Options As A Strategic Investment 5ed by Lawrence G. McMillan

asa
Themarketin listedoptionsandnon-
equityoptionproductsprovidesinvestors
and traderswith a wealthof new, strategicop-
portunities for managingtheir investments . This
updatedand revisedfifth editionof the bestse ll-
ing Optionsas a StrategicInvestmentgivesyou
the latest market-tested tools for improvingthe
earnings potentialof your portfoliowhile reduc-
ing downsiderisk- no matterhowthe marketis
performing.
Insidethis revisededitionarescoresof proven
techniques andbusiness-tested tacticsfor invest-
ing in manyof the innovative newoptionsproducts
available . Youwill find:
• A completeand in-depthdiscussion of the
newestclassof listedvolatilityderivatives ,
bothfuturesandoptions
• Portfolioprotection techniquesexplainedin
depth,usingbroad - basedindexput options
orthe moremodern approach - volatilitycall
options
• Newandupdated examples andtables,using
thecurrentoptionsymbo logy, lowercommis-
sionrates, decimalization of prices, portfolio
margin,andweek ly options
• Updated strategytechniques usingsynthetic
straddles, ironcondorspreads, backspreads,
putratiospreads, anddualcalendar spreads
Writtenespecially for investors whohavesome
familiaritywith the optionsmarket,this compre-
hensivereference alsoshowsyouthe concepts and
applicationsof variousoptionstrategies - howthey
work, in whichsituations,andwhy; techniques for
using indexoptionsand futuresto protectone's
portfolioandimprove one'sreturn;andtheimplica-
tions of the tax lawsfor option writers,including
allowablelong-termgainsandlosses . Detailedex-
amples,exhibits,andchecklists showyouthepower
of eachstrategyundercarefullydescribedmarket
conditions .
■
I
a a ~
I
I s
FIFTH EDITION
Lawrence G. McMillan
PRENTICE HALL PRESS

Contents
Preface ........................................................ . ... . .. xv
Part I
BASIC PROPERTIES OF STOCK OPTIONS
Chapter 1
Definitions ................................................... 3
Elenientary Definitions. . . ........... ........ . . .J
Factors Influencing the Price of an Option ................................... 9
Exercise and Assignment: The Mechanics ................................... 15
The Option Markets . .................................................... 21
Option Symbology . ..................................................... 22
Details of Option Trading . ......... . ..................................... 23
Ord er Entry. . ......... . . . . . . . . . . ... 27
Profits and Profi,t Graphs . . . . . . . . . . . . . . . . . . . . . . . . ............ . 29
Part II
CALL OPTION STRATEGIES
Chapter 2
Covered Call Writing .. .. ...................................... 33
The Importance of Covered Call Writing .................................... 33
Covered Writing Philosophy. . . . . . . ........ . . 36
The Total Return Concept of Covered Writing ............................... 39
Computing Return on Investrnent . ........................................ 41
Execution of the Covered Write Order . ..................................... 49
Ill
IV Contents
Selecting a Covered Writing Position. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

Writing Against Stock Already Owned ............................. ....... . 54
Diversifying Return and Protection in a Covered Write . ................... . ... 57
Follow-Up Action ............. . . . . . . . . ............. 60
Th e Partial Extraction Strategy . . . . . . . . . . . . . . . . . ....... 73
Special Writing Situations . . ......... . .. . ...... . ... 78
Covered Call Writing Summary . .......................................... 83
Chapter 3
Call Buying ................................................... 85
Why Buy ?. . . . . . . ......................................... . ...... 85
Risk and Reward for the Call Buy er . ........ .................. ... .......... 86
Which Opti on to Buy ? . . . . . . . . . . . . . . . . . . . . . . . . ................... 91
Advanced Selection Criteria . ..................... ........................ 93
Follow-Up Action . . . . . . . . . . . . . . . . . . . . . . . . . . ........ . ................. 97
A Fnrther Comment on Spreads . . . ....... 107
Chapter 4
Other Call Buying Strategies .................................. 108
The Protected Short Sale (or Synthetic Put) . ......................... .. ..... 108
Portfolio Margin ......................................... . . . .......... 111
Follow-Up Action ..................................................... 112
Synthetic Straddle (Reverse Hedge ) . ..................... ..... ...... . ..... 113
Follow-Up Action ..................................................... 116
Altering the Ratio of Long Calls to Short Stock ............ . .......... . ..... 118
Summary . . ......... . . .. ........................... . ...... .. . 121
Chapter 5
Naked Call Writing ........................ ................... 123
The Uncovered (Naked) Call Option . . . . . . . . . . . . . . . . . . . . . .......... 124
Investment Required . ......... ..... . . . . . . .............................. 126
The Philosophy of Selling Naked Options .................................. 128
Risk and Reward . ............ . ... . .................................... 129
Follov,;-Up Action ................... 131
Summary .. . ................... 134
Chapter 6
Ratio Call Writing .................... ................. ...... . 135
The Ratio Write . . . . . . . . . . . . ....................... 135
Contents V
Investment Required . .... . ....... . ............. ... ... ..... . . ........... 138
Selection Criteria . . .. ... .. . ...... ...... . . . ............................. 140
The Variable Ratio Write (Synthetic Short Strangle) ......................... 143
Follow-Up Action ......................... . ... . ....................... 146
Sumrna ry ............................................................ 156
Chapter 7
Bull Spreads Using Call Options ............................... 157
An Introduction to Call Spread Strategies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 157
Degrees of Aggressiveness . ....................................... .. .. . .. 162
Ranking Bnll Spreads .................................................. 163
Follow-Up Action .... . ......................................... . ...... 166
Oth er Uses of Bull Spreads . ................................. , ... . .... ... 167
mma ry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
S11 172
Chapter 8
Bear Spreads Using Call Options ............................... 173
The Bear Spread . . . . . . . . . . . . . ............................ 173
Selecting a Bear Spread . . . . . . . . . . .................................... 176
Follow-Up Action ......... . ..................... .. ...... . ... 177
Summ ary . . ................................................... 177
Chapter 9
Calendar Spreads ..... ....... .................... ............ 178
The Neutral Calendar Spread ............................................ 179
Follow-Up Action . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ............ . ....... 181
The Bullish Calendar Spread . ........................................... 183
Follow-Up Action ....................................... .. ... . ... . .. . . 184
U,;ing All Three Expiration Series . ..... ................................... 185
Summary .. .. . . .. . . ................ . ................................. 186
Chapter 10
The Butterfly Spread ......................................... 187
Selecting the Spread ....... . ...... . ...... . .......... . .................. 190
Follow-Up Action . . . . . . . . . . . . . . . . . . . . . . . . . . . ............. .. .......... 193
Summary ..... .. ............................... .. .................... 196
Chapter 11
Ratio Call Spreads . ........................................... 197
Diff ering Philosophi es . ........................................... . ..... 200
vi Contents
Follotc - UJJAction ... 204

Summary .. . 208
Chapter 12
Combining Calendar and Ratio Spreads ........................ 209
Ratio Calendar Spread. ....... . ... 209
Choosing the Spread. . ......... . .. . ... 212
Follow-Up Action ... . ..... .. ...... . . . .. 213
Delta-Neutral Calendar Spreads ......................................... 214
Follow-Up Action ......... ............ . .............. 215
Chapter 13
Reverse Spreads . ............................................. 217
Reverse Calendar Spread. . . . . . . . . . . . . 217
Rever e Ratio Spread (Back.sp read). . . . 219
Chapter 14
Diagonalizing a Spread ....................................... 223
The Diagonal Bull Spread . . . .... 223
Owning a Call for "Free". . .... 226
Diagonal Backspreads . . . ... 227
Call Option Summary. . . 228
Part III
PUT OPTION STRATEGIES
Chapter 15
Put Option Basics ... ..... ..... ..... ........ .. ............. ... 231
Put Strategies . . . . . . . . . . . . . . ......... 231
Pricing Put Options . ................................................... 233
The Effect of Dividends on Put Option Premiums ........................... 234
Exercise and Assignment ................................................ 236
Conversion . .......................................................... 239
Chapter 16
Put Option Buying . .................................... ....... 241
Put Buying versus Short Sale ............................................ 241
Selecting Which Put to Buy . ............................................. 243
Ranking Prospectfr ,e Put Purchases ....................................... 246
Contents vii
Follow-Up Act ion ... ... . .. . .... . ... . .. .. ....... .. ...... . ..... . .... .. . . 247
L oss-Limiting Actions . .... . . .. ... ... ...... .... .... .. . . ...... . . . ........ 251
Equivalent Positions ..... . ......................................... . ... 255
Chapter 17
Put Buying in Conjunction with Common
Stock Ownership ........................................... 256
\\?zich Put to B11y... . . . . . . . . . . . . . . . . . . . . . . ........... 258
Tax Considerations ......................... . .......................... 260
Put Buying as Protection for the Covered Call Wr iter ........................ 260
No-Cost Cullars . ...................................................... 263
Adjusting the collar . ................................................... 266
Chapter 18
Buying Puts in Conjunction with Call Purchases ................. 267
Straddle Buying . ..................... . .................. . ............ . 268
Selecting a Straddle Buy. . . . . . . . . . . . . . . . . . .............. . . 271
Fo!lou:-L'p Action . . . . . ....... . ... . ............................. 271
Buying a Strangle ......... . ....................... . ...... . ..... . ...... 2 74
Chapter 19
The Sale of a Put .......................................... . . . 278
The Uncovered Put Sale ...................................... . ......... 2 78
Follo1c-Up Action . . . . . . . . . . . . . . . . . . . . . . . . ......... . .. 281
Euzluati11g a .Vaked Put Write . . ........... . .............. 282
Buying Stock Below Its Market Price . .......... . .......................... 285
The Covered Put Sale .................................................. 286
Ratio Put Wr iting...................................................... 286
Chapter 20
The Sale of a Straddle .. . ..................................... 288
Tlw Cocered Straddle Write. . ............... . ... 288
The Uncovere d Straddl e Write . . ......................................... 291
Selecting a Straddle WritP . . . . . . . . . . . . . ............. . ......... . 29.3
Follou.:-UpAction ..................... . . ..... 2.94
Equiwle11t Stock Position Follme-Up . ... . . .. 298
Starting Out u.:ith the Protection in Place .. . . . .299
Stranglf' (Com/Jinatio11) Writing. . . . . . . . . . . . ........ . :wo
Furt her Comments on Uncovered Straddle and Strangle Writing ............... 304
VIII Contents
Chapter 21
Synthetic Stock Positions Created by Puts and Calls ......... ... .. 307
Synthetic Long Stock . .......... . ....................................... 307
Synthetic Short Sale ........................ , .......................... 309
Splittil!g the Strikes. .............. . . ........... .... .......... 311
Swn11wry . .................... . ................ 314
Chapter 22
Basic Put Spreads ................. ..... ...................... 316
Bear Spread. . ................. . ...................... 316
Bull Spread .......................................................... 319
Calendar Spread ...................................................... 320
Chapter 23
Spreads Combining Calls and Puts ............................. 323
The Butt erfly Spread . .................................................. 323
Condor and Iron Condor Spreads ........................................ 326
Combining an Option Purchase and
a Spread. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ............. 328
A Simple Follow-Up Action for Bull or Bear Spreads . ........................ 332
Three Useful but Complex Strategies ...................................... 334
Selecting the Spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... 343
S11m111ary. . .......... 346
Chapter 24
Ratio Spreads Using Puts ...................................... 348
The Ratio Put Spread .................................................. 348
Using Deltas . ......................................................... 353
The Ratio Put Calendar Spread . ........ . ................. 353
A Logical Extension (The Ratio Calendar Combination) . ..................... 355
Put Option Summary .................................................. 358
Chapter 25
Long-Term Option Strategies .................................. 359
Pricing LEAPS . ....................................................... 360
Comparing LEAPS and Short-Term Options ............................... 364
LEAPS Strategies . ..................................................... 365
Speculative Option Buying with LEAPS ................................... 373
Contents IX
Selling LEAPS ............................................. . .......... 381

Spreads Using LEAPS . ................................................. 394
Summary ............................................................ 400
Part IV
ADDITIONAL CONSIDERATIONS
Chapter 26
Buying Options and Treasury Bills ...... . ..................... . 403
How the Treasury Bill/Option Strategy Operates ............................ 403
Summary ................................................... : ........ 411
Chapt er 27
Arbitrage .. ..... ................................. .. .......... 412
Basic Put and Call Arbitrage ("Discounting") ............................... 413
Dividend Arbitrage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 415
Conversions and Reversals . ............................................. 418
More on Carrying Costs ................................................ 421
Back to Conversions and Reversals ....................................... 422
R isks in Conversions and Reversals ....................................... 424
Summary of Conversion Arbitrage . ....................................... 428
The "Interest Play". . . . . . . . . . . ... . ........... . ....... . ................. 429
The Box Spread ....................................................... 430
Variations on Equivalence Arbitrage ...................................... 434
The Effects of Arbitrage . ................................................ 434
Risk Arbitrage Using Options . ........................................... 435
Pairs Trading ......................................................... 444
Facilitation (Block Positioning) . .......................................... 445
Summary ............................................................ 446
Chapter 28
Mathematical Applications ....................... . . .. ......... 44 7
Th e Black-Scholes Model ............................................... 447
Computing Composite Implied Volatility .................................. 454
Expected R eturn ...................................................... 458
Applying the Calculations to Strategy Decisions . ............................ 465
Facilitation or Institutional Block Positioning . .............................. 474
Aidin g in Follmc -Up Ac tion ............ . . . 477
X Contents
ln1ple111rntotio11 . . . . . . . . ... .. . ... ... .... ... .... . .. . . .. ... .... .. .. . .. 480
Sumrnary ........... ... .... .. ..... ... ..... ... ................... .. ... 481
PartV
INDEX OPTIONS AND FUTURES
Chapter 29
Introduction to Index Option Products and Futures ...... ...... . . 485
Indic es . .... .... .. ......................... ... ................. .... . . 486
Cash-Based Options ................ , ................................... 493
F11t11rcs. ............... . .. . ... . ...... . .. 497
Futures Trading . ...................................................... 499
OJJfio11s 011 Iudc.r F11t11rcs. ........... . ... . .. 502
Standard Option Strategies Using Index Options . ........................... 506
Put-Call Ratio ........................................................ 510
S1111111wry
. ............... 512
Chapter 30
Stock Index Hedging Strategies ................................ 513
.'10rkct Baskets . . . . . . . . . . . . . . . . . . . . . . 513
Program Trading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 519
Index Arbitrage ....................................................... 528
Foll01c-l 'p St ratcgics. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ........... 537
Market Basket Risk .................................................... 540
Imp act on the Stock Market ............................................. 541
Si11111loti11g
(lit l11dex . .......... . .......... 546
Trading the Tmcki11g Error. . ................................ 5.55
Sumrnary ........................................................... . 557
Chapter 31
Index Spreading . ............................................. 559
Inter-Index Spreading . ................................................. 559
Su1nrnary ............................................................ 566
Chapter 32
Structured Products .......................................... 567
"Riskless" Ownership of a Stock Or Index . ................................. 568
Cash Value . .......................................................... 571
The Cost of the Imhedded Call Option .................................... 572
Contents xi
Price Behavior Prior to Maturity . . . . .. .. .... . ............................ 573

SI S ....... .................. ........... .574
Computing the Value of the Imbedded Call When the Underlying
Is Tmdi11g at a Discount . . . . . . . . . . ........... . .. Sf50
The Adjustment Factor ................................................. 580
Other Constructs . ..................................................... 586
Option Strategies Involving Structured Products ............................ 591
Li sts lf Struct11red Products. . . . . . . . . . . . . . . . . . . ... 596
Other Structured Products . ............................................. 597
Structured Product S1111111wry.. . . 599
Chapter 33
Mathematical Consid er ations for Index Products . ........... .. .. .600
Arbitrage ............................................................ 600
Mathematical Applications . ............................................. 603
Chapter 34
Futur es and Fut ures Opti ons .................................. 611
Fut ures Contracts . . . . . . . . . . . ........................ .. 612
Options on Futures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 619
Futures Option Trading Strategies . ....................................... 633
Commonplace Mispricing Strategies ...................................... 642
Summary ............................................................ 653
Chapt e r 35
Futures Option Strategi e s for Future s Spread s .................. 654
Futures Spreads . ...................................................... 654
Using Futures Options in Futures Spreads ................................. 662
SII II ll il(l ry ... 678
Part VI
MEASURING AND TRADING VOLATILITY
Chapter 36
The Basics of Volatility Trading ................................ 683
Definitions of Volatility . ................................................ 684
Another Approach: Garch. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 687
Moving Averages ...................................................... 688
Imp lied Volatility . . ......... .. 68i.,
xii Contents
The Volatility of Volatility . ...... ... .... .... ... .... .... .... ..... ........ . 690
Volatility Trading . ......... ........... ... ............. ................. 698
Why Does Volatility Reach Extremes? . .................................... 699
Summary ........... ·.................................................. 703
Chapter 37
How Volatility Affects Popular Strategies . ....................... 705
Vega . . . . . . . . . . . . . . . . . . . . . ...... . ...................... 705
Impli ed Volatility and Delta . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 710
E{fffts 011 Neutrality . . ........ .............. . ... . .......... . ........... 710
Position Vega . . ................................... 712
Out right Option Purchases and Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 713
Time Value Premium Is a Misnomer. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 718
Volatility rmd the Put Optio11 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .......... 721
Straddle or Strangle Buyin g and Selling ................................... 722
Call Bull SJJrcnds. . ................................ . .. . .... 723
Vertical Put Sprcnrls . . . . . .......... 731
. ..........
Put Bear Spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 733
Calendar Spreads . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 734
Rat io Spreads and Backspreads . ......................................... 736
Su11111wry. ...................... ns
Chapter 38
The Distribution of Stock Prices ............................... 739
Misconceptions About Volatility . .......................... .. ......... . ... 739
Volatility Buyer'.s Rule! . ................................................ 744
The Distrilmtiu11 1f Stock Prices. . . ............... . ............. . .. 745
What This Means for Option Traders . ................... . ...... . .......... 750
Stock Price Distribution Summary ....................................... 751
The Pricing of Options . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 753
The Probability of Stock Price Movement . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 753
Expected Return ...................................................... 764
Surnmary ............................................................ 765
Chapter 39
Volatility Trading Techniques .................................. 767
Two Ways Volatility Predictions Can Be Wrong ............................. 768
Trading the Volatility Prediction ......................................... 768
Contents XIII
Trading the Volatility Skew . .. .... ... ............................ . ....... 791

Summary of Volatility Trading ................ ... ........................ 798
Chapter 40
Advanced Concepts . ............... ......... . ................. 800
Se11trality. ..................... . ............ . ............... 800
The "Greeks" . . . . . . . . . . . . . . . . . . . . . . . . ....................... 801
Strategy Considerations: Using the "Greeks" ... ...... ...................... 820
Ad vanced Mathematical Concepts . ....................................... 855
Sum mary ............................................................ 860
Chapter 41
Volatility Derivatives . ......................................... 862
Historical and Implied Volatility ......................................... 863
Calculation of VIX..................................................... 864
Listed Volatility Futures. . . . ..................................... 867
Oth er Listed Volatility Products . ......................................... 882
Li sted VIX Options .................................................... 889
Tradi ng Strategies: Directional Signals .................................... 898
Using VIX Futures Information .......................................... 903
Using and Trading the Tenn Structure . . . . . . . . . . . . . . . . . . . . . . . . . . ......... 908
Protecting a Stock Portfolio with Volatility
Derivative s . ................................................... ..... 918
Other Macro Strategies . ................................................ 928
Hedged Strategies Using Volatility Derivatives . ............................. 933
Ratio Spreads With VIX Options. . . . . ................ . ... . ........... 941
Volatility Deriuttii:.es S111111/lary .. . .............. . ...... 947
Chapter 42
Taxes ...................................................... . 949
History ........................ . ..................... . ....... . ....... 949
Basic Tax Treatment . . . . . . . . . . . . . . . . . . . . . . . . . ........................ 951
Exerci se and Assignment . ....................... .. ............ .. ....... . 954
Special Tax Prohlems . ................ . .......... . ...... . .......... ... .. 963
Sumrriary .......................................................... .. 966
Tax Plannin g Strategies for Equity Options . ................................ 966
Su1nmary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 971
XIV Contents
Chapt er 43
The Best Strategy? . .... . . ... . . .. . .. . ... ...... ... ..... ......... 973
General Concepts: Market Attitude and Equivalent Positions . ... . ............. 973
What Is Best for Ale ,'1iglzt Not Be Best for You.............................. 975
Mathematical Ranking ................................................. 976
Sununary . ........................................................... 978
Postscript . . ................... .. .......................... ... 979
Part VII
APPENDICES
Appendix A
Strategy Summary ........ .. .............................. . .. . 983
Appendix B
Equivalent Positions .......................................... 985
Appendix C
Formulae . ................................................... 987
Appendix D
Graphs ..................................................... . 997
Appendi x E
Qualified Covered Calls ...................................... 1001
Appendi x F
Portfolio Margin ............................................ 1005
Glossary . ........................................................... 1009

I11dex .............................................................. 1031
Preface
\\!hen the listed option market originated in April 197.3,a new world of investment strate-
gies was ope1w<l to the investing public. The standardization of option terms and the
formation of a liquid secondary market created new investment vehicles that, adapted
properly , can enhance almost every investment philosophy, from the conservative to the
speculative. This book is about those option strategies-which ones work in which situa-
tions and why they work.
Some of these strategies are traditionally considered to be complex, but with the
proper knowledge of their underlying principles, most investors can understand them.
While this book contains all the basic definitions concerning options, little time or space
is spent on the most elementary definitions. For example, the reader should be familiar
with what a call option is, what the CBOE is, an<l how to find and read option quotes. In
essence, everything is contained here for the novice to build on, but the bulk of the discus-
sion is above the beginner level. The reader should also he somewhat familiar with techni-
cal analysis, understanding at least the terms support and resistance.
Certain strategies can be, and have been, the topic of whole books-call buying, for
example. \Vhile some of the strategies discussed in this book receive a more thorough
treatment than others, this is by no means a hook about only one or two strategies. Cur-
rent literature on stock options generally does not treat covered call writing in a great deal
of detail. But because it is one of the most widel)' used option strategies by the investing
public , call writing is the subject of one of the most in-depth discussions presented here.
The material presented herein on call and put buying is not particularly lengthy, although
much of it is of an advanced nature-especially the parts regarding buying rnlatility-
and should he useful even to sophisticated traders. In discussing each strategy, particular
emphasis is placed on showing why one would want to implement the strategy in the first
place and 011 demonstrating under which market scenarios the strateg_v works and 1111der
which ones it does not. The foll details of each strategy are presented, iuclmling nian.'·
xv
XVI Preface
graphical and tabular layouts of the profit and loss potentials, margin requirements, and
criteria for the selection of a position. A great deal of attention is also given to follow-up
action. It is often easier to decide to establish a position than it is to take action to limit
loss or take profits. Therefore, in the cases in which follow-up action applies, many of the
reasonable alternatives are spelled out in detail, with examples. Comparisons are also
made among similar strategies. An investor who is bullish, for example, may want to
implement a variety of strategies. A comparison of the benefits and deficiencies of similar
strategies helps the investor decide which one is right for his or her particular case. Pitfalls
that should be avoided are also pointed out. I have used the fictional stock XYZ to illus-
trate the examples, rather than naming actual stocks. Many of the examples are drawn
from actual prices that existed. It is, however, rather pointless to give an example starting
Bally at 60 when it might easily be 20 or 200 (or nonexistent) by the time the reader
peruses the example. The purpose of examples is to illustrate concepts, not record history.
XYZ fits this purpose best, since it is very versatile: It can, as the need arises, be low-priced
or high-priced, volatile or nonvolatile; and it changes price at will in order to illustrate
follow-up strategies.
Call option strategies are presented in the first part of the book and put option
strategies follow. \ Vhile this order of presentation may interrupt the purely strategic flow
a hit-for example, bear spreads are discussed using call options in the first part of the
book and then are discussed again later, using put options-this format is designed to aid
the novice and intermediate option investors in that they are more familiar with calls than
puts. For the majority of option investors, the development of the strategies in the more
familiar em·iromnent of calls should make them more understandable. Then, the applica-
tion of the concepts to put options is easier. Put option strategies are not slighted, however.
Their applications are necessary for strategists to have a full range of possibilities at their
command, and such strategies therefore occupy a sizable amount of text. Certain special
subjects are treated as well, such as computer models and their applications, how to use
options in arbitraging, and how the actions of market-makers and arbitrageurs affect the
public option investor.
SECOND EDITION
The bulk of the material added to the second edition concerned index options and futures.
Tl 1e same concepts used to describe equity option strategies are used to describe strate-
gic~ for thest' \·ehicles as well. The approach is necessaril~· slightly different in some cases.
The gt>neral concepts surrounding these options are introduced, and then many examples
arc gi,·t>11.In these examplt>s, the details of many of the more popular futures ancl options
contracts are presented.
Preface XVII
Many of tht' samt' stratt>gies availahlt> to the equity option trader are applicahle to
index options. These strategies art' explained in the first thirty chapters of the book, using
equity options. In most cast's, one net>d only substitute terms. For example, when underly-
ing stock is wferrt>d to, merely substitute underlying instrument. Such an instrument
could be a future, a bond, a currency, or an index.
A great deal of attt>ntion is given to hedging portfolios of stocks with index futures
and options. The techniques presented herein are applicable for any investor owning
stocks, from the indi\'idual to the largt' institution. Variations on the basic hedging
strategies are presented as well. These \·ariations are strategies unto themselves, allowing
strategists to profit from pricing discrepancies in futures or options. In addition, strategies
wherein one attempts to take ad\'antage of the movement of a certain group of stocks in
the marketplace are described. Spreads between various stock indices are also discussed
in detail.
The chapter 011 taxes was revised to reflect the changes in the tax laws. These
changes have made tax preparation more difficult, especially for the covered call writer.
Several tax strategies are no longer applicable, especially those in which gains could be
rolled from one year to the next. In addition, the changing of the holding period to qualify
for long-term gains has changed some of the tax aspects of options. Non-equity options
are subject to a different tax rate than equity options. This difference in rates is discussed
as well.
Certain additions and modifications were made to the original 28 chapters. One of
the largest expansions was in the discussion of risk arbitrage. This subject has been
the object of much attention in recent years, due to the well-advertised profits made by
risk arbitrageurs. The new material emphasizes the use of options to reduce the risk in risk
arbitrage situations. Another section that was expanded is the one discussing equivalence
arbitrage-reversals, conversions, and boxes. More of the concepts involving these popu-
lar forms of arbitrage were described. In addition, the risks of these strategies are delin-
eated more fully.
Modifications were made to other chapters. Position limits changed, for example.
There is also a greater emphasis on using the method of equivalent stock position (ESP)
to analyze a neutral position for follow-up action. This method is applicable to most ratio
writing strategies, straddle writes, and combinations. Both chapters on calendar spreads-
puts and calls-were expanded to discuss more fully the ratio calendar spread, a neutral
strategy that has limited risk if established with in-the-money options. A detailed example
of a Black-Scholes model calculation was added to the chapter on rnatht>matics. This was
in response to the many questions received over the years regarding computations i1l\'oh--
ing the model. Finally, more suggestions are made for using the computer as a tool in
follow-up action, including an example prilltout of an advanced follow-up anal>·sis.
XVIII Preface
THIRD EDITION
There were originally six new chapters in the thir<l edition. There were new chapters on
LEAPS, CAPS, and PERCS, since they were uew option or option-related products at
that time.
LEAPS are merely long-term options. However, as such, they require a little differ-
ent \·iewpoint than regular short-term options. For example, short-term interest rates have
a much more profo1mcl influence on a longer-term option than on a short-term one. Strate-
gies are presented for using LEAPS as a substitute for stock ownership, as well as for using
LEAPS in standard strategies.
PE RCS are actually a type of preferred stock, with a redemption feature built in.
They also pay significantly larger di\·idends than the ordinary common stock. The redemp-
tion feature makes a PERCS exactly like a covered call option write. As such, several
strategies apply to PER CS that would also apply to covered writers. Moreover, suggestions
are gi\·en for hedging PERCS. Subsequently, the PERCS chapter was enveloped into a
larger chapter in the fourth edition.
The chapters on futures and other non-equity options that were written for the second
edition wert' deleted and replaced hy two entirely new chapters on futures options. Strate-
gists should familiarize themst'lves with futures options, for many profit opportunities exist
in this area. Thus, e\·en though futures trading ma:· be unfamiliar to many customers and
brokers who are equity tradns, it behooves the serious strategist to acquire a knowledge of
futures options. A chapter on futures concentrates on definitions, pricing, and strategies that
arc unique to futures options; another chapter centers on the use of futures options in
spreading strategies. These spreading strategies are different from the ones described in the
first part of the book although the calendar spread looks similar, but is really not. Futures
traders and strategists spend a great deal of time looking at futures spreads, and the option
strategies prt'sented in this chapter are designed to help make that type of trading more
profitable.
A new chaptt'r clt'aling with advanced matht'matical concepts was added near the
t'ml of tht' hook. As option trading matured and the computer becamt' mort' of an integral
wa:· of lift' in monitoring and e\·aluating positions. more advanct'<l techniques were used
to monitor risk. This chapter dt'sc:ribes the six major measures of risk of an options posi-
tion or portfolio. The application of tht'se nwasures to initialize positions that are doubly
or trip!: neutral is cliscussecl. Mon-'OVt'r,the use of the computer to predict the results and
"shape" of a position at points in the future is described.
Tl1crc \\'t'rt' s11hsta11tialre\·isions to the chaptt'rs on index options as well. Part of the
rt'\·isio11s arc dut' to the fact that tht'st' Wt'rt' rt'latively nt'w products at the time of the writ-
in'.2;of tl1e St'cond edition: as a rt's11lt.rnam• chancrps M
wt're macle to the 1)rocl11cts-delistinab
Preface XIX
of somt> indt>:-,;
options and introduction of otlwrs. Also, aftt>r tht> crash of 1987, the USt'of
indt>xproducts charn;t>d sornt>what (with introductiou of circuit breakers, for t>xample).
FOURTH EDITION
Once again, in tht> t>\·er-changing world of options and derivatives, some important prod-
ucts had bet>n introduced and some 1ww concepts in trading had come to the forefront.
Mt>amvhile, otht>rs Wt're delisted or ft>llout of favor. There were five new chapters in the
fourth edition, four of which dealt with tlw most important approach to option trading
today-volatility trading.
The chapter on CAPS was dt>leted, since CAPS were <lelistecl by the option
exchanges. Moreover, the chapter on PERCS was incorporated into a much larger and
more comprehensi\'t' chapter on another relati\·ely new trading vehicle-structured prod-
ucts. Structured products encompass a fairly wide range of securities-many of which are
listed on the major stock exchanges. These versatile products allow for many attractive,
derivative-based applications-including inde:-.;funds that have limited downside risk for
example. Many astute investors buy structured products for their retirements accounts.
Volatility trading has become one of the most sophisticated approaches to option trad-
ing. The four new chapters actually comprise a new Part 6-Measuring And Trading Vola-
tility. This new part of the book goes in-depth into why one should trade volatility (ifs easier
to predict rnlatility than it is to predict stock prices), how volatility affects common option
strategies-sometimes in ways that are not initially obvious to the average option trader,
how stock prices are distributed (which is one of the reasons why volatility trading "works"),
and how to construct and monitor a volatility trade. A number of relatively new techniques
regarding measuring and predicting volatility are presented in these cliapters. Personally,
I think that volatility buying of stock options is the most useful strategy, in general, for trad-
ers of all levels-from beginners through experts. If construct<:'d properly, the strategy not
only has a high probability of success, but it also requires only a modest amount of work to
monitor the position after it has been established. This means that a volatility buyer can haw
a "life" outside of watching a screen with dancing number s on it all day.
Moreover, most of the previous chapters were expanded to include the latest tech-
niques and developments. For example, in Chapter l (Definitions), the entire area of
option symbology has been expanded, because of the wild movements of stocks in the past
few years. Also, the margin rules were changed in 2000, and those changes are nott-d
throughout the book.
Thost> chapters dealing with the sale of options-particularly naked options-were
expandt>d to include more discussion of the way that stocks behave and how that presents
problems and opportunities for the option writer. For example, in the chapter 011 Hen'rse
xx Preface
Spreads, the reverse calendar spread is described in detail because-in a high-volatility

environment-the strategy becomes much more viable.
Another strategy that receives expanded treatment is the "collar"-the purchase of
a put and sinmltaneons sale of a call against an underlying instrument. In fact, a similar
strategy can be used-with a slight adjustment-by the outright buyer of an option (see
the chapter on Spreads Combining Puts and Calls).
FIFTH EDITION
The largest addition to the hook in the fifth edition is the lengthy chapter on Volatility
Derivatives. This new asset class-volatility-is going to be one of the largest innovations
in listed derivatives trading. It is still in its infancy, but there is no denying that the ability
to trade and hedge volatility is an extremely important component to any portfolio man-
ager, as well as to any speculator.
At the current time, there are listed futures, options, and ETNs on primarily one
major volatility index-the CBOE's Volatility Index (VIX). However, steps are already
being taken to introduce volatility derivatives on many stocks, futures, and indices. In the
future, it will mostly likely be the case that most entities with listed options will trade
puts, calls, and volatility options (not to mention volatility futures as well). The CBOE has
already described VIX options as the single most successful product launch in its
history.
The new content spends a good deal of time explaining volatility futures, for they
an"' effectively the underlying instrument for cash-based volatility options. Hence, it is
irnportant that traders umlerstan<l the volatility futures-even if they are not planning to
trade them-if they are planning to trade volatility options. Various strategies involving
this new asset class are explained, much in the same manner as stock option strategies
were explained. The use of this new asset class as portfolio protection is fully explained
as well.
Another major change in this edition involves the Option Syrnbology Initiative (OSI),
completed in 2010, which necessitated a welcome change to the way option symbols are
displayed. This affects many of the examples and definitions. The examples have also been
updatt'd for currently lower commission rates and for decimalization. One particular out-
growth of the OSI is that LEAPS options are now merely long-term options, identified by
their t'xpiration date. However, the options industry is still using the term LEAPS, so it
co11tinues in ust' in this text as well. The reader should understand, though, that a LEAPS
option is not really anything different from any other listed option.
Otllt'r changt's include an expansion of the section on how option activity at expira-
tion and at otlwr timt's ma:· affect the stock market. This involves not only "circuit break-
ers" ll11ttlw actual effect of arbitrage on ex11iration dav. Se11aratelv, Portfolio Maro"in
l. ., ., b
is
Preface
described in Chapter 4, when margin is first discussed, and a new Appendix F has been
added with the current portfolio margin rules. However, the vast majority of examples in
the book continue to be from the viewpoint of a trader using customer margin, not port-
folio margin.
The application of certain strategies has been expanded, often because of the
nuances available from the generally more volatile markets that have existed in the past
decade. These include enhancements to the covered writing strategy (the partial extrac-
tion), the collar strategy, naked put writing, put ratio spreads, dual calendar spreads, and
an expansion of the discussion of butterfly-style strategies-specifically condor and iron
condor spreads. The section on ETFs has been expanded to include futures-based ETFs.
The chapter on mathematical applications has an addition as well: the way that I
compute and identify a volatility skevv in any entity's options. This is useful to volatility
traders, of course, for many volatility strategies are based on identifying and exploiting
either a horizontal or vertical skew (or both-diagonal).
A deletion involves the section on PERCS, the discussion of which has been removed
from the book. ·while there continue to be structured products being offered over the
counter, primarily from the major brokerage firms to preferred customers, there are not
nearly as many listed structured products any longer. Some discussion of structured prod-
ucts remains in this text, but those wanting a full strategy analysis of PE RCS are directed
to read the fourth edition of this book. I suspect there are not many who are interested
currently .
I am certain that many readers of this book expect to learn what the "best" option
strategy is. While there is a chapter discussing this subject, there is no definitively
"best" strategy. The optimum strategy for one investor may not be best for another. Option
professionals who have the time to monitor positions closely may be able to utilize an array
of strategies that could not possibly be operated diligently by a public customer employed
in another full-time occupation. Moreover, one's particular investment philosophy must
play an important part in determining which strategy is best for him. Those willing to
accept little or no risk other than that of owning stock may prefer covered call writing.
More speculative strategists may feel that low-cost, high-profit-potential situations suit
them best.
Every investor must read the Options Clearing Corporation Prospectus before trad-
ing in listed options. Options may not be suitable for every investor. There are risks
involved in any investment, and certain option strategies may involve large risks. The
reader must determine whether his or her financial situation and investment objectives
are compatible with the strategies described. The only way an investor can reasonably
make a decision on his or her own to trade options is to attempt to acquire a knowledge
of the subject.
Several years ago, I wrote that "the option market shows every sign of becoming a
XXII Preface
stronger force in the investment world. Those who understand it will be able to benefit
the most." Nothing has happened in the interim to change the truth of that statement,
and in fact, it could probably he even more forcefully stated today. For example, the Fed-
eral Resen-e Board now often makes decisions with an eye to how derivatives will affect
the markets. That shows just how important derivatives have become. The purpose of this
book is to provide the reader with that understanding of options.
I would like to express my appreciation to several people who helped make this book
possible: to Ron Dilks and Howard Whitman, vvho brought me into the brokerage busi-
ness: to the late Art Kaufman, whose hroad experience in options helped to crystallize
many of these strategies; to Peter Kopple for his help in reviewing the chapter on arbi-
trage; to Shelley Kaufman for his help on the last three editions in designing the graphs
and in the massive task of proofreading and editing; to Ben Russell (who titled the book)
and Freel Dahl for their suggestions on format ancl layout of the initial book; and to Jim
Dalton (then president of the CBOE) for recommending a little-known option strategist
when the New York Institnte of Finance asked him, in 1977, if he had any suggestions for
an author for a new hook on options. Special thanks go to Bruce Nemirow for his invalu-
able assistance, especially for reading and critiquing the original manuscript. I would also
like to thank the Options Industry Council for presenting me with the Joseph \V. Sullivan
Award in 2011-an honor that I was humbled and very proud to receive. Most of all, I am
grateful to my wife, Janet, who typed the original manuscript, and to Karen and Glenn,
our children, all of whom graciously withstood the countless hours of interrupted family
life that were necessary in order to complete this work.
LAWRENCE G. MCMILLAN
Basic Properties
of Stock Options
INt ODUCT ON
Each chapter in this book presents information in a logically sequential fashion. Many
chapters build on the information presented in preceding chapters. One should therefore
be able to proceed from beginning to encl without constantly referring to the glossary or
index. However, the reader who is using the text as a reference-perhaps scanning one of
the later chapters-many find that terms are being encountered that have been defined
in an earlier chapter. In this case, the extensive glossary at the back of the book should
prove useful. The index may provide aid as well, since some subjects are described, in
varying levels of complexity, in more than one place in the book For example, call buying
is discussed initially in Chapter :3; and mathematical applications, as they apply to call
purchases, are described in Chapter 28. The latter chapters address more complex topics
than do the early chapters.
Definitions
The successful implementation of various investment strategies necessitates a sound work-

ing knowledge of the fundamentals of options and option trading. The option strategist
must be familiar with a wide range of the basic aspects of stock options-h ow the price
of an option behaves under certain conditions or how the markets function. A thorough
understanding of the rudiments and of the strategies helps the investor who is not familiar
with options to decide not only whether a strategy seems desirable, but also-and more
important-ichether it is suitable. Determining suitability is nothing new to stock market
investors, for stocks themselves are not suitable for every investor. For example, if the
investor 's primary objectives are income and safety of principal, then bonds, rather than
stocks, would be more suitable. The need to assess the suitability of options is esp ecially
impo rtant : Option buyers can lose their entire investment in a short time, and unc overed
option writers may be subjected to large financial risks. D espite follow-up methods
designed to limit risk the individual investor must decide whether option trading is suit-
able for his or her financial situation and investment objective.
ELEMENTARY DEFINITIONS
A stock option is the right to buy or sell a particu lar stock at a certain price for a limited
period of time. The stock in question is called the underlying security. A call option gives
the owner (or holder) the right to buy th e underlying security, while a put option gives the
holder the right to sell the underlying security. The price at which th e stock may be bought
or sold is the exercise price, also called the striking price . (In the listed options market ,
"exercise price " and "striking price " are synonymous. ) A stock option affords this right to
buy or sell for only a limited period of time; thus, each option has an expiration date.
Throughout the hook the term "options" is always understood to mean listed options, that
3
4 PartI:BasicProperties
of StockOptions
is, options traded on national option exchanges where a secondary market exists. Unless
specifically mentioned, over-the-counter options are not included in any discussion.
DESCRIBING OPTIONS
Four specifications uniquely describe any option contract:
1. the type (put or call),

1( 2. the underlying stock name ,
:3. the expiration date , and
4. the striking price .
As an example, an option referred to as an "XYZ July ,50 call" is an option to buy (a call)
100 shares (nonnall:,;) of the underlying XYZ stock for $50 per share. The option expires
in July. The price of a listed option is quoted on a per-share basis, regardless of how many
shares of stock can be bought with the option. Thus, if the price of the XYZ July 50 call
is quoted at $,5, buying the option would ordinarily cost $,500 ($,5 x 100 shares), plus
commissions.
THE VALUE OF OPTIONS
An option is a "wasting" asset that is, it has only an initial value that declines (or "wastes"
awa: ·) as tinw passes. It may e,·ei1 expire worthless, or the holder may have to exercise it
in order to recm·er some rnlue before expiration. Of course, the holder may sell the option
in the listed option market before expiration.
An option is also a securit:· by itself. but it is a deri,·ative security. The option is irre-
,·ocabl: · linked to the unclerl:·ing stock its price fluctuates as the price of the underlying
stock rises or falls. Splits, stock cli\ idends, ancl special cash dividends affect the terms of
listed option s, although cash dividends do not. The holder of a call does not receive any
cash dividernls paid b: the un clcrlymg stock.
STANDARDIZATION
Tlw listed option e:,.;changesha, ·e standar dized the terms of option contr acts. The term s
of an option constitute the collecti,· e name that includes all of the four descriptive speci-
fications.\ \'hile the t_\·pe(put or call) and the umlerl:·ing stock are self-evident and essen-
tial!:· standardized. tl1e striking price and c:,.;pirntion date require more explanation.
Chapter
1:Definitions 5
Striking Price. Striking prices are spaced at diffPrent intervals for stocks, ETFs, and
indices, depending on the underl>·ing price and the liquidity of the option contracts. With
rare exceptions, striking prices are ,5points apart at most even for high-priced stocks like
COOG and AAPL or indices like SPX (the S&P .500 Index). For lower-priced stocks,
strikes are often just 1 point apart. prm·idecl that the options on that stock are relatively
he,ffily traded. There are occasional\ :2.5-point strikes as well, centered between .5-point
striking price interrnls. The simplest mt>' to tell what strikes are available 011 the stock you
wish to trade is to look at a quote montage (a free one is available online at www.cboe
.com, for example)_
Expiration Dates. Options hm·e expiration dates in one of three fixed cycles:
1. the January/April/July/October cycle,

2. the February/May/August/November cycle, or
3. the March/June/September/December cycle.
In addition, the two nearest months have listed options as well. However, at any given
time, the longest-term expiration dates are normally no farther away than 9 months.
Longer-term options, also called LEAPS (which stands for Long-term Equity Anticipation
Securities), are available 011 some stocks (see Chapter :25).Hence, in any cycle, options may
expire in 3 of the 4 mc~jormonths (series) plus the near-term months. For example, on
February I of any year, XYZ options ma>' expire in February, March, April, July, and
October-not in January . The February option (the clost'st series) is the short- or near-trr111
option; and the October, the far- or long-term option. If there were LEAPS options on
this stock, they would expire in January of the following year and in January of the year
after that.
The exact date of expiration is fixed within each month. The last trading day for an
option is the third Friday in the expiration month. Although the option actually does not
expire until the following clay (the Saturday following), a public customer must invoke the
right to buy or sell stock by notifying his broker hy ,5::30p.m., New York time, on the last
day of trading.
The above expiration elate-the Saturday after the third Friday-is consiclt'recl the
"regular" option expiration elate in any given month. But in recent :'ears, options hm·e
been introduced that expire at other times. There are quarterly options that expire 011 the
last trading clay of March, June, Septemlwr, and December. There are only a few of
these-mostly likely on large indices.
There are also 1ceek!y options. These art' gcnerall:' listed 011 a Tllllrsda:, and e:\pirc
of StockOptions
011 the Friday that occurs eight calendar days later. (Note: These weeklys do expire on
Friday, not the Saturday following.) An ever-growing number of stocks and indices have
weekly listed options, and it is likely that the option exchanges will seek to add even more,
since these are popular with the public.
The Price of an Option. Options trade in one-penny increments in many cases.

Otherwise, prices are quoted in ,5-cent increments. For stock options, the trading incre-
ment is one penny up until the price of the option reaches $.3.00. After that, the trading
increment is 5 cents. However, for liquid Exchange Traded Funds (ETFs) and indices,
options can trade in pennies at any price .
THE OPTION ITSELF: OTHER DEFINITIONS
Classes and Series. A class of options refers to all put and call contracts on the same
underlying security. For instance, all IBM options-all the puts and calls at various strikes
and expiration months-form one class. A series, a subset of a class, consists of all contracts
of the same class (IBM, for example) having the same expiration date and striking price.
Opening and Closing Transactions. An opening transaction is the initial transac-

tion, either a buy or a sell. For example, an opening buy transaction creates or increases a
long position in the custumer's account. A closing transaction reduces the customer's
position. Opening buys are often followed by closing sales; correspondingly, opening sells
often precede closing buy trades.
Open Interest. The option exchanges keep track of the number of opening and closing
transactions in each option series. This is called the open interest. Each opening transac-
tion adds to the open interest and each closing transaction decreases the open interest. The
open interest is expressed in a number of option contracts, so that one order to buy 5 calls
opening would increase the open interest by 5. Note that the open interest does not dif-
ferentiate between buyers and sellers-there is no way to tell if there is a preponderance
of either one.\ \'hile the magnitude of the open interest is not an extremely important piece
of data for tl1e im·estor, it is useful in determining the liquidity of the option in question. If
tht're is a large open interest, then there should be little problem in making fairly large
trades. Howe\·er, if the open interest is small-only a few hundred contracts outstanding-
then there might not be a reasonable secon dary market in that option series.
The Holder and Writer. Anyone who buys an option as the initial transaction-that
is. !mys opening-is called the holder. On the other hand, the investor who sells an option
as tlie initial transaction-an opening sale-is called the writer of the option. Commonly,
Chapter
1:Definitions 7
the writer (or seller) of an option is refe1-red to as being short the option contract. The term
"writer" dates back to the over-the-counter days, when a direct link existed between buy-
ers and sellers of optious; at that time, the seller was the writer of a new contract to buy
stock. In the listed option market. however, the issuer of all options is the Options Clear-
ing Corporation, and contracts are standardized. This important difference makes it pos-
sible to break the direct link between the buyer and seller, paving the way for the formation
of the secondary markets that now exist.
Exercise and Assignment. An option owner (or holder) who invokes the right to buy
or sell is said to exercise the option. Call option holders exercise to buy stock; put holders
exercise to sell. The holder of most stock options may exercise the option at any time after
taking possession of it, up until 8:00 p.m. on the last trading day; the holder does not have
to wait until the expiration date itself before exercising. (Note: Some options, called "Euro-
pean" exercise options, can be exercised only 011 their expiration elate and not before-but
they are generally not stock options.) These exercise notices are irrevocable; once gener-
ated, they cannot be recalled. In practical terms, they are processed only once a day, after
the market closes. \Vhenever a holder exercises an option, somewhere a writer is assigned
the obligation to fulfill the terms of the option contract: Thus, if a call holder exercises the
right to buy, a call writer is assigned the obligation to sell; conversely, if a put holder exer-
cises the right to sell, a put writer is assigned the obligation to buy. A more detailed
description of the exercise and assignment of call options follows later in this chapter; put
option exercise and assignment are discussed later in the book.
RELATIONSHIP OF THE OPTION PRICE AND STOCK PRICE
In- and Out-of-the-Money. Certain terms describe the relationship between the
stock price and the option's striking price. A call option is said to be out-of-the-money if
the stock is selling below the striking price of the option. A call option is in-the-money if the
stock price is above the striking price of the option. (Put options work in a converse manner,
which is described later.)
Example: XYZ stock is trading at $47 per share. The XYZ July .50 call option is
out-of-the-money, just like the XYZ October .SOcall and the XYZ July 60 call. However,
the XYZ July 4,5 call, XYZ October 40, and XYZ January 3,5 are in-the-money.
The intrinsic value of an in-the-money call is the amount by which the stock price'
exceeds the striking price. If the call is out-of-the-money, its intrinsic value is zero. Tlw
price that an option sells for is commonly referred to as the premium. The premium is
distinctly different from the time value premium (called time premium, for short), whiclt
8 Part/: BasicProperties
of StockOptions
is the amount hy which the option premium itself exceeds its intrinsic value. The time
value premium is quickly computed by the following formula for an in-the-money call
option:
Call time value premium = Call option price + Striking price - Stock price
Example: XYZ is trading at 48, and XYZ July 4,5 call is at 4. The premium-the total
price-of the option is 4. With XYZ at 48 and the striking price of the option at 4.5, the
in-the-monc:,; amount (or intrinsic value) is 3 points (48-4.5), and the time value is 1 (4-3).
If the call is out-of~the-money, then the premium and the time value premium are
the same.
Example: \\'ith XYZ at 48 and an XYZ July .50 call selling at 2, both the premium and
the time \·alue premium of the call are 2 points. The call has no intrinsic value by itself
with the stock price below the striking price.
An option normally has the largest amount of time value premium when the stock
prict' is t'qual to the striking price. As an option becomes deeply in- or out-of~the-money,
the time \·alue premium shrinks substantially. Table 1-1 illustrates this effect. Note that
TABLE 1-1.
Changes in time value premium.
XYZStock XYZJul50 Intrinsic TimeValue
Price CallPrice Value Premium
40 ½ 0 ½
43 l 0 l
35 2 0 2
47 3 0 3
➔SO 5 0 5
53 7 3 4
55 8 5 3
57 9 7 2
60 10.50 10 .50
70 19.50 20 -.50*
*Simplistically, a deeply in-the-money call may actually trade at a discount from intrinsic value, because call
buyers are more interested in less expensive calls that might return better percentage profits on an upward move
in the stock . This phenomenon is discussed in more detail when arbitrage techniques are examined.
Chapter
1:Definitions 9
TABLE 1-2.
Comparison of XYZ stock and call prices.
XYZJuly45 XYZStock Over
+
Striking
Price CallPrice Price Parity
(45 + l 45.50) .50
(45 + 2.50 47 } .50
(45 + 5.50 50 } .50
(45 + 15.50 60 } .50
the time value premium incrc->asesas the stock nears the striking price (.SO)and then
decreases as it draws awa:· from .50.The term "time value premium" implies that this part
of an option's premium is completely clue to the time remaining. In fact, that isn't really
true. The colatility of the underlying stock has a great deal to do with how much "time
premium" is in the option. So. really, "'time premium" is something of a misnomer, but it's
the standard term.
Parity. An option is said to be trading at parity with the underlying security if it is trad-
ing for its intrinsic rnlue. Thus, if XYZ is 48 and the XYZ July 4.5 call is selling for :3,the
call is at parity. A common practice of particular interest to option writers (as shall be
seen later) is to refer to the price of an option h:' relating how close it is to parity with the
common stock. Thus, the XYZ Jul:' 4.5 call is said to he a half-point over parity in any of
the cases shown in Table 1-2.
FACTORS INFLUENCING THE PRICE OF AN OPTION
An option's price is the result of properties of both the underlying stock and the terms of
the option. The major quantifiable factors influencing the price of an option are the:
1. price of the underlying stock,

2. striking price of the option itself,
.'3. time remaining until expiration of the option ,
4. volatility of the underlying stock ,
.5. current risk-free interest rate (such as for 90-day Treasury bills), and
6. dividend rate of the underlying stock.
10 Part/:BasicProperties
of StockOptions
The first four items are the major determinants of an option's price, while the latter two
are generally less important, although the dividend rate can be influential in the case of
high-yield stock.
THE FOUR MAJOR DETERMINANTS
Probably the most important inRuence on the option's price is the stock price, because
if the stock price is far above or far below the striking price, the other factors have
little inHuence. Its dominance is obvious on the day that an option expires. On that day, only
the stock price and the striking price of the option determine the option's value; the other
four factors have no hearing at all. At this time, an option is worth only its intrinsic value.
Example: On the expiration day in July, with no time remaining, an XYZ July .50 call has
the value shown in Table 1-3; each value depends on the stock price at the time.
The Call Option Price Curve. The call option price curve is a curve that plots the
prices of an option against various stock prices. Figure 1-1 shows the axes needed to graph
such a curve. The \·ertical axis is called Option Price. The horizontal axis is for Stock
Price. This figure is a graph of the intrinsic value. When the option is either out-of-the-money
or equal to the stock price, the intrinsic value is zero. Once the stock price passes the
striking price, it reRects the increase of intrinsic value as the stock price goes up. Since a
call is usually worth at least its intrinsic value at any tirne, the graph thus represents the
minimum price that a call may be worth.
\\'hen a call has time remaining to its expiration date, its tot al price consists of its
TABLE 1-3.
XYZ option's values on the expiration day.
XYZJuly50Call
(Intrinsic)
Value
XYZStock
Price atExpiration
40 0
45 0
48 0
50 0
52 2
55 5
60 10
Chapter
1:Definitions 11
FIGURE 1-1.
The value of an option at expiration, its intrinsic value.
0)
(.)
&
C:
0
E.
0 The intrinsic value line
bends at the
st~iking ~
pnce. ~
Stock Price
TABLE 1-4.
The prices of a hypothetical July 50 call with 6 months of time remaining,
plotted in Figure 1-2.
XYZJuly50 TimeValue
XYZ
Stock
Price CallPrice Intrinsic Premium
(Horizontal
Axis) (Vertical
Axis) Value (Shading)
40 1 0 1
45 2 0 2
48 3 0 3
➔SO 4 0 4
52 5 2 3
55 6.50 5 1.50
60 11 10
intrin sic value plus its time value premium. The resultant call option price curve takes the
form of an inverted arch that stretches along the stock price axis. If one plots the data from
Table 1-4 on the grid supplied in Figure 1-2, the curve assumes two characteristics:
1. The ti me value pre mium (the shaded area) is greatest when the stock price and the
striking price are the same.
12 Part /: BasicProperties of Stock Options
FIGURE 1-2.
Six-month July call option (see Table 1-4).
11
10
9
8
(I)
(.)
Greatest
7
~ Value for
C 6 Time Value
0
.li 5 Premium
0 4
3
2 represents the option's
time value premium.
o---------------- --L
40 --------L---------
45 50\
Stock Price
55
Intrinsic value
60
remains at zero
until striking price
is passed.
2. \ Vlwn the stock price is far above or far below the striking price (near the ends of the
cuffe), the option sells for nearly its intrinsic value. As a result, the curve nearly
touches the intrinsic value line at either end. [Figure 1-2 thus shows both the intrinsic
value and th e option price curve.]
This cun·e, howe\·er, shows only how one might expect the XYZ July .SOcall prices
to heha\·e with 6 months remaining until expiration. As the time to expiration grows
shorter, the arched line drops lower ancl lower, untiL on the final clay in the life of the
option, it merges cornpletel:· with the intrinsic \·alue line. In other words, the call is worth
only its intrinsic \·alue at expiration. £--::amine Figure 1-:3,which depicts three separate
XYZcalls. At an: giYen stock price (a fixed point on the stock price scale), the longest-term
call sells for the higliest price and the nearest-term call sells for the lowest price. At the
striking pric<!, the actual differences in the three option prices are the greatest. Near
eithtT encl of the scale, the thrt'e cuffes are much closer together, indicating that the
,,ctual price differences frorn one option to another are small. For a given stock price,
therefore , option prices decrease as the expiration date approaches .
Example: On Ja1mar: lsL XYZ is selling at 48. An XYZ July 50 call will sell for more than
an April 50 call, which in turn will sell for more than a January 50 call.
This statement is true no matter what the stock price is. The only reservation is
tl1at \\·itl1 tlw stock de(-ply in- or out-of-the-1n011(':·, the actual difference between the
Chapter1:Definitions 13
FIGURE 1-3.
Price Curves for the 3-, 6-, and 9-month call options.
9-Month Curve
Q)
(.)
~
C:
0
6-Month Curve
li As expiration date draws
0
closer, the lower curve
merges with the intrinsic
value line. The option
price then equals its
intrinsic value.
Striking Price
Stock Price
FIGURE 1-4.
Time value premium decay, assuming the stock price remains constant.
E
:::J
.E
e!
CL
Q)
:::J
~
Q)
E
i=
9 4 0
Time Remaining Until Expiration
(Months)
January, April, and July calls will he smaller than with XYZ stock selling at the striking
price of 50.
Time Value Premium Decay. In Figure 1-.3, notice that the price of the 9-rnonth
call is not three times that of the :1-rnonth call. Note next that the curve in Figure 1-4 for
the decay of time value premium is not straight: that is, the rate <f derny <fan option is
not linear. An option's time value premium decays much more rapid!:· in the last f1.'\\'
14 Part/: BasicProperties of StockOptions
weeks of its life (that is, in the weeks immediately preceding expiration) than it does in
the first few weeks of its existence. The rate of decay is actually related to the square root
of the time remaining. Thus, a 3-month option decays (loses time value premium) at twice
the rate of a 9-month option, since the square root of 9 is 3. Similarly, a 2-month option
decays at twice the rate of a 4-month option ( /4 = 2).
This graphic simplification should not lead one to believe that a 9-month option
necessarily sells for twice the price of a 3-month option, because the other factors also influence
the actual price relationship between the two calls. Of those other factors, the wlatility of
the underlying stock is particularly influential. More volatile underlying stocks have higher
option prices. This relationship is logical, because if a stock has the ability to move a relatively
large distance upward, buyers of the calls are willing to pay higher prices for the calls-and
sellers demand them as well. For example, if AT&Tand Xerox sell for the same price (as they
have been known to do), the Xerox calls would be more highly priced than the AT&T calls
because Xerox is a more volatile stock than AT&T
The interplay of the four major variables-stock price, striking price, time, and
volatility-can he quite complex. \Vhile a rising stock price (for example) is directing the
price of a call npwarcl, decreasing time may be simultaneously driving the price in the
opposite direction. Thus, the purchaser of an out-of-the-money call may wind up with a loss
even after a rise in price by the underlying stock, because time has eroded the call value.
~ THE TWO MINOR DETERMINANTS
The Risk-Free Interest Rate. This rate is generally construed as the current rate of 90-
day Treasur_vbills. Higher interest rates imply slightly higher option premiums, while lower
rates imply lower premiums. Although members of the financial community disagree as to
the extent that interest rates actually affect option price, they remain a factor in most math-
ematical models used for pricing options. (These models are covered much later in this book.)
The Cash Dividend Rate of the Underlying Stock. Though not classified as a
major determinant in option prices, this rate can be especially important to the writer
(seller) of an option. If the underlying stock pays no dividends at all, then a call option's
worth is strictly a function of the other five items. Dividends, hou;ecer, tend to lotcer call
UJJfio11prcn1i11111s:The larger the dir:idend of the underlying conmwn stock, the lower the
price of its call UJJtions.One of the most influential factors in keeping option premiums
low on high-yielding stock is the yield itself.
Example: XYZ is a n..,lativelylow-priced stock with low volatility selling for $2.5 per share.
It pa:·s a large annual dividend of $2 per share in four quarterly payments of $ ..50 each.
What is a fair price of an XYZ call with striking price 25?
Chapter
1:Definitions 15
A prospectiw buyer of XYZ options is determined to figure out a fair price. In six
months XYZ will pay $1 per share in dividends, and the stock price will thus be reduced
by $1 per share when it goes ex-dividend over that time period. In that case, ifXYZ's price
remains unchanged except for the ex-dividend reductions, it will then be $24. Moreover,
since XYZ is a nonvolatile stock, it may not readily climb back to 2.5 after the ex-dividend
reductions. Therefore, the call buyer makes a low bid- even for a 6-month call-because
the underlying stock's price will be reduced by the ex-dividend reduction, and the call
holder does not receive the cash dividends.
This particular call buyer calculated the value of the XYZ July 2.5 call in terms of
what it was worth with the stock discounted to 24-not at 2.5. He knew for certain that
the stock was going to lose 1 point of value over the next 6 months, provided the dividend
rate of XYZ stock did not change. In actual practice, option buyers tend to discount the
upcoming dividends of the stock when they bid for the calls. However, not all dividends
are discounted fully; usually the nearest dividend is discounted more heavily than are
dividends to be paid at a later date. The less-volatile stocks with the higher dividend pay-
out rates have lmver call prices than volatile stocks with low payouts. In fact, in certain
cases, an impending large dividend payment can substantially increase the probability of
an exercise of the call in advance of expiration. (This phenomenon is discussed more fully
in the following section.) In any case, to one degree or another, dividends exert an impor-
tant influence on the price of some calls.
OTHER INFLUENCES
These six factors, major and minor, are only the quantifiable influences on the price
of an option. In practice, nonquantitative market dynamics-investor sentiment-
can play various roles as well. In a bullish market, call premiums often expand because of
increased demand. In beansh markets, call premiums may shrink due to increased
supply or diminished demand. These influences, however , are normally short-lived and
generally come into play only in dynamic market periods when emotions are running
high.
EXERCISE AND ASSIGNMENT: THE MECHANICS
The holder of an option can exercise his right at any time during the life of an option: Call
option holders exercise to buy stock, while put option holde rs exercise to sell stock. In the
event that an option is exercised, the writer of an option with the same terms is assiglled
an obligation to fulfill the terms of the option contract.
of Stock Options
EXERCISING THE OPTION
The actu al mechanics of exercise and assignment are fairly simple, clue to the role of the
Options Clearing Corporation (OCC). As the issuer of all listed option contracts , it controls
all listed option exercises and assignments. Its activities are best explained by an example.
Example: The holder of an XYZ January 4,5 call option wishes to exercise his right to
buy XYZ stock at $45 per share. He instructs his broker to do so. The broker then notifies the
administrative section of the brokerage firm that handles such matters. The firm then notifies the
OCC that they wish to exercise one contract of the XYZ January 45 call series.
Now the OCC takes over the handling. OCC records indicate which member (bro-
kerage) Finns are short or which have written and not yet covered XYZ Jan 45 calls. The
OCC selects, at random, a member firm that is short at least one XYZ Jan 4,5 call, and it
notifies the short firm that it has been assigned. That firm must then deli,·er 100 shares
of XYZ at $4,5 per share to the firm that exercised the option. The assigned firm, in turn,
selects one of its customers who is short the XYZ January 45 call.Jhis selection for the
-----------------
assignment may be either :
1. at random,
2. on a first-in/first-out basis , or
3. on any other basis that is fair, equitable, and approved by the appropriate exchange.
The selection of the customer who is short the XYZ January 45 completes the exer-
cise/assignment process. (If one is an option writer, he should obviously determine exactly
how his brokerage firm assigns its option contract s.)
HON O RING THE ASSIGNMENT
The assigned customer nwst deli\·er the stock-he has no othe r choice. It is too late to t ry
buying the option back in the option market. He must, without fail, deli,·er 100 shares of
XYZstock at 84,5 per share. The assigned writer does, howe,·er, have a choice as to how to
fulfill the assignment. If he happens to be already long 100 shares of XYZ in his account,
he rnereh-. cleli,·ers that 100 shares as fulfillment of the assicrnrnent
t, notice. Alternativeh- ,
he can go into the stock market and bu:· XYZ at the current market price-presumably
something higher than %4,5-ancl then deliver the newl:· purchased stock as fulfillment. A
third alternati,·t' is merely to notif\· his brokt'rage firm that he wishes to go short XYZ
stock and to ask tlic1n to dt'lin"r tht' 100 shares of XYZ at 4,5 out of his short account. At
tilllcs. borrowing stock to go short ma:· not he possihle. so this third alternative is not
always available on every stock.
Chapter1:Definitions 17
Margin Requirements. If the assigned writer purchases stock to fulfill a contract,

reduced margin requirements generally apply to the transaction, so that he would not have
to fully margin the purchased stock merely for the purpose of delivery. Generally, the cus-
tomer only has to pay a day-trade margin of the difference between the current price of XYZ
and the delivery price of $45 per share. If he goes short to honor the assignment, then
he has to fully margin the short sale at the current rate for stock sold short on a margin basis.
AFTER EXERCISING THE OPTION
The OCC and the customer exercising the option are not concerned with the actual
method in which the delivery is handled by the assigned customer. They want only to
ensure that the 100 shares of XYZ at 45 are, in fact, delivered. The holder who exercised
the call can keep the stock in his account if he wants to, but he has to margin it fully or
pay cash in a cash account. On the other hand, he may want to sell the stock immediately
in the open market, presumably at a higher price than 4,5. If he has an established margin
account, he may sell right away without putting out any money. If he exercises in a cash
account, however, the stock must be paid for in full-even if it is subsequently sold on the
same day. Alternatively, he may use the delivered stock to cover a short sale in his own
account if he happens to be short XYZ stock.
COMM/ SION
Both the buyer of the stock via the exercise and the seller of the stock via the assignment
are charged a full stock commission on 100 shares, unless a special agreement exists between
the customer and the brokerage firm. Generally, option holders incur higher commission
costs through assignment than they do selling the option in the secondary market. So the
public customer u;ho holds an option is better off selling the option in the secondary m ar-
ket than exercising tl1e call.
Of course, sometimes a customer wants to own the underlying stock, perhaps
because it is attractive to him or because he wants to cover a short sale. In these cases,
the exercise of the call would be desirable.
ANTICIPATING ASSIGNMENT
The writer of a call often prefers to buy the option back in the secondary market, rather
than fulfill the obligation via a stock transaction. It should be stressed again that once the
writer receives an assignment notice, it is too late to attempt to buy back (cover) the call.
The writer must buy before assignment, or live up to the terms upon assignment. The
writer who is aware of the circumstances that generally cause the holders to exercise can
of StockOptions
antici1)ate assicrnment
M with a fair amount of certaintv., In antici1)ation of the assignment.
~
the writer can then close the contract in the secondary market. As long as the writer cov-
ers the position at ai1:· time during a trading day, he cannot be assigned on that option.
Assignment notices are determined on open positions as of the close of trading each da:··
The crucial question then becomes, "How can the writer anticipate assignment'?" Se,·eral
circumstances signal assignments:
1. a call that is in-the-money at expiration,

2. an option trading at a discount prior to expirat ion , or
:3. the underlying stock pa:·ing a large di,·idend and about to go e\-di,·idend.
Automatic Exercise. Assignment is all but certain if the option is in-the-mone:· at

e\piration. Should the stock close e,·en a penn:· abm·e the striking price on the last day of
trading, the holder will normally e\ercise. In fact. e,·en if the call trades in-the-mone:· at
any time during the last trading clay. it might be e\e1-cised if a market-maker has taken an
offsetting position and issued an e\ercise notice. Even if an option holder forgets that he
owns an option and fails to e\ercise, the OCC automatically e\e1-cises an:· option that is
one penny in the rnone:· at e\piration, unless the customer-through his brokerage firrn-
gi,·es specific instructions not to e\ercise. This automatic e:rercisc mechanism ensures
that no investor throws money away through carelessness.
Example: XYZ closes at 50 on the third Friday of January, the last trading da:· for the
Jarn1ar:· option series. Since options don't e\pire until Saturday, the ne\t da:·· the OCC
and all the brokerage firms hm·e the opportunity to re,·iew their records to see if an:·
options should hm·e been profitably e\ercised hut were not. If a customer owned a January
calL but failed to either sell or e\e1-cise it (perhaps due to illness or an inabilit:· to get
-1-.S
to a phone or computer while trm·eling), it is automaticall:· e\e1-cisecl. Since it is worth
S.300 per contract. less the commissions for bu:·ing the stock the customer stands to
recei,·e a substantial amount of monev. back. Howe,·er, he is now long the stock so that
'-
must be sold to realize the gain.

In the abon' e\arnple, note that the e\e1-cise creates a stock purchase in the account.
If there is not sufficient cash in the account to make this purchase. a margin call ma:·
result. This is wh:· some brokerage firms do not allow option buying in retirement accounts
1IR:\s. for e\amplel. because one cannot .just routineh-, add mone,·. into an IRA to fulfill
the requirements of an automatic exercise.
:\m· \\Titer ,,·ho ,,·ishes to a,·oid an assignment notice should ah,·,:l\'sbm· back (or cm·er1
• l._ • •
the option if it appears that the stock ,,·ill be abm·e the strike at e\piration. The prohabilit:·
oflwing assignee! is ,·irtuall:· 1007c-if the option e\pires in the mone:·· en'n b:· a penn:··
Chapter
1:Definitions 19
Early Exercise Due to Discount. When options are exercised prior to expiration,
th is is called early, or premature , exercise. The writer can usually expect an early exercise
when the call is trading at or below parity . A parity or discount situa tion in advance
of expiration may mean that an early exercise is forthcoming, even if the discount is
slight. A writer who does not want to deliver stock should buy back the option prior to
expiration if the option is apparently going to trade at a discount to parity. The reason is
that arbitrageurs (floor traders or member firm traders who pay only minimal commissions)
can take advantage of discount situations. (Arbitrage is discussed in more detail later in the
text; it is mentioned here to show why early exercise often occurs in a discount situation.)
Example: XYZ is bid at $50 per share, and an XYZ January 40 call option is offered at a
discount price of 9.80. The call is actually "worth" 10 points. The arbitrageur can take
advantage of this situation through the following actions, all on the same day:
1. Buy the January 40 call at 9.80.

2. Sell short XYZ common stock at 50.
3. Exercise the call to buy XYZ at 40.
The arbitrageur makes 10 points from the short sale of XYZ (steps 2 and 3), from which he
deducts the 9.80 points he paid for the call. Thus, his total gain is 20 cents-the amount of
the discount. Since he pays only a minimal commission, this transaction results in a net profit.
Also, if the writer can expect assignment when the option has no time value premium
left in it, then conversely the option will usually not be called if time premium is left in it.
Example: Prior to the expiration date, XYZ is trading at 50½, and the January ,50 call is
trading at 1. The call is not necessarily in imminent danger of being called, since it still
has half a point of time premium left.
Time value Call Striking Stock

premium
= price
+
price price
= 1 + 50 50.50
= .50
Early Exercise Due to Dividends on the Underlying Stock. Sometimes the

market conditions create a discount situation, and sometimes a large dividend gives rise
to a discount. Since the stock price is almost invariably reduced by the amount of the divi-
dend, the option price is also most likely reduced after the ex-dividend. Since the holder
20 Part /: BasicPropertiesof StockOptions
of a listed option does not recei\ 'e the dividend, he 111aydecide to sell th e option in the
sccomlarv market before the ex-date in antic ipation of the drop in price. If enough calls
are sold because of the impending ex-dividend reduction, the option may com e to parity
or even to a discount. Once again, the arbitrageurs 111aymove in to take advantage of the
situation by buying the se calls and exercising them .
If assigned prior to the ex-date, the writer does not receive the dividend for he no
longer owns the stock on the Px-clate. Furthermore, if he receives an assignmen t notice
on th e ex-date , he must deliver the stock with the dividend. It is therefore very irnportant
for the writPr to watch for discount situations on the clay prior to the ex-date.
A word of caution: Do not conclude from this discussion that a call will be exercised
for the di\·idencl if tlw dh,iclPnd is larger than the remaining time premium. It won' t . An
example will show why.
Example: XYZ stock, at .50, is going to pay its regular $1 dividend with the ex-date set for
the llt'\:t cla:'· An XYZ January 40 call is selling at 10.2.5; it has twenty-five cents of time
premium. (T\'P = 10.2.S+ 40 - .SO= .2,5.)The same type of arbitrage will not work. Sup-
pose that thP arbitrageur huvs tllt' call at 10.2,5and exercises it: He now owns the stock
for the ex-elate, and lie plans to sell the stock immediately at the open ing on the ex-date,
tllt' next clav. On tllt' Px-date, XYZ opens at 49, because it goes ex-dividend by $1. The
arbitra geur's transaction s thus con sist of:
1. Buy th e XYZ Janua ry 40 call at 10.25.

2. Exercise th e call th e sam e day to bu y XYZ at 40.
3. On th e ex-date, sell XYZ at 49 and collect the $1 dividend .
HP rnakPs 9 points on the stock (steps 2 and :3), and he receives a I-point d ividend, for a
total cash inflow of 10 points. However, he loses 10.2.Spoints paying for the cal l. The
overa ll transaction is a loser an d the arbitra geur would thus not attempt it.
A dividPnd pa: nwnt that Pxceeds the time premium in the call, therefore, does not
imp ly that the writer will be assigned.
\lore of a possihilitv, hut a much less certain one, is that the arbitrageur may attempt
a '"risk arhitra~p"
,
in such a situation. Risk arbitmac
~
is arbitrag:e
"
in which the arbitraaeur
h
runs
the risk of a loss in order to trv for a profit. ThP arbitrageur may suspect that the stock will
not he discounted tlw foll t'\-cli\'idcnd amount or that the call's time premium will increase
after the e\-clatl'. In either case (or botht he might make a profit: If the stock opens down
0111:60 cents or if the option premium P\pands hy 40 cents, the arhitrageur could profit on
tlw orwnin~. l11~eneraL lim\'C\'er, arliitragpurs do not like to take risks and therefore avoid
Chapter
1:Definitions 21
this type of situation. So the prohabilit!· of assignment as the result of a dividend payment
on the underl~ing stock is s111alLunless the call trades at parity or at a discount.
Of course, the anticipation of an early exercise assumes rational behavior on the part
of the call holder. If time premium is left in the call, the holder is always better off finan-
cially to sell that call in the secondar~· market rather than to exercise it. However, the
terms of the call contract give a call holclt-r the right to go ahead and exercise it anyway-
even if exercise is not the profitable thing to do. In such a case, a writer would receive an
assign111ent notice quite unexpectedly. Financially unsound early exercises do happen,
though not often, ancl an option writer must realize that, in a very small percentage of
cases, he could be assigned under ver! illogical circumstances.
THE OPTION MARKETS
The trader of stocks does not have to become very familiar with the details of the way the
stock market works in order to make money Stocks don't expire, nor can an investor be
pulled out of his investment unexpectedly . However, the option trader is required to do
more homework regarding the operation of the option markets. In fact, the option strate-
gist who does not know the details of the working of the option markets will likely find
that he or she eventually loses some money due to ignorance.
MARKET-MAKER
In at least one respect, stock and listed option markets are similar. Stock markets use
specialists to do two things: First, they are required to make a market in a stock by buying
and selling from their own inventory, when public orders to buy or sell the stock are
absent. Second, they keep the public book of orders, consisting of limit orders to buy and
sell, as well as stop orders placed by the public. When listed option trading began, the
Chicago Board Options Exchange (CBOE) introduced a similar method of trading, the
market-maker and the board broker system. The CBOE assigns several market-makers to
each optionable stock to provide bids and offers to buy and sell options in the absence of
public orders. Market-makers cannot handle public orders; they buy and sell for their own
accounts only. A separate person, the board broker, keeps the hook of limit orders. The
board broker, who cannot do any trading, opens the book for traders to see how many
orders to buy and sell are placed nearest to the current market (consisting of the highest
hid and lowest offer). (The specialist on the stock exchange keeps a more closed hook; he
is not required to formally disclose the sizes and prices of the public orders.)
In theory, the CBOE sy<,temis more efficient than the stock exchange s:vstcrn. \\Tith
several market-makers competing to create the market in a particular sec11rit:·, t lie market
of StockOptions
should be a more efficient one than a single specialist can provide. Also, the somewhat
open book of public orders should provide a more orderly market. In practice, whether
the CBOE has a more efficient market is usually a subject for heated discussion. The
strate gist need not b e conc ern ed with the question.
The American Stock E xchange uses specialists for its option trading, but it also has
floor traders who function similarly to market-makers. The regional option exchanges use
combinations of the two systems; some use market-makers, while others use specialists.
OPTION SYMBOLOGY
From the time that options were listed in 1973 until a complete overhaul of the
symbology in 2010, option symbols were a rather arcane combination of letters (to represent
strike and expiration month) and 3-cliaracter base symbols (even for stocks with four charac-
ters in their own symbol, like AAPL). But as more and more stocks, ETFs, and other entities
came to have listed options, and these options extended farther out in time (more than one
year), the old symbology system became unworkable. It lasted far longer than it should have,
mostly due to certain large brokPrage firms' and quote vendors' reluctance to change. But
eventually, the Options Cleating Corporation enlisted the aid of several industry representa-
tives to create the Options Symbol Initiative (OSI), whose purpose it was to create new option
codes . The implementation of the OSI took place in 2010, and the industry is far better for it.
If you want a historic look at option symbology , find a copy of the fourth edition of
this book and read the section in the first chapter. It is now a rather amusing look at his-
tory, but while it was happening, it took an army of clerks at various firms around the
world to keep the option databases updated daily with all of the changes that took place ,
which iucluded, but were not limited to, splits, special dividends, spinoffs, long-term
options (LEAPS), weekly and monthly option expirations, and a myriad of strikes caused
by highly volatile movemen t by th e underlying stock , et c.
Today, the situa tion is simpler, although it is no longer standardized. The OSI sug-
gested how option symbols should be created, but each firm, vendor, and exchange is free
to format th em how it sees fit. However , the individual customer really doesn't have to
worry about this too much , for most of the time brokerage and vendor software displays
an option as some thi ng like:
IB M Jan (21) 2011 45 call
\\ 'here IB:M is the stock symbol, Jan is the expiration month, 21 is the expiration day,
2011 is th e C'xpiratio n ;;ear, --1.5
is the striking price , and "call" is the type of option (as
oppo sed to "put ").
Chapter
1:Definitions 23
Some vendors don't show the expiration day if it is the "regular" Saturday following
the third Friday. But the clay must be shown for weekly or quarterly options. Some ven-
dors only show the last two digits of the expiration year. Some still use the old letter codes
for the expiration month ("A"==January call; "B" ==February call; ... "L" ==December
call; "M" ==January put; ·'N" ==February put; .. . ''X" ==December put).
But in any case, it's a lot more logical now than it used to be, because numbers are
used for strikes and expiration dates rather than the letters that were used before. And
because of the use of numbers for these items, only one stock symbol is necessary for all
of the options on a particular stock
DETAILS OF OPTION TRADING
The facts that the strategist should be concerned with are included in this section. They are
not presented in any particular order of importance, and this list is not necessarily complete.
Many more details are given in the discussion of specific strategies throughout this text.
1. Option trading can be frenetic near the end of the day. Listed stock options trade from
9:30 a.m. to 4 p.m. Eastern time. Some index options trade until 4: 15 p.m. Eastern
time. Waiting too long to place an order at the end of the trading day is not advisable.
In the crush of orders that might occur, even a market order could conceivably not be
filled. Also, one should be mindful of trading at the end of the last trading day of an
option's life (the third Friday for "regular" expiration cycle options, or any Friday for
weekly options). Again, it is advisable to place orders with plenty of time to spare,
rather than waiting for the "crush" of trading that comes at the end of the option's life.
2. Option trades have a one-day settlement cycle. The trade settles on the next business
day after the trade. Purchases must be paid for in full, and the credits from sales "hit"
the account on the settlement day. Some brokerage firms require settlement on the same
day as the trade, when the trade occurs on the last trading day of an expiration series.
3. Options are opened for trading in rotation. When the underlying stock opens for
trading on any exchange, regional or national, the options on that stock then go into
opening rotation on the corresponding option exchange. The rotation system also
applies if the underlying stock halts trading and then reopens during a trading day;
options on that stock reopen via a rotation.
In the rotation itself, interested parties make bids and offers for each particular
option series one at a time-the XYZ January 45 call, the XYZ January 50 call, and
so on-until all the puts and calls at various expiration elates and striking prices have
hecn opened. Trades do not necessarily have to take place in each series, just bids
of StockOptions
and offers. Orders such as spreads, which involve more than one option, are not
executed during a rotation.
While the rotation is taking place, it is possible that the underlying stock could make
a substantial move. This can result in option prices that seem unrealistic when
viewed from the perspectin' of each option's opening. Consequently, the opening
price of an option can be a somewhat suspicious statistic, since none of them open at
exactly the same time.
Also, it should be noted that most option traders do nut trade during rotation, so a
market order may receive a very poor price. Hence, if one is considering trading dur-
ing rotation, a limit order should be used. (Order entry is discussed in more detail in
a later section of this chapter.)
4. When the underlying stuck splits or pays a stock diddend, or pays a special cash
dicidc11d of greater than 12.S cents, or pays a regular dicidend in an amount greater
than 10% of the stock price, then the terms cf its options are adjusted. Such an adjust-
ment may result in fractional striking prices and in options for other than 100 shares
per contract. No adjustments in terms are made for cash dividends that are regularly
declared and paid on a quaterly or other basis. The actual details of splits, stock divi-
de nds, and rights offerings, along with their effects on the option terms, are always
published hy the option exchange that trades those options. Notices are sent to all
member firms, who then make that information available to their brokers for distribu-
tion to clients. In actual practice, the option strategist should ascertain from the
broker the specific terms of the new option series, in case the broker has overlooked
the information sent.
Example 1: XYZ is a $.SOstock with option striking prices of 4.5, .SO,and 60 for the Janu-
arr April, and July series. It declares a 2-for-l stock split. Usually, in a 2-for-l split situa-
tion, the number of outstanding option contracts is doubled and the striking prices are
haked. The owner of ,5 XYZ January 60 calls becomes the owner of 10 XYZ January :30
calls . Each call is still for 100 shares of the underlying stock.
After the split. XYZ has options with strikes of 22½, 2,5, and :30. In some cases, the
option exchange officials ma:· introduce another strike if they feel such a strike is neces-
sary; in this example , they might introduce a striking price of 20.
Example 2: U\'\ \' is trading at -1-0with strikes of .'1.5,40, and 4.5 for the January, April,
and Jul:· series. U\'\\' declart>s a .So/cstock cli\·idencl. The contractuall:' standardized 100
shares per contract is adjusted up to 10.S,and the striking prices are reduced by cliYicling
c>achh:· 1.05, roundt>d to the neart>st penny. Hence the 1ww strikes are :3:3.:3:1, :18.10,and
Chapter
1:Definitions 25
42.86, respectively. In aclclition, there will be a new base symbol assigned to these "non-
100 share" contracts: UVW1 (or UVW2, if UVWl is already in use).
After the split, the exchange usually opens for trading new strikes of 35, 40, and
45-each for 100 shares of the underlying stock. For a while, there are six striking prices
for UV\V options. As time passes, the fractional strikes are eliminated as they expire.
Since they are not reintroclucecl, they eventually disappear as long as UVW does not issue
further stock dividends.
Example 3: WWW Corp. (symbol WWW) is trading at $120 per share, with strike prices
of 110, 115, 120, 12,5, and 130. WWW declares a 3-for-l split. In this case, the strike
prices would be divided by 3 (and rounded to the nearest penny, becoming 36.67, 38.33,
40, 41.67, and 43.33); the number of contracts in every account would be tripled ; and each
option would still be an option on 100 shares of WWW stock. The general rule of thumb
is that when a split results in round lots (2-for-l, 3-for-l, 4-for-l, etc.), the number of
option contracts is increased and the strike price is decreased, and each option still rep-
resents 100 shares of the under lying stock.
Example 4: vVhen a split does not result in a round lot, a different adjustment must be
used for the options. Suppose that AAA Corp. (symbol: AAA) is trading at $60 per share
and declares a 3-for-2 split. In this case, each option's strike will be multiplied by
two-thirds (to reflect the ,3-for-2 split), hut the number of contracts held in an account
will remain the same and each option tcill he an option on 150 shares of AAA stock.
Suppose that there were strikes of ,5,5,60, and 65 preceding this split. After the split,
AAA common itself would be trading at $40 per share, reflecting the post-split 3-for-2
adjustment from its previous price of 60. There would be new options with strikes of
36.625, 40, and 43.37.5 (these had been the pre-split strikes of 5,5, 60, and 65).
Since each of these options would be for I.SOshares of the underlying stock, the
exchange creates a neu; option base synibol for these options, because they no longer
represent 100 shares of AAA common. Suppose the exchange says that the post-split,
150-share option contracts will henceforth use the option symbol AAAl.
After the split, the exchange will then list "normal" 100-share options on AAA,
perhaps with strike prices of 35, 40, and 45. This creates a situation that can sometimes
be confusing for traders and can lead to problems. There will actually be two options with
striking prices of 40-one for 100 shares and the other for 150 shares. Suppose the July
contract is being considered. The option with symbol AAA is a July 40 option on 100
shares of AAA Corp., while the option with symbol AAAl is a July 40 option on 1.50shares
of AAA Corp. Since option prices are quoted on a per-share basis, they icill have nearly
26 Part/:BasicProperties
al StockOptions
identical price quotes on any quote system (see item .5). If one is not careful, you might
trade the wrong one, thereby incurring a risk that you did not intend to take.
For example, suppose that you sell, as an opening transaction, the AAAl July 40 call
at a price of 3. Furthermore , suppose that you did not realize that you were selling the
150-share option; this was a mistake, but you don't yet realize it. A couple of days later,
you see that this option is now selling at 13-a loss of 10 points. You might think that you
had just lost $1,000, but upon examining your brokerage statement (or confirms, or day
trading sheet), you suddenly see that the loss is $1,,500 on that contract! Quite a differ-
ence, especially if multiple contracts are involved. This could come as a shock if you
thought you were hedged (perhaps you bought 100 shares of AAA common when you sold
this call), only to find out later that you didn't have a correctly hedged position in place
after all.
Even more severe problems can arise if this stock splits again during the life of this
option. Sometimes the options will be adjusted so that they represent a non-standard
number of shares, such as the 1.50-share options involved here; and after multiple splits,
the exchange may even apply a multiplier to the option, rather than adjusting its strike
price repeatedly. This type of thing wouldn't happen on the first stock split, but it might
occur on subsequent stock splits, spaced closely together over the life of an option. In such
a case, the dollar value of the option moves much faster than one would expect from look-
ing at a quote of the contract.
So you must be sure that you are trading the exact contract you intend to, and not
relying on the fact that the striking price is correct and the option price quote seems
to be in line. One must verify that the option being bought or sold is exactly the one
intended. In general, it is a good idea, after a split or similar adjustment, to establish open-
ing positions solely with the standard contracts and to leave the split-adjusted contracts
alone .
5. All options are quoted on a per-share basis, regardless of how many shares of stock the
option involves. Normally the quote assumes 100 shares of the underlying stock. Sup-
pose UVW had paid a .5% stock dividend, so that the options are for l0.5 shares each.
If the UVW April 38.10 is offered at a price of $3.00, it actually costs $315 ($3.00 x 105).
6. Changes in the price of the underlying stock can bring about neu; striking prices. As
a stock index, or ETF moves up and down, it can eventually outdistance the existing
striking prices. In that case , the exchange will list new ones. This can even be done
at the request of customers, at times . The idea is to have plenty of strikes to choose
from at all times. Sometimes, a stock will gap up or down so much that it is suddenly
trading in an area where no strikes exist at all. Often, the exchange will attempt to
get 11tw strikes listed immediately, but occasionally it takes until the next clay.
Chapter
1:Definitions 27
POSITION LIMIT AND EXERCISELIMIT
7. An im;,estor or a grouµ of investors cannot be long or short more than a set limit of
contracts i11one stock 011 the same side of the market. The actual limit varies accord-
ing to the trading activity in the underlying stock The most heavily tra<le<lstocks with
a large number of shares outstanding have position limits of 250,000 contracts.
Smaller stocks have position limits ranging from as low as ,5,000 contracts to 200,000
contracts, depending on liquidity. These limits can be expected to increase over time,
if stocks' capitalizations continue to increase. The exchange on which the option is
listed makes available a list of the position limits on each of its optionable stocks. So,
if one were long the limit of XYZ call options, he cannot at the same time be short
any XYZ put options. Long calls an<l short puts are on the same side of the market;
that is, both are bullish positions. Similarly, long puts and short calls are Loth on
the bearish side of the market. While these position limits generally exceed by
far any position that an individual investor normally attains, the limits apply to
"related " accounts. For instance, a money manager or investment advisor who is
managing many accounts cannot exceed the limit when all the accounts' positions are
combined.
8. The number of contracts that can be exercised in a µarticular period of time (usually
5 business days) is also limited to the same amount as the position limit. This exercise
limit prevents an investor or group from ·'cornering" a stock by repeatedly buying
calls one day and exercising them the next, day after day. Option exchanges set exact
limits, which are subject to change.
ORDER ENTRY
ORDER INFORMATION
Of the various types of orders, each specifies:
1. whether the transaction is a buy or sell,

2. the option to be bought or sold,
*
3. whether the trade is opening or closing a position,
4. whether the transaction is a spread (discussed later), and
5. the desired price.
of StockOptions
TYPESOF ORDERS
Many types of ordt-rs are acceptable for trading options, but not all are acceptable on all
exchanges that trade options. Since regulations change, information regarding which order
is valid for a given exchange is best supplied by the broker to the customer. The following
orders are acceptable on all option exchanges, but certain electronic trading platforms will
not take all typ es of order s:
Market Order. This is a simple order to buy or sell the option at the best possible price
as soon as the ord er gets to the exchange .
Market Not Held Order. This type of order can only be used in situations where pit
trading still exists-vvhere a physical broker is handling the order in a crowd; it is not apropos
to electronic trading. The customer who uses this type of order is giving the floor broker dis-
cretion in execnting the order. The floor broker is not held responsible for the final outcome.
For example, if a floor broker has a "market not held" order to buy, and he feels that the stock
will "downtick" (decline in price) or that there is a surplus of sellers in the crowd, he may often
hold off on the execution of the buy order, figuring that the price will decline shortly and that
the order can then be executed at a more favorable price. In essence, the customer is giving
the floor broker the right to use sollle judgment regarding the execution of the order. If the
floor broker has an opinion and that opinion is correct, the customer will probably receive a
better price than ifhe had used a regular lllarket order. If the broker's opinion is wrong, how-
ever, th e price of the execution may be worse th an a regular market order .
Limit Order. The limit order is an order to lmy or to sell at a specified price-the limit.
It may he executed at a better price than the limit-a lov-.'erone for buyers and a higher
one for sellers. Howe\·er, if the limit is 11e,·erreached, the order may never be executed.
In pit trading situations where a physical floor broker is handling the order some-
times a limit order may specif\· a discretionary margin for the floor broker. In other words,
the ordt'r ma:v read "Bu:· at .5 with clime discretion." This instruction enables the floor
broker to execute the order at ,S.10if ht' feels that tht' market will never reach ,5. Under
no circrnnstances, howt',·er, can the order be executed at a price higher than ,5.10.
Stop Order. Th is order is not always valid on all option exchanges . A stop ord er becomes
a market ordt'r when the sPcnrit:-.,trades at or through the pric e specified on the order.
Ruy stop orders are placed abo\'C'the current market price, ancl sell stop orders are entered
llt'lm\· tlic c111T('lltmarket price. Such orclt'rs art' 11seclto either limit loss or protect a profit.
For cxa1nplr, if a lioldt'r's option is sPlling for :3, a sell stop order for 2 is actiYated if the
Chapter
1:Definitions 29
market drops down below the 2 len'I, whereupon the floor broker would execute the order
as soon as possible. The customer, however, is not guaranteed that the trade will be
exactly at 2. It should be noted that some exchanges will consider a stop order for an
option to be elected (i.e., made li,·e) if the bid price of the option falls to the limit-not
necessaril>- the last sale of the option. This might mean that stop orders get elected in
illiquid rnarh,ts when the customer didn't really intend for it to. In general, one should be
cautious about using stop orders with illiquid options.
Stop-Limit Order. This order becomes a limit order when the specified price is
reached. \ Vhereas the stop order has to be executed as soon as the stop price is reached,
the stop-limit may or may not be filled, depending on market behavior. For example, sup-
pose the option is currently trading at 3, and one has a stop-limit order to sell at 2. The
market starts to drop, and trades at 2. Your stop-limit order becomes a limit order to sell
at 2. However, if the option ne,·er trades at 2, but continues on down-1.90, 1.8,S, 1.80
and so forth-you will not sell your option. It cannot be sold at a price less than 2.
Good-Until-Canceled Order. A limit, stop, or stop-limit order may be designated

"good until canceled." If the conditions for the order execution do not occur, the order
remains valid for 6 months without renewal by the customer.
Customers using an on-line broker will not be able to enter "market not held" orders,
and may not be able to use stop orders or good-until-canceled orders either, depending
on the brokerage firm.
PROFITS AND PROFIT GRAPHS
A visual presentation of the profit potential of any position is important to the over-all
understanding and evaluation of it. In option trading, the many multi-security positions
especially warrant strict analysis: stock versus options (as in covered or ratio writing) or
options versus options (as in spreads). Some strategists prefer a table listing the outcomes
of a particular strategy for the stock at various prices; otliers think the strategy is more
clearly demonstrated hy a graph. In the rest of the text, both a table and a graph will be
presented for each new strategy discussed.
Example: A customer wishes to evaluate the purchase of a call option. The potential profits
or losses of a purchase of an XYZ July .SOcall at 4 can he arrayed i11either a table or a graph
of outcomes at expiration. Both Table 1-,Sand Figure 1-.Sdepict the same information; the
graph is merely the line representing the colu111nmarked "Profit or I ,oss" in the table. The
of StockOptions
TABLE 1-5.
Potential profits and losses for an XYZ call purchase.
XYZ
Price
at CallPrice
at Profit
or
Expiration Expiration Loss
40 $ 0 -$ 400
45 0 400
50 0 400
55 5 + 100
60 10 + 600
70 20 + 1,600
FIGURE 1-5.
Graph of potential profits for an XYZ call purchase.
C
0
-~
·c..
X
w
al
<J)
<J)
0 $0
....J
0
e
CL
-$400
Stock Price at Expiration
\·ertical axis represents dollars of profit or loss, and the horizontal axis shows the stock price
at expiration. In this case, the dollars of profit and the stock price are at the expiration date.
Often. the strategist wants to determine what the potential profits and losses will be before
expiration, rather than at the expiration date itself. Tables and graphs lend themselves well
to the necessary analysis, as will be seen in detail in various places later on.
In 1Jrnctice. such an example is too simple to require a table or a graph-certainly

not both-to e\·alnate the potential profits and losses of a simple call purchase held to
t>xpiration. Howe\·er. as more complex strategies are discussed, these tools become ever
n1c>rt>11seful for quick!~· determining such things as when a position makes money and
when it loses, or how fast one's risk increases at certain stock prices.
Call Option
Strategies
J..__ ______________ __J

INTRODUCTION
The an"ragt' person de,din~ in option tradin~ 11tili1es prirn,1ri l: - L)llt' L)f hrn uptil )ll
stratt'~it's-call ln1:-i11~or cm t'rt'd c·,dl \\Titing. These stL1kgies ,lrt' . ,lt face\ ;1]11e.simplt'.
and tlit': arc tlit'rt>fort' tht' ones n1ost ofkn tried. There ,lrt' m,rn: lllL)rt' stLlk~ies im L)h-
ing tilt' 11st' of c·,111
options. lllall: of\\ hil'h \Yill bt' dt'Scriht>d btt>r in this L1rt. HL)\\t'\ t'r.
Chapters 2 and 3 deal with the fundamental call option strategies.
Both cm t'1nl call \n itin~ and call hu: -i11g ,1re rt>lati\ el:- simple stLlk~it's. hit. like
,lll: iml':-.tlllt'llL tht>: can ht> t>mplo:-t'd \\ith differin~ lc\t'b Li skill ,rnd l'l)lllplt''\it:. Tlit'
d iscussions to follm\ lwgin b: dt>scrihing tllt' basics of e,1d1 str,1kg\ ,md then diSL'llSSt';ll·h
in depth.
Covered Call Writing
Covered call 1criti11gis the name given to the strategy by which one sells a call option while
simultaneously owning the obligated number of shares of underlying stock. The writer
shou ld be mildly bullish, or at least neutral, toward the underlying stock. By writing a call
option against stock, one always decreases the risk of owning the stock. It may even be pos-
sible to profit from a covered write if the stock declines somewhat. However, the covered
call writer does limit his profit potential and therefore may not fully participate in a strong
upward move in the price of the underlying stock. Use of this strategy is becoming so com-
mon that the strategist must understand it thoroughly. It is therefore discussed at length.
THE IMPORTANCE OF COVERED CALL WRITING
COVERED CALL WRITING FOR DOWNSIDE PROTECTION
Example: An investor owns 100 shares of XYZ c01m11onstock which is currently selling
at $48 per share. If this investor sells an XYZ July .50 call option while still holding his
stock, he establishes a covered write. Suppose the investor receives $.300 from the sale of
the July ,50 call. If XYZ is below .50 at July expiration, the call option that was sold expires
worthless and the investor earns the $:100 that he originally· received for writing the call.
Thus, he receives $.300, or :3points, of downside protection. That is, he can afford to have
the XYZ stock drop by :3points and still break even on the total transaction. At that time
he can write another call option if he so desires.
Note that if the umk,rlying stock should fall by lllore than :3points, there will he a loss
on the overall position. Tlllls, tl1c risk i11tlw covered 1criti11gstmtcgy 111rtfcri(lli::..cs {{ tlze
stock falls hy (I distmu'(' greater tlw11the call 07JtionJJre111i11111
f/l({t 1rns origi1l({ll!Jtakrn i11.
33
34 PartII:CallOptionStrategies
THE BENEFITS OF AN INCREASE IN STOCK PRICE
If XYZ increases in price moderately, the trader may be able to have the best of both
worlds.
Example: If XYZ is at or just below 50 at July expiration, the call still expires worthless,
and the investor makes the $300 from the option in addition to having a small profit from
his stock purchase . Again, he still owns the stock.
Should XYZ increase in price by expiration to levels above 50, the covered writer has
a choice of alternatives. As one alternative, he could do nothing, in which case the option
would be assigned and his stock would be called away at the striking price of ,50. In that
case, his profits would be equal to the $300 received from selling the call plus the profit on
the increase of his stock from the purchase price of 48 to the sale price of 50. In this case,
however, he would no longer own the stock. If as another alternative he desires to retain
his stock ownership, he can elect to buy back (or cover) the written call in the open market.
This decision might involve taking a loss on the option part of the covered writing transac-
tion, but he would have a correspondingly larger profit, albeit unrealized, from his stock
purchase. Using some specific numbers, one can see how this second alternative works out.
Example: XYZ rises to a price of 60 by July expiration. The call option then sells near its
intrinsic \'alue of 10, If the investor covers the call at 10, he loses $700 on the option por-
tion of his covered write. (Recall that he originally received $:300 from the sale of the
option, and now he is buying it back for $1,000.) However, he relieves the obligation to sell
his stock at .50 (the striking price) by buying back the call, so he has an unrealized gain of
12 points in the stock, which was purchased at 48. His total profit, including both realized
and unrealized gains , is $500.
This profit is exactly the same as he would have made if he had let his stock be called
from him. If called, he would keep the $300 from the sale of the call, and he would make
2 points ($200) from buying the stock at 48 and selling it, via exercise, at .50. This profit,
again, is a total of $500. The major difference between the two cases is that the investor
no longer owns his stock after letting it be called away, whereas he retains stock ownership
if he buys back the written call. \\'hich of the two alternatives is the better one in a given
situation is not always clear .
:\o lllatter how high the stock climbs in price, the profit from a covered write is
Ii rnitecl because the writer has ohligated himself to sell stock at the striking price. The
con"red writer still profits when the stock climbs, but possibly not hy as much as he might
lian_, had he not written tltt> call. On the other hand, he is receiving $300 of immediate
Chapter
2: CoveredCallWriting 35
cash inflow, because the writer may take the premium immediat ely and do with it as he
pleas es. That income can represent a substantial increase in the income currently pro-
vided by the dividends on the underlying stock, or it can act to offset part of the loss in
case the stock decline s.
For readers who prefer formulae, the profit potential and break-even point of a cov-
ered write can be summarized as follows:
Maximum profit potential= Strike price - Stock price+ Call price

