.05 per share. If the share is at $40 by expiration, you will earn $7 per share (minus $0.05). If the share is at $20 by expiration, you will lose $13 per share (plus $0.05). The exact same way as if you bought the share at $33.05. Magic.

And you can pick a strike of $20 instead, that you will pay $13.05 or so. Why? Because your call has $13.05 of intrinsic value, and you pay for that. The extrinsic value of the call is paid by the extrinsic value of the short put. Same if you pick a $40 strike, you will get a $6.95 credit.

The market is quite efficient, and this holds pretty much true on all strikes, and both calls and puts. They all get repriced automatically as the share price changes and the extrinsic of the call will match the extrinsic of the put at the same price. Think of it this way, if there were some inefficiencies, someone would automate the arbitrage to profit from it. And they do. The same way market makers arbitrage ETF price with its holdings so they are close in sync, they will arbitrage options.

Something important to note is that the cost of this synthetic share will take into account the cost of money (close to zero these days) and the dividend. So no free lunch by buying the share, and selling a synthetic share to pocket the dividend with no risk. :)

Given that formula that we just discovered:

1 share = 1 call - 1 put

You will notice that:

1 call = 1 share + 1 put

On the way up, this moves the same way as a call (due to the long share)

Lose theta like a call (due to the long put)

On the way down, it cannot lose more than the premium (due to the put offsetting the long share).

And this:

1 put = 1 call - 1 share

On the way down, this moves the same way as a put (due to the short share)

Lose theta like a put (due to the long call)

On the way up, it cannot lose more than the premium (with long call offsetting the short share)

So when you buy a call, the market makers will do the opposite side of the trade and will hedge in a way that they have no risk. The MM will buy / sell shares/calls/puts as needed, arbitrage constantly, earn money on the slippage between the bid and the ask, and each of their trades will partially cancel each other, so at the end of the day, they have little to no risk, nor even a position.

Now that we deconstructed a share with puts and calls, you could build a trade like this:

SELL -1 ABC 100 17 JUL 20 26.0 PUT @ 0.60

BUY +1 ABC 100 17 JUL 20 40.0 CALL @ 0.60

This is a bullish position. Theta and volatility neutral. You will lose money only if the share price drops below $26 by expiration, you will get assigned the share if you don’t sell before. It won’t move 1:1 with the share price though, but depending on the range you pick, you can still make some good profit with a lower risk. Note that despite the value being correlated with the share price before expiration, it won’t be 1:1 especially if the strike difference is big, and both are OTM.

So if you look at this synthetic share, you should realize by now that you don’t need cash to profit from a share price going up. As long as you are not assigned, no need for margin anymore. You can even do this trade with additional credit, at a greater risk for assignment though.

Collars

A collar is the opposite of a synthetic share:

BUY +1 ABC 100 17 JUL 20 26.0 PUT @ 0.60

SELL -1 ABC 100 17 JUL 20 40.0 CALL @ 0.60

It is used to protect against the drop of your existing shares (through the put), and the protection is paid by selling the covered calls against your shares. Years ago, company execs would build collars on their existing, or soon to be vested, stock options and RSUs so they would have a steady income with little risk. Nowadays, most companies’ policies prevent you from trading options with company shares.

Straddle and Strangle

A straddle is buying a call and a put at the same strike and expiration.

BUY +1 ABC 100 17 JUL 20 33.0 PUT @ 1.80

BUY +1 ABC 100 17 JUL 20 33.0 CALL @ 1.85

The idea is to profit from the movement in the share price. It is theta negative and vega positive (both due to the double long). The hope is that the stock will move faster in one direction than the theta loss. This position is regularly used by gamma scalpers and they will go in and out and adjust as the stock moves. The strike is usually around the ATM strike, to reduce the intrinsic value that you may waste as the stock moves.

A strangle is similar except that the strikes are not the same between the call and the put.

BUY +1 ABC 100 17 JUL 20 26.0 PUT @ 0.60

BUY +1 ABC 100 17 JUL 20 40.0 CALL @ 0.60

Because you use OTM strikes, the cost is cheaper, with less sensitivity to theta and vega. Depending on the strikes you pick, you can also have a bullish or bearish bias in your position.

If the volatility is very high, and you like to yolo, you can actually build a short straddle or strangle. You expect that the share price will not move more than the implied volatility and that the double theta will provide a good income. Because only one of the legs will be at risk if the share moved up or down at expiration, you improved your profit/risk profile because you got a double premium. However, you are also exposing yourself to two risks. Don’t do it, unless you are looking forward to being ruined. It will work until it won’t, and you will blow up your account.

Also, straddles and strangles have a special tax treatment, another reason to avoid them.

Iron Condors and Butterflies

I am going to add two last strategies, mostly for completeness.

I played with Iron Condors in the past. I used to say “I could get a 5% return pretty much every month”, and that is true (although with the current volatility that would be more like 7-10%). However, my next sentence was “But once in a while, I would lose most of it.” That part is also true. :)

It is built with 2 credit spreads, one bullish, one bearish, both OTM:

BUY +1 SPY 100 17 JUL 20 245 PUT

SELL -1 SPY 100 17 JUL 20 250 PUT

SELL -1 SPY 100 17 JUL 20 330 CALL

BUY +1 SPY 100 17 JUL 20 335 CALL

This position can be sold today for $0.32 per share with a $4.68 risk. As long as by expiration the share price is between $250 and $330, you would keep the premium, so around 7% (minus trade fees) for 3 weeks, so around 120% annualized profit. It is a bit more advantageous right now because the volatility is quite high, and we kind of have some bounds between the top and the bottom of these 6 last months, but you can still blow up the trade, and lose everything. If you did an Iron Condor in February for a March expiration, you would have incurred the maximum loss.

This can be a very stressful position, as the market goes up and down constantly. As it gets closer to the edges, the Iron Condor gets more expensive. Then what do you do? Do you buy it back? Do you hope it gets back to the middle? If it passes the edges, do you buy it back at 50% loss? But what if you close, and the market reverses suddenly and you would have been in the green if you kept the position? Very stressful. Avoid. :)

However, if the market goes up on and on, you may want to build a far OTM bearish spread (thinking that the market could revert to the mean). Then when the market drops back and continues dropping, again and again, you could build a far OTM bullish spread. You would end up with an iron condor with a much better profit/risk profile than if you built it on a given day. This situation happens rarely though. Remember, as indicated in part 3a, to close the side of the spread that reached 90+% profit. No need to keep some risk there for a few more dollars of profit.

A butterfly has a similar behavior as an Iron Condor but expects even less movement:

BUY +1 SPY 100 17 JUL 20 300 PUT

SELL -2 SPY 100 17 JUL 20 310 PUT

BUY +1 SPY 100 17 JUL 20 320 PUT

This can be built with PUT and CALL, it can be extremely profitable if the stock ends in your middle strike by expiration. But it won’t, and you will probably lose your money. :)

The names of Condor and Butterfly are after the shape of their profit curve for the long version that (very) loosely looks like a condor and a butterfly. :)

Again, they are fun for shit and giggles, but can be very stressful. Just don’t do it. You have been warned.

The next post will explain the various trades I made recently using these strategies, and taking advantage of this very volatile market.

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