Downside break-even point = Stock price - Call price
QUANTIFICATION OF THE COVERED WRITE
Table 2-1 and Figure 2-1 depict the profit graph for the example involving the XYZ cov-
ered write of the July 50 call. The table makes the assumption that the call is bought back
at parity. If the stock is called away the same total profit of $.500 results; but the price
involved on the stock sale is always 50, and the option profit is always $300.
Several conclusions can be drawn. The break-even point is 45 (zero total profit) with
risk below 45; the maximum profit attainable is $500 if the position is held until expira-
tion; and the profit if the stock price is unchanged is $300, that is, the covered writer
makes $300 even if his stock goes absolutel y nowhere.
The profit graph for a covered write always has the shape shown in Figure 2-1. Note
that the maximum profit always occurs at all stock prices equal to or greater than the
striking price, if the position is held until expiration. However, there is downside risk. If
the stock declines in price by too great an amount, the option premium cannot possibly
compensate for the entire loss. Downside protective strategies, which are discussed later,
attempt to deal with the limitation of this downside risk.
TABLE 2-1.
The XYZ July SO call.
XYZPrice Stock July50Coll Coll Total
atExpiration Profit ofExpiration Profit Profit
40 -$ 800 0 +$300 -$500
45 - 300 0 + 300 0
48 0 0 + 300 + 300
50 + 200 0 + 300 + 500
55 + 700 5 - 200 + 500
60 + 1,200 10 - 700 + 500
FIGURE 2-1.
XYZ covered write.
C +$500
0
~
·o..
X
w Maximum Profit Range
cil
(/)
(/) $0
0
.....J 50 55 60
0
t
ct "' Downside Risk
COVERED WRITING PHILOSOPHY
The primar_v objective of covered writing, for most investors, is increased income through
stock ownership. An ever-increasing number of private and institutional investors are
writing call options against the stocks that they own. The facts that the option premium
acts as a partial compensation for a decline in price by the underlying stock and that the
premium represents an increase in income to the stockholder, are evident. The strategy
of 01rni11gthe stock and 1criti11gthe call icill outperform outright stock oicnership if the
stock falls, rc111ai11s tlie sarne, or ec.en rises sliglztl!).In fact, the only time that the outright
0\\'11erof the stock will outperform a cm·ered writer is if the stock increases in price by a
relatively substantial amount during the life of the call. Moreover, if one consistently
wntes call options against Ins stock lzis JJOr~folio1czll slime less utriahility of results
fro111quarter to (flWrtc,~ The total position-long stock and short option-has less
rnlatilit: · than the stock alone, so on a quarter-by-quarter basis, results will be closer to
m·erage than they would he with normal stock ownership. This is an attractive feature,
especially for portfolio managers.
I lowen_,r. one should not assnrne that cm·erecl writing will outperform stock owner-
ship. Stocks sonwtinws tend to make most of tlwir gains in large spurts. A covered writer
\\'ill not participate in rnm·es such as that. The long-term gains that are quoted for holding
stocks inclll(lc periods of large _gainsand sometimes periods of large losses as well. The
cm·en·d \\Titer will not participate in the largest of those gains, since his profit potential
is limited.
Chapter
PHYSICAL LOCATION OF THE STOCK
Before getting more im·okecl in the details of covered writing strategy, it may be useful
to re\·iew exactl:· what stock holdings may be written against. Recall that this discussion
applies to listed options. If one has deposited stock with his broker in either a cash or a
margin account, he may write an option for each 100 shares that he owns without any
additional requirement H owever, it is possible to write covered options without actu ally
depositing stock with a brokerage firm. There are several ways in which to do this, all
invoking the deposit of stock with a bank.
Once the stock is deposited with the bank, the investor may have th e hank issue an
escrow receipt or letter of guarantee to the brokerage firm at which the investor does his
option business . The bank must be an ·'approved" bank in order for the brokerage firm to
accept a letter of g1wra11tee,and not all firms accept letters of guarantee. These items cost
money, and as a new receipt or letter is required for each new option written, the costs
may become prohibitive to the customer if only 100 or 200 shares of stock are involved.
There is another alternative open to the customer who wishes to write options with-
out depositing his stock at the brokerage firm. He may deposit his stock with a bank that
is a member of the Depository Trust Corporation (DTC). The DTC guarantees the
Options Clearing Corporation that it will, in fact, deliver stock should an assignment
notice be given to the call writer. This is the most convenient method for the investor to
use, and is the one used by most of the institutional covered writing investors. There is
usually no additional charge for this service by the bank to institutional accounts. How-
ever, since only a limited number of banks are members of DTC, and these banks are
generally the larger hanks located in metropolitan centers, it may be somev,,hat difficult
for many individual investors to take advantage of the DTC opportunity.
TYPES OF COVERED WRITES
While all covered writes involve selling a call against stock that is owned, different terms
are used to describe various categories of covered writing. The two broadest terms, under
which all covered writes can be classified, are the out-of-thc-111011eycocered tcrite and
the in-the-rnoney cocered 1crite. These refer, obviously, to whether the option itself was
in-the-money or out-of-the-money when the write was first estahlished. Sometimes one
may see covered writes classified by the nature of the stock involved (low-priced covered
write, high-yield covered write, etc.), but these are only subcases of the two broad
categories.
In general, out-of-the-money covered writes offer higher potential rewards hut have
less risk protection than <loin-the-money covered writes. One can establish an aggressive
or defensive covered writing position, depending 011 how f~tr t lie call option is in- or
out-of-the-money when the write is established. In-the-money writes are more defensive
covered writing positions .
Some examples may help to illustrate how one covered write can be considernbly
more conservative , from a strategy viewpoint , than another.
Example: XYZ common stock is selling at 45 and two options are being considered
for writing: an XYZ July 40 selling for 8, and an XYZ July 50 selling for l. Table 2-2
depicts the profitability of utilizing the July 40 or the July 50 for the covered writing.
The in-the-money covered write of the July 40 affords 8 points, or nearly 18% protection
down to price of 37 (the break-even point) at expiration. The out-of-the-money covered
write of the July 50 offers only 1 point of downside protection at exp iration. Hence,
the in-the-nwney cocered u;rite offers greater downside protection than does the
out-of-the-money cocered u;rite. This statement is true in general-not merely for this
example .
In the balance of the financial world, it is normally true that investment positions
offering less risk also have lower reward potential. The covered writing example just given
is no exception. The in-the-money covered write of the July 40 has a maximum potential
profit of $300 at any point above 40 at the time of expiration. However, the out-of-the-money
covered write of the July 50 has a maximum potential profit of $600 at any point above
50 at expiration. Tlte maximum potential profit of an out-of-the-money cocered u;rite is
generally greater than that of an in-the-money write.
To make a true comparison between the two covered writes, one must look at what
happens with the stock between 40 and 50 at expiration. The in-the-money write attains
TABLE 2-2.
Profit or loss of the July 40 and July SO calls.
In-the-Money
Write Out-of-the-Money
Write
ofJuly40 ofJuly50
Stock
at Total Stock
at Total
ExpirationProfit Expiration Profit
35 -$200 35 -$900
37 0 40 - 400
40 + 300 44 0
45 + 300 45 + 100
50 + 300 50 + 600
60 + 300 60 + 600
Chapter
its maximum profit anywhere within that range. Even a .5-point decline by the underlying
stock at expiration would still leave the in-the-money writer with his maximum profit.
However, reali:::..ingthe maxi11wm prc~fitpotential with an out-of the-money cocered u;rite
alu:ays requires a rise in price by the underlying stock. This further illustrates the more
conservative nature of the in-the-money write. It should be noted that in-the-money
writes, although having a smaller profit potential, can still be attractive on a percentage
return basis , especia lly if the write is done in a margin account.
One can construct a more aggressive position by writing an out-of-the-money call.
One's outlook for the underlying stock should be bullish in that case. If one is neutral or
moderately bearish on the stock, an in-the-money covered write is more appropriate. If
one is truly bearish on a stock he owns, he should sell the stock instead of establishing a
covered write.
THE TOTAL RETURN CONCEPT

OF COVERED WRI TIN G
Wh en one writes an out-of-the-money option, the overall position tends to reflect more of
the result of the stock price movement and less of the benefits of writing the call. Since
the premium on an out-of-the-money call is relatively small, the total position will be
quite susceptible to loss if the stock declines. If the stock rises, the position will make
money regardless of the result in the option at expiration. On the other hand, an
in-the-money write is more of a "total" position-taking advantage of the benefit of the
relatively large option premium. If the stock declines, the position can still make a profit;
in fact, it can even make the maximum profit. Of course, an in-the-money write will also
make money if the stock rises in price, but the profit is not generally as great in percent-
age terms as is that of an out-of-the-money write.
Those who believe in the total return concept of covered u;riting consider both
downside protection and maximum potential return as important factors and are willing
to have the stock called away, if necessary, to meet their objectives. When premiums are
moderate or small, only in-th e-money writes satisfy the total return philosophy.
Some covered writers prefer never to lose their stock through exercise, and as a
resu lt will often write options quite far out-of-the-money to minimize the chances of
being called by expiration. These writers receive little downside protection and, to make
money, must depend almost entirely on the results of the stock itself. Such a philosophy is
more like being a stockholder and trading options against one's stock position than actu-
ally operating a covered writing strategy. In fact, some covered writers will attempt to lmy
back written options for quick profits if such profits materialize during the life of the
covered write. This, too, is a stock ownership philosophy, not a covered writing strateg~'-
The total return concept represents the true strategy in covered writing, whereby one
views the entire position as a single entity and is not predominantly concerned with the
results of his stock ownership.
THE CONSERVATIVECOVERED WRITE
Covered writing is genera lly accepted to be a conservative strategy. This is because the
covered writer always has less risk than a stockholder, provided that he holds the covered
write until expiration of the written call. If the underlying stock declines, the covered writer
will always offset part of his loss h:vthe amount of the option premium received, no matter
how small.
As was demonstrated in pre\·ious sections, however, some covered writes are clearly
more conservative than others. Not all option writers agree on what is meant by a conser-
rntin' con"recl write. Some believe that it involves writing an option (probably
out-of~the-money) on a conservative stock, generally one with high yield and low volatility.
It is true that the stock itself in such a position is conservative, but the position is more
aptly tt'rmed a cucercd 1crite 011 a consercatice stuck. This is distinctly different from a
conservative covered write.
A true conscn./atice couered 1critc is one in which the total position is conservative-
offering reduced risk and a goocl probability of making a profit. An in-the -money write,
e\·en on a stock that itse lf is not conservative, can become a conservative total position
when the option itself is properly chosen. Clearly, an investor cannot write calls that are
too deeply in-the-money. If he did, he would get large amounts of downside protection,
hut his returns would he severely limited. If all that one desired was maximum protection
of his mone:· at a nominal rate of profit, he could leave the money in a hank. Instead, the
consen·ati\·e cm·erecl writer stri\·es to make a potentially acceptable return while still
receiving an above-average amount of protection.
Example: Again assume XYZ common stock is selling at 4,5 and an XYZ July 40 call is
selling at 8. A covered write of the XYZ July 40 would require, in a cash account, an
im-estment of 8:3,700-$4,,500 to purchase 100 shares of XYZ, less the $800 received in
option premimus. The write has a maximum profit potential of $:300. The potential return
from this position is therefore $:300/%:3,700,just over 8% for the period during which the
\Hite must he held. Since it is most likely that the option has 9 months of life or less, this
rdurn \H)llkl lw well in excess of lOSlcon a per annum basis. If the write were clone in a
margin account , the return would be considerably higher.
Note that we ha\e ignored di\·iclen<ls paicl hy the underlying stock ancl commission
cl1ar~('S,factors that are clisc11ssedin detail in the next section. Also, one should be aware
that if lie is looking at an r11111110/i:::,cd
return from a covered write, there is no guarantee
Chapter
that such a return could actuallv be obtained. All that is ct'rtain is that the writer eould
make 8% in 9 months. Thert' is no guarantt'e that 9 months from now, wllt'n the call
expires, there will l)t' an equi,·alt'nt position to Pstablish that will extend the same return
for tht' remainder of tilt' annualization period. Annual returns should he used only for
comparative purposes between covered writes.
Tht' writer has a position that has an anmrnlizt'cl return (for comparative purposes)
of over 107c and 8 points of downside protection. Thus, the total position is an inVt'stment
that will not lose money unless XYZ common stock falls hvmore than 8 points, or about
18%; and is an im·estrnent that eould return the equivalent of 10% annually should XYZ
common stock rist', remain tht' same, or fall by .5points (to 40). This is a conservative posi-
tion. Even if XYZ itself is not a comen-ativt' stock, the action of writing this option has
made the total position a conservative one. The only factor that might detract from the
conservative natnrt' of the total position would be if XYZ were so volatile that it could
easily fall more than 8 points in 9 months.
In a strategic sense, the total position described above is better and more conserva-
tive than one in which a writer buys a conservative stock-yielding perhaps 6 or 7%-and
,vrites an out-of-the-money call for a minimal premium. If this conservative stock were to
fall in price, the writer would be in danger of being in a loss situation, because here the
option is not providing anything more than the most minimal downside protection. As
was described earlier, a high-yielding, low-rnlatilitv stock will not have much time pre-
mium in its in-the-mont'y options, so that one cannot t'ffectively establish an in-the-money
write on such a "conservative" stock
COMPUTING RETURNON INVESTMENT
Now that the reader has some gt'neral feeling for covered call writing, it is time to discms the
specifics of computing return on investment. One should always know exactly what his
potential returns are, mcluding all costs, when he establishes a covered writing position.
Commission rates are highly variable, depending on whether one uses a discount, electronic
broker or not. In the examples that follow, it will be arbitrarily assumed that commissions are
.3 cents per share for stock and $.5 for an option contract. Individuals should use their own
commission rates when actually caleulating returns. Once the procedure for computing
rt'turns is elt'ar, one can more logically decide ,,vhich covered writes are the most attractivt'.
There are three hasie elements of a covered write that should be computed l)t'fore
entering into tlw posi tion. The first is the return {[exe rcised. This is the return 011 irn't'St-
ment that one would achit've if tht' stock were callt'd awav. For an out-of-the-monev . cov-
t'red write, it is necessary for the stock to rise in prict' in order lc>rthe return if cwrciscd
to be achieved. However, for an in-the-money covered write, the return if exercised would
be attained even if the stock were unchanged in price at option expiration. Thus, it is often
advantageous to compute the return if unchanged-that is, the return that wou ld be real-
ized if the underlying stock were unchanged when the option expired. One can more fairly
compare out-of-the -money and in-the -money covered writes by using the return if
unchanged, since no assumption is made concerning stock price movement. The third
importa nt stati stic that t he covered writ er sho uld consid er is the exact downside
break-e-i;en point after all costs are included. Once this downside break-even point is
known, one can readily compute the percentage of downside protection that he would
recei ve from selling th e call.
Example 1: An investor is considering the following covered write of a 6-month call: Buy
500 XYZ common at 43, sell 5 XYZ July 45 calls at 3. One must first compute the net
investment required (Table 2-3). In a cash account, this investment consists of paying for
the stock in full, less the net proceeds from the sale of the options. Note that this net
im·estment figure includes all commissions necessary to establish the position. (The com-
missions used here are approximations, as they vary from firm to firm.) Of course, if the
i1ffestor withdraws the option premium, as he is free to do, his net investment will consist
of the stock cost plus commissions. Once the necessary investment is known, the writer
can compute the return if exercised. Table 2-4 illustrates the computation. One first com-
putes the profit if exercised and then divides that quantity by the net investment to obtain
the return if exercised. Note that dividends are included in this computation; it is assumed
that XYZ stock will pay $.500 in dividends on the 500 shares during the life of the call.
Moreover, all commissions are included as well-the net investment includes the original
stock purchase and option sale commissions, and the stock sale commission is explicitly
listed.
For the return computed here to be realized, XYZ stock would have to rise in price
from its current price of 43 to any price above 45 by expiration. As noted earlier, it may
be more useful to know what return could be made by the writer if the stock did not move
anywhere at all. Table 2-5 illustrates the method of computing the return if unchanged-
also called the static return and sometimes incorrecthJ referred to as the "expected
return." Again, one first calculates the profit and then calculates the return by dividing
the profit by the net investment. An important point should be made here: There is no
stock sale commission included in Table 2-5. This is the most common way of calculating
the return if unchanged; it is clone this way because in a majority of cases, one would
continue to hold the stock if it were unchanged and would write another call option
against the same stock. Rec all again, though, that if the u;ritten call is i11-thP-1r1011ey,the
return {fu11chongcclis the sa 111cas the return {f exercised. Stock sale commissions must
therefore be inclu ded in that case.
Chapter
TABLE 2-3.
Net investment required-cash account.
Stock cost (500 shares at 43) $21,500
Plus stock purchase commissions + 15
Lessoption premiums received 1,500
Plus option sale commissions + 25
Net cash investment $20,040
TABLE 2-4.
Return if exercised-cash account.
Stock sale proceeds (500 shares at 45) $22,500
Lessstock sale commissions 15
Plus dividends earned until expiration + 500
Less net investment - 20,040
Net profit if exercised $ 2,945
2 945
Return if exercised = $ , 14.7%
$20,040
TABLE 2-S.
Return if unchanged-cash account.
Unchanged stock value (500 shares at 43) $21,500
Plus dividends + 500
Less net investment 20,040
Profit if unchanged $ 1,960
Return ·f
I unc hange d l ' 960 = 9. 8 °
= $$201040 1
1,0
Once the necessary returns have been computed and the writer has a feeling for how
much money he could make in the covered write, he next computes the exact doic11side
hrenk-euell point to determine what kind of dmrnsid(J protection the written call provides
(Table 2-6). The total return COIH.:eptof covered writing necessitates \·iewing both poten-
tial income and downside protection as important critt>ria for st>lecting a writing position.
If the stock were held to expiration and the $.500 in dividends rt'cei,·ed, the writer would
break even at a price of :39.08. Again, a stock sale commission is not generally included in
ti)(' break-even point co111p11tation,hecal!Se tlic written call wonk! expire totally worth less
TABLE 2-6.
Downside break-even point-cash account.
Net investment $20,040
Less dividends 500
Total stock cost to expiration $19,540
Divide by shares held 500
Break-even price 39.08
and the writer rnight then write another call on the same stock. Later, we discuss the
subject of continuing to write against stocks already owned. It will be seen that in many
cases. it is advantageous to co11tinue to hold a stock and write against it again, rather than
to sell it and establish a covered writ e in a new stock.
Ne\t, we translate the break-even price into pcrant dotcnside protection (Table 2-7),
which is a conn:'11ientway of compari11g the levels of downside protection among variously
pri ced stocks. We will see later that it is actually better to compare the downside protection
with the w!atility of the underlym g stoc It ma kes no sense to quot e perc ent protection
without knowing the rnlatility of the underlying stock. For example, 10% protection on
AT&T is quite a bit more protection than the same percentage on a much more volatile
stock, like Google. sa_\·,because Google is much more volatile than AT&T. The formula for
cornputing protection in terms of \·olatility is in Chapter 28 (Mathematical Applications).
Before n1m ing 011 to discuss what kinds of returns one should attempt to strive for
in which situations , the same example will be worked through again for a covered write
in a rnargin account. The use of margin will provide higher potential returns, since the
net im·estnwnt will he smaller. Howe\·er, the margin interest charge incurred on the debit
balance (the amount of money borrowed from the brokerage firm) will cause the
hreak-ew'11 point to he higher, thus slightly reducing the amount of downside protection
m·ailahle from writing the call. Again, all commissions to establish the position are
included in the ne t investment com put ation.
TABLE 2-7
Percent downside protection-cash account.
Initial stoc k price 43
Less break-even price - 39.08
Points of protection 3.92
Divide by original stock price + 43
Equals percent downside pro tectio n 9.1%
Chapter
Example 2: Recall that the net investment for the cash write was $20,040. A margin cov-
ered write requires less than half of the investment of a cash write when the margin rate
(set b_,,the Federal Resen-e) is ,50o/c.In a margin account, if one desires to remove the
premium from tht' account, he may do so immt'diately provided that he has enough resen·e
equit~· in the account to cover the purchase of the stock. If he does so, his net investment
would be equal to the debit balance calculation shown on the right in Table 2-8.
TABLE 2-8.
Net investment required-margin account.
Stock cost $21,500
Plusstockcommissions + 15 Debit balance calculation:
Net stockcost $21,515 Net stockcost $21,515
Timesmargin rate X 50% Lessequity - 10,758
Equityrequired $10,758 Debit balance $10,757
Lesspremiumsreceived - 1,500 (at 50% margin)
Plusoption commissions + 25
Net margin investment $ 9,283
Tables 2-9 to 2-12 illustrate the computation of returns from writing on margin. If
one has already computed the cash returns, he can use method 2 most easily. Metho<l l
involves no prior profit calculations.
TABLE 2-9.
Return if exercised-margin account.
Method
l Method
2
Stock sale proceeds $22,500 Net profit if exercised-cash $2,945
Lessstock commission 15 Lessmargin interest charges 538
Plus dividends + 500 Net profit if exercised- $2,407
Less margin interest charges margin
(10% on $10,758 for 6 months) - 538
Lessdebit balance - 10,757
Less net margin investment - 9,283
Net profit-margin $ 2,407
Return if exercised = $ 214 o7 = 25 . 9 %

$9,283
TABLE 2-10.
Return if unchanged-margin account.
Method
l Method
2
Unchanged stock value (500 $21,500 Profit if unchanged-cash $1,960
shares at 43) Less margin interest charges 538
Plus dividends Net profit if unchanged- $1,422
+ 500 margin
Lessmargin interest charges
(10% on $10,910 debit for
6 months) 538
Lessdebit balance - 10,757
Lessnet investment (margin) - 9,283
Net profit if unchanged- $ 1,422
margin
11422
Return if unchanged = $ 15.3%
$9,283
TABLE 2-11.
Break-even point-margin write.
Net margin investment $ 9,283
Plus debit balance + 10,757
Lessdividends 500
Plus margin interest charges + 538
Total stock cost to expiration $20,078
Divide by shares held __,__ 500
Break-even point-margin 40.16
Tilt' rt--'tllrn if t':wrcisecl is 2.5.6o/cfor tht' cm·t'recl write using rnargin. In Example 1
tlw rdmn if t'\Crcist'cl for a cash write was computt'cl as 14.717c. Thus, tht' return if t'\er-
cisccl fron1 a 1nan.!)n\\Titc is crn1siderahl~, higher. In fact, unless a fairly deep i11-tht'-rnoney
write is being considered, the return on margin will always he higher than the re turn
frrnn ca,;!1.Tlw farther 011t-of~tlw-rn01w~,that the written call is, the bigger the clislTt'p-
ancy between cash and margin returns will be when t he return if exercised is
computed.
Chapter
TABLE 2-12.
Percent downside protection-margin write.1
Initial stock price 43
Less break-even price-margin - 40.16
Points of protection 2.84
Divide by original stock price +43
Equals percent downside protection-margin 6.6%
As with the computation for return if exercised for a write on margin, the return if
unchanged calculation is similar for cash and margin also. The only difference is the sub-
traction of the margin interest charges from the profit. The return if unchanged is also
higher for a margin write, provided that there is enough option premium to compensate
for the margin interest charges. The return if unchanged in the cash example was 9.8%
versus 15.3% for the margin write. In general, the father from the strike in either
direction-out-of-the-mone) or in-the-money-the less the return if unchanged on mar-
gin will exceed the cash return if unchanged. In fact, for deeply out-of-the-money or
deeply in-the-money calls, the return if unchanged will be higher on cash than on margin.
Table 2-11 shows that the break-even point on margin, 40.16, is higher than the break-even
point from a cash write, :39.08,because of the margin interest charges. Again, the percent
downside protection can he computed as shown in Table 2-12. Obviously, since the
break-even point on margin is higher than that on cash, there is less percent downside
protection in a margin covered write.
One other point should be made regarding a covered write on margin: The broker-
age firm will loan you only half of tlze strike price amount as a maximum. Thus, it is not
possible, for example, to buy a stock at 20, sell a deeply in-the-money call struck at 10
points, and trade for free. In that case, the brokerage firm would loan you only 5-half
the amount of the strike.
Even so, it is still possible to create a covered call write on margin that has little or
even ::.cro margin requirement. For example, suppose a stock is selling at :38 and that a
long-term LEAPS option struck at 40 is selling for 19. Then the margin requirement is
zero! This does not mean you're getting something for free, however. True, your invest-
ment is zero, but your risk is still 19 points. Also, your broker would ask for some sort of
minimnm margin to begin with and would of course ask for maintenance margin if the
nnderlying stock should fall in price. Moreover, you would be paying margin interest
all during the life of this long-term LEAPS option position. Lev erage can be a good
thing or a hacl thing, and this strategy has a great deal of lewrage. So he careful if yon
utilize it.
COMPOUND INTEREST
The astute reader will have noticed that our computations of margin interest have been
owrly simplistic; the compounding effect of interest rates has been ignored. That is, since
interest charges are normally applied to an account monthly, the investor will be paying
interest in the later stages of a covered writing position not only on the original debit, but on
all previous monthly interest charges. This effect is described in detail in a later chapter on
arbitrage techniques. Briefly stated , rather than computing the interest charge as the debit
times the interest rate multiplied by the time to expiration, one should technically use:
Margin interest charges= De bit [(1 + r)1 - l]
where r is the interest rate per month and t the number of months to expiration. (It would
be incorrect to use days to expiration, since brokerage firms compute interest monthly,
not daily.)
In Example 2 of the preceding section, the debit was $10,7.57,the time was 6 months,
an<l the annual interest rate was 10%. Using this more complex formula, the margin inter-
est charges would be $.549, as opposed to the $.5.38charge computed with the simpler
formu la. Thus , th e difference is usually small, in terms of percentage, and it is therefore
cu11ww 11practice to use the simpler method.
SIZE OF THE POSITION
If one is trading at a firm that does not have a minimum fixed commission cost (i.e., where
the per-share cost is the same , no matter how few shares are bought), then the number of
shares in th e covere d writ e is irrelevant to the return s. However, most brokers charge a
minimum commission , even the deep-discount electronic one s. Furth ermore a full ser-
vice broker often charges a lower per-share commission rate for larger trades (and, by
inferen ce, a h igher p er-share commis sion rate for small er trad es).
Th e cm ·erecl writer should keep this in mind, for a lower per-share commission cost
results in higher returns, of course. Even traders using deep discount brokers should make
ct>rtain that they are establishing the covered write with enough shares so that the bro-
ker's minimum commission charge is exceeded. Buying too few shares for covered writing
pmposes can lower returns considerably , if the minimum commission charge comes into
play.
WHAT A DIFFERENCE A DIME MAKES
Another aspt>ct of covered writing that can be important as far as potential returns are
conc( 'nwd is, of (·omst', the prict's of the stock and option im·oh-ed in the w rite. It may
Chapter
seem insignificant that one has to pa)· an extra few cents for the stock or possibly receives
a dime or 20 cents less for the call, but e\·en a relatively small fraction can alter the poten-
tial returns hy a surprising amount. This is especially true for in-the-money writes.
although any write will he affected. Let us use the previous ,500-share covered writing
example, again including all costs.
As before. the results are more dramatic for the margin write than for the cash write.
In neither case does the break-even point change hy much. However. the potential returns
are altered significant!)·· Notice that if one pays an extra clime for the stock and receives a
dime less for the call-the far right-hand column in Table 2.13-he may greatly negate the
effect of writing against a large number of shares. From Table 2.13, one can see that writting
against :300 shares at those prices (43 for the stock and 3 for the call) is approximately the same
return as writing against .500 shares if the stock costs 43.10 and the option brings in 2.90.
Table 2.13 should clearly demonstrate that entering a covered writing order at th e
market may not be a prudent thing to do, especially if one's calculations for the potential
returns are hased on last sales or on closing prices in the newspaper. In the next section,
we discuss in depth the proper procedure for entering a covered writing order.
TABLE 2.13.
Effect of stock and option prices on writing returns.
BuyStock
at43 BuyStock
at 43.10 BuyStock
at 43.10
SellCallat 3 SellCallat 3 SellCallat 2.90
Return if exercised 14.7% cash 14.4% cash 14.1% cash
25.9% margin 25.3% margin 24.6% margin
Return if unchanged 9.8% cash 9.8% cash 9.5% cash
15.3% margin 15.3% margin 14.7% margin
Break-even point 39.08 cash 39.18 cash 39.28 cash
40.16 margin 40.26 margin 40.36 margin
EXECUTION OF THE COVERED WRITE ORDER
When establishing a covered writing position, the question often arises: Which should be
done first-huy the stock or sell the option? The correct answer is t hat neither should
be done first! In fact, a simultaneous transaction of buying the stock a11dselling the
option is the only way of assuring that hath sides of the col."icred1crite are cstahlislicd at
d esired price /er;els.
If one "legs" into the position-that is. buys the stock first and then attempts to sell
the option. or vice versa-he is subjecting himself to a risk.
Example: An investor wants to buy XYZ at 43 and sell the July 4.S call at 3. If he first sells
the option at 3 ancl then tries to buy the stock, he may fincl that he has to pay more than
43 for the stock. On the other hand, if he tries to buy the stock first and then sell the
option, he may find that the option price has moved down. In either case the writer will
be accepting a lower return on his covered write. Table 2.13 demonstrated how one's
returns might be affected if he has to give up a dime by "legging" into the position.
ESTABLISHING A NET POSITION
What the covered writer really wants to do is ensure that his net price is obtained. If he
wants to buy stock at 4,3 and sell an option at 3, he is attempting to establish the position
at 40 net. He normally would not mind paying 43.10 for the stock if he can sell the call at
3.10, thereby still obtaining 40 net.
A "net" cm;ered u;riti11gorder must be placed either directly with a brokerage firm's
option desk or through the "spread order entry," if dealing with an online broker. If you
are planning on doing a lot of covered writing, make sure your brokerage firm offers the
placement of "net" orders-either online or directly through an order desk. This is also
referred to as a contingent order. Most major brokerage firms offer this service to their
clients, although some place a minimum number of shares on the order. That is, one must
write against at least .500 or 1,000 shares in order to avail himself of the service. There
are, however, brokerage firms that will take net orders even for 100-share covered writes.
Since the chances of giving away a dime are relatively great if one attempts to execute his
own order by placing separate orders on two exchanges-stock and option-he should
avail himself of the broker's service. Moreover, if his orders are for a small number of
shares, he should deal with a broker who will take net orders for small positions.
The reader must understand that there is no guarantee that a net order will be filled.
The net order is always a "not held" order, meaning that the customer is not guaranteed
an execution even if it appears that the order could be filled at prevailing market bids and
offers. Of course, the broker will attempt to fill the order if it can reasonably be accom-
plished, since that is his livelihood.
If one buys stock at 4:3 and sells the call at 3, is the return really the same as buying
the stock at 43.10 and selling the call at 3.10'? The answer is, yes, the returns are very
similar when the prices differ by small amounts. This can be seen without the use of a
tahle. If one pays a dime more for the stock, his investment increases by $10 per 100
shares, or 850 total on a .500-share transaction. However, the fact that he has received an
extra clime for the call means that the investment is reduced by $.SO.Thus, there is no
effect on the net investment except for commissions. The commission on ,500 shares at
-1:3.10 Illa\' he slightk higher than the commission for .500 shares at 43. Sirnilarlv, the com-
., ' ., l _,
mission on .S calls at :3.10 ma_\' he slightly higher than that on .S calls at 3. Even so, the
Chapter
increase in conm1issions would he so small that it would not afft>ct the return bv more
than one-tenth of 1%. ·
To carr.'-' this concept to extrernes may prove somewhat misleading. If one were to
buy stock at "40.,50and sell the call at .,50, he would still be receiving 40 net, but several
aspects would ha\·e changed consiclerahl:·· The return if exercised re,nains amazingly
constant but the return if unchanged an<l the percentage downside protection are
reduced dramaticall:·· If one were to buy stock at 48 and sell the call at 8-again for 40
net-he would i mpro\·e the return if unchanged and the percentage downside protection.
In realit:·, when one places a "net" order with a brokerage firm, he normally gets an execu-
tion with prices quite close to the ones at the time the order was first entered. It would be
a rare case, indeed, when either upside or downside extremes such as those mentioned
here would occur in the same trading day.
SELECTING A COVERED WRITING POSITION
The preceding sections, in describing types of covered writes and how to compute returns
and hreak-e\·en points, have laid the groundwork for the ultimate decision that every
covered writer nmst make: choosing which stock to buy and which option to write. This
is not necessarily an easy task, because there are large numbers of stocks, striking prices,
and expiration dates to choose from.
Since the primary objective of covered writing for most investors is increased income
through stock ownership, the return on investment is an important consideration in deter-
mining vvhich write to choose. However, the decision must not be made on the basis of
return alone. More volatile stocks will offer higher returns, but they may also involve more
risk because of their ability to fall in price c1uickly.Thus, the amount of dmvnside protec-
tion is the other important objective of covered writing. Finally, the quality and technical
or fundamental outlook of the underlying stock itself are of importance as well. The follow-
ing section will help to quantify how these factors should be viewed by the covered writer.
PROJECTEDRETURNS
The return that one strives for is somewhat a matter of personal preference. In general,
the a11n1w/i:::..Pdrcf1trn f unclumgcd should be used as the compamtice measure bct11.:crn
carious cocered 1crites. In using this return as the measuring criterion, one does not
make any assumptions about the stock moving up in price in order to attain the potential
return. A general rule used in deciding what is a minimally acceptable return is to crn1-
sider a covered writing position only wlwn the return if uncl1a11ged is at lca~t 17cper
111011th. That is, a :1-rnouth write would have to offer a return of at least 3% and a 6-month
write would han:>to han-' a return if unchanged of at least 6%. During periods of expanded
option pre1niurns, there may be so many writes that satisfy this criterion that one would
want to raise bis sights somewhat, say to 1½% or 2% per month. Also, one must feel per-
sonally comfortable that his minimum return criterion-whether it be 1% per month or
2o/c per month-is large enough to compensate for the risks he is taking. That is, the
downside risk of owning stock, should it fall far enough to outdistance the premium
recein--'cl, should he adequatel:v compensated for by the potential return. It should be
pointed out that 1o/cper month is not a return to be taken lightly, especially if there is a
reasonable assurance that it can be attained. However, if less risky investments, such as
bonds, were yielding 12% annually, the covered writer must set his sights higher.
Normally, the returns from various covered writing situations are compared by
annualizing the returns. One should not, however, be deluded into believing that he
can alwa:·s attain the projected annual return. A 6-month write that offers a 6% return
annualizes to 12%. But if one establishes such a position, all that he can achieve is 6% in
6 months. One does not really know for sure that 6 months from now there will be another
position available that will provide 6% over the next 6 months.
The deeper that the written option is in-the-money, the higher the probability that
the return if unchanged will actually he attained. In an in-the-money situation, recall
that the return if unchanged is the same as the return if exercised. Both would be attained
unless the stock fell below the striking price hy expiration. Thus, for an in-the-money
write, the projected return is attained if the stock rises, remains unchanged, or even falls
slightly h:· the time the option expires. Higher potential returns are available for
out-of-the-money writes if the stock rises. However, should the stock remain the same or
decline in price , the out-of-the-money write will gener ally underperfonn the in-the-money
write. This is wh:· the return if unchanged is a good comparison.
DOWNSIDE PROTECTION
Downside protection is more difficult to quantify than projected returns are. As men -
tioned earlier, the percentage of downside protection is often used as a measure. This is
soniewhat misleading, howe\·er, since the more volatile stocks will always offer a large
percentage of downside protection (their premiums are higher). The difficulty arises in
tn·ing
. to decide if 107c:protection on a volatile stock is better than or worse than, sav, ,
6%
protection 011a less \·olatile stock. There are mathematical ways to quantify this, but
becal!Se of the relati\ ely ach-anced nature of the computations involved, they are not dis-
cussed until later in the text, in Chapter 28 on mathematical applications.
Rat h('r than go into im·oked mathematical calculations, many covered writers use
tlw p<·rc<'11tagt'of downside prntPction and will only consider writes that offer a certain
111i11i11111111
len·l of prott--'ction, sa:· 100<. Although this is not exact, it does strive to ensure
Chapter
that one has minimal downside protection in a covered write, as well as an acceptable
return. A standard figure that is often used is the 10% le\·el of protection. Alternatively,
one rna~·also require that the write he a certain percent in-the-money, say 5%. This is just
another way of arriving at the same concept.
THE IMPORTANCE OF STRATEGY
In a con ser vative option writing stra tegy, one should be looking for minimum returns if
un chan ged of 1% per month, with dmvnside protection of at least 10%, as genera l guide-
lines. Emp loying such cr iteria automatically forces one to write in-the -money options
in line with the total return concept. The overall position constructed by using such
guidelines as these \vill be a relatively conservative position-regardless of the volatility
of the underlying stock-since the levels of protection will be large but a reasonable
return can still be attained. There is a clanger, however, in using fixed guidelines, because
market conditions change. In the early days oflisted options, premiums were so large that
virtually every at- or in-the-money covered write satisfied the foregoing criteria. How-
ever, now one should work with a ranked list of covered writing positions, or perhaps two
lists. A daily computer ranking of either or both of the following categories woul d help
establish the most attractive types of conservativ e covered writes. One list would rank, by
annualized return, the writes that afford, as a minimum, the desired downside protection
level, say 10%. The other list would rank by percentage downside protection, all the
writes that meet at least the minimum acceptable return if unchanged, say 12%. If pre-
mium levels shrink and the lists become quite small on a daily basis, one might consider
expanding the criteria to view more potential situations. On the other hand, if premiums
expand dramatically, one might consider using more restrictive criteria, to reduce the
number of potential writing candidates.
A different group of covered writers may favor a more aggressive strategy of
out-of-the-money writes. There is some mathematical basis to belieue, in the long nm,
that moderately ou t-<fthe-nwney coured iurites iuill pe1form bettC'r than in-the-rnoney
u;rite s. In falling or static markets, any covered writer, even the more aggressive one, will
outperform the stockowner who does not write calls. The out-of-the-money covered writer
has more risk in such a market than the in-the-money writer does. But in a rising market,
the out-of-the-money covered writer will not limit his returns as much as the in-the-money
writer will. As stated earlier, the out-of-the-money writer's performance will more closely
follow the performance of the underlying stock; that is, it will be more volatile on a
quarter-by-quarter basis.
There is merit in either philosophy . The in-the-money writes appeal to those inw 'stors
looking to earn a relatively consis tent, moderate ratf' of return. This is the total rl't11r11
cm ICt'JJl. These invcstors arc generally concerne d wit Ii preservation of capital, thus striving
for the greater le, els of <lownside protection a\'ailable from in-the-money writes. On the
other hand, some investors prefer to strive for higher potential returns through writing
out-of-the-money calls. These more aggressi\'e in\'estors are willing to accept more down-
side risk in their cm·cred writing positions in exchange for the possibility of higher returns
should the undcrl: ,ing stock rise in price. These investors often rel:· 011 a lmllish research
1
opinion on a stock in order to select out-of-the-money writes.

Although the type of cm·ere<l writing strateg:· pursued is a matter of personal philoso-
phy, it would seern that the benefits of in-the-money strategy-more consistent returns and
lessened risk than stock ownership will normally provide-woul<l lead the portfolio man-
ager or less aggressive im·estor toward this strategy. If the investor is interested in achie\'ing
higher returns, some of the strategies to be presente<l later in the hook may be able to
prm·ide higher returns with less risk than can out-of~the-money cm·erecl writing.
The final important consideration in selecting a covered write is the underlying stock
itself. O ne does not necessarily have to he bullish on the underly ing stock to take a cov-
ered writing position. As long as one does not foresee a potential decline in the underlying
stock, he can fet'l free to establish the cm ·e1-eclwriting position. It is generally best if one
is neutral or slight I:·bullish on the underlying stock. {f one is hcarislz, he slwuld not take
rt coccred 1criti11gposition 011that stock, regardless of the le\'els of protection that can be
obtained. An e,·en broader statement is that one should not establish a covered write on
a stock that he does not want to own. Some individual investors may have qualms about
buying stock they ft'el is too rnlatile for them. Impartially, if the return and protection are
adecpiate, the characteristics of the total position are difft'rent from those of the underly-
ing stock. Howe,-er, it is still true that one should not im·est in positions that he considers
too risky for his portfolio, nor should one establish a covered write just because he likes a
particular stock. If the potential return is unchanged or le,-els of downside protection do
not meet one's criteria, the write should not be established.
The covered writing strategist strives for a balance between acceptable returns an d
downside protection. He rejects situations that do not meet his criteria in either category
and rejects stocks on \\-hich he is bearish. The resulting situations will probably fulfill the
ohjecti,·es of a consen·ati\'e covered writing program: increased income, protection, and
less variability of res ults on a less volatile investment portfolio.
WRITING AGAINST STOCK ALREADY OWNED
Estahlislii11~ cm-ered writing positions against stock that has pre\'iousl:- been purchased
im oht'S ot I 1er hctors. It is often the ease that an investor owns stock that has listed
options trading. lrnt fE'<'lstl1at the returns from writing are too low in comparison to other
<·o, <'r<'d,niks that si11111ltane011sl: e\ist in the marketplace. This opinion may he \'alid,
Chapter
but often arises frorn the fact that the investor has seen a computer-generated list show-
ing returns on his stock as being low in comparison to similarly priced stocks. One should
note that such lists generally assume that stock is bought in order to estab lish the covered
write: the returns are usually not computed and published for wr iting against stock already
held. It ma:-,be the case that the commission costs for selling one stock and investing in
another may alter the returns so substantially that one would he better off to write against
the shares of stock initially held.
Example: An im·estor owns XYZ stock and is comparing it against AAA stock for writing
purposes. If AAA is more volatile than XYZ, the current prices might appear as follows:
Stock Oct50Call
XYZ:50 4
AAA: 50 6
\Vithout going into as much detail, the other significant aspects of these two writes
are:
XYZ AAA
Return .if exercised-margin 9.7% 13.4%
Downside break-even point-cash 45.58 44.08
Downside break-even point-margin 46.83 45.33
Seeing these calculations, the XYZ stockholder may feel that it is not advisable to write
against his stock, or he may even be tempted to sell XYZ and buy AAA in order to estab-
lish a covered write. Either of these actions could be a mistake .
When commission costs were higher, in the early years of listed option trading, one
wou ld be reluctant to switch out of a stock that he already owned to achieve larger returns
in a stock that he didn't own, for there would be rather onerous stock commissions on both
the buy and the sell. In fact, if the reader is paying a rather large commission rate, then
he should carefully assess the returns from the two writes. He should calculate returns
on the XYZ stock as if no commission wen-• paid upon entry and compare those with the
returns on AAA stock. For most investors, though, commissions arc rather low today, so
there isn't much of an impediment to switcl1 from XYZ to AAA in that regard.
However, commissions are not the only consideration. Each investor must decide for
himself whether it is worth the increase in return to switch to AAA, because he would be
switching to a more volatile stock that doesn't pay a dividend. Yes, the covered writing
static returns might justify it, but a volatility-based calculation of the risk would be neces-
sary to make the final decision.
This same logic might apply in situations where an investor has been doing covered
writing. If he owns stock on which an option has expired, he will have to decide whether to
write against the same stock again or to sell the stock and buy a new stock. In the
high-commission days, he might have decided to write against the same stock, even if the
return s weren't nearly as attractive going forward, merely because of the large commission
costs of selling one stock and buying another. But in the modern era oflow commission rates,
this really shouldn't be a concern. The writer should pursue the best overall total return cov-
ered write. In fact, it can be a lethargic mistake to get lured into just writing against the same
stock month after month, or quarter after quarter, even if the returns have diminished.
A WORD OF CAUTION
The stockholder who owns stock from a previous purchase and later contemplates writing
calls against that stock must be aware of his situation. He must realize and accept the fact
that he rnight lose his stock via assignment. If he is determined to retain ownership of the
stock, he may have to buy back the written option at a loss should the underlying stock
increase in price . In essence , he is limiting the stock's upside potential. If a stockholder is
gomg to he frustrated and disappointed when he 1s not fully participatmg durmg a rally
in his stock, he should not write a call in the first place. Perhaps he could utilize the incre-
men tal return concept of covered writing, a topic covered later in this chapter.
As stressed earlier, a covered writing strategy involves viewing the stock and option
as a total position. It is not a strategy wherein the investor is a stockholder tclw also
trades options against his stock position. If the stockholder is selling the calls because he
thinks thc>stock is going to decline in price and the call trade itself will be profitable, he
rna:v·be putting himself in a tenuous position. Thinking this way, he will probably be satis-
fit>donl:' if ht> makes a profit on the call trade, regardless of the unrealized result in the
unclc>rl:·ingstock. This sort of philosophy is contrary to a covered writing strategy philoso-
ph:·· Such an investor-he is really becoming a trader-should carefully review his
rnotin's for writing the call and anticipate his reaction if the stock rises substantially in
pr ice after the call has be en written.
In c>sscnce,1criting calls against stock that you have no intention of selling is tanta-
11akedcalls! If one is going to be extremely frustrated, perhaps even
11101111t to 1criti11;!_
e\p('riencing slc>C:'pless nights, if his stock rises ahove the strike price of the call that he
lias \\Tittl'1L tlic>nlw is experiencing trials and tribulations much as the writer of a naked
Chapter
call would if the same stock move occurred. This is an unacceptable level of emotional
worry for a true covered writing strategist.
Think about it. If _vouhm·e some ver:1 low-cost-basis stock that you don't really want
to sell , and then you sell covered calls against that stock, what do you wish will happen?
Most certainl: : 'OU wish that the options will expire worthless (i.e., that the stock won't
get called away)-exactl:' ,vhat a naked writer wishes for.
The problems can be compounded if th e stock rises , and one then decides to roll
these calls. Rather than spend a small debit to close out a losing position, an investor may
attempt to roll to more distant expiration months and higher strike prices in order to keep
bringing in credits. £\·entually, he runs out of room as the lower strikes disappear, and he
has to either sell some stock or pay a big debit to buy back the written calls. So, if the
underlying stock continues to run higher, the writer suffers emotional devastation as
he attempts to "fight the market." There have been some classic cases of Murphy's law
whe reby people have covered the calls at a big debit rather than let their "untouchable"
stock be called away, just before the stock itself or the stock market collapsed.
One should be very cautious about writing covered calls against stocks that he
doesn't intend to sell. If one feels tha t he cannot sell his stock, for whatever reason- ta x
considerations, emotional ties, etc.-he really should not sell covered calls against it. Per-
haps buying a protective put (discussed in a later chapter) would be a better strategy for
such a stockholder .
DIVERSIFYING RETURN AND PROTECTION

IN A COVERED WRITE
FUNDAMENTAL DIVERSIFICATION TECHNIQUES
Quite clearly, the covered writing strategist would like to have as much of a combination
of high potential returns and adequate downside protection as he can obtain. Writing an
out-of-the-money call will offer higher returns if exercised, but it usually affords only a
modest amount of downside protection. On the other hand, writing an in-the-money call
will provide more downside cushion but offers a lower return if exercised. For some strate-
gists, this diversification is realized in practice by writing out-of-the-money calls on some
stocks and in-the-moneys on other stocks. There is no guarantee that writing in this man-
ne r on a list of diversified stocks will produce superior results. One is still forced to pick the
stocks that he expects will perform better (for out-of-the-money writing), and that is dif-
ficult to clo. Moreover, the individual investor may not have enough fonds available to
diversify into many such situations. There is, however, another alternative to obtaining
diversification of hot Ii returns and downside protection in a cm·e1nl writing situation.
58 Part II:Call OptionStrategies
The u:riter may often do best by tcriting half of his position against in-the -moneys
and half against out-of the-moneys on the same stock. This is especially attractive for a
stock whose out-of-the-money calls do not appear to provide enough downside protection,
and at the same time, whose in-the-money calls do not provide quite enough return. By
writing both options, the writer may be able to acquire the return and protection diver-
sification that he is seeking.
Example: Th e following price s exist for 6-month calls:
XYZ common stock , 42;

XYZ April 40 call, 4; and
XYZ April 45 call , 2.
The writer wishing to establish a covered write against XYZ common stock may like the
protection afforded by the April 40 call, but may not find the return particularly attrac-
tive. He may be able to improve his return by writing April 4.S's against part of his posi-
tion. Assume the writer is considering buying 1,000 shares of XYZ. Table 2.14 compares
the attributes of ,,,riting the out-of-the-money (April 45) only, or of writing only the
in-the-money (April 40), or of writing 5 of each. The table is based on a cash covered
write, but returns and protection would be similar for a margin write. Commissions are
included in the figure s.
It is easily seen that the "combined" u:rite-half of the position against the April
40's and the other half against the April 45's-offers the best balance of return and pro -
tection. The in-the-money call, by itself, provides over 11% downside protection, but the
7.6% return if exercised is just a bit more than 1% per month. Thus, one might not want
to write April 40's against his entire position, because the potential return is small. At the
same time, the April 45's, if written against the entire stock position, would provide for an
attractive return if exercised (over 2% per month) but offer only 7% downside protection.
The combined write, which has the better features of both options, offers over 11% return
if exercised (nearly LS% per month) and affords over 8% downside protection. By writing
both calls, the writer has potentially solved the problems inherent in writing entirely
out-of-the-moneys or entirely in-the-moneys. The "combined" write frees the covered
writer from hm'ing to initially take a bearish (in-the-money write) or bullish
(out-of-the-money write) posture on the stock if he does not want to. This is often neces-
sary on a low-volatility stock trading bet ween striking prices .
For those who prefer a graphic representation, the profit graph shown in Figure 2-2
compares the combined write of both calls with either the in-the-money write or the
out-of-the-rnmw,· write (clashed lines). It can he observed that all three choices are equal
if XYZ is near 42 at expirat ion ; all thr ee lines inter sect there .
Chapter
TABLE 2.14
Attributes of various writes.
In-the-Money Out-of-the-Money Write
Write Write BothCalls
Buy 1,000 XYZ and sell 10 April 40's 10 April 45's 5 April 40's and
5 April 45's
Returnif exercised 7.6% 14.7% 11.2%
Returnif unchanged 7.6% 7.3% 7.4%
Percentprotection 11.7% 7.0% 9.3%
FIGURE 2-2.
Comparison: combined write vs. in-the-money write and out-of-the-money
write.
Out-of-the-Money Write
#"------►
,/ Combined Write
C:
0
,,
~ ,' In-the-Money Write
·a. -----------➔
X
UJ
cii
Cl)
Cl)
45
0
...J
, , /40
0 ,,
:.=
e , ,,
a..
,,
Jt
This technique can be useful in providing diversification between protection and

return, not only for an individual position but for a large part of a portfolio. In the modern
era, with commissions on a per-share basis, the pertinent returns can be computed essen-
tially by averaging the returns on the individual writes. For example, the return if exer-
cised for the April 40s was 7.6%; the return if exercised for the April 45s is 14.7%. So the
return for a write that utilizes half of each is the average, 11.2%.
OTHER DIVERSIFICATION TECHNIQUES
Holders of large positions in a particular stock may want even more diversification than
can be provi<le<lhy writing against two different striking prices. Institutions, pension
funds, and large individual stockholders may fall into this category. It is often advisable
for such large stockholders to diccrs{f!J their writing acer time as well as over at least two
striking prices. By diversifying over time-for example, writing one-third of the position
against near-term calls, one-third against middle-term calls, and the remaining third
against long-term calls-one can gain several benefits. First, all of one's positions need
not he adjusted at the same time. This includes either having the stock called away or
buying hack one written call ancl selling another. Moreover, one is not subject only to the
level of option premiums that exist at the time one series of calls expires. For example, if
one writes only 9-month calls ancl then rolls them over when they expire, he may unnec-
essarily be subjecting himself to the potential of lower returns. If option premium levels
happen to be low when it is time for this 9-rnonth call writer to sell more calls, he will be
establishing a less-than-optimum write for up to 9 months. By spreading his writing
out over time, he would, at worst, be subjecting only one-third of his holding to the
low-premium write. Hopefully, premiums would expand before the next expiration
:1 months later, and he would then be getting a relatively better premium on the next
third of his portfolio. There is an important aside here: The individual or relatively small
investor who owns only enough stock to write one series of options should generally not
w rite the longest-term calls for this very reason. He may not be obtaining a particularly
attrncti,·e le,·el of premiums, but ma:v feel he is forced to retain the position until expira-
tion. Thus, he could be in a relatively poor write for as long as 9 months. Finally, this type
of diversification may also lead to having calls at various striking prices as the market
fluctuates cyclically. All of one's stock is not necessarily committed at one price if this
di,·ersification technique is employed.
This concludes the discussion of how to establish a covered writing position against
stock. Covered writes against other types of securities are described later.
FOLLOW-UP ACTION
Establishing a cover ed write, or any option position for that matter, is on ly part of the
strategis t's job. Once the position has been taken, it must be monitored closely so that
adjustments may be made should the stock drop too far in price. Moreover, even if the
stock remains rt>latively unchanged, adjustments will net>clto he made as the written call
approaches expiration.
Sonw ,,riters take no follow-up action at all, preferring to let a stock he called away
if it rises ahm·e the striking price at the expiration of the option, or preft>rring to let the
original expire worthless if the stock is below the strike. These are not always optimum
actions; there may be much more decision making involved.
Chapter
Follow-up action can be divided into three general categories:
1. protective action to take if the stock drops,

2. aggressive action to take when the stock rises, or
3. action to avoid assignment if the time premium disappears from an in-the-money call.
There may be times when one decides to close the entire position before expiration or to
let the stock be called away. These cases are discussed as well.
PROTECTIVE ACTION IF THE UNDERLYING STOCK DECLINES IN PRICE
The covered writer who does not take protective action in the face of a relatively substan-
tial drop in price by the underlying stock may be risking the possibility of large losses.
Since covered writing is a strategy with limited profit potential, one should also take care
to limit losses. Otherwise, one losing position can negate several winning positions. The
simplest form of follow-up action in a decline is to merely close out the position. This
might be done if the stock declines by a certain percentage, or if the stock falls below a
technical support level. Unfortunately, this method of defensive action may prove to be
an inferior one. The investor will often do hetter to continue to sell more time value in the
form of additional option premiums .
Follow-up action is generally taken by buying back the call that was originally written
and then writing another call, with a different striking price and/or expiration date, in its
place. Any adjustment of this sort is referred to as a rolling action. When the underlying
stock drops in price, one generally buys back the original call-pr esumably at a profit
since the underlying stock has declined- and then sells a call with a lower striking price.
This is known as rolling down, since the new option has a lower striking price.
Example: The covered writing position described as "buy XYZ at ,51,sell the XYZ January
50 call at 6" would have a maximum profit potential at expiration of 5 points. Downside pro-
tection is 6 points down to a stock price of 4,5 at expiration. These figures do not include
commissions, but for the purposes of an elementary example, the commissions will be ignored.
If the stock begins to decline in price, taking perhaps two months to fall to 45, the
following option prices might exist:
XYZ common, 45;

XYZ January 50 call, l; and
XYZ January 45 call, 4.
The covered writer of the January ,50would, at this time, have a small unrealized loss of one
point in his overall position: His loss on the common stock is 6 points, but he has a ,5-point
gain in the January .50 call. (This demonstrates that prior to expiration, a loss occurs at the
"break-even" point.) If the stock should continue to fall from these levels, he could have a
larger loss at expiration. The call, selling for one point, only affords one more point of down-
side protection. If a further stock price drop is anticipated, additional dmc11sideprotection
rnn he obtained hlj rolling dou;11.In this example, if one were to buy back the January .SOcall
at 1 and sell the Januar:v 4.5 at 4, he would he rolling clown. This would increase his protec-
tion b:·another three points-the credit generated by buying the .SOcall at 1 and selling the
4.5 call at 4. Hence, his downside hreak-even point would be 42 after rolling down.
Mon:>over,if the stock were to remain unchanged-that is, if XYZ were exactly 4.5
at Januar:· t'xpiration-the writer would make an additional $300. If he had not rolled
down, the 111ostadditional income that he could make, if XYZ remained unchanged,
would be the remaining $100 fro111the January .50 call. So rolling dmcn gices more do1c11-
side protection against a further drop in stock price and 111aualso produce additional
income if the stock price stabilizes.
In order to more exactly e\·aluate the overall effect that was obtained by rolling
clown in this example, one can either compute a profit table (Table 2-1.5) or draw a net
profit graph (Figure 2-:3) that compares the original covered write with the rolled-down
position.
Note that the rolled-down position has a smaller ma ximum profit potential than the
original position did. This is because, by rolling clown to a January 4.5 call, the writt'r
limits his profits anywhere abm e 4.5 at expiration. He has committed himself to sell stock
5 points lower than the original position, wh ich utilized a January .50 call and thus had
limited profits above .SO.Rolling d01c11generally reduces tlic 11wxi11w111 prc~fitpotential <f
the rni-c1wl 1critc. Limiting the rnaxilllulll profit may he a secondary consideration. how-
e\ ·er, when a stock is breaking downward. Additional downside protection is often a more
pressing criterion in that case.
Anywhere below 4.S at expiration, the rolled-down position does $300 better than
the original position, because of the $300 credit generated from rolling clown. In fact, the
rolled-clown position will outperform the original position even if the stock rallies back
to, hut not ahm·e. a price of 48. At 48 at expiration, the two positions are equal, hoth pro-
d1win~ a 8:300 profit. If the stock should reverse directio11 and rally hack above 48 hy
expiration. the writer would hm·e bee11 hetter off not to h,we rolled down. All these facts
are clear from Table 2.1.Sand Figure 2-3.
ConsC'q1wntl:·· tl1e 0111:case in \\hich it does not pa:· to roll clown is the one in which
tlil· stock t'\1wrie11ccs a re\·ersal-a rise in price after the initial drop. The selection of
\\ ll('n' to roll do\\'11 is illlportaut, hecanst· rolli11g clown too early or at an inappropriate
Chapter
TABLE 2.15.
Profit table.
XYZPrice
at Profit
from Profit
from
Expiration January
50Write Rolled
Position
40 - $500 -200
42 - 300 0
45 0 + 300
48 + 300 + 300
50 + 500 + 300
60 + 500 + 300
FIGURE 2-3.
Comparison: original covered write vs. rolled-down write.
+$500 Original Write
Rolled-Down Write
C +$300
0
~
·a.
X
UJ
al
Cl)
Cl) $0
0
...J
50
0
:.=
e
a..
price could limit the returns. Technical support levels of the stock are often useful in
selecting prices at which to roll down. If one rolls down after technical support has been
broken, the chances of being caught in a stock-price-reversal situation would normally be
reduced.
The ahove example is rather simplistic; in actual prncticP , more complicated situa-
tions may arise , such as a sudden and fairly steep decline in price by the underlying stock.
This 111aypresent the writer with what is called a locked-in loss. This means , simply, that
there is no option to which the writer can roll down that will provide hilll with e11011gh
prenlium to realize any profit if the stock were then called away at expiration. These situ-
ations arise more commonly on lower-priced stocks , where the striking prices are rela-
tively far apart in percentage terms. Out-of-the-money writes are more susceptible to this
probl em th an are in-the-mone y w rit es. Although it is not emotionally satisfying to be in
an investment position that cannot produce a profit-at least for a limited period of
time-it may still he beneficial to roll down to protect as much of the stoc k price decline
as possible.
Example: For the covered write described as "huY XYZ at 20, sell the January 20 call at
2." the stock tmcxpectedl:v· drops very cplicklYto 16, and the following prices exist:
XYZ common , 16;

XYZ Janu ary 20 call , .50; and
XYZ Janu ary 15 call, 2.50.
The cm ·ered writer is faced with a difficult choice. He currentlv has an unrealized loss of
2 ..50 points-a 4-point loss 011 the stock which is partially offset bva 1..50-point gain on
the January 20 call. This represents a fairly substantial percentage loss on his investment
in a short period of time. He could do nothing, hoping for the stock to recover its loss.
Unfortu nately, thi s may pro ve to be wishfu l thi nk ing.
If he considers rolling clown, he will not be excited b:· what he sees. Suppose that
the writer wants to roll down from the Januar:· 20 to the January 1.5.He would thus buy
the Jammr:· 20 at .,50 and sell the Januar:· 1.5at 2.,50, for a net credit of 2 points. By rolling
down, he is obligating himself to sell his stock at 1.5,the striking price of the January 1.5
call. Suppose XYZwere abon' 1.5in January and were called awa:·· How would the writer
do? He would lose .Spoints on his stock since he originally bought it at 20 and is selling
it at 1.5.This .5-point loss is suhstantiall:· offset hy his option profits, which amount to 4
points: 1..50 points of profit on the January 20, sold at 2 and bought back at .,50. plus the
2 ..50 points recei\·ed from the sale of the Jam1ar:· 1.5. I Iowe\·ET,his net result is a 1-point
loss, since lie lost .5 points on the stock and made onl:· 4 points on the options. Moreover,
this I-point loss is the best that he can hope for! This is true because. as has been dem-
onstrated St'\·eral times, a con'recl writing position makes its maximum profit anywhere
abm·e th e striking price . Tlms , by rollin g down to the 1.5strike, he has limited the position
severely, to the extent of "locking in a loss."
fa·('ll considtTing what has been shown about this loss, it is still corrfft {<n-thistcritcr
to roll dmrn to the ]r1111u1r!J IS. Once the stock has fallen to 16, there is nothing anybody
can do aho11ttlie 1111realizedlosses. I lm\'e\·er, if the writer rolls clown, he can pre\·ent the
losses frnlll acc1111111lating
. at a faster rate. In fact, ht' will do better b\·. rollin(T
h clown if the
stock drops fmtlwL rt'111ai11s 111Khu1gecl.or l'\·en rises slight]_',·.Table 2.16 and Figure 2-4
Chapter
TABLE 2.16.
Profits of original write and rolled position.
Stock
Price
at Profit
from Profit
from
Expiration January
20Write Rolled
Position
10 - $800 - $600
15 - 300 - 100
18 0 - 100
20 + 200 - 100
25 + 200 - 100
FIGURE 2-4.
11
Comparison: original write vs. locked-in loss."
Original Write
C +$200
,Q
~
·5..
X
UJ
cii
en
en
0
...J
15 20
~ - $100
;;::
2 "Locked-in Loss" (-$100)
a..
compare the original write with the rolled-clown position. It is clear from the figure that
the rolled-clown position is locked into a loss. However, the rolled-clown position still out-
performs the original position unless the stock rallies back above 17 hy expiration. Thus, if
the stock continues to fall, if it remains unchanged, or even if it rallies less than 1 point, the
rolled-down position actually outperforms the original write. It is for this reason that the
writer is taking the most logical action by rolling clown, even though to do so locks in a loss.
Technical analysis may be able to provide a little help for the writer faced with the
dilemma of rolling clown to lock in a loss or else holding onto a position that has no further
clownsidt>protection. If XYZ has broken a support level or important trend line , it is added
evidence for rolling down. In our example , it is difficult to imagine tlw case in which a ~20
stock suddenly drops to become a $16 stock without substantial harm to its technical picture.
Ne\·ertheless, if the charts should show that there is support at 1.5..50or 16, it may be worth
the writer's while to wait and see if that support level can hold before rolling down.
Perhaps the best way to a\'Oiclhaving to lock in losses would be to establish positions
that are less likely to become such a problem. In-the-money covered writes on higher-priced
stocks that have a moderate amount of volatility will rare ly force the writer to lock in a loss
hy rolling clown. Of course , any stock, should it fall far enough and fast enoug h, could force
the writer to lock in a loss ifhe has to roll down two or three times in a fairly short time span.
Howe,·er, the higher-priced stock has striking prices that are much closer together (in per-
centages); it thus presents the writer with the opportunity to utilize a new option with a
lower striking price mucl1 sooner in the decline of the stock. Also, higher volatility should
help in generating large enough premiums that substantial portions of the stock's decline
can be hedged by rolling down. Com·ersely, low-priced stocks, especially non\'Olatile ones,
often prt'sent tht' !llost severe problems for the covered writer when they decline in price.
A related point concerning order entry can be inserted here. \Vhen one simultane-
ous!:,: lrn:'S one call and sells another, he is executing a spread. Spreads in general are
discussed at length later. However, the covered writer should be aware th at whe never he
rolls Im position, th e order ca n be placed as a spread order. This will normally help the
writn to obtain a better price execution.
AN ALTERNATIVE METHOD OF ROLLING DOWN
There is another alternative that the covered writer can use to attempt to gain some ad di-
tional downside protection without necessaril:' having to lock in a loss. Basically, the
writer rolls down only part of his covered writing position.
Example: One thousand shares of XYZ were bought at 20 and 10 January :20 calls were
sold at :2points each. As before, the stock falls to 16, with the following prices: XYZ Janu-
ary :20 call, .,50; and XYZ January 1.5call, :2)50. As was demonstrated in the last section,
if the writer were to roll all 10 calls clown from the January 20 to the January 1.5,he would
lw lockin1.;in a loss. Although there may be some justification for this action, the writer
would naturally rather not have to place himself in such a position.
One can attempt to achie\·e some balanct' between added downside protection and
np\\'arcl profit potential hy rolling clown only part of the calls. In this example, the writer
\rnuld lm:· hack onl:· 5 of the Jarniar:· :2(fs and sell .5January V5calls. He would then hm·e
this position:
long 1,000 XYZ at 20;

short 5 XYZ January 20's at 2;
Chapter
short 5 XYZ January 15's at 2.50; and

realized gain , $750 from 5 January 20's.
This strategy is generally referred to a partial roll-down, in which only a portion of the
original calls is rolled, as opposed to the more conventional complete roll-down. Analyz-
ing the partially rolled position makes it clear that the writer no longer locks in a loss.
IfXYZ rallies back above 20, the writer would, at expiration, sell 500 XYZ at 20 (break-
ing even) and 500 at 1.5(losing $2,500 on this portion). He would make $1,000 from the five
January 20's held until expiration, plus $1,250 from the five January L5's, plus the $750 of
realized gain from the January 20's that were rolled down. This amounts to $3,000 worth
of option profits and $2,500 worth of stock losses, or an overall net gain of $500, less com-
missions. Thus, the partial roll-down offers the writer a chance to make some profit if the
stock rebounds. Obviously, the partial roll-down will not provide as much downside protec-
tion as the complete roll-down does, but it does give more protection than not rolling down
at all. To see this, compare the results given in Table 2-17 if XYZ is at 1.5at expiration.
TABLE2-17.
Stock at 15 at expiration.
Option
Strategy StockLoss Profit Total
Loss
Original position - $5,000 + $2,000 - $3,000
Partial roll-down - 5,000 + 3,000 - 2,000
Complete roll-down - 5,000 + 4,000 - 1,000
In summary, the covered writer who would like to roll down , but who does not want
to lock in a loss or who feels the stock may rebound somewhat before expiration, should
consider rolling down only part of his position. If the stock should continue to drop, mak-
ing it evident that there is little hope of a strong rebound back to the original strike, the
rest of the position can then be rolled down as well.
UTILIZING DIFFERENT EXPIRATION SERIES WHEN ROLLING DOWN
In the examples thus far, the same expiration month has been used whenever rolling-down
action was taken. In actual practice, the writer may often want to use a more distant expi-
ration month when rolling down and, in some cases, he may even want to use a nearer
expiration month.
The advantage of rolling down into a more distant expiration series is that more actual
points of protection are received. This is a common action to take when the underlying stock
has become somewhat worrisome on a technical or fundamental basis. However, since

rolling down reduces the maximum profit potential-a fact that has been demonstrated
several times-every roll-clown should not be made to a more distant expiration series.
By utilizing a longer-term call when rolling down, one is reducing his maximum profit
potential for a longer period of time. Thus, the longer-term call should be used only if the
writer has grown concerned over the stock's capability to hold current price levels. The
partial roll-clown strategy is particularly amenable to rolling down to a longer-term call
since , by rolling down only part of the position, one has already left the door open for
profits if the stock should rebound. Therefore, he can feel free to avail himself of the
maximum protection possible in the part of his position that is rolled down.
The writer who must roll down to lock in a loss, possibly because of circumstances
beyond his control, such as a sudden fall in the price of the underlying stock, may actually
want to roll down to a near-term option. This allows him to make back the available time
pr emium in th e short -term call in th e least time poss ible .
Example: A writer bu~;sXYZ at 19 and sells a 6-month call for 2 points. Shortly thereafter,
howt>ver,bad news appears concerning the common stock and XYZ falls quickly to 14. At
that tinw, the following prices exist for the calls with the striking price 1.5:
XYZ common , 14;

nea r-term call , l ;
midd le-term call, 1.50: and
far-ter m call, 2.
If the writer rolls down into any of these three calls, he will be locking in a loss. There-
fore, the best strategy may be to roll down into the near-term call, planning to capture
one point of time premium in 3 months. In this way, he will be beginning to work himself
out of tht> loss situation by availing himself of the most potential time premium decay in
the shortest period of timt' . \\'hen the near-term call expires 3 months from now, he can
reasst>ss the situation to decide if lw wants to write another near-term call to continue
taking in short-term premiums, or perhaps write a long-term call at that time .
\\"ht>n rolling down into tht> near-term calL one is attempting to return to a poten-
tially profitable situation in the shortt>st period of time. By writing short-term calls one or
two times, the writer will eventuallv be able to reduce his stock cost nearer to 1.5in the
shortest time pt>riocl. Once his stock cost approaches 1.5, he can then write a long-term
call with striking price U5and return again to a potentially profitable situation. He will no
longer be locked into a loss.
Chapter
ACTION TO TAKE IF THE STOCK RISES
A more pleasant situation for the covered writer to encounter is the one in which the
underlying stock rises in price after the covered writing position has been established.
There are generall:v se\'eral choices available if this happens. The writer may decide to <lo
nothing and to let his stock be called away, thereby making the return that he had hoped
for when he established the position. On the other hand, if the underlying stock rises
fairly quickly and the written call comes to parity, the writer may either close the position
early or roll the call up. Each case is discussed.
Example: Someone establishes a covered writing position by buying a stock at 50 and

selling a 6-month call for 6 points. His maximum profit potential is 6 points anywhere
above 50 at expiration, and his downside break-even point is 44. Furthermore, suppose
that the stock experiences a substantial rally and that it climbs to a price of 60 in a short
period of time. With the stock at 60, the July 50 might he selling for 11 points and a July
60 might sell for as much as 7 points. Thus, the writer may consider buying back the
call that was originally written and rolling up to the call with a higher striking price.
Table 2-18 summarizes the situation.
TABLE 2-18
Comparison of original and current prices.
Original
Position Current
Prices
Buy XYZ at 50 XYZ common 60
Sell XYZJuly 50 call at 6 XYZJuly 50 11
XYZJuly60 7
If the writer were to roll-up-that is, buy back the July ,50 and sell the July 60-he
would be increasing his profit potential. If XYZ were above 60 in July and were called
away, he would make his option credits-6 points from the July 50 plus 7 points from the
July 60-less the 11 points he paid to buy back the July 50. Thus, his option profits would
amount to 2 points, which, added to the stock profit of 10 points, increases his maximum
profit potential to 12 points anywhere above 60 at July expiration.
To increase his profit potential by such a large amount, the covered writer has given
up some of his downside protection. The dou.:11sidebreak-e-i;enpoint is always raised /Jy
the amount of the debit required to roll up. The debit required to roll up in this example
is 4 points-buy the July ,50 at 11 and sell the July 60 at 7. Tlms, the break-even point is
increased from the original 44 level to 48 after rolling up. There is another method of
calculating the new profit potential and break-even point. In essence, the writer has raised
his net stock cost to ,5,5hy taking the realized ,5-point loss on the July ,50 call. Hence, he
is essentially in a covered write whereby he has bought stock at ,5,5and has sold a July 60
call for 7. \ Vhen expressed in this manner, it may be easier to see that the break-even point
is 48 and the maximum profit potential , above 60, is 12 points.
Note that 1d1c11011emils llJJ, there is a debit incurred. That is, the investor must
deposit additional cash into the covered writing position. This was not the case in rolling
down, because credits were generated. Debits are considered hy many investors to be a
seriously negative aspect of rolling up, and they therefore prefer never to roll up for debits.
Although the debit required to roll up may not be a negative aspect to every investor, it
does translate directly into the fact that the break-even point is raised and the writer is
subjecting himself to a potential loss if the stock should pull back. It is often advantageous
to roll to a more distant expiration when rolling up. This will reduce the debit required.
The rolled-up position has a break-even point of 48. Thus, if XYZ falls back to 48,
the writer who rolled up will be left with no profit. However, if he had not rolled up, he
would have made 4 points with XYZ at 48 at expiration in the original position. A further
comparison can be made between the original position and the rolled-up position. The
two are equal at July expiration at a stock price of .54; both have a profit of 6 points with
XYZ at ,54 at Jul:· expiration. Thus, although it may appear attractive to roll up. one should
determine the point at which the rolled-up position ancl the original position will he equal
at expiration. If the writer belie\·es XYZcould be subject to a 10% correction by expiration
from 60 to .54-certainl:· not out of the question for any stock-he should sta:· with his
original position.
Figure 2-,5 compares the original position with the rolled-up position. Note that the
break-e\·en point has mm·ecl up from 44 to 48; the maximum profit potential has increased
from 6 points to 12 points; and at expiration the two writes are equal, at 54.
In summary, it can be said that rolling up increases one's profit potential but also
exposes one to risk of loss if a stock price reversal should occur. Therefore, an element of risk
is introduced as well as the possibility of increased rewards. Generali:', it is not advisable to
roll up if at least a lOo/ccorrection in the stock price cannot he withstood. One's initial goals
for the covPred writP were st't when the position was established. If the stock a<lvances and
tlwse goals are being met, thP writer should be \·ery cautious about risking that profit.
A SERIOUS BUT ALL-TOO-COMMON MISTAKE
\ \'hen an irn·estor is on'rl:· intent 011 keeping his stock from being called amt:· (perhaps he
is ,,Titing calls against stock that he rPally has 110 intention of selling). then he will nor111all:
roll up and/or fcirward to a lllore distant expiration month whenever the stock rises to the
strike of tlH· written call. ,\Jost ofthest' rolls incur a debit. If the stock is 1xu-ticularh-strmw,
, ,--,
Chapter
FIGURE 2-5.
Comparison: original write vs. rolled-up position.
Rolled-Up Write
+$1,200
Original Write
+$600
54 60
or if there is a strong bull market, these rolls for debits begin to weigh heavily on the psy-
chology of the covered writer. Eventually, he wears down emotionally and makes a mis-
take. He typically takes one of two roads: (1) He buys hack all of the calls for a (large) debit,
leaving the entire stock holding exposed to downside movements after it has risen dramati-
cally in price and after he has amassed a fairly large series of debits from previous rolls; or
(2) he begins to sell some out-of.-the-money naked puts to bring in credits to reduce the
cost of continually rolling the calls up for debits. This latter action is even worse, because
the entire position is now leveraged tremendously, and a sharp drop in the stock price may
cause horrendous losses-perhaps enough to wipe out the entire account. As fate would
have it, these mistakes are usually made when the stock is near a top in price. Any price
decline after such a dramatic rise is usually a sharp and painful one.
The best way to avoid this type of potentially serious mistake is to allow the stock to
he called away at some point. Then, using the funds that are released, either establish a
new position in another stock or perhaps even utilize another strategy for a while. If that
is not feasible, at least avoid making a radical change in strategy after the stock has had a
particularly strong rise. Leveraging the position through naked put sales on top of rolling
th e calls up for debits should expressly be avoided.
The discussion to this point has heen directed at rolling up before expiration. At or
near expiration, when the time value premium has disappeared from the written call, one
may have no choict' hut to write the next-higher striking price if he wants to retain his
stock. This is discussed when we analyze action to take at or near expiration.
If the underlying stock rises, one's choices are not necessarily limited to rolling up
or doing nothing. As the stock increast's in price, the vvritten call will lose its time pre-
mium and may hegin to traclt' near parity. The writt'r may decide to close the position
himst'lf---perhaps well i11ach-anct' of expiration-by hnving hack the written call and
selling the stock out, hopefully near parity.
Example: A customer originally bought XYZ at 2,5 and sold tht' fi-month July 2.5 for
:3points-a net of 22. Now, thrt'e months later, XYZ has risen to :3:3and the call is trading
at 8 (parit:·) hecaust' it is so deeply in-tht'-money. At this point, the writer may want to sell
tht' stock at :3:3a11clbuy hack the call at 8, thereby realizing an effectiw net of 2.5 for the
cm·ered writt>.which is his maximum profit potential. This is certainly preferable to remain-
ing in the position for thret' more months with no more profit potential available. The
ach-antage of closing a parit:· cm·ered write t'arly is that one is realizing the maximum
rt'turn in a shortt'r period than anticipated. He is thert'hy increasing his annualized return
on the position. Although it is generally to the cash writer's advantage (margin writers
read 011) to takt' such action, there are a few additional costs involved that he would not
ex1wrience if he held the position until the call expired. First, the commission for the
option purchase (buy-hack) is an additional expenst'. Second, he will he selling his stock at
a higher prict' than the striking price, so he may pay a slightly higher commission on that
trade as well. If there is a dividend left until expiration, he will not he receiving
that di,·icleml if ht' closes the write early. Of course, if the trade was done in a margin
account, the writer will he reducing the margin interest that he had planned to pay in the
position, because the clehit will be erased t'arlier. 111most cast's. the increased commissions
are\ er:· small and the lost dividend is not significant compart'd to the increase in annual-
ized return that one can achieve by closing the position earl:·· However, this is not always
trn t', and rn1t' sl 1ould he aware of t'xactl:· what his costs are for closing the position early.
O1)\·iously,getting 0llt of a covered writing position can he as difficult as establishing

it. Therefort', ont' should plact' the order to close tlw position with his brokerage firm's
option desk to he executed as a ··net" order. The same traders who facilitate establishing
cm·erecl writing positions at net prict's will also facilitate getting out of' the positions. One
would 1icm11all:·place tlw order hy sa:'ing that he wanted to sell his stock and huy the
option "at parit< or. in the example. at "2,5 net." Just as it is often necessar:· to he in con-
to esta/Jlis/1a position. so is it necessary to
tact \\-ith hoth the option and stock (_'\:cha11g(-'S
maintain the same contacts to remove a position at parity.
Chapter2: CoveredCallWriting 73
THE PARTIAL EXTRACTION STRATEGY
This is a strategy that appli es if the stock has adv,mcecl and is in danger of being called
awa\'. If the writer 1cants to be assigned, then so be it. But in many cases, the writer would
• l ,
like an alternative to merely' bu)·ing back the call and rolling up. In this strat egy, a portion
of the underl) ·ing stock is sold, releasing proceeds that are then used to buy back the writ-
ten calls. A new call option , with a higher strike , can then be written if so desired.
Example: At some time in the past , an investor wrote February 4.5 calls against his XYZ
stock. This stock has a very low cost basis because it was purchased long ago (perhaps it
was inherited). So the writer would not like to be assigned, for that would create a large
tax burden. On the other hand , he is not particularly happy to pay a large debit to buy the
call s back. Suppose th at thi s is his po sition:
Long 3000 XYZ , curr ently trading at 50

Short 30 Februar y 45 call s, currentl y tradin g at 5.00
Since the time value premium is gone from the calls, he realizes that assignment could be
imminent. This lack of time value premium could be due to a large dividend payment or
perhaps impending expiration-it doesn't really matter. Suppose he does the following:
Buy back 30 Februar y 45 calls at 5.00 Cost : $15,000

Sell 300 shares of XYZ at 50 Pro ceeds : $15,000
Hence his net cost for this unwind of part of the covered write is zero. He is then left with
2700 shares that are "unencumbered," and he can decide if he wants to sell calls against
those or not.
The advantage of this strategy is that one retains a large portion of his position , while
getting out from under what he might feel is a bad situation of a ci-lllthat is about to be
assigned against stock that he doesn't reall y want to sell.
What are the tax ramifications here? First , he probably has a short-term loss on the
option trade. Second, he has a long-term gain on the stock, which might be as large as
most of the $1.5,000. But the loss on the option trade can be applied against the stock gain,
so there might not be that much of a net tax exposur e after all.
Moreover , this is a sort of backhanded way of selling high . After all, the stock has
been rising rapidly , and it might he a good time to dispose of some shares .
Hence the practical extraction strateg) ' has spveral useful featur es, hut tlw rnajor one
is that it allows one to extract oneself from an in-th e-money cm ·ered write ~vith a small
stock sale. It should he used before the written call gets too deeply i11the money. If one
waits until the option gets \'ery deeply in-the-money before applying the technique, then
a much larger number of shares will have to be sold in order to extract the stock from the
covered wr ite.
ACTION TO TAKE AT OR NEAR EXPIRATION
As expiration nears and the time value premium disappears from a written call, the cov-
ered writer may often want to mllfonca rd, that is, buy back the currently written call and
sell a longer-term call with the same striking price. For an in-the-money call, the opti-
mum time to roll forward is generally when the time value premium has completely dis-
appeared from the call. For an out-of-the-111011eycall, the correct time to move into the
more distant option series is when the return offered hy the near-term option is less than
th e return offere d by th e longer- term call.
The in-the-money case is quite simple to analyze. As long as there is time premium
left in the call, there is little risk of assignment, and therefore the writer is earning time
premium by remaining with the original call. However, when the option begins to trade
at parity or a discount, there arises a significant probability of exercise by arbitrageurs. It
is at this time that the writer should roll the in-the-money call forward. For example, if
XYZ were offered at .Sl and the July .SOcall were bid at I, the writer should be rolling
forwar d into the Octob er 50 or January 50 call.
The 011t-of-the-money case is a little more difficult to handle, hut a relatively straight-
forward anal:·sis can be applied to facilitate the writer's decision. One can compute the
return ptT clay remaining in the written call and compare it to the net return per clay from
the longer-term call. If the longer-term call has a higher return, one should roll forward.
Example: An i1n-estor pre\·iousl:· entered a cm·ered writing situation in which he wrote

fin, January 30 calls against ,500 XYZ crnmn011. The following prices exist currently , 1
month before expiration:
XYZ common, 29..50;

January 30 call , .50; and
April 30 call, 2.50.
The \niter can onk makt' .SOcents llH>rt'of time premium on this cm·ert'd write for the
tin](:' re111aini11g1111tilexpiration. It is possible that his money could be put to better llSt'
Ii:-,rollin~ fornard to tl1e April :30 call. C:olllrnissio11sfor rolling forward rnust l)(:' sub-
tracted from the April 30's premium to present a true comparison.
Chapter
By remaining in the January 30, the writer could make, at most, $250 for the .30 days
remaining until January expiration. This is a return of $8.33 per day. The commissions for
rolling forward would be approximately $100, including both the buy-back and the new
sale. Since the current time premium in the April .30 call is $250 per option, this would
mean that the writer would stand to make 5 times $250 less the $100 in commissions dur-
ing the 120-day period until April expiration; $1, 1.50divided by 120 clays is $9.58 per day.
Thus, the per-day return is higher from the April .30 than from the January .30, after com-
missions are included. The writer should roll forward to the April .30 at this time.
Rolling forward, since it involves a positive cash Row (that is, it is a credit transaction)
simultaneously increases the writer's maximum profit potential and lowers the break-even
point. In the example above, the credit for rolling forward is 2 points, so the break-
even point will be lowered by 2 points and the maximum profit potential is also increased
by the 2-point credit.
A simple calculator can provide one with the return-per-day calculation necessary
to make the decision concerning rolling forward. The preceding analysis is only directly
applicable to rolling forward at the same striking price. Rolling-up or rolling-down deci-
sions at expiration, since they involve different striking prices, cannot be based solely on
the differential returns in time premium values offered by the options in question.
In the earlier discussion concerning rolling up, it was mentioned that at or near
expiration, one may have no choice but to write the next higher striking price if he wants
to retain his stock. This does not necessarily involve a debit transaction, however. If the
stock is volatile enough, one might even be able to roll up for even money or a slight credit
at expiration. Should this occur, it would be a desirable situation and should always be
taken advantage of.
Example: The following prices exist at January expiration:
XYZ, 50;
XYZ January 45 call, 5; and
XYZ July 50 call, 7.
In this case, if one had originally written the January 45 call, he could now roll up to the
July 50 at expiration for a credit of2 points. This action is quite prudent, since the break-evm
point and the maximum profit potential are enhanced. The break-even point is lowered by
the 2 points of credit received from rolling up. The maximum profit potential is increased
s11hstantially-by 7 points-since the striking price is raised hy ,5 points and an additional
2 points of credit are taken in from the roll up. Consequently, whenever one can roll up for
a credit, a situation that would normally arise only on more volatile stocks, lw should do so.
Another choice that may occur at or near expiration is that of rolling don:n. The case
ma:· arise whereby one has allowed a written call to expire worthless with the stock more
than a small distance below the striking price. The writer is then faced with the decision
of either writing a small-premium out-of-the-money call or a larger-premium in-the-money
call. Again, an example may prove to be useful.
Example: Just after the January 25 call has expired worthless,
XYZ is at 22;
XYZ July 25 call at .75; and
XYZ July 20 call at 3.50.
If the investor were now to write the July 2.Scall, he would be receiving only .7,5of a point
of downside protection. However, his maximum profit potential would be quite large if
XYZ could rally to 2.5 by expiration. On the other hand, the July 20 at 3.,50 is an attractive
write that affords substantial downside protection, and its 1..50 points of time value pre-
miurn are twice that offered by the July 2.S call. In a purely analytic sense, one should not
base his decision on what his performance has been to date, but that is a difficult axiom
to appl:· in practice. If this investor owns XYZ at a higher price, he will almost surely opt
for the July 2.S call. If, however, he owns XYZ at approximately the same price, he will
han" no qualms about writing the July 20 call. There is no absolute rule that can be
applied to all such situations, but one is usually better off writing the call that provides
the best balance between return and downside protection at all times. Only if one is bull-
ish on the underlying stock should he write the July 25 call.
AVOIDING THE UNCOVERED POSITION
There is a margin rule that the covered writer must be aware of if he is considering taking
an:· sort of follow-up action on the clay that the written call ceases trading. If another call
is sold on that clay,e\·en though the written call is obviously going to expire worthless, the
writer will he considered uncovered for margin purposes over the weekend and will be
obligated to put forth the collateral for an uncovered option. This is usually not what the
writer intends to do: being aware of this rule will eliminate unwanted margin calls. Fur-
thcnnore, 1111cm·erecl options may be considered unsuitable for many covered writers.
Exarnple: A cnstomer owns XYZ ancl has January 20 calls outstanding on the last day of
trading of the January series (the third Friday of January; the calls actually clo not expire
1111til tll(' follm,·ing day, Satmcla:1 If XYZ is at 1.5on the last day of trading, the January
20 call \\·ill almost Ct'rtainl:· expire worthlt>ss. Howe\·er, should the writer decide to sell a
Chapter
longer-term call on that clay without buying back the January 20, he will be considered
uncovered over the weekend. Thus, ~f011eplans to u;ait for an UJJtionto expire totally
1corthless b(furc 1criti11ganother call, he must wait until the Monday after expiration
before u:riting again, assuming that he wants to remain covered. The writer should also
realize that it is possible for some sort of news item to be announced between the encl of
trading in an option series and the actual expiration of the series. Thus, call holders might
exercise because they believe the stock will jump sufficiently in price to make the exercise
profitable. This has happened in the past, two of the most notable cases being IBM in
January 1975 and Carrier Corp. in September 1978.
WHEN TO LETSTOCK BE CALLEDAWAY
Another alternative that is open to the writer as the written call approaches expiration is
to let the stock be called away if it is above the striking price. In many cases, it is to the
advantage of the writer to keep rolling options forward for credits, thereby retaining his
stock ownership. However, in certain cases, it may be advisable to allow the stock to be
called away. It should be emphasized that the writer often has a definite choice in this
matter, since he can generally tell -when the call is about to be exercised-when the time
value premium disappears .
Example: A covered write is established by buying XYZ at 49 and selling an April 50 call
for .3points. The original break-even point was thus 46. Near expiration, suppose XYZ has
risen to ,56 and the April 50 is trading at 6. If the investor wants to roll forward, now is
the time to do so, because the call is at parity. However, he notes that the choices are
somewhat limited. Suppose the following prices exist with XYZ at ,56: XYZ October ,50
call, 7; and XYZ October 60 call, 2. It seems apparent that the premium levels have
declined since the original writing position was established, but that is an occurrence
beyond the control of the writer, who must work in the current market environment.
If the writer attempts to roll forward to the October 50, he could make at most I
additional point of profit until October (the time premium in the call). This represents an
extremely low rate of return, and the writer should reject this alternative since there are
surely better returns available in covered writes on other securities.
On the other hand, if the writer tries to roll up and forward, it will cost 4 points to
do so-6 points to buy back the April .50 less 2 points received for the October 60. This
debit transaction means that his break-even point would move up from the original level
of 46 to a new level of 50. If the common declines below 54, he would be eating into
profits already at hand, since the October 60 provides only 2 points of protection frorn the
current stock price of ,56. If the writer is not confidently bullish on the outlook for XYZ,
he should not roll up and forward.
At this point the writer has exhausted his alternatives for rolling. His remaining
choice is to let the stock be called away and to use the proceeds to establish a covered
write in a new stock, one that offers a more attractive rate of return with reasonable
downside protection. This choice of allowing the stock to be called away is generally the
wisest strategy if both of the following criteria are met:
1. Rolling forward offers only a minima l return.

2. Rolling up and forward significantly raises the break-even point and leaves the posi-
tion relatively unprotected shou ld the stock drop in price.
SPECIAL WRITING SITUATIONS
Our discussions have pertained directly to writing against common stock. However, one
ma_valso write covered call options against convertible securities, warrants, or LEAPS. In
addition. a different type of covered writing strategy-the incremental return concept-is
described that has great appeal to large stockholders, both individuals and institutions.
COVERED WRITING AGAINST A CONVERTIBLE SECURITY
It may he more a(kantageous to buy a security that is convertible into common stock than
to buy tlie stock itself, for covered call writing purposes. Convertible bonds and convertible
preferred stocks are sc>curitiescommonly used for this purpose. One advantage of using the
corn·c>1tiblesecurity is that it often has a higher yield than does the common stock itself.
Before describing the covered write, it may be beneficial to review the basics of
com·ertible securities. Suppose XYZ common stock has an XYZ convertible Preferred A
stock that is com·ertihle into LS shares of common. The 1mmher of shares of common that
the com·ertible security converts into is an important piece of information that the writer
must know. It can be found in a Strmdard & Poor'.-,Stock Guide (or Bond Guide. in the
case of convertible bonds).
The writc>r also needs to determine how many shares of the convertible securit_v
nn1st he owned in order to equal 100 shares of the common stock. This is quickly deter-
mined by cli, iding 100 h_vthe conversion ratio-LS in our XYZ example. Since 100
di\·ided h_\ LS cq11als 66.666, one must own 67 shares of XYZ cv Pfcl A to cover the sale
of one XYZ option for 100 shares of common. Note that neither the market prices of XYZ
common nor the convertible security are necessary for this computation.
\\'hen using a conn'rtible honcl, the com·ersion information is usually statecl in a
f'orn1 s1H.·has. "crn1,·erts into .50 shares at a price of 20.'' The price is irrele,·ant. \\'hat is
Chapter
important is the number of shares that the bond converts into-.S0 in this case. Thus , if
one were using these bonds for covered writing of one call, he would need two (2,000)
bonds to own the equivalent of 100 shares of stock.
Once one knows how much of the convertible security must be purchased, he can
use the actual prices of the securities, and their yields, to determine whether a covered
write against the common or the convertible is more attractive.
Example: The following information is known:
XYZ common, 50;

XYZ CV Pfd A, 80;
XYZ July 50 call, 5;
XYZ dividend, 1.00 per share annually; and
XYZ cv Pfd A dividend, 5.00 per share annually.
Note that, in either case, the same call-the July SO-would be written. The use of the
com;ertible as the underlying security does not alter the choice of u;hich option to use.
To make the comparison of returns easier, commissions are ignored in the calculations
given in Table 2.19. In reality, the commissions for the stock purchase, either common or
preferred, would be very similar. Thus, from a numerical point of view, it appears to be
more advantageous to write against the convertible than against the common.
When writing against a convertible security, additional considerations should be
looked at. The first is the premium, of the com;ertible security. In the example, with XYZ
TABLE 2.19.
Comparison of common and convertible writes.
Write
against
Common Write
against
Convertible
Buy underlying security $5,000(100 XYZ) $5,360 (67 XYZ CV Pfd A)
Sell one July 50 call 500 500
---
Net cash investment $4,500 $4,860
Premiumcollected $ 500 $ 500

DividendsuntilJuly 50 250
Maximum profit potential $ 550 $ 750
Return(profit divided by
investment) 12.2% 15.4%
selling at ,50, the XYZcv Pfd A has a true value of 1..5times 50, or $75 per share. However,
it is selling at 80, which represents a premium of 5 points above its computed value of 75.
Normally, one icould not u;ant to buy a convertible security if the premium is too large.
In this example , the premium appears quite reasonable. Any convertible premium greater
th an 15% above computed value might be considered to be too large .
Another consideration when writing against convertible securities is the handling of
assignment. If the writer is assigned, he may either (l) convert his preferred stock into
common and deliver that, or (2) sell the preferred in the market and use the proceeds to
huy 100 shares of common stock in the market for delivery against the assignment notice.
The seconcl choice is usually preferable if the convertible security has any premium at all,
since converting the preferred into common causes the loss of any premium in the con-
vertible, as well as the loss of accrued interest in the case of a convertible bond.
The writer should also be aware of whether or not the convertible is callable and, if
so, what the exact terms are. Once the convertible has been called by the company, it will
no longer trade in relation to the underlying stock, but will instead trade at the call price.
Tims, if the stock should climb sharply, the writer could be incurring losses on his written
option without any corresponding benefit from his convertible security. Consequently, if
the convertible is called, the entire position should normally be closed immediately hy
sellin g th e convertibl e and buying the option back.
Other aspects of covered writing, such as rolling down or forward, do not change
e\ ·en if the option is written against a convertible security. One would take action based
on the relationship of the option price and the common stock price, as usual.
WRITING AGAINST WARRANTS
It is also possible to write covered call options against warrants. Again, one must own
enough warrants to convert into 100 shares of the underlying stock; generally , this would
he 100 warrants. The transaction must be a cash transaction, the warrants must be paid
for in full, and they have no loan value . Technically , listed warrants may be marginable,
but 111,mybrokerage houses still require payment in full. There may be an additional
i11ust11ze11trequirement. Warrants also have an exercise price. If the exercise price of the
warrant is higher than the striking price of the call, the covered writer must also deposit
the difference b etwee n the two as part of his investment.
The advantage of using warrants is that, if they are deeply in-the-money , they may
pro\·icle the cash cm·ered writer with a higher return, since less of an investment is
involved.
Example: XYZ is at ,50 and there are XYZ warrants to buy the common at 2,5. Since the
\\·arrant is so de eply in-the-money, it will be selling for approximately $2.5per warrant. XYZ
Chapter
pays no dividend. Thus, if the writer were considering a covered write of the XYZ July .50,
he might choose to use the warrant instead of the common, since his investment, per 100
shares of common, would only be $2,,500 instead of the $.5,000 required to buy 100 XYZ.
The potential profit would be the same in either case because no dividend is involved.
Even if the stock does pay a dividend (warrants themselves have no dividend), the
writer may still be able to earn a higher return by writing against the warrant than against
the common because of the smaller investment involved. This would depend, of course,
on the exact size of the dividend and on how deeply the warrant is in-the-money.
Covered writing against warrants is not a frequent practice because of the small
number of warrants on optionable stocks and the problems inherent in checking available
returns. However, in certain circumstances, the writer may actually gain a decided advan-
tage by writing against a deep in-the-money warrant. It is often not advisable to write
against a warrant that is at- or out-of-the-money, since it can decline by a large percentage
if the underlying stock drops in price, producing a high-risk position. Also, the writer's
investment may increase in this case if he rolls down to an option with a striking price
lower than the warrant's exercise price .
WRITING AGAINST LONG-TERM OPTIONS
A form of covered call writing can be constructed by buying LEAPS call options and
selling shorter-term out-of-the-money calls against them. This strategy is much like writ-
ing calls against warrants. This strategy is discussed in more detail in Chapter 2.5, under
the subject of diagonal spreads.
THE INCREMENTAL RETURN CONCEPT (ROLLING FOR CREDITS)
The incremental return concept of covered call writing is a way in which the cor;ered
writer can earn the full value of stock appreciation between today'.s stock price and a
target sale price, which may be substantially higher. At the same time, the writer can
earn an incremental , positive return from writing options.
Many institutional investors are somewhat apprehensive about covered call writing
because of the upside limit that is placed on profit potential. If a call is written against a
stock that subsequently declines in price, most institutional managers would not view this
as an unfavorable situation, since they would be outperforming all managers who owned
the stock and who did not write a call. However, if the stock rises substantially after tht>
call is written, many institutional managers do not like having their profits limited by the
written call. This strategy is not only for institutional money managers, although one should
have a relatively substantial holding in an underlying stock to attempt the stratt>gy-at least
.500 shares and preferably 1,000 shares or more. The incremental return cu11c<pt rn11 he
used by anyone iclw is planning to hold his stock, ecen {fit should temporarily decline in
price, until it reacl1esa predetermined, higher price at u.;hichhe is 1.,cilling
to sell the stock.
The basic strategy involves, as an initial step, selecting the target price at which the
writer is willing to sell his stock.
Example: A customer owns, 1,000 shares ofXYZ, which is currently at 60, and is willing
to sell the stock at 80. In the meantime, he would like to realize a positice cash jloll· from
writing options against his stock. This positive cash flow does not necessaril:· result in a
realized option gain until the stock is called away. Most likely, with the stock at 60, there
would not he options available with a striking price of 80, so one could not write 10 Jul: ·
80's, for example. This would not be an optimum strategy e\·en if the July so·s existed. for
the investor would be receiving so little in option premiums-perhaps 10 cents per call-
that writing might not be worthwhile. The incremental return strateg:· allows this im·estor
to achie,·e his objectives regardless of the existence of options with a higher striking price.
The foundation of the incremental return strategy is to write against only a part of
the entire stock holding initially, and to write these calls at the striking price nearest the
current stock price. Then, should the stock mm·e up to the next higher striking price, one
rolls up for a credit by adding to the number of calls written. Rolling for a credit is manda-
tor: · and is the ke:· to the strategy. Eventually, the stock reaches the target price and the
stock is called away, the investor sells all his stock at the target price, and in addition earns
th e total credits from all the option transactions.
Example: XYZ is 60, the i1ffestor owns 1,000 shares, and his target price is SO.One might
begin hy selling three of the longest-term calls at 60 for 7 points apiece. Table :?.-:20shows
how a poor case-one in which the stock climbs directly to the target price-might work.
As Table :2-:20shows, if XYZ rose to 70 in one month, the three original calls would be
bought back and enough calls at 70 would be sold to produce a credit-5 XYZ October
,o ·s. If the stock continued upward to 80 in another month, the 5 calls would be bought
back and the entire position-10 calls-would be written against the target price.
If XYZ remains abm·e 80, the stock will be called awav and all 1,000 shares 1cillbe
sold at the target price of 80. In addition. the im estor will earn all the option credits gener-
ated along the ,,·a:·· These amount to $:2,800. Thus. the writer obtained the full appreciation
of his stock to the target price plus an incremental, posifo·e return from option writing.
In a flat market. the strategy is relatively easy to monitor. If a written call loses its
time ,·alm' premium and therefore might be subject to assignment. the writer can roll
fonrnrcl to a more distant expiration series, keeping the quantity of written calls constant.
This transaction would generate additional credits as well.
Chapter
TABLE 2.20.
Two months of incremental return strategy.
Day 1: XYZ= 60
Sell 3 XYZ October 60's at 7 +$ 2,100 credit
One month later: XYZ= 70

Buy back the 3 XYZ Oct 60's at 11 and -$ 3,300 debit
sell 5 XYZ Oct 70's at 7 +$3,500 credit
Two months later: XYZ= 80

Buy back the 5 Oct 70's at 11 and -$ 5,500 debit
sell 10 XYZ Oct 80's at 6 +$6,000 credit
+$2,800 credit
If the target price is eventually reached, and the writer then decides that he wants
to retain some of the stock, the "partial extraction strategy" described earlier can be used
when the written calls begin to lose their time value premium. Once the position is
"extracted," a new, higher target can be set and the whole process begun once again.
COVERED CALL WRITING SUMMARY
This concludes the chapter on covered call writing. The strategy will be referred to later,
when compared with other strategies. Here is a brief summary of the more important
points that were discussed.
Covered call writing is a viable strategy because it reduces the risk of stock ownership
and will make one's portfolio less volatile to short-term market movements. It should be
understood, however, that covered call writing may underperform stock ownership in gen-
eral because of the fact that stocks can rise great distances, while a covered write has limited
upside profit potential. The choice of which call to write can make for a more aggressive or
more conservative write. Writing in-the-money calls is strategically more conservative than
writing out-of-the-money calls, because of the larger amount of downside protection
received. The total return concept of covered call writing attempts to achieve the maxi mum
halance between income from all sources-option premiums, stock ownership, and divi-
dend income-and downside protection. This balance is usually realized by writing calls
when tlie stock is near the striking price, either slightly in- or slightly out-of~the-money.
The writer should compute various returns before entering into the position: the
return if exercised, the return if the stock is unchanged at expiration, and the break-even
point. To truly compare various writes, returns should be annualized, and all commissions
and dividends should be included in the calculations. Returns will be increased by taking
larger positions in the underlying stock-500 or 1,000 shares. Also, by utilizing a broker-
age firm's capability to produce "net" executions, buying the stock and selling the call at
a specified net price differential, one will receive better executions and realize higher
return s in the long run.
The selection of which call to write should be made on a comparison of available returns
and downside protection. One can sometimes write part of his position out-of-the-money and
the other part in-the-money to force a balance between return and protection that might not
otherwise exist. Finally, one should not write against an underlying stock if he is bearish on
the stock. The writer should be slightly bullish, or at least neutral, on the underlying stock
Follow-up action can he as important as the selection of the initial position itself. By
rolling down if the underlying stock drops, the investor can add downside protection and
curre nt income . If one is unwilling to limit his upside potential too severely , he may con-
sider rolling clown only part of his call writing position. As the written call expires , the
writer should roll forward into a more distant expiration month if the stock is relatively
close to the original striking price . Higher consistent returns are achieved in this manner ,
because ont>is not spending additional stock commissions by letting the stock be called
away. An aggr essive follow-up action can also be taken when the underlying stock rises in
pric e: Th e writer can roll up to a higher striking price. This action increases the maximum
profit pot ential but also exposes the position to loss if the stock should subsequently
decline. One would want to take no follow-up action and let his stock be called if it is
ahm ·e the striking price and if there are better returns available elsewhere in other
securi ties.
Cm ·ered call writing can also be done against convertible securities-bonds or pre-
ft>rred stocks. Thes e com ·ertibles sometimes offer higher dividend yields and therefore
increase the m·erall return from covered writing. Also, the use of warrants in place of the
underl:·ing stock may be advantageous in certain circumstances, because the net invest-
ment is lowered while the profit potential remains the same. Therefore , the overall return
could be higher.
Finally, tlw larger indiv idual stockholder or institutional investor who wants to
achie\ ·e a certain price for his stock holdings should or)erate his covered writinab stratea)•
L b
11ncler the incremental return conc ept. This will allow him to realize the full profit poten-
tial of hi s 11nclerlying stock. up to the target sale price , and to earn additional positive
income from option writing.
Call Buying
The success of a call buying strategy depends primarily on one's ability to select stocks
that will go up and to time the selection reasonably well. Thus, call buying is not a strategy
in the same sense of the word as most of the other strategies discussed in this text. Most
other strategies are designed to remove some of the exactness of stock picking, allowing
one to be neutral or at least to have some room for error and still make a profit. Tech-
niques of call buying are important, though, because it is necessary to understand the long
side of calls in order to under stand more comple x strategies correctly.
Call buying is the simplest form of option investment, and therefore is the most
frequently used option "strategy" by the public investor. The following section outlines
the basic facts that one needs to know to implement an intelligent call buying program.
WHY BUY?
The main attraction in buying calls is that they prouide the speculator iuith a great deal
of leverage. One could potentially realize large percentage profits from only a modest rise
in price by the underlying stock. Moreover, even though they may be large percentage-
wise, the risks cannot exceed a fixed dollar amount-the price originally paid for the call.
Calls must be paid for in full; they have no margin value and do not constitute equity for
margin purposes. Note: The preceding statements regarding payment for an option in full
do not necessarily apply to very long-term (LEAPS) options, which were declared margin-
able in 1999. The following simple example illustrates how a call purchase might work.
Example: Assume that XYZ is at 48 and the 6-month call, the July .SO,is selling for :3.Thus ,
with an investment of $.300, the call buyer may participate, for 6 months, in a movt' upward
in the price of XYZ common. IfXYZ should rise in price by 10points (just ovt'r 20%), the Jul~·
85
.50 call will be worth at least $800 and the call buyer would have a 167% profit on a move in
thP stock of just over 20%. This is the leverage that attracts speculators to call buying. At
expiration, ifXYZ is below .SO,the buyer's loss is total, but is limited to his initial $:300 invest-
ment, en'11 if XYZ declines in price substantially. Although this risk is equal to 100% of his
initial im·pstment, it is still small dollarwise. One should normally not invest more than 15%
cf his risk capital in call buying, because of the relatively large percentage risks involved.
Some investors participate in call buying on a limited basis to add some upside
potential to tlwir portfolios while keeping the risk to a fixed amount. For example, if an
i1westor 11ormally only purchased low-volatilit y, conservative stocks because he wanted to
limit his downside risk. he might consider putting a small percentage of his cash into calls
on more rnlatile stocks. In this manner, he could "trade" higher-risk stocks than he might
nonnally clo. If these \'olatile stocks increase in price, the investor will profit handsomely.
Howewr, if they decli11e substan tially-as well they might, being volatile-the investor
has limited his dollar risk by owning the calls rather than the stock.
Another reason some investors buy calls is to be able to buy stock at a reasonable
price without missing a market.
Example: With XYZ at 7.5, this investor might buy a call on XYZ at 80. He would like to
own XYZ at 80 if it can prove itself capable of rallying and be in-the-money at expiration.
He would exercisP the call in that case. On the other hand, ifXYZ declines in price instead,
he has not tied up 111one~ ' in the stock and can lose only an amount equa l to the call pre-
lllirnn that he paid, an amount that is generally much less than the price of the stock itself.
AnothPr approach to call buying is sometimes utilized, also by an investor who does
not want to "miss the market." Suppose an investor knows that, in the near future, he will
haw' an amount of rnone:v large enough to purchase a particular stock; perhaps he is clos-
ing thP salt' of his house or a certificate of de11osit is maturing. However, he would like to
l <._;
lm: · tlH:'stock now, for he feelsa rally is imminent. He might buy calls at the present time
if hP had a small amount of cash ,l\'ailable. The call purchases would require an invest-
ment much smaller than the stock purchase. Then, when he receives the cash that he
k1ww was forthcoming. hE' could exprcise the calls and buy the stock. In this way, he might
haw participated in a rally hy the stock before he actually had the money available to pay
for the stock in full.
RISK AND REWARD FOR THE CALL BUYER
Tltc rnost in1porta11t fact for thP call hu\'er to realize is that he will normallv win onlv if
t lw stock rises in price. All tilt' worthwl~ile anal~·sis in the world spent in SE'l~ctingwl;ich
call to hn: \\·ill not product' profits if the underlying stock declines. Howe\·er, this fact
Chapter
3: CallBuying 87
should not dissuade one from making reasonable analyses in his call buying selections.
Too often, the call buyer feels that a stock will move up, and is correct in that part of his
projection, but still loses money on his call purchase because he failed to analyze the risk
and rewards involved with the various calls available for purchase at the time. He bought
the wrong call on the right stock.
Since the best ally that the call buyer has is upward movement in the underlying stock,
the selection of the underlying stock is the most important choice the call buyer has to make.
Since timing is so important when buying calls, the technical factors of stock selection prob-
ably outweigh the fundamentals; even if positive fundamentals do exist, one does not know
how long it will take in order for them to be reflected in the price of the stock. One must be
bullish on the underlying stock in order to consider buying calls on that stock. Once the
stock selection has been made, only then can the call buyer begin to consider other factors,
such as which striking price to use and which expiration to buy. The call buyer may have
another ally, but not one that he can normally predict: If the stock on which he owns a call
becomes more volatile, the call's price will rise to reflect that change.
The purchase of an out-of-the-money call generally offers both larger potential risk
and larger potential reward than does the purchase of an in-the-money call. Many call
buyers tend to select the out-of-the-money call merely because it is cheaper in price.
Absolute dollar price should in no way be a deciding factor for the call buyer. If one's
funds are so limited that he can only afford to buy the cheapest calls, he should not be
speculating in this strategy. If the underlying stock increases in price substantially, the
out-of-the-money call will naturally provide the largest rewards. However, if the stock
advances only moderately in price, the in-the-money call may actually perform better.
Example: XYZ is at 6.5 and the July 60 sells for 7 while the July 70 sells for .3. If the stock
moves up to 68 relatively slowly, the buyer of the July 70-the out-of-the-money call-
may actually experience a loss, even if the call has not yet expired. However, the holder
of the in-the-money July 60 will definitely have a profit because the call will sell for at least
8 points, its intrinsic value. The point is that, percentage-wise, an in-the-money call will
offer better retcards for a modest stock gain, and an out-of-the-money call is better for
larger stock gains.
When risk is considered, the in-the-money call clearly has less probability of risk. In
the prior example, the in-the-money call buyer would not lose his entire investment unless
XYZ fell by at least .5 points. However, the buyer of the out-of-the-money July 70 would
lose all of his investment unless the stock advanced by more than .5points by expiration.
Obviously, the probability that the in-the-money call will expire worthless is much smaller
than that for the out-of-the-money call.
The time remaining to expiration is also relevant to the call buyer. If the stock is fairly
close to the striking price, the near-term call will most closely follow the prict> rnovt>mt>nt
of the underlying stock, so it has the greatest rewards and also the greatest risks. The
far-term call, because it has a large amount of time remaining, offers the least risk and least
percentage reward. The intermediate-term call offers a moderate amount of each, and is
therefore often the most attractive one to buy. Many times an investor will buy the
longer-term call because it only costs a point or a point and a half more than the
intermediate-term call. He feels that the extra price is a bargain to pay for three extra
months of time. This line of thought may prove somewhat misleading, however, because
most call buyers don't hold calls for more than 60 or 90 days. Thus, even though it looks
attractive to pay the extra point for the long-term call, it may prove to be an unnecessary
expense if, as is usually the case, one will be selling the call in two or three months.
CERTAINTY OF TIMING
The certainty with which one expects the underlying stock to advance may also help to play
a part in his selection of which call to buy. If one is fairly sure that the underlying stock is
about to rise immediately, he should strive for more reward and not be as concerned about
risk. This would mean buying short-term, slightly out-of-the-money calls. Of course , this is
only a general rule; one would not normally buy an out-of-the-money call that has only one
week remaining until expiration, in any case. At the opposite end of the spectrum, if one is
vt>ryuncertain about his timing, he should buy the longest-term call, to moderate his risk in
case his timing is wrong by a wide margin. This situation could easily result, for example , if
one feels that a positive fundamental aspect concerning the company will assert itself and
cause the stock to increase in price at an unknown time in the future. Since the buyer does
not know whether this positive fundamental will come to light in the next month or six
months from now, he should buy the longer-term call to allow room for error in timing.
In many cases , one is not intending to hold the purchased call for any significant
period of time; he is just looking to capitalize on a quick, short-term movement by the
unclerl_ving stock. In this case , he would want to buy a relatively short-term in-the-money
call. Although such a call may be more expensive than an out-of-the-money call on the
same underlying stock, it will most surely move up on any increase in price by the underly-
ing stock. Thu s, the short -term trader would profit.
THE DELTA
Tlw rt'acler should by now be familiar with basic facts concerning call options: The time
prt'1nium is highest when the stock is at the striking price of the call; it is lowest deep in-
or 011t-of~the-m01wy ; option prices do not decay at a linear rate-the time premium dis-
app ea rs lllor e rapidly as the option approaches expiration. As a further means of review ,
tlw O/Jtio11pricing Cl/ITC introduced in Chapter l is reprinted here. Notice that all the
Chapter
3: CallBuying 89
FIGURE 3-1.
Option pricing curve; 3-, 6-, and 9-month calls.
9-Month Curve
(I)
(.)
;t
C
0
li As expiration date draws
0
closer, the lower curve
merges with the intrinsic
value line. The option
price then equals its
intrinsic value.
/
Intrinsic Value
Striking Price
Stock Price
facts listed above can be observed from Figure 3-1. The curves are much nearer the
"intrinsic value" line at the ends than they are in the middle, implying that the time value
premium is greatest when the stock is at the strike, and is least when the stock moves
away from the strike either into- or out-of-the-money. Furthermore, the fact that the
curve for the 3-month option lies only about halfway between the intrinsic value line and
the curve of the 9-month option implies that the rate of decay of an at- or near-the-money
option is not linear. The reader may also want to refer back to the graph of time value
premium decay in Chapter 1 (Figure 1-4).
There is another property of call options that the buyer should be familiar with, the
delta of the option (also called the hedge ratio). Simply stated, the delta of an option is the
amount by which the call will increase or decrease in price if the underlying stock moves
by 1 point.
Example: The delta of a call option is close to 1 when the underlying stock is well above
the striking price of the call. If XYZ were 60 and the XYZ July 50 call were 10.10, the call
would change in price by nearly 1 point if XYZ moved by 1 point, either up or down. A
deeply out-of-the-money call has a delta of nearly zero. If XYZ were 40, the July ,50 call
might be selling at .25 of a point. The call would change very little in price if XYZ moved
by one point, to either 41 or 39. When the stock is at the striking price, the delta is usually
between .,50and .60. Thus, if XYZ were 50 and the XYZ July 50 call were 5, the call might
increase to 5.,50 ifXYZ rose to 51 or decrease to 4.,50 if XYZ dropped to 49. Very long-term
calls may have even larger at-the-money deltas.
Actually, the delta changes each time the underlying stock changes even fractionally
in price; it is an exact mathematical derivation that is presented in a later chapter. This is
most easily seen by the fact that a deep in-the-money option has a delta of l. However, if the
stock should undergo a series of I-point drops down to the striking price, the delta will be
more like ..50, certainly not 1 any longer. In reality, the delta changed instantaneously all
during the price decline by the stock. For those who are geometrically inclined, the preced-
ing option price curve is useful in determining a graphic representation of the delta. The
delta is the slope of the tangent line to the price curve. Notice that a deeply in-the-money
option lies to the upper right side of the curve, very nearly on the intrinsic value line, which
has a slope of 1 above the strike. Similarly, a deeply out-of-the-money call lies to the left on
the price curve, again near the intrinsic value line, which has a slope of zero below the strike.
Since it is more common to relate the option's price change to a full point change in
the underlying stock (rather than to deal in "instantaneous" price changes), the concepts
of up delta and down delta arise. That is, if the underlying stock moves up by 1 full point,
a call with a delta of ..SOmight increase by ..S.S.However, should the stock fall by one full
point, the call might decrease by only .45. There is a different net price change in the call
when the stock moves up by 1 full point as opposed to when it falls by a point. The up
delta is observed to be .55 while the down delta is .45. In the true mathematical sense,
there is only one delta and it measures "instantaneous" price change. The concepts of up
delta and down delta are practical, rather than theoretical, concepts that merely illustrate
the fact that the true delta changes whenever the stock price changes, even by as little as
1 point. In the following examples and in later chapters, only one delta is referred to.
The delta is an important piece of information for the call buyer because it can tell
him how much of an increase or decrease he can expect for short-term moves by the
underlying stock. This piece of information may help the buyer decide which call to buy.
Example: If XYZ is 47.50 and the call buyer expects a quick, but possibly limited, rise in
price in the underlying stock, should he buy the 45 call or the 50 call? The delta may help
him decide. He has the following information:
XYZ:47.50 XYZJuly 45 call: price = 3.50, delta= .65

XYZJuly 50 call: price= 1.00, delta= .25
It will make matters easier to make a slightly incorrect, but simplifying, assumption that
the deltas remain constant over the short term. Which call is the better buy if the buyer
expects the stock to quickly rise to 49? This would represent a LSO-point increase in
XYZ, which would translate into a 97-cent increase in the July 45 call price (1..50 times
O.G.S)or a Ti-cent increase in the July ,50 call (LSO times 0.25). Consequently, the July 45
calL if it increased in price by 97 cents, would appreciate by 28%. The July 50 call, if it
Chapt
er 3: Call Buying 91
increased by 37 cents, would appreciate by :37%.Thus, the July 50 appears to be the bet-
ter buy in this simple example. Commissions should, of course, be included when making
an analysis for actual investment.
The investor does not have to bother with computing deltas for himself. Any good
call-buying data service will supply the information, and some brokerage houses provide
this information free of charge.
More advanced applications of deltas are described in many of the succeeding chap-
ters, as they apply to a variety of strategies.
WHICH OPTION TO BUY?
There are various trading strategies, some short-term, some long-term (even buy and
hold). If one decides to use an option to implement a trading strategy, the time horizon of
the strategy itself often dictates the general category of option that should be bought-in-
the-money versus out-of-the-money, near-term versus long-term, etc. This statement is
true whether one is referring to stock, index, or futures options. The general rule is this:
The shorter-term the strategy, the higher the delta should be of the instrument being
used to trade the strategy.
DAY TRADING
For example, day trading has become a popular endeavor. Statistics have been produced
that indicate that most day traders lose money. In fact, there are profitable day traders; it
simply requires more and harder work than many are willing to invest. Many day traders
have attempted to use options in their strategies. These day traders apparently are attracted
by the leverage available from options, but they often lose money via option trading as well.
What many of these option-oriented day traders fail to realize is that, for day-trading
purposes, the instrument with the highest possible delta should be used. That instrument
is the underlying, for it has a delta of 1.0. Day trading is hard enough without complicating
it by trying to use options. So of you're day trading Microsoft (MSFT), trade the stock, not
an option.
What makes options difficult in such a short-term situation is their relatively wide
bid-asked spread, as compared to that of the underlying instrument itself. Also, a day
trader is looking to capture only a small part of the underlying's daily move; an at-the-
money or out-of-the-money option just won't respond well enough to those movements.
That is, if the delta is too low, there just isn't enough room for the option day trader to
make money.
If a day trader insists on using options, a short-term, in-the-money should be bought,

for it has the largest delta available-preferably something approaching .90 or higher. This
opt ion will respond qu ickly to small movement s by th e und erlying .
SHORT-TERM TRADING
Suppose one employs a strategy whereby he expects to hold the underlying for approxi-
mately a week or two. In this case, just as with day trading, a high delta is desirable .
However, now that the holding period is more than a day, it may be appropriate to buy an
option as opposed to merely trading the underlying, because the option lessens the risk
of a surprisingly large downside move. Still, it is the short-term, in-the-money option that
should be bought, for it has the largest delta, and will thus respond most closely to the
movement in the underlying stock. Such an option has a very high delta, usually in excess
of .80. Part of the reason that the high-delta options make sense in such situations is that
one is fairly certain of the timing of day trading or very short-term trading systems. When
the system being used for selection of which stock to trade has a high degree of timing
accu racy, th en th e high -delta opt ion is called for.
INTERMEDIATE-TERM TRADING
As the time horizon of one's trading strategy lengthens, it is appropriate to use an option
with a lesser delta. This generally means that the timing of the selection process is less
exact. One might be using a trading system based, for example, on sentiment, which is
generally not an exact timing indicator, but rather one that indicates a general trend
change at ll1c\jor turning points. The timing of the forthcoming move is not exact, because
it often takes time for an extreme change in sentiment to reflect itself in a change of direc-
tion by th e un derly ing.
Hence, for a strategy such as this, one would want to use an option with a smaller
delta. The i1l\'estor would limit his risk by using such an option, knowing that large moves
are possible since the position is going to be held for several weeks or perhaps even a couple
of months or more. Therefore, an at-the-money option can be used in such situations.
LONG-TERM TRADING
If one\ strategy is even longer-term, an option with a lower delta can be considered. Such
strategies vmuld generally have only vague timing qualities, such as selecting a stock to
buy based on the general fondamental outlook for the company. In the extreme , it would
even apply to "buy and hold" stra tegies.
Chapter
3: CallBuying 93
Generally, buying out-of-the-money options is not recommenclecL hut for very long-
term strategies, one might consider something slight!!} out-of-the-money, or at least a fairly
long-term at-the-money option. In either case, that option will have a lower delta as com-
pared to the options that have been recommended for the other strategies mentioned
above. Alternatively, LEAPS options might be appropriate for stock strategies of this type.
ADVANCED SELECTION CRITERIA
The criteria presented previously represented elementary techniques for selecting which
call to buy. In actual practice, one is not usually bullish on just one stock at a time. In fact,
the investor would like to have a list of the "best" calls to buy at any given time. Then,
using some method of stock selection, either technical or fundamental, he can select
three or four calls that appear to offer the best rewards. This list should be ranked in
order of the best potential rewards available, but the construction of the list itself is
important.
Call option rankings for huuing p1Lrposes must be based 011 the wlatilities of the
underluing stocks. This is not easy to do mathematically, and as a result many published
rankings of calls are based strictly on percentage change in the underlying stock. Such a
list is quite misleading and can lead one to the wrong conclusions.
Example: There are two stocks with listed calls: NVS, which is not volatile, and VVS,
which is quite volatile. Since a call on the volatile stock will be higher-priced than a call
on the nonvolatile stock, the following prices might exist:
NVS: 40 VVS: 40
NVSJuly 40 call: 2 VVSJuly 40 call: 4
If these two calls are ranked for buying purposes, based strictly on a percentage change
in the underlying stock, the NVS call will appear to be the better buy. For example, one
might see a list such as "best call buys if the underlying stock advances by 10%." In this
example, if each stock advanced 10% by expiration, both NVS and VVS would be at 44.
Thus, the NVS July 40 would be worth 4, having doubled in price, for a 100% potential
profit. Meanwhile, the VVS July 40 would be worth 4 also, for a 0% profit to the call
buyer. This analysis would lead one to believe that the NVS July 40 is the better huy. Such
a conclusion may be wrong, because an incorrect assumption was made in the>ranking of
the potentials of the two stocks. It is not right to assume>that both stocks hm·t' the same
probability of moving 10% by expiration. Certainly, the volatile stock has a much hetter
chance of advancing by 10% (or more) than the nonvolatile stock does. Any ranking based
on equal percentage changes in the underlying stock, without regard for their volatilities,
is useless and should be avoided.
The correct method of comparing these two July 40 calls is to utilize the actual vola-
tilities of the underlying stocks. Suppose that it is known that the volatile stock, VVS,
could expect to move 1.5% in the time to July expiration. The nonvolatile stock, NVS,
howe ver, could only expect a move of .5% in the same period. Using this information, the
call buyer can arrive at the conclusion that VVS July 40 is the better call to buy:
Stock
Price
inJuly Call
Price
VVS:46 (up 15%) VVSJuly 40: 6 (up 50%)
NVS: 42 (up 5%) NVSJuly 40: 2 (unchanged)
By assuming that each stock can rise in accordance with its volatility, we can see that the
VVS July 40 has the better reward potential, despite the fact that it was twice as expen-
sive to begin with. This method of analysis is much more realistic.
One more refinement needs to be made in this ranking process. Since most call pur-
chases are made for holding periods of from 30 to 90 days, it is not correct to assume that
the calls will be held to expiration. That is, even if one buys a 6-month call, he will normally
liquidate it, to take profits or cut losses, in 1 to 3 months. The call buyer's list should thus
he based on hou; the call 1cillperform if held for a realistic tinw period, such as 90 days.
Suppose the rnlatile stock in our example, VVS, has the potential to rise by 12% in
90 days, while the less volatile stock, NVS, has the potential of rising only 4% in 90 days.
In 90 days, the July 40 calls will not be at parity, because there will Le some time remain-
ing until July expiration. Thus, it is necessary to attempt to predict what their prices will
be at the end of the 90-day holding period. Assume that the following prices are accurate
estimates of what the July 40 calls will be selling for in 90 days, if the underlying stocks
advance in relation to their volatilities:
Stock
Price
in90Days Call
Price
VVS:44.8 (up 12%) VVSJuly 40: 6 (up 50%)
NVS: 41.6 (up 4%) NVSJuly 40: 2.50 (up 25%)
\ \ 'ith some time remaining in the calls, they would both have time value premium at the end
of 90 da~;s.The bigger time premium would be in the VVS call, since the underlying stock is
lllore rnlatile. Under this method of analysis, the VVS call is still the better one to buy.
Chapter
3: CallBuying 95
The correct method of ranking potential reward situations for call buyers is as
follows:
1. Assume each underlying stock can advance in accordance with its volatility over a
fixed period (30, 60, or 90 days).
2. Estimate the call prices after th e advance .
3. Rank all potential call purchases by highest percentage reward opportunity for
aggre ssive purchase s.
4. Assume each stock can decline in accordance with its volatility.
5. Estimate the call prices after the decline .
6. Rank all purchases by reward/risk ratio (the percentage gain from item 2 divided by
the percentage loss from item 5).
The list from item 3 will generate more aggressive purchases because it incorporates
potential rewards only. The list from item 6 would be a less speculative one. This method
of analysis automatically incorporates the criteria set forth earlier, such as buying short-
term out-of-the-money calls for aggressive purchases and buying longer-term in-the-
money calls for a more conservative purchase. The delta is also a function of the volatility
and is essentially incorporated by steps 1 and 4.
It is virtually impossible to perform this sort of analysis without a computer. The call
buyer can generally obtain such a list from a brokerage firm or from a data service. For
those individuals who have access to a computer and would like to generate such an analy-
sis for themselves, the details of computing a stock's volatility and predicting the call
prices are provided in Chapter 28 on mathematical techniques .
OVERPRICED OR UNDERPRICED CALLS
Formulae exist that are capable of predicting what a call should be selling for, based on
the relationship of the stock price and the striking price, the time remaining to expira-
tion, and the volatility of the underlying stock. These are useful, for example, in perform-
ing the second step in the foregoing analysis, estimating the call price after an advance in
the underlying stock. In reality, a call's actual price may deviate somewhat from the price
computed by the formula. If the call is actually selling for more than the "fair" (com-
puted) price, the call is said to be overvalued. An undervalued call is one that is actually
trading at a price that is less than the "fair " price .
If the calls are truly overpriced, there may be a strategy that can help reduce their
cost while still preserving upside profit potential. This strategy, however, requires the
addition of a put spread to the call purchase, so it is beyond the scope of the subject matter
at the current time. It is described in Chapter 2:3 on spreads combining calls and puts.
Generally, the amount by which a call is overvalued or undervalued may be only a
small fraction of a point, such as 10 or 20 cents. In theory, the call buyer who purchases
an undervalued call has gained a slight advantage in that the call should return to its "fair"
value. However, in practice, this information is most useful only to market-makers or firm
traders who pay little or no commissions for trading options. The general public cannot
benefit directly from the knowledge that such a small discrepancy exists, because of com-
mission costs.
One should not base his call buying decisions merely on the fact that a call is under-
priced. It is small solace to the call buyer to find that he bought a "cheap" call that subse-
quently declined in price. The method of ranking calls for purchase that has been
described does, in fact, give some slight benefit to underpriced calls. However, under the
recommended method of analysis, a call will not automatically appear as an attractive
purchase just because it is slightly undervalued.
TIME VALUE PREMIUM IS A MISNOMER
This is a topic that will be mentioned several times throughout the book, most notably in
conjunction with volatility trading. It is introduced here because even the inexperienced
option trader must understand that the portion of an option's price that is not intrinsic
value-the part that we routinely call "time value premimn"-is really composed of
much more than just time value. Yes, time will eventually wear away that portion of the
option's price as expiration approaches. However, when an option has a considerable
amount of time remaining until its expiration, the more important component of the
option \·alue is really volatility. If traders expect the underlying stock to be volatile, the
option will be expensive; if they expect the opposite, the option will he cheap. This expen-
siveness ancl cheapness is reflected in the portion of the option that is not intrinsic value.
For example, a six-month option will not decay much in one day's time, but a quick change
in volatility expectations by option traders can heavily affect the price of the option, espe-
cially one with a good deal of time remaining. So an option buyer should carefully assess
his purchases, not just view them as something that will waste away. With careful analy-
sis, option buyers can do \·ery well, if they comicler what can happen during the life of the
option , and not merely what will happen at expiration .
CALL BUYERS' FRUSTRATIONS
Despite one's best efforts, it rna:' often seem that one does not make much money when a
fairl: n>latile stock lllakes a quick mon' of :3or 4 points. The reasons for this are somewhat
Chapter
3: CallBuying 97
more complex than can be addressed at this time, although they relate strongly to delta,
time decay, and the volatility of the underlying stock. They are discussed in Chapter :36,
"The Basics of Volatility Trading." If one plans to conduct a serious call buying strategy. he
should read that chapter before embarking on a program of extensive call buying.
FOLLOW-UP ACTION
The simplest follow-up action that the call buyer can implement when the underlying
stock drops is to sell his call and cut his losses. There is often a natural tendency to hold
out hope that the stock can rally back to or above the striking price. Most of the time, the
buyer does best by cutting his losses in situations in which the stock is performing poorly.
He might use a "mental" stop price or could actually place a sell stop order, depending on
the rules of the exchange where the call is traded. In general, stop orders for options
result in poor executions, so using a "mental" stop is better. That is, one should base his
exit point on the technical pattern of the underlying stock itself. If it should break down
below support, for example, then the option holder should place a market (not held) order
to sell his call option.
If the stock should rise, the buyer should be willing to take profits as well. Most buy-
ers will quite readily take a profit if, for example, a call that was bought for ,5 points had
advanced to be worth 10 points. However, the same investor is often reluctant to sell a call
at 2 that he had previously bought for 1 point, because "I've only made a point." The simi-
larity is clear-both cases resulted in approximately a 100% profit-and the investor
should be as willing to accept the one as he is the other. This is not to imply that all calls
that are bought at l should be sold when and if they get to 2, but the same factors that
induce one to sell the IO-point call after doubling his money should apply to the 2-point
call as well.
In fact, taking partial profits after a call holding has increased in value is often a
wise plan. For example, if someone bought a number of calls at a price of :3,and they later
were worth 5, it might behoove the call holder to sell one-third to one-half of his position
at 5, thereby taking a partial profit. Having done that, it is often easier to let the profits
run on the balance , and letting profits nm is generally one of the keys to successful
trading.
It is rarely to the call buyer's benefit to exercise the call if he has to pay commissions.
When one exercises a call, he pays a stock commission to buy the stock at the striking
price. Then when the stock is sold, a stock sale commission must also be paid. Since option
commissions are much smaller, dollarwise, than stock commissions, the call holder
will usually realize more net dollars by selling the call in the option market than hy exer-
cising it.
LOCKING IN PROFITS
\ Vhen the call buyer is fortunate enough to see the underlying stock advance relatively
quickly, he can implement a number of strategies to enhance his position. These strate-
gies are often useful to the call buyer who has an unrealized profit but is torn between
taking the profit or holding on in an attempt to generate more profits if the underlying
stock should continue to rise .
Example: A call buyer bought an XYZ October 50 call for 3 points when the stock was at
48. Then the stock rises to 58. The buyer might consider selling his October 50 (which
would probably be worth about 9 points) or possibly taking one of several actions, some of
which might involve the October 60 call, which may be selling for 3 points. Table 3-1
summarizes the situation. At this point, the call buyer might take one of four basic actions:
1. Liquidate the position by selling the long call for a profit.

2. Sell the October .50that he is currently long and use part of the proceeds to purchase
October 60's.
3. Create a spread by selling the October 60 call against his long October 50.
4. Do nothing and remain long the October 50 call.
TABLE 3-1.
Present situation on XYZ October calls.
Original
Trade Current
Prices
XYZ common: 48 XYZ Common: 58
Bought XYZ October 50 at 3 XYZ October 50: 9
XYZ October 60: 3
Each of these actions would produce different levels of risk and reward from this
point forward. If the holder sells the October .SOcall, he makes a 6-point profit, less com-
missions, and terminates the position. He can realize no further appreciation from the
call, nor can he lose any of his current profits; he has realized a 6-point gain. This is the
tactic of the follr. If the underlying stock continues to advance and rises
lrnst rz{.!.J.!,rcssii;e
abow 6:3.any of the other three strategies will outperform the complete liquidation of the
call. However, if the underlying stock should instead decline below .SOby expiration, this
action would have provided the most profit of the four strategies.
The other simple tactic, the fourth one listed, is to do nothing. If the call is then held
Chapter
3: CallBuying 99
to expiration, this tactic ivould be the riskiest of the four. It is the only one that could
produce a loss at expiration if XYZ fell back below 50. However, if the underlying stock
continues to rise in price, more profits would accrue on the call. Every call buyer realizes
the ramifications of these two tactics-liquidating or doing nothing-and is generally
looking for an alternative that might allow him to reduce some of his risk without cutting
off his profit potential completely. The remaining two tactics are geared to this purpose:
limiting the total risk while providing the opportunity for further profits of an amount
greater than those that could be realized by liquidating.
The strategy in which the holder sells the call that he is currently holding, the October
50, and uses part of the proceeds to buy the call at the next higher strike is called rolling up.
In this example, he could sell the October 50 at 9, pocket his initial 3-point investment, and
use the remaining proceeds to buy two October 60 calls at 3 points each. Thus, it is some-
times possible for the speculator to recoup his entire original investment and still increase
the number of calls outstanding by rolling up. Once this has been done, the October 60 calls
will represent pure profits, whatever their price. The buyer who "rolls up" in this manner
is essentially speculating with someone else'.s·nwney. He has put his own money back in his
pocket and is using accrued profits to attempt to realize further gains. At expiration, this
tactic would perform best ifXYZ increased by a substantial amount. This tactic turns out to
be the worst of the four at expiration ifXYZ remains near its current price, staying above 53
but not rising above 63 in this example.
The other alternative, the third one listed, is to continue to hold the October 50 call
but to sell the October 60 call against it. This would create what is known as a bull spread,
and the tactic can be used only by traders who have a margin account and can meet their
firm's minimum equity requirement for spreading (generally $2,000). This spread position
has no risk, for the long side of the spread-the October SO-cost 3 points, and the short
side of the spread-the October 60-brought in 3 points via its sale. Even if the underly-
ing stock drops below 50 by expiration and all the calls expire worthless, the trader cannot
lose anything except commissions. On the other hand, the maximum potential of this
spread is 10 points, the difference between the striking prices of 50 and 60. This maxi-
mum potential would be realized ifXYZ were anywhere above 60 at expiration, for at that
time the October 50 call would be worth 10 points more than the October 60 call, regard-
less of how far above 60 the underlying stock had risen. This strategy will he the best
performer of the four if XYZ remains relatively unchanged, above the lower strike but not
much above the higher strike by expiration. It is interesting to note that this tactic is never
the worst performer of the four tactics, no matter where the stock is at expiration. For
example, if XYZ drops below 50, this strategy has no risk and is therefore better than the
"do nothing" strategy. IfXYZ rises substantially, this spread produces a profit of 10 points,
which is better than the 6 points of profit offered by the "liquidate" strategy.
* * *
There is no definite answer as to which of the four tactics is the best one to apply in a
given situation. However, if a call can be sold against the currently long call to produce a bull
spread that has little or no risk, it may often be an attractive thing to do. It can never turn out
to he the worst decision, and it would produce the largest profits if XYZ does not rise sub-
stantially or fall substantially from its current levels. Tables 3-2 and 3-3 summarize the four
alternative tactics, when a call holder has an unrealized profit. The four tactics, again, are:
TABLE 3-2.
Comparison of the four alternative strategies.
Iftheunderlying
stockthen. . . Thebesttacticwas... Andtheworsttacticwas...
continues to rise dramatic- "roll up" liquidate
ally ...
rises moderately above the next do nothing liquidate or "roll up"
strike ...
remains relatively unchanged spread "roll up"
falls back below the original liquidate do nothing
strike ...
TABLE 3-3.
Results at expiration.
XYZ
Price
at "Roll-up" "DoNothing" "Spread" Liquidating
Expiration Profit Profit Profit Profit
50 or below $ 0 -$ 300(W) $ 0 +$600 (Bl
53 0(W) 0(Wl + 300 + 600 (Bl
56 0(Wl + 300 + 600(B) + 600 (Bl
60 0(Wl + 700 + l,000(B) + 600
63 + 600(Wl + 1,000 (Bl + l,000(Bl + 600(Wl
67 + 1,400 (Bl + 1,400 (Bl + 1,000 + 600(Wl
70 + 2,000 (B) + 1,700 + 1,000 + 600(W)
1. "Do nothing"-continue to hold the currently long call.

2. "Liq uidate "-se ll the long call to take profits and do not reinvest.
:3. "Roll 11p--- -sell the long call, pocket the original investment, and use the remaining
proceeds to purchase as many out-of-the-money calls as possible.
Chapter
3: CallBuying 101
4. "Spread"-create a bull spread by selling the out-of-the-money call against the cur-
rently profitable long call, preferably taking in at least the original cost of the long
call.
Note that each of the_fcwr tactics pro1.;esto be the best tactic in one case or another, but that
the spread tactic is nei;er the u:orst one. Tables 3-2 and 3-3 represent the results from hold-
ing until expiration. For those who prefer to see the actual numbers involved in making
these comparisons between the four tactics, Table 3-3 summarizes the potential profits and
losses of each of the four tactics using the prices from the example above. "W" indicates that
the tactic is the worst one at that price, and "B" indicates that it is the best one.
There are, of course, modifications that an investor might make to any of these tac-
tics . For example, he might decide to sell out half of his long call position, recovering a
major part of his original cost, and continue to hold the remainder of the long calls. This
still leaves room for further appreciation.
Selling a portion of the position and retaining the rest is known as "taking a partial
profit." This tactic and all of the above ones-except "do nothing"-can be harmful to a
position in which the underlying moves strongly in one's favor for an extended distance.
Every time one takes partial profits, rolls up, or takes other measures, he is doing some-
thing bearish to his position. Those little bearish actions will be harmful if the underlying
continues to perform favorably. There is a school of thought that says one is better off
merely using a trailing stop-a stop placed at the 20-day moving average of the underly-
ing, say-than to make bearish adjustments to a bullish position. Of course, in a choppy
market that is swinging up and down, partial profits may prove to be preferable, but a call
buyer's best way to maximize profits over time is to be lucky or good enough to be long in
a strong trend. He should do everything he can to maximize the profits and ride that
trend, which would be "do nothing " and use a stop that trails along behind the market.
DEFENSIVE ACTION
Two follow-up strategies are sometimes employed by the call buyer when the underlying
stock declines in price. Both involve spread strategies; that is, being long and short two
different calls on the same underlying stock simultaneously. Spreads are discussed in detail
in later chapters. This discussion of spreads applies only to their use by the call buyer.
✓.,Rolling Down. " If an option holder owns an option at a currently unrealized loss, it
may be possible to greatly increase the chances of making a limited profit on a relatively
small rebound in the stock price. In certain cases, the investor may be able to implement
such a strategy at little or no increase in risk.
102 PartII: CallOptionStrategies
Many call buyers have encountered a situation such as this: An XYZ October 35 call
was originally bought for 3 points in hopes of a quick rise in the stock price. However,
because of downward movements in the stock-to 32, say-the call is now at 1..50 with
October expiration nearer. If the call buyer still expects a mild rally in the stock before
expiration, he might either hold the call or possibly "average down" (buy more calls at
1.50). In either case he will need a rally to nearly 38 by expiration in order to break even.
Since this would necessitate at least a 15% upward move by the stock before expiration,
it cannot be considered very likely. Instead, the buyer should consider implementing the
following strategy, which will be explained through the use of an examp le.
Examp le: The investor is long the October 35 call at this time:
XYZ, 32;
XYZ October 35 call, 1.50; and
XYZ October 30 call, 3.
One could sell two October :35's and, at the same time, buy one October 30 for no addi-
tional investment before commissions. That is, the sale of 2 Oc tober 3.S's at $150 each
would bring in $300, exactly the cost, before commissions, of buying the October 30 call.
This is the key to implementing the roll-dotcn strategy: that one be able to buy the lower
strike call and sell two of the higher strike calls for nearly even money.
Note that the investor is now short the call that he previously owned, the October
:3.5.Where he previously owned one Oc tober 3,5, he has now sold two of them. He is also
now long one October 30 call. Thus, his position is:
long 1 XYZ October 30 call,

short 1 XYZ October 35 call.
This is technically known as a bull spread, but the terminology is not important. Table 3-4
surnnrnrizes the transactions that the buyer has made to acquire this spread. The trader
now "owns" the spread at a cost of $300, plus commissions. By making this trade, he has
lowered his break-e,·en point significantly without increasing his risk. However, the maxi-
mum profit potential has also been limited; he can no longer capitalize on a strong
rebound by the underlying stock.
In order to see tliat the break-even point has been lowered, consider what the results
are if XYZ is at :33 at October expiration. The October 30 call would be worth 3 points
and the Octoher :3.Swould expire worthless with XYZ at 33. Thus, the October :30 call
co11ldhe sold to bring in $.300 at that time, and there would not he any expense to buy
Chapter
3: CallBuying 103
TABLE 3-4.
Transactions in bull spread.
Trade Costbefore
Commissions
Original trade Buy 1 October 35 call at 3 $300 debit
Later trade Sell 2 October 35 calls at 1.50 $300 credit

Buy 1 October 30 call at 3 $300 debit
Net position Long 1 October 30 call $300 debit

Short 1 October 35 call
back the October 35. Consequently, the spread could be liquidated for $300, exactly the
amount for which it was "bought." The spread then breaks even at 33 at expiration. If the
call buyer had not rolled down, his break-even point would be 38 at expiration, for he paid
3 points for the original October 35 call and he would thus need XYZ to be at 38 in order
to be able to liquidate the call for 3 points. Clearly, the stock has a better chance of recov-
ering to 33 than to 38. Thus, the call buyer significantly lowers his break-even point by
utilizing this strategy.
Lowering the break-even point is not the investor's only concern. He must also be
aware of what has happened to his profit and loss opportunities. The risk remains essentially
the same-the $300 in debits, plus commissions, that has been paid out. The risk has actu-
ally increased slightly, by the amount of the commissions spent in "rolling down." However,
the stock price at which this maximum loss would be realized has been lowered. With the
original long call, the October 35, the buyer would lose the entire $300 investment any-
where below 35 at October expiration. The spread strategy, however, would result in a total
loss of $300 only if XYZ were below 30 at October expiration. With XYZ above 30 in Octo-
ber, the long side of the spread could be liquidated for some value, thereby avoiding a total
loss. The inuestor has reduced the chance of realizing the maximwn loss, since the stock
price at which that loss would occur has been lowered by 5 points.
As with most investments, the improvement of risk exposure-lowering the break-
even point and lowering the maximum loss price-necessitates that some potential reward
he sacrificed. In the original long call position (the October 35), the maximum profit
potential was unlimited. In the new position, the potential profit is limited to 2 points if
XYZ should rally hack to, or anywhere aboue, 35 by October expiration. To see this,
assume XYZ is 35 at expiration. Then the long October 30 call would be worth ,5 points,
while the October 35 would expire worthless. Thus, the spread could he liquidated for .5
points, a 2-point profit over the .'3points paid for the spread. This is the limit of profit for
the spread, however, since if XYZ is above 3,5 at expiration, any further profits in the long
October 30 call would be offset by a corresponding loss on the short October 3.5 call.
Thus, f xrz u:ere to rallv lieacil!J hy expiration, the "rolled dcncn" position tcould not
reali;:,eas large a profit as the original long call position icould /wee reali;:,ed.
Table 3-.5 and Figure :1-2 summarize the original and new positions. Note that the
new position is better for stock prices between 30 and 40. Below 30, the two positions are
TABLE 3-5.
Original and spread positions compared.
Stock
Price Long
Call Spread
atExpiration Result Result
25 -$300 -$300
30 - 300 - 300
33 - 300 0
35 - 300 + 200
38 0 + 200
40 + 200 + 200
45 + 700 + 200
FIGURE 3-2.
Companion: original call purchase vs. spread.
C
0
~ +$200
·a.
X
UJ
cil
(/)
(/)
0
....J
0
'5
ct -$300

Chapter
3: CallBuying 105
equal, except for the additional commissions spent. If the stock should rally back above
40, the original position would have worked out better. The 11eu;position is an improue-
111ent,prodded that XYZ does not rally hack above 40 by expiration. The chances that
XYZ could rally 8 points, or 25%, from 32 to 40 would have to be considered relatively
remote. Rolling the long call down into the spread would thus appear to be the correct
thing to do in this case.
This example is particularly attractive, because no additional money was re-
quired to establish the spread. In many cases, however, one may find that the long call
cannot be rolled into the spread at even money. Some debit may be required. This fact
should not necessarily preclude making the change, since a small additional investment
may still significantly increase the chance of breaking even or making a profit on a
rebound.
Example: The following prices now exist, rather than the ones used earlier. Only the
October 30 call price has been altered:
XYZ, 32;
XYZ October 35 call, 1.50; and
With these prices, a 1-point debit would be required to roll down. That is, selling 2 Octo-
ber :3.5calls would bring in $300 ($150 each), but the cost of buying the October 30 call
is $400. Thus, the transaction would have to be done at a cost of $100, plus commissions.
With these prices, the break-even point after rolling down would be 34, still well below
the original break-even price of 38. The risk has now been increased by the additional I
point spent to roll down. If XYZ should drop below 30 at October expiration, the investor
would have a total loss of 4 points plus commissions. The maximum loss with the original
long October 35 call was limited to 3 points plus a smaller amount of commissions. Finally,
the maximum amount of money that the spread could make is now $100, less commis-
sions. The alternative in this example is not nearly as attractive as the previous one, but it
might still be worthwhile for the call buyer to invoke such a spread if he feels that XYZ
has limited rally potential up to October expiration.
One should not automatically discard the use of this strategy merely because a debit is
required to convert the long call to a spread. Note that to "average down'' by buying an addi-
tional October ;3.5call at 1.50 would require an additional investment of $1.50. This is more
than the $100 required to convert into the spread position in the immediately preceding
example. The break-even point on the position that was "averaged down" would he over 37 at
expiration, whereas the break-even point on the spread is 34. Admittedly, the averaged-down
position has much more profit potential than the spread does, but the conversion to the spread
is less expensive than "averaging down" and also provides a lower break-even price.
In summary, then, if the call buyer finds himself with an unrealized loss because the
stock has declined, and yet is unwilling to sell, he may be able to improve his chances of
breaking even by "rolling down" into a spread. That is, he would sell 2 of the calls that he
is currently long-the one that he owns plus another one-and simultaneously buy one
call at the next lower striking price. If this transaction of selling 2 calls and buying 1 call
can be clone for approximately even money, it could definitely be to the buyer's benefit to
implement this strategy, because the break-even point would be lowered considerably and
the buyer would have a much better chance of getting out even or making a small profit
should the underlying stock have a small rebound.
Creating a Calendar Spread. A different type of defensive spread strategy is some-

times used by the call buyer who finds that the underlying stock has declined. In this
strategy, the holder of an intermediate- or long-term call sells a near-term call , with the
same striking price as the call he already owns. This creates what is known as a calendar
spread. The idea behind doing this is that if the short-term call expires worthless, the
overall cost of the long call will be reduced to the buyer. Then, if the stock should rally,
the call buyer has a better chance of making a profit.
Example: Suppose that an investor bought an XYZ October 35 call for 3 points
sometime in April. By June the stock has fallen to 32, and it appears that the stock might
remain depressed for a while longer. The holder of the October 35 call might consider sell-
ing a July 35 call, perhaps for a price of 1 point. Should XYZ remain below 3.5 until July
expiration, the short call would expire worthless, earning a small, I-point profit. The inves-
tor would still own the October 35 call and would then hope for a rally by XYZ before
October in order to make profits on that call. Even if XYZ does not rally by October, he
has decreased his overall loss by the amount received for the sale of the July 35 call.
This strategy is not as attractive to use as the previous one. If XYZ should rally
before Jul:· expiration, the investor might find himself with two losing positions. For exam-
ple, suppose that XYZ rallied back to 36 in the next week. His short call that he sold for
1 point would be selling for something more than that, so he would have an unrealized
loss 011 the short July 35. In addition, the October :15would probably not have appreciated
back to its original price of 3, and he would therefore have an unrealized loss on that side
of the spread as well.
Consequently. this strategy should be used with great caution, for if the underlying
stock rallies quickly before the near-term expiration, the spread could be at a loss on both
Chapter
3: CallBuying 107
sides. Note that in the former spread strategy, this could not happen. Even if XYZ rallied
quickly , some profit would be made on the rebound .
A FURTHERCOMMENTON SPREADS
Anyone not familiar with the margin requirements for spreads, under both the exchange
margin rules and the rules of the brokerage firm he is dealing with, should not attempt to
utilize a spread transaction. Later chapters on spreads outline the more common require-
ments for spread transactions. In general, one must have a margin account to establish a
spread and must have a minimum amount of equity in the account. Thus, the call buyer
who operates in a cash account cannot necessarily use these spread strategies. To do so
might incur a margin call and possible restriction of one's trading account. Therefore,
check on specific requirements before utilizing a spread strategy. Do not assume that a
long call can automatically be "rolled " into any sort of spread.
Other Call Buyin g Strategies
In this chapter, two additional strategies t hat utilize the purchase of call options are
described. Both of these strategies involve buying calls against the short sale of the underly-
ing stock.\ \Then listed puts are traded on the underlying stock, these strategies are often less
efft>cti\·e than when the:· are implemented with the use of put options. However, the con-
cept is irnportant, and sometimes these strategies are more viable in markets where calls are
ver:· liquid but puts are not. These strategies are generally known as "synthetic" strategies.
THE PROTECTED SHORT SALE (OR SYNTHETIC PUT)
P11rchasi11g a call at the same time that one is short tlie underlying stock is a means of
limiting the risk of the short sale to a fixed a11w1mt.Since the risk is theoretically unlim-
ited in a short sale, many investors are reluctant to use the strategy. Even for those inves-
tors who do sell stock short, it can be rather upsetting if the stock rises in price. One may
he forced into an emotional-and perhaps incorrect-decision to cover the short sale in
order to relieve the psychological pressure. By owning a call at the same time he is short,
the investor limits the risk to a fixed and generally small amount.
Example: An im·estor sells XYZ short at 40 and simultaneously purchases an XYZ July 40
call for :3points. If XYZ falls in price, the short seller will make his profit on the shor t sale,
less the :3points paid for the calL which will expire worthless. Thus, by buying the call for
pmtectio11,a Silla!!r111wu11t cf pnfzt potential is sacrificed. However, the advan tage of own-
ing tl1e call is demonstrated when the results are examined for a stock rise. If XYZ should
rise to an:-:price ahm·e 40 b:· Jul:· e.\piration, the short seller can cover his short by exercising
ti)(' long call and lrn:·ing stock at 40. Tims, the maximum risk that the short seller can incur
in this; t'\,llllple is the :3 points paid for the call. Table 4-1 and Figure 4-1 depict the results
108
Chapter
4: OtherCallBuying
Strategies 109
TABLE 4-1.
Results at expiration-protected short sale.
XYZPrice
at Profit CallPrice
at Profit Total
Expiration onXYZ Expiration onCall Profit
20 +$2,000 0 -$ 300 +$1,700
30 + 1,000 0 - 300 + 700
37 + 300 0 - 300 0
40 0 0 - 300 300
50 - 1,000 10 + 700 300
60 - 2,000 20 + 1,700 - 300
FIGURE 4-1.
Protected short sale.
C:
0
~
·o..
><
w
1il +$0
en
en
0
...J
0
'E
ct -$300
at expiration from utilizing this strategy. Commissions are not inclu<led. Note that the
hreak-even point is :37 in this example. That is, if the stock <lrops :1 points, the protected
short sale position will break even because of the :3-point loss on the call. The short seller
who di<l not spen<l the extra mmwy for the long call would, of course, have a :3-point profit
at :37.To the upside, however, the protectPd short sale outperforms a regular short sale if
the stock climbs anywhere above 43. At 43, both types of short sales have $300 losses. But
above that level, the loss would continue to grow for a regular short sale, while it is fixed
for the short seller who also bought a call. In either case, the short seller's risk is increased
slightly by the fact that he is obligated to pay out the dividends on the underlying stock,
if any are declar ed.
A simple formula is available for determining the maximum amount of risk when one
protects a short sale by buying a call option:
Risk = Striking price of purchased call + Call price - Stock price
Depending on how much risk the short seller is willing to absorb, he might want to buy
an out-of-the-money call as protection rather than an at-the-money call, as was shown in
the example above. A smaller dollar amount is spent for the protection when one buys an
out-of-the-money call, so that the short seller does not give away as much of his profit
potential. However, his risk is larger because the call does not start its protective qualities
until the stock goes above the striking price .
Example: With XYZ at 40, the short seller of XYZ buys the July 45 call at .50 for protec-
tion. His maximum possible loss, if XYZ is above 45 at July expiration, would be
.5.50 points-the five points between the current stock price of 40 and the striking price
of 45, plus the amount paid for the call. On the other hand, if XYZ declines, the protected
short seller will make nearly as much as the short seller who did not protect, since he only
spent .50 for the long call.
If one buys an in-the-money call as protection for the short sale, his risk will be quite
minimal. However, his profit potential will be severely limited. As an example, with XYZ
at 40, if one had purchased a July 35 call at .5.50, his risk woulrl.be limited to .50 anywhere
above :3.5at July expiration. Unfortunately, he would not realize any profit on the position
until the stock went below 34 ..50, a drop of 5.50 points. This is too much protection, for it
limits the profit so severely that there is only a small hope of making a profit.
Generally, it is best to buy a call that is at-the-money or only slightly out-of-the-
money as the protection for the sliort sale. It is not of much use to buy a deeply out-of-
t he-money call as protection, since it does very little to moderate risk unless the stock
climbs quite dramatically. Normally, one would cover a short sale before it went heavily
against him. Thus, the money spent for such a deeply out-of-the-money call is wasted.
Howe\er, if one wants to give a short sale plenty of room to "work" and feels very certain
that his bearish view of the stock is the correct view, he might then huy a fairly deep out-
of-tlie-mone:: call just as disaster protection, in case the stock suddenly bolted upward in
price (if it received a takeover bid, for example).
Chapter
4: OtherCallBuying
Strategies 111
MARGIN REQUIREMENTS
The newest margin rules now allow one to receive favorable margin treatment when a
short sale of stock is protected by a long call option. The margin required is the lower of
(1) 10% of the call's striking price plus any out-of-the-money amount, or (2) 30% of the
current short stock's market value. The position will be marked to market daily, and most
brokers will require that the short sale be margined at "normal" rates if the stock is below
the strike price.
Example: Suppose the following prices exist:
XYZ Common stock: 47

Oct 40 call: 8
Oct 50 call: 3
Oct 60 call: 1
Suppose that one is considering a short sale of 100 shares of XYZ at 47 and the pur-
chase of one of the calls as protection. Here are the margin requirements for the various
strike prices. (Note that the option price, per se, is not part of the margin requirement,
but all options must be paid for in full, initially).
Position + out-of-the-money
10%strike 30%stock
price
Short XYZ, long Oct 40 call 400 + 0 = 400* 1,410
Short XYZ, long Oct 50 call 500 + 300 = 800* 1,410
Short XYZ, long Oct 60 call 600 + 1,300 = 1,900 1,410*
*Since the margin requirement is the lower of the two figures, the items marked with an asterisk in this table are
the margin requirements.
Again, remember that the long call would have to be paid for in full, and that most brokers
impose a maintenance requirement of at least the value of the short sale itself as long as
the stock is below the strike price of the long call, in addition to the above requirements.
PORTFOLIO MARGIN
This is the first time in this hook that margin is being discussed, so this may be a good place
to talk about portfolio margin. Portfolio margin is a way that certain, sophisticated option
trading accounts-\1.. ith brokerage firm approval-can increase their leverage beyond Fed-
1
eral Reg T margin requirements. It applies to listed options only, not futures or FOREX.
Each brokerage firm may have different requirements for qualifying for portfolio
margin treatment, but they are generally along these guidelines: account size of at least
$100,000 (some brokers require as much as $.500,000); answering a questionnaire or appli-
cation that attests to your knowledge of options; and, at some firms, taking a brief options
test. Also, see Appendix F for a further elaboration on portfolio margin.
In general, portfolio margin requirements are risk-based and are very difficult to
calculate manually. The movements of the particularly underlying are estimated, based
on volatility, and margin is assessed on those calculations, which obviously are done by a
computer. Some brokerage firms have a calculator that portfolio margin customers can
use to estimate portfolio margin requirements before a trade is established, but a large
number of traders use the free calculator provided hy the OCC, which is in charge of
determining the essential data for portfolio margin. The OCC calculator can be found at
https://cpm.theocc .com/tims_online.htm.
In the previous example, a rnlatility was not specified for XYZ stock, but the margin
requirement for "Short XYZ, long Oct 40 Call" was $400. Under portfolio margin, if this
was not a particularly volatile stock, the requirement would likely be closer to $100.
The CBOE also has a great deal of information on their website, including examples
in the document at WW\v.cboe.com/micro/margin/margin_req_examples.pdf. Also peruse
the OCC website at www .optionsclearing.com/risk-management/cpm.
In the remainder of this book, margin examples will not assume portfolio margin
treatment unless specifically stated.
FOLLOW-UP ACTION
There is little that the protected short seller needs to perform in the way of follow-up
action in this strateg:·· other than closing out the position. If the underlying stock moves
clown quickly and it appears that it might rebound. the short sale could be covered with-
out selling the long call. In this manner, one could potentially profit on the call side as
well if the stock came hack above the original striking price. If the underlying stock rises
in price. a similar strategy of taking off only the profitable call side of the transaction is
not recommended. That is. if XYZ climbed from 40 to 50 and the July 40 call also rose
frolll :3to 10, it is not ackisable to take the 7-point profit in the call, hoping for a drop in
the stock price. The reason for this is that one is entering into a highlv
'- '- .
risk-oriented situ-
ati<m h: remm·i11g his protection when the call is in-the-money. Thus, when the stock
drops. it is all right-perhaps e\·en desirable-to take the profit, because there is little or
110 additional risk if tht' stock continues to drop. Howen"'r, when the stock rises, it is 11ot
Chapter
4: OtherCallBuying
Strategies 113
an equivalent situation. In that case, if the short seller sells his call for a profit and the
stock subsequently rises even further , large losses could result.
It may often be advisable to close the position if the call is at or near parity, in-the-
money, by exercising the call. In most strategies, the option holder has no advantage in exer-
cising the call because of the large dollar difference between stock commissions and option
commissions. However, in the protected short sale strategy, the short seller is eventually going
to have to cover the short stock in any case and incur the stock commission by so doing. It
may be to his advantage to exercise the call and buy his stock at the striking price, thereby
buying stock at a lower price and perhaps paying a slightly lower commission amount.
Example: XYZ rises to .SOfrom the original short sale price of 40, and the XYZ July 40 call
is selling at 10 somewhere close to expiration. The position could be liquidated by either (1)
buying the stock back at .SOand selling the call at 10, or (2) exercising the call to buy stock
at 40. In the first case, one would pay a stock commission at a price of $.SOper share plus an
option commission on a $10 option. In the second case, the only commission would be a
stock commission at the price of $40 per share. Since both actions accomplish the same end
result-closing the position entirely for 40 points plus commissions-clearly the second choice
is less costly and therefore more desirable. Of course, if the call has time value premium in it
of an amount greater than the commission savings, the first alternative should he used.
SYNTHETIC STRADDLE (REVERSE HEDGE)
There is another strategy involving the purchase of long calls against the short sale of
stock. In this strategy, one purchases calls on more shares than he has sold short. The
strategist can profit if the underlying stock rises far enough or falls far enough during the
life of the calls. This strategy is generally referred to as a reverse hedge or synthetic
straddle . On stocks for which listed puts are traded, this strategy is outmoded; the same
results can be better achieved by buying a straddle (a call and a put). Hence, the name
"synthetic straddle" is applied to the reverse hedge strategy.
This strategy has limited loss potential, usually amounting to a moderate percentage
of the initial investment, and theoretically unlimited profit pote11tial. When properly
selected (selection criteria are described in great detail in Chapter .36, which deals with
volatility trading), the percentage of success can be quite high in straddle or synthetic
straddle buying. These features make this an attractive strategy, especially when call
premiums are low in comparison to the volatility of the underlying stock.
Example: XYZis at 40 and an investor believes that the stock has the poteutial to move h~,
a relatively large distance, but he is not sure of the direction the stock will take. This i11n"stor
could short XYZ at 40 and buy 2 XYZ July 40 calls at 3 each to set up a synthetic straddle.
If XYZ moves up by a large distance, he will incur a loss on his short stock, but the fact that
he owns two calls means that the call profits will outdistance the stock loss. If, on the other
hand, XYZ drops far enough, the short sale profit will be larger than the loss on the calls,
which is limited to 6 points. Table 4-2 and Figure 4-2 show the possible outcomes for various
stock prices at July expiration. If XYZ falls, the stock profits on the short sale will accumu-
TABLE4-2.
Synthetic straddle at July expiration.
XYZ
Price
at Stock Profiton Total
Expiration Profit 2 Calls Profit
20 +$2,000 -$ 600 +$1,400
25 + 1,500 600 + 900
30 + 1,000 600 + 400
34 + 600 600 0
40 0 600 - 600
46 600 + 600 0
50 - 1,000 + 1,400 + 400
55 - 1,500 + 2,400 + 900
60 - 2,000 + 3,400 + 1,400
FIGURE 4-2.
Synthetic straddle {reverse hedge).
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Chapter
4: OtherCallBuying
Strategies 115
late, but the loss on the two calls is limited to $600 (3 points each) so that, below 34, the
synthetic straddle can make ever-increasing profits. To the upside, even though the short
sale is incurring losses, the call profits grow faster because there are two long calls. For
example, at 60 at expiration, there will be a 20-point ($2,000) loss on the short stock, but
each XYZ July 40 call will be worth 20 points with the stock at 60. Thus, the two calls are
worth $4,000, representing a profit of $3,400 over the initial cost of $600 for the calls.
Table 4-2 and Figure 4-2 illustrate another important point: The maximum loss
would occur if the stock u.:ereexactly at the striking price at expiration of the calls. This
maximum loss would occur if XYZ were at 40 at expiration and would amount to $600. In
actual practice, since the short seller must pay out any dividends paid by the underlying
stock, the risk in this strategy is increased by the amount of such dividends.
The net margin required for this strategy is .50% of the underlying stock plus the full
purchase price of the calls. In the example above, this would be an initial investment of
$2,000 (.50% of the stock price) plus $600 for the calls, or $2,600 total plus commissions.
The short sale is marked to market, so the collateral requirement would grow if the stock
rose. Since the maximum risk, before commissions, is $600, this means that the net
percentage risk in this transaction is $600/$2,600, about 23%. This is a relatively small
percentage risk in a position that could have very large profits. There is also very little
chance that the entire maximum loss would ever be realized since it occurs only at one
specific stock price. One should not be deluded into thinking that this strategy is a sure
money-maker. In general, stocks do not move very far in a 3- or 6-month period. With
careful selection, though, one can often find situations in which the stock will be able to
move far enough to reach the break-even points. Even when losses are taken, they are
counterbalanced by the fact that significant gains can be realized when the stock moves
by a great distance.
It is obvious from the information above that profits are made if the stock moves far
enough in either direction. In fact, one can determine exactly the prices beyond which
the stock would have to move by expiration in order for profits to result. These prices are
34 and 46 in the foregoing example. The downside break-even point is 34 and the upside
break-even point is 46. These break-even points can easily be computed. First, the maxi-
mum risk is computed. Then the break-even points are determined .
Maximum risk = Striking price + 2 x Call price - Stock price

Upside break-even point = Striking price + Maximum risk
Downside break-even point = Striking price - Maximum risk
In the preceding example, the striking price was 40, the stock price was also 40, and
the call price was 3. Thus, the maximum risk= 40 + 2 x 3 - 40 = 6. This confirms that the
maximum risk in the position is 6 points, or $600. The upside hreak-en~n point is tlwn
40 + 6, or 46, and the downside hreak-even point is 40 - 6, or 34. These also agree with
Table 4-2 and Figure 4-2 .
Before expiration, profits can be made euen closer to the striking price, because
ther e will be some tim e valu e pr emium left in the purchased calls.
Example: If XYZ moved to 45 in one month, each call might be worth 6. If this happened,
the invt>storwould have a ,5-point loss on the stock, but would also have a 3-point gain on
eaclt of the two options, for a net overall gain of 1 point, or $100. Before expiration, the
hreak-t>ven point is clt>arlysomewhere bt>low46, because the position is at a profit at 45.
Ideally. one would like to find relatively underpriced calls on a fairly volatile stock in
ordn to in1plernent this strategy most effectively. These situations, while not prevalent,
can ht>found. Normally. call premiurns quite accurately reflect the volatility of the under-
l_vingstock. Still, this strategy can be quite viable, because nearly every stock, regardless
of its rnlatility, occasionally experiences a straight-line, fairly large move. It is during these
tim es that th e investor can profit from thi s strate gy.
Gmt>rally, the underlying stock selected for the synthetic straddle should be volatile.
En--11though option premiums are larger on these stocks, they can still be outdistanced
hy a straight-line mon:>in a volatile situation. Another advantage of utilizing volatile stocks
is that they generally pay little or no dividends. This is desirable for the synthetic straddle ,
because the short seller will not be requir ed to pay out as much .
The technical pattern of the underlying stock can also be useful when selecting the
position. One generally would like to have little or no technical support and resistance within
the loss area. Tliis pattern would facilitate the stock's ability to make a fairly quick move either
up or clown. It is sometimes possible to find a stock that is in a wide trading range, frequently
swinging from one side of the range to the other. If a reverse' hedge can be set up that has its
loss area well within this trading range, the position may also be attractive.
Example: The XYZ stock in the previous example is trading in the range 30 to 50, perhaps
swinging to ont>t>ncland then the other rather frequently. Now the synthetic straddle exam-
plt> position , which would make profits above 46 or below 34, would appear more
att ractive.
FOLLOW-UP ACTION
Since tht> s:·ntht>tic straddle has a built-in limited loss feature, it is not necessary to take
an:· follow-11paction to avoid losses. The investor could quite easily put the position on
and tak<' no action at all until t>xpirntion. This is often the best method of follow-up action
in this strategy.
Chapter
4: OtherCallBuying
Strategies 117
Another follow-up strategy cau be applied, although it has some disadvantages asso-
ciated with it. This follow-up strategy is sometimes known as trading against the straddle.
When the stock moves far enough in either direction, the profit on that side can be taken.
Then, if the stock swings back in the opposite direction, a profit can also be made on the
other side. Two examples will show how this type of follow-up strategy works.
Example 1: The XYZ stock in the previous example quickly moves down to 32. At that
time , an 8-point profit could be taken on the short sale. This would leave two long calls.
Even if the:': expired worthless, a 6-point loss is all that would be incurred on the calls.
Thus, the entire strategy would still have produced a profit of 2 points. However, if the
stock should rally above 40, profits could be made on the calls as well. A slight variation
would be to sell one of the calls at the same time the stock profit is taken. This would result
in a slightly larger realized profit; but if the stock rallied back above 40, the resulting profits
there would be smaller because the investor would be long only one call instead of two.
Example 2: XYZ has moved up to a price at which the calls are each worth 8 points. One
of the calls could then be sold, realizing a 5-point profit. The resulting position would be
short 100 shares of stock and long one call, a protected short sale. The protected short sale
has a limited risk, above 40, of 3 points (the stock was sold short at 40 and the call was
purchased for 3 points). Even ifXYZ remains above 40 and the maximum 3-point loss has
to be taken, the overall synthetic straddle would still have made a profit of 2 points
because of the 5-point profit taken on the one call. Conversely, if XYZ drops below 40,
the protected short sale position could add to the profits already taken on the call.
There is a variation of this upside protective action.
Example 3: Instead of selling the one call, one could instead short an additional 100 shares
of stock at 48. If this was done, the overall position would be short 200 shares of stock (100
at 40 and the other 100 at 48) and long two calls-again a protected short sale. If XYZ
remained above 40, there would again be an overall gain of 2 points. To see this, suppose
that XYZ was above 40 at expiration and the two calls were exercised to buy 200 shares of
stock at 40. This would result in an 8-point profit on the 100 shares sold short at 48, and no
gain or loss on the 100 shares sold short at 40. The initial call cost of 6 points would be lost.
Thus, the overall position would profit by 2 points. This means of follow-up action to the
upside is rnore costly in commissions, but would provide bigger profits if XYZ fell hack
below 40, because there are 200 shares of XYZ short.
In theory, if any of the foregoing types of follow-up action were taken and the under-
lying stock did indeed reverse direction and cross back through the striking price, the
original position could again be established. Suppose that , after covering the short stock at
32, XYZ rallied back to 40. Then XYZ could be sold short again, reestablishing the original
position. If the stock moved outside the break-even points again, further follow-up action
could be taken. This process could theoretically be repeated a number of times. If the stock
continued to whipsaw back and forth in a trading range, the repeated follow-up actions
could produce potentially large profits on a small net change in the stock price. In actual
practice, it is unlikely that one would be fortunate enough to find a stock that moved that
far that quickly.
The disadvantage of applying these follow-up strategies is obvious: One can never make
a large profit ifhe continually cuts his profits cff at a srnall, limited amount. When XYZ falls
to 32, the stock can be covered to ensure an overall profit of 2 points on the transaction.
However, if XYZ continued to fall to 20, the investor who took no follow-up action would
make 14 points while the one who did take follow-up action would make only 2 points. Recall
that it was stated earlier that there is a high probability of realizing limited losses in the syn-
thetic straddle strategy, but that this is balanced by the potentially large profits available in
the remaining cases. If one takes follow-up action and cuts off these potentially large profits,
he is operating at a distinct disadvantage unless he is an extremely adept trader.
Proponents of using the follow-up strategy often counter with the argument that it
is frnstrating to see the stock fall to 32 and then return back to nearly 40 again. If no
follow-up action were taken, the unrealized profit would have dissolved into a loss when
the stock rallied. This is true as far as it goes, but it is not an effective enough argument
to counterbalance the negative effects of cutting off one's profits.
ALTERING THE RATIO OF LONG CALLS TO SHORT STOCK
Another aspect of this strategy should be discussed. One does not have to buy exactly two
calls against 100 shares of short stock. More bullish positions could be constructed by
buying three or four calls against 100 shares short. More bearish positions could be con-
structed by buying three calls and shorting 200 shares of stock. One might adopt a ratio
other than 2:1, because he is more bullish or bearish. He also might use a different ratio
if the stock is between two striking prices, but he still wants to create a position that has
break-even points spaced equidistant from the current stock price. A few examples will
illustrate these points .
Example: XYZ is at 40 and the investor is slightly bullish on the stock but still wants to
ernploy tlie synthetic straddle strategy, because he feels there is a chance the stock could
drop sliarpl_,,.He might then short 100 shares of XYZ at 40 and buy 3 July 40 calls for
:3 points apiece. Since he paid 9 points for the calls, his maximum risk is that 9 points if
Chapter
4: OtherCallBuying
Strategies 119
XYZ were to be at 40 at expiration. This means his downside break-even price is 31, for
at 31 he would have a 9-point profit on the short sale to offset the 9-point loss on the calls.
To the upside, his break-even is now 44.,50. IfXYZ were at 44.50 and the calls at 4.,50 each
at expiration, he would lose 4.50 points on the short sale, but would make 1..50on each of
the three calls, for a total call profit of 4.50.
A more bearish investor might short 200 XYZ at 40 and buy 3 July 40 calls at 3. His
break-even points would be 3,5.50 on the downside and 49 on the upside, and his maxi-
mum risk would be 9 points. There is a general formula that one can always apply to cal-
culate the maximum risk and the break-even points, regardless of the ratios involved.
Maximum risk= (Striking price - Stock price) X Round lots shorted

+ Number of calls bought X Call price
Upside break-even = Striking price Maximum risk

+ -----------
(Number of calls bought -
Number of round lots short)
D ·d b k St ·ki · Maximum risk
ownsi e rea -even = n ng pnce - Number of round lots short
To verify this , use the numbers from the example in which 100 XYZ were shorted at 40
and three July 40 calls were purchased for 3 each.
Maximum risk= (40 - 40) - 1 + 3 x 3 = 9

Upside break-even = 40 + 9/(3 - 1) = 40 + 4.50 = 44.50
Downside break-even = 40 - 9/1 = 31
It was stated earlier that one 1night use an acijusted ratio in order to space the break-even
points evenly around the current stock price.
Example: Suppose XYZ is at 38 and the XYZ July 40 call is at 2. If one wanted to set up a
synthetic straddle that would profit if XYZ moved either up or down by the same distance,
he could not use the 2: 1 ratio. The 2: 1 ratio would have break-even points of 34 and 46. Thus,
the stock would start out much closer to the downside break-even point-only 4 points
away-than to the upside break-even point, which is 8 points away. By alteri11gthe ratio, the
investor can set up a synthetic straddle that is more neutral on the underlying stock. Suppose
that the investor shorted 100 shares of XYZ at :38 and bought three July 40 calls at 2 each.
Then his hreak-even points would be 32 on the downside and 44 on the upside. This is a more
neutral situation, with the downside hreak-even point being 6 points below the current stock
price and the upside break-even point being 6 points away. The formulae above can he used
to verify that, in fact, the break-evens are 32 and 44. Note that the 3:1 ratio has a maximum
risk of 8 points, while the 2:1 ratio only had 6 points maximum risk
A final adjustment that can be applied to this strategy is to short the stock and buy
two calls, but with the calls having different striking prices. If XYZ were at 37..50 to start
with, one would have to use a ratio other than 2:l to set up a position with break-even
points spaced equidistant from the current stock price. When these higher ratios are used,
the maximum risk is increased and the investor has to adopt a bullish or bearish stance.
One may be able to create a position with equidistant break-even points and a smaller
maximum risk by utilizing two different striking prices.
Example: The following prices exist:
XYZ, 37.50;
XYZ July 40 call, 2; and
XYZ July 35 call, 4.
If one were to short 100 XYZ at 37.50 and to buy one July 40 call for 2 and one July 35
call for 4, he would have a position that is similar to a synthetic straddle except that the
nwxinwm risk u:ould be reali:::.edanyichere beticeen 3.5 and 40 at expiration. Although
this risk is over a much wider range than in the normal synthetic straddle, it is now much
smaller in dimension. Table 4-3 and Figure 4-3 show the results from this type of position
at expiration. The maximum loss is 3.50 points ($3,50), which is a smaller amount than
TABLE 4-3.
Synthetic straddle using two strikes.
XYZPrice
at Stock July40Coll July35Coll Total
25 +$1,250 -$200 -$ 400 +$ 650
30 + 750 - 200 - 400 + 150
31½ + 600 - 200 - 400 0
35 + 250 - 200 - 400 - 350
37½ 0 - 200 - 150 - 350
40 - 250 - 200 + 100 350
43½ - 600 + 150 + 450 0
45 750 + 300 + 600 + 150
50 - 1,250 + 800 + 1,100 + 650
Chapter
4: OtherCallBuying
Strategies 121
FIGURE 4-3.
Synthetic straddle using two strikes (synthetic strangle).
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could be realized using any ratio strictly with the July 35 or the July 40 call. However, this
maximum loss is realizable over the entire range, 35 to 40. Again, large potential profits
are available if the stock moves far enough either to the upside or to the downside.
This form of the strategy should only be used when the stock is nearly centered
between two strikes and the strategist wants a neutral positioning of the break-even
points. Similar types of follow-up action to those described earlier can be applied to this
form of the synthetic straddle strategy as well. When this strategy involves two strikes, it
is called a "synthetic strangle;" a normal strangle involves puts and calls with two different
strikes.
U.MMAR
The strategies described in this chapter would not normally be used if the underlying
stock has listed put options. However, if no puts exist, or the puts are very illiquid, and the
strategist feels that a volatile stock could move a relatively large distance in either direc-
tion during the life of a call option, he should consider using one of the forms of the
synthetic straddle strategy-shorting a quantity of stock and buying calls on more shares
than he is short. If the desired movement does develop, potentially large profits could
result. In any case, the loss is limited to a fixed amount, generally around 20 to 30% of the
initial investment. Although it is possible to take follow-up action to lock in small profits
and attempt to gain on a reversal hy the stock, it is wiser to let the position nm its course
to capitalize on those occasions when the profits become large. Normally a 2:1 ratio (long
2 calls, short 100 shares of stock) is used in this strategy, but this ratio can be adjusted if
the investor wants to be more bullish or more bearish. If the stock is initially between two
striking prices, a neutral profit range can be set up by shorting the stock and buying calls
at both the next higher strike and the next lower strike.
Naked Call Writing
The next two chapters will concentrate on various aspects of writing uncovered call
options. These strategies have risk of loss if the underlying stock should rise in price, but
they offer profits if the underlying stock declines in price. This chapter-on naked, or
uncovered, call writing-demonstrates some of the risks and rewards inherent in this
aggressive strategy. Novice option traders often think that selling naked options is the
"best" way to make money, because of time decay. In addition, they often assume that
market-makers and other professionals sell a lot of naked options. In reality, neither is
true. Yes, options do eventually lose their premium if held all the way until expiration.
However, when an option has a good deal of life remaining, its excess value above intrinsic
value-what we call "time value premium"-is, in reality, heavily influenced by the vola-
tility estimate of the stock. This is called implied volatility and is discussed at length later
in the book. For now, though, it is sufficient to understand that a lot can go wrong when
one writes a naked option, before it eventually expires. As to professionals selling a lot of
naked options, the fact is that most market-makers and other full-time option traders
attempt to reduce their exposure to large stock price movements if possible. Hence, they
may sell some options naked, but they generally try to hedge them by buying other options
or by buying the underlying stock.
Many novice option traders hold these misconceptions, probably because there is a
general belief that most options expire worthless. Occasionally, one will even hear or see
a statement to this effect in the mainstream media, but it is not true that most options
expire worthless. In fact, studies conducted by McMillan Analysis Corp. in both bull and
bear months indicate that about 65% to 70% of all options have some value (at least half
a point) when they expire. This is not to say that all option buyers make money, either, hut
it does serve to show that many more options do not expire worthless than do.
123
124 · PartII:CallOptionStrategies
THE UNCOVERED (NAKED) CALL OPTION
vVhen onP sells a call option without owning the underlying stock or any equivalent secu-
rity (convertible stock or bond or another call option), he is considered to have written an
uncor;ered call optio11.This strategy has limited profit potential and theoretically unlim-
ited loss. For this reason, this strategy is unsuitable for some investors. This fact is not
particularly attractive, but since there is no actual cash investment required to write a
naked call (the position can be financed with collateral loan value of marginable securi-
ties ), the strategy can be operated as an adjunct to many other investment strategies.
A simp le example will outline the basic profit and loss potential from naked
writing.
Example: XYZ is selling at .50 and a July .50 call is selling for 5. If one were to sell the July
.SOcall naked-that is, without owning XYZ stock, or any security convertible into XYZ,
or another call option on XYZ-he could make, at most, 5 points of profit. This profit
would accrue if XYZ v,ere at or anywhere below ,SOat July expiration, as the call would
then expire worthless. If XYZ were to rise , however , the naked writer could potentially
lose large sums of mone~·-Should the stock climb to 100, say, the call would be at a price
of ,SO.If the writer then covered (bought back) the call for a price of 50, he would have a
loss of 45 points on the transaction. In theory , this loss is unlimited, although in practice
the loss is limited by time. The stock cannot rise an infinite amount during the life of the
call. Clearly, dPfensive strategies are important in this approach , as one would never want
to let a loss run as far as the one here. Tahle .S-1 and Figure 5-1 (solid line) depict the
result s of this position at July expiration. Note that the break-even point in this example
is .S.S.That is, if XYZ rose 10%, or 5 points, at expiration, the naked writer would break
even. He could buy the call back at parity, 5 points, which is exactly what he sold it for.
There is some room for error to the upside. A naked u;rite 1cill not necessarily lose money
{f tlie stock 11wces up. It will only lose if the stock advances by more than the amount of
the time value premium that was in the call when it was originally written.
Naked call writing is not the same as a short sale of the underlying stock. While both
strategies have large potential risk, the short sale has much higher reward potential, but
the nak ed call writ e will do better if the underlying stock remains relatively unchanged. It
is possible for the naked call writer to make money in situations when the short seller would
haw" lost money . Using the example above, suppose one investor had written the July 50
call naked for .Spoints while another investor sold the stock short at .SO.If XYZ were at 52
at e.\piration, the naked call writer could buy the call back at parity , 2 points, for a 3-point
profit . Tlie short seller would have a 2-point loss. Moreover, the short seller pays out the
cli\·ideml s on tlw underlying stock, whereas the naked call writer does not. The naked call
Chapter
5: NakedCallWriting 125
TABLE 5-1.
Position at July expiration.
XYZPrice
at Coll
Price
at Profit
on
Expiration Expiration Naked
Write
30 0 +$ 500
40 0 + 500
50 0 + 500
55 5 0
60 10 - 500
70 20 - 1,500
80 30 - 2,500
FIGURE 5-1.
Uncovered (naked) call write.
Naked Write
+$500
C
0
~
·a.
X
UJ
co
(/)
(/) 45
0
_J
-e
0
.,:::::
a..
will expire, of course, but the short sale does not. This is a situation in which the naked
write outperforms the short sale. However, if XYZ were to fall sharply-to 20, say-the
naked writer could only make ,5 points while the short seller would make 30 points. The
dashed line in Figure ,5-1 shows how the short sale of XYZ at ,50 would compare with
the naked write of the July .50 call. Notice that the two strategies are equal at 4,5 at
expiration; they both make a ,5-point profit there. Above 45, the naked write does better;
it has larger profits and smaller losses. Below 45, the short sale does better, and the farther
the stock falls, the better the short sale becomes in comparison. As will be seen later, one
can more closely simulate a short sale by writing an in-the-money naked call.
INVESTMENT REQUIRED
The margin requirements for writing a naked call are 20% of the stock price plus the call
pre111ium,less the amount by which the stock is below the striking price. If the stock is
below the striking price, the differential is subtracted from the requirement. However, a
minimum of 10% of the stock price is required for each call, even if the computation
results in a smaller number. Table 5-2 gives four examples of how the initial margin
requir ement would be computed for four different stock prices. The 20% collateral figure
is the minimum exchange requirement and may vary somewhat among different broker-
age houses. The call prcmiu111may be applied against the requirement. In the first line of
Table .5-2, if the XYZ July .50 call were selling for 7 points, the $700 call premium could
be applied against the $1,800 margin requirement, reducing the actual amount that the
investor would have to put up as collatera l to $1,100.
TABLE 5-2.
Initial collateral requirements for four stock prices.
Out-of-the-
Call Stock
Price
When Call 20%of Money Total
Margin
Written CallWritten Price Stock
Price Differential Requirement
XYZ July 50 55 $700 $1,100 $0 $1,800
XYZ July 50 50 400 1,000 0 1,400
XYZ July 50 46 200 920 -400 720
XYZ July 50 40 100 800 -1,000 400*
*Requirement cannot be less than 10%.
In addition to the basic requirements, a brokerage firm may require that for a cus-
tomer to participate in uncovered writing, he have a minimum equity in his account. This
equity requirement may range from as low as $2,000 to as high as $l00,000. Since naked
call \\Titing is a high-risk strategy, some brokerage firms require that the customer be able
t() show both financial wherewithal and option trading experience before the account can
be approved for naked call writing.
Chapter
Naked Option Positions Are Marked to the Market Daily. This means
that the collateral requirement for the position is recomputed daily, just as in the short
sale of stock. The same margin formula that was described above is applied and, if the
stock has risen far enough, the customer will be required to deposit additional collateral
or close the position. The need for such a mark to market is obvious. If the underlying
stock should rise, the brokerage firm must ensure that the customer has enough collateral
to cover the eventuality of buying the stock in the open market and selling it at the strik-
ing price if an assignment notice should be received against the naked call. The mark
to market works to the customer's favor if the stock falls in price. Excess collateral is
then released back into the customer's margin account, and may be used for other
purposes.
It is important to realize that, in order to u;rite a naked call, collateral is all that is
required. No cash need be "invested" if one owns securities with sufficient collateral loan
value.
Example: An investor owns 100 shares of a stock selling at $60 per share. This stock is
worth $6,000. If the loan rate on stock is 50% of $6,000, this investor has a collateral loan
value equal to 50% of $6,000, or $3,000. This investor could write any of the naked calls
in Table 5-2 without adding cash or securities to his account. Moreover, he would have
satisfied a minimum equity requirement of at least $6,000, since his stock is equity.
This aspect of naked call writing-using collateral value to finance the writing-is
attractive to many investors, since one is able to write calls and bring in premiums without
disturbing his existing portfolio. Of course, if the stock underlying the naked call should
rise too far in price, additional collateral may be called for by the broker because of the
mark to market. Moreover, there is risk whether cash or collateral is used. If one buys in
a naked call at a loss, he will then be spending cash, creating a debit in his account.
Regardless of how one finances a naked option position, it is generally a good idea
to allow enough collateral so that the stock can move all the way to the point at which one
would cover the option or tak~ follow-up action. For example, suppose a stock is trading
at ,50 and one sells an April 60 call naked, figuring that he will cover the call if the stock
rises to 60 (that is, if the option becomes an in-the-money option). He should set aside
enough collateral to margin the position as if the stock were at 60 (even though the actual
margin requirement will be smaller than that). If he allows that extra collateral, then he
will never be forced into a margin call at a stock price prior to (that is, below) where he
wanted to take follow-up action. Simply stated, let the market take you out of a position,
not a margin call.
THE PHILOSOPHY OF SELLING NAKED OPTIONS
The first ancl foremost question one must address when thinking about selling naked
option s (or any strategy, for that matter) is: "Can I psychologically handle the thought of
naked options in m_vaccount'?'' Notice that the question does not have anything to do
with whether one has enough collateral or margin to sell calls (although that, too, is
important) nor does it ask how much money he will make. First, one must decide if he can
he comfortable with the risk of the strategy. Selling naked options means that there is
theor etically unlin1ited risk if the underlying instrument should make a large , sudden,
adverse move. It is one's attitude regarding that fact alone that determines whether he
should consider selling naked options. If one feels that he won't be able to sleep at night ,
then he slw11ldnot sell naked options, regardless of an_vprofit projections that might seem
attractive .
If one feels that the psychological suitability aspect is not a roadblock, then he can
consider whether he has the financial wherewithal to write naked options. On the surface,
naked option rnargin requirements are not large (althoug h in equity and index options,
the y are larger than they were prior to the crash of 1987).
In general, one would prefer to let the naked options expire worthless, if at all pos-
sible, without disturbing them, unless the underlying instrument makes a significant
adverse move. So, out-of-the-money options are the usual choice for naked selling. Then,
in order to reduce (or almost eliminate) the chance of a margin call, one sliould set aside
the l/largi11requirement as if the underlying had already moved to tlze strike price of the
option sold. B:· allowing margin as if the underlying were already at the strike, one will
almost never experience a margin call before the underlying price trades up to the strike
price , at \vhich time it is best to close the position or to roll the call to another strike.
Tims, for naked equity call options , allow as collateral 20% of the highest naked
strike price. In this author's opinion, the biggest mistake a trader can make is to initiate
trades because of margin or taxes. Thus , b_vallowing the "maxirnmn" margin, one can
mak e trading decisions based on what's happening in the market, as opposed to reacting
to a margin call from his broker.
"Suitahility " also means ,wt risking more money than one can afford to lose. If one
allows tlie "maximum" margin, then lie won't be risking a large portion of his equity
unless lie is unable to cover when the underlying trades through the strike price of his
naked option. Gaps in trading prices would be the culprits that could prevent one from
cmering. Caps are co111111011 in stocks, less common in futures, and almost nonexistent in
indices . Hrnce, index options are the options (f choice when it comes to naked u:riting.
Index options are discussed later in the book.
Fi nail:·, there is one more "rule" that a naked option writer must follow: Someone
futs lo /)(' 1rntclii11:.,!,tlic 1wsitio11at all times. Disasters could occur if one were to go on
Chapter
vacation ancl not pa:· attt:>ntion to his naked options. Usually , one's broker can watch the
position, even if the trader has to call him from his vacation site.
In sum, then, to writt> nakt>d options. one needs to be prepart>cl psychologically, have
sufficient funds, ht> willing to accept the risk, he able to monitor the position every day,
sell options whose implit>d Yolatility is extremely high, and cover any naked options that
become in-the-money options.
RISK AND REWARD
One can adjust the apparent risks and rewards from naked call writing by his selection of
an in-the-money or out-of-the-money call. Writing an out-of-the-money call naked, espe-
cially one quite deeply out-of-the-money, offers a high probability of achieving a small
profit Writing an in-the-money call naked has the most profit potential, but it also has
higher risks.
Example: XYZ is selling at 40 and the July 50 is selling for H. This call could be sold naked.
The probability that XYZ could rise to .50 by expiration has to be considered small, espe-
cially if there is not a large amount of time remaining in the life of the call. In fact, the stock
could rise 25%, or 10 points, by expiration to a price of 50, and the call would still expire
worthless. Thus, this naked writer has a good chance of realizing a $.50 profit, less commis-
sions. There could, of course, be substantial risk in terms of potential profit versus potential
loss if the stock rises substantially in price by expiration. Still, this apparent possibility of
achieving additional limited income with a high probability of success has led many inves-
tors to use the collateral value of their portfolios to sell deeply out-of-the-money naked calls.
For those employing this technique, a favored position is to have a stock at or just
about 15 and then sell the near-term option with striking price 20 naked. This option
would sell for one-eighth or one-quarter, perhaps, although at times there might not be
any bid at all. At this price, the stock would have to rally nearly one-third, or 33%, for the
writer to lose money. Although there are not usually many optionable stocks selling at or
just above $10 per share, these same out-of~the-money writers would also be attracted to
selling a call with a striking price 1.5when the stock is at 10, because a 50% upward move
by the stock would be required for a loss to be realized .
This strategy of selling deeply out-of-the-money calls has its apparent attraction in
that the writer is assured of a profit unless the underlying stock can rally rather substan-
tially before the call expires. The danger in this strategy is that one or two losst>s,perhaps
arnounting to only a couple of points each, could wipe out many periods of profits. The
stock market does occasionally rally lwavily in a short period, as wit1wsscd rqwatedl!·
throughout history. Thus, the writer who is adopting this strategy cannot regard it as a
sure thing and certainly cannot afford to establish the writes and forget them. Close
monitoring is required in case the market begins to rally, and by no means should losses
be allowed to accumulate.
The opposite end of the spectrum in naked call writing is the writing of fairly deeply
in-the-money calls. Since an in-the-money call would not have much time value premium
in it, this writer does not have much leeway to the upside. If the stock rallies at all, the
writer of the deeply in-the-money naked call will normally experience a loss. However,
should the stock drop in price, this writer will make larger dollar profits than will the
writer of the out-of-the-money call. The sale of the deeply in-the-money call simulates the
profits that a short seller could make, at least until the stock drops close to the striking
price , since the delta of a deeply in-the-money call is close to 1.
Example: XYZ is selling at 60 and the July 50 call is selling for 10½. If XYZ rises, the
naked writer will lose money, because there is only 0.,50 of time value premium in the call.
If XYZ falls, the writer will make profits on a point-for-point basis until the stock falls
much closer to ,50. That is, if XYZ dropped from 60 to .57, the call price would fall by
almost 3 points as well. Thus, for quick declines by the stock, the deeply in-the-money
write can pro\·ide profits nearly equal to those that the short seller could accumulate.
Notice that if XYZ falls all the way to 50, the profits on the written call will be large, but
will be accumulating at a slower rate as the time value premium builds up with the stock
near the striking price .
If one is looking to trade a stock on the short side for just a feu; points of nwuement, he
might use a deeply in-tlze-nwney naked call write instead of shorting the stock. His invest-
ment will be srnaller-20% of the stock price for the write as compared to 50% of the stock
price for the short sale-and his return will thus be larger. (The requirement for the in-the-
money amount is offset by applying the call's premium.) The writer should take great caution
in ascertaining that the call does have some times premium in it. He does not want to receive
an assignment notice 011 the written call. It is easiest to find time premium in the more distant
e:,,:pirationseries, so the writer would normally be safest from assignment by writing the
longest-term deep in-the-money call if he wants to make a bearish trade in the stock.
Example: An i1n-estor thinks that XYZ could fall 3 or 4 points from its current price of 60
in a quick downward move, and wants to capitalize on that move by writing a naked call.
If the April -10were the near-term call, he might have the choice of selling the April 40 at
20, the->July 40 at 201/1,or the->October 40 at 20½. Since all three calls will drop nearly
point for point with tlit> stock in a mm·e to .56 or .57,he should write the October 40, as it
Chapter
has the least risk of being assigned. A trader utilizing this strategy should limit his losses
in much the same way a short seller would, by covering if tlie stock rallies, perhaps break-
ing through overhead technical resistance.
FOLLOW-UP ACTION
Since naked call writing involves theoretically large upside risk, one must monitor the
positions constantly. The simplest way to limit losses is to have some sort of stop in mind.
For example, if one has written an out-of-the-money call, and now the stock rises to the
striking price, that is probably a good time to exit. Some traders prefer to set their stop
loss at the break-even point.
Example: With XYZ at 45, a trader writes the July .50 call naked, selling it for 1.00. The
break-even point on this write is ,51at expiration. Therefore, a trader might wait until the
stock rose to 51 (at any time prior to expiration) before he stopped himself out of the call.
Clearly, the call could be worth quite a bit more than 1.00 by the time that the stock rose
to 51, especially if the move is a swift one.
Another follow-up action is to take profits-that is, dose out the position-if there
really isn't that much money left to be made. One can calculate the remaining return to
be made by staying in the naked call position. If it is too small, then the call should be
covered, and a new position can be established elsewhere.
Example: At some point in the past, a trader wrote the July ,50call naked, selling it for 1.00.
Suppose that now, with one month to go until expiration, XYZis trading at 42, and the call
is offered at 0.05. Should it be covered? Suppose that, as stated earlier, this trader is setting
aside 20% of the striking price ($1,000) as his collateral for the position so that he doesn't
have to take any follow-up action unless the stock reaches 50. The return that is being made
on the required collateral can be calculated as follows:
Annualized current return = (call price) / (margin requirement x time remaining)

= (call price)/ (0.2 x strike x time)
= 5 I (0.2 x 5000 x (1/12))
=6%
Is it worth it to stay in this write, which is earning only 6% on the allocated collateral, as
opposed to setting up a new position that might have a much higher return? Prohahl~: not.
This call should be covered and a new position opened.
ROLLING FOR CREDITS
This is a strategy that should be avoided, although it always seems that it has appeal to a
certain set of option traders. In this strategy , one writes an at-the-money call. This could
also apply as a follow-up action to a previous naked call write, wherein the stock has risen
to the striking price, and so one is short an at-the-money call at that point.
In the rolling for credits strategy, one would wait until th e stock reached the next
strike and would then cover his short calls and simultaneously write more calls at the next
strike-either in the same month or a later month. He would write enough calls so that
the credit from writing the calls with the higher strike would compensate for the debit he
has to pay to buy back the calls at the lower strike. One would do this repeatedly until,
eventually , the stock pulled back, and the last set of written calls expired worthless. He
would then profit by the amount of the initial credit, plus any credits generated by further
rolls along the way. Mostly, though, those rolls are done for tiny credits, so that the entire
process is undertaken to profit by the amount of the initial write .
The problem is that great risk and use of collateral might be required, if one were
forced to roll up and up, month after month , while chasing that initial limited profit.
Tables .5-3 and 5-4 show how such a scenario might unfold, if XYZ rose so quickly
that one remained in the October calls all the way up. The collateral requirement for this
strategy can balloon out of control. Note that each transaction in Table .5-3 is a credit and
all (except the last) involve taking a realized loss.
In these tables, while the number of written calls has tripled from .5 to 1.5,the col-
lateral requirement has more than quadrupled, from $5,000 to $21,000.
TABLE 5-3.
Rolling for credits when stock is rising.
Initially: XYZ = 50
Sell 5 XYZ October 50's at 7 +$3,500 credit
Later: XYZ rises to 60
Buy 5 XYZ October 50's at 11 and - 5,500 debit
sell 8 XYZ October 60's at 7 + 5,600 credit
Later: XYZ rises further to 70
Buy 8 XYZ October 60's at 11 and - 8,800 debit
sell 15 XYZ October 70's at 6 + 9,000 credit
Finally: XYZ falls and the October 70's expire worthless
Net gain= +$3,800
Chapter
TABLE 5-4.
Increase in collateral requirement.
Initially: XYZ = 50
Sell 5 XYZ October 50's at 7 $ 5,000 collateral required
($3,500 net credit)
Later: XYZ = 60
Sell 8 XYZ October 60's at 7
Buy 5 October 50's at 11
($3,600 net credit to date) $ 9,600 collateral required
Later: XYZ = 70
Sell 15 XYZ October 70's at 6
Buy 8 XYZ October 60's at 11
($3,800 net credit to date) $21,000 collateral required
Any stock that rose swiftly would be a problem for this strategy. Furthermore, any
stock that gapped up and remained up (say, from a takeover bid, or from announcing a
huge contract or business partnership) would be ruinous.
This is really a Martingale strategy. That is, one that requires "doubling up" to succeed,
and one that can produce ruin if certain physical limits are reached. The classic Martingale
strategy is this: Begin by betting one unit; if you lose, double your bet and play again; if you
win that bet, you'll have netted a profit of one unit (you lost one, but won two); if you lost the
second bet, double your bet again. No matter how many times in a row you lose, keep dou-
bling your bet each time. When you eventually win, you will profit by the amount of your
original bet (one unit). Unfortunately, such a strategy cannot be employed in real life. For
example, in a gambling casino, after enough consecutive losses, one would bump up against
the table limit and would no longer be able to double his bet. While "rolling for credits"
doesn't exactly call for one to double the number of written calls each time, it does require
t hat one keep increasing his risk exposure in order to profit by the amount of the original
credit sold. There is actually a limit here as well: The OCC's position limit could eventually
restrict one from being able to roll into the required number of calls at the higher strike.
More likely, though, the size of one's collateral is a more common physical limit; eventually,
after rolling up repeatedly, the collateral requirement would be too large for the account, and
the strategy would result in a huge loss. Martingale strategies should he avoided.
This type of strategy works much better if the calls are covered (see "The Incremen-
tal Return Concept" of covered writing on page 81). Also, it might theoretically he possible
to use if one were writing puts, because in that case the stock c:::m'tfall helow zero, hut even
then the collateral requirements could easily become too onerous to withstand.
Once again, the topic of time value premium is discussed, as it was in Chapter :3. Many
novice option traders think that if they sell an out-of-the-money option (whether covered
or naked), all they have to do is sit back and wait to collect the premium as time wears it
away. However, a lot of things can happen between the time an option is sold and its
expiration elate. The stock can move a great deal, or implied volatility can skyrocket. Both
are bad for the option seller and both completely counteract any benefit that time decay
might be imparting. The option seller must consider what might happen during the life
of the option, and not simply view it as a strategy to hold the option until expiration.
Naked call writers, especially, should operate with that thought in mind, but so should
covered call writers, even though most don't. What the covered writer gives away is the
upside; and if he constantly sells options without regard to the possibilities of volatility or
stock price increases, he will be doing himself a disservice.
So, while it is still proper to refer to the part of an option's price that is not intrinsic
\'alue as "time value premium," the knowledgeable option trader understands that it is also
more heavily influenced by volatility and stock price movement than by time.
SUMMARY
In a majority of cases, naked call writing is applied as a deeply out-of-the-money strategy

in which the investor uses the collateral value of his security holdings to participate in a
strategy that offers a large probability of making a very limited profit. It is a poor strategy,
because one loss may wipe out many profits. The trader who desires an alternative to a
short sale may use the sale of an in-the-money naked call in order to attempt to make a
quick profit on a smaller investment than the short seller would have to make. Both of
these strategies could entail large risk if one does not have sufficient capital backing.
Follow-up action is necessary in order to keep losses from growing beyond reason-
able hounds. Generally, naked calls are bought back when the underlying stock rises
above the break-even point. A new, better write can then be established in another stock
or another series.
Ratio Call Writing
Two basic types of call writing have been described in previous chapters: covered call
writing, in which one owns the underlying stock and sells a call; and naked call writing.
Ratio writing is a combination of these two types of positions.
THE RATIO WRITE
Simply stated, ratio call writing is the strategy in which one owns a certain number of
shares of the underlying stock and sells calls against more shares than he owns. Thus,
there is a ratio of calls written to stock owned. The most common ratio is the 2:1 ratio,
whereby one owns 100 shares of the underlying stock and sells 2 calls. Note that this type
of position involves writing a number of naked call options as well as a number of covered
options. This resulting position has both downside risk, as does a covered write, and
unlimited upside risk, as does a naked write. The ratio write generally will provide much
larger profits than either covered writing or naked writing if the underlying stock remains
relatively unchanged during the life of the calls. However, the ratio write has two-sided
risk, a quality absent from either covered or naked writing.
Generally, when an investor establishes a ratio write, he attempts to be neutral in
outlook regarding the underlying stock. This means that he writes the calls with striking
prices closest to the current stock price.
Example: A ratio write is established by buying 100 shares ofXYZ at 49 and selling two XYZ
October ,50 calls at 6 points each. If XYZ should decline in price and be anywhere below .50
at October expiration, the calls will expire worthless and the writer will make 12 points from
the sale of the calls. Thus, even if XYZ drops 12 points to a price of 37, the ratio writer will
break even. The stock loss of 12 points would be offset by a 12-point gain on the calls. As with
135
any strategy in which calls are sold, the maximum profit occurs at the striking price of the
written calls at expiration. ln this example, if XYZ were at 50 at expiration, the calls would
still expire worthless for a 12-point gain and the writer would have a I-point profit on his
stock, which has moved up from 49 to .SO,for a total gain of 13 points. This position therefore
has ample downside protection and a relatively large potential profit. Should XYZ rise above
50 Gyexpiration, the profit will decrease and eventually become a loss if the stock rises too
far. To St'e this , suppose XYZ is at 63 at October expiration. The calls will be at 13 points
each, representing a ,-point loss on each call, because they were originally sold for 6 points
apiece. However, there would be a 14-point gain on the stock, which has risen from 49 to 63.
The overall net is a break-even situation at 63-a 14-point gain on the stock offset by 14
points of loss on the options (7 points each). Table 6-1 and Figure 6-1 summarize the profit
and loss potential of this example at October expiration. The shape of the graph resembles a
roof with its peak located at the striking price of the written calls, or .SO.It is obvious that the
position has both large upside risk above 63 and large downside risk below 37. Therefore, it
is imperative that the ratio writer plan to take follow-up action if the stock should move out-
side these prices. follow-up action is discussed later. If the stock remains within the range 37
to G:3,some profit will result before commission charges. This range between the downside
break-en·n point and the upside break-even point is called the profit range.
This example represents essentially a neutral position, because the ratio writer
will make some profit unless the stock falls by more than 12 points or rises by more than
t4 points before the expiration of the calls in October. This is frequently an attrac tive type
of strategy to adopt because , normally , stocks do not move very far in a 3- or 6-month time
period. Consequent!~·, this strategy has a rather high probability of making a limited profit.
The profit in this example would, of course , be reduced by commission costs and margin
interest charges if the stock is bought on margin.
TABLE 6-1.
Profit and loss at October expiration.
XYZ
Priceat Stock Call Profit Total
Expiration Profit Price onCalls Profit
30 -$1,900 0 +$1,200 -$ 700
37 - 1,200 0 + 1,200 0
45 - 400 0 + 1,200 + 800
50 + 100 0 + 1,200 + 1,300
55 + 600 5 + 200 + 800
63 + 1,400 13 - 1,400 0
70 + 2,100 20 - 2,800 - 700
Chapter6: RatioCallWriting 137
FIG URE 6-1.

Ratio write (2:1).
C:
0
~
·o..
X
w
~
Cl)
Cl)
0
.....J
e
a..
Before discussing the specifics of ratio writing, such as investment required, selec-
tion criteria, and follow-up action, it may be beneficial to counter two fairly common
objections to this strategy. The first objection, although not heard as frequently today as
when listed options first began trading, is "Why bother to buy 100 shares of stock and sell
2 calls? You will be naked one call. Why not just sell one naked call?" The ratio writing
strategy and the naked writing strategy have very little in common except that both have
upside risk. The profit graph for naked writing (Figure .S-1)bears no resemblance to the
roof-shaped profit graph for a ratio write (Figure 6-1). Clearly, the two strategies are quite
different in profit potential and in many other respects as well.
The second objection to ratio writing for the conservative investor is slightly more
valid. The conservative investor may not feel comfortable with a position that has risk if the
underlying stock moves up in price. This can be a psychological detriment to ratio writing:
When stock prices are rising and everyone who owns stocks is happy and making profits, the
ratio writer is in danger oflosing money. However, in a purely strategic sense, one should be
willing to assume some upside risk in exchange for larger profits if the underlying stock does
not rise heavily in price. The covered writer has upside protection all the way to infinity; that
is, he has no upside risk at all. This cannot be the mathematically optimum situation, because
stocks never rise to infinity. Rather, the ratio writer is engaged in a strategy that makes its
profits in a price range more in line with the way stocks actually behave. In fact, if one were
to try to set up the optimum strategy, he would want it to make its most profits in line with
the most prohahle outcomes for a stock's movement. Ratio writing is such a strategy .
Figure 6-2 shows a simple probability curve for a stock's rnon:>rncnt. It is 111ostlik('l_v
FIGURE 6-2.
Stock price probability curve overlaid on profit graph of ratio write.
30% "'C
~a
- O"
§, ~
(")
20% ~~
+$1,300 Probability
8. 9.
(J) (J)
Curve Co
(") (")
10% ;>i;":,i;-
;?.gi
(")
(1)::,
-·
(Cl
0%
50
Stock Price
that a stock will remain relatively unchanged and there is very little chance that it will rise
or fall a great distance. Now compare the results of the ratio writing strategy with the
graph of probable stock outcomes. Notice that the ratio write and the probability curve
have their "peaks" in the same area; that is, the ratio write makes its profits in the range of
most likely stock prices, because there is only a small chance that any stock will increase
or decrease by a large amount in a fixed period of time. The large losses are at the edges of
the graph, where the probability curve gets very low, approaching zero probability. It should
be noted that these graphs show the profit and probability at expiration. Prior to expira-
tion, the break-even points are closer to the original purchase price of the stock because
there will still be some time value premium remaining on the options that were sold.
INVESTMENT REQUIRED
The ratio writer has a combination of covered writes and naked writes. The margin
req uirements for each of these strategies have been described previously, and the require-
ments for a ratio writing strategy are the sum of the requirements for a naked write and
a covered write. Ratio writing is normally done in a margin account, although one could
technically keep the stock in a cash account.
Example: Ignoring commissions, the investment required can be computed as follows: Buy
100 XYZ at 49 on ,50o/cmargin and sell 2 XYZ October 50 calls at 6 points each (Table 6-2).
The commissions for buying the stock and selling the calls would be added to these require-
Chapt
er 6: RatioCallWriting 139
TABLE 6 -2 .
Inve stment re quir ed .
Covered writing portion (buy 100 XYZ and sell 1 call)
50% of stock price $2,450
Lesspremium received 600
Requirement for covered portion $1,850
Naked writing portion (sell 1 XYZ call)
20% of stock price $ 980

Lessout-of-the-money amount 100
Plus call premium + 600
Lesspremium received 600
Requirement for naked portion $ 880
Total requirement for ratio write $2,730
TABLE 6-3 .
Initial investment requ ired for a ra tio wr ite.
70% of stock cost (XYZ = 49) $3,430
Plus naked call premiums + 600
Lesstotal premiums received - 1,200
Plus or minus striking price differential
on naked calls 100
Total requirement $2,730 (plus commissions)
ments. A shorter formula (Table 6-3) is actually more desirable to use. It is merely a combi-
nation of the investment requirements listed in Table 6-2.
In add ition to the basic requirement, there may be minimum equity requ irements
and maintenance requirements, since naked calls are involved. As these vary from one
brokerage firm to another, it is best for the ratio writer to check with his broker to deter -
mine th e equity and maintenance requirements. Again, since naked calls are involved in
ratio wr iting, there will be a mark to market of the position. If the stock should rise in
price , the investor will have to put up more collateral.
It is conceivable that the ratio writer would want to stay with his original position as
long as the stock did not penetrate the upside break-even point of 63. Therefore, he should
allow for enough collateral to cover the eventuality of a move to 63. Assuming the October
,50 call is at 14 in this case, he would need $:3,910(see Table 6-4). This is the requirement
TABLE 6-4.
Collateral required with stock at upside break-even point of 63.
Covered writing requirement $1,850 (see Table 6-2)
20% of stock price (XYZ = 63) 1,260
Plus call premium 1,400
Lessinitial call premium received 600
Total requirement with XYZ at 63 $3,910
that the ratio writer should be concerned with, not the initial collateral requirement, and he
should therefore plan to invest $3,910 in this position, not $2,730 (the initial requirement).
Oh\·iously, he onl:1has to put up $2,730, hut from a strategic point of view, he should allow
$:3,910for the position. If the ratio writer does this with all his positions, he would not receive
a margin call even if all the stocks in his portfolio climbed to their upside break-even points.
SELECTION CRITERIA
To decide \vhether a ratio write is a desirable position, the writer must first determine the
hreak-e\·en points of the position. Once the break-even points are known, the writer can
then decide if the position has a wide enough profit range to allow for defensive action if it
should become necessary. One simple way to determine if the profit range is wide enough
is to require that the next higher and lower striking prices be within the profit range.
Example: The writer is buying 100 XYZ at 49 and selling 2 October 50 calls at 6 points
apiece. It was seen, by inspection, that the break-even points in the position are 37 on the
downside and 63 on the upside. A mathematical formula allows one to quickly compute
the break-even points for a 2:1 ratio write.
Points of maximum profit = Strike price - Stock price + 2 x Call price

Downside break-even point = Strike price - Points of maximum profit
Stock price - 2 x Call price
Upside break-even point Strike price + Points of maximum profit
In this exarnple, the points of maximum profit are .SO- 49 + 2 x 6, or 13. Thus, the
downside hreak-e\·en point would be 37 (50 - 1:1)and the upside break-even point would
lw (i1 (.'50+ 13). These numbers agree with the figures determined earlier by analyzing
the position.
This profit range is quite clearly wide enough to allow for defensive action should the
Chapter
6: RatioCallWriting 141
underlying stock rise to the next highest strikes of .5.5or 60, or fall to the next two lower
strikes, at 4,5 and -10. In practice, a ratio write is not automatically a good position merely
because the profit range extends far Pnough. Tht>orPtically, one would want the profit
range to be wide in relation to thP volatility of the underlying stock If the range is wide
in relation to the volatilit:· and the break-even points encompass the next higher and lower
striking prices, a desirable position is available. Volatile stocks are the best candidates for
ratio writing, since their premiums will more easily satisfy both these conditions. A non-
volatile stock may, at times, have relatively large premiums in its calls, but the resulting
profit range may still not be wide enough numerically to ensure that follow-up action
could be taken. Specific measures for determining volatility may be obtained from many
data services and brokerage firms. Moreover, methods of computing volatility are pre-
sented later in the chapter on mathematical applications, and probabilities are further
addressed in the chapters on volatility trading.
Technical support and resistance levels are also important in establishing the
position. If both support and resistance lie within the profit range, there is a better
chance that the stock will remain within the range. A position should not necessarily be
rejected if there is not support and resistance within the profit range, but the writer is then
subjecting himself to a possible undeterred move by the stock in one direction or the other.
The ratio writer is generally a neutral strategist. He tries to take in the most time
premium that he can to earn the premium erosion while the stock remains relatively
unchanged. If one is more bullish on a particular stock, he can set up a 2:1 ratio write with
out-of-the-money calls. This allows more room to the upside than to the downside, and
therefore makes the position slightly more bullish. Conversely, if one is more bearish on
the underlying stock, he can write in-the-money calls in a 2:1 ratio.
There is another way to produce a slightly more bullish or bearish ratio write. This
is to change the ratio of calls u;ritten to stock purchased. This method is also used to
construct a neutral profit range when the stock is not close to a striking price.
Example: An investor is slightly bearishly inclined in his outlook for the underlying stock,
so he might write more than two calls for each 100 shares of stock purchased. His position
might be to buy 100 XYZ at 49 and sell 3 XYZ October ,50 calls at 6 points each. This
position breaks even at 31 on the downside, because if the stock dropped by 18 points at
expiration, the call profits would amount to 18 points and would produce a break-even
situation. To the upside, the break-even point lies at ,59..SOfor the stock at expiration. Each
call would be worth 9½ at expiration with the stock at .59..50, and each call would thus lose
3.,50 points, for a total loss of 10½ points on the three calls. However, XYZ would have
risen from 49 to .59.,50-a 10½-point gain-therefore producing a break-even situation.
Again, a formula is available to aid in determining the break-even point for any ratio.
Maximum profit = (Striking price - Stock price) x Round lots

purchased+ Number of calls written X Call price
D owns1·d e b rea k-even= Striking - ___________
Maximum profit _
price Number of round lots purchased
Upsi•de b rea k-even= Striking

. + ----------'-- Maximum profit
_______ _
pnce (Calls written - Round lots purchased)
Note that in the case of a 2: l ratio write, where the number of round lots purchased
equals l ancl the number of calls written equals 2, these formulate reduce to the ones
given earlier for the more common 2: 1 ratio write. To verify that the formulae above are
correct, insert the numbers from the most recent example.
Example: Three XYZ October 50 calls at a price of 6 were sold against the purchase of
100 XYZ at 49. The number of round lots purchased is 1.
Maximum profit= (50 - 49) x 1 + 3 x 6 = 19

Upside break-even= 50 + 19/(3 -1) = 59.50
In the 2:1 ratio writing example given earlier, the break-even points were 37 and 63.
The 3:1 write has lower break-even points of 31 and 59 ..50, reflecting the more bearish
posture on the underlying stock.
A more bullish write is constructed by buying 200 shares of the underlying stock and
writing three calls. To quickly verify that this ratio (3:2) is more bullish, again use 49 for the
stock price and 6 for the call price, and now assume that two round lots were purchased.
Maximum profit= (50 - 49) x 2 + 3 x 6 = 20

Upside break-even = 50 + 20/(3 - 2) = 70
Thus, this ratio of 3 calls against 200 shares of stock has break-even points of 40 and 70,
reflecting a more bullish posture on the underlying stock.
A 2: 1 ratio may not necessarily be neutral. There is, in fact, a mathematically correct
way of determining exactly what a neutral ratio should be. The neutral ratio is determined
Uijdi1:iding the delta of the u;ritten call into 1. Assume that the delta of the XYZ October
50 call in the pre,·ious example is .60. Then the neutral ratio is 1.0/.60, or 5 to 3. This
means that one might buy :300 shares and sell .5 calls. Using the formulae above, the
details of this position can be observed:
Chapter
Maximum profit= (50- 49) x 3 + 5 x 6 = 33

Upside break-even= 50 + 33/(5 - 3) = 66.50
According to the mathematies of the situation, then, this would be a neutral position ini-
tially. It is often the case that a 5:3 ratio is approximately neutral for an at-the-money call.
By now, the reader should have recognized a similarity between the ratio writing
strategy and the reverse hedge (or synthetic straddle) strategy presented in Chapter 4. The
two strategies are the reverse of each other; in fact, this is how the reverse hedge strategy
acquired its name. The ratio write has a profit graph that looks like a roof, while the
reverse hedge has a profit graph that looks like a trough-the roof upside down (see Fig-
ure 4-2). In one strategy the investor buys stock and sells calls, while the other strategy
is just the opposite-the investor shorts stock and buys calls. Which one is better? The
answer depends on whether the calls are "cheap" or "expensive." Even though ratio writ-
ing has limited profits and potentially large losses, the strategy will result in a profit in a
large majority of cases, if held to expiration. However, one may be forced to make adjust-
ments to stock moves that occur prior to expiration. The reverse hedge (synthetic long
straddle) strategy, with its limited losses and potentially large profits, provides profits only
on large stock rnoves-a less frequent event. Thus, in stable markets, the ratio writing
strategy is generally superior. However, in times of depressed option premiums, the syn-
thetic long straddle gains a distinct advantage. If calls are underpriced, the advantage lies
with the buyer of calls, and that situation is inherent in the synthetic long straddle.
The summaries stated in the above paragraph are rather simplistic ones, referring
mostly to what one can expect from the strategies if they are held until expiration, without
adjustment. In actual trading situations, it is much more likely that one would have to make
adjustments to the ratio write along the way, thus disturbing or perhaps even eliminating the
profit range. Such travails do not befall the reverse hedge (simulated straddle buy). Conse-
quently, when one takes into consideration the stock movements that can take place prior to
expiration, the ratio write loses some of its attractiveness and the reverse hedge gains some.
THE VARIABLE RATIO WRITE

(SYNTHETIC SHORT STRANGLE)
In ratio writing, one generally likes to establish the position when the stock is trading rela-
tively close to the striking price of the written calls. However, it is sometimes the case that
the stock is nearly exactly between two striking prices and neither the in-the-money nor the
out-of-the-money call offers a neutral profit range. If this is the case, and one still wants to
he in a 2: 1 ratio of calls written to stock owned, he can sometimes write one in-the-money
call and one out-of-the-money call against each 100 shares of common. This strategy is
called a synthetic short straddle, although it is also known by the names variable ratio write
or trapezoidal hedge .
Example: Given the following prices: XYZ common, 6.5;XYZ October 60 call, 8; and XYZ
October 70 call, 3.
If one were to establish a 2:1 ratio write with only the October 60's, he would have
a somewhat bearish position. His profit range would be 49 to 71 at expiration. Since the
stock is already at 6.5, this means that he would be allowing room for 16 points of down-
side movement and only 6 points on the upside. This is certainly not neutral. On the other
hand, if he were to attempt to utilize only the October 70 calls in his ratio write, he would
have a bullish position. This profit range for the October 70 ratio write would be .59 to 81
at expiration. In this case, the stock at 6,5 is too close to the downside break-even point in
comparison to its distance from the upside break-even point.
A more neutral position can be established by buying 100 XYZ and selling one October
60 and one October 70. This position has a profit range that is centered about the current
stock price. Moreover, the new position has both an upside and a downside risk, as does a
more normal ratio write. However, nou; the maximum profit can be obtained anyu;here
beticeen the t1co strikes at expiration. To see this, note that if XYZ is anywhere between 60
and 70 at expiration, the stock will be called away at 60 against the sale of the October 60 call,
and the October 70 call will expire worthless. It makes no difference whether the stock is at
61 or at 69; the same result will occur. Table 6-,5 and Figure 6-3 depict the results from this
synthetic short strangle at expiration. In the table, it is assumed that the option is bought back
at parity to close the position, but if the stock were called away, the results would be the same.
Note that the shape of Figure 6-3 is something like a trapezoid. This is the source of
the name "trapezoidal hedge," although the strategy is more commonly known as a synthetic
short strangle or variable ratio write. The reader should observe that the maximum profit is
indeed obtained if the stock is anywhere between the two strikes at expiration. The maxi-
mum profit potential in this position, $600, is smaller than the maximum profit potential
available from writing only the October 60's or only the October 70's. However, there is a
vastly greater probability of realizing the maximum profit in a variable ratio write than
there is of realizing the maximum profit in a normal ratio write. Note that the profit graph
in Figure 6.3 is the inverse of the profit graph of the synthetic long strangle shown in
Figur e 4-3.
The break-even points for synthetic short strangle can be computed most quickly by
first computing the maximum profit potential, which is equal to the time value that the
writer takes in. The break-even points are then computed directly by subtracting the points
of rnaxirnurn profit from the lower striking price to get the downside break-even point and
Chapter
TABLE 6-5.
Results at expiration of variable hedge.
XYZ
Price
at XYZ October
60 October
70 Total
45 -$2,000 +$ 800 +$ 300 -$900
50 - 1,500 + 800 + 300 - 400
54 - 1,100 + 800 + 300 0
60 500 + 800 + 300 + 600
65 0 + 300 + 300 + 600
70 + 500 - 200 + 300 + 600
76 + 1,100 - 800 - 300 0
80 + 1,500 -$1,200 - 700 - 400
85 + 2,000 - 1,700 - 1,200 - 900
FIGURE 6-3.
Variable ratio write (trapezoidal hedge).
adding the points of maximum profit to the upper striking price to arrive at the upside
break-even point. This is a similar procedure to that followed for a normal ratio write:
Points of maximum profit = Total option premiums + Lower

striking price - Stock price
Downside break-even point = Lower striking price - Points of
maximum profit
Upside break-even point = Higher striking price + Points of
maximum profit
Substituting the numbers from the example above will help to verify the formula. The
total points of option premium brought in were 11 (8 for the October 60 and 3 for the
October 70). The stock price was 65, and the striking prices involved were 60 and 70.
Points of maximum profit = 11 + 60 - 65 = 6

Downside break-even point = 60 - 6 = 54
Upside break-even point = 70 + 6 = 76
Thus, the break-even points as computed by the formula agree with Table 6-5 and Figure
6-3. Note that the formula applies only if the stock is initially between the two striking
prices and the ratio is 2:1. If the stock is above both striking prices, the formula is not
correct. However, the writer should not be attempting to establish a variable ratio write
with two in-the-money calls.
FOLLOW-UP ACTION
Aside from closing the position completely, there are three reasonable approaches to fol-
low-up action in a ratio writing situation. The first, and most popular , is to roll the written
calls up if the stock rises too far, or to roll down if the stock drops too far. A second
method uses the delta of the written calls. The third follow-up method is to utilize stops
on the underlying stock to alter the ratio of the position as the stock moves either up or
down. In addition to these types of defensive follow-up action, the investor must also have
a plan in mind for taking profits as the written calls approach expiration. These types of
follow-up action are discussed separately.
ROLLING UP OR DOWN AS A DEFENSIVE ACTION
The reader should already be familiar with the definition of a rolling action: The cur-
rently written calls are bought back and calls at a different striking price are written. The
ratio writer can use rolling actions to his advantage to readjust his position if the underly-
ing stock moves to the edges of his profit range .
The reason one of the selection criteria for a ratio write was the availability of both
the next higher and next lower striking prices was to facilitate the rolling actions that
might become necessary as a follow-up measure. Since an option has its greatest time
premium when the stock price and the striking price are the same, one would normally
want to roll exactly at a striking price .
Example: A ratio writer bought 100 XYZ at 49 and sold two October 50 calls at 6 points
each. Subsequently, the stock drops in price and the following prices exist: XYZ, 40; XYZ
October 50, l; and XYZ October 40, 4.
Chapter
One would roll down to the October 40 calls by buying back the 2 October .S0'sthat
he is short and selling 2 October 40's. In so doing, he would reestablish a somewhat neu-
tral position. His profit on the buy-back of the October 50 calls would be 5 points each-
they were originally sold for 6-and he would realize a 10-point gain on the two calls.
This IO-point gain effectively reduces his stock cost from 49 to 39, so that he now has the
equivalent of the following position: long 100 XYZ at 39 and short 2 XYZ October 40 calls
at 4. This adjusted ratio write has a profit range of 31 to 49 and is thus a new, neutral posi-
tion with the stock currently at 40. The investor is now in a position to make profits ifXYZ
remains near this level, or to take further defensive action if the stock experiences a rela-
tively large change in price again .
Defensive action to the upside-rolling up-works in much the same manner.
Example: The initial position again consists of buying 100 XYZ at 49 and selling two
October 50 calls at 6. If XYZ then rose to 60, the following prices might exist: XYZ, 60;
XYZ October 50, 11; and XYZ October 60,6.
The ratio writer could thus roll this position up to reestablish a neutral profit range.
If he bought back the two October 50 calls, he would take a ,5-point loss on each one for
a net loss on the calls of 10 points. This would effectively raise his stock cost by 10 points,
to a price of 59. The rolled-up position would then be long 100 XYZ at 59 and short
2 October 60 calls at 6. This new, neutral position has a profit range of 47 to 73 at October
expiration.
In both of the examples above, the writer could have closed out the ratio write at a
very small profit of about 1 point before commissions. This would not be advisable,
because of the relatively large stock commissions, unless he expects the stock to continue
to move dramatically. Either rolling up or rolling down gives the writer a fairly wide new
profit range to work with, and he could easily expect to make more than l point of profit
if the underlying stock stabilizes at all.
Having to take rolling defensive action immediately after the position is established
is the most detrimental case. If the stock moves very quickly after having set up the posi-
tion, there will not be much time for time value premium erosion in the written calls, and
this will make for smaller profit ranges after the roll is done. It may be useful to use tech-
nical support and resistance levels as keys for when to take rolling action if these levels
are near the break-even points and/or striking pri ces.
It should be noted that this method of defensive action-rolling at or near striking
prices-automatically means that one is buying back little or no time premium and is
selling the greatest amount of time premium currently available. That is, if the stock rises,
the call's premium will consist mostly of intrinsic value and very little of time premium
value, since it is substantially in-the-money. Thus, the writer who rolls up by buying back
this in-the-money call is buying back mostly intrinsic value and is selling a call at the next
strike. This newly sold call consists mostly of time value. By continually buying back "real"
or intrinsic value and by selling "thin air" or time value, the writer is taking the optimum
neutral action at any given time.
If a stock undergoes a dramatic move in one direction or the other, the ratio
writer will not be able to keep pace with the dramatic movement by remaining in the
same ratio.
Example: If XYZ was originally at 49, but then undergoes a fairly straight-line move to
80 or 90, the ratio writer who maintains a 2: 1 ratio will find himself in a deplorable situ-
ation. He will have accumulated rather substantial losses on the calls and will not be able
to compensate for these losses by the gain in the underlying stock. A similar situation
could arise to the downside. If XYZ were to plunge from 49 to 20, the ratio writer would
make a good deal of profit from the calls by rolling down, but may still have a larger loss
in the stock itself than the call profits can compensate for.
Many ratio writers who are large enough to diversify their positions into a number
of stocks will continue to maintain 2: 1 ratios on all their positions and will simply close
out a position that has gotten out of hand by running dramatically to the upside or to the
downside. These traders believe that the chances of such a dramatic move occurring are
small, and that they will take the infrequent losses in such cases in order to be basically
neutral on the other stocks in their portfolios.
There is, however, a way to combat this sort of dramatic move. This is done by alter-
ing tl1e ratio of the covered write as the stock moves either up or down. For example, as
the underlying stock moves up dramatically in price, the ratio writer can decrease the
number of calls outstanding against his long stock each time he rolls. Eventually, the ratio
might decrease as far as 1:1, which is nothing more than a covered writing situation. As
long as the stock continues to move in the same upward direction, the ratio writer who is
decreasing his ratio of calls outstanding will be giving more and more weight to the stock
gains in the ratio write and less and less weight to the call losses. It is interesting to note
that this decreasing ratio effect can also be produced by buying extra shares of stock at
each new striking price as the stock moves up, and simultaneously keeping the number of
outstanding calls written constant. In either case, the ratio of calls outstanding to stock
owned is reduced.
\Vhen the stock moves down dramatically , a similar action can be taken to increase
the umnher of calls written to stock owned. Normally, as the stock falls, one would sell
out some of his long stock and roll the calls down. Eventually, after the stock falls far
enough, he would be in a naked writing position. The idea is the same here: As the stock
Chapter
falls, more weight is giYe11to the call profits and less weight is given to the stock losses that
are accumulating.
This sort of strateg:· is more orieutt>d to extremely large investors or to firm traders,
market-makers, and the like. Commissions will he exorbitant if frequent rolls are to be
made, and onl:· those investors who pay very small commissions or who have such a large
holding that their commissions are quite small on a percentage basis will be able to profit
substantially from such a strategy.
ADJUSTING WITH THE DELTA
The delta of the u.:rittrn calls can be used to determine the correct ratio to he used in this
ratio-arljusting defensi'Ce strategy. The basic idea is to use the call's delta to remain as
neutral as possible at all times.
Example: An investor initially sets up a neutral 5:3 ratio of XYZ October .50 calls to XYZ
stock, as was determined preYiously. The stock is at 49 and the delta is .60. Furthermore,
suppose the stock rises to 57 and the call now has a delta of .80. The neutral ratio would
currently be 1/.80 (= 1.20) or ,5:4. The ratio writer could thus buy another 100 shares of
the underlying stock.
Alternatively, he might buy in one of the short calls. In this particular example, buy-
ing in one call would produce a 4:3 ratio, which is not absolutely correct. If he had had a
larger position initially, it would be easier to adjust to fractional ratios. When the stock
declines, it is necessary to increase the ratio. This can be accomplished by either selling
more calls or selling out some of the long stock In theory, these adjustments could be
made constantly to keep the position neutral. In practice, one would allow for a few points
of movement by the underlying stock before adjusting. If the underlying stock rises too
far, it may be logical for the neutral strategist to adjust by rolling up. Similarly, he would
roll down if the stock fell to or below the next lower strike. The neutral ratio in that case
is determined by using the delta of the option into which he is rolling.
Example: With XYZ at 57, an investor is contemplating rolling up to the October 60's
from his present position of long 300 shares and short ,5XYZ October 50's. If the October
60 has a delta of .40, the neutral ratio for the October 60's is 2.5:1 (1 -,-.40). Since he is
already long :300 shares of stock, he should now be short 7..5calls (3 x 2 ..5). Obviously, he
would sell 7 or 8, probably depending on his short-term outlook for the stock.
If one prefers to adopt an even more sophisticated approach, lie can rnake adjust-
ments between striking prices by altering his stock position, and can make adj11st111e11ts
by rolling up or down if the stock reaches a new striking price. For those who prefer for-
mulae, the following ones summarize this information:
l. When establishing a new position or when rolling up or down, at the next strike:
Round lots
s t o se 11= ---,--,---,--~- held long
Num b er of ca 11
Delta of call to be sold
Note: When establishing a new position , one must first decide how many shares of
the underlying stock he can buy before utilizing the formula; 1,000 shares
would be a workable amount.
2. When adjusting between strikes by buying or selling stock:
Number of
round lots= Current delta x Number of short calls - Round lots held long
to buy
Note: If a negative number results, stock should be sold, not bought.
These formulae can be verified by using the numbers from the examples above. For
example, when the delta of the October .SOwas .80 with the stock at 57, it was seen that
buying 100 shares of stock would reestablish a neutral ratio.
Number of round lots to buy= .80 x 5 - 3 = 4 - 3 = 1
Also, if the position was to be rolled up to the October 60 (delta= .40), it was seen that
7.5 October 60's would theoretically be sold:
Number of calls to sell=~= 7.5

.40
There is a more general approach to this problem, one that can be applied to any
strategy, no matter how complicated. It involves computing whether the position is net
short or net long. The net position is reduced to an equivalent number of shares of com-
n 1on stock and is commonly called the "equivalent stock position" (ESP). Here is a simple
formula for the equivalent stock position of any option position:
ESP = Option quantity x Delta x Shares per option

Chapter
Example: Suppose that one is long 10 XYZ July 50 calls, which currently have a delta of
.45. The option is an option on 100 shares of XYZ. Thus, the ESP can be computed:
ESP= 10 x .45 x 100 = 450 shares
This is merely saying that owning 10 of these options is equivalent to owning 450 shares
of the underlying common stock, XYZ. The reader should already understand this, in that
an option with a delta of .45 would appreciate by .45 points if the common stock moved
up 1 dollar. Thus, 10 options would appreciate by 4.,5 points, or $450. Obviously, 450
shares of common stock would also appreciate by $450 if they moved up by one point.
Note that there are some options-those that result from a stock split-that are for
more than 100 shares. The inclusion of the term "shares per option" in the formula
accounts for the fact that such options are equivalent to a different amount of stock than
most options .
The ESP of an entire option and stock position can be computed, even if several
different options are included in the position. The advantage of this simple calculation is
that an entire, possibly complex option position can be reduced to one number. The ESP
shows how the position will behave for short-term market movements.
Look again at the previous example of a ratio write. The position was long 300 shares
and short 5 options with a current delta of .80 after the stock had risen to 57. The ESP of
the 5 October 50's is short 400 shares (5 x .80 x 100 shares per option). The position is also
long 300 shares of stock, so the total ESP of this ratio write is short 100 shares.
This figure gives the strategist a measure of perspective on his position. He now
knows that he has a position that is the equivalent of being short 100 shares of XYZ. Per-
haps he is bearish on XYZ and therefore decides to do nothing. That would be fine; at least
he knows that his position is short.
Normally, however, the strategist would want to adjust his position. Again returning
to the previous example, he has several choices in reducing the ESP back to neutral. An
ESP of O is considered to be a perfectly neutral position. Obviously, one could buy 100
shares of XYZ to reduce the 100-share delta short. Or, given that the delta of the October
50 call is .80, he could buy in 1.25 of these short calls (obviously he could only buy l;
fractional options cannot be purchased).
Later chapters include more discussions and examples using the ESP. It is a vital
concept that no strategist who is operating positions involving multiple options should be
without. The only requirement for calculating it is to know the delta of the options in one's
position. Those are easily obtainable from one's broker or from a number of computer
services , software programs , or websites .
For investors who do not have the funds or are not in a position to utilize such a ratio
adjusting strategy, there is a less time-consuming method of taking defensive action in a

ratio write .
USING STOP ORDERS AS A DEFENSIVE STRATEGY
A ratio writer can use buy or sell stops on his stock position in order to automatically and
unemotionally adjust the ratio of his position. This type of defensive strategy is not an
aggressive one and will provide some profits unless a whipsaw occurs in the underlying
stock.
As an example of how the use of stop orders can aid the ratio writer, let us again
assume that the same basic position was established by buying XYZ at 49 and selling two
October .SOcalls at 6 points each. This produces a profit range of 37 to 63 at expiration. If
the stock begins to move up too far or to fall too far, the ratio writer can adjust the ratio
of calls short to stock long automatically, through the use of stop orders on his stock.
Example: An investor places a "good until canceled" stop order to buy 100 shares ofXYZ
at .57 at the same time that he establishes the original position. If XYZ should get to .57,
the stop would be set off and he would then own 200 shares of XYZ and be short 2 calls.
That is, he would have a 200-share covered write of XYZ October .SOcalls.
To see how such an action affects his overall profit picture, note that his average
stock cost is now .53; he paid 49 for the first 100 shares and paid .57 for the second 100
shares bought via the stop order. Since he sold the calls at 6 each, he essentially has a
covered write in which he bought stock at .53 and sold calls for 6 points. This does not
represent a lot of profit potential, but it will ensure some profit unless the stock falls back
below the new break-even point. This new break-even point is 47-the stock cost, .53, less
the 6 points received for the call. He will realize the maximum profit potential from the
covered write as long as the stock remains above .SOuntil expiration. Since the stock is
alread y at .57,the probabilities are relatively strong that it will remain above .SO,and even
stronger that it will remain above 47, until the expiration date. If the buy stop order was
placed just above a technical resistance area, this probability is even better.
Hence, the use of a buy stop order on the upside allows the ratio tcriter to automati-
cally com.;ert the ratio icrite into a covered write if the stock moves up too far. Once the
stop goes off, he has a position that will make some profit as long as the stock does not
experience a fairly substantial price reversal.
Downside protective action using a sell stop order works in a similar manner.
Example: The investor placed a "good until canceled" sell stop for 100 shares of stock
after establishing the original position. If this sell stop were placed at 41, for example, the
Chapter
position would become a naked call writer's position if the stock fell to 41. At that time,
the 100 shares of stock that he owned would be sold, at an 8-point loss, but he would have
the capability of making 12 points from the sale of his two calls as long as the stock
remained below .SOuntil expiration. In fact, his break-even point after converting into the
naked write would actually be .52 at expiration, since at that price, the calls could be
bought back for 2 points each, or 8 points total profit, to offset the 8-point loss on the
stock. This action limits his profit potential, but will allow him to make some profit as long
as the stock does not experience a strong price reversal and climb back above .52 by
expiration.
There are several advantages for inexperienced ratio writers to using this method of
protection. First, the implementation of the protective strategies-buying an extra 100
shares of stock if the stock moves up, or selling out the 100 shares that are long if the stock
moves down-is unemotional if the stop orders are placed at the same time that the origi-
nal position is established. This prevents the writer from attempting to impose his own
market judgment in the heat of battle. That is, if XYZ has moved up to .57,the writer who
has not placed a buy stop order may be tempted to wait just a little longer, hoping for the
stock to fall in price. If the stop orders are placed as soon as the position is established, a
great deal of emotion is removed. Second, this strategy will produce some profit-
assuming that the stops are properly placed-as long as the stock does not whipsaw or
experience a price reversal and go back through the striking price in the other direction.
Most follow-up actions in any writing strategy, whether they involve rolling actions or the
use of stops, are subject to losses if the stock whipsaws back and forth.
The disadvantage to using this type of protective action is that the writer may be
tying up relatively large amounts of capital in order to make only a small profit after the
stop order is set off. However, in a diversified portfolio, only a small percentage of the
stocks may go through their stop points, thereby still allowing the ratio writer plenty of
profit potential on his other positions.
Once either the buy stop or the sell stop is set off, the writer still needs to watch the
position. His.first action after one stop is touched should be to cancel the other stop order,
because the stops are good orders until they are canceled. From that time on, the writer
need do nothing if the stock does not experience a price reversal. In fact, he would just as
soon have the stock experience a greater move in the same direction to minimize the
chances of a price reversal.
If a price reversal does occur, the most conservative action is to close out the position
just after the stock crosses back through the striking price. This will normally result in a
small loss, but, again, it should happen in only a relatively small number of his positions.
Recall that in a limited profit strategy such as ratio writing, it is important to limit losses
as well. If the stock does indeed whipsaw and the position is closed, the writer will still
have most of his original equity and can then reestablish a new position in another under-
lying stock.
Placement of Stops. The writer would ideally like to place his stops at prices that
allow a reasonable rate of return to be made, while also having the stops far enough away
from the original striking price to reduce the chances of a whipsaw occurring. It is a fairly
simple matter to calculate the returns that could be made, after commissions are included,
if one or the other of the stops goes off. Dividends should be included as well, since they
will accrue to the writer. If the writer is willing to accept returns as low as 5% annually
for those positions that go through their stop points, he will be able to place his stops
farther from the original striking price. If he feels that he needs a higher return when the
stops go off, the stops must be placed closer in. As with any stock or option investment,
the writer who operates in large size will experience less of a commission charge, percent-
agewise. That is, the writer who is buying 500 shares of stock and selling 10 calls to start
with will be able to place his stop points farther out than the writer who is buying 100
shares of stock and selling 2 calls.
Technical analysis can be helpful in selecting the stop points as well. If there is
resistance overhead, the buy stop should be placed above that resistance. Similarly, if
there is support, the sell stop should be placed beneath the support point. Later, when
straddles are discussed, it will be seen that this type of strategy can be operated at less of
a net commission charge, since the purchase and sale of stock will not be involved.
CLOSING OUT THE WRITE
The methods of follow-up action discussed above deal with the eventuality of preventing
losses. However, if all goes well, the ratio write will begin to accrue profits as the stock
remains relatively close to the original striking price. To retain these paper profits that
have accrued, it is necessary to move the protective action points closer together.
Example: XYZ is at 51 after some time has passed, and the calls are at 3 points each. The
writer would, at this time, have an unrealized profit of $800-$200 from the stock pur-
chase at 49, and $300 each on the two calls, which were originally sold at 6 points each.
Recall that the maximum potential profit from the position, if XYZ were exactly at 50 at
1:xpiration, is $1,300. The writer would like to adjust the protective points so that nearly
all of the $800 paper profit might be retained while still allowing for the profit to grow to
the $1,300 maximum.
At expiration, $800 profit would be realized if XYZ were at 45 or at 55. This can be
verified by referring again to Table 6-1 and Figure 6-1. The 4,5 to 55 range is now the area
that the writer must be concerned with. The original profit range of 39 to 61 has become
Chapter
meaningless, since the position has performed well to this point in time. If the writer is
using the rolling method of protection, he would roll forward to the next expiration series
if the stock were to reach 4,5 or 55. If he is using the stop-out method of protection, he
could either close the position at 45 or 55 or he could roll to the next expiration series and
readjust his stop points. The neutral strategist using deltas would determine the number
of calls to roll forward to by using the delta of the longer-term call.
By moving the protective action points closer together, the ratio writer can then
adjust his position while he still has a profit; he is attempting to "lock in" his profit. As even
more time passes and expiration draws nearer, it may be possible to move the protective
points even closer together. Thus, as the position continues to improve over time, the
writer should be constantly "telescoping" his action points and finally roll out to the next
expiration series. This is generally the more prudent move, because the commissions to
sell stock to close the position and then buy another stock to establish yet another position
may prove to be prohibitive. In summary, then, as a ratio write nears expiration, the writer
should be concerned with an ever-narrowing range within which his profits can grow but
outside of which his profits could dissipate if he does not take action.
COMME NTS ON DELTA-NEUTRAL TRADING
Since the concept of delta-neutral positions was introduced in this chapter, this is an
appropriate time to discuss them in a general way. Essentially, a delta-neutral position is
a hedged position in which at least two securities are used-two or more different options,
or at least one option plus the underlying. The deltas of the two securities offset each
other so that the position starts out with an "equivalent stock position" (ESP) ofO. Another
term for ESP is "position delta." Thus, in theory, there is no price risk to begin with; the
position is neutral with respect to price movement of the underlying. That definition lasts
for about a nanosecond.
As soon as time passes, or the stock moves, or implied volatility changes, the deltas
change and therefore the position is no longer delta-neutral. Many people seem to have
the feeling that a delta-neutral position is somehow one in which it is easy to make money
without predicting the price direction of the underlying. That is not true.
Delta-neutral trading is not "easy": Either (1) one assumes some price risk as soon as
the stock begins to move, or (2) one keeps constantly adjusting his deltas to keep them
neutral. Method 2 is often not feasible for public traders because of commissions. It is
even difficult for market-makers, who pay no commissions. Most public practitioners of
delta-neutral trading establish a neutral position, but then refrain from adjusting it too
often.
A common mistake that novice traders make with delta-neutral trading is to short
options in a neutral manner, figuring that they have little exposure to price change because
the position is delta -neutral. However, a sizeable move by the underlying (which often
happens in a short period of time) ruins the neutrality of the position and inevitably costs
the trader a lot of money. A simple example: If one sells a naked straddle (i.e., he sells a
naked put and a naked call with both having the same striking price) with the stock ini-
tially just below the strike price, that's a delta-neutral position. However, the position has
naked options on both sides, and therefore has tremendous liability.
In practice, professionals watch more than just the delta; they also watch other mea-
sures of the risk of a position. Even then, price and volatility changes can cause problems.
Advanced risk concepts are addressed more fully in the chapter on Advanced Concepts.
SUMMAR¥
Ratio writing is a viable, neutral strategy that can be employed with differing levels of
sophistication. The initial ratio of short calls to long stock can be selected simplistically by
comparing one's opinion for the underlying stock with projected break-even points from
the position. In a more sophisticated manner, the delta of the written calls can be used to
determine the ratio.
Since the strategy has potentially large losses either to the upside or the downside,
follow-up action is mandatory. This action can be taken by simple methods such as rolling
up or down in a constant ratio, or by placing stop orders on the underlying stock. A more
sophisticated technique involves using the delta of the option to either adjust the stock
position or roll to another call. By using the delta, a theoretically neutral position can be
maintained at all times.
Ratio writing is a relatively sophisticated strategy that involves selling naked calls. It
is therefore not suitable for all investors. Its attractiveness lies in the fact that vast quanti-
ties of time value premium are sold and the strategy is profitable for the most probable
price outcomes of the underlying stock. It has a relatively large probability of making a
limited profit, if the position can be held until expiration without frequent adjustment.
Bull Spreads
Using Call Options
AN INTRODUCTION TO CALL SPREAD STRATEGIES
A spread is a transaction in which one simultaneously buys one option and sells another
option, with different terms, on the same underlying security. In a call spread, the options
are all calls. The basic idea behind spreading is that the strategist is using the sale of one
call to reduce the risk of buying another call. The short call in a spread is considered
covered, for margin purposes, only if the long call has an expiration date equal to or lon-
ger than the short call. Before delving into the individual types of spreads, it may be
beneficial to cover some general facts that pertain to most spread situations.
All spreads fall into three broad categories: vertical, horizontal, or diagonal. A uerti-
cal spread is one in which the calls involved have the same expiration date but different
striking prices. An example might be to buy the XYZ October 30 and sell the October :35
simultaneously. A horizontal spread is one in which the calls have the same striking price
but different expiration dates. This is a horizontal spread: Sell the XYZ January 3,5 and
buy the XYZ April 35. A diagonal spread is any combination of vertical and horizontal
and may involve calls that have different expiration dates as well as different striking
prices. These three names that classify the spreads can be related to the way option prices
are listed in any newspaper summary of closing option prices. A vertical spread involves
two options from the same column in a newspaper listing. Newspaper columns run verti-
cally. A horizontal spread involves two calls whose prices are listed in the same row in a
newspaper listing; rows are horizontal. This relationship to the listing format in newspa-
pers is not important, hut it is an easy way to remember what vertical spreads and
157
horizontal spreads are. There are many types of vertical and horizontal spreads, and
several of them are discussed in detail in later chapters.
SPREADORDER
The term "spread" designates not only a type of strategy, but a type of order as well. All
spread transactions in which both sides of the spread are opening (initial) transactions
must he done in a margin account. This means that the customer must generally main-
tain a minimum equity in the account, normally $2,000. Some brokerage houses may also
have a maintenance requirement, or "kicker."
It is possible to transact a spread in a cash account, but one of the sides must be a
closing transaction. In fact, many of the follow-up actions taken in the covered writing
strategy are actually spread transactions. Suppose a covered writer is currently short one
XYZ April call against 100 shares of the underlying stock. If he wants to roll forward to
the July 35 call, he will be buying back the April 35 and selling the July 35 simultaneously.
This is a spread transaction, technically, since one call is being bought and the other is
being sold. However, in this transaction, the buy side is a closing transaction and the sell
side is an opening transaction. This type of spread could be done in a cash account. When-
ever a covered writer is rolling-up, down, or forward-he should place the order as a
spread order to facilitate a better price execution.
The spreads discussed in the following chapters are predominantly spread strategies,
ones in which both sides of the spread are opening transactions. These are designed to
have their own profit and risk potentials, and are not merely follow-up actions to some
previously discussed strategy.
When a spread order is entered, the options being bought and sold must be speci-
fied. Two other items must be specified as well: the price at which the spread is to be
executed, and whether that price is a credit or a debit. If the total price of the spread
results in a cash inflow to the spread strategist, the spread is a credit spread. This merely
means that the sell side of the spread brings in a higher price than is paid for the buy side
of the spread. If the reverse is true-that is, there is a cash outflow from the spread
transaction-the spread is said to be a debit spread. This means that the buy side of the
spread costs more than is received from the sell side. It is also common to refer to the
purchased side of the spread as the long side and to refer to the written side of the spread
as the short side.
The price at which a certain spread can be executed is generally not the difference
between the last sale prices of the two options involved in the spread.
Example: An investor wants to buy an XYZ October 30 and simultaneously sell an XYZ
October :3.5call. If the last sale price of the October 30 was 4 points and the last sale price
Chapter
7: BullSpreadsUsingCalfOptions 159
of the October 35 was 2 points, it <loes not necessarily mean that the spread could be done
for a 2-point debit (the difference in the last sale prices). In fact, the only way to deter-
mine the market price for a spread transaction is to knotc what the bid and asked prices
of the options inr:olued are. Suppose the following quotes are available on these two calls:
Bid Asked Last

Sale
October 30 call 3.90 4 .10 4.00
October 35 call 1.95 2.00 2.00
Since the spread in question involves buying the October 30 call and selling the October 35,
the spreader will, at market, have to pay 4.10 for the October 30 (the asked or offering
quote) and will receive only 1.95 (the bid quote) for the October 35. This results in a debit
of 2.15 points, significantly more than the 2-point difference in the last sale prices. Of
course, one is free to specify any price he wants for any type of transaction. One might
enter this spread order at a 2.10-point debit and could have a reasonable chance of having
the order filled if the executing broker can do better than the bid side on the October 3,5
or better than the offering side on the October 30.
The point to be learned here is that one cannot assume that last sale prices are
indicative of the price at which a spread transaction can be executed. This makes com-
puter analysis of spread transactions via closing price data somewhat difficult. Some com-
puter data services offer (generally at a higher cost) closing bid and asked prices as well as
closing sale prices. If a strategist is forced to operate with closing prices only, however, he
should attempt to build some screens into his output to allow for the fact that last sale
prices might not be indicative of the price at which the spread can be executed. One
simple method for screening is to look only at relatively liquid options-that is, those that
have traded a substantial number of contracts during the previous trading day. If an
option is experiencing a great deal of trading activity, there is a much better chance that
the current quote is "tight," meaning that the bid and offering prices are quite close to the
last sale price .
In the early days of listed options, it was somewhat common practice to "leg" into a
spread. That is, the strategist would place separate buy and sell orders for the two transac-
tions comprising his spread. As the listed markets have developed, adding depth and
liquidity, it is generally a poor idea to leg into a spread. If the floor broker handling the
transaction knows the entire transaction, he has a much better chance of"splitting a quote,"
buying on the bid, or selling on the offering. Splitting a quote merely means executing at
a price that is between the current bid and asked prices. For example, if the bid is 3.90 and
the offering is 4.10, a transaction at a price of 4 would be "splitting the quote."
The public customer must be aware that spread transactions may involve substan-
tially higher commission costs, because there are twice as many calls involved in any one
transaction. Some brokers offer slightly lower rates for spread transactions, but these are
not nearly as low as spreads in commodity trading, for example .
The hull spread is one of the most popular forms of spreading. In this type of spread,
one buys a call at a certain striking price and sells a call at a higher striking price. Gener-
ally, both options have the same expiration date. This is a vertical spread. A bull spread
trnds to be profitable if the underlying stock moves up in price; hence, it is a bullish posi-
tion. The spread has both limited profit potential and limited risk. Although both can be
substantial percentagewise, the risk can never exceed the net investment. In fact, a bull
spread requires a smaller dollar investment and therefore has a smaller maximum dollar
loss potential than does an outright call purchase of a similar call.
XYZ common, 32;

XYZ October 30 call, 3; and
A bull spread would be established by buying the October 30 call and simultaneously
selling the October 3,5 call. Assume that this could be done at the indicated 2-point debit.
A call bull spread is alu;ays a debit transaction, since the call with the lower striking
price must always trade for more than a call with a higher price, if both have the sarne
expiration date. Table 7-1 and Figure 7-1 depict the results of this transaction at expira-
tion. The indicated call profits or losses would be realized if the calls were liquidated at
parity at expiration. Note that the spread has a maxinwm profit and this profit is reali::.ed
if the stock. is anyichcre above the higher striking price at expiration. The maxirnum loss
is realized if the stock is anywhere below the lower strike at expiration, and is equal to the
net investment, 2 points in this example.
Morem·er, there is a break-even point that always lies between the two striking
prices at expiration. In this example, the break-even point is :32. All bull spreads have
profit graphs with the same shape as the one shown in Figure 7-1 when the expiration
dates are the same for both calls.
The investor who establishes this position is bullish on the underlying stock, but is
generally looking for a way to hedge himself. If he were rampantly bullish, he would
merely buy the October :30 call outright. However, the sale of the October 3,5 call against
the purchase of the October 30 allmvs him to take a position that will outperform the
011tright purchase of the October 30. dollarwise, as long as the stock does not rise above
:1(i hy e:-,,:piration.This fact is demonstrated by the dashed line in Figure 7-1.
Chapter
7: BullSpreadsUsingCallOptions 161
TABLE 7-1.
Results at expiration of bull spread.
XYZPrice
at October
30 October
35 Total
h~~oo ~fu Profit Profit
25 -$300 +$100 -$200
30 - 300 + 100 - 200
32 - 100 + 100 0
35 + 200 + 100 + 300
40 + 700 - 400 + 300
45 + 1,200 - 900 + 300
FIGURE 7-1.
Bull spread.
c
0
+$300
, , ,,
,,
~
~
·a.. ,,
,,
X
UJ
cil $0 f-------------''---.......,...--='---'-------
(J)
(J) 30 ,
3~' 35
_g ,,
0
.... -$200 ,,
ea.. -$300 •------ -----,' / Call Purchase
Therefore, the strategist establishing the bull spread is h11llish,b11tnot 01;erlyso. To

verify that this comparison is correct, note that if one bought the October 30 call outright
for 3 points, he would have a 3-point profit at expiration ifXYZ were at :36.Both strategies
have a 3-point profit at 36 at expiration. Below 36, the bull spread does better because the
sale of the October 3,5 call brings in the extra point of premium. Above 36 at expiration,
the outright purchase outperforms the bull spread, because there is no limit 011 the profits
that can occur in an outright purchase situation.
The net investment required for a hull spread is the net debit plus commissions. Since
the spread must be transacted in a margin account, there will generally he a minimum
equity requirement imposed by the brokerage firm. In addition, there may be a mainte-
nance requirement by some brokers. Suppose that one was establishing 10 spreads at the
prices given in the example above. His investment, before commissions, would be $2,000
($200 per spread), plus commissions. It is a simple matter to compute the break-even point
and the maximum profit potential of a call bull spread:
Break-even point= Lower striking price+ Net debit of spread

Maximum profit Higher striking Lower striking Net debit
potential price price - of spread
In the example above, the net debit was 2 points. Therefore, the break-even point
would be 30 + 2, or 32. The maximum profit potential would be 35 - 30 - 2, or 3 points.
These figures agree with Table 7-1 and Figure 7-1. Commissions may represent a signifi-
cant percentage of the profit and net inrnstment, and should therefore be calculated
before establishing the position. If these commissions are included in the net debit to
establish the spread, they conveniently fit into the preceding formulae. Commission
charges can be reduced percentagewise by spreading a large quantity of calls. For this
reason , it is generall y advisable to spread at least 5 options at a time .
DEGREES OF AGGRESSIVENESS
AGGRESSIVE BULL SPREAD
Depending on how the bull spread is constructed, it may be an extremely aggressive or

more conservative position. The most commonly used bull spread is of the aggressive
type; the stock is generally well below the higher striking price when the spread is estab-
lished. This aggressive bull spread generally has the ability to generate substantial per-
centage returns if the underlying stock should rise in price far enough by expiration.
Aggressive bull spreads are most attractive when the underlying common stock is rela-
tively close to the lower striking price at the time the spread is established. A bull spread
established under these conditions will generally be a low-cost spread with substantial
profit pot ential, even after commissions are included.
EXTREMELYAGGRESSIVE BULL SPREAD
An extremely aggressive type of bull spread is the "out-of-the-money" spread. In such a

spread, uoth calls are out-of-the-money when the spread is established. These spreads are
extremely inexpensive to establish and have large potential profits if the stock should
Chapter
climb to the higher striking price by expiration. However, they are usually quite decep-
tive in nature. The underlying stock has only a relatively remote chance of advancing such
a great deal by expiration, and the spreader could realize a 100% loss of his investment
even if the underlying stock advances moderately, since both calls are out-of-the-money.
This spread is akin to buying a deeply out-of-the-money call as an outright speculation. It
is not recommended that such a strategy be pursued with more than a very small percent-
age of one's speculative funds.
LEASTAGGRESSIVE BULL SPREAD
Another type of bull spread can be found occasionally-the "in-the-money" spread. In

this situation, both calls are in-the-money. This is a much less aggressive position, since it
offers a large probability of realizing the maximum profit potential, although that profit
potential will be substantially smaller than the profit potentials offered by the more
aggressive bull spreads.
Example: XYZ is at 37 some time before expiration, and the October 30 call is at 7 while
the October 35 call is at 4. Both calls are in-the-money and the spread would cost 3 points
(debit) to establish. The maximum profit potential is 2 points, but it would be realized as
long as XYZ were above 3,5 at expiration. That is, XYZ could fall by 2 points and the
spreader would still make his maximum profit. This is certainly a more conservative posi-
tion than the aggressive spread described above. The commission costs in this spread
would be substantially larger than those in the spreads above, which involve less expensive
options initially, and they should therefore be figured into one's profit calculations before
entering into the spread transaction. Since this stock would have to decline 7 points to fall
below 30 and cause a loss of the entire investment, it would have to be considered a
rather low-probability event. This fact adds to the less aggressive nature of this type of
spread.
RANKING BULL SPREADS
To accurately compare the risk and reward potentials of the many bull spreads that are
available in a given clay, one has to use a computer to perform the mass calculations. It is
possible to use a strictly arithmetic method of ranking bull spreads, but such a list will not
be as accurate as the correct method of analysis. In reality, it is necessary to incorporate
the volatility of the underlying stock, and possibly the expected return from the spread as
well , into one's calculations. The concept of expected return is described in detail in
Chapter 28, where a bull spread is used as an example .
The exact method for using volatility and predicting an option's price after an upward
movement are presented later. Many data services offer such information. However, if the
reader wants to attempt a simpler method of analysis, the following one may suffice. In
any ranking of bull spreads, it is important not to rank the spreads by their maximum
potential profits at expiration. Such a ranking will always give the most weight to deeply
out-of-the-money spreads, which can rarely achieve their maximum profit potential. It
would be better to screen out any spreads whose maximum profit prices are too far away
from the current stock price. A simple method of allowing for a stock's movement might
be to assume that the stock could, at expiration, advance by an amount equal to twice the
time value premium in an at-the-money call. Since more volatile stocks have options with
greater time value premium, this is a simple attempt to incorporate volatility into the
analysis. Also, since longer-term options have more time value premium than do short-
term options, this will allow for larger movements during a longer time period. Percentage
returns should include commission costs. This simple analysis is not completely correct,
but it may prove useful to those traders looking for a simple arithmetic method of analysis
that can be computed quickly.
FURTHER CONSIDERATIONS
The bull spreads described in previous examples utilize the same expiration date for both
the short call and the long call. It is sometimes useful to buy a call with a longer time to
maturity than the short call has. Such a position is known as a diagonal bull spread and is
discussed in a later chapter.
Experienced traders often turn to bull spreads when options are expensive. The sale
of the option at the higher strike partially mitigates the cost of buying an expensive option
at the lower strike. However, one should not always use the bull spread approach just
because the options have a lot of time value premium, for he would be giving up a lot of
upside profit potential in order to have a hedged position.
With most types of spreads, it is necessary for some time to pass for the spread to
become significantly profitable, even if the underlying stock moves in favor of the spreader.
For this reason, hull spreads are not for traders unless the options involved are very short-
term in nature. If a speculator is bullishly oriented for a short-term upward move in an
underlying stock, it is generally better for him to buy a call outright than to establish a bull
spread. Since the spread differential changes mainly as a function of time, small move-
ments in price hy the underlying stock will not cause much of a short-term change in the
price of the spread. However, the bull spread has a distinct advantage over the purchase
of a call if the underlying stock advances moderately by expiration.
I11 the previous example, a bull spread was established by buying the XYZ October
:30call for :3points and simultaneously selling the October 3,5call for 1 point. This spread
Chapter
7: BullSpreadsUsingCaH
Options 165
can be compared to the 011trightpurchase of the XYZ October 30 alone. There is a short-
term advantage in using the outright purchase.
Example: The underlying stock jumps from 32 to 3.S in one day's time. The October 30
would be selling for approximately .S..S0if that happened, and the outright purchaser
would be ahead by 2 ..50 points, less one option commission. The long side of the bull
spread would do as well, of course, since it utilizes the same option, but the short side, the
October 3.S, would probably be selling for about 2 ..50. Thus, the bull spread would be
worth 3 points in total (.S..S0on the long side, less 2 ..50 loss on the short side). This repre-
sents a I-point profit to the spreader, less two option commissions, since the spread was
initially established at a debit of 2 points. Clearly, then, for the shortest time period-one
day-the outright purchase outperforms the bull spread on a quick rise.
For a slightly longer time period, such as 30 days, the outright purchase still has the
advantage if the underlying stock moves up quickly. Even if the stock should advance above
3.Sin 30 days, the bull spread will still have time premium in it and thus will not yet have
reached its maximum spread potential of .Spoints. Recall that the maximum potential of a
bull spread is always equal to the difference between the striking prices. Clearly, the out-
right purchaser will do very well if the underlying stock should advance that far in 30 days'
time. vVhen risk is considered, however, it must be pointed out that the bull spread has
fewer dollars at risk and, if the underlying stock should drop rather than rise, the bull
spread will often have a smaller loss than the outright call purchase would.
The longer it takes for the 1mderl1Jing stock to advance, the more the advantage
swings to the spread. Suppose XYZ does not get to 3.S until expiration. In this case, the
October 30 call would be worth .Spoints and the October 3.Scall would be worthless. The
outright purchase of the October 30 call would make a 2-point profit less one commission,
but the spread would now have a 3-point profit, less two commissions. Even with the
increased commissions, the spreader will make more of a profit, both dollarwise and
percentagewise.
Many traders are disappointed with the low profits available from a bull spread when
the stock rises almost immediately after the position is established. One way to partially
offset the problem with the spread not widening out right away is to use a greater distance
between the two strikes. When the distance is great, the spread has room to widen out,
even though it won't reach its maximum profit potential right away. Still, since the strikes
are "far apart," there is more room for the spread to widen even if the underlying stock
rises immediately .
The conclusion that can be drawn from these examples is that, in general, the out-
right purchase is a better strategy if one is looking for a quick rise by the underlying stock.
Overall, the hull spread is a less aggressive strategy than the outright purchase of a call.
The spread will not produce as much of a profit on a short-term move, or on a sustained,
large upward move. It will, however, outperform the outright purchase of a call if the
stock advances slowly and moderately by expiration. Also, the spread always involves fewer
actual dollars of risk, because it requires a smaller debit to establish initially. Table 7-2
summarizes which strategy has the upper hand for various stock movements over differ-
ing tim e p eriod s.
TABLE 7-2.
Bull spread and outright purchase compared.
Iftheunderlying
stock. ..
Remains
Relatively Advances Advances
Declines Unchanged Moderately . Substantially
in
l week Bull spread Bull spread Outright purchase Outright purchase
l month Bull spread Bull spread Outright purchase Outright purchase
At expiration Bull spread Bull spread Bull spread Outright purchase
FOLLOW-UP ACTION
Since the strategy has both limited profit and limited risk, it is not mandatory for the spreader
to take any follow-up action prior to expiration. If the underlying stock advances substan-
tially, the spreader should watch the time value premium in the short call closely in order to
close the spread if it appears that there is a possibility of assignment. This possibility would
increase substantially if the time value premium disappeared from the short call. If the stock
falls, the trader may want to close the spread in order to limit his losses even further.
vVhen the spread is closed, the order should also be entered as a spread transaction.
If the underlying stock has moved up in price, the order to liquidate would be a credit
spread involving two closing transaction. The maximum credit that can be reco1:;eredfrom
a bull spread is an amount equal to the difference between the striking prices. In the
previous example, if XYZ were above 35 at expiration, one might enter an order to liqui-
date the spread as follows: Buy the October 35 (it is common practice to specify the buy
side of a spread first when placing an order); sell the October 30 at a 5-point credit. In
reality , because of the difference between bids and offers, it is quite difficult to obtain the
entire 5-point credit even if expiration is quite near. Generally, one might ask for a 4.80
or 4.90 credit. It is possible to close the spread via exercise, although this method is nor-
mally advisable only for traders who pay little or no commissions. If the short side of a
Chapter
7: BullSpreadsUsingCaH
Options 167
spread is assigned, the spreader may satisfy the assignment notice by exercising the long
side of his spread. There is no margin required to do so, but there are stock commissions
involved. Since these stock commissions to a public customer would be substantially larger
than the option commissions involved in closing the spread by liquidating the options, it
is recommended that the public customer attempt to liquidate rather than exercise.
A minor point should be made here. Since the amount of commissions paid to liqui-
date the spread would be larger if higher call prices are involved, the actual net maximum
profit point for a bull spread is for the stock to be exactly at the higher striking price at
expiration. If the stock exceeds the higher striking price by a great deal, the gross profit
will be the same (it was demonstrated earlier that this gross profit is the same anywhere
above the higher strike at expiration), but the net profit will be slightly smaller, since the
investor will pay more in commissions to liquidate the spread.
Some spreaders prefer to buy back the short call if the underlying stock drops in
price, in order to lock in the profit on the short side. They will then hold the long call in
hopes of a rise in price by the underlying stock, in order to make the long side of the
spread profitable as well. This amounts to "legging" out of the spread, although the overall
increase in risk is small-the amount paid to repurchase the short call. If he attempts to
"leg" out of the spread in such a manner, the spreader should not attempt to buy back
the short call at too high a price. If it can be repurchased at ¼; or ½6,the spreader will be
giving away virtually nothing by buying back the short call. However, he should not be
quick to repurchase it if it still has much more value than that, unless he is closing out the
entire spread. At no time should one attempt to "leg" out after a stock price increase, tak-
ing the profit on the long side and hoping for a stock price decline to make the short side
profitable as well. The risk is too great.
Many traders find themselves in the somewhat perplexing situation of having seen
the underlying make a large, quick move, only to find that their spread has not widened
out much. They often try to figure out a way to perhaps lock in some gains in case the
underlying subsequently drops in price, but they want to be able to wait around for the
spread to widen out more toward its maximum profit potential. There really isn't any
hedge that can accomplish all of these things. The only position that can lock in the profits
in a call bull spread is to purchase the accompanying put bear spread. This strategy is
discussed in Chapter 23, Spreads Combining Calls and Puts.
OTHER USES OF BULL SPREAD S
Superficially, the bull spread is one of the simplest forms of spreading. However, it can be
an extremely useful tool in a wide variety of situations. Two such situations were described
in Chapter .'3.If the outright purchaser of a call finds himself with an unrealized loss, he
may be able to substantially improve his chances of getting out even by "rolling down"
into a bull spread. If, however, he has an unrealized profit, he may be able to sell a call at
the next higher strike, creating a bull spread, in an attempt to lock in some of his profit.
In a somewhat similar manner, a common stockholder who is faced with an unreal-
ized loss may be able to utilize a bull spread to lower the price at which he can break even.
He may often have a significantly better chance of breaking even or making a profit by
using options. The following example illustrates the stockholder's strategy.
Example: An investor buys 100 shares of XYZ at 48, and later finds himself with an unre-
alized loss with the stock at 42. A 6-point rally in the stock would be necessary in order
to break en'11. However, if XYZ has listed options trading, he may be able to significantly
reduce his break-even price. The prices are:
XYZ common, 42;

XYZ October 40, 4; and
XYZ October 45, 2.
The stock owner could enhance his overall position by buying one October 40 call and
selling t1co October 45 calls. Note that no extra money, except commissions, is required
for this transaction, because the credit received from selling two October 45's is $400 and
is equal to the cost of buying the October 40 call. However, maintenance and equity
requirements still apply, because a spread has been established.
The resulting position does not have an uncovered, or naked, option in it. One of the
October 45 calls that was sold is covered by the underlying stock itself. The other is part
of a bull spread with the October 40 call. It is not particularly important that the resulting
position is a cmnhination of both a bull spread and a covered write. What is important is
the profit characteristic of this new total position.
If XYZ should continue to decline in price and be below 40 at October expiration,
all the calls will expire worthless, and the resulting loss to the stock owner will be the
same (except for the option commissions spent) as if he had merely held onto his stock
without having done any option trading.
Since both a covered write and a bull spread are strategies with limited profit poten-
tial, this 11e1cposition obi;io11slvmust have a limited profit. If XYZ is anywhere above 45
at October expiration, the maximum profit will be realized. To determine the size of the
maximum profit, assunw that XYZ is at exactly 45 at expiration. In that case, the two short
October 45's would expire worthless and the long October 40 call would be worth ,5 points.
The option trades v-.rouldhave resulted in a $400 profit on the short side ($200 from each
October .-15call) plus a $100 profit on the long side, for a total profit of $500 from the
Chapter
option tradt>s. SincP tlw stock was originally bought at 48 in this Pxarnple, the stock portion
of the position is a $:300 loss with XYZ at 4,5 at expiration. The overall profit of the position
is thus $500 less $300 , or $200.
For stock prices betwet'll 40 and 45 at t>xpiratio11,the results are shown in Table 7-,'3
and Figurt> 7-2. Figure 7-2 depicts the two columns from the table labeled "Profit on
Stock" and "Total Profit," so that one can visualize how the new total position compares
with the original stockholcler's profit. Several points should be noted from either the graph
or the table. First, the break-even point is lowered from 48 to 44. The new total position
breaks even at 44, so that only a 2-point rally by the stock by expiration is necessary in
order to break e\·en. Tht> two strategies are equal at 50 at expiration. That is, the stock
would have to rally more than 8 points, from 42 to .50, by expiration for the original stock-
holder's position to outperform the new position. Below 40, the two strategies produce the
same result. Finally, between 40 and .SO,tht' new position outperforms the original stock-
holder's position.
In summary, then, the stockholder stands to gain much and gives away very little by
adding the indicated options to his stock position. If the stock stabilizes at all-anywhere
between 40 and 50 in the example above-the new position would be an improvement.
Moreover, the investor can break even or make profits on a small rally. If the stock con-
tinues to drop heavily, nothing additional will he lost except for option commissions. Only
if the stock rallies very sharply will the stock position outperform the total position.
This strategy-combining a covered write and a bull spread-is sometimes used as
an initial (opening) trade as well. That is, an investor who is considering buying XYZ at 42
TABLE 7-3.
Lowering the break-even price on common stock.
XYZ
Price
at Profit
on Profit
onShort Profit
onLong Total
Expiration Stock October45's October
40 Profit
35 -$1,300 +$400 -$400 -$1,300
38 1,000 + 400 - 400 1,000
40 800 + 400 - 400 800
42 600 + 400 200 400
43 500 + 400 100 200
44 400 + 400 0 0
45 300 + 400 + 100 + 200
48 0 - 200 + 400 + 200
50 + 200 - 600 + 600 + 200
FIGURE 7-2.
Lowering the break-even price on common stock.
C
0
Profit with Options
~
"6,_+$200
, ,,
,,
X
LU
ca
en
,,
en $0
0
....J 40
, , ,~s 50
,,
e-
0
,
(l_
,,
, , ,' Stock Profit
,,
, ,,
,,
,,
,,
-$800 Stock Price at Expiration
might decide to buy the October 40 and sell two October 4.S's (for even money) at the out-
set. The resulting position would not be inferior to the outright purchase of XYZ stock, in
terms of profit potential, unless XYZ rose above 46 by October expiration.
Bull spreads may also be used as a "substitute" for covered writing. Recall from
Chapter 2 that writing against warrants can be useful because of the smaller investment
required, especially if the warrant was in-the-money and was not selling at much of a
premium. The same thinking applies to call options. If there is an in-the-money call with
little or 110 time premium remaining in it, its purchase may be used as a substitute for
b11ui11~ the stock itself. Of course, the call will expire, whereas the stock will not; but the
profit potential of owning a deeply in-the-money call can be very similar to owning the
stock. Sinet' such a call costs less to purchase than the stock itself would, the buyer is get-
ting essentially the same profit or loss potential with a smaller investment. It is natural,
tht'11. to think that one might write another call-one closer to the money-against the
Chapter
deeply in-the-money purchased call. This position would have profit characteristics much
like a covered write, since the long call "simulates" the purchase of stock. This position
reall:· is, of course, a bull spread, in which the purchased call is well in-the-money and the
written call is closer to the mone:·· Clearl:·, one would not want to put all of his money into
such a strategy ancl forsake covered writing, since, with bull spreads, he could be entirely
wiped out in a moderate market decline. In a covered writing strategy, one still owns the
stocks e\·en after a severe market decline. However, one may achieve something of a com-
promise by im·esting a much smaller amount of money in bull spreads than he might have
im·estecl in cm·erecl writes. He can still retain the same profit potential. The balance of
the investor's funds could then be placed in interest-bearing securities .
XYZ common, 49;

XYZ April 35 call, 14.
Since the deeply in-the-money call has no time premium, its purchase will perform much
like the purchase of the stock until April expiration. Table 7-4 summarizes the profit
potential from the covered write or the bull spread. The profit potentials are the same
from a cash covered write or the bull spread. Both would yield a $400 profit before com-
missions ifXYZ were above 50 at April expiration. However, since the bull spread requires
a much smaller investment, the spreader could put $3,500 into interest-bearing securi-
ties. This interest could be considered the equivalent of receiving the dividends on the
stock. In any case, the spreader can lose only $1,100, even if the stock declines substan-
tially. The covered writer could have a larger unrealized loss than that if XYZ were below
3.5at expiration. Also, in the bull spread situation, the writer can "roll down" the April .SO
call if the stock declines in price, just as he might do in a covered writing situation.
TABLE 7-4.
Results for covered write and bull spread compared.
Covered
Write: Bull
Spread:
Buy
XYZandSell Buy
XYZApril
35Coll
and
April
50Coll Sell
April
50Coll
Maximum profit potential
(stock over 50 in April) $ 400 $ 400
break-even point 46 46
Investment $4,600 $1,100
Thus, the hull spread offers the same dollar rewards, the same break-even point,
snialler commission costs, less potential risk, and interest income from the fixed-income
portion of the i1l\"estment. While it is not always possible to find a deeply in-the-money
call to use as a "substitute" for buying the stock, when one does exist, the strategist should
consider using the bull spread instead of the covered write.
SUMMARY
Tlw hull spread is one of the simplest and most popular forms of spreading. It will gener-
all_1,·
perform best in a moderately bullish environment. A bull spread will not widen out
to its maximum profit potential right away, though; so for short-term trades, the outright
purchase of a call is a better choice. The bull spread can also be applied for more sophis-
ticated purposes in a far wider range of situations than merely wanting to attempt to capi-
talize 011 a moderate a(kance by the underlying stock. Both call buyers and stock buyers
may he able to use hull spreads to "roll clown" and produce lower break-even points for
their positions. The cm·erecl writer may also be able to use bull spreads as a substitute for
cm·erecl writes in certain situations in which a deeply in-the-money call exists.
Bear Spreads Using
Call Options
Options are versatile investment vehicles. For every type of bullish position that can be
established, there is normally a corresponding bearish type of strategy. For every neutral
strategy, there is an aggressive strategy for the investor with an opposite opinion. One
such case has already been explored in some detail; the synthetic straddle buy (or reverse
hedge) is the opposite of a ratio write. For many of the strategies to he described from this
point on, there is a corresponding strategy designed for the strategist with the opposite
point of view. In this vein, a bear spread is the opposite of a bull spread.
THE BEAR SPREAD
In a call bear spread, one buys a call at a certain striking price and sells a call at a loicer
striking price. This is a vertical spread, as was the bull spread. The bear spread tends to
be profitable if the underlying stock declines in price. Like the bull spread, it has limited
profit and loss potential. However, unlike the bull spread, the bear spread is a credit
spread when the spread is set up with call options. Since one is selling the call with the
lower strike, and a call at a lower strike always trades at a higher price than a call at a
higher strike with the same expiration, the bear spread must be a credit pmition. It should
he pointed out that most bearish strategies that can be established with call options may
be more advantageously constrncted using put options. Many of these same strategies are
therefor e discussed again in Part III.
173
Example: An investor is bearish on XYZ. Using the same prices that were used for the
examples in Chapt er 7, an example of a bear spread can be constructed for:
XYZ common, 32;

XYZ October 30 call, 3; and
XYZ October 35 call, l.
A lwar spread wo11lcllw established by hu:·ing the October :3,5call and selling the Octo-
lwr :30call. This we_mldlw clone for a :2-point credit, before commissions. In a bear sprC'ad
sit1wtio11.tl1e stmtcgist is hoping that t!1estock 1cill drop in price and that hath options
1ci!l <'XJJire1curtliless. If this happens, he will not have to pay anything to close his spread;
he will profit Ii: the entir e a111ountof the original credit taken in. In this example, then,
the 111axim11111 profit pott:>ntial is 2 points, since that is the amount of the initial credit.
This profit would he realized if XYZ were anywhere below ,30 at t>xpiration, because both
options wou ld expire wort hless in tha t case.
If th e spr ead expands in price, rather than contracts, the hear spreader will be losing
1110IH':
·· This e:-.;pansionwo11ld occur in a rising rnarket. The maximum amount that this
sprt>aclcould c:-.;pamlto is .Spoints-the difference between the striking prices. Hence, the
,nost that tlw lwar spreader would have to pay to buy back this spread would he ,5 points,
resulting in a rnaxinmm potential loss of :3points. This loss would he realized if XYZ were
an:wh('rt' ahm t' :3,5at October expiration. Table 8-1 and Figure 8-1 depict the actual profit
and loss pott>ntial of this example at expiration (commissions are not included). The astute
rt>aclcrwill nok that the figures in the table are exactly the reverse of those shown for the
bull spread exaniple in Chapt er 7. Also, the profit graph of the hear spread looks like a hull
spread profit graph that has been turned upside down. All bear spreads have a profit graph
with th e same shape at expira tion as th e gra ph shown in Figur e 8-1.
TABLE 8-1.
Bear spread.
XYZPriceat October
30 October
35 Total
Expirat
ion Profit Prof
it Profit
25 +$300 -$100 +$200
30 + 300 - 100 + 200
32 + 100 - 100 0
35 - 200 - 100 300
40 - 700 + 400 300
Chapter
8: BearSpreadsUsingCallOptions 175
FIGURE 8-1.
Bear spread.
6 +$200
~
·o..
X
w
Cl)
Cl) 30 35
0
...J
0
'5
ct -$300
The break-even point, maximum profit potential, and investment required are all
quite simple computations for a bear spread.
Maximum profit potential = Net credit received
Break -even point = Lower striking price + Amount of credit
Maximum Collateral investment Difference in Credit ..

. d + Comm1ss10ns
risk required striking prices receive
In the example above, the net credit received from the sale of the October 30 call at
3 an<l the purchase of the October 35 call at 1 was two points. This is the maximum profit
pot ential. The break-even point is then easily computed as the lower striking price, 30,
plus the amount of the credit, 2, or 32. The risk is equal to the investment. It is the dif-
ference between the striking prices-5 points-less the net credit received-2 points-
for a total investment of 3 points plus commissions. Since this spread involves a call that
is not '"covered" by a long call with a striking price equal to or lower than that of the short
call, some brokerage firms may require a higher maintenance requirement per spread
than would be required for a bull spread. Again, since a spread must be done in a margin
account, most brokerage firms require that a minimum amount of equity be in the account
as well.
Since this is a credit spread, the investor does not really "spend" any dollars to estab-
lish the spread. The investment is really a reduction in the buying power of the customer's
margin account, hut it does not actually require dollars to be spent when the transaction
is initiated.
176 PartII: CallOptionStrategies
SELECTING A BEAR SPREAD
Depending on where the underlying stock is trading with respect to the two striking
prices, the hear spread may be very aggressive, with a high profit po tential, or it may be
less aggressive, with a low profit potential. If a large credit is initially taken in, there is
obviously the potential for a good deal of profi t. However, for the spread to take in a large
credit, the underlying stock must be well above the lower striking price. This means that
a relativelv substantial downward move would be necessary in order for the maximum
profit potential to be realized. Thus, a large credit bear spread is usually an aggressive
position; the spreader needs a substantial move by the underlying stock in order to make
his maximum profit. The probabilities of this occurring cannot be considered large.
A less aggressive type of bear spread is one in which the underlying stock is actually
be/o11;the lower striking price when the spread is estab lished. The credit received from
establishing a bear spread in such a situation wou ld be small, but the spreader would real-
ize his maximum profit even if the underlying stock remained unchanged or actually rose
slightly in price by expiration.
Example: XYZ is trading at a price of 25. The October 30 call might be sold for 1.50
points and the October 3.5call bough t for .50 with the stock at 29. W h ile the net credit
and hence the rnaximum profit potential, is a small dol lar amount, 1 point, it will be real-
ized e,·en if XYZ rises slightly by expiration, as long as it does not rise above 30.
It is not always clear which type of spread is better, the large credit bear spread or
the small credit bear spread. One has a small probability of making a large profit and the
other has a much larger probability of making a much smaller profit. In general, bear
sprmds establisl1ed u;lze11the underlying stock is closer to the lower striking price will
be the best ones. To see this, note that if a bear spread is initiated when the stock is at the
higher striking price, the spreader is selling a call that has mostly intrinsic value and litt le
time \'alue premium (since it is in-the-money), and is buying a ca ll that is nearly all time
,·alue. This is just the opposite of what the option strategist should be attempting to do.
Tlic basic philosophy of option strategy is to sell time wlue and buy intrinsic calue. For
this reason, the large credit bear spread is not an op timum strategy. It wi ll be interesting
to ohscrn"' later that bear spreads with puts are more attractive when the underlying stock
is at the higher striking price!
A ht>ar spread will not collapse right away, even if the underlying stock drops in
price. This is somewhat similar to the effect that was observed with the call bull spreads
in Chapter 7. The:· · too. do not accelerate to their maximum profit potential right away.
Of cmirst>. as tirne winds down and expiration approaches, then the spread will approach
its 111a\i11mrnprofit potential. This is important to understand because, if one is expecting
Chapter
8: BearSpreadsUsingCallOptions 177
a quick moYe down b:· the underlying stock, he might need to use a call bear spread in
which the lower strike is actuall) 1 somewhat deeply in-tht>-money, while the upper strike
is out-of-the-monev.. In this case, the in-tlw-monev. call will decline in value as the stock
moves down. even if that dowmvarcl move happt>ns immediately. Meanwhile, tlw out-of-
tht>-money long call protects against a disastrous upside breakout by the stock. This type
of bear spread is really akin to st>llinga deep in-the-money call for its raw downside profit
pott>ntial and buying an out-of-the-money call merely as disaster insurance.
FOLLOW-UP ACTION
Follow-up strategies are not difficult, in general, for bear spreads. The major thing that
the strategist must be aware of is impending assignment of the short call. If the short side
of the spread is in-the-money and has no time premium remaining, the spread should be
closed regardless of how much time remains until expiration. This disappearance of time
value premium could be caused either by the stock being significantly above the striking
price of the stock call, or by an impending dividend payment. In either case, the spread
should be closed to avoid assignment and the resultant large commission costs 011 stock
transactions. Note that the large credit bear spread (one established with the stock well
above the lower striking price) is dangerous from the viewpoint of early assignment, since
the time value premium in the call will be small to begin with.
SUMMARY
The call bear spread is a bearishly oriented strategy. Since the spread is a credit spread,
requiring only a reduction in buying power but no actual layout of cash to establish, it is
a moderately popular strategy. The bear spread using calls may not be the optimum type
of bearish spread that is available; a bear spread using put options may be.
Calendar Spreads
A calendar spread, also frequently called a time spread, involves the sale of one option
and the simultaneous purchase of a more distant option, both with the same striking
price. In the broad definition, the calendar spread is a horizontal spread. The neutral
philosophy for using calendar spreads is that time will erode the value of the near-term
option at a faster rate than it will the far-term option. If this happens, the spread will
widen and a profit may result at near-term expiration. With call options, one may con-
struct a more aggressive, bullish calendar spread. Both types of spreads are discussed.
Example: The following price s exist sometime in late January :
50Call
April July50Call October
50Call
call)
(3-month call)
(6-month call)
(9-month
XYZ
:50 5 8 10
If one sells the April .50 call and buys the July ,50 at the same time, he will pay a debit of
3 points-the difference in the call prices-plus commissions. That is, his investnient is
the net dehit of the spread plus commissions. Furthermore, suppose that in 3 months, at
April expiration, XYZis unchanged at ,50.Then the 3-month call should be worth .5points,
and the 6-month call should be worth 8 points, as they were previously, all other factors
bein g equal.
50Coll
April July50Coll October
50Coll
(Expiring) (3-monthcall) call)
(6-month
XYZ
:50 0 5 8
178
Chapter
9: Calendar
Spreads 179
The spread bt'hveen tlw April ,50 and the July ,50 has now widened to .5 points. Sinc.;ethe
spread cost :1 points originally, this widening effect has prod11ced a 2-point profit. The
spread could be closed at this tinw in order to realize the profit, or tht' spreader may
decide to continue to hold the Jul_,,,50 call that he is long. By continuing to hold the July
,50 calL ht' is risking tht' profits that have accrued to date, but he could profit handsomely
if the underlying stock rises in price over the next :3months, before July expiration.
It is not necessary for the underlying stock to be exactly at the striking price of the
options at near-term expiration for a profit to result. In fact, some profit can be made in a
range that extends both below and above the striking price. The risk in this type of posi-
tion is that the stock will drop a great deal or rise a great deal, in which case the spread
between the two optiom will shrink and the spreader will lose money. Since the spread
between two calls at the same strike cannot shrink to less than zero, however, the risk
is li111itedto the anw1111tof the original debit spent to establish the spread, plus
commissions.
THE NEUTRAL CALENDAR SPREAD
As mentioned earlier, the calendar spreader can either have a neutral outlook on the stock
or he can construct the spread for an aggressively bullish outlook. The neutral outlook is
described first. The calendar spread that is established when the underlying stock is at or
near the striking price of the options used is a neutral spread. The strategist is interested
in selling time and not in predicting the direction of the underlying stock. If the stock is
relatively unchanged when the near-term option expires, the neutral spread will make a
profit. In a neutral spread, one should initially !wee the intent of closing the spread by
the time the near-term option expires.
Let us again turn to our example calendar spread described earlier in order to more
accurately demonstrate the potential risks and rewards from that spread when the near-
term, April, call expires. To do this, it is necessary to estimate the price of the July .50 call
at that time. Notice that, with XYZ at .50 at expiration, the results agree with the less
detailed example presented earlier. The graph shown in Figure 9-1 is the "total profit"
from Table 9-1. The graph is a curved rather than straight line, since the July ,50 call still
has time premium. There is a slightly bullish bias to this graph: The profit range extends
slightly farther above the striking price than it does below the striking price. This is due
to the fact that the spread is a call spread. If puts had been used, the profit range would
have a bearish bias. The total width of the profit range is a function of the volatility of the
underlying stock, since that will determine the price of the remaining long call at expira-
tion , as well as a function of the time remaining to near-term expiration.
FIGURE 9-1.
Calendar spread at near-term expiration.
C
0
~ + $200
·5.
X
UJ
C1l
CJ)
CJ)
0
....J
0
'5
0:: - $300
TABLE 9-1.
Estimated profit or losses at April expiration.
XYZ
Stock April
50 April
50 July50 July50 Total
Price Price Profit Price Profit Profit
40 0 +$500 .50 -$750 -$250
45 0 + 500 2.50 - 550 - 50
48 0 + 500 4 - 400 + 100
50 0 + 500 5 - 300 + 200
52 2 + 300 6 - 200 + 100
55 5 0 8 0 0
60 10 - 500 10.50 + 250 - 250
Table 9-1 and Figure 9-1 clearly depict several of the more significant aspects of the
calendar spread. There is a range icitlii11 ichich the spread is pnfztablc at near-term
r."l.piration.That range would appear to be about 46 to .5,5in the example. Outside that
range, losses can occur, hut they are limited to the amount of the initial debit. Notice in
the example that tlw stock would have to be well below 40 or well above 60 for the maxi-
11nm1loss to ocTm. E\·en if the stock is at 40 or 60, there is some time premium left in the
longer-ten11 option, and the loss is not quite as large as the maximum possible loss of $300.
This type of calendar spread has limited profits and relatively large c0111mission
costs. It is ge1wrall:-,·hest to establish such a spread 8 to 12 weeks before the near-term
Chapter
9: Calendar
Spreads 181
option expires. If this is done, one is capitalizing on the rnaxinmm rate of decay of the
near-term option with respect to the longer-term option. That is, when a call has less than
8 weeks of life. tlw rate of deca~· of its time value premium increases substantially with
respect to the longer-term options on the same stock.
THE EFFECTOF VOLATILITY
The implied rnlatility of the options (and hence the actual volatility of the underlying
stock) will have an effect on the calendar spread. As colatilit9 increases, the spread u;id-
ens; as colatility contracts, tlie spread shrinks. This is important to know. In effect, buy-
ing a calendar spread is an alltiwlatility strategy: One wants the underlying to remain
somewhat unchanged. Sometimes, calen<lar spreads look especially attractive when the
underlying stock is rnlatile. However, this can be misleading for two reasons. First of alL
since the stock is volatile, there is a greater chance that it will move outside of the profit
area. Second, if the stock does stabilize and trades in a range near the striking price, the
spread will lose value because of the decrease in volatility. That loss may be greater than
the gain from time decay!
FOLLOW-UP ACTION
Ideally, the spreader would like to have the stock be just below the striking price when
the near-term call expires. The spreader would also ideally like the implied volatility of
the remaining long call option to be as high as possible, for that will increase the price
of the call. If this happens, he can close the spread with only one commission cost, that of
selling out the long call, although most traders would close out both sides near the close of
the day on expiration clay, so that the long call would not have to be held over the
weekend-and therefore exposed to a downward gap in the un<lerlying stock on Monday
morning. lf the calls are in-the-money at the expiration date, he \;vill, of course, have to
pay two commissions to close the spread. As with all spread positions, the order to close
the spread should be placed as a single order. "Legging" out of a spread is highly risky and
is not recommended.
Prior to expiration, the spreader should close the spread if the near-term short call
is trading at parity. He does this to avoid assignment. Being called out of spread position
is devastating from the viewpoint of the stock commissions involved for the pnhlic cus-
tomer. The near-term call would not normally be trading at parity until quite close to the
last clay of trading, unless the stock has undergone a substantial rise i11price.
In the case of an early downside breakout hy the tmderl~1i11gstock, the spreader
has several choices. He could immediately close the spread and take a srnall loss 011 the
position. Another choice is to leave the spread alone until the near-term call expires and
then to hope for a partial recovery from the stock in order to be able to recover some value
from the long side of the spread. Such a holding action is often better than the immediate
close-out, because the expense of buying back the short call can be quite large percent-
agewise. A riskier downside defensive action is to sell out the long call if the stock begins
to break clown heavily. In this way, the spreader recovers something from the long side of
his sprt'acl immediately , and then looks for the stock to remain depressed so that the short
side of the spread will expire worthless. This action requires that one have enough col-
lateral available to margin the resulting naked call, often an amount substantially in excess
of the original <lebit paid for the spread. Moreover, if the underlying stock should reverse
direction and rally back to or above the striking price, the short side of the spread is naked
and could produce substantial losses. The risk assumed by such a follow-up violates the
initial 1H::>utral premise of the spread, and should therefore be avoided. Of these three
typt's of downside defensive action, the easiest and nwst conservative one is to do nothing
at all, lt'tting tht' short call expire worthless and then hoping for a recovery by the under-
lying stock. If this tack is taken, the risk remains fixed at the original debit paid for the
spread, and occasionally a rally may pro<luce large profits on the long call. Although this
rall:· is a non frequent event, it generally costs the spreader very little to allow himself the
opportunit y to take advantage of such a rally if it should occur .
In fact. the strategist can employ a slight modification of this sort of action, even if
the sprt'acl is not at a large loss. If the underlying stock is moderately below the striking
price at near-tt'nn t'xpiration, the short option will expire worthless and the spreader will
be lt'ft holding the long option. He could sell the long side immediately and perhaps take
a small gain or loss. However, it is often a reasonable strategy to sell out a portion of the
long side-rt'covering all or a substantial portion of the initial investment-and hold the
rernain<ler. If the stock rises, the remaining long position may appreciate substantially.
Although this sort of action <leviates from the true nature of the time spread, it is not
overly risky.
An early breakout to the upside by the underlying stock is generally handled in much
the same way as a downside breakout. Doing nothing is often the best course of action. If
the unclerl_vingstock rallies shortly after the spread is established, the spread will shrink
h:· a small amount hut not substantially, because both options will hold premium in a
rally. If tht' spreader were to rush in to close the position, he would be paying commissions
on two rather expensive optiom. He will usually do better to wait and give himself as
much of a chance for a reversal as possible. In fact, even at near-term expiration, there
will nonnall:· he some time premium left in the long option so that the maximum loss
wonld not ha\·e to he realized. A highly risk-oriented upside defensive action is to cover
the short call on a technical breakout and continue to hold the long call. This can become
clisastro11sif the hrt'akont fails and the stock drops, possibly resulting in losses far in excess
Chapter
9: Calendar
Spreads 183
of the original debit. Therefore, this action cannot be considered anything but extremely
aggressive and illogical for the neutral strategist.
If a breakout does not occur, the spreader will normally be making unrealized prof-
its as time passes. Should this be the case, he may want to set some mental stop-out points
for himself. For example, if the>underlying stock is quite close to the striking price with
onl~,;two weeks to go, there will be some more profit potential left in the spread, but the
spreader should he rc>aclyto close the position quickly if the stock begins to get too far
away from the striking price. In this manner, he can leave room for more profits to accrue,
but he is also attempting to protect the profits that have already built up. This is somewhat
similar to the action that the ratio writer takes when he narrows the range of his action
points as more and more time passes.
THE BULLISH CALENDAR SPREAD
A less neutral and more bullish type of calendar spread is preferred by the more aggres-
sive investor. In a bullish calendar spread, one sells the near-term call and buys a longer-
term call, but he does this ichen the underlying stock is some distance below the striking
price of the calls. This type of position has the attractive features of low dollar investment
and large potential profits. Of course, there is risk involved as well.
Example: One might set up a bullish calender spread in the following manner:
XYZ common, 45;

sell the XYZ April 50 for l; and
buy the XYZ July 50 for 1.50.
This investor ideally wants two things to happen. First, he icould like the near-term
call to expire 1corthless. That is why the bullish calendar spread is established with out-
of-the-money calls: to increase the chances of the short call expiring worthless. If this
happens, the investor will then own the longer-term call at a net cost of his original debit.
In this example, his original debit was only 50 cents to create the spread. If the April 50
call expires worthless, the investor will own the July 50 call at a net cost of 0.,50, plus
commissions.
The inuestor now needs a second criterion to be fulfilled: The stock must rise in
price by the tilne the July 50 call expires. In this example, even if XYZ were to rally to
only ,52between April and July, the July .50 call could be sold for at least 2 points. This
represents a substantial percentage gain, because the cost of the call has been reduced to
,50 cents. Thus, there is the potential for large profits in lmllish calendar spreads if the
underlying stock rallies above the striking price before the longer-term call expires, pro-
vided that the short-term call has already expired worthless.
\ Vhat chance does the investor have that both ideal conditions will occur? There is
a reasonably good chance that the written call will expire worthless, since it is a short-term
call and the stock is below the striking price to start with. If the stock falls, or even rises
a little-up to, hut not above, the striking price-the first condition will have been met.
It is the second condition, a rally above the striking price by the underlying stock before
the longer-term expiration date, that normally presents the biggest problem. The chances
of this happening are usually small, but the rewards can be large when it does happen.
Thus, this strategy offers a small probability of making a large profit. In fact, one large
profit can easily offset several losses, because the losses are small, dollarwise. Even if the
stock remains depressed and the July ,50 call in the example expires worthless, the loss is
limited to the initial debit of ,50. Of course, this loss represents 100% of the initial invest-
ment, so one cannot put all his money into bullish calendar spreads.
This strategy is a reasonable way to speculate, provided that the spreader adheres to
the following criteria when establishing the spread:
1. Select ll11derlying stocks that are volatile enough to move above the striking price
1cithi11the alloted time. Bullish calendar spreads may appear to be very "cheap" on non-
rnlatile stocks that are well below the striking price. But if a large stock move, say 20%,
is required in only a few months, the spread is not worthwhile for a nonvolatile stock.
2. Do not use options more than one striking price above the current market. For
example, if XYZ were 26, use the 30 strike, not the 3.5 strike, since the chances of a
rally to 30 are many times greater than the chances of a rally to 3.5.
:3. Do not i111.;esta large percentage of available trading capital in bullish calendar
spreads. Since these are such low-cost spreads, one should be able to follow this rule
easily and still diversify into several positions.
FOLLOW-UP ACTION
If the underlying stock should rally before the near-term call expires, the bullish calendar
spreader must never consider "legging" out of the spread, or consider covering the short
call at a loss and attempting to ride the long call. Either action could turn the initial small,
limited loss into a disastrous loss. Since the strategy hinges on the fact that all the losses
will lw small and the infrequent large profits will he able to overcome these small losses,
one sl1onld do nothing to jeopardize the strategy and possibly generate a large loss.
Chapter
9: Calendar
Spreads 185
The only reasonable sort of follow-up action that the bullish calen<lar sprea<ler can
take in adrnnce of expiration is to close the sprea<l if the underlying stock has moved up
in price and the spread has widened to become profitable. This might occur if the stock
mm·es up to the striking price after some time has passed, and/or the implied volatility of
the options has increased. In the example above, if XYZ moved up to 50 with a month or
so of life left in the April ,SOcalL the call might be selling for 1..50while the July 50 call
might be selling for :3 points. Thus, the spread could be closed at 1..50, representing a
1-point gain 0\-er the initial debit of .50 cents. Two commissions would h,we to he paid to
close the spread, of course, but there would still be a net profit in the spread.
USING ALL THREE EXPIRATION SERIES
In either the neutral calendar sprea<l or the bullish calendar spread, the investor has
three choices of which months to use. He could sell the nearest-term call and buy the
intermediate-term call. This is usually the most common way to set up these spreads.
However, there is no rule that prevents him from selling the intermediate-term and buy-
ing the longest-term, or possibly selling the near-term and buying the long-term. Any of
these situations would still be calendar spreads.
Some proponents of calendar spreads prefer initially to sell the near-term and buy
the long-term call. Then, if the near-term call expires worthless, they have an opportunity
to sell the intermediate-term call if they so desire .
Example: An investor establishes a calendar sprea<l by selling the April 50 call and buying
the October 50 call. The April call would have less than 3 months remaining and the
October call would be the long-term call. At April expiration, if XYZ is below ,50, the April
call will expire worthless. At that time, the July ,50 call could be sold against the October
50 that is held long, thereby creating another calendar spread with no a<l<litionalcommis-
sion cost on the long side .
The advantage of this type of strategy is that it is possible for the two sales (April ,50
and July 50 in this example) to actually bring in more credits than were spent for the one
purchase (October 50). Thus, the spreader might be able to create a position in which he
has a guaranteed profit. That is, if the sum of his transactions is actually a cre<lit, he can-
not lose money in the spread (provided that he does not attempt to "leg'' out of the spread).
The <lisadvantage of using the long-term call in the calendar spread is that tlie initial debit
is larger, an<l therefore more dollars are initially at risk. If the underlying stock mow's
substantially up or clown in the first 3 months, the spreader could realize a larger dollar
loss with the October/April spread because his loss will approach the initial dchit.
The remaining combination of the expiration series is to initially buy the longest-
term call and sell the intermediate-term call against it. This combination will generally
require the smallest initial debit, but there is not much profit potential in the spread until
the intermediate-term expiration date draws near. Thus, there is a lot of time for the
underlying stock to move some distance away from the initial striking price. For this rea-
son, this is generally an inferior approach to calendar spreading.
S MARY
Calendar spreading is a low-dollar-cost strategy that is a nonaggressive approach, pro-

vided that the spreader does not invest a large percentage of his trading capital in the
strategy, and provided that he does not attempt to "leg" into or out of the spreads. The
neutral calendar spread is one in which the strategist is mainly selling time; he is attempt-
ing to capitalize on the known fact that the near-term call will lose time premium more
rapidly than will a longer-term call. A more aggressive approach is the bullish calendar
spread, in which the speculator is essentially trying to reduce the net cost of a longer-term
call by the amount of credits taken in from the sale of a nearer-term call. This bullish
strategy requires that the near-term call expire worthless and then that the underlying
stock rise in price. In either strategy, the most common approach is to sell the nearest-
term call and buy the intermediate-term call. However, it may sometimes prove advanta-
geous to sell the near-term and buy the longest-term initially, with the intention of letting
the near-term expire and then possibly writing against the longer-term call a second time .
In all cases, an increase in the implied volatility of the options while the spread is in place
would be a benefit to the calendar spreader, and conversely a decrease in implied volatil-
ity would be to his detriment.
The Butterfly Spread
The recipient of one of the more exotic names given to spread positions, the butterfly
spread is a neutral position that is a combination of both a bull spread and a bear spread.
This spread is for the neutral strategist, one who thinks the underlying stock will not
experience much of a net rise or decline by expiration. It generally requires only a small
investment and has limited risk. Although profits are limited as well, they are large than
the potential risk. For this reason, the butterfly spread is a viable strategy. However , it is
costly in terms of commissions. In this chapter, the strategy is explained using only calls.
The strategy can also be implemented using a combination of puts and calls, or with puts
only, as will be demonstrated later .
There are three striking prices involved in a butterfly spread. Using only calls, the
butterfly spread consists of buying one call at the highest striking price. The following
example will demonstrate how the butterfly spread works.
Example: A butterfly spread is established by buying a July ,50 call for 12, selling 2 July
60 calls for 6 each, and buying a July 70 call for :3. The spread requires a relatively low
debit of $300 (Table 10-1), although there are four option commissions involved and these
may represent a substantial percentage of the net investment. As usual, the maximum
amount of profit is realized at the striking price of the written calls. With most types of
spreads, this is a useful fact to remember, for it can aid in quick computation of the poten-
tial of the spread. In this example, if the stock were at the striking price of the written
options at expiration (60), the two July 60's that are short would expire worthless for a
$1,200 gain. The long July 70 call would expire worthless for a $300 loss, and the long July
,50 call would be worth 10 points, for a $200 loss on that call. The sum of the gains and
losses would thus be a $700 gain, less commissions. This is the maximum profit potential
of the spread.
187
TABLE 10-1.
Butterfly spread example.
Current prices:
XYZ common: 60
XYZJuly 50 call: 12
XYZJuly 60 call: 6
XYZJuly 70 call: 3
Butterflyspread:
Buy 1 July 50 call $1,200 debit
Sell 2 July 60 calls $1,200 credit
Buy 1 July 70 call $300 debit
Net debit $300 (pluscommissions)
Tlzc risk is limited in rt lmtterfly spread, both to tlzc upside and to the dou;nsicle,
and is equal to the a11w1111t of the net debit rec1uired to establish the spread. In the
example above, the risk is limited to $300 plus commissions.
Table 10-2 and Figure 10-1 depict the results of this butterfly spread at various
prices at expiration. The profit graph resembles that of a ratio write, except that the loss
is limited 011hoth tht> upsidt> and the downside. There is a profit range within which the
lmtterfl_vspread makes rnoney-,53 to 67 in tht> example, before commissions are included.
Outside this profit range, losses will occur at t>xpirntion, lmt these losses are limited to the
amount of the original debit plus commissions.
In accordance with lllore lenient 1nargi11requirements passed in 2000, the invest-
ment required for a butterfly spread is equal to the net debit expended, which is the risk
in the spread. \Vhen tht' options expire in the same month and the striking prices are
e\·enlv spaced (the spacing is 10 points in this example). the following formulae can be
used to quick ly compute the important details of the butterfly spre~d:
Net investment= Net debit of the spread

Maximum profit= Distance between strikes - Net debit
Downside break-even= Lowest strike + Net debit
Upside break-even= Highest strike - Net debit
In the example, tht> distance ht>tWt't'll strikes is 10 points, tlw net debit is 3 points
(lwfore c0111n1issionsl.tlw lowt'st strike used is ,50.and the hight'st strikt' is 70. These for-
mulae would then yield the following results for this example spread.
Chapter10: TheButterfl
y Spread, 189
Net investment= 3 points= $300

Maximum profit = 10 - 3 = $700
Downside break-even = 50 + 3 = ,53
Upside break-even = 70 - 3 = 67
TABLE 10-2.
Results of butterfly spread at expiration.
XYZ at
Price July50 July60 July70 Total
40 -$1,200 +$1,200 -$300 -$300
50 - 1,200 + 1,200 - 300 - 300
53 - 900 + 1,200 - 300 0
56 - 600 + 1,200 - 300 + 300
60 - 200 + 1,200 - 300 + 700
64 + 200 + 400 - 300 + 300
67 + 500 - 200 - 300 0
70 + 800 - 800 - 300 - 300
80 + 1,800 - 2,800 + 700 - 300
FIGURE 10-1.
Butterfly spread.
+$700
C
0
~
·5..
><
UJ
cil
en $0
en 70
0
_J
0
e -$3 00
c..

Note that all of these answers agree with the results that were previously obtained by
analyzing the example spre ad in detail.
In this example, the maximum profit potential is $700, the maximum risk is $:300,
and the investment required is also $:300, commissions excluded . In percentage terms,
this means that the butterfly spread has a loss limited to about 100% of capital invested
and could make profits of nearly 1:3:3%in this case. These represent an attractive risk/
reward relationship. This is, however, just an example, and two factors that exist in the
actual marketplace may greatly affect these numbers . First, commissions are large; it is
possible that eight commissions might have to be pa id to establish and liquidate the
spread . Second, depending on the level of premiums to be found in the market at any
point in time, it may not be possible to establish a spread for a debit as low as :3 points
whe n th e stri kes are 10 point s apart.
SELECTING THE SPREAD
Ideally, one would want to establish a bu tterfly spread at as small of a debit as possible in
order to limit his risk to a small amount, although that risk is still equal to 100% of the
dollars im·ested in the spread. One would also like to have the stock be near the middle
striking price to begin with, because he will then be in his maximum profit area if the
stock remains relatively unchanged. Unfortunately, it is difficult to satisfy both conditions
simult aneou sly.
The smallest-debit butterfly spreads are those in u;hich the stock is som(>distance
mcay from the middle striking price. To see this , note that if the stock were well above
the middle strike and all the options were at parity , the net debit would be zero. Although
no one would attempt to establish a butterfly spread with parity options because of the
risk of early assignment, it may be somewhat useful to try to obtain a small debit by taking
an opinion on the underlying stock. For example, if the stock is close to the higher striking
price , the debit would be small normally , but the investor would have to be somewhat
bearish on the underlying stock in order to maximize his profit; that is, the stock would
have to decline in price from the upper striking price to the middle striking price for the
maximum profit to be realized. An analogous situation exists when the underlying stock
is originally close to the lower striking price. The investor could establish the spread for a
small debit in this case also, but he would now have to he somewhat bullish on the under-
lying stock in ord er to att empt to rea lize his maximu m profit.
Example: XYZ is at 70. One may be able to establish a low-debit butterfly spread with the
.S0's, 60's, and ?O's if th e following prices exist :
Chapter10:TheButterflySpread· 191
XYZ common , 70;

XYZ July 50, 20 ;
XYZ July 60 , 12; and
XYZ July 70, 5.
The butterfly spread would require a debit of only $LOOplus commissions to establish,
because the cost of the calls at the higher and lower strike is 25 points, and a 24-point
credit would be obtained by selling two calls at the middle strike. This is indeed a low-cost
butterfly spread, but the stock will have to move down in price for much of a profit to be
realized. The maximum profit of $900 less commissions would be realized at 60 at expira-
tion. The strategist would have to be bearish on XYZ to want to establish such a spread.
\iVithout the aid of an example, the reader should be able to determine that if XYZ
were originally at ,50, a low-cost butterfly spread could be established by buying the 50,
selling two 60's, and buying a 70. In this case , however, the investor would have to be
bullish on the stock, because he would want it to move up to 60 by expiration in order for
the maximum profit to be rea lized .
In general, then, if the butterfly spread is to be established at an extremely low debit,
the spreader will have to make a decision as to whether he wants to be bullish or bearish
on the underlying stock. Many strategists prefer to remain as neutral as possible on the
underlying stock at all times in any strategy. This philosophy would lead to slightly higher
debits, such as the $:300 debit in the example at the beginning of this chapter, but would
theoretically have a better chance of making money because there would be a profit if the
stock remained relativel y unchanged , the most probable occurren ce.
In either philosophy, there are other considerations for the butterfly spread. The best
butterfly spreads are generally found on the more expensive and/or more volatile stocks
that haue striking prices spaced 10 or 20 points apart. In these situations, the maximum
profit is large enough to overcome the weight of the commission costs involved in the but-
terfly spread. ·when one establishes butterfly spreads on lower-priced stocks whose strik-
ing prices are only ,5 points apart, he is normally putting himself at a disadvantage unless
the debit is extremely small. One exception to this rule is that attractive situations are
often found on higher-priced stocks with striking prices 5 points apart (,50,55, and 60, for
example ). They do exist from time to tim e.
In analyzing butterfly spreads, one commonly works with closing prices. It was men-
tioned earlier that using closing prices for analysis can prove somewhat misleading, since
the actual execution will have to be clone at bid and asked prices, and these may differ
somewhat from closing prices. Normally, this difference is small, but since there are three
different calls involved in a butterfly spread, the difference could be substantial. Therefore,
it is usually necessary to check the appropriate bid and asked price for each call before
entering the spread, in order to be able to place a reasonable debit on the order. As with
other types of spreads, the butterfly spread order can be placed as one order.
Before moving on to discuss follow-up action, it may be worthwhile to describe a
tactic for stocks with 5 points between striking prices. For example, the butterfly spreader
might work with strikes of 4,5, ,50, and 60. If he sets up the usual type of butterfly spread,
he would encl up with a position that has too much risk near 60 and very little or none at
all near 4.5. If this is what he wants, fine; but if he wants to remain neutral, the standard
type of butterfly spread will have to be modified slightly.
XYZ common, 50;

July 45 call, 7;
July 50 call, 5; and
July 60 call, 2.
The normal type of butterfly spread-buying one 45, selling two .50's,and buying one oO-
can actually be done for a credit of 1 point. However, the profitability is no longer symmetric
about the middle striking price. In this example, the investor cannot lose to the downside
because, e\'en if the stock collapses and all the calls expire worthless, he will still make his
I-point credit. However, to the upside, there is risk: If XYZ is anywhere above 60 at expira-
tion, the risk is 4 points. This is no longer a neutral position. The fact that the lower strike is
only ,5points from the middle strike while the higher strike is 10 points away has made this
a somewhat bearish position. If the spreader wants to be neutral and still use these striking
prices, he will have to put on two bull spreads and only one bear spread. That is, he should:
Buy 2 July 45's: $1,400 debit

Sell 3 July 50's: $1,500 credit
Buy 1 July 60: $200 debit
This position now has a net debit of$ 100 but has a better balance of risk at either end. If
XYZ drops and is below 45 at expiration, the spreader will lose his $100 initial debit. But
now, if XYZ is at or abm·e 60 at expiration, he will lose $100 in that range also. Thus, by
establishing two bull spreads with a 5-point difference between strikes versus one bear
spread with a IO-point difference between strikes, the risk has been balanced at both
ends. \\'hen one uses strike prices that are not evenly spaced apart, his margin rf'quire-
ment increases suhstantiall:·· In such a case, one has to margin the individual component
spreads separate]:·· Therefore, in this example, he would hm·e to pay for the two bull
Chapter10:TheButterflySpread 193
spreads ($200 eaclL for a total of $400) and thc11 margin the additional call hear spread
($700: the $ L000 differe11ce in the strikes, lf'ss tllf' $300 crf'dit take11 in for that portion
of the sprf'acl). Hf'nce, in this example, thf' 111argi11requirf'ment woulcl he $1,100, evf'n
though the risk is onl:· $100. Teclmicall:·, of that $1,100 requirement, the spread trader
pays out onl:· $100 i11cash (tllf' actual debit of the spread), and the rest of the requirement
can be satisfied with excess equity in his account.
The same analysis obviousl:· applies whenever ,5-point striking price intervals exist.
There are numerous combinations that could be worked out for lower-priced stocks by
merely skipping m·er a striking price (using the 2,S's, 30's, and 40's, for example). Although
there are not normally many stocks trading over $100 per share, the same analysis is
applicable using 130's, 140's, and 160's , for example.
FOLLOW-UP ACTION
Since the butterfly spread has limited risk by its construction, there is usually little that the
spreader has to do in the way of follow-up action other than avoiding early exercise or pos-
sibly closing out the position early to take profits or limit losses even further. The only part
of the spread that is subject to assignment is the call at the middle strike. If this call trades
at or near parity, in-the-money, the spread should be closed. This may happen before expi-
ration if the underlying stock is about to go ex-dividend. It should he noted that accepting
assignment will not increase the risk of the spread (because any short calls assigned would
still be protected by the remaining long calls). However, the rnargi11 requirement would
change substantially, since one would now have a synthetic put (long calls, short stock) in
place. Plus, there may he more onerous commissions for trading stock. Therefore, it is usu-
ally wise to avoid assignment in a butterfly spread, or in any spread, for that matter.
If the stock is near the middle strike after a reaso11able amount of time has passed,
an unrealized profit will begin to accrue to the spreader. If one feels that the underlying
stock is about to move away from the middle striking price and thereby jeopardize these
profits, it may be advantageous to close the spread to take the available profit. Be certain
to include commission costs when determining if an unrealized profit exists.
Normally, one would not close the spread early to limit losses, since these losses are
limited to the original net debit in any case. However, if the original debit was large and
the stock is beginning to break out above the higher strike or to break down below the
lower strike, the spreader may want to close the spread to limit losses even further.
It has been repeatedly stated that one should not attempt to "leg" out of a spread
because of the risk that is incurred if one is wrong. However, there is a method of legging
out of a butterfly spread that is acceptable and may even he prudent. Since the spread
consists of both a hull spread and a bear spread, it may often he the case that the stock
t>xperienct's a relatively substantial move in one direction or the other during the life of
the butterfly spread, and that the bull spread portion or the bear spread portion could be
closed out near their maximum profit potentials. If this situation arises, the spreader may
vvant to take advantage of it in order to be able to profit more if the underlying stock
reverses direction and comes back into the profit range.
Example: This strategy can be explained by using the initial example from this chapter
and then assuming that the stock falls from 60 to 4,5. Recall that this spread was initially
established with a 3-point debit and a maximum profit potential of 7 points. The profit
rangt>was 5:3to 67 at July expiration. However, a rather unpleasant situation has occurred:
The stock has fallen quickly and is below the profit range. If the spreader does nothing and
keeps the spread on, he will lose :3points at most if the stock remains below ,50 until July
expiration. However, by increasing his risk slightly, he may be able to improve his position.
Notice in Table 10-:3that the bear spread portion of the overall spread-short July 60, long
July 70-has very nearly reached its maximum potential. The bear spread could be bought
hack for 50 cents total (pay 1 point to buy back the July 60 and receive .,50 from selling out
the Jul:' 70). Thus, the spreader could convert the butterfly spread to a bull spread by
spending 50 cents. \ Vhat would such an action <lo to his overall position? First, his risk
would be increased by the ,50 cents spent to close the bear spread. That is, ifXYZ continues
to remain below ,50 until July expiration, he would now lose :3.,50rather than 3 points, plus
commissions in eitht>r case. He has, however, potentially helped his chances of realizing
something close to the maximum profit available from the original butterfly spread.
TABLE 10-3.
Initial spread and current prices.
Initial
Spread Current
Prices
XYZ common: 60 XYZ common: 45
July 50 call: 12 July 50 call: 2
July 60 call: 6 July 60 call: l
July 70 call: 3 July 70 call: .50
Aftt>r lm:'ing back the bear sprt>ad, he is left with the following bull spread:
.
Long July 50 call - N e t d eb't1 3 . 50 pomts
Short July 60 call
Ht>l1as a liull spread at the total cost paid to date-3.,50 points. From the earlier discus-
sion oflmll spreads, the rt>ader should know that tht> break-even point for this position is
,'53.."50at ('\piration, and it could makt> a 6.,50 point profit if XYZ is anywhere over 60 at
Chapter10:TheButterfly
Spread 195
July expiration. Hence, the break-even point for the position was raised from ,5:3to 53.50
by the expense of the 50 cents to buy back the bear spread. However, if the stock should
rally back above 60, the strategist will be making a profit nearly equal to the original
maximum profit that he was aiming for (7 points). Moreover, this profit is now available
anywhere over 60, not just exactly at 60 as it was in the original position. Although the
chances of such a rally cannot be considered great, it does not cost the spreader much to
restructure himself into a position with a much broader maximum profit area.
A similar situation is available if the underlying stock moves up in price. In that
case, the bull spread may be able to be removed at nearly its maximum profit potential,
thereby leaving a bear spread. Again, suppose that the same initial spread was estab-
lished but that XYZ has risen to 75. When the underlying stock advances substantially,
the bull spread portion of the butterfly spread may expand to near its maximum potential.
Since the strikes are 10 points apart in this bull spread, the widest it can grow to is
10 points. At the prices shown in Table 10-4, the bull spread-long July 50 and short
July 60-has grown to 9.50 points. Thus, the bull spread position could be removed
within 50 cents of its maximum profit potential and the original butterfly spread would
become a bear spread. Note that the closing of the bull spread portion generates a 9.,50
point credit: The July ,50 is sold at 25 ..50 and the July 60 is bought back at 16. The original
butterfly spread was established at a 3-point debit, so the net position is the remaining
position:
Long July 70 call - Net ere d't1 6 . 50 porn

. ts
Short July 60 call
This bear spread has a maximum profit potential of 6.,50 points anywhere below 60 at July
expiration. The maximum risk is 3.50 points anywhere above 70 at expiration. Thus, the
original butterfly spread was again converted into a position such that a stock price rever-
sal to any price below 60 could produce something close to the maximum profit. More-
over, th e risk was only increased by an additional 50 cents.
TABLE 10-4.
Initial spread and new current prices.
Initial
Spread Current
Prices
XYZ July50 call: 12 July50 call: 25.50
July60 call: 6 July60 call: 16
July70 call: 3 July70 call: 7
SUMMARY
The>lmtterAy sprc>ad is a viable, low-cost strategy with both limited profit potential and
limited risk. It is actnall:· a combination of a lmll spread and a bear spread, and involves
using three> striking pricc>s. The risk is limited should the underl:-ing stock fall below the
lowest strike or rise abm·e the highest strike. The maximum profit is obtained at the
middle> strike. One can kc>ephis initial debits to a minimum by initially assuming a bullish
or bearish posture on the> underlying stock. If he would rather remain nentral, he will
normally hm·e to pa:· a slightl:· larger dc>bitto establish the sprc>ad, but may have a better
chance> of making mm1e:·· If the un<lerlying stock experiencc>s a large move in one direc-
tion or the other prior to c>xpiration, the spreader may want to close the profitable> side of
his hutterAy sprc>aclnear its maximum profit potential in order to be>able to capitalize on
a stock price reversal, should one occur.
Ratio Call Spreads
A ratio call spread is a neutral strategy in which one buys a number of calls at a lower
strike and sells more calls at a higher strike. It is somewhat similar to a ratio write in con-
cept, although the spread has less downside risk and normally requires a smaller invest-
ment than does a ratio write. The ratio spread and ratio write are similar in that both
involve uncovered calls, and both have profit ranges within which a profit can be made at
expiration. Other comparisons are demonstrated throughout the chapter.
XYZ common, 44;

A 2:1 ratio call spread could be established by buying one April 40 call and simultane-
ously selling two April 45's. This spread would be done for a credit of 1 point-the sale of
the two April 45's bringing in 6 points and the purchase of the April 40 costing 5 points.
This spread can be entered as one spread order, specifying the net credit or debit for the
position. In this case, the spread would be entered at a net credit of l point.
Ratio spreads, unlike ratio writes, have a relatively small, limited doicnside risk. In
fact, if the spread is established at an initial credit, there is no downside risk at all. In a
ratio spread, the profit or loss at expiration is constant below the lower striking price,
because both options would be worthless in that area. In the example above, if XYZ is
below 40 at April expiration, all the options would expire worthless and the spreader
would have made a profit of his initial I-point credit, less commissions. This 1-point gain
would occur anywhere below 40 at expiration; it is a constant.
197
The maximum profit at expiration for a ratio spread occurs if the stock is exactly at
the striking price of the written options. This is true for nearly all types of strategies
involving written options. In the example, if XYZ were at 4,5 at April expiration, the April
45 calls would expire worthless for a gain of $600 on the two of them, and the April 40
call would he worth ,5points, resulting in no gain or loss on that call. Thus, the total profit
would be $600 less commissions.
The greatest risk in a ratio call spread lies to the upside, where the loss may the-
oretically he unlimited. The upside break-even point in this example is ,51, as shown in
Table 11-1. The table and Figure 11-1 illustrate the statements made in the preceding
paragraphs .
In a 2:1 ratio spread, two calls are sold for each one purchased. The maximum profit
amount and the upside break-even point can easily be computed by using the following
formulae:
Points of maximum profit= Initial credit+ Difference between strikes or

= Difference between strikes - Initial debit
Upside break-even point = Higher strike price + Points of maximum profit
In the preceding example, the initial credit was 1 point, so the points of maximum
profit= l + 5 = 6, or $600. The upside break-even point is then 45 + 6, or ,51. This agrees
with the results determined earlier. Note that if the spread is established at a debit rather
than a credit, the debit is subtracted from the striking price differential to determine the
points of maximum profit.
Many neutral investors prefer ratio spreads over ratio writes for two reasons:
TABLE 11-1.
Ratio call spread.
XYZPrice
at April
40Call April
45Call Total
Expiration Profits Profits Profits
35 -$ 500 +$ 600 +$100
40 - 500 + 600 + 100
42 - 300 + 600 + 300
45 0 + 600 + 600
48 + 300 0 + 300
51 + 600 - 600 0
55 + 1,000 - 1,400 - 400
60 + 1,500 - 2,400 - 900
Chapter11:RatioCallSpreads' 199
FIGURE 11-1.
Ratio call spread (2: 1).
+$600
C
0
~
·c..
X
~ +$100
: $0 1------........__ __ _._ _____ ~-------
C/)
0
....J
0
ea..
l. The downside risk or gain is predetermined in the ratio spread at expiration, and
therefore the position does not require much monitoring on the downside.
2. The margin investment required for a ratio spread is normally smaller than that
required for a ratio write, since on the long side one is buying a call rather than buy-
ing the common stock itself.
For margin purposes, a ratio spread is really the combination of a bull spread and a
naked call write. There is no margin requirement for a bull spread other than the net debit
to establish the bull spread. The net investment for the ratio spread is thus equal to the
collateral required for the naked calls in the spread plus or minus the net debit or credit
of the spread. In the example above, there is one naked call. The requirement for the
naked call is 20% of the stock price plus the call premium, less the out-of-the-money
amount. So the requirement in the example would he 20% of 44, or $880, plus the call
premium of $300, less the one point that the stock is below the striking price-a $1,080
requirement for the naked call. Since the spread was established at a credit of one point,
this credit can also be applied against the initial requirement, thereby reducing that
requirement to $980. Since there is a naked call in this spread, there will be a mark to
market if the stock moves up. Just as was recommended for the ratio write, it is recom-
mended that the ratio spreader allow at least enough collateral to reach the upside
hreak-euen point. Since the upside breakeven point is ,51 in this example, the spreader
should allow 20% of .51,or $1,020, plus the 6 points that the call would lw worth less the
I-point initial net credit-a total of $1,.520 for this spread ($1,020 + $GOO- $100).
DIFFERING PHILOSOPHIES
For many strat egies , there is more than one philosophy of how to implement the strategy.
Ratio spreads are no exception, with three philosophies being predominant. One philoso-
phy holds that ratio spreading is quite similar to ratio writing-that one should be looking
for opportunities to purchase an in-the-rnonc>y call with little or no time premium in it so
that the ratio spread simulates the profit opportunities from the ratio write as closely as
possible with a smaller im ·estment. The ratio spreads established under this philosophy
ma:: have rather large debits if the purchased call is substantially in-the-money. Another
philosophy of ratio sprt>ading is that spreads should be established for credits so that
there is no chance of losing money on the downside. Both philosophies have merit and
both are described. A third philosophy , called the "delta spread, " is more concerned with
neutrality , regardles s of th e initial debit or credit. It is also described.
RATIO SPREAD AS RATIO WRITE
Then:> art' Se\·eral spread strategies similar to strategies that invoke common stock. In
this cast>, the ratio sprt>acl is similar to the ratio write. \ Vhenever such a similarity exists,
it rna; be possible for the strategist to buy an in-the-money call with little or no time pre-
rni11Jnas a substitute for buying the common stock. This was seen earlier in the covered
call writing strategy, wlwre it vvas shown that the purchase of in-the-money calls or war-
rants might be a viablt> substitute for the purchase of stock. If 011c is able to buy an
for tl1e stock, he icill not affect l1is JJmfit potential s11b-
C'IJas a s11bstit11te
i11-tl1e-11w11call
sta11tially. \\Then cornparing a ratio spread to a ratio write, the maximum profit potential
and the profit range are reduced by the ti111evalue premium paid for the long call. If this
call is at parity (the time \·alue premium is thus zero) , the ratio spread and the ratio write
have exactly the same profit potential. Moreover, the net investment is reduced and there
is less downside risk should the stock fall in price below the striking price of the pur-
cliasecl call. The spread also involves smallt>r commission costs than does the ratio write,
\\'hich im ·ohes a stock purchase . The ratio writer does receive stock dividends , if any are
paid , wh ere as th e spr eader does not.
Example: XYZ is at ,50,and an XYZ July 40 call is selling for 11 while an XYZ July .50 call
is st>lling for ,5.Table 11-2 compares the important points between tlte ratio write and the
ratio spread.
I11 C-:haptt>ro, it was pointed out that ratio writing was one of the better strategies
frrnn a probabilit:· of profit \·iewpoint. That is, the profit pott'ntial conforms well to the
'
t'\]Wded 111on"11ient of th t> und t>rlying stock. The same statement holds true for ratio
Chapter11:RatioCallSpreads 201
TABLE 11-2.
Ratio write and ratio spread compared.
RatioWrite: Ratio
Spread:
Buy XYZat50and Buy1July40at11and
Sell2July at5
S0's Sell2July at5
S0's
Profit range 40 to 60 41 to 59
Maximum profit 10 points 9 points
Downside risk 40 points l point
Upside risk Unlimited Unlimited
Initial investment $3,000 $1,600
spreads as substitutes for ratio writes. In fact, the ratio spread may often be a better
position than the ratio write itself, when the long call can be purchased with little or no
time value premium in it.
RATIO SPREAD FOR CREDITS
The second philosophy of mtio spreads is to establish them only for credits. Strategists
who follow this philosophy generally want a second criterion fulfilled also: that the under-
lying stock be below the striking price of the written calls when the spread is established.
In fact, the farther the stock is below the strike, the more attractive the spread would be.
This type of ratio spread has no downside risk because, even if the stock collapses, the
spreader will still make a profit equal to the initial credit receh·ed. This application of the
ratio spread strategy is actually a suhcase of the application discussed above. That is, it
may be possible both to buy a long call for little or no time premium, thereby simulating
a ratio write , and also to be able to set up the position for a credit.
Since the underlying stock is generally below the maximum profit point when one
establishes a ratio spread for a credit, this is actually a mildly bullish position. The inves-
tor would want the stock to move up slightly in order for his maximum profit potential to
he realized. Of course, the position does have unlimited upside risk, so it is not an overly
bullish strategy.
These two philosophies are not mutually exclusive. The strategist who uses ratio
spreads without regard for whether they are debit or credit spreads will generally have a
broader array of spreads to choose from and will also be able to assume a more neutral
posture on the stock. The spreader who insists 011generating credits only will he forced
to estahlish spreads on which his rt>turn will ht> slightly smaller if tht> unclerl:·ing stock
remains relatively m1cha11gecl. Hmwver, he will not have to wmT:' about downside
deft'nsive action, since he has no risk to the downside. The third philosophy, the "delta
sprtwl," is described after the next section, in which the uses of ratios other than 2:1 are
described.
ALTERING THE RATIO
Undt-r either of the two philosophies discussed above, the strategist may find that a
:3:1 ratio or a :3:2 ratio better suits his purposes than the 2:1 ratio. It is not common to
write in a ratio of greater than 4: 1 because of the large increase in upside risk at such high
ratios. The higher the ratio that is used, the higher will he the credits of the spread. This
means that the profits to the downside will be greater if the stock collapses. The lower the
ratio that is used, the higher the upside break-even point will be, thereby reducing
upside risk.
Example: If the same prices are used as in the initial example in this chapter, it will be
possible to demonstrate these facts using three different ratios (Table 11-3):
XYZ common, 44;

In Chapter 6 on ratio writing, it was seen that it was possible to alter the ratio to
adjust the position to one's outlook for the underlying stock. The altering of the ratio in a
ratio spread accomplishes the same objective. In fact, as will be pointed out later in the
chapter, the ratio may be adjusted continuously to achieve what is considered to be a
"neutral spread." A similar tactic, using the option's delta, was described for ratio writes.
TABLE 11-3.
Comparison of three ratios.
3:2Ratio: 2:1Ratio: 3:1Ratio:
Buy2April
40's Byl April
40 Buyl April
40
Sell3April
45's Sell2April
45's Sell3April
45's
Price of spread 1 debit 1 credit 4 credit
(downside risk)
Upside break-even 54 51 49.50
Downside break-even 40.50 None None
Maximum profit 9 6 9
Chapter11:RatioCallSpreads , 203
The following formulae allow one to determine the maximum profit potential and
upsid e brea k-even point for any ratio:
Point s of maximum = Net credit+ Numb er of long calls x

profit Difference in str iking prices or
= Numbe r of long calls x Difference in

striking pric es - Net debit
Upside break- even _ Point s of maximum profit ff h t .k .

point - Number of naked calls + ig er s n mg pnce
These formulae can easily be verified by checking the numbers in Table 11-3.
THE.,.,DELTA
SPREAD.,.,
The third philosophy of ratio spreading is a more sophisticated approach that is often referred
to as the delta spread, because the deltas of the options are used to establish and monitor the
spread. Recall that the delta of a call option is the amount by which the option is expected to
increase in price if the underlying stock should rise by one point. Delta spreads are neutral
spreads in that one uses the deltas of the two calls to set up a position that is initially neutral.
Example: The deltas of the two calls that appeared in the previous examples were .80
and .50 for the April 40 and April 45, respectively. If one were to buy 5 of the April 40's
and simultaneously sell 8 of the April 45's, he would have a delta-neutral spread. That is,
if XYZ moved up by one point, the 5 April 40 calls would appreciate by .80 point each,
for a net gain of 4 points. Similarly, the 8 April 45 calls that he is short would each appreci-
ate by .,50for a net loss of 4 points on the short side. Thus, the spread is initially neutral-
the long side and the short side will offset each other. The idea o_fsetting up this type of
neutral spread is to be able to capture the time value preniium decay in the preponder-
ance of short calls without subjecting the spread to an inordinate amount" of rnarket risk.
The actual credit or debit of the spread is not a det ermining factor .
It is a fairly simple matter to determine the correct ratio to use in the delta spread:
Merely divide the delta of the purchased call by the delta of the written call. In the
example, this implies that the neutral ratio is .80 divided by .50, or 1.6:1. Obviously,
one cannot sell 1.6 calls, so it is common practice to express that ratio as 16:10. Thus, the
neutral spread would consist of buying 10 April 40 's and selling 16 April 45's. This is the
same as an 8:.5 ratio. Notice that this calculation does not include anything about debits
or credits involved in the spread. In this example, an 8:.5ratio would involve a small debit
of one point (.5 April 40's cnst 2.S points and 8 April 4.S's bring in 24 points). Generally ,
reasonably selecte d delta spre ads involve small debit s.
Certain selection criteria can be offered to help the spreader eliminate some of the
myriad possibilities of delta spreads on a day-to-day basis. First, one does not want the ratio
of the spread to be too large. An absolute limit, such as 4: 1, can be placed on all spread
candidates. Also, if one eliminates any options selling for less than ..SOpoint as candidates
for the short side of the spread, the higher ratios will be eliminated. Second, one does not
want the ratio to he too small. If the delta-neutral ratio is less than 1.2:1 (6:.5),the spread
should prohabl:' be rejected. Finally, if one is concerned with downside risk, he might want
to limit the total debit outlay. This might be done with a simple parameter, such as not pay-
ing a debit of more than 1 point per long option. Thus, in a spread involving 10 long calls,
the total debit must he 10 points or less. These screens are easily applied, especially with the
aicl of a c0111puteranalysis. One merely uses the deltas to determine the neutral ratio. Then,
if it is too small or too large, or if it requires the outlay of too large a debit, the spread is
rejecte d from consideration. If not, it is a pot enti al candidat e for investment.
FOLLOW-UP ACTION
Depending 011 the initial credit or debit of the spread, it may not be necessary to take any
downside defensive action at all. {{ the initial dehit teas large, the writer may roll dozen
the written calls as in a rat io wr ite.
Example: An investor has established the ratio write by buying an XYZ July 40 call and
selling two July 60 calls with the stock near 60. He might have done this because the July
-10was selling at parity. If the underlying stock declines, this spreader could roll down to
the ,5(fs and then to the 4,S's, in the same manner as he would with a ratio write. On the
utlicr liand, if tl1c SJJrcrzd1cas initially set up icitlz contiguous striking prices, the loieer
strike hci11gj11st/Jc/methe liigher strike , 110 rolli11g-don:11 action 1co11ldbe necessary.
REDUCING THE RATIO

1
Lpsiclcfoll01c-11p(lcfio11 docs not normally consist of rolling up as it does in a ratio write.
Rather, one slzo11ldusually !my sorne 111orelong calls to reduce the ratio in the spread.
fa·entuall:·· he would want to reduce the spread to 1:L or a normal bull spread. An exam-
ple may help to illustrate this concept.
Example : In the initial example, one April 40 call was bought and two April 45s were sokL
for a nd creelit of one point. Assume that the spreader is going to buy one more April 40 as
Chapter11:RatioCallSpreads · 205
a means of upside defensive action if he has to. \Vlwn and if he buys this second long call,
his total position will be a normal bull spread-long 2 April 40's and short 2 April 4,S's.
The liquidating value of this hull spread would be 10 points if XYZ were above 4.5 at April
expiration, since each of the two bull spreads would widen to its maximum potential
(5 points) with the stock above 4.5in April. The ratio spreader originally brought in a one-point
credit for the 2: 1 spread. If he were later to pay 11 points to buy the additional long April 40
call, his total outlay would have been 10 points. This would represent a break-even situation
at April expiration ifXYZ were above 45 at that time, since it was just shown that the spread
could be liquidated for 10 points in that case. So the ratio spreader could wait to take defen-
sive action until the April call was selling for 11 points. This is a dynamic type of follow-up
action, one that is dependent on the options' price, not the stock price per se.
This outlay of 11 points for the April 40 would leave a break-even situation as long
as the stock did not reverse and fall in price below 45 after the call was bought. The
spreader may decide that he would rather leave some room for upside profit rather than
merely trying to break even if the stock rallies too far. He might thus decide to buy the
additional long call at 9 or 10 points rather than waiting for it to get to 11. Of course, this
might increase the chances of a whipsaw occurring, but it would leave some room for
upside profits if the stock continues to rise.
\Nhere ratios other than 2:1 are involved initially, the same thinking can be applied.
In fact, the purchase of the additional long calls might take place in a two-step process.
Example: If the spread was initially long .5 calls and short 10 calls, the spreader would
not necessarily have to wait until the April 40's were selling at 11 and then buy all 5
needed to make the spread a normal bull spread. He might decide to buy 2 or 3 at a lower
price, thereby reducing his ratio somewhat. Then, if the stock rallied even further, he
could buy the needed long calls. By buying a few at a cheaper price, the spreader gives
himself the leeway to wait considerably longer to the upside. In essence, all 5 additional
long calls in this spread would have to be bought at an average price of 11 or lower in
order for the spread to break even. However, if the first 2 of them are bought for 8 points,
the spreader would not have to buy the remaining 3 until they were selling around 13.
Thus, he could wait longer to the upside before reducing the spread ratio to 1:1 (a hull
spread). A formula can be applied to determine the price one would have to pay for the
additional long calls, to convert the ratio spread into a bull spread. If the calls are bought,
such a bull spread would break even with the stock above the higher striking price at
expiration:
Break-even cost of Number of short calls x Difference in strikes - Total debit to date
long calls Number of naked calls
In the simple 2: 1 example, the number of short calls was 2, the difference in the
strikes was .5, the total debit was minus one (-1) (since it was actually a 1-point credit),
and the number of naked calls is 1. Thus, the break-even cost of the additional long call
is [2 x ,5 - (-1)( l)]/1 = 11. As another verification of the formula, consider the 10:.5 spread
at the same prices. The initial credit of this spread would be ,5 points, and the break-even
cost of the five additional long calls is 11 points each. Assume that the spreader bought
two additional April 40's for 8 points each (16 debit). This would make the total debit to
date of the spread equal to 11 points, and reduce the number of naked calls to 3. The
break-even cost of the remaining 3 long calls that would need to be purchased if the stock
continued to rally would he (10 x ,5 - 11)/3 = 13. This agrees with the observation made
earlier. This formula can be used before actual follow-up action is implemented. For
example, in the 1():.5spread, if the April 40's were selling for 8, the spreader might ask:
"To what would I raise the purchase price of the remaining long calls if I buy 2 April 40's
for 8 right now?" By using the formula, he could easily see that the answer would be 13.
ADJUSTING WITH THE DELTA
The theoretically oriented spreader can use the delta-neutral ratio to monitor his spreads as
well as to establish them. If the underlying stock moves up in price too far or down in price
too far, the delta-neutral ratio of the spread will change. The spreader can then readjust his
spread to a neutral status by buying some additional long calls on an upside movement by
the stock, or by selling some additional short calls on a downward movement by the stock.
Either action will serve to make the spread delta-neutral again. The public customer who is
employing the delta-neutral adjustment method of follow-up action should be careful not to
overadjust, because the commission costs would become prohibitive. A more detailed
description of the use of deltas as a means of follow-up action is contained in Chapter 28 on
mathematical applications, under the heading "Facilitation or Institutional Block Position-
ing." The general concept, however, is the same as that shown earlier for ratio writing.
Example: Early in this chapter, when selection criteria were described, a neutral ratio
was determined to be 16: 10, with XYZ at 44. Suppose, after establishing the spread, that
the common rallied to 47. One could use the current deltas to adjust. This information is
summarized in Table 11-4. The current neutral ratio is approximately 14:10. Thus, two of
the short April 4,5's could be bought closing. In practice, one usually decreases his ratio
h_\ adding to the long side. Consequently, one would buy two April 40's, decreasing his
m·erall ratio to 16: 12. which is 1.33 and is close to the actual neutral ratio of 1.38. The
position would therefore be delta-neutral once more.
An alternative way of looking at this is to use the equivalent stock position (ESP),
which. for an:· option, is the multiple of the quantity times the delta times the shares per
Chapter11:RatioCallSpreads 207
TABLE 11-4.
Original and current prices and deltas.
Original
Situation Current
Situation
XYZ common 44 47
Apr il 40 call 5 8
April 45 call 3 5
April 40 delta .80 .90
Apr il 45 delta .50 .65
Neutral ratio 16:l O (.80/.50) 14:10 (.90/.65 = 1.38)
April 40 ESP 800 long (10 x .8 x 100) 900 long (10 x .9 x 100)
Apr il 45 ESP 800 shrt (16 x .5 x 100) 1,040 shrt (16 x .65 x l 00)
Total ESP 0 (neutral) 140 shrt
option. The last three lines of Table 11-4 show the ESP for each call and for the position
as a whole. Initially, the position has an ESP ofO, indicating that it is perfectly delta-neutral.
In the current situation, however, the position is delta short 140 shares. Thus, one could
adjust the position to be delta-neutral by buying 140 shares of XYZ. If he wanted to use
the options rather than the stock, he could buy two April 45's, which would add a delta
long of 130 ESP (2 x .65 x 100), leaving the position delta short 10 shares, which is very
near neutral. As pointed out in the above paragraph, the spreader probably should buy the
call with the most intrinsic value-the April 40. Each one of these has an ESP of 90 (1 x
.9 x 100). Thus, if one were bought, the position would be delta short 50 shares; if two
were bought, the total position would be delta long 40 shares. It would be a matter of
individual preference whether the spreader wanted to be long or short the "odd lot" of 40
or 50 shares , re spectively .
The ESP method is merely a confirmation of the other method. Either one works well.
The spreader should become familiar with the ESP method because , in a position with
many different options, it reduces the exposure of the entire position to a single number.
TAKING PROFITS
In addition to defensive action, the spreader may find that he can close the spread early
to take a profit or to limit losses. If enough time has passed and the underlying stock is
close to the maximum profit point-the higher striking price-the spreader may want to
consider closing the spread and taking his profit. Similarly, if the underlying stock is
somewhere between the two strikes as expiration draws near, the writer will normally
find himself with a profit as the long call retains some intrinsic value and the short calls
208 - PartII:CallOptionStrategies
are nearl_vworthless. If at this time one feels that there is little to gain (a price decline
might wipe out the long call value), he should close the spread and take his profit.
SUMMARY
Ratio spreads can he an attractive strategy, similar in some ways to ratio writing. Both
strategies offer a large probability of making a limited profit. The ratio spread has limited
downside risk, or possibly no downside risk at all. In addition, if the long call(s) in the
spread can be bought with little or no time value premium in them, the ratio spread
becomes a superior strategy to the ratio write. One can adjust the ratio used to reflect his
opinion of the underlying stock or to make a neutral profit range if desired. The ratio
adjustment can he accomplished by using the deltas of the options. In a broad sense, this
is one of the more attractive forms of spreading, since the strategist is buying mostly
intrinsic value and is selling a relatively large amount of time value.
Combining Calendar and
Ratio Spreads
The previous chapters on spreading introduced the basic types of spreads. The simplest
forms of bull spreads, bear spreads, or calendar spreads can often be combined to produce
a position with a more attractive potential. The butterfly spread, which is a combination
of a bull spread and a bear spread, is an example of such a combination. The next three
chapters are devoted to describing other combinations of spreads, wherein the strategist
not only mixes basic strategies-bull, bear, and calendar-but uses varying expiration
dates as well. Although they may seem overly complicated at first glance, these combina-
tions are often employed by professionals in the field.
RATIO CALENDAR SPREAD
The ratio calendar spread is a combination of the techniques used in the calendar and
ratio spreads. Recall that one philosophy of the calendar spread strategy was to sell the
near-term call and buy a longer-term call, with both being out-of-the-money. This is a bull-
ish calendar spread. If the underlying stock never advances, the spreader loses the entire
amount of the relatively small debit that he paid for the spread. However, if the stock
advances after the near-term call expires worthless, large profits are possible. It was stated
that this bullish calendar spread philosophy had a small probability of attaining large prof-
its, and that the few profits could easily exceed the preponderance of small losses.
The ratio calendar spread is an attempt to raise the probabilities while allowing for
large pott>ntial profits. In the ratio calrndar spread, one sells a 1u1111/Jer
cf 11ertr-fer111rnlls
209
tchile buying fewer of the intermediate-terrn or long-term calls. Since more calls are
being sold than are being bought, naked options are involved. It is often possible to set up
a ratio calendar spread for a credit, meaning that if the underlying stock never rallies
above the strike, the strategist will still make money. However, since naked calls are
involved, the collateral requirements for participating in this strategy may be large.
Example: As in the bullish calendar spreads described in Chapter 9, the prices are:
XYZ common, 45;

XYZ April 50 call, l; and
XYZJuly 50 call, 1.50.
In the bullish calendar spread strategy, one July ,SOis bought for each April 50 sold. This
means that the spread is established for a debit of 50 cents and that the investment is $50
per spread, plus commissions. The strategist using the ratio calendar spread has essen-
tially the same philosophy as the bullish calendar spreader: The stock will remain below
50 until April expiration and may then rally. The ratio calendar spread might be set up as
follows:
Buy 1 XYZ July 50 call at l ½ 1.50 debit

Sell 2 XYZ April 50 calls at 1 each 2 credit
Net .50 credit
Although there is no cash involved in setting up the ratio spread since it is done for a
credit , there is a collateral requirement for the naked April 50 call.
If the stock remains below .SOuntil April expiration, the long call-the July 50-will
be owned free. After that, no matter what happens to the underlying stock, the spread
cannot lose money. In fact, if the underlying stock advances dramatically after near-term
expiration, large profits will accrue as the July 50 call increases in value. Of course, this
is entirely dependent on the near-term call expiring worthless. If the underlying stock
should rally above .SObefore the April calls expire, the ratio calendar spread is in danger
of losing a large amount of money because of the naked calls, and defensive action must
be taken. Follow-up actions are described later.
The collateral required for the ratio calendar spread is equal to the amount of col-
lateral required for the naked calls less the credit taken in for the spread. Since naked
calls will be marked to market as the stock moves up, it is always best to allow enough
collatPral to get to a defensive action point. In the example above, suppose that one felt
he would definitely be taking defensive action if the stock rallied to 53 before April expira-
Chapter12:Combining
Calendar
andRatioSpreads 211
tion. He should then figure his collateral requirement as if he stock were at 53, regardless
of what the collateral requirement is at the current time. This is a prudent tactic when-
ever naked options are involved, since the strategist will never be forced into an unwanted
close-out before his defensive action point is reached. The collateral required for this
example would then be as follows, assuming the call is trading at 3½:
20% of53 $1,060

Call premium + 350
Less initial credit 50
Total collateral to set aside $1,360
The strategist is not really "investing" anything in this strategy, because his requirement
is in the form of collateral, not cash. That is, his current portfolio assets need not be dis-
turbed to set up this spread, although losses would, of course, create debits in the account.
Many naked option strategies are similar in this respect, and the strategist may earn
additional money from the collateral value of his portfolio without disturbing the portfo-
lio itself. However, he should take care to operate such strategies in a conservative man-
ner, since any income earned is "free," but losses may force him to disturb his portfolio.
In light of this fact, it is always difficult to compute returns on investment in a strategy
that requires only collateral to operate. One can, of course, compute the return on the
maximum collateral required during the life of the position. The large investor participat-
ing in such a strategy should be satisfied with any sort of positive return.
Returning to the example above, the strategist would make his $50 credit, less com-
missions, if the underlying stock remained below 50 until July expiration. It is not possible
to determine the results to the upside so definitively. If the April 50 calls expire worthless
and then the stock rallies, the potential profits are limited only by time. The case in which
the stock rallies before April expiration is of the most concern. If the stock rallies imme-
diately, the spread will undoubtedly show a loss. If the stock rallies to ,50 more slowly, but
still before April expiration, it is possible that the spread will not have changed much.
Using the same example, suppose that XYZ rallies to ,50 with only a few weeks of life
remaining in the April 50 calls. Then the April 50 calls might be selling at 1..50while the
July 50 call might be selling at 3. The ratio spread could be closed for even money at that
point; the cost of buying back the 2 April 50's would equal the credit received from selling
the one July 50. He would thus make .50, less commissions, on the entire spread transac-
tion. Finally, at the expiration date of the April ,50 calls, one can estimate where he would
break even. Suppose one estimated that the July 50 call would be selling for 5.50 points
if XYZ were at ,53 at April expiration. Since the April ,50 calls would be selling for 3 at that
time (they would be at parity), there would be a debit of 50 cents to close the ratio spread.
The two April .50 calls would be bought for 6 points and the July ,50 call sold for 5.50-a
..50 debit. The entire spread transaction would thus have broken even, less commissions,
at .5:1at April expiration, since the spread was put on for a .50 credit and was taken off for
a ..50 debit. The risk to the upside depends clearly, then, on how quickly the stock rallies
above 50 before April expiration.
CHOOSING THE SPREAD
Some of the same criteria used in setting up a bullish calendar spread apply here as well.
Select a stock that is volatile enough to move above the striking price in the allotted
time-after the near-term expires, but before the long call expires. Do not use calls that
are so far out-of-the-money that it would be virtually impossible for the stock to reach the
striking price. Always set up the spread for a credit, commissions included. This will
assure that a profit will be made even if the stock goes nowhere. However, if the credit
has to be generated by using an extremely large ratio-greater than 3 short calls to every
long one-one should probably reject that choice, since the potential losses in an imme-
diate rally would be large.
Tht> upside break-ecen J)()int prior to April expiration should be determined using a
pricing model. Such a model, or the output from one, can generally be obtained from a data
sen·ice or from some brokerage firms. It is useful to the strategist to know exactly how
much room he has to the upside if the stock begins to rally. This will allow him to take
clefensi\·e action in the form of closing out the spread before his break-even point is reached.
Since a pricing model can estimate a call price for any length of time, the strategist can
compute his break-even points at April expiration, l month before April expiration, 6 weeks
before, and so on. \Vhen the long option in a spread expires at a different time from the
short option, the break-e\·en point is dynamic. That is, it changes with time. Table 12-1
shows how this information might be accumulated for the example spread used above.
Since this example spread was established for a ..SO-point credit with the stock at 45, the
hreak-e\·en points would be at stock prices where the spread could be removed for a .50-
point debit. Suppose the spread was initiated with 9.5 days remaining until April expiration.
In each line of the table, the cost for buying 2 April .50's is .50 more than the price of the
July .50. That is, there would he a .,SO-point debit involved in closing the spread at those
prices. Notice that the /Jreak-eccn price increases as time passes. Initially, the spread would
shm,· a loss if thl' stock moved up at all. This is to be expected, since an immediate move
would not allow for any erosion in the time value premium of the near-term calls. As more
and more time passes, time weighs more heavil:v on the near-term April calls than on the
longer-krill July call. Once the strategist has this information, he might then look at a chart
Chapter12:Combining
Calendar
andRatioSpreads 213
of the underlying stock. If there is resistance for XYZ below .S:3,his eventual break-even
point at April expiration, he could then feel more confident about this spread.
FOLLOW-UP ACTION
The main purpose of defensiYe action in this strategy is to limit losses if the stock should
rally before April expiration. The strategist should be quick to close out the spread before
any serious losses accrue. The long call quite adequately compensates for the losses on the
short calls up to a certain point, a fact demonstrated in Table 12-1. However, the stock
cannot be allowed to run. A rule of thumb that is often useful is to close the spread if the
stock breaks out above technical resistance or if it breaks above the eventual break-even
point at expiration. In the example above , the strategist would close the spread if, at any
time , XYZ rose above 53 (before April expiration, of course).
If a significant amount of time has passed, the strategist might act even more quickly
in closing the spread. As was shown earlier, if the stock rallies to 50 with only a few weeks
of time remaining, the spread may actually be at a slight profit at that time. It is often the
best course of action to take the small profit, if the stock rises above the striking price.
TABLE 12-1.
Break-even points changing over time.
Estimated Estimated
Days
Remaining
until Break-Even
Point April
50 July50
April
Expiration (Stock
Price) Price Price
90 45 1.50
60 48 1.50 2.50
30 51 2.50 4.50
0 53 3 5.50
THE PROBABILITIES ARE GOOD
This is a strategy with a rather large probability of profit, provided that the defensive
action described above is adhered to. The spread will make money if the stock never ral-
lies above the striking price, since the spread is established for a credit. This in itself is a
rather high-probability event, because the stock is initially below the striking price. In
addition, the spread can make large potential profits if the stock rallies after the near-tt>rrn
calls expire. Although this is a much less probable event, the profits that can accrue add
to the expected return of the spread. The only time the spread loses is when the stock
rallies quickly, and the strategist should close out the spread in that case to limit losses.
Although Table 12-2 is not mathematically definitive, it can be seen that this strategy
has a positive expected return. Small profits occur more frequently than small losses do, and
sometimes large profits can occur. These expected outcomes, when coupled with the fact
that the strategist may utilize collateral such as stocks, bonds, or government securities to
set up these spreads, demonstrate that this is a viable strategy for the advanced investor.
TABLE 12-2.
Profitability of ratio calendar spreading.
Event Outcome Probability
Stock never rallies above Small profit Large probability
strike
Stock rallies above strike in a Small loss if defensive Small probability
short time action employed
Stock rallies above strike after Large potential profit Small probability
near-term call expires
DELTA-NEUTRAL CALENDAR SPREADS
The preceding discussion dealt with a specific kind of ratio calendar spread, the
out-of-the-money call spread. A more accurate ratio can be constructed using the deltas
of the calls involved, similar to the ratio spreads in Chapter 11. The spread can be created
with either out-of-the-money calls or in-the-money calls. The former has naked calls,
while the latter has extra long calls. Both types of ratio calendars are described.
In either case, the number of calls to sell for each one purchased is determined by
cli\·iding the delta of the long call by the delta of the short call. This is the same for any
ratio spread , not just calendars .
Example: Suppose XYZ is trading at 4.5 and one is considering using the July .SOcall and
the April .SOcall to establish a ratio calendar spread. This is the same situation that was
described earlier in this chapter. Furthermore, assume that the deltas of the calls in ques-
tion are .2.5 for the July and .LS for the April. Given that information, one can compute
the neutral ratio to be 1.667 to 1 (.2.5/.l.S).That is, one would sell 1.667 calls for each one
he bou ght ; restated, he would sell 5 for each 3 bought.
This out-of-the-money neutral calendar is typical. One normally sells more calls than
he hu:·s to establish a neutral calendar when the calls are out-of-the-money. The ramifications
Chapter12:Combining
Calendarand
RatioSpreads 215
of this strategy have already been described in this chapter. Follow-up strategy is slightly
different, thou gh , and is descri bed later.
THE IN-THE-MONEY CALENDAR SPREAD
VVhen the calls are in-the-money , the neutral spread has a distinctly different look. An
example will help in describin g th e situation .
Example: XYZ is trading at 49, and one wants to establish a neutral calendar spread
using the July 45 and April 45 calls. The deltas of these in-the-money calls are .8 for the
April and .7 for the July. Note that for in-the-money calls, a shorter-term call has a higher
delta th an a longer-term call.
The neutral ratio for this in-the-money spread would be .875 to 1 (.7/.8).This means
that .875 calls would be sold for each one bought; restated, 7 calls would be sold and 8
bought. Thus, the spreader is buying more calls than he is selling when establishing an
in-the-money neutral calendar. In some sense, one is establishing some "regular" calendar
spreads (seven of them, in this example) and simultaneously buying a few extra long calls
to go along with th em (one extra long call, in thi s example).
This type of position can be quite attractive. First of all, there is no risk to the upside
as there is with the out-of-the-money calendar; the in-the-money calendar would make
money, because there are extra long calls in the position. Thus, if there were to be a large
gap to the upside in XYZ-perhaps caused by a takeover attempt-the in-the-money
calendar would make money. If, on the other hand, XYZ stays in the same area, then the
regular calendar spread portion of the strategy will make money. Even though the extra
call would probably lose some time value premium in that event, the other seven spreads
would make a large enough profit to easily compensate for the loss on the one long call.
The least desirable result would be for XYZ to drop precipitously. However, in that case ,
the loss is limited to the amount of the initial debit of the spread. Even in the case of XYZ
dropping, though, follow-up action can be taken. There are no naked calls to margin with
this strategy , making it attractive to many smaller investors. In the above example, one
would need to pay for the entire debit of the position, but there would be no further
requirement s.
FOLLOW-UP ACTION
If one decides to preserve a neutral strategy with follow-up action in either type of ratio
call calendar , he would merely need to look at the deltas of the calls and keep the ratio
neutral. Doing so might mean that one would switch from one type of calendar spread to
the other, from the out-of-the-money with naked calls to the in-the-money with extra
long calls, or vice versa. For example, if XYZ started at 45, as in the first example, one
would have sold more calls than he bought. If XYZ then rallied above 50, he would have
to move his position into the in-the-money ratio and get long more calls than he is short.
While such follow-up action is strategically correct-maintaining the neutral ratio-
it might not make sense practically, especially if the size of the original spread were small.
If one had originally sold 5 and bought 3, he would be better to adhere to the follow-up
strategy outlined earlier in this chapter. The spread is not large enough to dictate adjust-
ing via the delta-neutral ratios. If, however, a large trader had originally sold 500 calls and
bought :300, then he has enough profitability in the spread to make several adjustments
along the way.
In a similar manner, the spreader who had established a small in-the-money calendar
might decide not to bother ratioing the spread if the stock dropped below the strike. He
knows his risk is limited to his initial debit, and that would be small for a small spread. He
might not want to introduce naked options into the position if XYZ declines. However, if
the same sprea<l were established by a large trader, it should be adjusted because of the
greater tolerance of the spread to being adjusted, merely because of its size.
Reverse Spreads
In general, when a strategy has the term "reverse" in its name, the strategy is the opposite
of a more commonly used strategy. The reader should be familiar with this nomenclature
from the earlier discussions comparing ratio writing (buying stock and selling calls) with
reverse hedging (shorting stock and buying calls). If the reverse strategy is sufficiently
well-known, it usually acquires a name of its own. For example, the bear spread is really
the reverse of the bull spread, but the bear spread is a popular enough strategy in its own
right to have acquired a shorter, unique name.
REVERSECALENDAR SPREAD
The reverse calendar spread is an infrequently used strategy, at least for public customers
trading stock or index options, because of the margin requirements. However, even then,
it does have a place in the arsenal of the option strategist. Meanwhile, professionals and
futures option traders use the strategy with more frequency because the margin treat-
ment is more favorable for them .
As its name implies, the reverse calendar spread is a position that is just the opposite
of a "normal" calendar spread. In the recerse calendar spread, one sells a long-term call
option and simultaneously buys a shorter-term call option. The spread can be constructed
with puts as well, as will be shown in a later chapter. Both calls have the same striking price.
This strategy will make money if one of two things happens: Either (1) the stock
price moves away from the striking price by a great deal, or (2) the implied volatility of
the options involved in the spread shrinks. For readers familiar with the ''normal" calen-
dar spread strategy, the first way to profit should be obvious, because a "normal,, calendar
spread makes the most money if the stock is right at the strike price at expiration, and it
loses money if the stock rises or falls too far.
217
2 18 PartII: CallOptionStrategies
As with any spread involving options expiring in differing months, it is common

practice to look at the profitability of the position at or before the near-term expiration.
An example will show how this strateg y can profit.
Example: Suppose the current month is April and that XYZ is trading at 80. Fur ther-
more, suppose that XYZ's options are quite expensive, and one believes the underlying
stock will be volatile. A reverse calendar spread would be a way to profit from these
assumption s. The following prices exist:
XYZ December 80 call: 12

XYZ July 80 call: 7
A reverse calendar spread is established by selling the December 80 call for 12

points, and buying the July 80 call for 7, a net credit of 5 points for the spread.
If, later, XYZ falls dramatically, both call options will be nearly worth less and the
spread could be bought back for a price well below ,5. For example, if XYZ were to fall to
50 in a month or so, the July 80 call would be nearly worthless and the December 80 call
could be bought back for about a point. Thus, the spread would have shrunk from its
initial price of 5 to a price of about 1, a profit of 4 points.
The other way to make money would be for implied volatility to decrease. Suppose
implied volatility dropped after a month had passed. Then the spread might be worth
something like 4 points-an unrealized profit of about 1 point, since it was sold for a price
of 5 initi ally.
Tlie profit graph in Figure 13-1 shows the profitability of the reverse calendar. There
are two lines on the graph, both of which depict the results at the expiration of the
near-term option (the July 80 call in the above example). The lower line shows where
profits and losses would occur if implied volatility remained unchanged. You can see that
the position could profit if XYZ were to rise above 98 or fall below 70. In addition, the
higher curve on the graph shows where profits would lie if implied volatility fell pr ior to
expiration of the near-term options. In that case, additional profits would accrue, as
depicted on th e graph .
So there are two ways to make money with this strategy, and it is therefore best to
establish it when implied volatility is high and the underlying has a tendency to be volatile.
The problem with this spread, for stock and index option traders, is that the call that
is sold is considered to be naked. This is preposterous, of course, since the short-term call
is a perfectly valid hedge until it expires. Yet the margin requirements remain onerous.
When they were overhauled recently , this glaring inefficiency was allowed to stand
because none of the member firms cared about changing it. Still, if one has excess col-
lateral-perhaps from a large stock portfolio-and is interested in generating excess
Chapter
13:ReverseSpreads 219
FIGURE 13-1.
Calendar spread sale at near-term expiration.
$400
Implied Volatility
$300 Lower
$200 \
<I)
<I) $100
0
....J
~ $0
:,=
e 50 60 110 120
a.. -$100
-$200
-$300
Implied Volatility
-$400 Remains High
-$500
Underlying Price
income in a hedged manner, then the strategy might be applicable for him as well. Futures
option traders receive more favorable margin requirements, and it thus might be a more
economical strategy for them.
REVERSE RATIO SPREAD (BACKSPREAD)
A more popular reverse strategy is the reverse ratio call spread, which is commonly
known as a backspread. In this type of spread, one would sell a call at one striking price
and then would buy several calls at a higher striking price. This is exactly the opposite of
the ratio spread described in Chapter 11. Some traders refer to any spread with unlimited
profit potential on at least one side as a backspread. Thus, in most backspreading strate-
gies, the spreader wants the stock to move dramatically. He does not generally care
whether it moves up or down. Recall that in the reverse hedge strategy (similar to a
straddle buy) described in Chapter 4, the strategist had the potential for large profits if
the stock moved either up or down by a great deal. In the backspread strategy discussed
here, large potential profits exist if the stock moves up dramatically, but there is limited
profit potential to the downside.
Example: XYZ is selling for 43 and the July 40 call is at 4, with the July 4.S call at 1. A
reverse ratio spread would be established as follows:
Buy 2 July 45 calls at 1 each 2 debit

Sell 1 July 40 call at 4 4 credit
Net 2 credit
Thest->spreads are gpnerally established for credits . In fact , if the spread cannot be
initiated at a credit , it 11otattracti,:;e. If the underlying
is 11s11ally stock drops in price and
is bt'iow 40 at Jul>' expiration , all the calls will expire worthless and the strategist will
mak e a profit equal to his initial credit . The maximum do11.. :11sidepotential of the reverse
ratio spread is equal to the initial credit received. On the other band, if the stock rallies
substantial!>, tht' pot e ntial upside profits ctre unlimitecL since the spreader owns more
estor is bullish and is buying out-of-the-nwney
thr i11,:;
calls than lw is short. Si111plistic:a!ly,
mils !mt is sim11ltm1co11 .s1y hedging himself hy selling another call. He can profit if the
stock rises in price , as he thought it wo11lcl, but he also profits if th e stock collapses and all
th e call s expir e wor thl ess.
This strategy · has limited risk. \Villi most spreads , the rna:rimum loss is attained at
expiration at the striking price of the purchased call. This is a true statement for
back spr ead s.
Example: If XYZ is at Pxactly 4.5 at July expiration , the July 4.5 calls will expire worthless
for a loss of $200 a11d the July 40 call will have to be bought back for .5 points, a $100 loss
on that call. ThP total loss would thus he $:300, and this is the most that can be lost in this
example. If the u11clerl> 1ing stock should rally dramatically , this strategy has unlimited
profit pot e 11tial, si11ce thne arp two long calls for each short one . In fact , one can always
compute the upside break-ev e n point at expiration. That break-ev e n point happens to be
48 in this t>xample. At 48 at July expiration , each July 4.5 call would be worth :3points, for
a nPt gain of $400 on the two of them. The July 40 call would he worth 8 with the stock
at 48 at expiration , representing a $400 loss 011 that call. Thus , the gain and the loss are
offsetti11g and thP sprt>ad breaks eve11, except for commissions, at 48 at expiration. If the
stock is hi gher th an 48 at July expiration , profits will result.
Table' 1:3-1and Figure 1:3-2depict the potential profits and losses from this example
of a rev erse' ratio spread. Note that the profit graph is exactly like the profit graph of a ratio
spn"'ad that has he e 11rotated around the stock price axis. Refer to Figure 11-1 for a graph
of the ratio spread. Th ert' is actually a rang e outside of which profits can be macle-helow
-t2 or ahm ·p 48 in this exa1npl P. The maximm11 loss occurs at the striking price of the
purcha se d ca lls , or 4.5, at expi ra tion .
Th ere are no n ake d call s in this strateg y, so the investment is relati vely small .
Tlw stra tt'~ >· is actual!> · a lorn!; call added to a bt'ar spread. In this pxample , the hear
Chapter13:ReverseSpreads 221
TABLE 13-1.
Profits and losses for reverse ratio spread.
XYZ at
Price Profit
on Profit
on Total
JulyExpiration 1July40 2 July45's Profit
35 +$ 400 -$ 200 +$ 200
40 + 400 200 + 200
42 + 200 200 0
45 100 200 300
48 400 + 400 0
55 - 1,100 + 1,800 + 700
70 - 2,600 + 4,800 + 2,200
spread portion is long the July 45 and short the July 40. This requires a $500 collateral
requirement, because there are 5 points difference in the striking prices. The credit of
$200 received for the entire spread can be applied against the initial requirement, so that
the total requirement would be $300 plus commissions. There is no increase or decrease
in this requirement , since there are no nak ed calls.
Notice that the concept of a delta-11eutral spread can be utilized in this strategy, in
much the same way that it was used for the ratio call spread. The number of calls to buy
and sell can be computed mathematically by using the deltas of the options involved.
Example: The neutral ratio is determined by dividing the delta of the July 45 into the
delta of the July 40.
Prices Delta
XYZ common: =43
XYZ July 40 call: 4 .80
XYZJuly 45 call: .35
In this case, that would be a ratio of 2.29: 1 (.80/.35). That is, if one sold 5 July 40's, he
would buy 11 July 45's (or if he sold 10, he would then buy 2:3). By beginning with a neu-
tral ratio, the spreader should be able to make money on a quick move by the stock in
either direction.
The neutral ratio can also help the spreader to avoid being too bearish or too bullish
to begin with. For example, a spreader would not be bullish enough if he merely used a
2: 1 ratio for convenience, instead of using the 2.:1:1 ratio. If anything, one might normally
FIGURE 13-2.
Reverse ratio spread (backspread).
C
0
~ +$200
·a.
X
UJ
1ii $0
(/)
(/)
0
....J
e-
0
a..
-$300
establish the spread with an extra bullish emphasis, since the largest profits are to the
upside. There is little reason for the spreader to have too little bullishness in this strategy.
Thus, if the deltas are correct, the neutral ratio can aid the spreader in the determination
of a more accurate initial ratio.
The strategist must be alert to the possibility of early exercise in this type of spread,
since he has sold a call that is in-the-money. Aside from watching for this possibility, there
is little in the way of defensive follow-up action that needs to be implemented, since the
risk is limited by the nature of the position. He might take profits by closing the spread if
the stock rallies before expiration.
This strategy presents a reasonable method of attempting to capitalize on a large
stock movement with little tie-up of collateral. Generally, the strategist would seek out
wlatile stocks for implementation of this strategy, because he would want as much poten-
tial movement as possible by the time the calls expire. In Chapter 14, it will be shown that
this strategy can become more attractive hy buying calls with a longer maturity than the
calls sold.
Diagonalizing a Spread
When one uses both different striking prices and d~fferent expiration dates in a spread,
it is a diagonal spread. Generally, the long side of the spread would expire later than the
short side of the spread. Note that this is within the definition of a spread for margin
purposes: The long side must have a maturity equal to or longer than the maturity of the
short side. With the exception of calendar spreads, all the previous chapters on spreads
have described ones in which the expiration dates of the short call and the long call were
the same. However, any of these spreads can be diagonalized; one can replace the long
call in any spread with one expiring at a later date .
In general, diagonalizing a spread in this manner makes it slightly more bearish at
near-term expiration. This can be seen by observing what would happen if the stock fell
or rose substantially. If the stock falls, the long side of the spread will retain some value
because of its longer maturity. Thus, a diagonal spread will generally do better to the
downside than will a regular spread. If the stock rises substantially, all calls will come to
parity. Thus, there is no advantage in the long-term call; it will be selling for approximately
the same price as the purchased call in a normal spread. However, since the strategist had
to pay more originally for the longer-term call, his upside profits wou ld not be as great.
A diagonalized position has an advantage in that one can reestablish the position if
the written calls expire worthless in the spread. Thus, the increased cost of buying a
longer-term call initially may prove to be a savings if one can write against it twice. These
tactics are described for various spread strategies .
THE DIAGONAL BULL SPREAD
A vertical call bull spread consists of buying a call at a lower striking price and selling a
call at a higher striking price, both with the same expiration date. The diagonal bull
223
spread 1..couldbe similar except that one u;ould buy a lon ger-t erm call at the lower strike
and 1co11ldsell a near-term call at the higher strike. The number of calls long and short
would still be the same. By diagonalizing the spread, the position is hedged somewhat on
th e downside in case the stock does not advance by near-term expiration. Moreover, once
the near-term option expires, the spread can often be reestablished by selling the call
with the next maturity.
Strike April July October Price

Stock
XYZ 30 3 4 5 32
XYZ 35 1.50 2 32
A vertical hull spread could be established in any of the expiration series by buying the
call with 30 strike and selling the call with 35 strike. A diagonal bull spread ,voulcl consist
of buying the July 30 or October 30 and selling the April 3,5. To compare a vertical bull
spread with a diagonal spread, the following two spreads will be used:
Vertical bull spread: buy the April 30 call, sell the April 35-2 debit
Diagonal bull spread: buy the July 30 call, sell the April 35-3 debit
The ,·ertical hull spread has a .3-point potential profit if XYZ is above :3.5at April expira-
tion. The maximum risk in the normal bull spread is 2 points (the original debit) if XYZ
is ;_lJ1:1where below 30 at April expiration. By diagonalizing the spread, the strategist low-
ers his potential profit slight I:' at April expiration, but also lowers the probability of losing
2 points in the position. Table 14-1 compares the two types of spreads at April expiration.
The price of the July :30 call is estimated in order to derive the estimated profits or losses
frorn the diagonal bull spread at that time. If the underlying stock drops too far-to 20,
for ernmple-both spreads will experience nearly a total loss at April expiration. How-
e,·er. the diagonal spread will not lose its entire value if XYZ is much above 24 at expira-
tion. according to Table 14-1. The diagonal spread actually has a smaller dollar loss than
the normal spread between 27 and 32 at expiration, despite the fact that the diagonal
spread was more expensive to establish. On a percentage basis, the diagonal spread has
an ewn larger advantage in this range. If the stock rallies ahove 3.5 hy expiration, the
nornial .:;pread will pro,·icle a larger profit. There is an interesting characteristic of the
diagonal spread that is shown in Table 14-1. If the stock aclrn11cessubstantially and all
the calls come to parity , the profit on the diagonal spread is li1uited to 2 points. However,
if tht' stock is near :1,5at April expiration, the long call will have some time premium in it
Chapter14:Diagonalizing
a Spread 225
TABLE 14-1.
Comparison of spreads at expiration.
Vertical
Bull
XYZPrice
at April
30 April
35 July30 Spread Diagonal
April
Expiration Price Price Price Profit Spread
Prof
it
20 0 0 0 -$200 -$300
24 0 0 .50 -200 -250
27 0 0 -200 -200
30 0 0 2 -200 -100
32 2 0 3 0 0
35 5 0 5.50 + 300 + 250
40 10 5 10 + 300 + 200
45 15 10 15 + 300 + 200
and the spread will actually widc>nto more than 5 points. Thus, the maximum area of
profit at April expiration for the diagonal spr<:>ad is to hai;e the stock near the striking
price of the 1critten call. The figures demonstrate that the diagonal spread gives up a
small portion of potential upside profits to provide a hedge to the downside.
Once the April :3.5call expires, the diagonal spread can be closed. However, if the
stock is belmv :3.5at that time, it may be more prudent to then sell the July :35 call against
the July :30 call that is held long. This would establish a normal bull spread for the
:3 months remaining until July expiration. Note that if XYZ were still at :32at April expira-
tion, the July :3.5call might be sold for l point if the stock's volatility was about the same.
This should be true, since the April :3.5call was worth 1 point with the stock at :32 three
months before expiration. Consequently, the strategist who had pursued this course of
action would encl up with a normal July bull spread for a net debit of 2 points: He origi-
nally paid 4 for the July .30 call, but then sold the April :3,5for 1 point and subsequently
sold the July :35 for 1 point. By looking at the table of prices for the first example in this
chapter, the reader can see that it would have cost 2.,50 points to set up the normal July
bull spread originally. Thus, by diagonalizing and having the near-term call expire worth-
less, the strategist is able to acquire the normal July bull spread at a cheaper cost than he
could have originally. This is a specific example of how the diagonali:::.ingeffect can prove
beneficial if the writer is able to write against the same long call flco timf's, or three times
if he originally purchased the longest-term call. In this example, if XYZ were anywhere
b etween .'30and .1.5at April expiration, the sprc>adwould he>converted to a normal July
bull spread. If the stock were above :15, the spread should be closed to take the profit.
Below :10,the July :30call would probably be closed or left outright long.
226 . PartII:CallOptionStrategies
In summary, the diag(mal bull spread may often be an improvement over the normal
bull spread. The diagonal spread is an improvement when the stock remains relatively
unchanged or falls, up until the near-term written call expires. At that time, the spread
can be converted to a normal bull spread if the stock is at a favorable price. Of course, if
at any time the underlying stock rises above the higher striking price at an expiration date,
the diagonal spr ead will be profitable .
OWNING A CALL FOR "FREE"
Diagonalization can be used in other spread strategies to accomplish much the same
purposes already described; but in addition, it may also be possible for the spreader to
wind up owning a long call at a substantially reduced cost, possibly even for free.
The easiest way to see thi s would be to consider a diagonal bear spr ead .
Example: XYZ is at 32 and the near-term April 30 call is selling for 3 points while the
longt-r-term July 35 call is selling for 1..50points. A diagonal bear spread could be estab-
lished by selling the April 30 and buying the July 35. This is still a bear spread, because
a call with a lower striking price is being sold while a call at a higher strike is being pur-
chased. Howe\·er, since the purchased call has a longer maturity date than the written
call, th e spread is diagonalized.
This diagonal bear spread will make money ifXYZ falls in price before the near-term
April call expires. For example, if XYZ is at 29 at expiration, the written call will expire
worthless and the July 3.5 will still have some value, perhaps .50. Thus, the profit would
be 3 points on the April 30, less a 1-point loss on the July 3.5, for an overall profit of
2 points. The risk in the position lies to the upside, just as in a regular bear spread. If XYZ
should ad\·ance by a great deal, both options would be at parity and the spread would have
widened to 5 points. Since the initial credit was 1..50 points, the loss would be 5 minus
1..50,or 3..50 points in that case. As in all diagonal spreads, the spread will do slightly bet-
ter to the downside because the long call will hold some value, but it will do slightly worse
to the up side if th e underlying stock advances substantially .
The reason that a strategist might attempt a diagonal bear spread would not be
for the slight downside advantage that the diagonalizing effect produces. Rather it would
bt' because he has a chance of oirning the July 35 call-the longer-term call-for a sub-
stantially reduced cost. In the example, the cost of the July 35 call was 1..50 points and
tlw premium received fro111the sale of the April 30 call was 3 points. If the spreader can
rnake LSO points from the sale of the April 30 call, he will have completely covered the
cost of his July option. He can then sit back and hope for a rally by the underlying stock.
Chapt
er 14: Diago
nalizinga Spread 227
If such a rally occurred, he could make unlimited profits on the long side. If it did not, he
loses nothing.
Example: Assume that the same spread was established as in the last example. Then, if
XYZ is at or below 31..50 at April expiration, the April 30 call can be purchased for LS0
points or less. Since the call was originally sold for 3, this would represent a profit of at
least 1.50 points on the April 30 call. This profit on the near-term option covers the entire
cost of the July 35. Consequently, the strategist owns the July 35 for free. If XYZ never
rallies above 35, he would make nothing from the overall trade. However, if XYZ were to
rally above 3.Safter April expiration (but before July expiration, of course), he could make
potentially large profits. Thus, ichen one establishes a diagonal spread for a credit, there
is alt.cays the potential that he could own a call for free. That is, the profits from the sale
of the near-term call cou ld equal or exceed the original cost of the long call. This is, of
course, a desirable position to be in, for if the underlying stock should rally substantially
after profits are realized on the short side, large profits could accrue .
DIAGONAL BACKSPREADS
In an analogous strategy, one might buy more than one longer-term cal1 against the
short -term call that is sold. Using the foregoing prices, one might sell the April 30 for
3 points and buy 2 July 35's at 1.50 points each. This would be an even rnoney spread. The
credits equal the debits when the position is established. If the April 30 call expires worth-
less, which would happen if the stock was below 30 in April, the spreader would own 2 July
35 calls for free. Even if the April 30 does not expire totally worthless, but if some profit
can be made on the sale of it, the July 35's will be owned at a reduced cost. In Chapter 13,
when reverse spreads were discussed, the strategy in which one sells a call with a lower
strike and then buys more calls at a higher strike was termed a reverse ratio spread, or
backspread. The strategy just described is merely the diagonalizing of a backspread. This
is a strategy that is favored by some professionals, because the short call reduces the risk
of owning the longer-term calls if the underlying stock declines. Moreover, if the underly-
ing stock advances, the pre-ponderance of long calls with a longer maturity will certainly
outdistance the losses on the written call. The worst situation that could result would be
for the underlying stock to rise very slightly by near-term expiration. If this happened, it
might be possible to lose money on both sides of the spread. This would have to be consid-
ered a rather low-probability event, though, and would still represent a limited loss, so it
does not substantially offset the positive aspects of the strategy.
Any type of spread may be diagonalized. There are some who prefer to diagonalize
even butterfly spreads, figuring that the extra time to maturity in the purchased calls will
be of benefit. OvernlL the benefits of diagonalizing can be generalized by recalling the

way in which the decay of the time value premium of a call takes place. Recall that it was
determined that a call loses most of its time value premium in the last stages of its life.
\\'hen it is a \·er:· long-term option, the rate of decay is slllall. Knowing this fact, it makes
sense that one would want to sell options with a short life remaining, so that the maximum
benefit of the decay could he obtained. Correspondingly, the purchase of a longer-term
call would mean that the bu:·er is not subjecting himself to a substantial loss in time value
premium, at least over the first three months of ownership. A diagonal spread encom-
passes both of these features-selling a short-term call to try to obtain the maximum rate
of time <leca:··while buying a longer-term call to try to lessen the effect of time decay on
the long side.
CALL OPTION SUMMARY
This concludes the description of strategies that utilize only call options. The call option
has been seen to he a vehicle that the astute strategist can use to set up a wide variety of
positions. He can he bullish or bearish. aggressive or conservative. In addition, he can
attempt to be neutral, trying to capitalize on the probability that a stock will not move
very far in a short time period.
The im·estor who is not familiar with options should generally begin with a simple
strateg:·, such as cm·ered call writing or outright call purchases. The simplest types of
spreads are the bull spread, the bear spread, and the calendar spread. The more sophis-
ticated im·estor might consider using ratios in his call strategies-ratio writing against
stock or ratio spreading using only calls.
Once the strategist feels that he understands the risk and reward relationships
between longer-term and short-term calls, between in-the-money and out-of-the-money
calls. and betweeu long calls and short calls. he could then consider utilizing the most
advanced types of strategies. This might include reverse ratio spreads, diagonal spreads,
and more advanced types of ratios, such as the ratio calendar spread.
A great deal of information, some of it rather technical in detaiL has been presented
in preceding chapters. The best pattern for an investor to follow would be to attempt only
strategies that he fully comprehends. This does not lllean that he merely understands the
profitability aspects (especiall:· the risk) of the strategy. One must also be able to readily
llnclerstancl the potential efft>cts of early assignments, large dividend payments, striking
price adjustments. and the like, if he is going to operate advanced strategies. Without a
f11llunderstanding of liow these things might affc.,ctone's position, one cannot operate an
advanced strategy correctly .
Put Option
Strategies
INTRODUCTION
A put option gives the holder the right to sell the underlying sec urity at the striking price
at any time until the expiration date of the option. Listed put options are slightly newer
than listed call options, having been introduced on June 3, 1977. The introduction of
listed puts has provided a much wider range of strategies for both conservative and
aggressive investors. The call option is least effective in strategies in which downward
price movement by the underlying stock is concerned. The put option is a useful tool in
that case.
All stocks with listed call options have listed put options as well. The use of puts or
the combination of puts and calls can provide more versatility to the strategist.
When listed put options exist, it is no longer necessary to implement strategies
involving long calls and short stock. Listed put options can be used more efficiently in
such situations. There are many similarities between call strategies and put strategies. For
example, put spread strategies and call spread strategies employ similar tactics, although
there are technical differences, of course. In certain strategies, the tactics for puts may
appear largely to be a repetition of those used for calls, but they are nevertheless spelled
out in detail here. The strategies that involve the use of both puts and calls together-
straddles and combinations-have techniques of their own, but even in these cases the
reader will recognize certain similarities to strategies previously discussed. Thus, the
introduction of put options not only widens the realm of potential strategies, but also
makes more efficient some of the strategies previously described.
Put Option Basics
Much of the same terminology that is applied to call options also pertains to put options.
Underlying security, striking price, and expiration date are all terms tha t have the same
meaning for puts as they do for calls. The expiration dates oflisted put options agree with the
expiration dates of the calls on the same underlying stock. In addition, puts and calls have the
same striking prices. This means that if there are options at a certa in strike, say on a particu-
lar underlying stock that has both listed puts and calls, both calls at 50 and puts at 50 will be
trading, regardless of the price of the underlying stock. Note that it is no longer sufficient to
describe an option as an "XYZ July ,50."It must also be stated whether the option is a put or
a call, for an XYZ July 50 call and an XYZ July ,50 put are two different securities.
In many respects, the put option and its associated strategies will be very nearly the
opposite of corresponding call-oriented strategies. However, it is not correct to say that
the put is exactly the opposite of a call. In this introductory section on puts, the charac-
teristics of puts are described in an attempt to show how they are similar to calls and how
they are not.
PUT STRATEGIES
In the simplest terms, the outright buyer of a put is hoping for a stock price decline in
order for his put to become more valuable. If the stock were to decline well below the
striking price of the put option, the put holder could make a profit. The holder of the put
could buy stock in the open market and then exercise his put to sell that stock for a profit
at the striking price , which is higher .
Example: If XYZ stock is at 40, an XYZ July 50 put would be worth at least 10 points, for
the put grants the holder the right to sell XYZ at ,50-10 points above its current price.
231
232 PartIll:PutOptionStrategies
On the other hand, if the stock price were aboue the striking price of the put option at
expiration, the put would be worthless. No one would logically want to exercise a put
option to sell stock at the striking price when he could merely go to the open market and
sell the stock for a higher price. Thus, as the price of the underlying stock declines, the
put becollles more ut!uable. This is, of course, the opposite of a call option's price action.
The meaning of in-the-money and out-of-the-money are altered when one is speak-
ing of put options. A put is considered to be in-the-money when the underlying stock is
/Jclmc the striking price of the put option; it is out-ofthe-11w11ey ichen the stock is aboue
the striking price. This, again, is the opposite of the call option. If XYZ is at 4.5, the XYZ
July .50 put is in-the-money and the XYZ July .50 call is out-of-the-money. However, ifXYZ
were at .5.5,the July .50 put would be out-of-the-money while the July ,50 call would be
in-the-money. The broad definition of an in-the-money option as "an option that has
intrinsic value" would cover the situation for both puts and calls. Note that a put option
has intrinsic value when the underlying stock is below the striking price of the put. That
is, the put has some "real" value when the stock is below the striking price.
The intrinsic value of an in-the-money put is merely the difference between the
striking price and the stock price. Since the put is an option (to sell), it will generally sell
for more than its intrinsic value when there is time remaining until the expiration date.
This excess value over its intrinsic value is referred to as the time ualue premium, just as
is the case with calls.
Example: XYZ is at 47 and the XYZ July .50 put is selling for .5, the intrinsic value is
:3points (,50- 47), so the time value premium must be 2 points. The time value premium
of an in-the-money put option can always be quickly computed by the following
formula:
Time value premium .

. I
(m-t 1e-money put
) = Put option + Stock price - Striking price
This is not the same formula that was applied to in-the-money call options, although it is
always true that the time value premium of an option is the excess value over intrinsic
value.
Time value premium

. h
(m-t e-money ca
ll) = Call option + Striking price - Stock price
If the p11tis out-of-the-money, the entire premium of the put is composed of time value
prerni11n1,for the intrinsic \·alue of an out-of-the-money option is always zero. The time
rnl11cprrn1i11111if a put is largc>st1cl1rnthe stock is at the striking price>of the put. As
the option hecomes cleepl:· in-the-money or deeply out-of-the-money, the time rnlue
Chapter15:PutOptionBasics 233
premium will shrink substantially. These statements on the magnitude of the time value
premium are true for both puts and calls. Table 1.5-1will help to illustrate the relationship
of stock price and option price for both puts and calls. The reader may want to refer to
Table 1-L which described the time value premium relationship for calls. Table 1.5-1
describes the prices of an XYZ July .SOcall option and an XYZ July ,50 put option.
Table 1.5-1demonstrates se\·end basic facts. As the stock drops, the actual price of a
call option decreases while the value of the put option increases. Conversely, as the stock
rises, the call option increases in value ancl the put option decreases in value. Both the
put and the call han' their maximum time \·alue premium when the stock is exactly at the
striking price. Howe\·er, the call icill generally sell}<n-nwrc than the put 1chcn the stock
is at the strike. Notice in Table 1.5-1that, with XYZ at .SO,the call is worth .5points while
the put is worth only ..J.points. This is true in general, except in the case of a stock that
pays a large di\·idend. This phenomenon has to do with the cost of carrying stock More
will be said about this effect later. Table 1.5-1also describes an effect of put options that
normally holds true: An i11-tlic-nwney µ11t(stock is belmc strike) loses time i:alue premium
more quickly than an i11-thc-nw11eycall does. Notice that with XYZ at 43 in Table 15-1,
the put is 7 points in-the-m011ey and has lost all its time value premium. But when the call
is 7 points in-the-money, XYZ at .57, the call still has 2 points of time value premium.
Again, this is a phenomenon that could be affected by the dividend payout of the underly-
ing stock, but is true in general.
PRICIN G PUT OPTIONS
The same factors that determine the price of the call option also determine the price of
the put option: price of the underlying stock, striking price of the option, time remaining
until expiration, volatility of the underlying stock, dividend rate of the underlying stock,
and the current risk-free interest rate (Treasury bill rate, for example). Market dynam-
ics-supply, demand, and investor psychology-play a part as well.
Without going into as much detail as was shown in Chapter 1, the pricing curve of
the put option can be developed. Certain facts remain true for the put option as they did
for the call option. The rate of decay of the put option is not linear; that is, the time value
premium ,vill decay more rapidly in the weeks immediately preceding expiration. The
more volatile the underlying stock the higher will he the price of its options, both puts
and calls. Moreover, the marketplace may at any time value options at a higher or lower
volatility than the underlying stock actually exhibits. This is called implied volatility, as
d istinguished from actual volatility. Also, the put option is usually worth at least its intrin-
sic value at any time, and should he worth exactly its intrinsic value on the day that it
expires. Figure 1.5-1 shows where one might expect the XYZ July .SOput to sell, for an~,
234 PartIll: PutOptionStrategies
TABLE 15-1.
Call and put options compared.
XYZ XYZ Call Call XYZ Put Put
Stock July50 Intrinsic TimeValue July50 Intrinsic TimeValue
Price CallPrice Value Premium ·PutPrice Value Premi
um
40 .50 0 .50 9.75 10 -.25*
43 0 7 7 0
45 2 0 2 6 5 1
47 3 0 3 5 3 2
50 5 0 5 4 0 4
53 7 3 4 3 0 3
55 8' 5 3 2 0 2
57 9 7 2 0
60 10.50 10 .50 .50 0 .50
70 19.75 20 -.25* .25 0 .25
*A deeply in-the-money option may actually trade at a discount from intrinsic value in advance of expiration.
stock price, if there are 6 months remaining until expiration. Compare this with the simi-
lar pricing curve for the call option (Figure 1.5-2). Note that the intrinsic value line for
the put option faces in the opposite direction from the intrinsic value line for call options;
that is, it gains value as the stock falls below the striking price. This put option pricing
curve demonstrates the effect mentioned earlier, that a pu t option loses time value pre-
mium more quickly when it is in-the-money, and also shows that an out-of-the-money put
holds a great deal of time value premium .
THE EFFECTOF DIVIDEN DS ON PUT OPTION PREMIUMS
The dividend of the underlying stock is a negative factor on the price of its call options.
The opposite is true for puts. The larger the diuidend, the more ualuable the puts will be.
This is true because, as the stock goes ex-dividend, it will be reduced in price by the
amount of the dividend. That is, the stock will decrease in price and therefore the put
will become more valuable. Consequently, the buyer of the put will be willing to pay a
higher price for the put and the seller of the put will also demand a higher price. As
with listed calls, listed puts are not adjusted for the payment of cash dividends on the
1mderl~,ing stock. Howe\·er, the price of the option itself will reflect the dividend pay-
ments on the stock.
FIGURE 15-1.
Put option price curve.
Cl)
(..)
&
C
0
'E_ Intrinsic Value
0 (Value at Expiration)
Striking Stock Price

Price (50)
FIGURE 15-2.
Call option price curve.
11
10
9
Cl)
8
(..) Greatest
7
& Value for
C 6 Time Value
0
E. 5 Premium
0 4 ----------------------
3
2 -
represents the option's
1 - time value premium.
0---------------~--------'
1----
40 ---------
45 50\
Stock Price
55
Intrinsic value
60
remains at zero
until striking price
is passed.
Example: XYZ is selling for $2.S per share and will pay $1 in dividends over the next
6 months. Then a 6-month put option with strike 2.5 should automatically be worth at
least $1, regardless of any other factor c011cerning the underlying stock. During the next
6 months, the stock will be reduced in price by the amount of its clividends-$1-ancl if
everything else remained the same, the stock would the11 be at 24. \\Tith the stock at 24,
the put would be 1 point in-the-money and would thus he worth at least its intrinsic ,·aluc
of 1 point. Thus, in advance, this large dividend payout of the underlying stock will help
to increase the price of the put options on this stock.
On the day before a stock goes ex-dividend, the time value premium of an
i11-tlic-11wncyput slzo11ldhe at least as large as the impending cash dividend payment.
That is, if XYZ is 40 and is about to pay a $..50 dividend, an XYZ January 50 put should
sell for at least 10..50.This is true because the stock will be reduced in price by the amount
of its dividend on the day of the ex-dividend.
EXERCISE AND ASSIGNMENT
\Flzc11tlze holder <fa put option e.i.:crriseshis option, he sells stock at the striking price.
He may exercise this right at any time during the life of the put option. When this hap-
pens, t!1c 1critcr of a put option icitli tl1e sa111eterms is assigned an obligation to buy
stock at the striking price. It is important to notice the difference between puts and calls
in this case. Tlw call holder exercises to buy stock and the call writer is obligated to sell
stock. The reverse is true for the put holder and writer.
The lllcthods of assignment \ ia the OCC and the brokerage firm are the same for
puts a11dcalls; any fair method of random or first-in/first-out assignment is allowed. Stock
commissio11s are charged on both the purchase and sale of the stock via the assignment
and exercise.
\\'hen the holder of a put option exercises his right to sell stock, he may be selling
stock that lw currently holds in his portfolio. Second, he may simultaneously go into the
open market ancl bu:· stock for sale via the put exercise. Finally, he may want to sell the
stock i11his short stock account; that is, he may short the underlying stock by exercising
his put option. He would have to be able to borrow stock and supply the margin collateral
for a short sale of stock if he chose this third course of action.
The writer of the put option also has several choices in how he wants to handle the
stock purchase that he is required to make. Tlze put writer iclw is assigned must receive
stock.. (The call writer who is assigned deli\'er:· stock.) The put writer may currently be short
the u11derl:·ingstock i11which case he will rnerel_vuse the receipt of stock from the assign-
ment to CO\l'rhis short sale. He may also decide to immediately sell stock in the open market
to offset the purchase that lie is forced to make \·ia the put assignment. Finally, he may
decide to retain the stock that is dehcred to him; he merely keeps the stock in his portfolio.
I le would, of course, I1m·eto pay for (or margin) the stock if he decides to keep it.
The n1echa11icsas to how the put holder wants to deliver the stock and how the put
\niter wants to rcceiw the stock are relati\·ely sirnplt>.Each one merely notifies his broker-
age finll of tll(' \\·a:-·in \Yhich lw wants to operate and, provided that he can meet the
111an2:in req11in_,11wnts, tlw cwrcise or assigmnent will be made in the desired manner.
ANTICIPATING ASSIGNMENT
The writer of a put option can anticipate assigrnueut in the sarne way that the writtT of a
(f a11i11-tlie-1mmC'!J
call can. \Vhcn the time rnlue JJre111i11111 put option di.Wt/JJ)Ntrs,there
regardless cifthe ti111crrnwi11i11g1111til
is a risk (f assig11111c11t, npirntion. In Chapter 1, a
form of arbitrage was described in which market-makers or firrn traders, \vho pay little or
no cornrnissions, can take advantage of an in-the-money call selling at a discount to parity.
Similarly, there is a method for these traders to take advantage of an in-the-money put
selling at a discount to parity.
Example: XYZ is at 40 and an XYZ July .SOput is selling for 9.80-a .20 discount from
parity. That is, the option is selling for .20 points below its intrinsic value. The arbitrageur
could take advantage of this situation through the following actions:
1. Buy the July put at 9.80.

2. Buy XYZ common stock at 40.
3. Exercise the put to sell XYZ at 50.
The arbitrageur makes 10 points Oll the stock portion of the transaction, buying the com-
mon at 40 and selling it at .50 via exercise of his put. He paid 9.80 for the put option and
he loses this entire amount upon exercise. However, his overall profit is thus .2.Spoint, the
amount of the original discount from parity. Since his cmmnission costs are minimal, he
can actually make a net profit on this transaction.
As was the case with deeply in-the-money calls, this type of arbitrage with deeply
in-the-money puts provides a secondary market that might not otherwise exist. It allows
the public holder of an in-the-money put to sell his option at a price near its intrinsic value.
Without these arbitrageurs, there might not be a reasonable secondary market in which
public put holders could liquidate.
Dividend payment dates may also !wee mi effect on the frequency cif assignmrnt. For
call options, the writer might expect to receive an assignment on the day the stock goes
ex-dividend. The holder of the call is able to collect the dividend by so exercising. Things are
slightly different for the writer of puts. He might expect to receive an assignment on the day
after the ex-dividend date of the underlying stock. Since the writer of the put is obligated to
buy stock, it is unlikely that anyone would put the stock to him until after the dividend has
been paid. In any case, the writer of the put can use a relatively simple gauge to anticipate
assignment near the ex-dividend date. If the time value premium clan in-the-money put is less
than the amount of the dividend to he paid, the writer may often anticipate that he will lw
assigned immediately after the ex-dividend of the stock. An e\.ample will shmv why this is tnw.
Example: XYZ is at -l-.5and it will pay a $.50 dividend. Furthermore, the XYZ July ,50 put is
selling at ,S.:Z..5.
>-Jo
te that the time \·alue premium of the July 50 put is 25 cents-less than the
alllouut of the dividend, which is .SOcents. An arbitrageur could take the following actions:
1. Buy XYZ at 45.

2. Buy the July 50 put at 5.25.
:1. Collect the .SO-cent di\ iclend (he must hold the stock until the ex-elate to collect the
dividend ).
-1-. Exercise his put to sell XYZ at .SO(writer would receive assignment on the day after
th e ex-date).
The arbitrag eur makes 5 points on the stock trades, buying XYZ at 45 and selling it at 50
via exercise of the put. He also collects the ,SO-cent dividend, making his total intake
equal to .S.,50points. He loses the 5.25 points that he paid for the put but still has a net
profit of 2,5 cents. Thus, r,s the ex-dicide11d date of a stock approaches, the time value
of a!! i11-tlw-111011cy
JJrc111i11111 puts 011 that stock icill tend to equal or exceed the amount
of the dividend payment .
This is quite different from the call option. It was shown in Chapter l that the call
writer only needs to obsen-e whether the call was trading at or below parity, regardless of
the amount of the di\·idencl, as the ex-dividend date approaches. The put writer must deter-
mine if the time mine premium of the put exceeds the amount of the dividend to be paid .
If it docs. tht>re is a 1m1ch smaller chance of assignment because of the dividend. In any
case. the put writer can anticipate the assignment if he carefully monitors his position.
POSITION LIMITS
Recall that the position limit rule states that one cannot have a position of more than the
limit of options on the same side of tht> market in the same underlying security. The limit
\·aries dt>pemling 011 th e trading activity and volatility of the underlying stock and is set
h:-,·the l'xchangt> 011 which tlw options are traded. The actual limits are 13,,500,22,500,
:31..500.(-j().()00,or 7.5.000contracts. depending on these factors. One cannot have more
than 7.S.000option contracts on the bullish side of the market-long calls and/or short
puts-nor can he ha\ e niore than 75,000 c011tracts on the bearish side of the market-
short ca1ls and/or long puts. He may, howt'\·er, have 7.5,000contracts on each side of the
1narkt>t: he co11lclsinmltaneonsly be long 7,5,000calls and long 75,000 puts.
For th e following example s, assume that one is concerned with an underlying stock
whose position limit is 75,000 contracts.
Long 7.5,000 calls, long 7.5,000 puts-no violation; 7.5,000 contracts bullish (long calls)
and 7.5,000 contracts bearish (long puts).
Long 38,000 calls, short 37,000 puts-no violation; total of 7.5,000 contracts bullish. Long
38,000 calls, short :38,000 puts-violation; total of 76,000 contracts bullish.
Money managers should be aware that these position limits apply to all "related" accounts,
so that someone managing several accounts must total all the accounts' positions when
considering the position limit rule.
Many of the relationships between call prices and put prices relate to a process known
as a c01rcersion. This term dates back to the over-the-counter option days when a
dealer who owned a put (or could buy one) was able to satisfy the needs of a potential call
buyer by "converting" the put to a call. This terminology is somewhat confusing, and
the actual position that the dealer would take is little more than an arbitrage position. In
the listed market, arbitrageurs and firm traders can set up the same position that the
converter did.
The actual details of the conversion process, which must include the carrying cost
of owning stock and the inclusion of all dividends to be paid by the stock during the time
the position is held, are described later. However, it is important for the put option trader
to understand what the arbitrageur is attempting to do in order for him to fully understand
the relationship between put and call prices in the listed option market.
A conversion position has no risk. The arbitrageur will do three things:
1. Buy 100 shares of the underlying stock.

2. Buy 1 put option at a certain striking price.
3. Sell I call option at the same striking price.
The arbitrageur has no risk in this position. If the underlying stock drops, he can
always exercise his long put to sell the stock at a higher price. If the underlying stock rises,
his long stock offsets the loss on his short call. Of course, the prices that the arbitrageur
pays for the individual securities determine whether or not a conversion will be profitable.
At times, a public customer may look at prices in the newspaper and see that he could
establish a position similar to the foregoing one for a profit, even after commissions. How-
ever, unless prices are out of line, the public customer would not normally he ahle to make
a better return than he could by putting his money into a bank or a Treasury hill, because
of the commission costs he would pay.
\Vithout needing to understand, at this time, exactly what prices would make an
attracti,·e conversion , it is possible to see that it would not always be possible for the arbi-
trageur to do a conversion. Tht> mere action of many arbitrageurs doing the same conver-
sion would force the prices into line. The stock price would rise because arbitrageurs are
buying the stock, as would the put pricf'; and the call price would drop because of the
prepo nderance of sellers.
When this happens, another arbitrage, known as a rcccrsal (or reverse conversion),
is possible. In this case, the arbitrageur does the opposite: He shorts the underlying stock,
sells l put, and buys 1 call. Again, this is a position with no risk. If the stock rises, he can
always t>wrcisf' his call to buy stock at a lower price and cover his short sale. If the stock
falls, hi s short sto ck will offset any losses on his short put.
Tht> point of introducing this information, which is relatively complicated, at this
place in the tt>xtis to demonstrate that there is a relationship hettcec11put and call prices,
1che11huth !wee the same striking price and expiration date. They are not independent
of ont' another. If the put becomes "cheap" with respect to the call, arbitrageurs will move
in to do cmffersions ancl force the prices back in line. On the other hand, if the put
becomt's expmsive with relationship to the call, arbitrageurs will do reversals until the
pri ces move b ack into line.
Because of tlw wa:,;in which tlw c,trrying cost of the stock and the dividend rate of
the stock are im·olved in doing these conversions or reversals, two facts come to light
regarding thf' rt>lationship of put prices ancl call prices. Both of these facts have to do with
the carrying costs incurred during the conversion. First, a put option 1cill generally sell
for !C'ssthan a call option u;hc11the 1111dcrlying stuck is exactly at the striking price, unless
thf' stock pays a large dividend. hi the older over-the-counter option market, it was often
stated that the reason for this relationship was that the demand for calls was larger than
the clt>rnandfor puts. This may ha,·t' been partially true, hut certainly it is 110 longer true
in thf' listed option targets, where a large supply of both listed puts and calls is available
through the OCC. Arbitrageurs again serve a useful function in increasing supply and
demand where it might not otherwise' t>xist.The second fact concerning the relationship
of puts and calls is that a put option u:ill lose its ti111ewlue premium much more quickly
i11-tl1c-11w11ey than a call option 1cill (ancl, conversely, a put option will generally hold
out-of-the-mone:· time ,·,due premium better than a call option will). Again, the conver-
sion and re,·ersal processes play a large role in this prict' action phenomenon of puts and
calls. Both of these facts hm·e to do with the carrying costs involved in the conversion.
I 11 the chapter 011 Arbitrage, exact details of com·ersions and re,·ersals will be spelled
out \\ith specific reasons wh:· these procedurt>s affect the relationship of put and call
prices as statt>clabm e. Howe\·er, at this time, it is sufficient for tlw reader to understand
that tlwrt' is an arbitrage process that is quite widt>l:·practiced that will, in fact make true
the foregoing relatio nships between put s and calls.
\'( ,Z'k « ....,;."'.\*~~'
,. "'" "''ill',i:r:.
'
~~
&
""-
,,.-,&:¥,_
......
~
~"" 'N -
.,,,_
Put Option Buying
The purchase of a put option provides leverage in the case of a downward move by the
underlying stock. In this manner, it is an alternatice to the short sale of stock, much as
the purchase of a call option is a leveraged alternative to the purchase of stock.
PUT BUYING VERSUS SHORT SALE
In the simplest case, when an investor expects a stock to decline in price, he may either
short the underlying stock or buy a put option on the stock. Suppose that XYZ is at .50 and
that an XYZ July ,50 put option is trading at .5. If the underlying stock declines substan-
tially, the buyer of the put could make profits considerably in excess if his initial incest-
rnent. However , if the underlying stock rises in price, the put buver has limited risk; he
can lose only the amount of money that he originally paid for the put option. In this
example , the most that the put buyer could lose would be .5points, which is equal to his
entire initial investment. Table 16-1 and Figure 16-l depict the results, at expiration, of
thi s simple purchase of the put option.
The put buyer has limited profit potential, since a stock can never drop in price
below zero dollars per share. However, his potential profits can be hugf>,percentagewise.
His loss, which normally would occur if the stock rises in price, is limited to the amount
of his initial investment. The simplest use of a put purchase is for speculatir;e p11rposes
when expecting a price decline in the underlying stock .
These results for the profit or loss of the put option purchases can he compared to a
similar short sale of XYZ at ,50 in order to observe the benefits ofleverage and limited risk
that the put option buyer achieves. In order to sell short 100 XYZ at .50, assume that the
trader would have to use $2,.500 in margin. Several points can be verified from Table 16-2
and Figure 16-1. If the stock drops in price sufficiently far, tlw percentage profits are
241
TABLE 16-1.
Results of put purchase at expiration.
XYZPrice
at PutPrice
at PutOption
Expiration Expiration Profit
20 30 +$2,500
30 20 + 1,500
40 10 + 500
45 5 0
48 2 300
50 0 500
60 0 500
70 0 500
FIGURE 16-1.
Put option purchase.
C
0
~
·5.
X
lJ.J
co $0
Cl)
Cl)
0
....J
0
ea..
-$500
much grPater on the put option purchase than they are on the short sale of the underlying
stock. This is the leveraging effect that an option purchase can achieve. If the underlying
stock remains relatively unchanged, the short seller would do better because he does not
risk losing his entire investment in a limited amount of time if the underlying stock
Chapter 16:PutOption Buying 243
TABLE 16- 2.
Results of selling short.
XYZPrice
at PutOption
Expiration Short
Sale Purchase
20 +$3,000 (+120%) +$2,500 (+ 500%)
30 + 2,000 (+ 80%) + 1,500 (+ 300%)
40 + 1,000 (+ 40%) + 500 (+ l 00%)
45 + 500 (+ 20%) 0 ( 0%)
48 + 200 (+ 8%) 300 (- 60%)
50 0 ( 0%) 500 (- 100%)
60 - 1,000 (- 40%) 500 (- 100%)
75 - 2,500 (-100%) 500 (- 100%)
100 - 5,000 (-200%) 500 (- 100%)
changes only slightly in price. Howe\·er, if the underlying stock should rise dramatically,
the short seller can actually lose more than his initial investment. The short sale of stock
has theoretically unlimited risk. Such is not true of the put option purchase, whereby the
risk is limited to the amount of the initial investment. One other point should he made
when comparing the purchase of a put and the short sale of stock. The short seller of stock
is obligated to pay the dividends on the stock but the put option holder has no such obliga-
tion. This is an additional advantage to the holder of the put.
SELECTING WHICH PUT TO BUY
Many of the same types of analyses that the call buyer goes through in deciding which
call to buy can be used by the prospective put buyer as well. First, when approaching put
buying as a speculative strategy, one should not place more than 1.5%of his risk capital in
the strategy. Some investors participate in put buying to add some amount of downside
protection to their basically bullishly oriented common stock portfolios. More is said in
Chapter 17 about buying puts on stocks that one actually owns.
The out-of-the-money put offers both higher re1card potentials and higher risk
p otentials than does the in-the-money put. If the underlying stock drops substantially, the
percentage returns from having purchased a cheaper, ont-of-thc-money put will he
greater. However, should the un<lc>rlyingstock decline only moderately in price, the
in-the-money put will often prow to be the hetter choice. In fact, since a put option tt>nds
to lose its time \'al11epremium quickly as it becomes an in-the-money option, there is an

even greater advantage to the purchase of the in-the-money put.
Example: XYZ is at 49 and the following prices exist:
XYZ, 49;
xyz July 45 put, l; and
XYZ July 50 put, 3.
If the midt>rlying stock \\'erf' to drop to 40 b:· expiration, the July 45 put would be
worth .5points, a 400% profit. The July 50 put would be worth 10points, a 233% profit over its
initial purchase price of 3. Tlms. in a substantial dowmvarcl move, the out-of-the-money put
pmchase pro\"ides higher reward potential. However, if the underlying stock drops only
moderately, say to 4,5, the purchaser of the July 4,5 put would lose his entire investment,
since the put would be worthless at expiration. The purchaser of the in-the-money July 50
put would have a 2-point profit with XYZ at 45 at expiration.
The preceding analysis is based on holding the put until expiration. For the option
lmyt>c this is gennally an erroneous form of analysis, because the buyer generally tends
to liquidate his option purchase in ach'ance of expiration. \Vhen considering what happens
to the put option in ackance of expiration, it is helpful to remember that an in-the-money
put tends to lose its time premium rather quickly. In the example above, the July 45 put
is completel:' composed of time value premium. If the underlying stock begins to drop
helm,, 4,5, the price of the put will not increase as rapidly as would the price of a call that
is going into-the-money.
Example: If XYZ ft>llby ,5 points to 44, definitely a move in the put buyer's favor, he may
find that the Jul:,; 45 put has increased in value only to 2 or 2½ points. This is somewhat
disappointing because, with call options, one would expect to do significantly better on a
.5-point stock rnon'ment in his fan>r. Thus, when purchasing put options for speculation,
it is !!..('llcrrdly /Jest to rn11crntmte 011 i11-tlie-11w11ey
puts unless a e,en.1substantial decline
in the price of the underlying stock is anticipated.
Once the put option is in-the-rno1w\', the time value premium will decrease even in
the longer-tenn series. Since this time premium is small in all series, the put buyer can
often pmcliase a longer-tPrm option for wr:· little extra money, thus gaining more time to
\rnrk \\'it I 1. Call option lrn:,ers are geut>rall:' forced to a\'oicl the longer-term series because
tll(' ('\tra cost is not \\'Ortli the risk im·olwd, especially in a trading situation. However, the
p11thmcr does not necpssaril:· l1a\e this disackantage. Ifhe can purchase the longer-term
Chapter16:PutOptionBuying 245
put for nearl:· the same price as the near-terlll put, he should do so in case the underlying
stock takes longer to drop than he had originally anticipated it would.
It is not uncommon to see such prices as the following:
XYZ common, 46:

XYZ April 50 put, 4;
XYZ July 50 put, 4.50; and
XYZ October 50 put, 5.
None of these three puts han:>much time value premium in their prices. Thus, the buyer
might be willing to spend the extra 1 point and huy the longest-term put. If the underly-
ing stock should <lrop in price immediately, he will profit, but not as much as if he had
bought one of the less expensive puts. However, should the underlying stock rise in price,
he will own the longest-term put and will therefore suffer less of a loss, percentagewise.
If the underl_vingstock rises in price, some amount of time value premium will come back
into the various puts, and the longest-term put will have the largest amount of time pre-
mium. For example, if the stock rises hack to ,50, the following prices might exist:
XYZ common, 50;

XYZ April 50 put, l;
XYZ July 50 put, 2.50; and
XYZ October 50 put, 3.50.
The purchase of the longer-term October .50 put would have suffered the least loss, per-
centagewise, in this event. Conse(p1ently, when one is purchasing an in-the-money put,
he may often want to consider buying the longest-term put if the time value premium is
small when compared to the time premium in the nearer-term puts.
In Chapter .'3,the delta of an option was described as the amount by which one might
expect the option will increase or decrease in price if the underlying stock moves by a
fixed amount (generally considered to be one point, for simplicity). Thus, if XYZ is at 49
and a call option is priced at .'3with a delta of .,50,one would expect the call to sell for 3 ..50
with XYZ at .SOand to sell at 2 ..50 with XYZ at 48. In reality, the delta changes e\·en on a
fractional move in the underlying stock, hut one generally assumes that it will hold trne
for a 1-point move. Obviously, put options have deltas as well. The delta of a put is a nega-
tive number, reflecting the fact that the put price and the stock price an~ inversely related.
As rm approximation, one could say that the dclt(l of the call option 111i1111s the deft([ <f
the put option with the same terms is equal to 1. That is,
Delta of put = Delta of call - 1.

This is an approxirnation and is accurate unless the put is deeply in-the-money. It has
al read:' been pointed out that the time value premium behavior of puts and calls is differ-
ent, so it is inaccurate to assume that this formula holds true exactly for all cases.
The delta of a put ranges between 0 and minus 1. If a July .50put has a delta of -.,50,
and the Ull(lerlying stock rises hy l point, the put will lose .,50. The delta of a deeply
out-of-tlie-mo11ey put is close to zero. The put's delta would decrease slowly at first as the
stock declined in value, then \vould begin to decrease much more rapidly as the stock fell
through the striking price, and would reach a value of minus L (the minimum) as the stock
fell only modt'rately below the striking price. This is reflective of the fact that an out-of-
the-money put tt>nds to hold time premium quite well and an in-the-money put comes to
parity rather quickly .
RANKING PROSPECTIVE PUT PURCHASES
In Chapter :1,a llll'thod of ranking prospective call purchases was developed that encom-
passed certain factors, such as the volatility of the underlying stock and the expected
holding period of the purchased option. The same sort of analysis should be applied to
put option purchases.
The steps are summarized below. The reader may refer to the section titled
''Ackauce d Selection Criteria" iu Chapter :1 for a more detailed description of why this
method of ranking is superior.
1. Ass11!llethat each uuclerl:·ing stock can decrease in price in accordance with its vola-
tility over a fixed holding period (30, 60, or 90 days).
2. Estimate the put option prices after the decrease.
:l Rank all potential put purchases hy the highest reward opportunity for aggressive
purchases .
..J:. Esti111atehow much would be lost if the underlying stock instead rose in accordance
with its rnlatilit:·, and rank all potential put purchases hy best risk/reward ratio for a
more conservative list of put purchases.
As was stated earlieL it is necessary to have a computer to make an accurate analysis of

all listed options. The a\·erage customer is forced to obtain such data from a brokerage
fir111or data seffice. He should he sure that the list he is using conforms to the above-
1ne11tiom_.d criteria. If the data service is ranking option purchases by how well the puts
mrnlcl do if eacl1 11nderl:·i11gstock fell h:· a fixed percentage (such as .5%or LOI¼),the list
sl101dd lw rejC'ckcl lwcamt:-' it is not incorporating the volatility of the underlying stock
into its anal: <;is. .--\lso, if tlw list is based on holding the put purchase until expiration, the
list should be rejected as well, because this is not a realistic assumption. There are enough
reliable and sophisticated data services that one should not have to work with inferior
analyses in today's option market.
For those readers who are more mathematically advanced and have the computer
capability to construct their own anal)'Ses, the details of implementing an analysis similar
to the one described abm·e are presented in Chapter 28, Mathematical Applications. An
application of put purchases, combined with fixed-income securities, is described in
Chapter 26, Buying Options and Treasury Bills.
FOLLOW-UP ACTION
The put buyer can take advantage of strategies that are very similar to those the call buyer
uses for follow-up action, either to lock in profits or to attempt to improve a losing situation.
Before discussing these specific strategies, it should be stated again that it is rarely to the
option buyer's benefit to exercise the option in order to liquidate. This precludes, of course,
those situations in which the call buyer actually wants to own the stock or the put buyer
actually wants to sell the stock. If, however, the option holder is merely looking to liquidate
his position, the cost of stock commissions makes exercising a prohibitive move. This is true
even ifhe has to accept a price that is a slight discount from parity when he sells his option.
LOCKING IN PROFITS
The reader may recall that there were four strategies (perhaps "tactics" is a better word)
for the call buyer with an unrealized profit. These same four tactics can be used with only
slight variations by the put option buyer. Additionally, a fifth strategy can be employed
when a stock has both listed puts and calls.
After an underlying stock has moved down and the put buyer has a relatively sub-
stantial unrealized gain, he might consider taking one of the following actions:
1. Sell the put and liquidate the position for a profit.

2. Do nothing and continue to hold the put.
3. Sell the in-the-money long put and use part of the proceeds to purchase
out-of-the-money puts.
4. Create a sprea<l by selling an out-of-the-money put against the one he currently holds.
These are the same four tactics that were discussed earlier with respect to call buying. In
the fifth tactic, the holder of a listed p11twho has an unrealize<l profit might consider lmy-
ing a listed call to protect his position.
TABLE 16-3.
Background table for profit alternatives.
Original
Trade Current
Prices
Bought XYZ October 50 put at 2 XYZ October 50 put: 6
XYZ October 45 put: 2
Example: A speculator originally purchased an XYZ October 50 put for 2 points when the
stock was 52. If the stock has now fallen to 45, the put might be worth 6 points, represent-
ing an unrealized gain of 4 points and placing the put buyer in a position to implement one
of these five tactics. After some time has passed, with the stock at 45, an at-the-money
October 4,5 put might be selling for 2 points. Table 16-:3 summarizes the situation. If the
trader merely liquidates his position by selling out the October ,50 put, he would realize a
profit of 4 points. Since he is terminating the position, he can make neither more nor less
than 4 points. This is the most conserrntive of the tactics, allowing no additional room for
appreciation, but also eliminating any chance of losing the accumulated profits.
If the trader does nothing, merely continuing to hold the October ,50 put, he is taking
an aggressive action. If the stock should re\'erse and rise back above .50 by expiration, he
would lose everything. However, if the stock continues to fall, he could build up substantially
larger profits. This is the only tactic that could eventually result in a loss at expiration.
These two simple strategies-liquidating or doing nothing-are the easiest alterna-

ti\'es. The remaining strategies allow one to attempt to achieve a balance between retain-
ing built-up profits and generating even more profits. The third tactic that the speculator
could use would be to sell the put that he is currently holding and use some of the pro-
ceeds to purchase the October 45 put. The general idea in this tactic is to µ11llone\ initial
i11rcst111c11tout of the market and then to increase the number of option contracts held by
buying the out-of-the-money option.
Example: The trader would recei\'e 6 points from the sale of the October 50 put. He should
take 2 points of this amount and put it hack into his pocket, thus covering his initial invest-
ment. Then he could buy 2 October 45 puts at 2 points each with the remaining portion of the
proceeds from the sale. He has no risk at expiration with this strategy, since he has recovered
his initial im,estment. Moreover, if the underlying stock should continue to fall rapidly, he
could profit hanclsomel:· because he has increased the number of put contracts that he holds.
The fourth choice that the put holder has is to create a spread by selling the October
4,5 put against the October ,50 that ht' cmTentl:· holds. This would create a hear spread,
technically. This type of spread is described in more detail later. For the time being, it is
sufficient to understand what happens to the trader's risks and rewards by creating this
spread. The sale of the October 45 put brings in 2 points, which covers tlw initial 2-point
purchase cost of the October 50 put. Thus, liis ''cost"for this spread is nothing; he has no
risk except for commissions. If the underlying stock should rise above 50 by expiration,
all the puts would expire worthless. (A put expires worthless when the underlying stock is
above the striking price at expiration.) This would represent the worst case; he would
recover nothing from the spread. If the stock should be below 45 at expiration, he
would realize the maximum potential of the spread, which is 5 points. That is, no matter
how far XYZ is below 45 at expiration, the October 50 put will be worth 5 points more
than the October 45 put, and the spread could thus be liquidated for 5 points. His maxi-
mum profit potential in the spread situation is 5 points. This tactic would be the best one
if the underlying stock stabilized near 45 until expiration .
To analyze the fifth strategy that the put holder could use, it is necessary to intro-
duce a call option into the picture .
Example: With XYZ at 45, there is an October 45 call selling for 3 points. The put holder
could buy this call in order to limit his risk and still retain the potential for large future
profits. If the trader buys the call, he will have the following position:
. ts
Long 1 October 50 put - C omb'me d cost : 5 porn
Long 1 October 45 call
The total combined cost of this put and call combination is ,5points-2 points were origi-
nally paid for the put, and now 3 points have been paid for the call. No matter where the
underlying stock is at expiration, this combination will be worth at least 5 points. For
example, if XYZ is at 46 at expiration, the put will he worth 4 and the call worth l; or if
XYZ is at 48, the put will be worth 2 and the call worth 3. If the stock is above ,50 or
below 45 at expiration, the combination will be worth more than 5 points. Thus, the
trader has no risk in this combination, since he has paid ,5points for it and will be able to
sell it for at least ,5points at expiration. In fact, if the underlying stock continues to drop,
the put will become more valuable and he could build up substantial profits. Moreover, if
the underlying stock should reverse direction and climb substantially, he could still profit,
because the call will then become valuable. This tactic is the best one to use if the under-
lying stock does not stabilize near 45, but instead makes a relatively dramatic move either
up or <lown by expiration. The strategy of simultaneously owning both a put and a call is
discussed in much greater detail in Chapter 23. It is introduced here merely for the pur-
poses of the put huycr wanting to obtain protection of his unrt:>alizeclprofits.
Each of these five strategies may work out to be the best one under a different set of
circumstances. The ultimate result of each tactic is dependent on the direction that XYZ
moves in the future. As was the case with call options, the spread tactic never turns out
to be the worst tactic, although it is the best one only if the underlying stock stabilizes.
Tables 16-4 and 16-5 summarize the results the speculator could expect from invoking
each of these five tactics. The tactics are:
1. Liquidate-sell the long put for a profit and do not reinvest.

2. Do nothing-continue to hold the long put.
TABLE 16-4.
Comparison of the five tactics.
andtheworst
Byexpiration,
ifXYZ... thebeststrategy
was... strategy
was...
Continues to fall dramatically "Roll down" Liquidate
Falls moderately further Do nothing Combine
Remains relatively unchanged Spread Combine or "roll down"
Rises moderately Liquidate "Roll down" or do nothing
Risessubstantially Combine Do nothing
TABLE 16-5.
Results of adopting each of the five tactics.
XYZ
Priceat "Roll
Down" Do-Nothing Spread Liquidate Combine
Expiration Profit Profit Profit Profit Profit
30 + $3,000 (B) +$1,800 + $500 +$400 (W) + $1,500
35 + 2,000 (B) + 1,300 + 500 + 400 (W) + 1,000
41 + 800 (Bl + 700 + 500 + 400 (W) + 400
42 + 600 (B) + 600 (B) + 500 + 400 + 300 (W)
43 + 400 + 500 (B) + 500 (B) + 400 + 200 (W)
45 0(W) + 300 + 500 (B) + 400 0(W)
46 0(W) + 200 + 400 (B) + 400 (B) 0(W)
48 0(W) 0(W) + 200 + 400 (B) 0(W)
50 0 - 200 (W) 0 + 400 (B) 0
54 0 - 200 (W) 0 + 400 (B) + 400 (B)
60 0 - 200(W) 0 + 400 + 1,000 (B)
3. "Roll dmvn"-sell the long put, pocket tht> initial investment, and invest the rt>main-
ing proceed s in out-of-the-mon ey put s at a lower strik e.
4. "Spread"-create a spread by selling the out-of-the-money put against the put already
held.
5. "Combint>"-create a combination by buying a call at a lower strike while continuing
to hold the put.
Note that each tactic is the best one uI1der one of the scenarios, but that the spread tactic
is never the worst of the five. The actual results of each tactic, using the figures from the
example above, are depicted in Table 16-5, where B denotes best tactic and W denotes
worst one.
All the strategies are profitable if the underlying stock continues to fall dramatically,
although the "roll down," "do nothing," and combinations work out best, because they
continue to accrue profits if the stock continues to fall. Every time one takes partial prof-
its, rolls down, or takes other measures, he is doing something bullish to his position.
Those little bullish actions will be harmful if the underlying continues to decline. Rather,
a trailing stop, placed aboce the declining stock price, might be the best tactic of all,
because it allows one's profits to run. If the underlying stock rises instead, only the com-
bination outdistances the simplest tactic of all, liquidation .
If the underlying stock stabilizes, the "<lo-nothing" and "spread" tactics work out
best. It would generally appear that the combination tactic or the "roll-down" tactic would
be the most attractive, since neither one has any risk and both could generate large profits
if the stock moved substantially. The advantage for the spread was substantial in call
options, but in the case of puts, the premium received for the out-of-the-money put is not
as large, and therefore the spread strategy loses some of its attractiveness. Finally, any of
these tactics could be applied partially; for example, one could sell out half of a profitable
long position in order to take some profits, and continue to hold the remainder.
LOSS-LIMITING ACTIONS
The foregoing discussion concentrated on how the put holder could retain or incn:'ase his
profit. However, it is often the case in option buying that the holder of the option is faced
with an unrealized loss. The put holder may also have several choices of action to take in
this case. His first, and simplest, course of action would he to sell the put and take his loss.
Although this is advisable in certain cases, especially when the underlying stock seems to
have assumed a distinctly bullish stance, it is not always the wisest thing to do. The put
holder who has a loss may also consider either "rolling up" to create a bearish spr('ad or
entering into a calendar spread. Either of these actions could help him recover part or all
of his loss.
THE "ROLLING-UP" STRATEGY
The rt'ader may recall that a similar action to "rolling up," termed "rolling down," was
availahlt' for call options held at a loss and was described in Chapter 3. The put buyer who
owns a put at a loss may ht' able to create a spread that allows him to break even at a more
farnrahle price at expiration. Such action will ine\·itably limit his profit potential, but is
gt'nernll:· ust'ful in recon ..ring something from a put that might otherwise expire totally
0
worthl ess.
Example: An investor initially purchases an XYZ October 4,5 put for 3 points when the
undt'rl:·ing stock is at 45. However, the stock rises to 48 at a later date and the put that
was originally bought for 3 points is now selling for 1..50points. It is not unusual, by the
wa:·, for a put to retain this much of its rnlue even though the stock has moved up and
some amount of time has passed, since out-of-the-money puts tend to hold time value
prt'mirnu rather wt'll. With XYZ at 48, an October .50 put might be selling for 3 points.
The put holder could CTt'atf'a position designed to permit recovery of some of his losses
b:· selling tu.;ocfthe puts that he is long-October 4.5'.s--and simultaneously buying one
Octoher SOput. The net cost for this transaction would be only commissions, since he
rect'in's $300 from selling two puts at 1..50 each, which completely cm·ers the $300 cost
of lm:'ing the October .50 put. The transactions are summarized in Table 16-6.
By st'lling :2 of the October 4.5 puts, the investor is now short an October 45 put.
Sinct' lw also purchased an October .50 put. he has a spread (technically, a bear spread).
Ht' has spent no additional money , except commissions, to set up this spread, since the
salt' of the October 4.5's cm·erecl the purchase of the October 50 put. This strategy is most
attmctice 1cl1c11 the dc/Jit inwfrcd to create the spread is small. In this example, the debit
,is zero .
The effect of CTt'ati11gthis spread is that the i11cestorhas not increased his risk at
all. !mt lws raised the hrcak-eren point for his 7)()sitio11. That is, ifXYZ merely falls a small
distcrnct'. he will he able tu get out e\·e11.Without the effect of creating the spread, the put
holder would need XYZ to fall back to 4:2 at expiration in order for him to break even,
sinct' ht' originall:' paid :3points for the October 4,5 put. His original risk was $300. If XYZ
continues to rise in price and the puts in the sprt'ad t'xpire worthlt>ss, the net loss will still
hP 0111:·8:300 plus additional commissions. AdmittPdl:·· the commissions for the spread
\\'ill increase tht' loss slight I:··hut they art' small in comparison to the debit of the position
,s:mm 011 tht' other hand. if tht' stock should fall hack only slightl:·, to 47 by expiration,
Chapter16:PutOptionBuying · 253
TABLE 16-6.
Summary of rolling-up transactions.
O riginal trade: Buy 1 October 45 put for 3 with
XYZ at 45 $300 debit
Later: With XYZ at 48 , sell 2
October 45 's for 1.50 each $300 credit
and buy 1 Octobe r 50 put for 3 $300 debit
Net position: Long 1 October 50 put
Short l October 45 put $300 debit
the spread will break even. At expiration, with XYZ at 47, the in-the-money October 50
put will be worth 3 points and the out-of-the-money October 45 put will expire worthless.
Thus, the investor will recover his $300 cost, except for commissions, with XYZ at 47 at
expiration. His break-even point is raised from 42 to 47, a substantial improvement of his
ch an ces for recovery.
The implcmentatio11 of this spread strategy reduces the prcifctpotential cif the posi-
tion, lwicecer. The maximum potential of the spread is 2 points. If XYZ is anywhere below
45 at expiration, the spread will be worth ,5 points, since the October .50 put will sell for
5 points more than the October 45 put. The investor has limited his potential profit to
2 points-the 5-point maximum width of the spread, less the 3 points that he paid to get
into the position. He can no longer gain substantially on a large drop in price by the under-
lying stock. This is normally of little concern to the put holder faced with an unrealized
loss and the potential for a total loss. He generally would be appreciative of getting out even
or of making a small profit. The creation of the spread accomplishes this objective for him.
It should also be pointed out that he does not incur the maximum loss of his entire
debit plus commissions, unless XYZ closes above ,50 at expiration. If XYZ is anywherP
below 50, the October 50 will have some value and the investor \\·ill be able to recover
something from the position. This is distinctly different from the original put holding of
the October 45, whereby the maximum loss would be incurred unlPss the stock wPrP
below 4.5 at expiration. Thus, the i11troductio11of the sprC'adalso red11as the rlw11ces<if
having to realize the maximum loss.
In summary, the put holder faced with an unrPalized loss ma:v ht> able to create a
spread by selling twice the number of puts that he is currently long and sim11ltaneousl:·
buying the put at the next higher strike>.This action should he>ust>clonl:· if the sprt>ad can
he transacted at a small dehit or, prc>ferahly, at even 111rn1e_v (zero dt>hit). Tlw spread
position offers a much better chance of breaking even and also reduces the possibility of
having to realize the maximum loss in the position. However, the introduction of these
loss-limiting measures reduces the maximum potential of the position if the underlying
stock should subsequently decline in price by a significant amount. Using this spread
strategy for puts would require a margin account, just as calls do.
THE CALENDAR SPREAD STRATEGY
Another strategy is sometimes available to the put holder who has an unrealized loss. If
the put that ht' is holding has an intermediate-term or long-term expiration date, he
might be able to create a calendar spread by selling the near-term put against the put that
he currently holds.
Example: An im·estor bought an XYZ October 4.5 put for :3points when the stock was at
4.5. The stock rises to 48, moving in the wrong direction for the put buyer, and his put falls
in \·alue to 1..50. He might, at that time, consider selling the near-term July 4.5 put for 1
point. The ideal situation would be for the July 4.5 put to expire worthless, reducing the
cost of his long put by 1 point. Then, if the underlying stock declined below 4.5, he could
profit after July expiration.
The major drawback to this strategy is that little or no profit will be made-in fact, a
loss is quite possible-if the underlying stock falls back to 4.5 or below before the near-term
July option expires. Puts display different qualities in their time value premiums than calls
do, as has been noted before. With the stock at 4.5, the differential between the July 4,5 put
and the October 4.5put might not widen much at all. This would mean that the spread has
not gai1wd anything, and the spreader has a loss equal to his commissions plus the initial
unrealized loss. In the example above, if XYZ dropped quickly back to 4.5,the July 4.5 might
be worth 1..50 and the October worth 2..50. At this point, the spreader would have a loss
on both sides of his spread: He sold the July 4.5 put for 1 and it is now 1..50;he bought the
October .J,5for :3and it is now 2 ..50; plus he has spent two commissions to date and would
have to spend two more to liquidate the position.
At this point, the strategist may decide to do nothing and take his chances that the
stock will subst'quently rally so that the July 4.5 put will expire worthless. However, if the
stock coutinut's to decline below 4,5, the spread will most certainly bt>come more of a loss
as both puts come closer to parity.
This typt> of spmctcl stratt>gy is not as attracti\·e as the "rolling-up" strategy. In the
"rolling-up" strategy, m1t' is not subjected to a loss if the stock declines after the spread is
t'StahlislwcL although he dot's limit his profits. The fact that the calendar spread strategy
ca11lead to a loss e\·t'n if the stock declines makes it a less desirable alternative.
Chapter 16:Put OptionBuying 255
EQUIVALENT POSITIONS
Before considering other put-oriented strategies, the reader should understand the defi-
nition of an equivalent position. Two strategies, or positions, are equivalent when they
have the same profit potential. They may have different collateral or investment require-
ments, but they have similar profit potentials. Many of the call-oriented strategies that
were discussed in Part II of the book have an equivalent put strategy. One such case has
already been described: The "protected short sale," or shorting the common stock and
buying a call, is equivalent to the purchase of a put. That is, both have a limited risk above
the striking price of the option and relatively large profit potential to the downside. An
easy tCalJ to tell {f tico strategiE's are equiualent is to see if their profit graphs have the
same shape. The put purchase and the "protected short sale" have profit graphs with
exactly the same shape (Figures 16-1 and 4-1, respectively). As more put strategies are
d iscussed, it will always be mentioned if the put strategy is equivalent to a previously
described call strategy. This may help to clarify the put strategies, which understandably
may seem complex to the reader who is not familiar with put options.
Put Buying in Conjunction
with Common Stock
Ownership
:-\notlwr useful feature of put options. in addition to their speculatiw le, -erage in a dmn1-
,, -ard rnm eh:- the rn1derl:·ing stock is that tlw )JIitµ11rchase rnn /}(' used to li111itclo1c11sidc
loss in a stock that is 01cnecl.\\.hen one sinmltaneoush- mn1s hoth the common stock and
a put on that same stock he has a position ,,-ith limited clm,-nsidc risk during the life of
the p11t. This position is also called a synthetic long calL because the profit graph is the
same shape as a long call's.
Example: .-\n im·estor m,-ns \.YZ stock "·hich is at .'"5:2. and purchases an \.YZ October .SO
put for :2.The put gin's hi Ill the right to sell \.YZ at .'"50.so the most that the stockholder
can lose 011 l1is stock is :2points. Since he pa:·s :2points for the put protection. his ma\:i-
murn potential loss until October e\:piration is --1- points, no matter hmY far \.YZ might
decline up until that tiuw. IL 011 the other liall(L the price of the stock should mm·e up h:-
Octoher. the inwstor ml\lkl realize an:- gain in the stock less the :2points that he paid for
tlw p11t protection. The e11tfunctions 11111cl1 like an insurance policy 1cith a _finite l~fc-
Tabl e 17-1and figun__, 17-1depict the results at Octoher e\:piration for this position: hu:·-
ing ti H' Cktuher .'"50put for :2points to protect a holding in \.YZ common stock \\-hich is
st'lling at .'"5:2.
Tht' dashed line on the graph rcprt'sents the profit pott'ntial of the common
stm-k <>,,nnsliip h: itst'lf. :\otice that if tlw stock were belmY --1-8 in October, the common
"tock<>\\ ll(T ,,mild l1an__,!wen hetter off Im: ing tlw put. Hmwwr. ,,·ith \.YZ ahon' --1-S at
<'\pi ration. tl1c p11t p11rcl1ase ,,·,ts a h11rde11that cost a small portion of potential profits.
256
Chapter17:PutBuyingin Conjunction
withCommon
StockOwnership 257
TABLE 17-1.
Results at expiration on a protected stock holding.
XYZPrice
at Stock Put Total
Expiration Profit Profit Profit
30 $2,200 + $1,800 -$ 400
40 - 1,200 + 800 - 400
50 200 200 - 400
54 + 200 200 0
60 + 800 200 + 600
70 + 1,800 200 + 1,600
80 + 2,800 200 + 2,600
FIGURE 17-1.
Long common stock and long put.
, ,,
,,
, ,,
,,
Long ,,
Stock ,,
C
,,
,,
0
-~ ,
·o..
X
, ,,
,,
UJ
co so
rJ)
rJ) 48 50 , ,'52
0
,
,,
_J
-
0
'§
ct ,,
, ,,
,
,,
-$400
This strategy. howe\·er. is not necessaril:· geared to 111c1\irnizi11g011e·sprofit potential on

the common stock. hut rather prmides the stock m,·11er \\·ith 1m>tcctio11. elilllinating tlw
possibility of an:· de\·astating loss 011the stock holding during the lift· of the p11t.In all tlw
put buying strntcgips discussed in this chapter and Chapter I~- t lw put 1ll11sthe paid for
in full. That is the only increase in investment.
Although any common stockholder may use this strategy, two general classes of stock
owners find it particularly attractive: First, the long-term holder of the stock who is not
considering selling the stock may utilize the put protection to limit losses over a short-term
horizon. Second, the buyer of common stock who wants some "insurance" in case he is
wrong may also find the put protection attractive.
The long-term holder who strongly feels that his stock will drop should probably sell
that stock. However, his cost basis may make the capital gains tax on the sale prohibitive.
He also may not be entirely sure that the stock will decline-and may want to continue
to hold the stock in case it does go up. In either case, the purchase of a put will limit the
stockholder's downside risk while still allowing room for upside appreciation. A large
number of individual and institutional investors have holdings that they might find diffi-
cult to sell for one reason or another. The purchase of a low-cost put can often reduce the
negati ve effects of a bear market on their holdings.
The second general class of put buyers for protection includes the investor who is
establishing a position in the stock. He might want to buy a put at the same time that he
buys the stock, thereby creating a position with profitability as depicted in the previous
profit graph. He immediately starts out with a position that has limited downside risk with
large potential profits if the stock moves up. In this way, he can feel free to hold the stock
during the life of the put without worrying about when to sell it if it should experience a
temporary setback. Some fairly aggressive stock traders use this technique because it
eliminates the necessity of having to place a stop loss order on the stock. It is often frus-
trating to see a stock fall and touch off one's stop loss limit order, only to subsequently rise
in price. The stock owner who has a put for protection need not overreact to a downward
move. He can afford to sit back and wait during the life of the put, since he has built-in
protection.
WHICH PUT TO BUY
The selection of which put the stock owner purchases will determine how much of his
profit potential he is giving up and how much risk he is limiting. An out-of-the-money put
will cost very little. Therefore, it \Nill be less of a hindrance on profit potential if the
underlying stock rises in price. Unfortunately, the put's protective feature is small until
th e stock falls to the striking price of the put. Therefore , the purchase of the
011t-oftl1e-nw11eyput 1cill not procide as 11wchdmrnside protection as an at- or i11-the-
11w11eyput 1co11ld.The purchase of a deeply out-of-the-money put as protection is more
like "disaster insurance": It 'Nill prevent a stock owner from experiencing a disaster in
tt'rrns of a downside loss clming the life of the put, but will not provide much protection
in the case of a limited stock decline.
Chapter17:PutBuying
inCon;unction
withCommon
StockOwnership 259
Example: XYZ is at 40 aud the October :1,5put is selling for .50. The purchase of this put
as protection for the common stock would not reduce upside potential much at all, only
by .50. However, the stock owner could lose 5.50 points if XYZ fell to :3.5or below. That
is his maximum possible loss, for if XYZ were below 3.5 at October expiration, he could
exercise his put to sell the stock at 3,5, losing 5 points on the stock, and he would have paid
50 cents for the put , bringing his total loss to 5.50 points.
At the opposite end of the spectrum, the stock owner might buy an in-the-money
put as protection. This would quite severely limit his profit potential, since the underlying
stock would have to rise above the strike and more for him to make a profit. However, the
in-the-money· put provides vast quantities of downside protection, limiting his loss to a
very small amount.
Example: XYZ is again at 40 and there is an October 45 put selling for 5.50. The stock
owner who purchases the October 45 put would have a maximum risk of .SOcents, for he
could always exercise the put to sell stock at 45, giving him a .S-point gain on the stock,
but he paid .S..50 points for the put, thereby giving him an overall maximum loss of
50 cents. He would have difficulty making any profit during the life of the put, however.
XYZ would have to rise hy more than 5.,50 points (the cost of the put) for him to make any
total profit on the position by October expiration.
The deep in-tlze-nwney put purchase is overly conservative and is usually not a
good strategy. On the other hand, it is not wise to purchase a put that is too deeply
out-of-the-money as protection. Generally, one should purchase a slightly out-ofthe-nw11e1J
put as protection. This helps to achieve a balance between the positive feature of protec-
tion for the common stock and the negative feature of limiting profits.
The reader may find it interesting to know that he has actually gone through this
analysis, back in Chapter .1. Glance again at the profit graph for this strategy of using the
put purchase to protect a common stock holding (Figure 17-1). It has exactly the same
shape as the profit graph of a simple call purchase. Therefore, the call purchase and the
long put/long stock strategies are equicalent. Again, by equivalent it is meant that they
have similar profit potentials. Obviously, the ownership of a call differs substantially from
the ownership of common stock and a put. The stock owner continues to maintain his
position for an indefinite period of time, while the call holder does not. Also, the stock-
holder is forced to pay substantially more for his position than is the call holder, and he
also receives dividends whereas the call holder does not. Therefore, "equivalent" does not
mean exactly the same when comparing call-oriented and put-oriented strategies, lmt
rather denotes that they have similar profit potentials.
In Chapter :1, it was cletennined that the slightly in-the-rnorn'y call often offers the
best ratio between risk and reward. When the call is slightly in-the-rnom':,.1,the stock is
above the striking price. Similarly, the slightly out-of-the-money put often offers the best
ratio between risk and reward for the common stockholder who is buying the put for
protection. Again, the stock is slightly above the striking price. Actually, since the two
positions are equivalent, the same conclusions should be arrived at; that is why it was
stated that the reader has been through this analysis previously.
TAX CONSIDERATIONS
Although tax considerations are covered in detail in a later chapter, an important tax law con-
cerning the purchase of puts against a common stock holding should be mentioned at this
time . If the stock owner is already a long-term holder of the stock at the time that he buys the
put, the put purchase has no effect on his tax status. Similarly, if the stock buyer buys the stock
at the time that he buys the put and identifies the position as a hedge, there is no effect on the
tax status of his stock. However, if one is currently a short-term holder of the common stock
at the time that he buys a put, he eliminates any accrued holding period on his cornmon
stock. Moreocer, the holding period for that stuck dues not begin again until the put is sold.
Example: Assume the long-term holding period is 6 months. That is, a stock owner must
own the stock for 6 months before it can be considered a long-term capital gain. An investor
who bought the stock and held it for .Smonths and then purchased a put would wipe out
his entire holding period of .Smonths. Suppose he then held the put and the stock simul-
taneously for 6 months, liquidating the put at the end of 6 months. His holding period
would start all over again for that common stock. Even though he has owned the stock for
11 months-,5 months prior to the put purchase and 6 months more while he simultane-
ously owned the put-his holding period for tax purposes is considered to be zero!
This law could have important tax ramifications, and one should consult a tax advisor if
he is in doubt as to the effect that a put purchase might have on the taxability of his com-
mon stock holdings.
PUT BUYING AS PROTECTION FOR THE COVERED CALL WRITER
Since put purchases afford protection to the owner of common stock, some investors
naturall}· feel that the same protective feature could he used to limit their downside risk
in the covered call writing strategy. Recall that the covered call writing strategy involves
the purchase of stock and the sale of a call option against that stock. The covered write
lias limited upside profit potential and offers protection to the downside in the amount of
withCommon
StockOwnership 261
the call premium. The cm·ered writer will make money if the stock falls a little, remains
unchanged, or rises by expiration. The covered writer can actually lose money only if the
stock falls b~; more than the call premium received. He has potentially large downside
losses. This strateg:v is known as a prof('cticc collar or, more simply, a "collar." (It is also
called a "hedge wrapper," although that is an outdated term.)
Tlie purchase of an out-of-the-111011C'IJ p11t option can eliminate the risk of large
potential losscsfor tlie coccrcd n:ritC',although the money spent for the put purchase will
reduce the m·erall return from the covered write. One must therefore include the put cost
in his initial calculations to determine if it is worthwhile to buy the put.
Example: XYZ is at .39 and there is an XYZ October 40 call selling for .3 points and an
XYZ October .3.5put selling for ..SO.A covered write could be established by buying the
common at .39 and selling the October 40 call for .3. This covered write would have a
maximum profit potential of 4 points if XYZ were anywhere above 40 at expiration. The
write would lose money ifXYZ were anywhere below .36, the break-even point, at October
expiration. By also purchasing the October .3.Sput at the time the covered write is initi-
ated, the covered writer will limit his profit potential slightly, but will also greatly reduce
his risk potential. If the put purchase is added to the covered write, the maximum profit
potential is reduced to .3.,50points at October expiration. The break-even point moves up
to .36.,50, and the writer will experience some loss if XYZ is below .36..50 at expiration.
However, the most that the writer could lose would he 1.,50points if XYZ were below .3.S
at expiration. The purchase of the put option produces this loss-limiting effect. Tahle 17-2
and Figure 17-2 depict the profitability of both the regular covered write ancl the covered
write that is protected by the put purchase .
Commissions should be carefully included in the covered writer's return calcula-
tions, as well as the cost of the put. It was demonstrated in Chapter 2 that the covered
writer must include all commissions and margin interest expenses as well as all dividends
received in order to produce an accurate "total return" picture of the covered write. Fig-
ure 17-2 shows that the break-even point is raised slightly and the overall profit potential
is reduced by the purchase of the put. However, tlie maxi1111m1 risk is quite' small mid the
writer need never be forced to roll down in a disadvantageous situation.
Recall that the covered writer who does not have the protective put in place is forced
to roll down in order to gain increased downside protection. Rolling down merely means
that he buys back the call that is currently written and writes another call, with a lower
striking price, in its place. This rolling-down action can be helpful if the stock stabilizes
after falling; hut if the stock reverses and clirnhs upward in price again, the covered writer
who rolled clown would have limited his gains. In fact, he may even have "locked in" a loss.
Tlie writer who has the protective put need not he bothered with such things. I le 11<'\.('r
has to roll clown, for he has a lirnitecl maxinmrn loss. Therefore, lw should lH'H'r gd into
TABLE 17-2.
Comparison of regular and protected covered writes.
XYZ
Price
at Stock October
40 October
35 Total
Expiration Profit Coll
Profit PutProfit Profit
25 -$1,400 +$300 +$950 -$150
30 900 + 300 + 450 - 150
35 - 400 + 300 - 50 - 150
36.50 250 + 300 - 50 0
38 100 + 300 - 50 + 150
40 + 100 + 300 - 50 + 350
45 + 600 - 200 - 50 + 350
50 - + 1,100 - 700 - 50 + 350
FIGURE 17-2.
Covered call write protected by a put purchase.
, , ,----------•
+$400
, ,, , ------• +$350
,
,,
,,
C:
0 Regular ,'
~ Covered , ,,
·5. Write ,,
w
X ,
36,'
cil
en $0 ---------'--------------
en 40
_,
0
0
e
a..
-$150
a --locked-in" loss situation. This can be a great advantage, especially from an emotional
\"it'\\'point, because the writer is never forced to make a decision as to the future price of
tlw stock in the middle of the stock's decline. With the put in place, he can feel free to
tah· 110 action at all, since his overall loss is limited. If the stock should rally upward later,
he will still be in a position to make his maximum profit.
Chapt mon Stock Ownership
er 17: Put Buying in Conjunctionwith Com 263
The longer-terrn effects of buying puts in combination with covered writes are not
easily definable, but it would appear that the writer reduces his overall rate of return
slightly bvbuying the puts. This is because he gives something away if the stock falls
slightly, remains unchanged, or rises in price. He only "gains" something if the stock falls
heavily. Since the odds of a stock falling heavily are small in comparison to the other
events (falling slightly, remaining unchanged, or rising), the writer will be gaining some-
thing in only a small percentage of cases. Hmvever, the put buying strategy may still prove
useful in that it removes the emotional uncertainty oflarge losses. The covered writer who
buys puts may often find it easier to operate in a more rational manner when he has the
protective put in place .
This strategy is equivalent to one that has been described before, the bull spread.
Notice that the profit graph in Figure 17-2 has the same shape as the bull spread profit
graph (Figure 7-1). This means that the two strategies are equivalent. ln fact, in Chapter 7
it was pointed out that the bull spread could sometimes be considered a "substitute" for
covered writing. Actually , the bull spread is more akin to this strategy-the covered write
protected by a put purchase. There are, of course, differences between the stra tegies.
They are equivalent in profit and loss potential, but the covered writer could never lose
all his investment in a short period of time, although the sprea der could. In order to actu-
ally use bull spreads as substitutes for covered writes, one would invest only a sma ll por-
tion of his available funds in the spread and would place the remainder of his funds in
fixed-income securities. That strategy was discussed in more depth in Chapter 7.
NO-COST COLLARS
The "collar" st rategy is often arrived at in ano ther manner: a stockholder begins to worry
about the downs ide potential of the stock market and decides to buy puts on his stock as
protection. However, he is dismayed hy the cost of the puts and so he also considers the
sale of calls. If he buys an out-of-the-money put, it is quite possible that he might be able
to sell an out-of-the-money call whose proceeds completely cover the cost of the put.
Thus, he has estab lished a protective collar at no cost-at least no debit. His "cost" is the
fact that he has forsaken the upside profit potential on his stock, above the striking price
of the written call.
In fact, certain large institutional traders are able to t ransact collars through
large over-the-counter option brokers, such as Goldman Sachs or Morgan Stanley. They
might even give the broker instructions such as this: ·'I own XYZ and I want to buy a put
10 percent out of the money that expires in a year. What would the striking price of a
one-year call have to be in order to create a no-cost collar?'- The broker rnight then tell
him that such a call would have to be struck 30 percent out of the 111orn-y.The actual strike
TABLE 17-3.
Highest Call Strike That Pays for an At-the-Money Put {Assuming 2.S years
to expiration)
CallStrike
Volatility ofUnderlying
30% 30% out of money
50 % 40% out of money
70% 50 % out of money
price of the call \\'ould depend 011 the rnlatility estimate for the underlying stock as
wPII as interest rates and di\·idends. These t:Tles of transactions occur with a fair amount
of frequency.
Some H'r:· interesting situations can be created with long-term options. One of the
lllost interesting occurred in 1999, when a c0111pa11:· that owned .5 million shares of Cisco
\CSCO) decided it would like to hedge them h:· c.-rPatinga no-cost collar on'r the next three
:·ears. At the time, CSCO was trading at ahout 1:30.and its rnlatility was about 50%. It
turns out that a three-year put struck at 1:30sells for about the same price as a three-year
call struck at :200!That ma:· set>rn illogical, hut tht> figures can be checkt>clout with the aid
of an option-pricing model. Thus, this compan:· was able to hedge all of its CSCO stock
\\·ith 110dmn1siclt> risk (the striking price of tht> puts was the same as the current stock
prict>l and still had profit potential of oYer .SOCJcto tlw upside m·er tht> next three :·e,us.
Thus, one should consider using LEAPS options when he establishes a collar-e\·en
if he is not an institutional trader-bt>caust' the striking price of tht> calls can Le quite
high in comparison to that of the pufs strike or in comparison to the prict' of the underly-
ing stock. Tahlt> 17-:3shows how far out-of-the-rnone:· a written call could be that still
cm·ers the cost of lrn:·i11g an at-the-money put. Tlw time to expiration in this table is
2..5 years-the longest term listed option that curre ntl y exists.
USING LOWER STRIKES AS A PARTIAL COVERED WRITE
It shrndd also he pointed out that one clews not 11ect>ssarilyha\'f' to forsake all of the profit
potential from his stock. He rnight Lu:· thP puts. as usuaL and tht>n st>llcalls with a smnt'-
\\·hat lowt'r strike than 11cPded for a lm\·-cost collar, hut tht> quantit:· of calls sold would
lw less than that of stock m\·nPd. In that \\'a:·· tlwrc would lw u11limitt>dprofit potential
on some of the shares of the un derly ing stock.
withCommon
StockOwnership 265
Example: Suppose that the following prices exist:
XYZ: 61
Apr 55 put: 1
Apr 65 call: 2
Furthermore, suppose that one owns 1000 shares of XYZ. Thus, the purchase of 10
Apr 5,5 puts at 1 point apiece \vmdd protect the downside. In order to cover the cost of
those puts (81000). one need only sell fii;e of the Apr 6.5 calls at 2 points apiece. Thus,
the protection would have cost nothing and there would still be unlimited profit potential
on 500 of the shares of XYZ, since only five calls were sold against the 1000 shares that
are owned.
In this manner, one could get quite creative in constructing collars-deciding what
call strike to use in order to strike a balance between paying for the puts and allowing
upside profit potential. The lower the strike he uses for the written calls, the fewer calls
he will have to write; the higher the strike of the written calls, the more calls will he
necessary to cover the cost of the purchased puts. The tradeoff is that a lower call strike
allows for more eventual upside profit potential, but it limits what has been written against
to a lower price.
Using the above example once again, these facts can be demonstrated:
Example (continued): As before, the same prices f'xist, but now one more call will be
brought into the picture:
XYZ: 61
Apr 55 put: 1
Apr 65 call: 2
Apr 70 call: 1
As before one could sellfii;e of the Apr 6.5 calls to cover the cost of ten puts, or as an
alternative he could sell trn of the Apr 70 calls. If he sells the five, he has unlimited profit
potential on .500 shares, but the other ,500 shares will be called away at 6,5. ln the alternative
strategy, he has limited upside profit potential, but nothing will be called away nntil the
stock reaches 70. Which is "better?" It's not easy to say. In the former stratt>gy,if the stock
climbs all the way to 7.5,it results in the same profit a:i if the stock is called away at 70 in the
lattt'r strategy. This is trne because .500 shares would he worth 7,5,hut the other .500 would
have been called away at G.5-rnaking for an average of 70. Hem·c, the fonncr stratcg:· onl:'
outperforms the hitter if the stock actnall:,.:climbs {l/)()U' 7.S-a rather unlikely C\cnt, one
would have to surmise. Still, many investors prefer the former strategy because it gives them
protection without asking them to surrender all of their upside profit potential.
ADJUSTING THE COLLAR
A collar might be adjusted if the underlying stock declines sharply in price. After the
stock has clroppecl, the put would be worth a considerable amount, while the call would
be worth very little. If the investor felt that the majority of the decline in the stock was
finished, he could merely sell the put. Whether or not he covered the call, that would
leave him with large profit potential if the stock should rally. On the other hand, if the
investor is not certain that the stock has stopped declining, he might roll just the put-or
perhaps both the put and the call-down to lower strikes, thereby taking a large credit
out of the position in cloing so (the credit comes from selling the original put, which is
now quite valuable). As a third choice, he could also consider selling some out-of-money
puts against the puts that are owned. This would bring in some credit, but would expose
th e stock to losses below th e striking pri ce of th e short put s.
On the other hand, if the underlying stock increases substantially in price after the
collar has been established, the only way out of the collar is to cover the written calls-
and that is going to require a (large) debit. Of course, the underlying stock has risen in
price, so that is an unrealized profit that could be used to offset the loss in the calls. In
esse nce, there is no convenient exit strategy from a collar on th e upsid e.
In summary, one can often be quite creative with the ·'collar" strategy. One thing to
keep in mind: if one sells options against stock that he has no intention of selling, he is
actually writing naked calls in his own mind. That is, if one owns stock that "can't" be
sold-perhaps the capital gains would he devastating or the stock has been "in the family"
for a long time-then he should not sell covered calls against it, because he will be forced
into treating the calls as nakecl (if he refuses to sell the stock). This can cause quite a bit
of consternation if the unclt'rlying stock rises significantly in price-consternation that
could hm·e easily been arnidecl by not writing calls against the stock in the first place.
Buying Puts in Conjunction
with Call Purchases
There are several ways in which the purchases of both puts and calls can be used to the
speculator 's advantage. One simple method is actually a follow-up strategy for the call
buyer. If the stock has advanced and the call buyer has a profit, he might consider buying
a put as a means of locking in his call profits u;hi/e still allowingfor more potential upside
appreciation. In Chapter 3, four basic altt'rnatives were listed for the call buyer who had
a profit: He could liquidate the call and take his profit; he could do nothing; he could "roll
up" by selling the call for a profit and using part of the proceeds to purchase more
out-of-the-money calls; or he could create a bull spread by selling the out-of-the-money
call against the profitable call that he hokls. If the underlying stock has listed puts, he has
another alternative: He could buy a put. This put purchase would serve to lock in some of
the profits on the call and would still allow room for further appreciation if the stock
should continue to rise in price.
Example: An investor initially purchased an XYZ October .SOcall for 3 points when the
stock was at 48. Sometime later, after the stock had risen to .58, the call would be worth
about 9 points. If there was an October 60 put, it might be selling for 4 points, and the
call holder could buy this put to lock in some of his profits. His position, after purchasing
the put, would be:
Lon g 1 October .SOcall at 3 points

- Net cost: 7 points
Long 1 October 60 put at 4 points
267
He would own a "strangle"-any position consisting of both a put and a call with differing
terms-that is always worth at least 10 points. The combination will be worth exactly 10
points at expiration ifXYZ is anywhere between ,50 and 60. For example, ifXYZ is at 52 at
expiration, the call will be worth 2 points and the put will be worth 8 points. Alternatively,
if the stock is at 58 at expiration, the put will be worth 2 points and the call worth 8 points.
Should XYZ be above 60 at expiration, the combination's value will be equal to the call's
value, since the put will expire worthless with XYZ above 60. The call would have to be
worth more than 10 points in that case, since it has a striking price of 50. Similarly, if XYZ
were below ,50 at expiration, the combination would be worth more than 10 points, since
the put would be more than 10 points in-the-money and the call would be worthless.
The speculator has thus created a position in which he cannot lose money, because
he paid only 7 points for the combination (:3points for the call and 4 points for the put).
No matter v,,hat happens, the combination will be worth at least 10 points at expiration,
and a :3-point profit is thus locked in. If XYZ should continue to climb in price, the specu-
lator could make more than :3points of profit whenever XYZ is above 60 at expiration.
Moreover, ifXYZ should suddenly collapse in price, the speculator could make more than
:3points of profit if the stock was below 50 by expiration. The reader must realize that such
a position can never be created as an initial position. This desirable situation arose only
because the call had built up a substantial profit before the put was purchased. The simi-
lar strategy for the put buyer who might buy a call to protect his unrealized put profits
was described in Chapter 16.
STRADDLE BUYING
A straddle purchase consists of buying both a put and a call with the same terms-same
underlying stock, striking price, and expiration date. The straddle purchase allows the
buyer to make large potential profits if the stock moves far enough in either direction. The
buyer has a predetermined maximum loss, equal to the amount of his initial investment.
XYZ common, 50;

XYZ July 50 call, :3;and
XYZ July ,50 put, 2.
If one purchased hotli the July ,50 call and the July ,50 put, he would be buying a straddle.
This \\'Ould cost P5points plus commissions. The investment required to purchase a straddle is
the net clchit. If the underlying stock is exactly at ,50 at expiration, the buyer would lose all
Chapter18:Buying
Putsin Conjunction
withCallPurchases 269
his investment, since both the put and the call would expire worthless. If the stock were
above ,5,5at expiration, the call portion of the straddle would be worth more than .5 points
and the straddle hu_verwould make money, e,·en though his put expired worthless. To the
downsidt>, a similar situation exists. lf XYZ were he low 4.5 at expiration, the put would be
worth more than .Spoints and he would have a profit despite the fact that the call expired
worthless. Table 18-1 and Figure 18-1 depict the results of this example straddle purchase
at expiration. The straddle buyer can immediately determine his break-even points at
expiration-4.S and .S.5in this example. He will lose money if the underlying stock is between
those break-even points at expiration. He has potentially large profits if XYZ should move
a great distance away from 50 by expiration.
One would normally purchase a straddle on a relatively volatile stock that has the
potential to move far enough to rnake the straddle profitable in the allotted time. This
strategy is particularly attractive when option premiums are low, since low premiums will
mean a cheaper straddle cost. Although losses may ocrnr in a relaticely large percentage
of cases that are held all tlze 1cay until their expiration date, there is actually only a minute
probability of losing one's entire investment. Even if XYZ should be at .SOat expiration,
there would still be the opportunity to sell the straddle for a small amount on the final
day of trading.
TABLE 18-1.
Results of straddle purchase at expiration.
XYZ
Price
at Total
Straddle
Expiration Call
Profit PutProfit Profit
30 -$ 300 +$1,800 +$1,500
40 - 300 + 800 + 500
45 - 300 + 300 0
50 - 300 - 200 500
55 + 200 - 200 0
60 + 700 200 + 500
70 + 1,700 200 + 1,500
EQUIVALENCES
Straddle huying is equivalent to the reuerse hedge , a strategy described in Chapter 4 in

which one sells the underlying stock short and purchases two calls 011 the 1mdcrlvi11gstock.
That's the reason that the reverse hedge is called a synthetic long straddle. Both strategies
have similar profit characteristics: a limited loss that would occm at the striking pric<' of
FIGURE 18-1.
Straddle purchase.
C
0
~
·c.
X
L.LJ
cii $0
(f)
(f)
0
....J
0
'5
ct
-$500
the options invoked, and potentially large profits if the underlying stock should rise or fall
far enough in price. The straddle purchase is superior to the reverse hedge with calls,
however, and where listed puts exist on a stock, the reverse hedge strategy with calls
becomes obsolete. The reasons that the straddle purchase is superior are that dividends are
not paid hy the holder and that commission costs are smaller in the straddle situation.
REVERSE HEDGE (SYNTHETIC LONG STRADDLE) WITH PUTS
A third strategy is equivalent to both the straddle purchase and the reverse hedge with
calls. It co11sistsof lmying the underlying stock and buying two put options. If the stock
rises substantially in price, large profits will accrue, for the stock profit will more than
offaet the fiwd loss 011 the purchase of two put options. If the stock declines in price by a
large amount, profits will also he generated. In a decline, the profits generated by 2 long
puts will lllore than off'>d the loss on 100 shares of long stock. This form of the straddle
purchase has limited risk as well. The worst case would occur if the stock were exactly at
the striking price of the puts at their expiration date-the puts would both expire worth-
k,ss. The risk is li111ited,percentagewise and dollar-wise, since the cost of two put options
wrndd norlllally be a relati\·ely small percentage of the total cost of buying the stock.
Fmt henuore, the im cstor may receiw' sonw dividends if the underlying stock is a
di\ idrnd-pa:,-·ing stock. B11:,-·ingstock and buying two puts is superior to the reverse hedge
stra tegy wit h calls, but is still inferior to the straddle purchase .
Chapter18:Buying
PutsinConjunction
SELECTING A STRADDLE BUY
In theory, one could find the best straddle purchases by applying the analyses for best call
purchases and best put purchases simultaneously. Then, if both the puts and calls on a
particular stock showed attractive opportunity, the straddle could be bought. The strad-
dle should be Yiewed as an entire position. A similar sort of analysis to that proposed for
either put or call purchases could be used for straddles as well. First, one would assume
the stock would move up or down in accordance with its volatility within a fixed time
period, such as 60 or 90 clays. Then, the prices of both the put and the call could be pre-
dicted for this stock movement. The straddles that offer the best reward opportunity
under this analysis would be the most attractive ones to buy.
To demonstrate this sort of analysis, the previous example can be utilized again.
Example: XYZ is at 50 and the July ,50 call is selling for 3 while the July 50 put is selling for
2 points. If the strategist is able to determine that XYZ has a 25% chance of being above 54
in 90 days and also has a 25% chance of being below 46 in 90 days, he can then predict the
option prices. A rigorous method for determining what percentage chance a stock has of
making a predetermined price movement is presented in Chapter 28 on mathematical appli-
cations. For now, a general procedure of analysis is more important than its actual implemen-
tation. If XYZ were at ,54 in 90 days, it might be reasonable to assume that the call would be
worth 5..50 and the put would be worth l point. The straddle would therefore be worth
6.50 points. Similarly, if the stock were at 46 in 90 days, the put might be worth 4.50 points,
and the call worth l point, making the entire straddle worth ,5.50 points. It is fairly common
for the straddle to be higher-priced when it is a fixed distance in-the-money on the call side
(such as 4 points) than when it is in-the-money on the put side by that same distance. In this
example, the strategist has now determined that there is a 25% chance that the straddle will
be worth 6.50 points in 90 days on an upside movement, and there is a 25% chance that the
straddle will be worth 5.,50 points on a downside movement. The average price of these two
expectations is 6 points. Since the straddle is currently selling for 5 points, this would repre-
sent a 20% profit. If all potential straddles are ranked in the same manner-allowing for a
2,5% chance of upside and downside movement by each underlying stock-the straddle
buyer will have a common basis for comparing various straddle opportunities.
FOLLOW-UP ACTION
It has been mentioned frequently that there is a good chance that a stock will remain rela-
tively unchanged over a short time period. This does not mean that the stock will never
move much one way or the other, hut that its net movement over the time period will
generally be small.
272 . PartIll:PutOptionStrategies
Example: If XYZ is currently at 50, one might say that its chances of being over 55 at the
end of 90 days are fairly small, perhaps 30%. This may even be supported by mathemati-
cal analysis based on the volatility of the underlying stock. This does not imply, however,
that the stock has only a :30% chance of ever reaching 5,5 during the 90-day period.
Rather, it implies that it has only a 30% chance of being over 5,5 at the end of the 90-day
period. These are two distinctly different events, with different probabilities of occur-
rence. Even though the probability of being over 55 at the end of 90 days might be only
.30%, the probability of ever being over 55 during the 90-day period could be amazingly
high, perhaps as high as 80%. It is important for the straddle buyer to understand the
differences between these events occurring, for he might often be able to take.follow-up
action to improve his position.
Many times, after a straddle is bought, the underlying stock will begin to move
strongly, making it appear that the straddle is immediately going to become profitable.
Howe\·er, just as things are going well, the stock reverses and begins to change direction,
perhaps so quickly that it would now appear that the straddle will become profitable on
the other side. These volatile stock movements often result in little net change, however,
and at expiration the straddle buyer may have a loss. One might think that he would take
profits 011 the call side when they became available in a quick upward movement, and then
hope for a downward reversal so that he could take profits on the put side as well. Taking
small profits, h01cci;cr,is a poor strategy. Straddle buying has limited losses and poten-
tially unlimited profits. One might have to suffer through a substantial number of small
losses before hitting a big winner, but the magnitude of the gain on that one large stock
movement can offset many small losses. By taking small profits, the straddle buyer is
immediately cutting off his chances for a substantial gain; that is why it is a poor strategy
to limit the profits.
This is one of those statements that sounds easier in theory than it is in practice. It
is emotionally distressing to watch the straddle gain 2 or 3 points in a short time period,
only to lose that and more when the stock fails to follow through. By using a different
example, it is possible to demonstrate the types of follow-up action that the straddle buyer
might take.
Example: One had initially bought an XYZ January 40 straddle for 6 points when the
stock was 40. After a fairly short time, the stock jumps up to 45 and the following
prices exist:
XYZ common, 4,5:

XYZ January 40 call, 7;
Chapter18:Buying
PutsinConjunction
XYZ January 40 put , l ; and

XYZ January 45 put, 3.
The straddle itself is now worth 8 points. The January 45 put price is included because it
will be part of one of the follow-up strategies. What could the straddle buyer do at this
time? First, lie might do nothing, preferring to let the straddle run its course, at least for
three months or so. Assuming that he is not content to sit tight, however, he might sell the
call, taking his profit, and hope for the stock to then drop in price. This is an inferior
course of action, since he would be cutting off potential large profits to the upside.
In the older, over-the-counter option market, one might have tried a technique
known as trading against the straddle. Since there was no secondary market for
over-the-counter options, straddle buyers often traded the stock itself against the strad-
dle that they owned. This type of follow-up action dictated that, if the stock rose enough
to make the straddle profitable to the upside, one would sell short the underlying stock.
This involved no extra risk, since if the stock continued up, the straddle holder could
always exercise his call to cover the short sale for a profit. Conversely, if the underlying
stock fell at the outset, making the straddle profitable to the downside, one would buy
the underlying stock. Again, this involved no extra risk if the stock continued down,
since the put could always be exercised to sell the stock at a profit. The idea was to be
able to capitalize on large stock price reversals with the addition of the stock position
to the straddle. This strategy worked best for the brokers, who made numerous com-
missions as the trader tried to gauge the whipsaws in the market. In the listed options
market, the same strategic effect can be realized (without as large a commission
expense) by merely selling out the long call on an upward move, and using part of the
proceeds to buy a second put similar to the one already held. On a downside move, one
could sell out the long put for a profit and buy a second call similar to the one he already
owns. In the example above, the call would be sold for 7 points and a second January
40 put purchased for l point. This would allow the straddle buyer to recover his initial
6-point cost and would allow for large downside profit potential. This strategy is not
recommended, however, since the straddle buyer is limiting his profit in the direction
that the stock is moving. Once the stock has moved from 40 to 45, as in this example, it
would be more reasonable to expect that it could continue up rather than experience a
drop of more than 5 points.
A more desirable sort of follow-up action would be one whereby the straddle buyer
could retain much of the profit already built up without limitingfurther potential profits
if the stock continues to run. In the example above, the straddle buyer could use the Janu-
ary 45 put-the one at the higher price-for this purpose.
Example: Suppose that when the stock got to 45, he sold the put that he owned, the Janu-
ary 40, for 1 point, and simultaneously bought the January 45 put for 3 points. This trans-
action would cost 2 points, and would leave him in the following position:
Long 1 January 40 call - C om b'm~ d cost : 8 porn

. ts
Long 1 January 45 put
He now owns a combination at a cost of 8 points. However, no matter where the underly-
ing stock is at expiration, this combination will be worth at least 5 points, since the put
has a striking price 5 points higher than the call's striking price. In fact, if the stock is
above 45 at expiration or is below 40 at expiration, the straddle will be worth more than
.5points. This follow-up action has not limited the potential profits. If the stock continues
to rise in price, the call will become more and more valuable. On the other hand, if the
stock reverses and falls dramatically, the put will become quite valuable. In either case,
the opportunity for large potential profits remains. Moreover, the investor has improved
his risk exposure. The most that the new position can lose at expiration is 3 points, since
the combination cost 8 points originally, and can be sold for ,5points at worst.
To summarize, if the underlying stock moves up to the next strike, the straddle
buyer should consider rolling his put up, selling the one that he is long and buying the
one at the next higher striking price. Conversely, if the stock starts out with a downward
mace, he should consider rolling the call dou;n, selling the one that he is long and buying
the one at the next lower strike. In either case, he reduces his risk exposure without limit-
ing his profit potential-exactly the type of follow-up result that the straddle buyer should
be aiming for.
BUYING A STRANGLE
A strangle is a position that consists of both a put and a call, which generally have the same
expiration date, but different striking prices. The follou;ing example depicts a strangle.
Example: One might buy a strangle consisting of an XYZ January 45 put and an XYZ
January ,50call. Buying such a strangle is quite similar to buying a straddle, although there
are some differences, as the following discussion will demonstrate. Suppose the following
prices exist:
XYZcommon , 4 7;
XYZ January 45 put , 2; and
XYZ Janua ry 50 call, 2.
Chapter18:Buying withCallPurchases
PutsinConjunction 275
In this example, both options are out-of~thc-111011ey when pmchascd. This, again, is the
most normal application of the strangle purchase. If XYZ is still hetweeu 4.5 and .SOat
January expiration, hotli options will t>xpirt' worthless and the strangle buyt>rwill lose his
entire investment. This investrnent-$400 in tht' examplP-is generally smaller than that
requir ed to buy a straddle on XYZ. If XYZ 111m·esin either direction, rising above .SOor
falling below 45, the strangle will have some value at expiration. In this example, if XYZ
is above 54 at expiration, the call will be worth more than 4 points (the put will expire
worthless) and the buyer will make a profit. In a similar manner, if XYZ is helow 4 l at
expiration, the put will have a value greater than 4 points and the buyer would make a
profit in that case as well. The potential pro.fits are quite large if the underlying stuck
should moi;e a great deal before the options e:rpirc.Table 18-2 and Figure 18-2 depict the
pot ential profits or losses from this position at January expiration. The maximum loss is
possible over a much wider range than that of a straddle. The straddle achieves its maxi-
mum loss only if the stock is exactly at the striking price of the options at expiration.
However , the strangle has its maximum loss anywhere between the two strikes at expira-
tion. The actual amount of the loss is smaller for the strangle, and that is a compensating
factor. The potential profits are large for both strategies.
The example above is one in which both options are out-of-the-money. It is also pos-
sible to construct a very similar position by utilizing in-the-money options.
Example: With XYZ at 47 as before, the in-the-money options might have the following
prices: XYZ January 45 call, 4; and XYZ January ,50put, 4. If one purchased this i11-the-mo11ey
TABLE 18-2.
Results at expiration of a strangle purchase.
at
Price
XYZ Put Coll Total
25 +$1,800 -$ 200 +$1,600
35 + 800 200 + 600
41 + 200 200 0
43 0 200 200
45 200 200 - 400
47 200 200 - 400
50 200 200 - 400
54 200 + 200 0
60 200 + 800 + 600
70 200 + 1,800 + 1,600
FIGURE 18-2.
Strangle purchase.
C
0
-~
·a.
X
w
cil
CJ)
CJ)
$0
0
....J
0
e -$400
a...
stra11glc,lw \\'011ldpay a total cost of 8 points. Hmvever, the value of this strangle will always
he at least ,5 points, since the striking price of the put is 5 points higher than that of the call.
Tht>rt>ader has set>nthis sort of position before, when protective follow-up strategies for strad-
dlt> huyi11gand for call or put bu:ing were described. Because the strangle will always be
worth at lt>ast5 points, the most that the in-the-money strangle buyer can lose is 3 points in
this t>xamplt>.His pott>ntial profits are still unlimited should the underlying stock move a large
distance. Tims, en:>11 though it requires a larger initial investment, the in-the-money strangle
I/lay c~fte11be a superior strategy to the out-of-the-11w11ey strangle,from a buyer's viewpoint.
Tlw i11-tht>-111011e~,strangle purchase certainly invokes less percentage risk: The buyer can
nt>,·er lost>all his im·estment. since he can always get back .5 points, even in the worst case
(when XYZ is hetwet>n 4,5 and 50 at expiration). His percentage profits are lower with the
in-the-mont>:· strnnglt> purchase, since ht> paid more for the strangle to begin with. These
ohsen-ations should come as no suqxist>, sinct>when the outright purchase of a call was dis-
cussed, it was shown that tht> purchase of an in-the-money call was more conservative than
tlw purchasP of an 011t-of-tht>-111oney call, in general. The same was true for the outright pur-
chase of puts, perhaps t>,·enmcfft>so, because of the smaller time value of an in-the-money put.
Thcrefort>, tht>strangle creatt>d hy the two-an in-the-money call and an in-the-moneyput-
should be more conservative than the out-of-the-money strangle.
If the 11ndcrlying stock moves quickly in either direction, the strangle buyer may
srnnetirnt's lw able to take action to protect some of his profits. He would do so in a man-
1wr similar to that dt>scribed for the straddle buyer. For example, if the stock moved up
q11ickl:--·,
lw co11lclsell tlw p11tthat he originally bought and buy the put at the next higher
Chapter18:Buying
Putsin Conjunction
striking price in its place. If he had started from an out-of-the-rnoney strangle position,
th is would then place him in a straddle. The strategist should not blindly take tliis sort of
follow-up action, however. It ma)' be overly expensive to "roll up" the put in such a man-
ner, depending on the amount of tirne that has passed and the actual option prices
invoked. Therefore, it is best to anah-ze .
each situation on a case-bv-case
- basis to see
whether it is logical to take any follow-up action at all.
As a final point, the out-of-the-mone)· strangles may appear deceptively cheap, both
options selling for fractions of a point as expiration nears. However, the probability of
realizing the maximum loss equal to one's initial investment is fairly large with strangles.
This is distinctly different from straddle purchases, whereby the probability of losing the
entire investment is small. The aggressive speculator should not place a large portion of
hi s funds in out-of-the-money strangle purchases. The percentage risk is smaller with the
in-the-money strangle, being equal to the arnount of time value prerniurn paid for the
options initially, but commission costs will be somewhat larger. In either case, the under-
lying stock still needs to move by a relatively large amount in order for the buyer to profit.
The Sale of a Put
The huycr of a put stan<ls to profit if the underlying stock drops in price. As might then
be expected, the seller of a put will make money if the underlying stock increases in pr ice.
The 11ncon:'red sale of a put is a more common strategy than the covered sale of a put, and
is therefore described first. It is a bullishly oriented strategy.
THE UNCOVERED PUT SALE
Since the buyer of a put has a right to sell stock at the striking price, the wri ter of a put is
obligating himself to buy that stock at the striking price. For assuming this obligation, he
recei\·es the put option premium. If the underlying stock advances and the put expires
worthless. the put writer will not be assigned and he could make a maximum profit equal
to the prc111i1t111rcceiccd. He has large downside risk, since the stock cou ld fall substan-
tiall:·, tlwreby increasing the rnlue of the written put and causing large losses to occur. An
exarnple will aid in explaining these general statements about risk and reward.
Example: XYZ is at .50 ancl a 6-rnonth put is selling for 4 points. The naked put wri ter has
a fiwd potential profit to the upside-$400 in this example-and a large potential loss to
the downside (Table 19-1 and Figure 19-1). This downside loss is limited only by the fact
that a stock cannot go below zero.
The collakral requirernent for writing naked puts is the same as that for writing
naked calls. The requirernent is equal to 20% of the current stock price plus the put pre-
mium minus any out-of-the-money amount.
Example: If XYZ is at .SO.the collateral requirement for writing a 4-point put with a
striking price of .50 would he $1.000 (209c:of .5,000) plus $400 for the put premium for
278
Chapter19:TheSaleof a Put 279
TABLE 19-1.
Results from the sale of an uncovered put.
XYZPrice
at PutPrice
at PutSale
Expiration Expiration
(Parity) Profit
30 20 -$1,600
40 10 - 600
46 4 0
50 0 + 400
60 0 + 400
70 0 + 400
FIGURE 19-1.
Uncovered sale of a put.
$400
C
0
~
·a.
X
UJ
1il
Cl)
Cl)
$0
0
_J
e-
0
CL
a total of $1,400. If the stock were above the striking price, the striking price differen-
tial would be subtracted from the requirement. The minimum requirement is 10% of
the put's striking price, plus the put premium, even if the computation above yields a
smaller result.
The uncocered put writing strategy is similar in many 1cays to the covered call writ-
ing strategy. Note that the profit graphs have the same shape; this means that the two
strategies are equivalent. It may be helpful to the reader to describe the aspects of naked
put writing hy comparing them to similar aspects of covered call writing.
In either strategy, one needs to be somewhat bullish, or at least neutral, on the

underlying stock. If the underlying stock moves upward, the uncovered put writer will
make a profit, possibly the entire amount of the premium received. If the underlying stock
should be unchanged at expiration-a neutral situation-the put writer will profit by the
amount of the time value premium received when he initially wrote the put. This could
represent the maximum profit if the put was out-of-the-money initially, since that would
mean that the entire put premium was composed of time value premium. For an
in-the-money put, however, the time value premium would represent something less than
the entire value of the option. These are similar qualities to those inherent in covered call
writing. If the stock moves up, the covered call writer can make his maximum
profit. However, if the stock is unchanged at expiration, he will make his maximum
profit only if the stock is above the call's striking price. So, in either strategy, if the
position is established 1cith the stuck abuce the striking price, there is a greater probabil-
ity 4 achiecing the 11wxim1tmprofit. This represents the less aggressive application:
writing an out-of-the-money put initially, which is equivalent to the covered write of an
in-the-mone y call.
The more aggressive application of naked put writing is to write an in-the-money
put initially. The writer will receive a larger amount of premium dollars for the
in-the-money put and, if the underlying stock advances far enough, he will thus make a
large profit. By increasing his profit potential in this manner, he assumes more risk. If the
underlying stock should fall, the in-the-money put writer will lose money more quickly
than one who initially wrote an out-of-the-money put. Again, these facts were demon-
strated much earlier with covered call writing. An in-the-money covered call write affords
more downside protection but less profit potential than does an out-of-the-money covered
call write .
It is fairly easy to summarize all of this by noting that in either the naked put writing
strategy or the covered call writing strategy, a less aggressice position is established u:hen
the stock is higher than the striking price of the 1critten option. If the stock is belou; the
striking price initially , a more aggressive position is created.
There are, of course, some basic differences between covered call writing and naked
put writing. First, the naked put write will generally require a smaller investment, since
one is only collateralizing 20% of the stock price plus the put premium, as opposed to .50%
for the covered call write on margin. Also, the naked put writer is not actually investing
cash; collateral is used, so he may finance his naked put writing through the value of his
prest>nt portfolio, wht>ther it he stocks, bonds, or government securities. However, an:'
los<;eswould create a dt>bit and might therefore cause him to disturb a portion of this
portfolio. It should be pointed out that one can, if he wishes, write naked puts in a cash
account by depositing cash or cash equivalents equal to the striking price of the put. This
Chapter19:TheSaleof a Put 281
is called '·cash-based put writing." The covered call writer receives the dividends on the
underlying stock, but the naked put writer does not. In certain cases, this may be a sub-
stantial amount, but it should also be pointed out that the puts on a high-yielding stock
will have more value and the naked put writer will thus be taking in a higher premium
initially. From strictly a rate of return viewpoint, naked put writing is superior to covered
call writing. Basically, there is a different psychology involved in writing naked puts than
that required for covered call writing. The covered call write is a comfortable strategy for
most investors, since it involves common stock ownership. Writing naked options, how-
ever, is a more foreign concept to the average investor, even if the strategies are equiva-
lent. Therefore, it is relatively unlikely that the same investor would be a participant in
both strategies .
FOLLOW-UP ACTION
The naked put writer would take protective follow-up action if the underlying stock
drops in price. His simplest form of follow-up action is to close the position at a small
loss if the stock drops. Since in-the-money puts tend to lose time value premium rap-
idly, he may find that his loss is often quite small if the stock goes against him. In the
example above, XYZ was at 50 with the put at 4. If the stock falls to 45, the writer may be
able to quite easily repurchase the put for 5.50 or 6 points, thereby incurring a fairly
small loss.
In the covered call writing strategy, it was recommended that the strategist roll
down wherever possible. One reason for doing so, rather than closing the covered call
position , is that stock commissions are quite large and one cannot generally afford to be
moving in and out of stocks all the time. It is more advantageous to try to preserve the
stock position and roll the calls down. This commission disadvantage does not exist with
naked put writing. When one closes the naked put position, he merely buys in the put.
Therefore, rolling down is not as advantageous for the naked put writer. For example, in
the paragraph above, the put writer buys in the put for ,5.,50or 6 points. He could roll
down by selling a put with striking price 45 at that time. However , there may be better
put writing situations in other stocks, and there should be no reason for him to continue
to preserve a position in XYZ stock.
In fact, this same reasoning can be applied to any sort of rolling action for the naked
put writer. It is extremely advantageous for the covered call writer to roll forward; that is,
to buy back the call when it has little or no time value premium remaining in it and sell a
longer-term call at the same striking price. By doing so, he takes in additional premium
without having to disturb his stock position at all. However, the naked put writer has little
282 Part Ill: Put OptionStrategies
advantage in rolling forward. He can also take in additional premium, but when he closes
the initial uncovered put, he should then evaluate other available put writing positions
before deciding to write another put on the same underlying stock. His commission costs
are the same if he remains in XYZ stock or if he goes on to a put writing position in a dif-
ferent stock.
EVALUATIN G A NA KED PUT WRIT E
The computation of potential returns from a naked put write is not as straightforward as
were the computations for covered call writing. The reason for this is that the collatera l
requirement changes as the stock moves up or down, since any naked option position is
marked to the market. The must consen;ative approach is to all0tc enough collateral in
the position in case the underlying stock should fall, thus increasing the requirement. In
this way, the naked put writer would not be forced to prematurely close a position because
he cannot maintain the margin required.
Example: XYZ is at 50 and the October ,SOput is selling for 4 points. The initial collateral
requirement is 20% of ,SOplus $400, or $1,400. There is no additional requirement, since
the stock is exactly at the striking price of the put. Furthermore, let us assume that the
writer is going to close the position should the underlying stock fall to 43. To maintain his
put write, he should therefore allow enough margin to collateralize the position if the
stock were at 43. The requirement at that stock price would be $1,,560(20% of 43 plus at
least 7 points for the in-the-money amount). Thus, the put writer who is establishing this
position should allow $1,560 of collateral value for each put written. Of course, this col-
lateral requirement can be reduced by the amount of the proceeds received from the put
sale, $400 per put less commissions in this example. If we assume that the writer sells 5
puts, his gross premium inflow would be $2,000 and his commission expense would be
about $75, for a net premium of $1,925.
Once this information has been determined, it is a simple matter to determine the
maximum potential return and also the downside break-even point. To achieve the maxi-
11nm1 potential return, the put would expire worthless with the underlying stock above
the striking price. Therefore, the maximum potential profit is equal to the net premium
received. The return is merely that profit divided by the collateral used. In the example
above, the maximum potential profit is $1,925. The collateral required is $1,560 per put
(allowing for the stock to drop to 43) or $7,800 for 5 puts, reduced by the $1,925 premium
received, for a total requirement of $.5,875.The potential return is then $1,925 divided by
$,5,875, or 32.8%. Table 19-2 summarizes these calculations .
Chapt
er 19:TheSaleof a Put 283
TABLE 19-2.
Ca lcula tion of the poten tial re turn of uncovere d put wr iting .
XYZ: 50
XYZ January 50 put: 4
Potentialprofit:
Sell 5 puts $2,000
Lesscommissions 75
Potential maximu m profit (premium received) $1 ,925
Break-even point:
Striking price $50.00
Less premium per put ($1,925/5) 3.85
Break-even stock pr ice 46.15
Collateral required (allowing for stock to drop to 43):

20% of 43 $ 860
Plus put premium + 700
$1,560
X 5
Requirement for 5 puts $7,800
Less premium received - 1,925
Net collatera l $5,875
Potential return:
Premium divided by net collateral $1,925/$5,875 = 32.8%
There are differences of opinion on how to compute the potential returns from
naked put writing. The method presented above is a more conservative one in that it takes
into consideration a larger collateral requirement than the initial requirement. Of course,
since one is not really investing cash, but is merely using the collateral value of his present
po rtfolio, it may eve n be correct to claim that one has no investment at all in such a posi-
tion. This may be true, but it would be impossible to compare various put writing oppor-
tunities without having a return computation available .
One other important feature of return computations is the return if unchanged.
If t he put is initially out-of-the-money, the return if unchanged is the same as the maxi-
mum potential return. However, if the put is initially in-the-money, the computation must
take into consideration what the writer would have to pay to buy back the put when it
expires.
Example: XYZ is 48 and the XYZ January .SOput is selling for .Spoints. The profit that
could he made if thf' stock were unchanged at expiration would be only 3 points, less com-
missions, since the put would have to be repurchased for 2 points with XYZ at 48 at expi-
ration. Commissions for the buy-hack should he included as well, to make the computation
as accurate as possible .
As was the case with covert'd call writing, one can create several rankings of naked
put writes. One list might be the /zig/zest potential returns. Another list could be the put
writes that provide the most dou:nside protection; that is, the ones that have the least
chance of losing money Both lists need some screening applied to them, however. When
considering the maximum potential returns, one should take care to ensure at least some
room for downside movement.
Example: If XYZ wert' at .50, the XYZ January 100 put would be selling at .SOalso and
would most assuredly have a tremendously large maximum potential return. However,
tllt're is no room for downsidt' movement at all, and one would surely not write such a put.
One simple way of allowing for such cases would be to reject any put that did not offer at
lt'ast .5% downside prott'ction. Alternatively, one could also reject situations in which the
return if unchanged is below 5% .
The other list, im·olving maximum downside protection, also must have some screens
applied to it.
Example: With XYZ at 70, the XYZ January .SOput would be selling for ..SOat most. Thus,
it is extremely unlikely that one would lose money in this situation; the stock would have
to fall 20 points for a loss to occur. However, there is practically nothing to be made from
this position, and one would most likely not ever write such a deeply out-of-the-money put.
A leccl of return must accompany the items on this list of put

111i11i11111111accepta/Jlc
1crites. For example, one might dt'cide that the return would have to be at least 12% on an
annualized basis in order for the put write to be on the list of positions offering the most
downside protection. Such a requirement would preclude an extreme situation like that
showll above. Once these screens have been applied, the lists can then be ranked in a nor-
mal manner. The put writes offering the highest returns would be at the top of the more
aggressh·f' list alld those offc.,ringthe highf'st percentage of downside protection would be
at the top of the 111oreconst'1Yatin' list. In thf' strictest sense, a more advanced technique
Chapter
19:TheSaleof a Put 285
to incorporate the volatility of tht->undnl)'ing stock should rightfully he employed. As men-

tioned pre,·iously, that technique is presented in Chapter 28 on mathematical applications.
BUYIN G STOCK BELOW ITS MARKET PRICE
In addition to viewing naked put writing as a strategy unto itself, as was the case in the
previous discussion, so111cinccstors u:lw actually tcant to acquire stock tcill often u;rite
naked puts as well.
Example: XYZ is a $60 stock and an investor feels it would be a good buy at .S.S.He places
an open buy order ,vith a limit of ,55. Three months later, XYZ has drifted down to 57 but
no lower. It then turns and rises heavily, but the buy limit was never reached, and the
investor misses out on the advance.
This hypothetical investor could have used a naked put to his advantage. Suppose
that when XYZ was originally at 60, this investor wrote a naked three-month put for
5 points instead of placing an open buy limit order. Then, if XYZ is anywhere below 60 at
expiration, he will have stock put to him at 60. That is, he will have to buy stock at 60.
However, since he received 5 points for the put sale, his net cost for the stock is .S.S.Thus,
even if XYZ is at ,57 at expiration and has never been any lower, the investor can still buy
XYZ for a net cost of 55.
Of course, if XYZ rose right away and was above 60 at expiration, the put would not
be assigned and the investor would not own XYZ. However, he would still have made
$,500 from selling the put, which is now worthless. The put writer thus assumes a more
active role in his investments by acting rather than waiting. He receives at least some
compensation for his efforts, even though he did not get to buy the stock.
If, instead of rising, XYZ fell considerably, say to 40 by expiration, the investor would
be forced to purchase stock at a net cost of ,55, thereby giving himself an immediate paper
loss. He was, however, going to buy stock at 55 in any case, so the put writer and the inves-
tor using a buy limit have the same result in this case. Critics may point out that any buy
order for common stock may be canceled if one's opinion changes about purchasing the
stock. The put writer, of course, may do the same thing by closing out his obligation
through a closing purchase of the put.
This technique is useful to many types of investors who are oriented toward eventually
owning the stock. Large portfolio managers as well as individual investors may find the sale
of puts useful for this purpose. It is a method of attempting to acrnm1date a stock position
at JJrices lower than todffy'.s market price. If the stock rises and the stock is not bought, the
investor will at least have received the put premium as compensation for his efforts.
SOME CAUTION IS REQUIRED
Despite the seemingly benign nature of naked put writing, it can be a highly dangerous
strategy for two reasons: (1) Large losses are possible if the underlying stock takes a nasty
foll, and (2) collateral requirements are small, so it is possible to utilize a great deal of lever-
age. It may seem like a good idea to write out-of-the-money puts on "quality" stocks that you
"wouldn't mind owning." However, any stock is subject to a crushing decline. In almost any
year there are serious declines in one or more of the largest stocks in America (IBM in 1991,
Procter and Gamble in 1999, and Xerox in 1999, just to name a few). If one happens to be
short puts on such stocks-and worse yet, if he happens to have overextended himself
because he had the initial margin required to sell a great deal of puts-then he could actu-
ally be wiped out on such a decline. Therefore, do not leverage your account heavily in the
naked put strategy , regardless of the "quality" of the underlying stock
THE COVERED PUT SALE
By definition, a put sale is covered only if the investor also owns a corresponding put with
striking price equal to or greater than the strike of the written put. This is a spread. How-
e\·er,_fcJrmargin pllrposes, one is cocered if he sells a put and is also short the underlying
stock. The margin required is strictly that for the short sale of the stock; there is none
required for the short put. This creates a position with limited profit potential that is
obtained if the underlying stock is anywhere below the striking price of the put at expira-
tion. There is unlimited upside risk since if the underlying stock rises, the short sale of
stock will accrue losses, while the profit from the put sale is limited. This is really a position
equi\·,tlent to a naked call write, except that the covered put writer must pay out the divi-
dend on the nnderlying stock, if one exists. The naked sale of a call also has an advantage
m·er this strategy in that commission costs are considerably smaller. In addition, the time
\·alue premium of a call is generally higher than that of a put, so that the naked call writer
is taking in more time premium. The covered put sale is a little-used strategy that appears
to be inferior to naked call writing. As a result, the strategy is not described more fully.
RATIO PUT WRITING
:-\ ratio put write involves the short sale of the underlying stock plus the sale of 2 puts for
each 100 shares sold short. This strategy has a profit graph exactly like that of a ratio call
\\Titt'. achieving its maximum profit at the striking price of the written options, and hav-
ing large potential losses if the underlying stock should move too far in either direction.
Chapter19:TheSaleof a Put . 287
The ratio call write is a highly superior strategy, however, for the reasons just outlined. The
ratio call writer receives dividends while the ratio put writer would have to pay them out.
In addition, the ratio call writer will generally be taking in larger arnounts of time value
premium, because calls have more time premium than puts do. Therefore, the ratio put
writing strategy is not a viable one .
The Sale of a Straddle
St>lling a straddle inrnln°s selling both a put and a call with the same terms. As with any
t_vpe of option sale, the stradcllt' sale may be Pither covered or uncovered. Both uses are
fairly common. The cm·pred sale of a straddle is very similar to the covered call writing
strateg:· and would gent>rally appeal to the same type of investor. The uncovered straddle
write is u1ore similar to ratio call writing, and is attractive to the more aggressive strategist
who is intert'stt>d in selling large amounts of time premium in hopes of collecting larger
profits if the underlying stock remains fairly stable.
THE COVERED STRADDLE WRITE
In this strategy, one 01rns the underlui11gstock and silllultaneouslu writes a straddle on
thot stock. This may be particularly appealing to investors who are already involved in
covered call writing. In reality, this position is not totally covered-only the sale of the
call is cm·ered by the ownership of the stock. The sale of the put is uncovered. However,
tht' nanw "cm·ered straddle" is generally used for this type of position in order to distin-
guish it from the uncovered straddle write.
Example: XYZ is at .5l and an XYZ January .SOcall is selling for .5points while an XYZ
Januar:· .SOput is selling for 4 points. A cm·ered straddle writt' would be established by
lm: ing 100 sharps of the underlying stock and simulta1wously selling one put and one call.
1
Tlw similarity lwtween this position and a cm·pred call writer's position should be obvious.
Tlit' cm erecl straddle writt' is actually a covered write-long 100 shares of XYZ plus short
rnw call-coupled with a naked put write. Since the naked put write has already been
sl1m,·n to lie equi,·alent to a cm·ered call write, this position is quite silllilar to a 200-share
288
Chapter
20: TheSaleof a Straddle 289
coccrcd call 1critc. In fact_ all tlw profit and loss characteristics of a covered call write are
the same for the cm·ered straddle write. ThtTe is limited upside profit potential and poten-
tially large downside risk
Readers will remember that the sale of a naked put is equiutlent to a covered
call write. Hern.'l\ a covered straddle write can be thought of either as the equivalent
of a 200-slrnre cm·ered call write, or as the sale uf tu;o 1rncoi;,ercdputs. In fact, there
is some merit to the strategy of selling two puts instead of establishing a covered
straddle write. Commission cost would be smaller in that case, and so would the ini-
tial investment required (although the introduction ofleverage is not always a good thing).
The maximum profit is attained if XYZ is anywhere above the striking price of.SO at
expiration. The amount of maxinmm profit in this example is $800: the premium received
from selling the straddle, less the I-point loss on the stock if it is called away at 50. In fact,
the maximum profit potential of a covered straddle write is quickly computed using the
following formula:
Maximum profit = Straddle premium + Striking price - Initial stock price
The break-even point in this example is 46. Note that the covered writing portion of this
example-buying stock at 51 und selling a call for 5 points-has a break-even point of 46. The
naked put portion of the position has a break-even point of 46 as well, since the January 50
put was sold for 4 points. Therefore, the combined position-the covered straddle write-
must have a break-even point of 46. Again, this obsel"\'ation is easily defined by an ec1uation:
.
Brea k-even pnce = Stock price + Strike price - Straddle premium
2
Tab le 20-1 and Figure 20-1 compare the covered straddle write to a 100-share covered
call write of the XYZ January 50 at expiration.
The attractio11far the cocercd rnll 1criter to hec0111ca cocercd straddle u.:ritcr is that
he may be able to increase his return 1citlw11tsubstantially altcri11gthe prtralJl('ters<fhis
cocered call icriting position. Using the prices in Table 20-1, if one had decided to estab-
lish a covered write by buying XYZ at 51 and sc'lling the January .50 call at .S points, he
would have a position with its maximum potential return anywliere above 50 and with a
break-even point of 46. By adding the naked put to his cm·erecl call position, he does not
change the price parameters of his position; he still makes his maximum profit anyv-1hert'
above .50 and lw still has a break-even point of 46. Therefore, lie does not haw to cliangt>
his outlook on the underlying stock in order to become a covered strackllt-•writer.
TABLE 20-1.
Results at expiration of covered straddle write.
Stock (A)100-Share (B)Put Covered
Straddle
Price Covered
Write Write Write
(A+B)
35 -$1,100 -$1, 100 -$2,200
40 600 - 600 - 1,200
46 0 0 0
50 + 400 + 400 + 800
60 + 400 + 400 + 800
FIGURE 20-1.
Covered straddle write.
t-$800
100-Share Covered
Call Write
§ + $400
, , ,~-----------------►
~ ,,
X
a.
UJ , ,,
co
en
,,
en $0
0 50
....J
0
'5
a:
The investment is increasc>d by the addition of the naked put, as are the potential
dollars of profit if the stock is above .SOand the potential dollars ofloss if the stock is below
..J-6at expiration. The covered straddle writer loses money twice as fast 011 the downside,
since his position is sirnilar to a 200-share covered write. Because the commissions are
smaller for tlw nakt>d put write than for the covered call write, the cm·ered call writer who
adds a nakt>clput to his position will genc>rally increase his return somewhat.
Chapter
Follow-up action can he implemented in much the same way it would he for a covered
call write. \Vhenever one would normally roll his call in a covered situation, he now rolls
the entire straddle-rolling down for protection, rolling up for an increase in profit poten-
tiaL and rolling forward when the time \'alue premium of the straddle dissipates. Rolling
up or down would probably inrnlve debits, unless one rolled to a longer maturity.
Some writers might prefer to make a slight adjustment to the covered straddle writ-
ing strategy. Instead of selling the put and call at the same price, they prefer to sell an
out-of-the-money put against the covered call write. That is, if one is buying XYZ at 50
and selling the call, he might then also sell a put at 45. This would increase his upside
profit potential and would allow for the possibility of both options expiring worthless if
XYZ were anywhere between 45 and .50 at expiration. Such action would, of course,
increase the potential dollars of ri~k if XYZ fell below 4.5 by expiration, but the writer
could always roll the call down to obtain additional downside protection.
One final point should be made with regard to this strategy. The covered call writer
who is writing on margin and is fully utilizing his borrowing power for call writing will
have to add additional collateral in order to write covered straddles. This is because the
put write is uncovered. However, the covered call writer who is operating on a cash basis
can switch to the covered straddle writing strategy without putting up additional funds.
He merely needs to move his stock to a margin account and use the collateral value of the
stock he already owns in order to sell the puts necessary to implement the covered strad-
dle writes .
THE UNCOVERED STRADDLE WRITE
In an uncovered straddle write, one sells the straddle tcitlwut owning the underlying
stock. In broad terms, this is a neutral strategy with limited profit potential and large risk
potential. However, the probability of making a profit is generally quite large, and meth-
ods can be implemented to reduce the risks of the strategy .
Since one is selling both a put and a call in this strategy, he is initially taking in large
amounts of time value premium. If the underlying stock is relatively unchanged at expira-
tion, the straddle writer will be able to buy the straddle back for its iutrinsic value, which
would normally leave him with a profit.
XYZ common, 45;

XYZ January 45 put , 3.
A straddle could be sold for 7 points. If the stock were above 38 and below .52 at expira-
tion, the straddle writer would profit, since the in-the-money option could be bought
back for less than 7 points in that case, while the out-of-the-money option expires worth-
less (Table 20-2).
TABLE20-2.
The naked straddle write.
XYZ
Price
at Call Put Total
30 +$ 400 -$1,200 -$800
35 + 400 700 300
38 + 400 400 0
40 + 400 200 + 200
45 + 400 '+ 300 + 700
50 - 100 + 300 + 200
52 - 300 + 300 0
55 - 600 + 300 - 300
60 - 1,100 + 300 - 800
Notice that Figure 20-2 has a shape like a roof. The 11wxi11mmpotential profit point
is at tlic striking price at expiration, and large potential losses exist in either direction if
the 11nderlyingstock s!wuld 11wcctoo far. The reader may recall that the ratio call writing
strategy-buying 100 shares of the underlying stock and selling two calls-has the same
profit graph. These two strategies, the naked straddle write and the ratio call write, are
equivalent. The two strategies do have some differences, of course, as do all equivalent
strategies; but they are similar in that both are highly probabilistic strategies that can be
somewhat complex. In addition, both hm·e large potential risks under adverse market
conditions or if follow-up strategies are not applied.
The im·estment required for a naked straddle is the greater of the requirement
on the call or the put. In general, this means that the margin requirement is equal to
the requirement for the in-the-mone~' option in a simple naked write. This require-
ment is 20o/cof the stock price plus the in-the-money option premium. The straddle writer
should rt!l01c enough collateral so that he rnn take u;hatecer fol/me-up actions he
deems 11eccs.wtry1citlw11tlwci11gto inrnr a margin call. If he is intending to close out the
straddle if the stock should reach the upside break-even point-.52 in the example above-
then lw should allmY enough collateral to finance the position with the stock at .52. If,
Chapter
FIGURE 20-2.
Naked straddle sale.
C
0
~
·a.
X
w
co
(f)
(f)
.3
0
however, he is planning to take other action that might involve staying with the position
if the stock goes to ;3.5or .56, he should allow enough collateral to be able to finance that
action. If the stock never gets that high, he will have excess collateral while the position
is in place .
SELECTING A STRADDLE WRITE
Ideally, one would like to receive a premium for the straddle write that produces a profit range
that is wide in relation to the volatility of the underlying stock In the example above, the profit
range is 38 to .52. This may or may not be extraordinarily wide, depending on the volatility of
XYZ. This is a somewhat subjective measurement, although one could construct a simple
straddle writer's index that ranked straddles based on the following simple formula:
d _ Straddle time value premium

1
n ex - Stock price x Volatility
Refinements would have to be made to such a ranking, such as eliminating cases in which
either the put or the call sells for less than ½ point (or even l point, if a more restrictive
requirement is desired) or cases in which the in-the-money time premium is small.
Furthermore , the index would have to be annualized to be able to compare straddles for
different expiration months. More advanced selection criteria , in the form of an expected
return analysis, will be presented in Chapter 28 on mathematical applications.
More screens can be added to produce a more conservative list of straddle writes.
For example, one might want to ignore any straddles that are not worth at least a fixed
percentage, say 10%, of the underlying stock price. Also, straddles that are too short-term,
such as ones with less than 30 days of life remaining, might be thrown out as well. The
remaining list of straddle writing candidates should be ones that will provide reasonable
returns under favorable conditions, and also should be readily adaptable to some of the
follow-up strategies discussed later. Finally, one would generally like to have some amount
of technical support at or above the lower break -eve n price and some technical resistance
at or below the upper break-even point. Thus, once the computer has generated a list of
stradclles ranked hy an index such as the one listed above, the straddle writer can further
pare down the list by looking at the technical pictures of the underlying stocks.
FOLLOW-UP ACTION
The risks ini;o/r,cd in straddle icriting can be quite large. When market conditions are
fa\·orable, one can make considerable profits, even with restrictive selection require-
ments, and even by allowing considerable extra collateral for adverse stock movements.
However, in an extremely volatile market, especially a bullish one, losses can occur rap-
idly and follow-up action must be taken. Since the time premium of a put tends to shrink
when it goes into-the-money, there is actually slightly less risk to the downside than there
is to the upside. In an extremely bullish market, the time value premiums of call options
will not shrink much at all and might even expand. This may force the straddle writer to
pay excessi\·e amounts of time value premium to buy back the written straddle, especially
if the movement occurs well in advance of expiration.
Th<:'simplest from <ffollmc-up action is to buy the straddle back ichen and if the
1111derlyi11g stock reaches a break-ecen point. The idea behind doing so is to limit the
losses to a small amount, because the straddle should be selling for only slightly more
than its original \·alue when the stock has reached a break-even point. In practice,
there are several flaws in this theory. If the underlying stock arrives at a break-even point
well in ach-ance of expiration, the amount of time value premium remaining in the strad-
dle may be extremely large and the writer will be losing a fairly large amount by repur-
chasing the strncl<lle.Tims, a break-even point at expiration is probably a loss point prior
to expiration.
Example: After the straddle is established with the stock at 4.5, there is a sudden rally in
tht> stock and it climbs quickly to .52. The call might be selling for 9 points, even though
Chapter
it is 7 points in-the-money. This is not unusual in a bullish situation. Moreover, the put
might be worth 1..50points. This is also not unusual, as out-of-the-money puts with a large
amount of time remaining ten<l to hol<ltime value premium very well. Thus, the straddle
writer would have to pay 101/~points to buy back this straddle, even though it is at the
break -even point, 7 points in-the-money on the call side.
This example is included merely to demonstrate that it is a misconception to believe

that one can ahcays buy the straddle back at the break-even point and hold his losses to
mere fractions of a point by doing so. This type of buy-back strategy works best when
there is little time remaining in the straddle. In that case, the options will indeed be close
to parity and the straddle will be able to be bought back for close to its initial value when
the stock reaches the break-even point.
Another follow-up strategy that can be employed, similar to the previous one but
with certain improvements, is to buy back only the in-the-money option u:hen it reaches
a price equal to that of the initial straddle price .
Example: Again using the same situation, suppose that when XYZbegan to climb heavily,
the call was worth 7 points when the stock reached ,50. The in-the-money option-the
call-is now worth an amount equal to the initial straddle value. It could then be bought
back, leaving the out-of-the-money put naked. As long as the stock then remained above
45, the put would expire worthless. In practice, the put could be bought back for a small
fraction after enough time had passed or if the underlying stock continued to climb in
price.
This type of follow-up action does not depend on taking action at a fixed stock price,
but rather is triggered by the option price itself. It is therefore a dynamic sort of follow-up
action, one in which the same action could be applied at various stock prices, depending
on the amount of time remaining until expiration. One of the problems with closing the
straddle at the break-even points is that the break-even point is only a valid break-even
point at expiration. A long time before expiration, this stock price will not represent much
of a break-even point, as was pointed out in the last example. Thus, buying back only the
in-the-money option at a fixed price may often be a superior strategy. The drawback is that
one does not release much collateral by buying back the in-the-money option, an<l he is
therefore stuck in a position with little potential profit for what could amount to a consid-
erable length of time. The collateral released amounts to the in-the-money amount; the
writer still needs to collateralize 20% of the stock price.
One could adjust this follow-up method to attempt to retain some profit. For exam-
ple, he might decide to buy the in-the-money option when it has reached a value that is
1 point less than the total straddle value initially taken in. This would then allow him the
chance to make a 1-point profit overall, if the other option expired worthless. In any case,
there is always the risk that the stock would suddenly reverse direction and cause a loss
on the remaining option as well. This method of follow-up action is akin to the ratio writ-
ing foilow-up strategy of using buy and sell stops on the underlying stock.
Before describing other types of follow-up action that are designed to combat the
problems described above , it might be worthwhile to address the method used in ratio
writing-rolling up or rolling down . In straddle u;riting, there is open little to be gained
_f,-0111
rolling up or rolling do1cn. This is a much more viable strategy in ratio writing; one
does not want to he constantly moving in and out of stock positions, because of the com-
missions involved. Howe\·ei·, with straddle writing, once one position is closed , there is no
need to pursu e a similar straddle in that same stock. It may be more desirable to look
elsewhere for a new stra ddle position.
Th ere are two other very simple forms of follow-up action that one might consider
using, although 1wither one is for most strategists. First, one might consider doing nothing
at all. even if the underlying stock mm·es by a great deal, figuring that the advantage lies
in the probability that the stock will be back near the striking price by the time the
options expire. This action should be used only by the most diversified and well-heeled
investors . for in extreme market periods, almost all stocks may move in unison, generating
tremendous losses for anyone who does not take some sort of action. A more aggressii;e
<ffollou:-up action 1co11ldhe to attempt to "leg out" of the straddle, by buying in the
f!JJJC'
profitable side and then hoping for a stock price reversal in order to buy back the remain-
ing side. In the example above, when XYZ ran up to .52, an aggressive trader would buy
in the put at 1..50, taking his profit, and then hope for the stock to fall hack in order to buy
the call in cheaper. This is a \·ery aggressive type of follow-up action, because the stock
could easily continue to rise in price, thereby generating larger losses. This is a trader's
sort of action, not that of a disciplined strat egist, and it should be avoided.
In essencc,follou:-up action should be designed to do t1co tlzings: First , to limit the
risk in the position, and second, to still allo1c mmnfora potential profit to be made . None
of the above types of follow-up action accomplish both of these purposes. There is, how-
ever, a follow-up strategy that does allow the straddle writer to limit his losses while still
allowing for a potenti al pro fit.
Example: After th e straddle was originally sold for 7 points when the stock was at 45, the
stock experiences a rally and th e following prices exist :
XYZ common, .50;

XYZ January 45 call , 7;
XYZ January 45 put , l ; and
XYZ January 50 call, 3.
Chapter
The January .SOcall price is included because it will he part of the follow-up strategy.
Notice that this straddle has a considerablt> amount of time value premium remaining in
it, and thus would be rather c>xpensiveto huy hack at tlw cmTc>nttime. Suppose, however,
that the straddle writc>rdoes not touch the January 4.5 straddle that he is short, but instead
buys the Januar~· .SOcall for protection to the upside. Since this call costs 3 points, he will
now have a position with a total credit of 4 points. (The straddle was originally sold for
7 points credit and he is now spending 3 points for the call at .SO.)This action of buying a
call at a higher strike than the striking price of the straddle has limited the potential loss
to the upside, no matter how far the stock might run up. If XYZ is anywhere above .SOat
expiration, the put will c>xpireworthless and the writer will have to pay .5 points to close
the call spread-short Januar~· 4,5, long January .50. This means that his maximum poten-
tial loss is 1 point plus commissions if XYZ is anywhere above .50 at expiration.
In addition to being able to limit the upside loss, this type of follow-up action still
allows room for potential profits. If XYZ is anywhere between 41 and 49 at expiration-
that is, less than 4 points away from the striking price of 45-the writer will be able to
buy the straddle back for less than 4 points , thereby making a profit.
Thus, the straddle writer has both limited his potential losses to the upside and also
allowed room for profit potential should the underlying stock fall back in price toward the
original striking price of 4.5. Only severe price reversal, with the stock falling back below
40, would cause a large loss to be taken. In fact, by the time the stock could reverse its
current strong upward momentum and fall all the way back to 40, a significant amount of
time should have passed, thereby allowing the writer to purchase the straddle back with
only a relatively small amount of time premium left in it.
This follow-up strategy has an effect on the margin requirement of the position.
When the calls are bought as protection to the upside, the writer has, for margin pur-
poses, a bearish spread in the calls and an uncovered put. The margin for this position
would normally be less than that required for the straddle that is .Spoints in-the-money.
A secondary move is available in this strategy.
Example: The stock contillues to climb over the short term and the out-of-the-money put
drops to a price of less than .50 cents. The straddle writer might now consider buying back
the put, thereby leaving himself with a bear spread in the calls. His net credit left in the
position, after buying back the put at ..SO,would be 3.,50 points. Thus, ifXYZ should reverse
direction and be within 3.,50 points of the striking price-that is, anywhere below 48 ..50-
at expiration, the position will produce a profit. In fact, if XYZ should be below 4,5 at expira-
tion, the entire bear spread will expire worthless and the strategist will have made a
:3..50-point profit. Finally, this repurchase of the put releases the margill requirement for
the naked put, and will generally free up excess fonds so that a new straddle position can
he established in allother stock while the low-rc><piircme11t bear spread rernains in place.
298 .PartIll:PutOptionStrategies
In summary, this type of follow-up action is broader in purpose than any of the
simpler buy-back strategies described earlier. It will limit the writer's loss, but not prevent
him from making a profit. Moreover, he may be able to release enough margin to be able
to <:'Stablisha nt'w position in another stock by buying in the uncovered puts at a fractional
price. This would prevent him from tying up his money completely while waiting for the
original straddle to reach its expiration date. Tht' same type of strategy also works in a
downward market. If the stock falls after the straddle is written, one can buy the put at
tlw next lower strike to limit the downside risk, while still allowing for profit potential if
the stock rises back to the striking price.
EQUIVALENT STOCK POSITION FOLLOW-UP
Since thert' are so many follow-up strategies that can be used with the short straddle, the
mw rnt'thod that summarizes the situation best is again the equivalent stock position
(ESP). Rt'call that tlw ESP of an option position is the rnultiple of the quantity times the
delta times tlw shares per option. Tht' quantity is a negative number if it is referring to a
short position. Using the abow scenario, an example of the ESP method follows:
Example: As before, assume that the straddle was originally sold for 7 points, but the
stock rallied. The following prices and deltas exist:
XYZ common, 50;

XYZ Jan 45 call, 7; delta , .90;
XYZ Jan 45 put, l ; delta , -.10; and
XYZ Jan 50 call, 3; delta, .60.
Assume that 8 straddles were sold initially and that each option is for l00 shares of XYZ.
The ESP of these 8 short straddles can then be computed:
Option Position Delta ESP

Jan 45 call short 8 0.90 short 720 (-8 x .9 x 100)
Jan 45 put short 8 -0.10 long 80 (-8 X-.1 X 100)
Total ESP short 640 shares
Obviously, the position is quite short. Unlt'ss the trader were extremely bearish on
XYZ, lie should 111akt'an adjustment. Tht' simplest adjustment would he to buy 600 shares
Chapter
of XYZ. Anotlwr possihilit: wo11ldhl' to b11yhack 7 of the short January 4,5 calls. S11cha
purcl1ase mmld add a dl·lta lo11gof 6:30 sl1arcs to t!te position (7 x .~)x 100). This would
lean' the position csscntiall:· lll'lltral. As pointed out in the previous exa111ple,however,
the strategist ma: not \\'ant to l)\\y that option. If, instead, he decided to try to huy the
Januar:· ,5()call to hedge thl' short straddle, he would have to buy 10 of those to make the
position neutral. Ill' \\'ould hm. that niam·. because the delta of that fanuan·. .SOis 0.60; a
~
purchase of 10 would add a delta long of 600 shares to the position.

fa ell though the purchase of 10 is theoretically correct, since one is only short
S straddles. he would prohahl:· lmy 0111:· 8 January .50 calls as a practical matter.
STARTING OUT WITH THE PROTECTION IN PLACE
In certain cases, the straddle writer ma:· be able to initially establish a position that has
110 risk in om' direction: He can bu:· au out-of-the-money put or call at the same time the
straddle is written. Tl1is accomplishes the same purposes as the follow-up action described
in the last few paragraphs, but the protecti\·e option will cost less since it is out-of-the-money
when it is purchased. There are, of course, hoth positive and negative aspects involved in
adding an out-of-the-money long option to the straddle write at the outset.
Example: Given the following prices:
XYZ, 45;
XYZ January 45 straddle, 7; and
XYZ January ,50 call, 1.50,
the upside risk will he limited. If one writes the January 4,5 straddle for 7 points and buys
the Ja11uary .50 call for 1..50points, his overall credit will be ,5..SOpoints. He has no upside
risk in this positio11, for if XYZ should rise and be over 50 at expiration, he will he able to
close the position by buying back the call spread for ,5 points. The put will expire worth-
less. The out-of-the-moHcy call has eliminated any risk aLow .50 on the position. Another
advantage of buying the protection initially is that one is protected if the stock should
experience a gap opening or a trading halt. If he already owns the protection, such stock
price movc111cntin the direction of the protection is oflittle consequence. Hmvever, if he
was planning to buy the protection as a follow-up action, the sudden surge in the stock
price may ruin his strategy.
Tlw m-erall profit potential of this position is smaller tlian that of the normal straddle
write, since tltc prerni11111paid for the long call will he lost if the stock is below .50 at
300 · PartIll:PutOptionStrategies
expiration. I Iowever, the a11tomatic risk-limiting feature of the long call may prove to be
worth rnore than the decrease in profit potential. The strategist has peace of mind in a
rall_vand does not hm·e to worr_vabo11tunlimited losses accruing to the upside.
Downside protection for a straddle writer can be achieved in a similar manner by
buying an out-of-the-money put at the outset.
Example: With XYZ at LJ5,one might write the January 4.5 straddle for 7 and buy a Janu-
ary 40 put for I point if he is concerned about the stock dropping in price.
It sho11ldnow he fairly easy to see that the straddle writer could limit risk in either
direction h~,initially buying hoth an out-of-the-money call and an out-of-the-money put
at the same tirne that the straddle is written. The major benefit in doing this is that risk is
limited in eitl1er dirt>ction. ~lorem·er, tlw margin requirements are significantly reduced,
sinct' the whole position consists of a call spread and a put spread. There are no longer any
nah--d options. Tlw detriment of hu:'ing protection on both sides initially is that commis-
sion costs inc-reast' and the m·erall profit potential of the straddle write is reduced, perhaps
significant I:·, hy the cost of two long options. Therefore, one must evaluate whether the
cost of the protection is too large in comparison to what is received for the straddle write.
This completely protected strateg:· can be very attractive when available, and it is
described again in Chapter 23, Spreads Combining Calls and Puts.
In s11111111ar:·,
an:· strategy in which the straddle writer also decides to buy protec-
tion presents both ach-antages and disadvantages. Obviously, the risk-limiting feature of
the purchased options is an ad\·antage. However, the seller of options does not like to
purchase purt> tirne \·alue premium as protection at any time. He would generally prefer
to lm:· intrinsic rnlue. The reader will note that, in each of the protective buying strate-
gies discussed ahme. the purchased option has a large amount of time value premium
left in it. Therefore. the writer must often try to strike a delicate balance between trying
to limit his risk 011 one hand and trying to hold down the expenses of buying long options
on the other hand. In the final analysis, however, the risk must be limited regardless of
the cost.
STRANGLE (COMBINATION) WRITING
Recall that a strangle is any position involving both puts and calls, when there is some
diffrrencc-- in the terms of the options. Commonly, the puts and calls will have the same
('\:piration dalP lmt dil'fr·ring striking prices. A sf rang/(>1crif(>is 11s11ally established by
si'!li11;!, /)()f /1 r111011t-(ftlie-111011ey 7ntf and an 011t-lftlic-1110ney call u;itli the stock
r11111roxi111otel!J C<'llfi'red lwflcec11 the t1co striking price's. In this way, the naked option
Chapter
writer can re111ain11e11tralon the outlook for the 1111derlyi11g stock ('\·en when the stock is
not near a striking price.
This strateg_',is quite silllilar to straddle writillg, except that tl1cstrangle 1critcr 111akes
JJn!fiturer a 1111,c/1
his 11wxi11111111 1cidcr ra11gethan the straddle 1criter docs. In this or any
other naked writillg strategy, the most m011eythat the strategist can make is the amount of
the premium recein·cl. The straddle writer has only a minute drnnce of rnakillg a profit of
the entire straddle premium, since the stock would have to be exactly at the striking price at
expiration in order for both the written put and call to expire worthless. The strangle writer
will make his maximum profit potential if the stock is anywhere between the two strikes at
expiration, because both options will expire worthless in that case. This strategy is equivalent
to the \·ariable ratio write described previously in Chapter 6 on ratio call writing.
Example: Given the following prices:
XYZ common, 65;

XYZ January 60 put, 3,
a strangle write would be established by selling the January 70 call and the January 60
put. IfXYZ is anywhere between 60 aud 70 at January expiration, both options will expire
worthless and the strangle writer will make a profit of 7 poillts, the amount of the original
credit taken in. If XYZ is abon' 70 at expiration, the strategist will have to pay something
to buy back the call. For example, if XYZ is at 77 at expiration, the January 70 call will
have to be bought back for 7 points, thereby creating a break-even situation. To the down-
side, if XYZ were at .5:1at expiration, the January 60 put would have to be bought back for
7 points, thereby defining that as the downside break-even point. Table 20-3 and Figure
20-3 outline the potential results of this strangle write. The profit range in this example
is quite wide, extending from 5:1 on the downside to 77 on the upside. VVith the stock
presently at 65, this is a relatively neutral position.
At first glance, this may seem to be a more conservative strategy than stra<ldle writ-
ing, because the profit range is wider and the stock needs to move a great deal to reach
the break-even points. In the absence of follow-up action, this is a true observation. How-
ever, if the stock begins to rise quickly or to drop dramatically , the strangle writer often
has little recourse but to huy back the in-the-money option in order to limit his losses. This
can, as has been shown previously, entail a purchase price invoking e\.cess amounts of
time value premium, thereby generating a significant loss.
The only other alternative that is available to the strangle writer (outside of atternpt-
ing to trade out of the position) is to convert the position into a straddle if tlw stock
reaches either break-even point.
TABLE20-3.
Results of a combination write.
Stock
Price
at Coll Put Total
40 +$ 400 ·-$1,700 -$1,300
50 + 400 700 300
53 + 400 - 400 0
57 + 400 0 + 400
60 + 400 + 300 + 700
65 + 400 + 300 + 700
70 + 400 + 300 + 700
73 + 100 + 300 + 400
77 - 300 + 300 0
80 - 600 + 300 300
90 - 1,600 + 300 - 1,300
FIGURE 20-3.
Sale of a combination.
C
~ +$700
·a.
X
w
co
(/)
(/)
$0
0
....J
0
e
0..
Example: If XYZ rost' to ,O,1or in tht' previous t'\amplt>, the January ,0 put would bt>
sold. Depending 011 tl1e amount of collateral m·ailahle, the January GOput may or ma:v not
lw hought hack wlit>n t!tt' J,miiar~, ,() put is sold. This action of connTting the stranglt>
\Hitt' into a straddle writt' will work out wt->11if the stock stabilizes. It will also lessen the
Chapter
20: TheSaleal a Straddle 303
pain if the stock co11tinm's to rise. However, if the stock reverses direction, the January
70 put \nite will pro\·e to he unprofitable. Technical analysis of the underlying stock may
prove to be of sollle help in deciding whether or not to c011vert the strangle write into a
straddle. If there appears to he a relatively large chance that the stock could fall hack in
price , it is probably not worthwhile to roll the put up.
This e:\arnple of a strangle write is one in which the writer received a large amount
of premium for selling the put and the call. Many times, however, an aggressive strangle
writer is telllpted to sell two out-of~the-money options that have only a short life remain-
ing. Thest:' options would generally be sold at fractional prices. This can be an extremely
aggressive strateg)· at times, for if the underlying stock should move quickly in either
direction through a striking price, there is little the strangle writer can do. He must buy
in the options to limit his loss. Nevertheless, this type of strangle writing-selling
short-term, fractionally priced, out-of-the-money options-appeals to many writers. This
is a similar philosophy to that of the naked call writer described in Chapter .5,who writes
calls that are nearly restricted, figuring there will be a large probability that the option
will expire worthless. It also has the same risk: A large price change or gap opening can
cause such devastating losses that many profitable trades are wiped away. Selling fraction-
, ally priced combinations is a poor strategy and should be avoided.
Before leaving the topic of strangle writing, it may be useful to determine how the
margin requirements apply to a strangle write. Recall that the margin requirements for writ-
ing a straddle is 20% of the stock price plus the price of either the put or the call, which-
ever is in-the-money. In a strangle write, however, both options may be out-of-the-money, as
in the example above. \Vhen this is the case, the straddle writer is allowed to deduct the
smaller out-of~the-money amount from his requirement. Thus, if XYZ were at 68 and the
January 60 put and the January 70 call had been written, the collateral requirement would
be 20% of the stock price, plus the call premium, less $200-the lesser out-of-the-money
amount. The call is 2 points out-of-the-money and the put is 8 points out-of-the-money. Actu-
ally, the true collateral requirement for any write involving both puts and calls-straddle
write or strangle write-is the greater lf the requirement on the put or the call, plus the
ammmt by u;hic/1the other option is i11-tl1e-nwney.The last phrase, the amount by which
the other option is in-the-money, applies to a situation in which a strangle had been con-
structed by selling two in-the-money options. This is a less popular strategy, since the writer
generally receives less time value premium by writing two in-the-money options. An example
of an in-the-money strangle is to sell the January 60 call and the January 70 put with the
stock at 6.5.
304 PartIll: Put OptionStrategies
FURTHER COMM ENTS ON UNCOVERED STRADDLE

AND STRANGLE WR ITING
When ratio writing was discussed, it was noted that it was a strategy with a high probability
of making a limited profit. Since the straddle write is equivalent to the ratio write and the
strangle write is equivalent to the variable ratio write, the same statement applies to these
strategit's. The practitioner of straddle and strangle writing must realize, however, that
protective follow-up action is mandatory in limiting losses in a very volatile market. There
are other techniques that the straddle writer can sometimes use to help reduce his risk.
It has often been mentioned that puts lose their time value premium more quickly
when they become in-the-money options than calls do. One can often construct a neutral
position by u.:riting an extra put or tu.:o.That is, if one sells ,5 or 6 puts and 4 calls with
the same terms, he may often have created a more neutral position than a stradd le write.
If the stock moves up and the call picks up time premium in a bullish market, the extra
puts will help to offset the negative effec t of the calls. On the other hand, if the stock
drops, the .5or 6 puts will not hold as much time premium as the 4 calls are losing-again
a neutral, standoff position. If the stock begins to drop too much, the writer can always
balance out the position by selling another call or two. The advantage of writing an extra
put or two is that it coun terbalances the straddle writer's most severe enemy: a quick,
extremely bullish rise by the underlying stock.
USING THE DELTAS
This analysis. that adding an extra short put creates a neutral position, can be substanti-
ated more rigorously. Recall that a ratio wr iter or ratio spreader can use the deltas of the
options inrnh-ed in his position to determine a neutral ratio. The straddle writer can do
the same thing, of course. It was stated that the difference between a call's delta and a
put's delta is approximately one. Using the same prices as in the previous straddle writing
example, and assuming the call's delta to be .60, a neutral ratio can be determined.
Prices Deltas
XYZ common: 45
XYZJanuary45 call: 4 .60
XYZJanuary45 put: 3 - .40 (.60 - l)
The put has a negati\·e delta, to indicate that the put and the underlying stock are inversely
relakcl. A nt'11tral ratio is determined by dividing the call 's delta by the put's delta and
Chapter
ignoring the minus sign. The resultant rntio-1..5:l (.60/.40) in this case-is the ratio of
puts to sell for each call that is sold. Tims, mw should sell 3 puts and sell 2 calls to estab-
lish a neutral position. Tlte reader 1rn1)· wonder if the assumption that an at-the-money
call has a delta of .60 is a fair one. It generally is, although very long-term calls will have
higher
, at-the-monev. deltas, and \'erv. short-term calls will have deltas near }50. Conse-
quentl)·, a :3:2ratio is often a neutral one. \Vhen neutral ratios were discussed with respect
to ratio writing, it was mentioned that selling 5 calls and buying 300 shares of stock often
results in neutral ratio. Tlte reader should notf' that a straddle constructed by selling 3
puts and 2 calls is equirnlent to the ratio write in which one sells 5 calls and buys 300
shares of stock.
If a straddle writer is going to use the deltas to determine his neutral ratio, he should
compute each one at the time of bis initial investment, of course, rather than relying on a
generality such as that 3 puts and 2 calls often result in a neutral position. The deltas can
be used as a follow-up action, by adjusting the ratio to remain neutral after a move by the
underlying stock.
AVOID EXCESS TRADING
In any of the straddle and strangle writing strategies described above, too much follow-up
action can be detrimental because of the commission costs involved. Thus, although it is
important to take protective action, the straddle writer should plan in advance to make
the minimum number of strategic moves to protect himself. That is why buying protec-
tion is often useful; not only does it limit the risk in the direction that the stock is moving,
but it also involves only one additional option cornmission. In fact, if it is feasible, buying
protection at the outset is often a better strategy than protecting as a secondary action.
An extension of this concept of trying to avoid too much follow-up action is that the
strategist should not attempt to anticipate m01;en1ent in an underlying stock. For exam-
ple, if the straddle writer has planned to take defensive action should the stock reach 50,
he should not anticipate bytaking action with the stock at 48 or 49. It is possible that the
stock could retreat back clown; then the writer would have taken a defensive action that
not only cost him corn missions, but reduced his profit potential. Of course, there is a little
trader in everyone, and the temptation to anticipate (or to wait too long) is always there.
Unless there are very strong technical reasons for doing so, the strategist should resist the
temptation to trade, and should operate his strategy according to his original plan. The
ratio writer may actually have an advantage in this respect, because he can use buy and
sell stops on the underlying stock to remove the emotion from his follow-up strategy. This
technique was described in Chapter 6 on ratio call vvriting. Unfortunately, no such emo-
tionless technique exists for the straddle or strangle writ er.
USING THE CREDITS
In previous chapters, it was mentioned that the sale of uncovered options does not require
any cash investment on the part of the strategist. He may use the collateral value of his
present portfolio to finance the sale of naked options. Moreover, once he sells the uncov-
ered options, he can take the premium dollars that he has brought in from the sales to buy
fixed-income securities, such as Treasury bills. The same statements naturally apply to
the straddle writing and strangle writing strategies. However, the strategist should not be
overly ohsessed with continuing to maintain a credit balance in his positions, nor should
he strive to hold onto the Treasury bills at all costs. If one's follow-up actions dictate that
he must take a debit to avoid losses or that he should sell out his Treasury bills to keep a
credit, he should by all means do so.
Synthetic Stock Positions
Created by Puts and Calls
It is possible for a strategist to establish a position that is essentially the same as a stock
position, and he can do this using 011lyoptions. The option position generally requires a
smaller margin im·estment and may have other residual benefits over simply buying stock
or selling stock short. In brief, the strategies are summarized by:
1. Buy call and sell put instead of buying stock.

2. Buy put and sell call instead of selling stock short.
SYNTHETIC LONG STOCK
\ Vhen one hnys a call ancl sells a put at the same strike, he sets up a position that is
equivalent to owning the stock. His position is sometimes called "synthetic'' long
stock.
Example: To verifi, that this option position acts nmch like a long stock position would,
suppose that the following prices exist:
XYZ common, ,50;

307
If one were bullish on XYZ and wanted to buy stock at 50, he might consider the alterna-
tive strategy oflmying the January 50 call and selling (uncovered) the January ,50 put. By
using the option strateg: 1,, the im·estor has nearly the same profit and loss potential as the
stock buyer, as shown in Table 21-1. The two right-hand columns of the table compare the
results of the option strategy with the results that would be obtained by merely owning
the stock at 50.
The table shows that tlw reslilt of the option strategy is exactly $100 less than the
stock results for any price at expiration. Thus, the ·'synthetic" long stock and the actual
long stock hm·e nearl:', the sanw profit and loss potentials. The reason there is a difference
in tl w results of the two equi\·alent positions lies in the fact that the option strategist had
to pay 1 point of time premium in order to set up his position. That $100 represents the
carrying cost of the stock and the dividends to be paid, so in effect, this is exactly the same
as m,·ning stock frnlll that point of ,·iew (the complete relationship between stock owner-
ship and "synthetic stock" is explained as conwrsion arbitrage in Chapter 27). This time
pwnli11m represents the ~100 h:· which the "s:·nthetic" position unclerperfonns the actual
stock position at expiration. Note that, with XYZ at 50, both the put and the call are
cornplckl:· co111posedof time value prellliurn initially. The synthetic position consists of
pa_'·ing out .5 points of time premium for the call and recei,·ing in 4 points of time pre-
mium for the put. The net time premium is thus a I-point payout.
The reason one would consider using the synthetic long stock position rather than
the stock position itself is that the synthetic position may require a much smaller invest-
ment than hu_'ing the stock would require. The purchase of the stock requires $5,000 in
1
a cash account or 82,,500 in a margin account (if the margin rate is ,50%). However, the
s:·nthetic position requires only a $100 debit plus a collateral requirement-20% of the
stock price, plus the put premium, minus the difference between the striking price and
tht' stock price. The balance, im·ested in short-term funds, would earn enough money,
TABLE 21-1.
Synthetic long stock position.
XYZPrice
at January
50 January
50 Total
Option Long
Stock
Expiration CallResult PutResult Result Result
40 -$500 -$600 -$1,100 -$1,000
45 - 500 - 100 600 500
50 - 500 + 400 100 0
55 0 + 400 + 400 + 500
60 + 500 + 400 + 900 + 1,000
Chapter
21: Synthetic
StockPositions
Createdby PutsandCalls 309
theoreticall:·, to offset the $100 paid for the synthetic position. In this example, the col-
lateral requirement would be 201¼of $,5,000, or $1,000, plus the $400 put premiu111,plus
the $100 debit incurred b_\'pa_\'ing.Sfor the call and only receiving 4 for the put. This is a
total of~] ,.SOOinitiall:·· There is no initial clifft>rence between the stock price and the
striking price. Of course, this collatPral requirt'ment would increase if the stock fell in
price, and would dPcrease if the stock rose in price, since there is a naked put. Also notice
that buying stock creatt's a $.S,000 dt>bit in the account, vvhereas the option strategy's debit
is $100; the rest is a collateral requirement , not a cash requirement.
The effect of this reduction in margin required is that some le,·erage is obtained in
the position. If XYZ rose to 60, the stock position profit would be $l,OOOfor a return of
40% on margin ($1,000/$2,.SOO).With the option strategy, the percentage return would
be higher. The profit would he $900 and the return thus 60% ($900/$1,.500). Of course,
le,·erage works to the downside as well, so that the percent risk is also greater in the option
strategy.
The s:·nthetic stock strategy is generally not applied merely as an alternative to buy-
ing stock. Besides possibly having a smaller profit potential, the option strategist does not
collect dicidends, u;/iereas the stock 01c11t:>r docs. However, the strategist is able to earn
interest on the funds that he did not spend for stock ownership. It is important for the
strategist to understand that a long call plus a short put is equivalent to long stock. It thus
may he possible for the strategist to substitute the synthetic option position in certain
option strategies that normally call for the purchase of stock.
SYNTHETIC SHORT SALE
A position that is eq11iwle11t to the short sale cf the underlying stock can he established
by selling a rnll and simultaneously huyi11g a put. This alternative option strategy, in
general, offers significant benefits when compared with selling the stock short. Using the
prices above-XYZ at .SO,January ,50 call at .5, and January .50 put at 4-Table 21-2
depicts the potential profits and losses at January expiration.
Both the option position and the short stock position have similar results: large
potential profits if the stock declines and unlimited losses if the underlying stock rises in
price. However, the option strategy does better than the stock position, because the option
strategist is getting the benefit of the time value premium. Again, this is because the call
has more time value prt>mium than the put, which works to the option strategist's ad,,an-
tage in this case, when he is selling the call and buying the put.
Two important factors make the option strategy preferable to tlw short sale of stock:
(1) There is no need to borrow stock, and (2) there is no need for an 11ptick. \ Vhen one
sells stock short, he 11111st
first borrow the stock from someone wlio owns it. This prm·t>durc
310 _ PartIll:PutOptionStrategies
TABLE 21-2.
Synthetic short sale position.
XYZPrice
at January
50 January
50 Total
Option Short
Stock
Expiration CallResult PutResult Result Result
40 +$500 +$600 +$1,100 +$1,000
45 + 500 + 100 + 600 + 500
50 + 500 - 400 + 100 0
55 0 - 400 - 400 500
60 - 500 - 400 - 900 - 1,000
is handled hy one's brokerage firm's stock loan department. If, for some reason, no one
who owns tlw stock wants to loan it out, then a short sale cannot be executed. In addition,
both tl1e NYSE and NASDAQ require that a stock being sold short must be sold on an
uptick. That is, the price of the short sale must he higher than the previous sale. This rule
was introduced (for tlw NYSE) years ago in order to prevent traders from slamming the
market down in a "bear raid."
\Vith the option "synthetic short sale" strategy, however, one does not have to
worry about either of these factors. First, calls can be sold short at will; there is no need
to borrow an:·thing. Also, calls can be sold short (ancl puts bought) even though the under-
1:·ing stock might be trading 011 a minus tick (a downtick). Many professional traders
use the "synthetic short sale" strategy because it allows them to get equivalently short
the stock in a \·en·. tirneh-. manner. If one wants to short stock and if he has not
pre\·iousl:· arranged to borrow it, then some time is wasted while one's broker checks
with the stock loan department in order to make sure that the stock can indeed be
borrowed.
There is a caveat, however. If one sells calls on a stock that cannot be borrowed, then
he must be sure to anJid assignment. For if one is assigned a call, then he too will be short
the stock. If the stock cannot be borrowed, the broker will buy him in. Tims, in situations
in which the stock might be difficult to borrow, one should use a striking price such that
the call is out-of-the-money when sold initially. This will decrease, but not eliminate, the
possibility of early assignment.
Le\·erage is a factor in this strategy also. The short seller would need $2,.500 to col-
lateralize this position. assuming that the margin rate is .50%. The option strategist ini-
tial!:· only needs 20% of the stock price, plus the call price, less the credit received, for a
SI .-1-00 rt'q11irernent. Moreon'r, one of the major disath-antages that was mentioned
\\'ith the s:·nthetic long stock position is not a disadrnntage in the s:·nthetic short sale
Chapter
21: Synthetic
StockPo.sitions
strateg:·: The option trader d(ws not hm,e to pay out dividents on the options, but the short
seller of stock must.
Becamt' of tht' adrnntages of the option position in not having to pay out the divi-
dend and also ha\·ing a slightl:· larger profit potential from the excess time value premium,
it ma:· often be feasible for the trader who is looking to sell stock short to instead sell a call
and buy a put. It is also important for the strategist to understand the equivalence between
the short stock position and the option position. He might be able to substitute the option
position in cer tain cases whe n th e short sale of stock is normall y called for.
SPLITTING THE STRIKES
The strategist may he ahle to use a slight variation of the synthetic strategy to set up an
aggressi\·e, but attracti\·e, position. Rather than using the same striking price for the put
and call, he can use a lower striking price for the put and a higher striking price for the
call. This action of splitting apart the striking prices gives him some room for error, while
still retaining the pot enti al for large profit s.
BULLISHLYORIENTED
If an out-of-the-money put is sold naked, and an out-of-the-money call is simultaneously

purchased, an aggressive bullish position is established-often for a credit. This position
is sometimes called a split-strike conversion, even though it doesn't contain a position in
the underlying stock. If the underlying stock rises far enough, profits can be generated on
both the long call and the short put. If the stock remains relatively unchanged, the call
purchase will he a loss, !mt the put sale will be a profit. The risk occurs if the underlying
stock drops in price, producing losses on both the short put and the long call.
Example: The following prices exist: XYZ is at 5:3, a January 50 put is selling for 2, and a
January 60 call is selling for l. An investor who is lmllish on XYZ sells the January 50 put
naked and simultaneously buys the January 60 call. This position brings in a credit of l
point, less commissions. There is a collateral requirement necessary for the naked put. If
XYZ is anywhere between 50 and 60 at January expiration, both options would expire
worthless, and the investor would make a small profit equal to the amount of the initial
credit received. If XYZ rallies above 60 by expiration, however, his potential profits
are unlimited, since he owns the call at 60. His losses could be very large if XYZ
should decline well below ,50 before expiration, since he has written the naked put at .SO.
Table 21-:3 and Figure 21-1 depict the results at expiration of this strategy.
312 _ PartIll:PutOptionStrategies
TABLE 21-3.
Bullishly split strikes.
XYZ
Price
at January
50 January
60 Total
Expiration PutProfit Call
Profit Profit
40 -$800 -$100 -$900
45 300 100 400
50 + 200 - 100 + 100
55 + 200 - 100 + 100
60 + 200 - 100 + 100
65 + 200 + 400 + 600
70 + 200 + 900 + 1,100
FIGURE 21-1.
Bullishly split strikes.
C
0
:;:;
~
·a.
X
w -,-$100
nl
~ $0 1---------------'------------'60'--------
....J
0
~
ct
Essentially, the investor who uses this strategy is bullish on the underlying stock and
is attempting to buy an out-of-the-money call for free. If he is moderately wrong and the
underlying stock rallies only slightly or even declines slightly, he can still make a small
profit. If he is correct, of course, large profits could be generated in a rally. He may lose
hecJYil_vif he is very wrong and the stock falls by a large amount instead of rising.
This strategy is often useful when options are overpriced. Suppose that one has a
lmllisl1 opinion 011 the underlying stock, yet is dismayed to find that the calls are quite
Pxpe11sin_'.If ht> buys one of these expensive calls, he can mitigate the expensiveness
Chapter21: SyntheticStockPositionsCreatedby PutsandCalls 313
sonH:'what b:· also selling an out-of~tlw-rn011cyput which is presumably somewhat expen-

sin' also. Thus, if he is right about the bullish attitude on the stock, he owns a call that is
more "fairly priced" because its cost was reduced by the amount of the put sale.
BEARISHLY ORIENTED
There is a companion strategy for the inwstor who is bearish on a stock. He could attempt
to huy an out-of the-money put, gi\·ing himself the opportunity for substantial profits in a
stock price decline, and could "finance" the purchase of the put by writing an
out-of~the-rnone:· call naked. The sale of the call would provide profits if the stock sta:·ed
below the striking price of the call, but could cost him heavily if the underlying stock ral-
lies too far. This strategy is also called a split-strike reversal.
Example: \\'ith XYZ at 6.5, tlw bearish investor buys a February 60 put for 2 points, and
sirnultaneousl:· sells a February 70 call for 3 points. These trades bring in a credit of
1 point, less commissions. The investor must collateralize the sale of the call. If XYZ
should decline substantially by February expiration, large profits are possible because the
February 60 put is owned. Even if XYZ does not perform as expected, but still ends up
anywhere between GOand 70 at expiration, the profit will be equal to the initial credit
because both options will expire worthless. However, if the stock rallies above 70, unlim-
ited losses arc possible because there is a naked call at 70. Table 21-4 and Figure 21-2
show the results of this strategy at expiration.
This is clearly an aggressively bearish strategy. The investor would like to own an
out-of-the-money put for downside potential. In addition, he sells an out-of-the-money
TABLE 21-4.
Bearishly split strikes.
XYZPrice
at February
60 February
70 Total
Expiration PutProfit CallProfit Profit
50 +$800 +$300 +$1,100
55 + 300 + 300 + 600
60 - 200 + 300 + 100
65 - 200 + 300 + 100
70 - 200 + 300 + 100
75 - 200 - 200 - 400
80 - 200 - 700 - 900
FIGURE 21-2.
Bearishly split strikes.
C
0
~
·5.
X
w
ni +$100
~
~ $0 1-----------'------_.__--- ____ _
0 60
....I
0
2a..
call, normally for a price greater than that of the purchased put. The call sale essentially
lets him own the put for free. In fact, he can still make profits even if the underlying stock
rises slightly or only falls slightly. His risk is realized if the stock rises above the striking
price of the written call.
This strategy of splitting the strikes in a bearish manner is used very frequently in
conjunction with the ownership of common stock. That is, a stock owner who is looking
to protect his stock will buy an out-of-the-money put and sell an out-of-the-money call to
finance the put purchase. This strategy is called a "protective collar" and was discussed
in more detail in the chapter on Put Buying in Conjunction with Common Stock Owner-
ship. A strategy that is similar to these, but modifies the risk, is presented in Chapter 23,
Spreads Combining Calls and Puts.
SUMMARY
In either of these aggressive strategies, tlze incestor 11111st

!wee a definite opillio11about
tlic f11t11rcprice nwcc111ent1f the undcrluing stock. He buys an out-of-the-money option
to pro\·ide profit potential for that stock movement. However, an investor can lose the
entire purchase proceeds of an out-of-the-money option if the stock does not perform as
expected. An aggressive i1ffestor, who has sufficient collateral, might attempt to eounter-
act this effPct hy also writing an out-of-the-money option to cover the cost of the option
that he hought. Then, he will not only make money if the stock performs as expected, but
Chapter
21:Synthetic
StockPositions
he will also make money if the stock remains relatively unchanged. He will lose quite
heavily , however, if the underlying stock goes in the opposite direction from his original
anticipation. That is why he rnust have a definite opinion on the stock and also he fairly
certain of his timing .
Basic Put Spreads
Put spreading strategies do not differ substantially in theory from their accompanying call
spread strategies. Both bullish aud bearish positions can be constructed with put spreads,
as was also the case with call sprt>a<ls.However, because puts are more oriented toward
downward stock movement than calls are, some bearish put spread strategies are superior
to their equivalent bearish call spread strategies.
The three simplest forms of option spreads are:
1. the bull spread,

2. the bear spread, and
3. the calendar spread.
The same types of spreads that were constructed with calls can be established vvith puts,
but there are some differences.
B-eARSP EAO
In a call bear spread, a call with a lower striking price was sold while a call at a higher
striking price>\Vas bought. Similarly, a put bear spread is establislzed by selling a put at
a lower strike while buying a put at a higher strike. The put bear spread is a debit
spread. This is true because a put with a higher striking price will sell for niore than a put
with a lower striking price. Thus, 011 a stock with both puts and calls trading, one could
set np a hear spread for a credit (using calls) or altcrnati'v·ely set one up fm a debit (using
put s):
316
Chapter 22:BasicPutSpreads. 317
PutBear
Spread CallBear
Spread
Buy XYZJanuary 60 put BuyXYZJanuary60 call
Sell XYZJanuary 50 put Sell XYZJanuary50 call
(debit spread) (creditspread)
The put bear spread has the same sort of profit potential as the call hear spread.
There is a limited maximum potential profit, and this profit wonld he realize<l if XYZ were
below the lower striking price at expiration. The put spread would widen, in this case, to
equal the difference between the striking prices. The maximum risk is also limited, and
would be realized if XYZ were anywhere above the higher striking price at expiration.
Example: Th e following pric es exist:
XYZ common, 55;

XYZ Janua ry 50 put , 2; and
XYZ Janua ry 60 put , 7.
Buying the January 60 put and selling the January ,50 would establish a hear
spread for a r5-point dehit. Tahle 22-1 will help verify that this is indeed a bearish posi-
tion. The reader will note that Figure 22-1 has the same shape as the call hear spread's
graph (Figure H-1). The investment rec1uired for this spread is the net debit, and it
must be paid in full. l'\otice that the nwxinuun profit potential is reali::.edaw_Ju ..:here
belou; 50 at expiration, and the maximurn risk potential is reali::.edanyu;here aboi;e 60
at expiratio11.The maximum risk is always equal to the initial debit required to establish
the spread plus commissions. The break-even point is .S.Sin this example. The following
formulae allow one to quickly compute the meaningful statistics regarding a put
bear spread.
Maximum risk = Initial debit

Maximum profit = Difference between strikes - Initial debit
Break-even price = Higher striking price - Initial debit
Put bear spreads have an advantage over call hear spreads. With puts, one is selling
an out-of-the-money options when setting up the spread. Thus, one is not risking early
exercise of his tcritten option before the spread hecoJ11esJJro_fitahlc.For the written put
to be in-the-money, and thus in clanger of being exercised, the spread would have to he
profitable, because the stock would have to he helow the lower striking price. Such is not
the case with call hear spreads. In the call spr<::'ad,one sells an i11-tlw-n~orn_.y
call as part
TABLE 22-1.
Put bear spread.
XYZPrice
at January
50 January
60 Total
Expiration PutProfit PutProfit Profit
40 -$800 · +$1,300 +$500
45 300 + 800 + 500
50 + 200 + 300 + 500
55 + 200 - 200 0
60 + 200 - 700 - 500
70 + 200 - 700 - 500
80 + 200 700 - 500
FIGURE 22-1.
Put bear spread.
+$500
C
0
~
·a.
><
UJ
(Tj
CJ)
CJ)
$0
0
_J
0
ea...
-$500
of the bear spread, and thus could be at risk of early exercise before the spread has a
chance to become profitable.
Beside this difference in the probability of early exercise, the put bear spread
holds another advantage over the call bear spread. In the put spread, if the underlying stock
drops quickly, thereby making both options in-the-nwney, the spread icill normally 1cide11
</llicklyas u:cl!. This is because, as has been mentioned previously, put options tend to lose
tinw \·alue premium rather quickly when they go into-the-money. In the example ahm e, if
XYZ rapidly dropped to 48, the January 60 put would be near 12, retaining very little time
Chapter
22:BasicPutSpreads. 319
premium. Howt'n'r, the Januar)· .SOput that is short would also not rt>tain much time value
prt'mimn, perhaps selling at 4 points or so. Thus, the spread would have widened to
8 points. Call ht'ar spreads often do not product' a similar result on a short-term downward
rnm·ement. Since tht' call spread inrnkes being short a call with a lower striking price, this
call 111cl)' actuall)' pick np tinw value premium as the stock falls close to the lower strike.
Thus, t'\'en though the call spread rnight have a similar profit at expiration, it often will not
perform as well on a quick downward movement.
For these two reasons-less chance of early exercise and better profits on a short-term
rnovement-tht> put hear spread is superior to the call bear spread. Some investors still
prt'ft'r to use the call spread, since it is t'Stablished for a credit and thus does not require
a cash im,estment. This is a rather wt'ak reason to avoid the superior put spread an<l should
not he an O\'eJTiding consideration. Note that the margin requirement for a call bear
spread will result in a reduction of one's buying power by an amount approximately equal
to the debit re(1uirt>d for a similar put hear spread. (The margin required for a call bear
spread is the difference between the striking prices less the credit received from the
spread.) Thus, the onl:' accounts that gain any substantial advantage from a credit spread
art' those that are near the minimum equity requirement to begin with. For most broker-
age firms, the minimum equity requirement for spreads is $2,000.
BULL SPREAD
A hull spread can he established icith put options by buying a put at a loicer striking price
and sinwlta11eo11slyselling a put icith a higher striking price. This, again, is the same way a
bull spread was constructed with calls: selling the higher strike and buying the lower strike.
Example: The same prices can be used:
XYZ common, 55;

XYZ January 50 put, 2; and
The bull spread is constructed by buying the January .SOput and selling the January
60 put. This is a credit spread. The credit is .Spoints in this example. If the underlying
stock advanct>s by January expiration and is anywhere above 60 at that time, the maximum
profit potential of the spread will be realized. In that case, with XYZ anywhere above 60,
both puts would expirt' worthless and the spreader would make a profit of the entire
crt'clit - .5points in this exarnplt>. Thus, the nurximum 7Jrofitpotential is lilllitcd, and the
11wxim1t111 7Jrofit occurs if the underlying stock rises i11price abo1.A'the higher strike.
These are the same qualities that were displayed by a call bull spread (Chapter 7). The
name "bull spread" is derived from the fact that this is a bullish position: The strategist
wants the underlying stock to rise in price .
The risk is limited in this spread. If the underlying stock should decline b:· expira-
tion, the maximum loss will be realized with XYZ anywhere below 50 at that time. The
risk is 5 points in this example. To see this, note that if XYZ were anywhere below 50 at
expiration, the differential between the two puts would widen to 10 points, since that is
the difference between their striking prices. Tims, the spreader would hm·e to pa:·
10 points to buy tlw spread back or to close out the position. Since he initiall:· took iu a
.S-point credit this means his loss is equal to 5 points-the 10-point cost of closing out
less the 5 points he received initially .
The investment required for a lmllish put spread is actually a collateral requirement
since the spread is a credit spread. The amount of collateral required is equal to the dif-
ference between the striking prices less the net credit received for the spread. In this
example, the collateral requirement is $.500-the $1,000, or 10-point, differential in the
striking prices less the $500 credit received from the spread. Note that the nwxi11111111
possible loss is alu:nus equnl to the collnteml rcq11ircm('J1tinn b11llishput sprcnd.
It is not difficult to calculate the break-even point in a bullish spread. In this exam-
ple, the break-e\·en point before commissions is .S.Sat expiration. \\"ith XYZ at .5,5in Janu-
ary, the January ,50 put would expire worthless and the January GOput would have to be
bought back for ,5 points. It would be ,5 points in-the-money with XYZ at 55. Thus, the
spreader would break e\·en, since he originally received ,5points credit for the spread and
would then pay out .5 points to close the spread. The following formulae allow one to
quickly compute the details of a bullish put spread:
Maximum potential risk = Initial collateral requirement

= Difference in striking prices - Net credit received
Maximum potential profit= Net credit
Break-even price= Higher striking price - Net credit
CALENDAR SPREAD
In a calendar spread, a near-term option is sold and a longer-term option is bought both
with the same striking price. This definition applies to either a put or a call calendar
spread. In Chapter 9, it was shown that there were two philosophies arnilablt' for call
calendar sprt'acls. either neutral or bullish. Similarly, there are two philosophit's m·ailable
for put calendar spreads: neutral or bearish.
Chapter
22:BasicPutSpreads 321
In a neutral calendar spread, one sets up the spread with the idea of closing the
spread when the 1war-krm call or put expirt>s. In this type of spread, the maximum profit
will he realized if the stock is exactl:· at tht> striking price at expiration. Tht> spreader is
merel:· atkmpting to capitalize 011the fact that the time value premium disappears more
rapidly from a near-term option than it does from a longer-term one.
Example: XYZ is at 50 and a January .50 put is selling for 2 points while an April .50 put
is selling for 3 points. A neutral calt>ndar spread can lw established for a 1-point debit by
selling the Jam1ar:' ,50 put and buying the April 50 put. The investment required for this
position is the amount of the nt>tdebit, and it must be paid for in full. IfXYZ is exactly at
,50 at Januar:· expiration, the January 50 put will expire worthless and the April 50 put will
he worth about 2 points, assuming other factors are the same. The neutral spreader would
then sell the April .50 put for 2 points and take his profit. The spreader's profit in this case
would be one point before commissions, because he originally paid a I-point debit to set
up the spread ancl then liquidates the position hy selling the April ,50 put for 2 points.
Since commission costs can cut into available profits substantially, spreads should be
established in a large enough quantity to minimize the percentage cost of commissions.
This means that at least 10 spreads should be set up initially.
In any type of calendar spread, tlie risk is limited to the amount of the net debit. This
maximum loss would he realized if the underlying stock mm·ed substantially far away
from the striking price by tlw time the near-term option expired. If this happened, both
options would trade at nearly the same price and tht> differential would shrink to practi-
cally nothing, the worst case for the calendar spreader. For example, if the underlying
stock drops substantially, say to 20, both the near-term and the long-term put would trade
at nearly 30 points. On the other hand, if the underlying stock rose substantially, say to
80, both puts would trade at a very low price, say 1/ic;or 1/\,and again the spread would
shrink to nearly zero.
Neutral call calendar spreads are ge11erallysuperior to neutral put calendar spreads.
Since the amount of time value premium is usually greater in a call option (unless the
underlying stock pays a large dividend), the spreader who is interested in selling time
value would be better off utilizing call options.
The second philosophy of calendar spreading is a more aggressive one. With put
options, a bearish strategy can he constructed using a cale11dar spread. In this case, one
would establish the spread with out-of-the-money puts.
Example: With XYZ at 5.5, one would sell the January ,50 put for 1 point and huy the April
,50 put for 1..50. He would then like the underlying stock to remain above tht> striking
price until tlie near-tt>rn1 January put expires. If this happens, he would malw tlit> I-point
profit from the sale of that put, reducing his net cost for the April 50 put to ,50 cents. Then,
he would become bearish, hoping for the underlying stock to decline in price substantially
before April expiration in order that he might be able to generate large profits on the April
50 put he holds.
Just as the bullish calendar spread with calls can be a relatively attractive strategy,
so can the bearish calendar spread with puts. Granted, two criteria have to be fulfilled in
order for the position to work to the optimum: The near-term put must expire worthless,
and then the underlying stock must drop in order to generate profits on the long side.
Although these conditions may not occur frequently, one profitable situation can more
than make up for several losing ones. This is true because the initial debit for a bearish
calendar spread is small, ,50 cents in the example above. Thus, the losses will be small and
the potential profits could be very large if things work out right.
The aggressive spreader must be careful not to "leg out" of his spread, since he could
generate a large loss by doing so. The object of the strategy is to accept a rather large
number of small losses, with the idea that the infrequent large profits will more than offset
the sum of the losses. If one generates a large loss somewhere along the way, this may
ruin the overall strategy. Also, if the underlying stock should fall to the striking price
before the near-term put expires, the spread will normally have widened enough to pro-
duce a small profit; that profit should be taken by closing the spread at that time.
Spreads Combining
Calls and Puts
Certain types of spreads can be constructed that utilize both puts and calls. One of
these strategies has been discussed before: the butterfly spread. However, other
strategies exist that offer potentially large profits to the spreader. These other strate-
gies are all variations of calendar spreads and/or straddles that involve both put and
call options .
THE BUTTERFLY SPREAD
This strategy has been described previously, although its usage in Chapter 10 was
restricted to constructing the spread with calls. Recall that the butterfly spread is a neu-
tral position that has limited risk as well as limited profits. The position involves three
striking prices, utilizing a bull spread between the lower two strikes and a bear spread
between the higher two strikes. The maximum profit is realized at the middle strike at
expiration, and the maximum loss is realized if the stock is above the higher strike or
below the lower strike at expiration.
Since either a bull spread or a bear spread can be constructed with puts or calls, it
should be obvious that a butterfly spread (consisting of both a bull spread and a bear
spread) can be constructed in a number of ways. In fact, there are four ways in which the
spread can be established. If option prices are fairly balanced-that is, the arbitrageurs
are keeping prices in line-any of the four ways will have the same potential profits and
323
losses at e\piratio11 of the options. Howe\"f'L because of the ,rn:·s in" hich puts and calls
behm e prior to their e.\piration. certain acl, ant ages or clisa(kantages are com1ected \\·ith
some of the methods of establishing the butterfly spread.
XYZcommon:
60
Strike: 50 60 70
Call: 12 6 2
Put: 5 11
The method 11sinu . tht> calls indicates that Olk' mmld bm·. the .:SO
:-, 0111' calL sell t,rn GOcalls.
and lm:· the 70 call. Tillis. there ,rnulcl be a bull spread in the calls bt>t,-:t>en the ,SOand
60 strikes. a11d a hear spread in the calls bet\\-t't'll the 60 and 70 strikes. I 11 a si111ilar man-
ner, one could establish a I n1tterfl:· spread h:· crnnhini11g t>itllt'r type oflmll spread hetwt>en
the .:SOand 60 strikt>s ,,·ith an:· t:-i)e of hear sprt>ad lwh,·een the GOand 70 strikes. Some
of these spreads \Hmld he credit spreads. "·hile others ,, cmld be debit spreads. In fact.
one·s pt>rso11al choict' lwt\\·ee11 t\\·o rather equi,·,tle11t makeups of tht> buttt>rtl:· spread
might be decided by whether there were a credit or a debit involved.
Table 2:3-1 s11111rnarizesthe four ,,·a:s in ,,-hich the lmtterfl:· spread rni~.d1tht> con-
structt'd. In ordt>r to ,·erib.- the debits and crt>dits listt>d. the rt>ader should rt>call that a
bull spread consists of lm:·ing a lm,·er strikt> and selling a higher strikl'. "hetllt'r puts or
calls arl' l!St'd. Similar!:, hear spreads ,,·ith t>ither puts or calls consist oflm:ing a hight>r
strike and st>Ili11ga lmwr strike. :'\ote that the third choice-hnll spread ,,·ith puts and
bear sprt>ad \\·ith calls-is a short straddle prntt'cted h:· lrn: ing tht' out-of-tht>-lllOllt':· put
and call.
In each oft he four spreads. the rna.\inmrn pott>ntial profit at e\piration is S points if the
underl:in g stock is t'\actl:· at 60 at that tirne. Tlw ma\i1mrn1 possible loss ill an: of tllt' four
spreads is 2 points. if the stock is :tt or ahm·e 70 at e\piration or is at or hl'lm,· .SOat e\pira-
tion. For e\arnplc. either the top line in the table. "·l1ere tllt' spread is st't np on!: ,,·ith calls:
or the bottom line. ,,-llt're the spread is set up onl: ,,ith puts. has a risk t>qual to tht> dt>bit
inrnlwd-2 points. Tlw large-debit sprt>ad \St'co11d lint' of tablt:·l ,,·ill bt> ahle to lw liqui-
dated for a mi11i11111111of 10 points at t>.\pirntio11110 111attt'r"·here the stock is. so tht> risk is
also 2 point'>.\ It cost 12 poi!lts to begin ,,-itl1.) Finall:·· the credit c0111hinatio11\third li1lt'l
has a 1na\inm111 h11:-hack of 10 points. so it also has risk of 2 points. I11addition, sinct' tlw
striking prict's art' 10 point,;; apart. the llla\i1111m1potential profit is S points \111a\i111u111
profit = striking price differential minus maximum risk) in all the cases.
Chapter23: Spreads Combining
Calls andPuts 325
TABLE 23-1 .
Butterfly spread .
BullSpread Bear Spread
(BuyOptionat50, ... plus... (BuyOptionat70,
Sellat60) Sellat60) Total
Money
Calls (6 debit) Calls(4 credit) 2 debit
Calls (6 debit) Puts(6 debit) 12 debit
Puts(4 credit) Calls(4 credit) 8 credit
Puts(4 credit) Puts(6 debit) 2 debit
The fact()r that ca11ses all tht•<.,(·co11dJinati<J11st<Jlw E-:'.f{llal

ill risk a11clre\\ard i'i tlie
arbitrageur. If put and call priu·s ~d t<JOfar <Jlltof lillt'.. tliP arbitrar!;r,11rcan takP riskless
action to force tl1ern hack . Tl1is particular fonn of arbitrage. k11CJ\\J1 as the box spread. is
described later in Chapter 27 Arbitrage.
E\ Pn tl1rn1gh all four \\·a:-:sof e<mstrncting the lmttnfiy spread are eqllal at Pxpira-
ticm. <;orneare supt'.rior to others for certaill price rn<JH:'111c11t'i prior to expiratioJJ. Recall
that it \\·as prp\·io11sl: stated that hull spreads arc best crn1stnrctcd \\·itl1 calls. and !war
spreads are lwst constrnctE:'d \\·itli p11t1.;_Since the lmtterfiy '>prPad is incrt'l: tl1c crnnhiJJa-
a:·
ti(Jn of a bull spread and a bear spread. the lwst \\ to sd 11ptlw lmtterfi: spn·ad is to
use calls for tlw bull spread and pllts for the: hear spread. Tliis crm1hinatioJJ i'i tl1e ()J1e
listed rm the SE::'C(Jnd line of Table 2:3-1. This strateg:· i11\okes tlw large'it dPhit of tl1e four
UJrnbinati()ns and. as a result. 1nan:· i11\·estorsslnlll this approach. Hm\-e\CL all the otl1er
cornbinaticms innJh-e selling an i11-the-mrrne:· put or call at tlw <J11t'id.a 'iit11atirm that
C(Juld lead to earh-. exercise. The reader n1a\· . also recall that tlH· credit cornhiJJation. listed
on the third li11e()f Table 2:3-1. \\·as pre\·icmsl: clcscrihPd a'i a protected straddle position.
T hat is. one sells a straddle and siinultane<Jusl: h11:s lJotl1 an rn1t-of~the-111011ey p11tand an
out-of~the-rncme\· call \\·itl1 the sarnP expiration 111ontl1.as prntectiou for the straddle.
Thus, a butterfiy <;pread is actw.1.II:·the er 111i\·aler1t
of a crn npletel:· prntectt'd straddle \Hite.
A. hutterfi: '->prPadis not an o\·erly attracti\e strateg:·- altlicmgl1 it rna:· !Je 11sPfolfr()Jn
time t<Jtirne. Tht' stratE::'g:-sh()11l<lnot he considered unlt'ss 011€:-' l1as Im\· co1inJ1i'isioncmts.
EH:'.n then. the strateg: has only lirnited profit potential althrn1gl1 it can be a large per-
1
centr1ze pnJfit if the iI1itial ckhit is small The lilJlitE-'drisk ff'atme is good to ha\E::'ill a
1.
p<J'iition_but it alone cann()t compensate fcx tlw less attracti\·e f"t,atmE:'sof tlw strateg:.
Esst'ntialh. the stratE-'gist is lo()king for the stock to 111m·t'tm\arcl tlw rnidclle strih· at or
near rJptic;11Pxpiration. If tliE-'potential profit is at least t!in__,P
ti1J1t'Sth(, 111a\i1rn1111ri'ik and
prdt=:rabl: four tin1c·<,aI1cltlw m1clerl:·inQ;stock appears to lw iJJ tradiJJ'! ra11ge. the strat-
egy is feasible. Otherwise , it is not.
CONDOR AND IRON CONDOR SPREADS
Condor spreads are very similar to butterfly spreads, except that one uses two dUferent
strikes in the center of the spread. Condor spreads are constructed with all call options,
or with all put options. Iron condors are essentially the same thing, except that they are a
mix of puts and calls. Both have profit graphs with the same shape, so they are equivalent.
In actual practice, most traders use the iron condor strategy if they desire to establish a
stratt'gy of this type, for all of the options are initially out-of-the-money, and the position
is established for a credit:
Example: Assume XYZ is trading at 120. An iron condor spread might be established as
follows:
Buy 1 XYZ Dec 135 call: .50

Sell I XYZ Dec 130 call: 1.00
Sell l XYZ Dec llO put: 1.00
Buy 1 XYZ Dec 105 put: .50
Net Credit: 1.00
In its basic form, the difference in the call strikes and the put strikes should be the
same (.5 points in this t'xample). All the options are out of the money to begin with. With
these criteria, the position is always established for a credit, since the options being sold
hm·e strikes closer to the current underlying price than those being bought. If the under-
l:';ing stock closes between the two middle strikes at expiration, all the options will expire
worthless. and the trader will profit by the amount of the initial credit (less commissions).
That is the maximum profit available from the trade: $100 in this example.
Conwrselv, if the underlying is outside of either of the long strikes at expiration, the
maximum loss is realized, which would be $400 in this example. Figure 2:3-1 shows the
profit potential for this spread:
Maximum loss = Difference In High Strikes - Initial Credit

= 135 - 130 - 1.00 = 4.00
The rnaxinmrn loss is also the difference in the low strikes minus the initial credit,
"·hen tlw put spread and the call spread ha\·e the same differential in their strikes. If the
differenticd in the lower strikes is greater than that for the upper strikes, the maximum loss
\,·011ldlw the difference between the two low strikes minus the initial credit. In general,
tll{' llla\in11m1 loss would he the greater of the two differences in strike prices minus the
initial credit.
Chapter
23: SpreadsCombining
CallsandPuts 327
FIGURE 23-1.
Condor spread.
+$100
The margin required for this spread is the maximum risk. Therefore one can lose as
much as 100% of his investment in this position, if the underlying is above the higher
strike or below the lower strike at expiration. As a result, this strategy has great risk.
Ideally, one would set those strikes so far away from the current stock price as
to make the probability of realizing that maximum loss quite small. For example, it is
common to attempt to St't the short strikes at one or more standard deviations from
the current stock price. The actual implementation of standard deviation calcula-
tions is discussed in tht' chapter on mathematical applications-Chapter 28. However,
the probability of loss is not zero, and there is always a possibility of realizing the
maximum risk.
It should also he pointP<l out that an increase in volatility will harm this strategy in
two ways: ( 1) the stock will hm ea greater probability of moving outside the short strikes
than one had initially estimated, and (2) the options will all become more expensive,
which will cause a mark-to-market loss in the spread, although many traders may not be
too concerned about that since the losses are still limited.
Traders disagree on the best follow-up method. One theory holds that the call spread
should be closed immediately or shortly after the stock rises above the short call strike
(1:30in the above example), or the put spread should be closed if the stock falls below the
short pnt strike (110 in the above example). However, that method-while it may limit
losses-will cause nwn' losses than a more laissez-faire approach would. That is lwcausl',
if' the stock qnickly probes above 1:30,say, and then falls hack to l :20 at expiration, rnw
would han' alread y been stopped out for a "small" loss. If one had doue nothing, the
maximum profit would have been realized.
So the other theory of follow-up action is to let the spread nm until expiration with-
out adjusting. That theor:v would he ruinous, of course, if one put all of his capital in any
one spread. Henct->,a 111011e:· management approach is required, something like this: allo-
cate a certain portion of your entire capital to this strategy. In addition, only establish
co11clorswith one-third to ont>-half of tht' capital that one is allocating to the strateg_\'· In
that manner, if tht' maxi 11mmloss occurs, there is still capital left to trade vvith, and the
same percentage limit s apply to allocation of that capital.
In summary, tht' condor stratcg_\' has a grt>at dt>al of popularity. There is a large
chance of making a small profit (assuming that the short strikes are set sufficiently far
from the i11itial stock price). Thfft' is also a small chance of ruin, so the trade cannot be
t'stahlishccl with a significant portion of 011e'scapital. Overall, there are far more attractive
strategies in general, especially when th e stock market is volatile.
COMBINING AN OPTION PURCHASE AND A SPREAD
It is possible to combine the purchase of a call and a credit put spread to produce a posi-
tio11that ht'l1aves much like a call buy, although it has less risk over much of the profit
range. This strategy is often ust'd when one has a quite bullish opinion regarding the
urnlt>rl: ing st'curit_\·,:·et tht' call one wishes to purchase is "overpriced." In a similar man-
nt>Lif one is hearisli on the underlying, he can sometimes combine the purchase of a put
\\·ith the sale of a call credit spread. Both approaches are described in this section.
THE BULLISH SCENARIO
It sometimes happens that one arri\·es at a bullish opinion regarding a stock, only to find
tliat the options are \·ery e:\pensi\·e. In fact, tlwy may he so expensive as to preclude
tho11ghts of 111akingan outright call purchast'. This might happen, for example, if the
stock has suddenly pl11rnrnetecl in price (perhaps during an ongoing, rapid hearish move
lA the m·erall stock rnarket). To huv. calls at this time would he m·erlv., riskv. If the under-
~ ./
!_'fog began to rally, it wou kl often he tlw case that the implied volatility of the calls would
shrink, thus harming one's long call position.
As a countt'r to this, it 111ightrnake sense to bu:· the call, hut at the same time to sell
a p11tCTt'dit sprt'ad. Rt'call that a put credit spread is a bullish strategy. Moreover, since it
is prt's11111cdthat tl1e options arc expemi\·e 011 this particular stock, the puts being med
in tlw sprl'ad \\'011ldht' expensi\·t' as well. Tims, the creclit recei\'ecl frorn the spread would
be slightly larger than "normal" because the options are expensive.
Chapter
CallsandPuts 329
Example: XYZ is selling at 100. One wishes to purchase the December 100 call as an
outright bullish speculation. Tliat call is selling for 10. However, one determines that the
December 100 call is m·erpriced at these le\·els. (Iu order to make this determination, one
would use an option model whose techniques are described in Chapter 28 011 mathemati-
cal applications.) Hence, he decides to use the following put spread in addition to b11ying
the December 100 call:
Sell December 90 put, 6

Buy December 80 put, 3
The sale of the put spread brings in a 3-point credit. Thus, his total expenditure for the
entire position is 7 points (10 for the December 100 call, less 3 credit from the sale of the
put spread). Ifone is correct about his bullish outlook for the stock (i.e., the stock goes up),
he can in some sense consider that he paid 7 for the call. Another way to look at it is this:
The sale of the put spread reduces the call price clown to a more moderate level, one that
might be in line with its ''theoretical value." ln other words, the call would not be consid-
ered expensive if it were priced at 7 instead of 10. The sale of the put spread can be con-
sidered a way to reduce the overall cost of the call.
Of course, the sale of the put spread brings some extra risk into the position because,
if the stock were to fall dramatically, the put spread could lose 7 points (the width of the
strikes in the spread, 10 points, less the initial credit received, 3 points). This, added to
the call's cost of 10 points, means that the entire risk here is 17points. In fact, that is the
margin required for this spread as well. Tims, the overall spread still has limited risk,
because both the call purchase and the put credit spread are limited-risk strategies. How-
ever, the total risk of the two combined is larger than for either one separately.
Remember that one must he bullish on the underlying in order to employ this strat-
egy. So, if his analysis is correct, the upside is what he wants to maximize. If he is wrong
on his outlook for the stock, then he needs to employ some sort of stop-loss measures
before the maximum risk of the position is realized.
The resulting position is shown in Figure 23-2, along with two other plots. The
straight line marked "Spread at expiration'' shows how the profitability of the call purchase
combined with a bull spread would look at December expiration. In addition, there is a
plot with straight li1ws of the purchase of the December 100 call for 10 points. That plot
can be compared with the three-way spread to see where extra risk and reward occur.
Note that the three-way spread does better than the outright purchase of the December
100 call as long as the stock is higher than 87 at expiration. Since the stock is initially at
100 and since one is initially bullish on the stock, one would have to surmise that the odds
of it falliug to 87 are fairly srnall. Thus, the three-way spread outperforms the outright
purchase of the call over a large range of stock prices.
FIGURE 23-2.
Call buy and put credit (bull) spread.
,
.,,,
+$2,000
Spread Halfway
to Expiration
(f)
(f)
+$1,000
~,,
0
...J
Stock
0 $0
70 80 90 120 130
0
ct
-$1,000 "" Spread at Expiration
Call Buy Only, at Expiration

-$2,000
The final plot in Figure 2:3-2 is that of the three-way spread's profit and losses
lialfirny to the expiration date. You can see that it looks much like the profitability of
merely owning a call: The curve has the same shape as the call pricing curve shown in
Chapter 1.
Hence, this three-way strategy can often be more attractive and more profitable
than merely owning a call option. Remember, though, that it does increase risk and
require a larger collateral deposit than the outright purchase of the at-the-money call
would. One can experiment with this strategy, too, in that he might consider buying an
out-of-the-money call and selling a put spread that brings in enough credit to completely
pay for the call. In that way, he would have no risk as long as the stock relllainecl above
the higher striking price used in the put credit spread.
THE BEARISH SCENARIO
Ill a silllilar manner, one can construct a position to take advantage of a bearish opinion
on a stock. Again, this would be most useful when the options were overpriced and one
felt that an at-the-money put was too expensive to purchase by itself.
Example: XYZis trading at 80, and one lias a definite bearish opinion on the stock. How-
en_,r, tht> Dt>cemher 80 put which is selling for 8, is expensive according to an option
Chapter
CallsandPuts 331
anal::sis. Therefore, rnH' 111iglitconsider selling a call credit spread (out-of-the-money) to

help reduce the cost of the put. The entire position would thus be:
Buy 1 December 80 put: 8 debit

Sell 1 December 90 call: 4 credit
Buy 1 December 100 call: 2 debit
Total cost: 6 debit ($600)
The profitahilit:; of this position is shown in Figure 2:3-3. The straight line on that graph
sho\\'s hm,· tl1c position would lwhave at expiration. The introduction of the call credit
spread has increased tlw risk to $L600 if the stock should rally to 100 or higher by expira-
tion. !\'.ote that the risk is lilllitt'd since hoth the put purchase and the call credit spread
are limitt'd-risk strategit's. The margin requirt'cl would be this maximum risk, or $1,600.
The c11nnl line on Figure 2:1-:3shows how tht' three-way spread would behave if
ont' looked at it halfwa_v to its t'xpiration date. In that case, it has a curved appearance
much like the outright purchase of a put option.
Thus, this stratt'gy could be appealing to bearishly oriented traders, especially when
the options arc t'Xpt'nsi,·e. It might hm·t' certain advantages over an outright put purchase
in that case, but it dues require a larger margin investment and has theoretically larger risk.
FIGURE 23-3.
Put buy and call credit (bear} spread.
+ $1,000 Halfway to Expiration
(/)
(/)
/ Stock
0
..J
0 60 110
e
Cl.
At Expiration
-$1,000
-$2,000
A SIMPLE FOLLOW-UP ACTION

FOR BULL OR BEAR SPREADS
Anotli(•r \\'a:· of combining puts aud calls in a spread can sometimes be used when one
lias a hull or hear spread already in place. Suppose that one owns a call bull spread and
t IH' 11n(krl:-ing stock has a(krnced nicely. In fact, it is above hotli of tbe strikes used in
tlw spread. Howe\ ·er. as is often the case, the bull spread may not have widened out to its
n1,t.\inrn111profit pote11tiaL One can use the puts for two purposes at this point: (1) to
dekr111i11e whether the call spread is trading at a "reasonable" value, and (2) to try to lock
i11sonw profits. First. let's look at an example of the "reasonable value" verification.
Example: A trader buys an XYZ call hull spread for .5points. The spread uses the January
70 calls and the Ja1111arySO calls. Later, XYZ aclrnnces to a price of 88, but there is still a
good deal of ti!lle ren1ai11i11gin the options. Perhaps the spread has widened out only to
7 points at that ti11w.Tlw trader finds it somewhat disappointing that the spread has not
profit potential of 10 points. However, this is a fairly common
widened oul to its 111axi11111n1
occ111Tcncc\\'itli hull and !war spreads, and is one of the factors that may make them less
attractive than outright call or put purchases.
In any case, suppose the following prices exist:
January 80 put , 5
January 70 put , 2
\ \ ·c can use tht'se put prices to\ erify that the call spread is "in line." Notice that the
p11tspread is :3points and the call spread is 7 points (both are the January 70-January 80
sprt>adl. Thus, the:· add up to 10 points-the width of the strikes. When that occurs, we
can conclnclt' that the spreads are ''in line" and are trading at theoretically correct prices.
Knowing this information doesn't help one lllake any rnort' profits , hut it does provide
some n·rification of tllP prices. Many times, one feels frustrated when he sees that a call bull
spread l1as not widt'1ied 011tas he expected it to. Using the put spread as verification can help
kt:'E'Ptlw strategist "011track,, so that he rnakes rational, not emotional, decisions.
:\'m,· lt't's look at a similar exa1nple, in which perhaps the puts can be used to lock in
profits on a call bull spread.
Example: Using ti 1csan1e l)lJII spread as in the pre\·ious example, suppose that one owns
a11.\YZ call Im II spread, hm ing bo11ght the Januar:· 70 call and sold the January 80 call
l<>ra dcliit of ,S points. :\'ow ass11rnt' it is approaching expiration, and tlte stock is once
a~ai11 at .<-;,<-;_.\.t this ti111c,the spread is th eoretica lly nearing its maximum price of 10.
Chapter
CallsandPuts 333
Howe\·er. since hoth calls arc fair!_\·deeply in-tllt'-ll10Jlt'Y,the 111arket-makersare making

\·ery wide spreads in the calls. Perhaps these are the markf'ts, 1cith the stork at 88 and
only a week or two remaining until expiration:
Call BidPrice Asked

Price
January 70 call 1750 18.50
January 80 call 780 8.20
If onf' were to rernm·e this spreacl at market prices, he would sell his long January 70
call for 17..50and would buy his short January 80 call back for 8.20, a credit of 9.30. Since
the maximum \·alue of the spread is 10, one is gi\·ing away 70 cents, quite a bit for just such
a short time remaining.
Howe ver, suppose that one looks at the puts and finds these prices:
Put BidPrice Asked

Price
January 80 put 0.20 0.40
January 70 put none 0.10
One could "'lock in'' his call spread profits hy buying the January 80 put for 40 cents.
Ignoring commissions for a moment, if he bought that put ancl then held it along icith the
call spread until expiration, he would unwind thf' call spread for a 10 credit at expiration.
He paid 40 cents for the put, so his net credit to exit the spread would be 9.60-considerably
better than the 9.30 he could have gotten above for the call spread alone.
This put strategy has one big adrnntage: If the underlying stock should suddenly
collapse and tumble beneath 70-admittedly, a remote possibility-large profits coulcl
accrue. The purchase of the January 80 put has protf'ctecl the bull spread's profits at all
prices. But below 70, thf' put starts to make extm money, and the spreacler could profit
handsomely. Such a drop in pricf' would only occur if some materially damaging news
surfaced regarding XYZ Company, but it does occasionally happen.
If one utilizes this strategy, he needs to carefully consider his commission costs and
the possibility of early assignmf'nt. For a professional trader, these are irrelevant, and so
tlw professional traclt'r should endeavor to exit bull spreads in this manner whenever it
makes sense. However, if the public customer allows stock to be assigned at 80 and exer-
cises to huy stock at 70, he will haw two stock commissions plus one put option commis-
sion. That should be compared to the cost of two in-the-rnoney call option commissions
to rf'move the call spread directly. Furthermore, if the public customer receives an early
assignment notice on the short January 80 calls, he may net>clto provide da_\'-tradc margin
as he exercise his January 70 calls the next day.
\ Vithout going into as n1uch detail, a hear spread's profits can be locked in via a simi-
lar strategy. Suppose that one owns a January oO put and has sold a January .SOput to
create a !war spread. Later, with the stock at 4.5, the spreader wants to remove the spread,
hut auain
h finds that the lllarkets for the in-the-lllonev, puts are so wide that he cannot
realize anvwhere near the 10 points that the spread is theoretically worth. He should then
see what the January .50 call is selling for. If it is fractionally priced, as it most likely will
be if expiration is drawing nigh, then it can be purchased to lock in the profits from the
p11tspread. Again, commission costs should be considered hy the public customer before
finalizing his strategy.
THREE USEFUL BUT COMPLEX STRATEGIES
The three stratL'gies pn--'senteclin this section are all designed to limit risk while allowing
for large potential profits if correct market conditions develop. Each is a combination
strateg:-,-that is, it inrnh-es both puts and calls-and each is a calendar strategy, in which
near-term options arc sold and longer-term options are bought. (A fourth strategy that is
similar in nature to those about to be discussed is presented in the next chapter.) Althcmgh
all of these are some\,·lwt complex and arf' for the most advanced strategist, they do pro-
\·idc attracfo·e risk/reward opportunities. In addition, the strategies can be employed by
the public custumer; the:-,·are not designed strictly for professionals. All three strategies
are described conceptuall:-,· in this section; specific selection criteria are presented in the
next section.
A TWO-PRONGED ATTACK (THE DUAL CALENDAR SPREAD)
A lmllish calendar spread was shown to be a rather attractive strategy. A bullish call cal-
endar spread is established with out-of-the-rnone:-,· calls for a relatively srnall debit. If the
11ear-tern1 call expires worthless and the stock then rises substantially before the
longtT-tcrrn call expires, the profits could potentially he large. In any case, the risk is
limited to the slllall clehit required to establish the spread. In a similar manner, the bear-
ish calendar spread that uses put options can he an attractive strateg:-, as well. In this
1
strnteg:-,, one \rn11kl set up the spread with out-of-the-money puts. He woulcl then want
tiw 1war-ten11 p11tto expire worthless, followed 6:-,'a substantial clrop in the stock price in
order to profit on the longer-term put.
Since both strate~ies are attracti\·e h:-,·themseh-es, the combination of the two should
he attractin' as well. Tliat is, 1cith a stock n1ichrny bct1cce11flco striking prices, one 111ight
sd ll)J o lm!lis/1 011t-<ftl1e-11w11ey call calrndar SJJrcada11c! si1111t!fr111rn11.';/!I
cstahlis/1 a
lworis/1 011t-<ft!1c-11w1u·!1 put rnlrndar.'>pr('{{d.If the stock remains relatively stable, both
Chapter
CallsandPuts 335
near-term options would expire worthless. Then a substantial stock price movement in
either di rectiun could produce large profits.\ \'ith this strategy, the spreader does not care
which direction thP stock rnm•ps after the near options expire worthless; he only hopes
that the stock hecollles \·olatik and llloves a large distance in either direction.
Example: Suppose that the following prices exist three months before the January options
expire:
common:
XYZ 65
January 70 call: 3 January 60 put: 2
April 70 call: 5 April 60 put: 3
The lmllish portion of this com hi nation of calendar spreads would be set up by selling the
shorter-term January 70 call for 3 points and simultaneously buying the longer-term April
70 call for .5 points. This portion of the spread requires a 2-point debit. The bearish por-
tion of the spread would be constructed using the puts. The near-term January 60 put
would be sold for 2 points, while the longer-term April 60 put would be bought for 3.
Thus, the put portion of the spread is a 1-point debit. Overall, then, the combination of
the calendar spreads requires a 3-point debit, plus comrnissions. This debit is the required
investrnent; no additional collateral is required. Since there are four options involved, the
commission cost will he large. Again, establishing the spreads in quantity can reduce the
percentage cost of commissions.
Note that all the options involved in this position are initially out-of-the-money. The
stock is below the striking price of the calls and is above the striking price of the puts.
One has sold a near-term put and call combination and purchased a longer-term combina-
tion. For nomenclature purposes, this strategy is called a "dual calendar spread."
Figure 23-4 shows the results of the spread at expiration of the near-term options
(in April). There are a variety of possible outcornes from this position. First, it should be
understood that tlie risk is limited to the amount of the initial debit, ,'3points in this
example. If the underlying stock should rise dramatically or fall dramatically before the
near-term options expire, both the call spread and the put spread will shrink to nearly
nothing. This would be the least desirable result. In actual practice, the spread would
probably have a small positive differential left even after a premature move by the under-
lying stock, so that the probability of a loss of the entire debit would be small.
In Figure 2:3-4, there are two profit peaks, one at each strike. Due to the way that
puts and calls are priced in equity options, the peak for the call calendar (at the striking
price of 70, in the examplP) produces a greater profit than the peak for the put calendar,
at 60. Those peaks can he evened out if one initially establishes an c:,,:traput calendar
336 _PartIll:PutOptionStrategies
FIGURE 23-4.
Dual calendar spread.
spread or two. For example, buying 3 call calendars and 4 put calendars might produce
peaks of equal height.
This type of strategy is often very useful when one feels that the underlying stock
might gap after the spread is established, but before the near-term options expire. Such a
gap might be caused by an earnings announcement, or an FDA hearing for a biotech
company, or a potentially volatile lawsuit. In all of these cases, the near-term options
would be more expensive, in terms of implied volatility, than the long-term options, mak-
ing the dual calendar spread a theoretically attractive strategy. One would generally try
to estimate the extent of the forthcoming gap, and place the calendars at those spots. The
price of the near-term straddle can sometimes be a useful guide.
Example: XYZ is trading at 80, and is due to report earnings. Suppose that XYZ has a
history of gapping on its earnings reports. Furthermore, suppose that the nearest-term,
Jul:' 80 straddle is selling for 10 points. That is more or less the option market's estimate
of how far XYZ is going to move on the earnings report. One doesn't know ifXYZ will rise
or fall on the earnings, but based on whatever information is available, option traders have
estimated that the stock will move approximately 10 points on the earnings news. One
might therefore buy a call calendar spread with a strike of 90 and a put calendar spread
with a strike of 70-each 10 points from the current stock price (actually, he might buy 3
call spreads and 4 put spreads if he wants to balance his profit potential at either strike).
He \\'ould sell July options (the first expiration after the gap is expected to occur) and buy
August , September, or October options-whichever is available .
Chapter
CallsandPuts 337
If the near-term options both expire vvorthless, a profit will generally exist at
that time .
Example: If XYZ were still at 6,5 at January expiration in the prior example, the position
should be profitable at that time. The January call and put would expire worthless with
XYZ at 6.5, and the April options might he worth a total of .Spoints. The spread could thus
be closed for a profit with XYZ at 65 in January, since the April options could be sold for
5 points and the initial "cost" of the spread was only 3 points. Although commissions
wo11ldsubstantially reduce this 2-point gross profit, there would still be a good percentage
profit on the m·erall position. If the strategist decides to take his profit at this time, he
would be operating in a conservative manner.
Howevec the strategist may want to be more aggressive and hold onto the April
combination in hopes that the stock might experience a substantial movement before
those options expire. Should this occur, the potential profits could he quite large.
Example: If the stock were to undergo a very bullish move and rise to 100 before April
expiration, the April 70 call could be sold for 30 points. (The April 60 put would expire
worthless in that case.) Alternatively, if the stock plunged to 30 by April expiration, the
put at 60 could he sold for :30 points while the call expired worthless. In either case, the
strategist would have made a substantial profit on his initial 3-point investment.
It may be somewhat difficult for the strategist to decide what he wants to do after
the near-term options expire worthless. He may he torn between taking the limited profit
that is at hand or holding onto the combination that he owns in hopes of larger profits. A
reasonable approach for the strategist to take is to do nothing immediately after the
near-term options expire worthless. He can hold the longer-term options for some time
before they will decay enough to produce a loss in the position. Referring again to the
previous example, when the January options expire worthless, the strategist then owns the
April combination, which is worth .Spoints at that time. He can continue to hold the April
options for perhaps 6 or 8 weeks before they decay to a value of :3points, even if the stock
remains close to 65. At this point, the position could be closed for a net loss of the com-
mission costs involved in the various transactions.
As a general rule, one should be willing to hold the combination, even if this means
that he lets a small profit decay into a loss. The reason for this is that one should gice
himse(f the maxinwm opportunity to reali:::..e large profits. He will probably sustain a
number of small losses by doing this, but by giving himself the opportunity for large prof-
its, he has a reasonable chance of having the profits outdistance the losses.
338 _PartIll:PutOptionStrategies
Tl1ac i, o tinu' fl) takt' ,n111!!

pn'.tit, i11tl1i, ,trut t·::,!1-
Thi.-;\\"l)uld bt' \\ht'll t'itht'r tlit'
puts or the calls \\·ere sli~htl: i11-the-rnone: ,1.-;tht"' llt',lr-knn L)ptilm.-;t'\.pirt'.
Example: If :\.YZ rnm·ed to -:-1_iu.-;t,ls the J,1rn1,u·: L)ptions wert' t'\.pirin~. tht' 1..\dlpl)r-
tion of the .-;pre,1dshould he dosed. The Jam1,1r:· -:-u c,1ll l'l)UlLlbt' bL)ll~ht b.ll..'K
t~)r l p1..)i11t
and the .-\pril -:-oc,1ll \\Ould prnb,1bl: be \\\)rth about .3 pL)ints. Thus. tht' L\lll pL)rfo,n 1 f 1.
the spread nmkl be "sold-- for--! points. t'1wu~h to L·o,·t'r tht' t'ntirt' L'L)St1..)ftht' J:'l)_-;itiL)ll.
The .\pril GO put ,nnild not han' much \·,dut' \\·ith tht' .-;tock ,1t -:-1.but it .-,hL 1 uld h,
held just in case the stock should t>\.perience ,1br~e priL't' dt'L·lint'. ~imibr rt'.-;ult.-;\\\ 1 ,illl
occur 011the put side of the spre,1d if the under!: in~ .-;tL1L-k \\·t'rt' .-;li~hth-in-t ht'-lllL)llt'\.
sa:· at .S'l or .SU.at Jamiar: t>\.piration.. -\t 110time dot'-" the str,1k~ist ,,·,mt h) risk b,,in~
assignt'd on an option that ht>is short. so ht' must ,d\\·,1:·sL'lL)St' tht' pL)rfo)ll Li th,, }'L)SitiL)ll
that is i11-the-111011e:· ,1t near-tt'rrn t'\.piration. This i.-;onh- nt'L't's.-;,1n.Lif 1..'L)llr-"t'.if t ht'
stock has risen ahow the strikin~ price of the L·allsor h,i.-;fallt>n bt'lO\\ tht' .-;trikin~ priL't'
of the puts.
In s1mrn1ar:··thi.-;is a reason,1blt>stratt'~: if one opt>rc1k.-; it u,·t'r ,1pt'riL)LiLi tim,' 11..
1 11~
t'nou~h to em·ompass St'\·er,d market c: cles. The str,1kgi.-;t must bt> L\lrt>ful Ill )t h) p bl't' ,l
large portion of his tradin~ L'apibl in the stratt'~:-- ho\\"t'\t'L .-;im't't'\t'n thL)U~htht' lL)SSt'-"
art' lirnitt'cl. the:· still represent his entire 1wt inwstrnt>nt .. -\ , ,1ri,1tiLmL)fthis stuk~::y.
\\·hereb:· one st'lls mort' options than he bu:·s. is describt>d in tht> llt'\.t d1aptt'r.
THE CALENDAR STRADDLE
.-\notlwr strnte~:- that combines c,1lembr sprt',1ds on both put ,rnd 1.."cdl L)ptiL)l1S
1..\lllbt'
constructed h:· selling a near-term str,1ddle and sirnult,mt>oush- pun·h,1si11~,1 lL)ll~tT-krrn
stracldlt'. Since the tinw ,·,due premium of the ne,H-tt'rm str,1ddlt' \\·ill L1t'LTt',lSt'llll)rt'
rapid!:· than that of tht' longer-term str,1ddle. one nmld rn,1ke profits L)n~l lirnitt'd irn t'St-
ment. This stratt'?::· is smne\\·hat inferior to the one desnibt>d in tht' prt>, iLHlSSc'diL)ll.but
it is interesting enough to examine.
Example: Suppose that three month~ bt'it)rt' Januar: t>\.pir~1tiun.tht' follL)\\·in~priL't'St'\.ist:
XYZ
common:40
January 40 straddle: 5 April 40 straddle: 7
.-\ c-alt'mlar sprt'acl of tlw straddles could bt' t'stablished b:· sellin~ tht' Jcrnu,m· -W
c;traddle clml si11niltaneo11sl:·lm:·ing the .-\pril --!Ostraddlt'. This \\t)uld irnt)ht' ,1 L'l)StL1f
2 points or the debit of the transaction, plus commissions.
Chapter23: SpreadsCombining
CallsandPuts 339
Tht> risk is li11litL'dto tht> amount of this clt>bit11/J 1111til

t/i(' ti111ethe 11cr1r-tern1
strad-
dle npircs. That is, cwn if:\YZ rnmes up in price by a substantial an1mmt or declines in
price b:· a substantial amount, the \\'orst that can happen is that the difference between
tlw stracldk, prices shrinks to zero. This could cause rnlt' to lose an arnount equal to his
original debit, plus con1missio11s.This li111it011 the risk applies 011/y u11tilthe ll<'rtr-tenn
optio11s npirc. If tlw strategist decides to b11:·hack the near-tenn straddle and continue
to hold the longer-tt>rn1 01w, his risk then increases by the cost of buying back the
near- term stra ddl e.
Example: XYZ is at -1:3wht>n the January options expire. The January 40 call can now be
bought back for :3points. The put expires worthless; so the whole straddle was closed out
for :3points. The April 40 straddle might be selling for 6 points at that time. If the strate-
gist wants to hold 011to tlw April straddle, in hopes that the stock might experience a large
price swing, he is fret>to do so after buying back the January 40 straddle. However, he has
now im·ested a total of .5points in the position: the original 2-point debit plus the 3 points
that he paid to lm:· back the January 40 straddle. Hence, his risk has increased to
3 points. If XYZ were to be at exactly 40 at April expiration, he would lose the entire
.5 points. \\'hile the probability of losing the entire .5 points must be considered small,
there is a substantial cliance that he niight lose more than 2 points-his original debit.
Tims, lw has increased his risk by buying hack the near-term straddle and continuing to
hold th e longer -term one .
Tliis is actually rt neutral strategy. Recall that when calendar spreads were <liscussecl
previously, it was pointed out that one establishes a neutral calendar spread with the stock
near the striking price. This is true for either a call calendar spread or a put calendar
spread. This strategy-a calendar spread with straddles-is merely the colllbination of a
neutral call calendar spread and a neutral put calendar spread. Moreover, recall that the
neutral calendar spreader generally establishes the position with the intention of closing
it out once the near-term option expires. He is lllainly interested in selling ti!lle in an
atte111ptto capitalize on the fact that a near-terlll option loses time \·,due premium more
rapidly than a longtT-tenn option does. The>straddle calendar spread should he treated in
the same maimer. It is gern:'rall:· best to close it out at near-terlll expiration. If the stock is
near the striking price at that tillle, a profit will generally result. To verify this, refer again
to the prices in the preceding paragraph, with XYZ at 43 at January expiration. The Janu-
ary 40 straddle can he bought hack for 3 points and the April 40 straddle can be sold for
6. Tims. tlw differential between the two straddles has widened to ,'3points. Since the
ori~inal cliffprential was 2 points, this represents a profit to the strategist.
Tlw 111(t.ri11w111 JJr<ftu:011/dIH' rea/i::..cd if XYZ 1cae CX(lcf!y at the striking price at
11er1r-tcn11 r'.'l.pimtio11. In this cast', the January-10 straddle conic! be bought back for a nT:·
s1nall fraction and the April 40 straddle might be worth about ,5 points. The differential
would ha\'e widened from the original 2 points to nearly ,5 points in this case.
This strategy is infl'rior to the one described in tlie previous section (the "calendar
combination"). In order to h,ffe a chance for unlimited profits, the investor must increase his
net debit by the cost of buying back the near-term straddle. Consequently, this strategy
should he used onl:,-in cases when the near-term straddle appears to be extremely overpriced.
1
Fmthern1ore. the position should be closed at near-term expiration unless the stock is so close
to the striking price at that time that the near-term straddle can be bought back for a frac-
tional price. This fractional buy-back would then give the strategist the opportunity to make
large potential profits with only a small increase in his risk. This situation of being able to buy
hack the near-term straddle at a fractional price will occur very infrequently, much more
infrcq11ently than the case in which both the out-of-the-money put and call expire worthless
in the pn'\·ious strategy. Tims. the ··calendar combination" strategy will afford the spreader
more opportunities for large profits, and will also never force him to increase his risk.
OWNING A "FREE" COMBINATION (THE "DIAGONAL

BUTTERFLYSPREAD")
The strategies described in the previous sections are established for debits. This means that
en 'n if tl1e near-term options expire worthless. the strategist still has risk. The long options
lie then holds could proceed to e:s-.:pireworthless as well, thereby leaving him with an overall
loss equal to his original debit. There is another strategy involving both put and call options
that gi\·es the strategist the opportunity to own a "free" combination. That is. the profits
frolll the near-term options could equal or exceed the entire cost of his long-term options.
Tliis stmtrgy consists ofsrlling a nrar-tenn straddle and simultaneously p11rcliasi11g
/}()fli a longcr-tcr111,011t-cftlie-111m1eucall and a longer-term, out-cf the-money put. This
d{ifi'rs fro111tlie protfftcd straddle 1crite preuiouslu described in that the long options
have a more distant maturity than do the short options.
Example:
XYZ 40
common:
April 35 put: 1.50
January 40 straddle: 7
April 45 call: 2.50
If one to sell the short-term Januar:,-'40 straddle for 7 points and simultaneously pur-
\\'CIT
cl1ast' the 011t-of-the-111011t'y put and call combination-April 3.5 pnt and April 4,5 call-he
(t cr('dit SJJr('({d.ThP credit for the position is :3points less co11m1issions.since
1rn11ldc.,·ta!Jlis/1
Chapter
CallsandPuts 341
7 points are brought in from the straddle sale and 4 points are paid for the 011t-of~the-money
combination. Note that the position tecl111icall)·consists of a bearish spread in the calls-buy
the higher strike and sell the lower strike-coupled with a bullish spread in the pnts-huy
the lower strike and sell the higher strike. The investment required is in the form ofcollateral
since both spreads are credit spreads, and is equal to the differential in the striking prices,
less the net credit recei\·ed. In this example, then, the inwstment would he 10 points for the
striking price differential (.5points for the calls and ,5 points for the puts) less the :3-point
credit recein:>cLfor a total collateral reynirement of $700, plus commissions.
The potential results from this position may vary widely. However, tlze risk is limit<'d
IHJcm'11car-ter111 expiration. If the underl~,.:ingstock should advance substantially before
January expiration, the puts would be nearly worthless aud the calls would both be trading
near parit)·· \Vith the calls at parity, the strategist would have to pay, at most, 5 points to close
the call spread, since the striking prices of the calls are .5points apart. In a similar manner,
if the underlying stock had declined substantially hefore the near-term January options
expired, the calls would be nearly worthless and the puts would be at parity. Again, it would
cost a maximum of .5points to close the put spread, since the cliHerence in the striking prices
of the puts is also 5 points. The worst result would be a 2-point loss in this example-
3 points of credit were initiall_vreceived, and the most that the strategist would have to pay
to close the position is .5 points. This is the theoretical risk. In actual practice, it is \·ery
unlikely that the calls would trade as much as 5 points apart, even if the underlying stock
ad\·anced by a large amount, because the longer-term call should retain some small time
value premium e\·en if it is deeply in-the-money. A similar analysis might apply to the puts.
The risk can always be quickly computed as being equal to the difference between two
contiguous striking prices (two strikes next to each other), less the net credit received.
The strategis(c:;objectiue u;ith this position is to he able to buy back tl1e near-tcr111
straddle for a price less than the original credit received. If he can do this, he will own
the longer-term combination for free .
Example: Near January expiration, the strategist is able to repurchase the January 40
straddle for 2 points. Since he initially received a J-point credit and is then able to buy
back the written straddle for 2 points, he is left with an overall credit in the position of
l point, less commissions. Once he has clone this, the strategist retains the long options,
the April :35 put and April 4,5 call. If tlze underlying stock should then adv({Jicesubsta11-
tially or decline substantially, lze could make very large 7m!fits. However, even if the long
combination expires worthless, the strategist still makes a profit, since he was able to lm)'
the straddl e back for less than the amount of the original credit.
In this example, the strategist's objective is to buy hack the Januar)' 40 straddle for
less than :3points, since that is the amount of the initial credit. At expiration, this wrnild
11wa11that tlw stock woul<l hm·e to be between 37 and 43 for the buy-back to be made for
:3points or less. Although it is possible, certainl:v, that the stock will be in this fairly narrow
range at near-term expiration, it is not probable. However, the strategist who is willing to
add to his risk slightly can often achie\·e the same result b:: "legging ouf' of the Januar:·
-10 straddle. It has repeated!:· been stated that one should not attempt to leg out of a
spread, hut this is an exception to that rule, since one owns a long combination and there-
fore is protected: he is not subjecting himself to large risks h:· attempting to "leg out" of
the straddle he has written.
Example: XYZ rallies before January expiration ancl the January 40 put drops to a price
of ..SOduring the rall:·· fa·en though there is time remaining until expiration, the strategist
might decide to bu_vback the put at ..SO.This could potentially increase his overall risk by
.SOcents if the stock continues to rise. Howe\·er, if the stock then reversed itself and felL
he could attempt to lrn: tlw call hack at 2.,50 points or less. In this manner, he would still
achiew his ohjccti\·e of lm:'ing the short-term stracl<lle back for 3 points or less. In fact.
he might he able to close both sides of the straddle well before near-term expiration if
the urnlerl:·ing stock first mm·es quickly in one direction and then reverses direction by a
large amount.
The maxinmm risk and the optimum potential objecti\·es have been described, but
interim results might also be considered in this strategy.
Example: XYZ is at -l-l at January expiration. The January 40 straddle 111nstbe bought
back for -l points. This 111eansthat the long combination will not be owned free, but will
hm·e a cost of 1 point plus commissions. The strategist must decide at this time if he wants
to hold on to the April options or if he wants to sell them, possibly producing a small
m·erall profit on the entire position. There is 110ironclad rule in this type of situation. If
the decision is made to holcl on to the longer-term options, the strategist realizes that he
has assumed additional risk h:· doing so. :t\e\-ertheless, he ma:· decide that it is worth own-
ing the long combination at a relati,·el:· low cost. The cost in this exarnplC'would be 1 point
pl11scommissions, since he paid -l points to buy hack the straddle after only taking in a
:3-point credit initiall:·· The more expensi\·e the lm:·-back of the near-term straddle is, the
1non' the strategist should be readil:· willing to sell his long options at the same time. For
example. if XYZ were at -18 at Januar: expiration and the January 40 straddle had to be
hou~ht back for 8 points, there should be no question that he should simultaneous!:' sell
his .--\priloptions as well. The most difficult decisions come when the stock is just outside
the oph111111nlm:-hack area at near-term expiration. In this example, the strategist would
lia, (' a fairh- difficult dt>cision if XYZ were in the -14 to -l.5 area or in the 3.S to :16 area at
January expiration.
CallsandPuts 343
Tlw rt>ader Ilia:' recall that, in C:haptt>r l..J.on diagonalizing a spread, it was men-
tioned that one is s01nctin1cs able to own a call frt>t' by entering into a diagonal credit
sprt>ad, A diagonal hear sprt>ad was giwn as an cxarnplt>.The same thing happens to be
tnw of a diagonal lmllish put spread. si11ct'that is a credit spread as well. The strategy
discussed in this St'ction is lllt'rt'ly a combination of a diagonal bearish call spread and a
diagonal bullish put spread and is k:nou:n as a "diagonal butterfly spread." The same
concept that was df'scrihcd in Chapter 14-bt>ing able to make more on the short-term
call than one originally paid for the long-tt'nn call-applit>s here as well. One enters into
a credit pusitio11 1citlzthe hope of being ahle to buy hack the near-term u:ritten options
_{lJra pn!fi.t greater than tl1c cost uf the long options. If he is able to do this, he will own
options for free and could make large profits if the underlying stock moves substantially
in either direction. Even if tht' stock does not move after the buy-back, he still has no risk.
The risk occurs JJrior to tlie expiration of tlie near-ter111optiu11s,but this risk is limited.
As a result, this is an attractive strategy that, wht>n operated over a period of market
cycles , should produce some large profits. Ideally, these profits would offset any small
losses that had to bP taken. Since large commission costs are involved in this strategy, the
strategist is remindt>d that establishing the spreads in quantity can help to reduce the
percentage effect of the commissions.
SELECTING THE SPREADS
Now that the concepts of these thret' strategies have het'n laid out, let us define selection
criteria for them. The "calendar crnnbination'' is the easiest of these strategies to spot.
One would like to have the stock nearly halfway between two striking prices. The most
attractive positions can normally he found when the striking prices are at least 10 points
apart and the underlying stock is relatively volatile. The optimum time to establish the
"calendar combination" is two or three months before the near-term options expire.
Additionally, one would like the sum of the prices of the near-term options to be equal to
at least one-half of the cost of the longer-terrn options. In the example given in the previ-
ous section on tht' "calendar combination:· the near-term combination was sold for
.5points, and the longt>r-tt'nn combination was bought for 8 points. Thus, the near-term
combination was worth more than one-half of the cost of the longer-term combination.
These five criteria can be summarized as follows:
1. Relatively volatile stock.

2. Stock price nearly midway between two strikes.
3. Striking prices at least 10 points apart.
4. Two or three months remaining until near-term expiration .

.S. Price of near-term combination greater than one-half the price of the longer-term
combination.
Even though five criteria have been stated, it is relatively easy to find a position that satis-
fies all five conditions. The strategist may also be able to rely upon technical input. If the
stock seems to be in a near-term trading range, the position may be more attractive, for
that would indicate that the chances of the near-term combination expiring worthless are
enhanced.
The "'calendar straddle" is a strategy that looks deceptively attractive. As the reader
should know by now, options do not decay in a linear fashion. Instead, options tend to hold
time value premium until they get quite close to expiration, when the time value premium
disappears at a fast rate. Consequently, the sale of a near-term straddle and the simultane-
ous purchase of a longer-term straddle often appear to be attractive because the debit
seems small. Again, certain criteria can be set forth that will aid in selecting a reasonably
attractin' position. The stock should be at or very near the striking price when the position
is established. Since this is basically a neutral strategy, one that offers the largest potential
profits at near-term expiration, one should want to sell the most time premium possible.
This is why the stock must be near the striking price initially. The underlying stock does
not have to be a volatile one, although volatile stocks will most easily satisfy the next two
criteria. The near-term credit should be at least two-thirds of the longer-term debit. In
the examplt> used to explain this strategy, the near-term straddle was sold for .S,while the
longer-term straddle was bought for 7 points. Thus, the near-term straddle was worth
more than two-thirds of the longer-term straddle's price. Finally, the position should be
established with two to four months remaining until near-term expiration. If positions
with a longer time remaining are used, there is a significant probability that the underly-
ing stock will have moved some distance away from the striking price by the time the
near-term options expire. Summarizing, the three criteria for a "calendar straddle" are:
1. Stock near striking price initially .

2. Two to four months remaining until near-term expiration.
:3. Near-tt>rn1 straddle price at least two-thirds of longer-term straddle price.
Tht>"diagonal butterfly" is the most difficult of these three types of positions to locate.
Again, ont' would like the stock to be near the middle striking price when the position is
established. Also, one would like the underlying stock to be somewhat volatile, since there
is the possibility that long-term options will be owned for free. If this comes to pass, the
strategist \\'ants the stock to be capable of a large move in order to have a chance of generat-
CallsandPuts 345
ing large profits. The most restrictive criterion-one that will eliminate all but a few possi-
bilities on a daily basis-is that the near-term straddle price should be at least one and
one-half times that of the longer-term, out-of~the-mmwy combination. By adhering to this
criterion, one gives himself a reasonable chance of being able to huy the near-term straddle
back for a price low enough to result in owning the longer-term options for free. In the
example used to describe this strategy, the near-term straclclle was sold for 7 while the
out-of-the-moue:·, longer-term combination cost 4 points. This satisfies the criterion. Finally,
one should limit his possible risk before near-term expiration. Recall that the risk is equal
to the difference between any two contiguous striking prices, less the net credit received.
In the example, the risk would be .5minus :3,or 2 points. The risk should always be less than
the credit taken in. This precludes selling a near-term straddle at 80 for 4 points and buying
the put at 60 and the call at 100 for a combined cost of 1 point. Although the credit is sub-
stantially more than one and one-half times the cost of the long combination, the risk would
be ridiculously high. The risk in fact, is 20 points (the difference between two contiguous
striking prices) less the 3 points credit , or 17 points-much too high.
The criteria can be summarized as follows:
1. Stock near middle striking price initially.

2. Three to four months to near-term expiration.
3. Price of written straddle at least one and one-half times that of the cost of the
longer-term , out-of-the-money combination.
4. Risk before near-term expiration less than the net credit received.
One way in which the strategist may notice this type of position is when he sees a rela-
tively short-term straddle selling at what seems to be an outrageously high price. Profes-
sionals, who often have a good feel for a stock's short-term potential, will sometimes bid
up straddles when the stock is about to make a volatile move. This will cause the near-term
straddles to be very overpriced. vVhen a straddle seller notices that a particular straddle
looks too attractive as a sale, he should consider establishing a diagonal butterfly spread
instead. He still sells the overpriced straddle, but also buys a longer-term, out-of-the-money
combination as a hedge against a large loss. Both factions can he right. Perhaps the stock
will experience a very short-term volatile movement, proving that the professionals were
correct. However, this will not worry the strategist holding a diagonal butterfly, for he has
limited risk. Once the short-term move is over, the stock may drift hack toward the origi-
nal strike, allowing the near-term straddle to be bought back at a low price-the e\·entual
objective of the strategist utilizing the diagonal butterfly spread.
These are admittedly three quite complex stratE'gies and thus are not to be attempted
by a novice investor. If one wants to gain experience in how he would operate such a
strategy, it woul<l be far better to operate a "paper strategy" for a while. That is, one would
not actually make investments, but would instead follow prices in the newspaper and
make <lay-to-day decisions without actual risk. This will allow the inexperienced strategist
to gain a feel for how these complex strategies perform over a particular time period. The
astute investor can, of course, obtain price history information and track a number of
market cycles in this same way.
SUMMARY
Puts and calls can be combined to make some very attractive positions. The addition of a
call or put cre<lit spread to the outright purchase of a put or call can enhance the overall
profitability of the position, especially if the options are expensive. In addition, three
advanced strategies were presented that combined puts and calls at various expiration
<lates. These three various types of strategies that involve calendar combinations of puts
and calls may all be attractive. One should be especially alert for these types of positions
\vhen near-term calls are overpriced. Typically, this would be during, or just after, a bull-
ish period in the stock market. For nomenclature purposes, these three strategies are
called the "calendar combination," the "calendar straddle," and the "diagonal butterfly."
All three strategies offer the possibility of large potential profits if the underlying
stock remains relatively stable until the near-term options expire. In addition, all three
strategies have limited risk, even if the underlying stock should move explosively in either
directio n prior to near-term expiration. If an intermediate result occurs-for example, the
stock moves a moderate distance in either direction before near-term expiration-it is still
possible to realize a li1nited profit in any of the strategies, because of the fact that the time
premiums decay much more rapidly in the near-term options than they do in the
longer-term options.
The three strategies have many things in common, but each has its own advantages
and disackantages. The" diagonal butterfly" is the only one of the three strategies whereby
the strategist has a possibility of owning free options. Admittedly, the probability of actu-
ally being able to own the options completely for free is small. However, there is a rela-
ti\·ely large probability that one can substantially reduce the cost of the long options. The
"calendar combination," the first of the three strategies discussed, offers the largest prob-
ability of capturing the entire near-term premium. This is because both near-term options
are out-of-the-money to begin with. The "calendar straddle" offers the largest potential
profits at near-term expiration. That is, if the stock is relatively unchanged from the time
the position was established until the time the near-term options expire, the "calendar
straddle" will show the best profit of the three strategies at that time.
Chapter
CallsandPuts 347
Looking at the negative side, the "calendar straddle" is the least attractive of the
three strategies, primarily because one is forced to increase his risk after near-term expi-
ration, if he wants to continue to hold the longer-term options. It is often difficult to find
a "diagonal butterfly .. that offers enough credit to make the position attractive. Finally,
the '•calendar combination" has the largest probability oflosing the entire debit eventually,
because one may find that the longer-term options expire worthless also. (They are
out-of-the-money to begin with, just as the near-term options were.)
The strategist will not normally be able to find a large number of these positions
available at attractive price levels at any particular time in the market. However, since
they are attractive strategies with little or no margin collateral requirements, the strategist
should constantly be looking for these types of positions. A certain amount of cash or
collateral should be reserved for the specific purpose of utilizing it for these types of
positions-perhaps 15 to 20% of one 's dollars.
Ratio Spreads Using Puts
The put option spreader ma:· want to sell more puts than he owns. This creates a ratio
sprt>ad. Basically, two t_\pt>s of put ratio spreads !llay prow· to be attractive: the standard
1
ratio put spread and the ratio calendar spread using puts. Both strategies are designed for
the morc->aggrc->ssivc->
inn:>stor; when opc->ratedproperly, both can present attractive reward
opportunities.
THE RATIO PUT SPREAD
This strateg_\· is designed for a neutral to slightly bearish outlook on the unclerlving stock.
In a ratio put spread, onc->lm_\'Sa munber of puts at a highc->rstrike and sells more puts at
a lower strike. This position involves naked puts, since one is short more puts than he is
long. There is li111itedIIJJSiderisk in the position, hut the downside risk can he very large.
Tlw maximm11 profit can be obtained if the stock is exactly at the striking price of the
written puts at expiration.
Example: Given the following:
XYZ common, 50;

XYZ January 45 put, 2; and
A ratio put spread 111ighthe established h:· buying one January ,50 put and si11111ltaneo11sly
selling two Jarni;lr_\'.__J.,S
puts. Since 011t· would be paying %400 for the purchased put and
wo11ld he collc->cting 8.__J.()()
from tlw sale of the two out-of-the-11101w:· puts, the spread
co11ld he drnw for ('H'n lllOlle_\. Tlwrc is no 11psidt>risk in this position. Il'XYZshould rally
348
Chapter
24:RatioSpreadsUsingPuts 349
and be above 50 at January expiration, all the puts would expire worthless and the result
would be a loss of commissions. However, there is downside risk. If XYZ should fall bv a
great deal, one would have to pay much more to buy back the two short puts than he
would receive from selling out the one long put. The maximum profit would he realized
if XYZ were at 45 at expiration, since the short puts would expire worth 5 points and
could be sold at that price. Table 24-1 and Figure 24-1 summarize the position. Note that
there is a range within which the position is profitable-40 to .50 in this example. If XYZ
is above 40 and below 50 at January expiration, there will be some profit, before commis-
sions, from the spread. Below 40 at expiration, losses will he generated and, although
these losses are limited by the fact that a stock cannot decline in price below zero, these
losses could become very large. There is no upside risk, however, as was pointed out ear-
lier. The following formulae summarize the situation for any put ratio spread:
Maximum upside risk = Net debit of spread (no upside risk if done for
a credit)
Maximum profit Striking price differential x Number of long
potential puts - Net debit (or plus net credit)
Downside break-even price = Lower strike price - Maximum profit potential+
Number of naked puts
The investment required for the put ratio spread consists of the collateral require-
ment necessary for a naked put, plus or minus the credit or debit of the entire position.
Since the collateral requirement for a naked option is 20% of the stock price, plus the
TABLE 24-1.
Ratio put spread.
XYZPrice
at Long
January
50 Short
2 January
45 Total
Expiration PutProfit PutProfit Profit
20 +$2,600 -$4,600 -$2,000
30 + 1,600 - 2,600 - 1,000
40 + 600 600 0
42 + 400 200 + 200
45 + 100 + 400 + 500
48 200 + 400 + 200
50 400 + 400 0
60 400 + 400 0
FIGURE 24-1.
Ratio put spread.
r $500
C
0
:.=
~
·c..
X
UJ
cii
(/)
(/)
$0
0
...J
0
e
(l_
premium, minus the amount by which the option is out-of-the-money, the actual dollar
requirement in this example would be $700 (20% of $.S,000, plus the $200 premium,
minus the $.500 by which the January 4.S put is out-of-the-money). As with all types of
naked writing positions, the strategist should allow enough collateral for an adverse stock
move to occur. This will allow enough room for stock movement without forcing early
liquidation of the position due to a margin call. If, in this example, the strategist felt that
he might stay with the position until the stock declined to 39, he should allow $1,380 in
collateral (20% of $3,900 plus the $600 in-the-money amount).
The ratio put spread is generally most attractive when the underlying stock is initially
between the two striking prices. That is, ifXYZ were somewhere between 4.S and .SO,one
might find the ratio put spread used in the example attractive. If the stock is initially below
the lower striking price, a ratio put spread is not as attractive, since the stock is already
too close to the downside risk point. Alternatively, if the stock is too far above the striking
price of the written calls, one would normally have to pay a large debit to establish the
position. Although one could eliminate the debit by writing four or five short options to
each put bought, large ratios have extraordinarily large downside risk and are therefore
very aggressive.
Follow-up action is rather simple in the ratio put spread. There is very little that one
rn_•Pcl
do, except for closing the position if the stock breaks below the downside break-even
point. SincP put options tend to lose time value premium rather quickly after they become
i11-the-u1oney options, there is not normally an opportunity to roll down. Rather, one
shonlcl be able to close the position with the puts close to parity if the stock breaks below
Chapter
tlw downside hrt'ak-en:'11 point. The sprcadt'r rnay want to !my in additional long puts, as
was described for call spreads in Cliaptt'r 1L but this is not as advantageous in the put
spread because of the time value premium shrinkage.
Tl1is stratl'g:· nia: · prmr psychologically pleasing to the less experienced investor
heca11se he \\·ill not lose rnom'y on an upward move by the underlying stock. Many of the
ratio strategies that invoke call options have upside risk, and a large number of investors
do not likl' to lose monc:· when stocks move up. Thus, although these investors might be
attractt>d to ratio strategics lwcause of the possibility of collecting the profits on the sale
of rnultiplt' out-of-the-m01wy options, they may often prefer ratio put spreads to ratio call
spreads because of the small upside risk in the put strategy.
There is a \·ariation of the put ratio spread that can sometimes be even more attrac-
ti\·e, for it pushes the downside break-even point even lower-thereby recludng the
chance that the stock will fall below it.
Example: Using three strikes in the put ratio spread.

Suppose the following prices exist:
XYZ: 127
XYZ December 125 put: 3.00
These are fairly typical one-month option prices for a hroad-hased index or ETF,
such as SPY. The implied volatility of the options with the lower strikes is greater than the
implied volatility of the highest strike. A put ratio spread can be established as follows:
Buy 1 Dec 125 put, and Sell l Dec 121 put, and Sell l Dec 116 put
For a net overall credit of 0.25.
This is similar to the put ratio spread described above. If XYZ is above 125 at expira-
tion, the position will profit hy the amount of the initial credit, 25 cents. However, there
is a rather wide profit range for tliis spread, and the maximum profit is attainable over a
good portion of that range.
Downside break-even = Lower Strike - (Difference in two Higher Strikes) - Net credit
= 116 - (125 - 121) - 0.25
= 111.75
So this spread will not lost' money at expiration unless XYZ falls below 111.7,5.Since
it is 127 at tlie tillle the spread is established, tl,at is a sizeable dmvnside cushion.
FIGURE 24-2.
Ratio put spread using three strikes.
§ +$425
~
0..
X
w
cu
(/)
(/)
0 $0
_J
0 121 125
-.::
e
0...
Stock Price At Expiration
Figure 24-2 shows the profit graph for this spread.

Fmtlwnnore, the maximum profit potential of the spread is attainable at any point
between the two lower strikes-anywhere between 116 and 121 in this example.
Maximum Profit Potential = (Difference in two Higher Strikes)+ Net credit

= (125 - 121) + 0.2,5 = 4.25
One must margin the 116 put as a naked put. The other two puts constitute a bear
spread, and thus don't require any collateral. It is generally wise to margin the put as if
the stock wt're at the lower strike, in ordt>r to allow some excess collateral, so that a margin
call isn't generated as soon as the underlying begins to drop in price.
Once the position is in place, it should be monitored in case the underlying begins
to decli ne. If that happens, a profit may exist-before expiration-as tht' underlying falls
through the maximum profit potential area (between 116 and 121 in this example). If that
is the case, the spreader may want to remove part or all of tht' position to take a profit,
especially if he is worried that a far greater price drop might occur.
On the upside, if the underlying is slightly above the upper strike-say up to 1:30in
this example-a profit greatt'r than the initial credit may t'xist as well. This has to do with
the rate at which options dt>ca:-,·, and so if tht' 11ndt>rl:-,
1 ing is near 128. for t'xample, with a
week to go, the entire spread might be able to be removed for a credit.
Hence it is possible to establish this t:-,pt>of position for a credit. and then to exit later
1
for another credit. This is tht' objt>ct of this strategy and it is oftt>n attainable. Tht> worr:-,·,
Chapter
of course, is the downside risk lmt if the spreader monitors that and exits when the down-
side hreak-e,·e11 point is breached (even if m·erall losses have to be taken at that tirne), the
net effects of this strategy over time are quite favorable.
USING DELTAS
The '"delta spread" ccmcept can also be used for establishing and adjusting neutral ratio
put spreads. The delta spread was first described in Chapter 11. A neutral put spread can
be constructed by using the deltas of the two put options involved in the spread. The
neutral ratio is determined by dividing the delta of the put at the higher strike by the
delta of the put at the lower strike. Referring to the previous example, suppose the delta
of the January 4,5 put is -.30 and the delta of the January .50 put is -..50. Then a neutral
ratio would be 1.67 (- ..50 divided hy -.30). That is, 1.67 puts would be sold for each put
bought. One might thus sell .5January 4,5 puts and buy 3 January .SOputs.
This type of spread would not change much in price for small fluctuations in the
underlying stock price. However, as time passes, the preponderance of time value pre-
mium sold ,·ia the January 4.Sputs would begin to turn a profit. As the underlying stock
moves up or down by more than a small distance, the neutral ratio between the two puts
will change. The spreader can adjust his position back into a neutral one by selling more
January 45's or buying more January 50's.
THE RATIO PUT CALENDAR SPREAD
The ratio put calendar spread consists of buying a longer-term put and selling a larger
quantity of shorter-term puts, all with the same striking price. The position is generally
established with out-of-the-money put-that is, the stock is above the striking price-so
that there is a greater probability that the near-term puts will expire worthless. Also, the
position should be established for a credit, such that the money brought in from the sale
of the near-term puts more than covers the cost of the longer-term put. If this is clone and
the near-term puts expire worthless, the strategist will then own the longer-term put free,
and large profits could result if the stock subsequently experiences a sizable downward
movement.
Example: If XYZ were at .5.5,and the January 50 put was at 1..50with the April .SOat 2,
one could establish a ratio put calendar spread by buying the April .SOand selling two
January .SOputs. This is a credit position, because the sale of the two January ,50 puts
would hring in $:300 while the cost of the April .50 put is only $200. If the stock remains
above .50 until January expiration, the January 50 puts will expire worthless and the April
,50 put will be owned for free. In fact, even if the April ,50 put should then expire worth-
less, the strategist will make a small profit on the overall position in the amount of his
original credit-$100-less commissions. However, after the Januarys have expired
worthless, if XYZ should drop dramatically to 25 or 20, a very large profit would accrue
on the April 50 put that is still owned.
The risk in the position could be very large if the stock should drop well below ,50
before the January puts expire. For example, if XYZ fell to 30 prior to January expiration,
one would have to pay $4,000 to buy back the January 50 puts and would receive only
$2,000 from selling out his long April 50 put. This would represent a rather large loss. Of
course, this type of tragedy can be avoided by taking appropriate follow-up action. Nor-
mally, one 1co11ldclose tlze position {f the stock fell more than 8 to 10% belou.:the striking
price before the near-term puts expire.
As with any type of ratio position, naked options are involved. This increases the
collateral requirement for the position and also means that the strategist should allow
enough collateral in order for the follow-up action point to be reached. In this example,
the initial n"quirement would be $750 (20% of $.5,,500,plus the $150 January premium,
less the $500 by which thf' naked January .50 put is out-of-the-money). However, if the
strategist decides that he will hold the position until XYZ falls to 46, he should allow
$1,320 in collateral (20% of $4,600 plus the $400 in-the-money amount). Of course, the
$100 credit, less commissions, generated by the initial position can be applied against
these collateral requirements.
This strategy is a sensible one for the investor who is willing to accept the risk of
writing a naked put. Since thP position should be established with the stock above the
striking price of the put options, there is a reasonable chance that the near-term puts will
expire worthless. This means that some profit will be generated, and that the profit could
he large if the stock should then experience a large downward move before the longer-term
puts expire. One should take care, however, to limit his losses before near-term expiration,
since the e,·entual large profits will he ablf' to overcome a series of small losses, hut could
not overcome a preponderance of large losses.
RATIO PUT CALENDARS
Using the deltas of the puts in the spread, the strategist can construct a neutral position.
If the puts are initially out-of-the-money, then the neutral spread generally involves sell-
ing more puts than one buys. Another type of ratioed put calendar can be comtructecl
with in-the-mcmey puts. As with the companion in-the-money spread with calls, one
wou ld buy more puts than he sells in order to create a neutral ratio.
Chapter
In either case, the delta of the put to be purchased is divided by the delta of the put
to be sold. The result is the neutral ratio, which is used to determine how many puts to
sell for each one purchased.
Example: Consider the out-of-the-money case. XYZ is trading at ,59. The January .SOput
has a delta of 0.10 and the April .50 put has a delta of -0.17. If a calendar spread is to be
established, one would be buying the April .50 and selling the January ,50. Thus, the neu-
tral ratio would be calculated as 1.7 to 1 (-0.17/-0.10). Seventeen puts would be sold for
every 10 purchased.
This spread has naked puts and therefore has brge risk if the underlying stock
declines too far. However, follow-up action could be taken if the stock dropped in an
orderly manner. Such action would be designed to limit the downside risk.
Conversely, the calendar spread using in-the-money puts would normally have one
buying more options than he is selling. An example using deltas will demonstrate this fact:
Example: XYZ is at .59. The January 60 put has a delta of -0.4.5 and the April 60 put has
a delta of -0.40. It is normal for shorter-term, in-the-money options to have a delta that is
larger (in absolute terms) than longer-term, in-the-money options.
The neutral ratio for this spread would be 0.889 (-0.40/-0.4.5). That is, one would sell
only 0.889 puts for each one he bought. Alternatively stated, he would sell 8 and buy 9.
A spread of this type has no naked puts and therefore does have large downside
profit potential. If the stock should rise too far, the loss is limited to the initial debit of the
spread. The optimum result would occur if the stock were at the strike at expiration
because, even though the excess long put would lose money in that case, the spreads
involving the other puts would overcome that small loss.
Another risk of the in-the-money put spread is that one might be assigned rather
quickly if the stock should drop. In fact, one must be careful not to establish the spread
with puts that are too deeply in-the-money, for this reason. While being put will not nec-
essarily change the profitability of the spread, it will mean increased commission costs and
margin charges for the customer, who must buy the stock upon assignment.
A LOGICAL EXTENSION (THE RATIO CALENDAR COMBINATION)
The previous section demonstrated that ratio put calendar spreads can he attractive. The
ratio call calendar spread was described earlier as a reasonably attractive strategy for the
bullish investor. A logical combination of these two types of ratio calendar spreads (put
and call) would be the ratio co111bi11ation-buying a longer -term out-of-the-money com-
bination and selling several near-term out-of-the-money combinations.
55
common:
XYZ
XYZ January 50 put: 1.50 XYZ April 50 put: 2
XYZ January 60 call: 3.50 XYZ April 60 call: 5
One could sell the 11ear-term January combination (January ,50 put and January 60 call)
for .5 points. It \\'011lcl cost 7 points to Im\· the longer-term April comhination (April .SOput
and April 60 call). B\' selling more Ja11uar\' comhi11ations than April combinations hought,
a ratio calendar comhi11ation could he established. For example, suppose that a strategist
sold two of the near-term Ja11uary comhinatio11s, bri11ging in 10 points, and simultaneously
bought one April con1hination for 7 points. This would he a credit position, a credit of :3
points in this example. If the near-term, out-of~the-money combination expires worthless,
a guarantet>d profit of :3points will exist, e\'t'n if the longer-term options procet>d to expire
to tall\ 1 worthless. If tltc ncar-ferlll co111/Ji11{ltio11
expires u;ortliless, tlte longcr-ter111colll-
hi11r1tio11 is 01c11cd.for.frcc, and a large JJrofit could result m1 rt s1thstr111tialstock JJrice
movement in either direction.
Although this is a supt>rhl:· attracti\ e strategy if the near-term options do, in fact,
exp ire worthless, it must also he monitored closely so that large losses do not occur. These
large losses would he possible if tht' stock brokt' out i11either direction too quickly, before
the near-term options expire. In the abst>11ceof a technical opinion on the underlying
stock, one can gent>rally compute a stock prict' at which it might he reasonable to takt'
follow-up action. This is a similar cmal\1sis to tlw one clescrilwcl for ratio call calt>mlar
spreads in Chapter 12. Suppose the stock in this example began to rally. There would lw
a point at which the stratt'gist would h,:l\'e to pay :3points of debit to close the call sidt> of
the combination. That would be his break-even point.
Example: \\'ith XYZ at 6,5 at Januar\' expiration (,5 points ahove the higher strikt> of the
original combination), the near-tt>rm Januar\· 60 call would be worth ,5 points and tlw
longt>r-tcrm April 60 call might he worth 7 points. If one: closed the call side of the com-
bination, lw would haw to pa\· 10 points to buy hack two January 60 calls, and would
rt-'cein-' 7 points fron1 selling out his April 60. This closing transaction would he a :3-point
debit. This rt>prt>st'ntsa hreak-t'n'n situation up to this point in timt', except for commissions,
Chapter
since a 3-point credit was initially taken in. The strategist would continue to hold the April
50 put (the January 50 put would expire worthless) just in case the improbable occurs an<l
the underlying stock plunges below 50 before April expiration. A similar analysis could be
performed for the put side of the spread in case of an early downside breakout by the
underlying stock. It might be determined that the downside break-even point at January
expiration is 46, for example. Thus, the strategist has two parameters to work with in
attempting to limit losses in case the stock moves by a great deal before near-term expira-
tion: 6.5on the upside and 46 on the downside. In practice, if the stock should reach these
levels before, rather than at, January expiration, the strategist would incur a small loss by
closing the in-the-money side of the combination. This action should still be taken, how-
ever, as the objecti-ce of risk management of this strategy is to take small losses, if 11eces-
sary. Eventually, large profits may be generated that could more than compensate for any
small losses that were incurred.
The foregoing follow-up action was designed to handle a volatile move by the under-
lying stock prior to near-term expiration. Another, perhaps more common, time when
follow-up action is necessary is when the underlying stock is relatively unchanged at
near-term expiration. If XYZ in the example above were near ,5,5at January expiration, a
relatively large profit would exist at that time: The uear-term combination would expire
worthless for a gain of 10 points on that sale, and the longer-term combination would
probably still be worth about ,5points, so that the unrealized loss on the April combination
would be only 2 points. This represents a total (realized and unrealized) gain of 8 points.
In fact, as long as the near-term combination ca11be bought back for less than tlw original
3-point credit of the position, the position will show a total unrealized gain at near-term
expiration. Should the gain be taken, or should the longer-term combination he held in
hopes of a volatile move by the underlying stock'? Although the strategist will normally
handle each position on a case-by-case basis, the general philosophy should be to hold on
to the April combination. A profit is already guaranteed at this time-the worst that can
happen is a 3-point profit (the original credit). Consequently, the strategist should allow
himself the opportunity to make large profits. The strategist may want to attempt to trade
out of his long combination, since he will not risk making the position a losing one by
doing so. Technical analysis may be able to provide him with buy or sell zones on the
stock, and he would then consider selling out his long options in accordance with these
technical levels.
In summary, this strategy is very attractive and should he utili::.:edhy strategists
who have the expertise to trade in positions with naked options. As long as risk manage-
ment principles of taking small losses are adhered to, there will be a large probability of
overall profit from this strategy.
PUT OPTION SUMMARY
This concludes the section on put option strategies. The put option is useful in a variety
of situations. First, it represents a more attractive way to take advantage of a bearish atti-
tude with options. Second, the use of the put options opens up a new set of strategies-
straddles and combinations-that can present reasonably high levels of profit potential.
Many of the strategies that were described in Part II for call options have been discussed
again in this part. Some of these strategies were described more fully in terms of philoso-
phy, selection procedures, and follow-up action when they were first discussed. The sec-
ond description-the one involving put options-was often shortened to a more
mechanical description of how puts fit into the strategy. This format is intentional. The
reader who is planning to employ a certain strategy that can be established with either
puts or calls (a bear spread, for example) should familiarize himself with both applications
by a simultaneous review of the call chapter and its analogous put chapter.
The combination strategies generally introduced new concepts to the reader. The
combination allows the construction of positions that are attractive with either puts or
calls (out-of-the-money calendar spreads, for example) to be combined into one position.
The four combination strategies that involve selling short-term options and simultaneously
buying longer-term options are complex, but are most attractive in that they have the
desirable features of limited risk and large potential profits.
Long-Term Option
Strategies
Long-term option strategies are very similar to those involving short-term options, but
there arc some nuances. Listt->dlong-term options are actually a slightly different class of
options called LEAPS. While that term still exists, it is somewhat outmoded. Rather, in
the modern vernacular, long-term options are just referred to by their month and year.
For example>,in the year 2012, one might refer to an "IBM Jan '14 call"-one expiring in
January 2014.
LEAPS options were first introduced hy the CBOE in October 1990, and were
offered on a handful of blue-chip stocks. They proved quite popular, and eventually
long-term options were listed on more stocks. Today, they exist 011 many stocks and indices
with listed options. Prior to the Options Symbol Initiative (OSI) (see Chapter l), an
entirely different set of symbols was required to describe them. But once the OSI came
into effect in 2010, the term LEAPS was no longer mandatory.
Strategies involving long-term options are not substantially different from those
involving shorter-term options. However_ the fact that the option has so much time
remaining seems to favor the buyer and he a detriment to the seller. This is one reason
why LEAPS have been popular. As a strat<:>gist,one knows that the length of time remain-
ing has little to do with whether a certain strategy makes sense or not. Rather, it is the
relative value of tl1e option that <lictates strategy. If an option is overpriced, it is a viable
candidate for sc>lling,whether it lias two years of life remaining or two months. Obviously,
follow-up action rnay become much more of a necessity during the life of a two-year
option ; that matter is discussed later in this chapter.
359
Lonu-term
,..., options are buenerallv., listed about 2..5 ,vears hefore they, expire. For exam-
pie, in the fall of 2011, long-term options expiring in January of 2014 were listed on most
stocks. These listings med to occur in tlw spring, meaning that the longest-term options
had about 2.7,5 years until expiration, hut in 2008, the listed period was shortened. For
long-term stock options, tlw only expiration month is January. However, for some index
options, long-term options expire in December instead. The details stated above in this
paragraph could easily change in the future.
PRICING LEAPS
The factors influencing tlw prices of LEAPS are the same as those for any other option:
1. . underlying stock price,

2. striking price ,
:3. time remaining,
4. volatility ,
.5. risk-free interest rate, and
6. dividend rate .
The relative influence of these factors may he a little more pronounced for LEAPS
than it is for shorter-term equity options. Consequent!}·, the trader may think that a
LEAPS is m·erly expensin' or cheap by inspection, when in reality it is not. One should
he carcf11!in his eixzluatio11<>/LEAPSuntil lie has acquired expcrie11C('in obsen:,ing lune
their prices relate to the slwrter-term equity options 1citlz1cltich he is experienced.
It might prove useful to reexamine the option pricing curve with some LEAPS
included. Please refer to Figure 2,5-1 for the pricing curves of several options. As always.
the solid intrinsic \·alue line is the bottom line; it is the same for any call option. The
curves are all drawn with the same \·alues for the pertinent variables: stock price, striking
price, \ olatility, sliort-term interest rate, and dividends. Thus, they can he compared
directly.
The most ol)\'ious thing to notice about the cun-es in Figure 2.5-1 is that the curve
depicting the 2-year LEAPS is quite flat. It has the grneral shape of the shorter-term
c11n-es, hut there is so nmcl1 ti111e\·alue at stock prices e\·e112.So/rin- or out-of-the-money,
that the 2-year curve is much flatter than the others.
Other ohscn-ations can he made as well. Notice the at-the-rnone}· options: The
:2-:car LEAPS sells for a little lllorc than four tilllt'S the :3-rnonth option. As we shall see,
Chapter
25:Long-Term
OptionStrategies 361
FIGURE 25-1.
Call option pricing curve.
Various Expiration Dates

45 Strike= 80
40
35
(1)
(.)
30
~ 25
cij
0 20
15
10
5
3 Months
0
60 70 80 90 100 110
Stock Price
this can change with the effects of interest rates and dividends, but it confirms something
that was demonstrated earlier: Time decay is not linear. Thus, the 2-year LEAPS, which
has eight times the amount of time remaining as compared to the 3-rnonth call, only
sells for about four times as much. This LEAPS might appear cheap to the casual observer,
but remember that these graphs depict the fair values for this set of input parameters. Do
not he deluded into thinking tliat a LEAPS looks clicap merely hy comparing its price to
a nearer-term option; use a model to eua!uatc it, or at least use the output of someone
else's model.
The curves in Figure 2.5-1 depict the relationships between stock price, striking price,
and time remaining. The most important remaining determinant of an option's price is the
volatility of the underlying stock. Changes in volatility can greatly change the price of any
option. This is especially true for LEAPS, since a long-term option's price will fluctuate
greatly when volatility changes only a little. Some observations on the differing effects that
volatility changes have on short- and long-term options are presented later.
Before that discussion, however, it may he beneficial to examine the effects that
interest rates and dividends can have on LEAPS. These effects are much, much greater
than those on conventional equity options. Recall that it was stated that interest rates and
dividends are minor determinants in the price of an option, unless the dividends wert'
large. That statement pertains mostly to short-term options. For longt'r-tern1 options, the
cmrrnlative effect of an interest rate or dividend over such a long period of time can h,ffe
a magnified effect in terms of the absolute price of the option.
FIGURE 25-2.
2-year call pricing curve, interest rate comparison.
35
30
25
Q)
(.)
~ 20
C
0
li 15
0
10
Stock Price
Figure 2,5-2 presents the option pricing curve again, but the only option depicted is
a 2-year call option. The striking price is 100, and the straight line at the right depicts the
intrinsic ,·cdue. The three curves represent option prices for risk-free interest rate of 3%,
6%, and 9o/c.All other factors (time to expiration, volatility, and dividends) are fixed. The
difference between option prices caused merely hy a shift in rates of 3% is very large.
The difference in LEAPS prices increases as the LEAPS becomes in-the-money.
Note that in this figure, the distance between the curves gets wider as one scans them
from left to right. The price difference for 011t-of-tlie-r1101u:1j LEAPS is large enough-
nearly a point e,·en for options fairly far out-of-the-money (that is, the points on the
left-hand side of the graph). A shift of 3% in rates causes a larger price difference of over
2 points in the at-tlie-11w11eu,2-year LEAPS. The largest differential in option prices
occurs i11-thc-11w11euf This may seem somewhat illogical, but when LEAPS strategies are
examined later, the reasons for this will become clear. Suffice it to say that the in-the-money
LEAPS are changed in price by m·er 4 points when rates change by 3%. That is a mon-
strous differential and should cause any trader who is considering trading in-the-money
LEAPS to consider what his outlook is for short-term interest rates.
There is alwa~:s a substantial probability that rates can change hy 3% in two years.
Tims, it is difficult to predict with any certainty what risk-free rate to use in the pricing of
Chapter
2S:Long-Term
FIGURE 25-3.
Long-term call pricing curve as dividends increase.
With Dividend
Current > Increases
30 Dividend $1
25
T Increases
Q)
()
·;:: 20 $2
a..
C:
:2
0..
15
0
10
0
70 80 90 100 110 120
Stock Price
two-year LEAPS. Moreover, one should be very careful when deciding LEAPS are "cheap"
or "expensive" because, conventionally, the short-term interest rate is not usually consid-
ered as a significant factor in making such an analysis. For LEAPS, however, Figure 2.5-2
is obvious proof that interest rate considerations are importants .
Now consider dividends. Figure 2,5-3 depicts the prices of two-year calls. The three
curves on the graph are for different dividend rates-the top line representing the current
rate, the middle line representing prices if the dividend were raised by $1 annually, and
the bottom line showing what prices would be if the dividend were raised by $2 annually.
All other factors (volatility, time remaining, and risk-free interest rates) are the same for
each curve in this graph. The increase in dividends manifests itself by decreasing the
LEAPS call price. The reason that this is true, of course, is that the stock will be reduced
in price more when it goes ex-dividend hy tlw larger amounts of the increased
dividends.
The actual amount that the calls lose in price increases slightly as the call is more
in-the-money. That is, the curves are closer together on the left-hand (out-of-the-money)
side than they are on the right-hand (in-the-money) side. For the in-the-money call, a $1
increase in dividends over two years can cause the LEAPS to he worth about 1½ points
less in value .
Figure 2.5-.3is to the same scale as Figure 2.5-2, so they can be compared directly
in terms of magnitude. Notice that the effect of a $1 increase in dividends on the call
prices is nmch s111allerthan that of an increase in interest rates by 3%. Graphically speak-
ing , ont' can ohserve this by noting that the spaces between the three curves in the previ-
ous figure are much widc>rthan the spaces between the three curves in this figure.
Finally, note that di\·idend increases hm·e the opposite effect on puts. That is, an
increase in the dividend payout of the underlying common will cause a put to increase in
price. If the put is a long-term put, then the effect of the increase will be even larger.
Lest one think that LEAPS are too difficult to price objectively, note the following.
The prior figures of interest rate and dividend effects tend to magnify the effects on prices
for two reasons. First they depict the effects on 2-year LEAPS. That is a large amount of
life. The effects would he diminished somewhat for options with 10 to 23 months of life
left. Second, the figures depict the change in rates or dividends as being instantaneous.
This is not completely realistic. If rates change, they will change by a little bit at a time,
11s11all~, Wlc-or ½o/rat a time, perhaps as much as 1%. If dividends are increased, that
increase ma, he instantaneous, but it will not likely occur immediately after the LEAPS
arc purchased or sold. I lowe\·er, the point that these figures are meant to convey is that
interest rates and di\·iclends hm e a much greater effect on LEAPS than on ordinary
shorter-term equity options, and that is certainly a true statement.
COMPARING LEAPS AND SHORT-TERM OPTIONS
Tahlc 2.5-1 will help to illustrate the problem in valuing LEAPS, either mentally or with
a model. All of the variables-stock price, rnlatility, interest rates, and dividends-are
gi\·en in increments and the comparison is shown between 3-month equity options and
2-~;ear LEAPS. There are three se1.sof comparisons: for options 20% out-of-the-money,
options at-the-money, and options 20% in-the-money.
TABLE 25-1.
Comparing LEAPS and Short-Term Calls.
Change
inPrice
oftheOptions
20%out at 20%in
Variable Increment 3-mo. 2-yr. 3-mo. 2-yr. 3-mo. 2-yr.
Stock Pre. + lpt .03 .41 .54 .70 .97 .89
Volatility +1% .03 .43 .21 .48 .04 .33
Int. Rate + ½% .01 .27 .08 .55 .14 .72
Dividend + $.25/qtr 0 -.62 -.08 -1.18 -.14 -1.50
Chapter
25: Long-Term
A fevvwords are needPd lwrc to explai11how volatility is shown in this tahlt'. Volatility
is non11all:· t'xpressed as a percPnt. Tlw rnlatility of the stock markt't is aho11t 1.5%.The
table shows what would happen if volatilit:v changed by ont' 1wrccntage point, to 16%,,for
example. Of course. tlw tablt' also shows what would happen if the other factors changt'd
by a small amount.
Most of the disc.:rt'pancies between the :3-month and the 2-year options are large.
For example, if n)latility increases hy one percentage point, the 3-rnonth out-of-the-n1oney
call will increase in price hy only 3 cents (0.03 in the left-hand column) while the 2-ycar
LEAPS call will increase by 43 cents. As another example, look at the bottom right-hand
pair of numbers, which show the effect of a dividend increase on the options that are 207c
in-the-money Tht' assumption is that the dividend will increase 2.5 cents this quarter (and
will be 2.5 cents higher every quarter thereafter). This translatPs into a loss of 14 cents for
the 3-month call, since there is only one ex-dividend period that affects this call; hut it
translates into a loss of I½ for the 2-year LEAPS, since the stock will go ex-dividend by
an extra $2 over the life of that call.
The table also shows that only three of the discrepancies are not large. Two involve
the stock price change. If the stock changes in price by 1 point, neither the at-the-money
nor the in-the-money options behave very differt'ntly, although the at-the-money LEAPS
do jump by 70 cents. The observant reader will notice tlrnt the top lint' of the table depicts
the delta of the options in question; it shows the changt' in option price for a one-point
change in stock price. The only other comparison that is not extremely divergent is that
of volatility change for the at-the-money option. The 3-month call changes by 21 cents
while the LEAPS changes by nearly ½ point. This is still a factor of two-to-one, but is
much less than the other comparisons in the table .
Study the other comparisons in the table. The traclf-r who is used to dealing with
short-term options might ordinarily ignore the effect of a rise in interest rates of½ of 1%, of a
25-cent increase in the quarterly dividend, of the volatility increasing by a mere 1%, or maybe
even of the stock moving by one point (only if his option is out-of-the-money). The LEAPS
option trader will gain or suffer substantially and immediately if any of these occur. In almost
every case, his LEAPS call will gain or lose½ point of value-a significant amount, to he sme.
LEAPS STRATEGIES
Many of the strategies involving LEAPS are not significantly different from their coun-
terparts that involve short-term options. However, as shown earlier, the long-term 11atnrt'
of the LEAPS can sometimes cause the strategist to experience a result dif'fr·rcnt fr0111
that to which he has become accustomed.
As a general rule, one would want to be a buyer of LEAPS when interest rates were
low and when the volatilities being implied in the marketplace are low. If the opposite
were true (high rates and high volatilities), he would lean toward strategies in which the
sale of LEAPS is used. Of course, there are many other specific considerations when it
comes to operating a strategy, but since the long-term nature of LEAPS exposes one to
interest rate and volatility movements for such a long time, one may as well attempt to
position himself favorably with respect to those two elements when he enters a position.
LEAPSAS STOCK SUBSTITUTE
Any in-the-money option can be used as a substitute for the underlying stock. Stock own-
ers may be able to substitute a long in-the-money call for their long stock. Short sellers of
stock may be able to substitute a long put for their short stock. This is not a new idea; it
was discussed briefly in Chapter .3 under reasons why people buy calls. It has been avail-
able as a strategy for some time with short-term options. Its attractiveness seems to have
increased somewhat with the introduction of LEAPS, however. More and more people
are examining the potential of selling the stock they own and buying long-term calls
(LEAPS) as a substitute, or buying LEAPS instead of making an initial purchase in a
particular common stock.
Substitution for Stock Currently Held Long. Simplistically, this strategy involves
this line of thinking: If one owns stock and sells it, an investor could reinvest a small por-
tion of the proceeds in a call option, thereby providing continued upside profit potential
if the stock rises in price, and invest the rest in a bank to earn interest. The interest earned
would act as a substitute for the dividend, if any, to which the investor is no longer entitled.
Moreover, he has less downside risk: If the stock should fall dramatically, his loss is limited
to the initial cost of the call.
In actual practice, one should carefully calculate what he is getting and what he is
giving up. For example, is the loss of the dividend too great to be compensated for by the
investment of the excess proceeds? How much of the potential gain will be wasted in the
form of time value premium paid for the call? The costs to the stock owner who decides
to switch into call options as a substitute are commissions, the time value premium of the
call, and the loss of dividends. The benefits are the interest that can be earned from free-
ing up a substantial portion of his funds, plus the fact that there is less downside risk in
own ing the call than in owning the stock.
Example: XYZ is selling at ,50. There are one-year LEAPS with a striking price of 40
that sell for £12. XYZ pays an annual dividend of $0 ..50 and short-term interest rates are
S7c. \\'hat are the economics that an owner of 100 XYZ common stock must calculate in
Chapter
25:Long-Term
Optio~Strategies 367
order to determine whether it is viable to sell his stock and buy the one-year LEAPS as
a substitute?
The call has time value premium of 2 points (40 + 12 - .SO).Moreover, if the stock is
sold and the LEAPS purchased, a credit of $3,800 less commissions would be generated.
First , calculate the net credit generated:
Credit balance generated :

Sale of l 00 XYZ stock $5,000
Lessstock commission 25
Net sale proceeds : $4,975 credit
Cost of one LEAPScall $1,200

Plus option commission 15
Net cost of call: $1,215 debit
Total credit balance: $3,760 credit
Now the costs and benefits of making the switch can be computed:
Costs of switching:
Time value premium -$200
Lossof dividend -$ 50
Stock commissions -$ 25
Option commissions -$ 15
Total cost: -$290
Fixed benefit from switching:
Interest earned on
credit balance of $3,760
at 5% interest for one year= 0.05 x $3,760; + $188
Net cost of switching: -$102
The stock owner must now decide if it is worth just over $1 per share in order to have
his downside risk limited to a price of 39½ over the next year. The price of 39½ as his
downside risk is merely the amount of the net credit he received from doing the switch
($3,760) plus the interest earned ($188), expressed in per-share terms. That is, if XYZ falls
dramatically over the next year and the LEAPS expires worthless, this investor will still
have $:3,948 in a bank account. That is equivalent to limiting his risk to about :39½ on the
original 100 shares.
If the investor decides to make the substitution, he should invest the proceeds from
the sale in a 1-year CD or Treasury Lill, for two reasons. First, he locks in the current
rat e-the one used in his calculations-for the year. Second, he is not tempted to use the
money for something else, an action that might negate the potential benefits of the
substitution.
The above calculations all assume that the LEAPS call or the stock would have been
held for the full year. If that is known not to he the case, the appropriate costs or benefits
must be recalculated.
Caveats. This ($102) seems like a reasonably small price to pay to make the switch from
common stock to call ownership. However, if the investor were planning to sell the stock
before it fell to :19½ in any case, he might not feel the need to pay for this protection. (Be
aware , however, that he could accomplish essentially the same thing, since he can sell his
LEAPS call whenever he wants to.) Moreover, when the year is up, he will have to pay
another stock commission to repurchase his XYZ common if he still wants to own it (or he
,vill have to pay two option commission to roll his long call out to a later expiration date).
One other detriment that might exist, although a relatively unlikely one, is that the under-
lying common might declare an increased dividend or, even worse, a special cash divi-
dend. The LEAPS call owner would not he entitled to that dividend increase in whatever
form, while, obviously, the common stock owner would have Leen. If the company
cleclarecl a stock dividend, it would have no effect on this strategy since the call owner is
entitled to those. A change in interest rates is not a factor either, since the owner of the
LEAPS should i1l\'est in a 1-vear
,
Treasurv. bill or a 1-vear
,
CD and therefore would not Le
subject to interim changes in short-term interest rates.
There may be other mitigating circumstances. Mostly these would involve tax consid-
erations . If the stock is currently a profitable investment, the scile would generate a capital
gain, and taxes might be owecl. If the stock is currently being held at a loss, the purchase
of the call would constitute a wash sale and the loss could not he taken at this time. (See
Chapter 41 on taxes for a broader discussion of the wash sale rule>and option trading.)
In theory, the calculations above could produce an overall credit, in which case the
stockholdc>rwould normally want to substitute with the call, unless he has overriding tax
considerations or suspects that a cash dividend increase is going to be announced. Be very
rnrcful about su;itrlzing if tlzis situation should arise. Normally, arbitrageurs-persons
trading for exchange members and paving no commission-would take advantage of such
a situation hefore the general public could. If they are letting the opportunit:' pass by,
tlwre 11111st he a reason (probablY . thP cash clividPncl),so he extremelv. certain of .vour eco-
nomics and research before venturing into such a situation.
Chapter OptionStrategies
2S:Long-Term 369
In summary, holders of common stock on which there exist in-the-money LEAPS

should evaluate the economics of substituting the LEAPS call for the common stock.
Even if arithmetic calculations call for the substitution, the stockholder should consider
his tax situation as well as his outlook for the cash dividends to be paid by the common
before making th e switch.
BUYING LEAPS AS THE INITIAL PURCHASE

INSTEAD OF BUYING A COMMON STOCK
Lo gic similar to that used earlier to determine whether a stockholder might want to sub-
stitute a LEAPS call for his stock can be used by a prospective purchaser of common
stock. In other words, this investor does not already own the common. He is going to buy
it. This prospective purchaser might want to buy a LEAPS call and put the rest of the
money he had planned to use in the bank , instead of actually buying the stock itself.
His costs-real and opportunity-are calculated in a similar manner to those
expressed earlier. The only real difference is that he has to spend the stock commission in
this case, whereas he did not in the previous example (since he already owned the stock).
Example: As before, XYZ is selling at 50; there are I-year LEAPS with a striking price
of 40 that sell for $12; XYZ pays an annual dividend of $0.50, and short-term interest rates
are 5%.
The initial purchaser of common stock would have certain "opportunity'- costs and
savings if he decided instead to buy the LEAPS calls. First, calculate the difference in
investment required for the stock versus the LEAPS:
Prospective initial investment:

Stock: $5,000 + $25 commision $5,025
LEAPS:$1,200 + $15 commision $1,215
Net difference: $3,810
Now calculate the costs versus the savings:
Costs:
Lossof dividend -$ 50
Savings:
Interest on $3,810 for one year at 5%: +$190
Net opportunity cost: -$ 60
In this case, it seems even more likely that the prospective stock purchaser would
instead buy the LEAPS call. His net "cost" of doing so, provided he puts the difference
in initial investment in a 1-year CD or Treasury bill, is only $60. For this small amount,
he has all the upside appreciation (except $60 worth), but has risk only down to 40 (he will
have $4,000 in his bank account at the end of one year even if the LEAPS expire
worthless).
This strategy of buying in-the-rnoney LEAPS and putting the difference between
the LEAPS cost and the stock cost in an interest-bearing instrument is an attractive one.
It might seem it would be especially attractive if interest rates for the differential were
high. Unfortunately, those high rates would present something of a catch-22 because, as
was shown earlier, higher rates will cause the LEAPS to be more expensive.
In this margin strategy , one has the risk of not participating in cash dividend
increases or specials as the stockholder who substitutes does. But the other concerns of
the stockholder, such as taxes, are not pertinent here. Again, these specific calculations
only apply if the stock were to be held for the entire year. Adjustments would have to be
made if the holding period envisioned is shorter.
Using Margin. The same prospective initial purchaser of common stock might have
been contemplating the purchase of the stock on margin. If he used the LEAPS instead,
he could save the margin interest. Of course, he wouldn't have as much money to put in the
bank , but he should also compare his costs against those of buying the LEAPS call instead.
Example: As before, XYZ is selling at 50; there are 1-year LEAPS with a striking price
of 40 that sell for $12; XYZ pays an annual dividend of $0.50; and short-term interest rates
are 5o/c.Furthermore, assume the margin rate is 8% on borrowed debit balances.
First, calculate the difference in prospective investments:
Cost of buying the stock:

$5,000 + $25 commission: $5,025
Amount borrowed (50%) -2,512
Equity required $2,513
Cost of buying LEAPS:
$1,200 + $15 commission: $1,215
Difference (available to be placed in bank account) $1,298
:'\/ow the costs and opportunities can be compared, if it is assumed that he buys the
LEAPS:
Chapter 25:Long
-Ter
m OptionStrategies 371
Costs:
Dividend loss - 50
Savings:
Interest on $1,298 at 5% +$ 65
Margin interest on $2,512 debit balance at 8% for one year + 201
Net Savings: +$ 16
For the prospective margin buyer, there is a real savings in this example. The fact
that he does not have to pay the margin interest on his debit balance makes the purchase
of the LEAPS call a cost-saving alternative. Finally, it should be noted that current margin
rules allow one to purchase a LEAPS option on margin. That can be accounted for in the
above calculations as well; merely reduce the investment required an<lincrease the mar-
gin charges on the debit balance .
In summary, a prospective purchaser of common stock may often find that if there
is an in-the-money option available, the purchase of that option is more attractive than
buying the common stock itself. If he were planning to buy on margin, it is even more
likely that the LEAPS purchase will be attractive . The main drawback is that he will not
participate if cash dividends are increased or a special dividend is declared. Read on,
however , because the next strategy may be better than the one above .
PROTECTING EXISTING STOCK H O LDINGS WITH LEAPS PUTS
What was accomplished in the substitution strategy previously discussed'? The stock
owner paid some cost ($102 in the actual example) in order to limit the risk of his stock
ownership to a price of 39½ . What if he had bought c.l LEAPS put instead'? Forgetting the
pr ice of the put for a moment, concentrate on what the strategy would accomplish. He
would be protected from a large loss on the downside since he owns the put, and he could
participate in upside appreciation since he still owns the stock. Isn't this what the substi-
tution strategy was trying to accomplish'? Yes, it is. In this strategy, only one commission
is paid-that being on a fairly cheap out-of-the-money LEAPS put-and there is no risk
of losing out on dividend increases or special dividends.
The c.:omparisonbetween substituting a call or buying a put is a relatively simple one.
First, do the calculations as they were performed in the initial example above. That
exan1ple showed that the stockholder's cost would be $102 to substitute the LEAPS call
for the stock and such a substitution wonlcl protect him at a price of 39½. In effect, he is
pa:-;ing ~1.52 for a LEAPS pnt with a strike of 40-the $102 cost plus the difference
hetwet>n 40 and the 39½ protection price. Now, if an XYZ 1-year LEAPS put with strike
40 were available at l ½, he could accomplish everything he had initially wanted merely
by buying the put.
Moreover, he would sm·e commissiom and still be in a position to participate in
increased cash di\·idemls. These additional benefits should make the put worth even more
to the stockholder, so that he might pa~; e\·en slightly more than l ½ for the put. If the
LEAPS put were m·ailable at this price, it wonlcl clearly be the better choice and should
be bought instead of substituting the LEAPS call for the common stock.
Tillis, any stockholder who is thinking of protecting his position can do it in one of
two ways: Sell tl1e stock and s11bstitute a call, or continue to hold his stock and buy a put
to protect it. LEAPS calls and puts are amenable to this strategy. Because of the LEAPS'
long-term nature, one does not have to keep reestablishing his position and pay numerous
commissions, as he would with short-term options. The stockholder should perform the
simplP calculations as sl1own above in order to decide whether the move is feasible at all,
and if it is, whether to use the call substitution strategy or the put protection strategy.
LEAPS INSTEAD OF SHORT STOCK
Just as in-the-mmw:-,· LEAPS calls may sometimes be a smarter purchase than the stock
puts ma:-,·sometimes be a better purchase than shorting the common
itsplf_ in-the-111011e:-,·
stock. Recall that either the put purchase or the short sale of stock is a bearish strategy,
general!:-,·impleniented h:-,·someone who expects the stock to decline in price. The strate-
gist knows, howevec that short stock is a component of many strategies and might reflect
other opinions than pme bearishness on the common. In any case, an in-the-money put
ma:-,·pro\·e to be a viable substitute for shorting the stock itself The two main advantages
that the put owner has are that he has limited risk (whereas the short seller of stock has
theoretically unlimited risk); and he does not have to pay out any dividends on the under-
1:-,·ingstock as the short seller would. Also, the commissions for buying the put would
normally be smaller than those required to sell the stock short.
There is not nmch in tlw wa:-,·of calculating that needs to be done in order to make
tlw comparison between buying the in-the-money put and shorting the stock. If the time
\ alne prcmilllll spent is srnall in con1parison with the dividend payout that is saved, then
the put is probably the better choice .
Prnft'ssio11al arbitrageurs and other exchange members, as well as some large cus-
trnners, rccci\·e interest 011 their short sales. For these traders, the put would have to be
trading \\·itl1 \·irt11all:-,·
110time premium at all in order for the comparison to favor the put
Chapter
25: Long-Term
purchase over the stock short sale. However, the public customer who is going to he short-
ing stock should he aware of the potential for buying an in-the-money put instead.
SPECULATIVE OPTION BUYING WITH LEAPS
Strategists know that bu~·i11gcalls and puts can have various applications; witness the
stock substitution strategies above. However, the most popular reason for buying options
is for speculative gain. The leverage inherent in owning options and their limited risk
feature make them attractive for this purpose as well. The risk, of course, ca11be 100%
of the investment, and time decay works against the option owner as well. LEAPS calls
and puts fit all of these descriptions; they simply have longer maturities.
Time decay is the major enemy of the speculative option holder. Purchasing LEAPS
options instead of the shorter-term equity options generally exposes the buyer to less risk
of time decay on a daily basis. This is true because the extreme negative effects of time
decay magnify as the option approaches its expiration. Recall that it was shmvn in Chapter :3
that time decay is not linear: An option decays more rapidly at the end of its life than at
the beginning. Eventually, a LEAPS put or call will become a normal short-term equity
option and time will begin to take a more rapid toll. But in the beginning of the life of
LEAPS, there is so much time remaining that the short-term decay is not large in terms
of price.
Table 25-2 and Figure 25-4 depict the rate of decay of two options: one is
at-the-money (the lower curve) and tl1e other is 20% out-of-the-money (the uppt>r curve).
The horizontal axis is months of life remaining until expiration. The vertical axis is the
percent of the option price that is lost daily due to time decay. The options that qualif)·
as LEAPS are ones with more than 9 months of life remaining, and would thus be the
ones on the lower right-hand part of the graph.
The upward-sloping nature of both curves as time to expiration wanes shows that
time decay increases more rapidly as expiration approaches. Notice how mm:h more rap-
idly the out-of-the-money option decays, percentagewise, than the at-the-money. LEAPS,
however, do not decay much at all compared to normal equity options. Most LEAPS, even
the out-of-the-money ones, lose less than ½ of one percent of their value daily. This is a
pittance when compared with a 6-rnonth equity option that is 20% out-of.-the-rnoney-
that option loses well over l % of its value daily and it still has h mouths of life
remaining.
From the accompanying table, observe that the out-of-the-money 2-rnonth option
loses over 4% of its value daily!
Thus, LEAPS do not decay at a rapid rate. This gives the LEAPS holder a chance to
have his opinion about the stock price work for him withont hm·ing to worry as m11cl1
TABLE25-2.
Daily percent time value decay.
Percent
Decoy
Months
remaining At-the-money 20%Out-of-the-money
24 .12 .18
18 .14 .27
12 .19 .55
9 .22 .76
6 .27 1.18
3 .60 3.57
2 .73 4 .43
l.27
2 wks 3.33
FIGURE 25-4.
Daily percent time value decay.
125
100
20% Out-of-the-Money
0
0
,.....
X 75
~ -
(.)
Q)
0
c
~ 50
Q) LEAPS
a.. At-the-Money
25
0
3 6 9 12 15 18 21 24
Months Remaining
Chapter
25:Long-Term
about the passage of time as the average t'quity option holder would. An advantage of
owning LEAPS, therefore, is that one's timing of the option purchase does not have to be
as exact as that for shorter-term option buying. This can be a great psychological advan-
tage as well as a strategic advantage. The LEAPS option buyer who feels strongly that the
stock will move in the desired direction has the luxury of being able to wait calmly for the
anticipated move to take place. If it does not, even in perhaps as long as 6 months' time,
he may still be able to recoup a reasonable portion of his initial purchase price because of
the slow percentage rate of decay.
Do not be deluded into believing that LEAPS don't decay at all. Although the rate
of decay is slow (as shown previously), an option that is losing 0.1.5%of its value daily will
still lose about 25% of its value in six months.
Example: XYZ is at 60 and there are 18-month LEAPS calls selling for $8, with a striking
price of 60. The daily decay of this call with respect to time will be minuscule; it will take
about a week for even an eighth of a point to be lost due to time. However, if the option is
held for six months and nothing else happens, the LEAPS call will be selling for about 6.
Thus, it will have lost 25% of its value if the stock remains around 60 at the end of six months.
Those familiar with holding equity calls and puts are more accustomed to seeing an
option lose 25% of its value in possibly as little as four or five weeks' time. Thus, the advan-
tage of holding the LEAPS is obvious from the viewpoint of slower time decay.
This observation leads to the obvious question: "When is the best time to sell my call
and repurchase a longer-term one?" Referring again to Figure 25-4 may help answer the
question. Note that for the at-the-money option, the curve begins to bend dramatically
upward soon after the 6-rnonth time barrier is passed. Thus, it seems logical that to mini-
mize the effects of time decay, all other things being equal, one would sell his long
at-the-money call when it has about 6 months of life left and simultaneously buy a 2-year
LEAPS call. This keeps his time decay exposure to a minimum.
The out-of-the-money call is more radical. Figure 25-4 shows that the call that is
20% out-of-the-money begins to decay much more rapidly (percentagewise) at sometime
just before it reaches one year until expiration. The same logic would dictate, then, that if
one is trading out-of-the-money options, he would sell his option held long when it has
about one year to go and reestablish his position by buying a 2-year LEAPS option at the
same time.
ADVANTAGES OF BUYING "CHEAP"
It has been demonstrated that rising interest rates or rising volatility would make the
price of a LEAPS call increase. Therefore, if one is attempting to participate in LEAPS
speculative call buying strategies, he should be more aggressive when rates and volatili-
ties are low.
A few sample prices may help to demonstrate just how powerful the effects of rates
and volatilities are, and how they can be a friend to the LEAPS call buyer. Suppose that
one buys a 2-year LEAPS call at-the-money when the following situation exists:
XYZ:
100
January 2-year LEAPScall with strike of 100: 14
Short-term interest rates: 3%
Volatility: below average (historically)
For the purposes of demonstration, suppose that the current volatility is low for XYZ (his-
torically ) and that 3% is a low level for rates as well. If the stock moves up, there is no
problem , because the LEAPS call will increase in price. But what if the stock drops or
stays unchanged? Is all hope of a profit lost? Actually, no. If interest rates increase or the
volatility that the calls trade at increases, we know the LEAPS call will increase in value
as well. Thus, even though the direction in which the stock is moving may be unfavorable,
it might still be possible to salvage one's investment. Table 2.5-:3shows where volatility
would have to he or where short-term rates would have to go in order to keep the value of
the LEAPS call at 14 even after the indicated amount of time had expired.
To demonstrate the use of this table, suppose the stock price were 100 (unchanged)
after one month. If interest rates had risen to .3.4% from their original level of 3% during
that time, the call would still be worth 14even though one month had passed. Alternatively,
if rates were the same, hut rnlatility had increased by only .5% from its original level, then
the call would also still be worth 14. Note that this means that volatility would have to
increase only slightly (by ½oth) from its original level, not by .5 percentage points.
TABLE 25-3.
Factors necessary for January 2-year LEAPS to be = 14.
Stock
price Afterl month After6 months
l 00 (unchanged) r = 3.4% or r = 6% or
v+5% v+20%
95 r = 6% or r = 9.4% or
v+ 20% v+45%
90 r = 8.5% or r = 12.6% or
v+45% v+70%
Chapter
25:Long-Term
Even if the stock \Vere to drop to 90 ancl six months had passed, tht' LEAPS call
holder would still bt' even if rates had risen to 12.6% (highly unlikely) or volatility had
risen by 70%. It is often possible for volatilities to fluctuate to that extent in six months,
but not likely for interest rates.
In fact. as intt'rest rates go, only the top line of the table probably represents realistic
interest rates; an increase of 0.4% in one month, or :3%in 6 months, is possible. The other
lines, where the stock drops in price, probably require too large a jump in rates for rates
alone to be able to salvage the call price. However, any increase in rates will be helpful.
Volatility is another matter. It is often feasible for volatilities to change by as much as 50%
from their previous level in a month, and certainly in six months. Hence, as has been
stated before , the volatility factor is the more dominant one.
This table shows the effect of rising interest rates and volatilities on LEAPS calls. It
would be beneficial to the LEAPS call owner and, of course, detrimental to the LEAPS
call seller. This is clear evidence that one should be aware of the general level of rates and
volatility before using LEAPS options in a strategy.
THE DELTA
The delta of an option is the amount by which the option price will change if the underly-
ing stock changes in price by one point. In an earlier section of this chapter, comparing
the differences between LEAPS and short-term calls, mention was made of delta. The
subject is explored in more depth here because it is such an important concept, not only
for option buyers, but for most strategic decisions as well.
Figure 25-5 depicts the deltas of two different options: 2-year LEAPS and :3-rnonth
equity options. Their terms are the same except for their expiration dates; striking price
is 100, and volatility and interest rate assumptions are equal. The horizontal axis displays
the stock price while the vertical axis shows the delta of the options.
Several relevant observations can be made. First, notice that the delta of the
at-the-money LEAPS is very large, nearly 0.70. This means that the LEAPS call will move
much more in line with the common stock than a comparable short-term equity option
would. Very short-term at-the-money options have deltas of about ½, while slightly
longer-term ones have deltas ranging up to the 0.55 to 0.60 area. What this implies is that
the longer the life of an at-the-money option , the greater its delta .
In addition, the figure shows that the deltas of the :3-month call and the 2-year
LEAPS call are about equal when the options are approximately 5% in-the-money. If the
options are more in-the-money than that, then the LEAPS call has a lower delta. This
means that at--and out-of-the-money LEAPS will move more in line with the common
stock than comparable short-term options will. Restated, the LEAPS calls will move
FIGURE 2S-S.
Call delta comparison, 2-year LEAPS versus 3-month equity options.
90
80
70
8 60
; 50
Q)
O 40
30 t = 3 months
20
10
0
70 80 90 100 110 120 130
Stock Price
faster than the ordinary short-term equity calls unless both options are more than 5%
in-the-money. Note that the movement referred to is in absolute terms in change of price,
not in percentage terms.
The delta of the 2-year LEAPS does not change as dramatically when the stock
moves as does the delta of the 3-month option (see Figure 25-5). Notice that the LEAPS
curve is relatively flat on the chart, rising only slightly above horizontal. In contrast, the
delta of the 3-month call is very low out-of-the-money and very large in-the-money. \Vhat
this means to the call buyer is that the amount by which he can expect the LEAPS call
to increase or decrease in price is somewhat stable. This can affect his choice of whether
to buy the in-the-money call or the out-of-the-money call. With normal short-term options,
he can expect the in-the-money call to much more closely mirror the movement in the
stock so he might be tempted to buy that call ifhe expects a small movement in the stock.
With LEAPS, however, there is much less discrepancy in the amount of option price
movement that will occur.
Example: XYZ is trading at 82. There are 3-month calls with strikes of 80 and 90, and
there are 2-yt>arLEAPS calls at those strikes as well. The following table summarizes the
available information:
Chapter
25:Long-Term
XYZ:82 Date:
January,
2002
Option Price Delta
April ('02) 80 call 4 %
April ('02) 90 call Va
January ('04) 80 LEAPScall 14 ¾
January ('04) 90 LEAPScall 7 ½
Suppose the trader expects a 3-point move by the underlying common stock from 82 to
8.5. If he were analyzing short-term calls, he would see his potential as a gain of E{ in the
April 80 call versus a gain of 1/~in the April 90 call. Each of these gains is projected by
multiplying the call's delta times 3 (the expected stock move, in points). Thus, there is a
large difference between the expected gains from these two options, particularly after
commissions are considered.
Now observe the LEAPS. The January 80 would increase by 2¼ while the January
90 would increase by 1½ if XYZ moved higher by 3 points. This is not nearly as large a
discrepancy as the short-term options had. Observe that the January 90 LEAPS sells for
half the price of the January 80. These movements projected by the delta indicate that the
January 90 LEAPS will move by a larger percentage than the January 80 and therefore
would be the better buy.
PUT DELTAS
Many of the previous observations regarding deltas of LEAPS calls can be applied to
LEAPS puts as well. However, Figure 2.5-.5changes a little when the following formula
is applied. Recall that the relationship between put deltas and call deltas, except for
deeply in-the-money puts, is:
put delta = Call delta - 1
This has the effect of inverting the relationships that have just been described. In
other words, while the short-term calls didn't move as fast as the LEAPS, the short-term
puts move faster than the LEAPS puts in most cases. Figure 2.5-6 shows the deltas of
these options.
The vertical axis shows the puts' delta. Notice that out-of-the-money LEAPS puts
and short-term equity puts don't behave very differently in terms of price change (bottom
right-hand section of figure).
380 ·PartIll:PutOptionStrategies
FIGURE 25-6.
Put delta comparison, 2-year LEAPS versus 3-month equity options.
90
80
70 t = 3 months
0 60
0
1><so
Jg
Q)
40
0
30 t = 2 years
20
10
0
70 80 90 100 110 120 130
Stock Price
In-the -money puts (when the stock is below the striking price) move faster if they
are shorter-term. This fact is accentuated even more when the puts are more deeply
in-the-money. The left-hand side of the figure depicts this fact.
The LEAPS put delta curve is flat, just as the call delta curve was. Moreover, the
delta is not very large anywhere across the figure. For example, at-the-money 2-year
LEAPS puts move only about :30 cents for a one-point move in the underlying stock.
LEAPS put buyers 1clw ica11tto speculate on a stock\ dcncmcard mouement must realize
that the leceragefactor is not large; it takes approximately a :3-point move by the underly-
ing common for an at-the-money LEAPS put to increase in value by one point. Long-term
puts don't mirror stock movement nearly as well as shorter-term puts do.
In summary, the option buyer who is considering buying LEAPS puts or calls as
speculation should be aware of the different price action that LEAPS exhibit when com-
pared to shorter-term options. Due to the large amount of time that LEAPS have remain-
ing in their lives, the time decay of the LEAPS options is smaller. For this reason, the
LEAPS option hnyer doesn't need to be as precise in his timing. In general, LEAPS calls
mm·e faster when the underlying stock moves, and LEAPS puts move more slowly. Other
than that, the general reasons for speculati\·e option buying apply to LEAPS as well: lever-
age and limited risk.
Chapter
25:Long-Term
SELLING LEAPS
Strategies involving selling LEAPS options do not differ substantially from those involv-
ing shorter-term options. The discussions in this section concentrate on the two major
differences that sellers of LEAPS will notice. First, the slow rate of time decay of LEAPS
options means that option writers who are used to sitting back and watching their written
options waste awa)· will not experience the same effect with LEAPS. Second, follow-up
action for writing strategies usually depends on being able to buy back the written option
when it has little or no time value premium remaining. Since LEAPS retain time value
e\·en when substantially in- or out-of-the-money, follow-up action involving LEAPS may
involve the repurchase of substantial amounts of time value premium.
COVERED WRITING
LEAPS options can he sold against underlying stock just as short-term options can. No
extra collateral or investment is required to do so. The resulting position is again one with
limited profit potential, but enhanced profitability (as compared to stock ownership), if
the underlying stock remains unchanged or falls. The maximum profit potential of the
covered write is reached whenever the underlying stock is at or above the striking price
of the written option at expiration.
The LEAPS covered writer takes in substantial premium, in terms of price, when
he sells the long-term option. He should compare the return that he could make from the
LEAPS write with returns that can be made from repeatedly writing shorter-term calls.
Of course, there is no guarantee that he will actually be able to repeat the short-term
writes during the longer life of the LEAPS.
As an aside, the strategist who is utilizing the incremental return concept of covered
writing may find LEAPS call writing quite attractive. This is the strategy wherein he has
a higher target price at which he would be willing to sell his common stock, and he writes
calls along the way to earn an incremental return (see Chapter 2 for details). Since this
type of writer is only concerned with absolute levels of premiums being brought into the
account and not with things like return if exercised, he should utilize LEAPS calls if avail-
able, since the premiums are the largest available. Moreover, if the incremental return
writer is currently in a short-term call and is going to be called away, he might roll into a
LEAPS call in order to retain his stock and take in more premium.
The rest of this section discusses covered writing from the more normal viewpoint of
the investor who buys stock and sells a call against it in order to attain a particular return.
Example: XYZ is selling at ,50. The investor is considering a .500-share covered write and
he is unsure whether to use the 6-month call or the 2-vear
-
LEAPS. The .Jnlv-
.50 call sells
382 · PartIll:PutOptionStrategies
for 4 and has 6 months of life remaining; the January 50 LEAPS call sells for 8½ and has
2 years of life. Further assume that XYZ pays a dividend of $0.25 per quarter.
As \Vas done in Chapter 2, the net required investment is calculated, then the return
(if exercised) is computed, and finally the downside break-even point is determined.
NetInvestment
Required
July50call January
50LEAPS
Stock cost (500 shares @ 50) $25,000 $25,000
Plus stock commission + 300 + 300
less option premiums received - 2,000 - 4,250
Plus option commissions + 50 + 100
Net cash investment $23,350 $21,150
Obviously, the LEAPS covered writer has a smaller cash investment, since he is selling a
more expensive call in his covered write. Note that the option premium is being applied
against the net investment in either case, as is the normal custom when doing covered
writing.
Now, using the net investment required, one can calculate the return (if exercised).
That return assumes the stock is above the striking price of the written option at its expira-
tion, and the stock is called away. The short-term writer would have collected two dividends
of the common stock, while the LEAPS writer would have collected eight by expiration.
IfExercised
Return
July50call January
50LEAPS
Stock sale (500 @ 50) $25,000 $25,000
less stock commission 300 300
Plus dividends earned
until expiration + 250 + 1,000
less net investment - 23,350 - 21,150
Net profit if exercised $ 1,600 $ 4,550
Return if exercised 6.9% 21.5%
(net profit/net investment)
The LEAPS writer has a much higher net return if exercised, again because he
wrote a more expensive option to begin with. However, in order to fairly compare the two
writes, one must annualize the returns. That is, the July ,50 covered write made 6.9% in
six months. so it could make twice that in one year, if it can be duplicated six months
Chapter
25:Long-Term
from no1c. In a similar manner, the LEAPS covered writer can make 21.5% in two
years if the stock is called away. However, 011 an annualized basis, he would make only
half that amount.
If Exercised,
Return Annualized
July50call January
50LEAPS
13.8% 10.8%
Thus, 011 an annualized basis, the short-term write seems better. The shorter-term call
will generally have a higher rate of return, annualized, than the LEAPS call. The prob-
lems with annualizing are discussed in the following text.
Finally, the downside break-even point can be computed for each write.
Downside
Break-Even
Calculation
July50call January
50LEAPS
Net investment $23,350 $21,150
Lessdividends received 250 1,000
Total stock cost to expiration $23,100 $20,150
Divided by sharesheld (500),
equals break-evenprice: 46.2 40.3
The larger premium of the LEAPS call that was written produces this dramatically lower
break-even price for the LEAPS covered write.
Similar comparisons could be made for a covered write on margin if the investor is
using a margin account. The steps above are the mechanical ones that a covered writer
should go through in order to see how the short-term write compares to the longer-term
LEAPS write. Analyzing them is often a less routine matter. It would seem that the
short-term write is better if one uses the annualized rate of return. However, the annual-
ized return is a somewhat subjective number that depends on several assumptions.
The first assumption is that one will be able to generate an equivalent return six
months from now when the July .50 call expires worthless or the stock is called away. If
the stock were relatively unchanged, the covered writer would have to sell a 6-·month call
for 4 points again six months from now. Or, if the stock were called away, he would have
to invest in an equivalent situation elsewhere. Moreover, in order to reach the 2-year
horizon offered by the LEAPS write, the 6-month return would have to be regenerated
three more times (six months from now, one year from now, and a year and a half from
now). The covered writer cannot assume that such returns can be repeated with any cer-
tainty every six months.
The second assumption that was made when the annualized returns were calculated
was that one-half the return if exercised on the LEAPS call would be made when one
:·ear had passed. But, as has been demonstrated repeatedly in this chapter, the time decay
of an option is not linear. Therefore, one year from now, if XYZ were still at ,50, the Janu-
ar:· ,50 LEAPS call would not he selling for half its current price (½ x 8 1/2 - 4½). It would
he selling for something more like .5.00, if all other factors remained unchanged. How-
ever, given the variability of LEAPS call premiums when interest rates, volatility, or divi-
dend pa:·outs change, it is extremely difficult to estimate the call price one year from now.
Co11seq11ently,to say that the 21..5% :2-year return if exercised vvould be 10.8% after one
year may well be a false statement.
Tims, the covered writer must make his decision based on what he knows. He knows
that with the sl10rt-ten11July ,50write, if the stock is called away in six months, he will make
G.9%, period. Ifhe opts for the longer term, he will make 21..5% ifhe is called away in two
yt>ars. \ Vhich is ht>tter? The qtwstion can only be answered by each covered writer indi-
\'idually. One's attitude toward long-term investing will he a major factor in making the
decision. If he thinks XYZ has good prospects for the long term, and he feels conservative
returns will bC'helow 10% for the next couple of years, then he would probably choose the
LEAPS write. Howe\·er, if he feels that there is a temporary expansion of option premium
in the short-term XYZ calls that should be exploited, and he would not really want to he a
long-term holder of the stock then he would choose the short-term covered write.
Downside Protection. ThP actual downside break-even point might enter into one's
thinking as well. A downside hreak-even point of 40.3 is available hy using the LEAPS
write, and that is a known quantity. No matter how far XYZ might fall, as long as it can
recm·er to slightly over 40 by expiration two years from now, the investment will at least
break e\·en. A problem arises if XYZ falls to 40 quickly. If that happened, the LEAPS call
would still have a significant amount of time value premium remaining on it. Thus, if the
investor attempted to sell his stock at that time and bu:-,1 hack his call, he would have a loss,
not a break-even situation.
The short-term write offt>rs downside protection only to a stock price of 46.2. Of
course, repeatt>d writes of 6-month calls O\'er the next 2 years would lower the break-even
point he low that level. The problem is that if XYZ declines and one is forced to keep sell-
ing G-month calls e\·er:-,·6 months, he 1uay he forced to use a lower striking price, thereby
locking in a smaller profit (or possibly even a loss) if premium levels shrink The concepts
of rolling down are described in detail in Chapter 2.
A further word ahont rolling down ma:-,·he in order here. Recall that rolling down
nieans l)l]ying hack the call that is currently written ancl selling another one with a lower
Chapter
25: Long-Term
striking price. Such action ahrnys rt'duces the profitability of the overall position, although
it may he 11ect-'ssar~1
to prevent fortlwr downside losses if the common stock keeps declin-
ing. Now that LEAPS art-' arnilahlP, the short-ttTm writer facpd with rolling clown may
look to the LEAPS as a means of bri11ging in a healthy premium even though he is rolling
down. It is true that a large premium could be brought i11tothe acco1111t.But remember
that h~ doi11g so, one is committing himself to sell the stock at a lower price than he had
1
origi11ally intended. This is why the rolling down rednces the original profit potential. If
he rolls dmrn into a LEAPS rnll, he is reducing his rnaximu111profit potential for a longer
period of tinw Co11sequently, one should not always roll down into an option with a longer
maturitv.. Instead, he should carefullv. analvze
. whether he wants to be committed for an
even longer time to a position in which the underlying common stock is declining.
To summarize, the large absolute premimns available in LEAPS calls may make a
covered write of those calls seem unusually attractive. However, one shonld calculate the
returns available and decide whether a short-term write might not serve his purpose as
well. Even though the large LEAPS premium might rednce the initial investment to a
mere pittance, be aware that this creates a great amount of leverage, and leverage can be
a dangerous thing.
The large amount of downside protection offered by the LEAPS call is real, but if
the stock falls quickly, there would definitely be a loss at the calculated downside
break-even point. Finally, one cannot always roll down into a LEAPS call if trouble devel-
ops, because he will he committing himself for an even longer period of time to sell his
stock at a lower price than he had originally intended.
"FREE" COVERED CALL WRITES
In Chapter 2, a strategy of writing expensive LEAPS options was briefly described. In

this section, a more detailed analysis is offered. A certain type of covered call write, one
in which the call is quite expensive, sometimes attracts traders looking for a "free ride."
To a certain extent, this strategy is something of a free ride. As you might imagine, though,
there can be major problems.
The investment required for a covered call write on margin is ,50% of the stock price,
less the proceeds received from selling the call. In theory, it is possible for an option to
sell for more than .50% of the stock cost. Thus in a margin account, a covered write could
he established for "free." Let's discuss this in terms of two types of calls: the in-the-money
call write and the out-of-the-money call write.
Out-of-the-Money Covered Call Write. This is the simplest way to approach the
strategy. One may he able to find LEAPS options that are just slightly out-of-thP-rnoney,
which sell for .50% of the stock price. Understandably, such a stock would lw (p1ite volatile.
386 - PartIll:PutOptionStrategies
Example: COCO stock is selling for $38 per share. COCO has listed options, and a
2-year LEAPS call with a striking price of 40 is selling for $19. The requirement for this
covered write would be zero, although some commission costs would be involved. The
debit balance would be 19 points per share, the amount the broker loans you on margin.
Certain brokerage firms might require some sort of minimum margin deposit, but technically
there is no further requirement for this position. Of course, the leverage is infinite. Suppose
one decided to buy 10,000 shares of COCO and sell 100 calls, covered. His risk is $190,000
if the stock falls to zero! That also happens to be the debit balance in his account. Thus, for a
minimal investment, one could lose a fortune. In addition, if the stock begins to fall, one's
broker is going to want maintenance margin. He probably wouldn't let the stock slip more than
a couple of points before asking for margin. If one owns 10,000 shares and the broker wants
two points maintenance margin, that means the margin call would be $20,000.
The profits wouldn't be as big as they might at first seem. The maximum gross profit
potential is $210,000 if the 10,000 shares are called away at 40. The covered write makes
21 points on each share-the $40 sale price less the original cost of $19. However, one
will have had to pay interest on the debit balance of $190,000 for two years. At 10%, say,
that's a total of $38,000. There would also be commissions on the purchase and the sale.
In summary, this is a position with tremendous, even dangerous, leverage.
In-the-Money Covered Call Write. The situation is slightly different if the option
is in-the-money to begin with. The above margin requirements actually don't quite accu-
rately state the case for a margined covered call write. vVhen a covered call is written
against the stock there is a catch: Only 50% of the stock price or the strike price, which-
ei:er is less, is acailahle for "release." Thus, one will actually be required to put up more
than 50% of the stock price to begin with.
Example: XYZ is trading at ,50, and there is a 2-year LEAPS call with a strike price of
30, selling for 2.5 points. One might think that the requirement for a covered call write
would be zero, since the call sells for .50% of the stock price. But that's not the case with
in-the-money covered calls.
Margin requirement:
Buy stock: 50 points
Lessoption proceeds -25
Less margin release* -15*
Net requirement: 10 points
*50% of the strike price or 50% of stock price, whichever is less.
Chapter
25:Long-Term
This position still has a lot of leverage: One invests 10 points in hopes of making .5, if
the stock is called awa:· at 30. One also would have to pay interest on the LS-point
debit balance, of course, for the two-year duration of the position. Furthermore, should
the stock fall below the strike price, the broker would begin to require maintenance
margin.
Note that the above "formula" for the net requirement works equally well for the
out-of-the-mone~· covered call write, since .SO%of the stock price is always less than .SO%
of the strike price in that case.
To summarize this ''free ride'' strategy: If one should decide to use this strategy, he
must be extremely aware of the dangers of high leverage. One must not risk more money
than he can afford to lose, regardless of how small the initial investment might be. Also,
he must plan for some method of being able to make the margin payments along the way.
Finally , the in-the-money alternative is probably better, because there is less probability
that maintenance margin will be asked for.
SELLING UNCOVERED LEAPS
Uncovered option selling can be a viable strategy, especially if premiums are overpriced.
LEAPS options may be sold uncovered with the same margin requirements as short-term
options. Of course, the particular characteristics of the long-term option may either help
or hinder the uncovered writer, depending on his objective .
Uncovered Put Selling. Naked put selling is addressed first because, as a strategy, it
is equivalent to covered writing, and covered writing was just discussed. Two strategies
are equivalent if they have the same profit picture at expiration. Naked put selling and
covered call writing are equivalent because they have the profit picture depicted in Graph I,
Appendix D. Both have limited upside profit potential and large loss exposure to the
downside. In general, when two strategies are equivalent, one of the two has certain
advantages over the other.
In this case, naked put selling is normally the more advantageous of the two because
of the way margin requirement are set. One need not actually invest cash in the sale of a
naked put; the margin requirement that is asked for may be satisfied with collateral. This
means the naked put writer may use stocks, bonds, T-bills, or money market funds as col-
lateral. Moreover, the actual amount of collateral that is required is less than the cash or
margin investment required to buy stock and sell a call. This means that one could operate
his portfolio normally-buying stock, then selling it and putting the proceeds in a Trea-
sury hill or perhaps buying another stock-without disturbing his naked put position, as
long as he maintained the collateral requirement.
Consequently, the strategist who is buying stock and selling calls should probably be
selling naked puts instead. This does not apply to covered writers who are writing against
existing stock or who are using the incremental return concept of covered writing, because
stock ownership is part of their strategy. However, the strategist who is looking to take in
premium to profit if the underlying stock remains relatively unchanged or rises, while
having a modicum of downside protection (which is the definition of both naked put writ-
ing and covered writing), should be selling naked puts. As an example of this, consider the
LEAPS covered write discussed previously .
Example: XYZ is selling at 50. The investor is debating between a ,500-share covered
write using 2-year LEAPS calls or selling five 2-year LEAPS puts. The January 50 LEAPS
call sells for 8..50 and has two years oflife, while the January ,50 LEAPS put sells for 3.,50.
Further assume that XYZ pays a dividend of $0.25 per quart er.
The net investment required for the covered write is calculated as it was before;
assume that commissions are 3 cents per share for stock and $.5for an option contract.
NetInvestment
Required-Covered
Write
Stock cost (500 shares@ 50) $25,000
Plus stock commission + 15
Lessoption premiums received - 4,250
Plus option commissions + 25
Net cash investment $20,790
The collateral requirement for the naked put write is the same as that for any naked
equity option: 20o/c:of the stock price, plus the option price, less any out-of-the-money
amount , with an absolute minimum requirement of 15% of the stock price .
Collateral
Requirement-Naked
Put
20% of stock price (.20 x 500 x$50) $5,000
Plus option premium 1,750
Lessout-of-the-money amoun t 0
Total collateral requirement $6,750
'.\Jote that the actual premium recei\·ecl hy the naked put seller is $1,750 less commissions
of ~25, or $L72.5. This net premium could he used to reduce the total collateral
requ iremen t .
Chapter
25:Long-Term
Now one can compare the profitability of the two investments:
Return
IfStock
Over50at Expiration
Covered
Write
Stock sale (500 @ 50) $25,000
Lessstock commission 15
Plus dividends earned until expiration + 1,000
Lessnet investment - 20,790
Net profit if exercised $ 5,195
Naked
PutSale
Net put premium received $1,725
Dividends received 0
Net profit $1,725
Now the returns can be compared, if XYZ is over ,50 at expiration of the LEAPS:
if XYZ
Return over50
(net profit/net investment)
Naked put sale: 25.6%
Covered write: 25.0%
The naked put write has a better rate of return, even before the following fact is
considered. The strategist who is using the naked put write does not have to spend the
$6,7.50 collateral requirement in the form of cash. That money can be kept in a Treasury
bill and earn interest over the two years that the put write is in place. Even if the T-bill
were earning only 4% per year, that would increase the overall two-year return for the
naked put sale by 8%, to :3:3.6%.This should make it obvious that naked put selling is more
strategically advantageous than covered call writing.
Even so, one might rightfully wonder if LEAPS put selling is better than selling
shortC'r-term equity puts. As was the case with covered call writing, the answer depends
on what the investor is trying to accomplish. Short-term puts will not bring as much
premiurn into the account, so when they expire, one will be forced to find another suitable
put sale to replace it. On the other hand, the LEAPS put sale brings in a larger premimn
and one does not have to find a replacement until the longer-term LEA PS put expires.
The negative aspect to selling the LEAPS puts is that time decay won't lwlp much right
away and, even if the stock moves higher (which is ostensibly good for tlw position), the
put won't decline in price by a large amount, since the delta of the put is relative!:· s111all.
One other factor might enter in the decision regarding whether to use short-term
puts or LEAPS puts. Some put writers are actually attempting to buy stock below the
market price. That is, they would not mind being assigned on the put they sell, meaning
that they would buy stock at a net cost of the striking price less the premium they received
from the sale of the put. If they don't get assigned, they get to keep a profit equal to the
premium they received when they first sold the put. Generally, a person would only sell
puts in this manner on a stock that he had faith in, so that if he was assigned on the put,
he would view that as a buying opportunity in the underlying stock. This strategy does not
lend itself well to LEAPS. Since the LEAPS puts will carry a significant amount of time
premium, there is little (if any) chance that the put writer will actually be assigned until
the life of the put shortens substantially. This means that it is unlikely that the put writer
will become a stock owner via assignment at any time in the near future. Consequently,
if one is attempting to write puts in order to eventually buy the common stock when he is
assigned , he would be better served to write shorter-term puts.
UNCOVERED CALL SELLING
There are very few differences between using LEAPS for naked call selling and using
shorter-term calls, except for the ones that have been discussed already with regard to sell-
ing uncovered LEAPS: Time value decay occurs more slowly and, if the stock rallies and
the naked calls have to be covered, the call writer will normally be paying more time pre-
mium than he is used to when he covers the call. Of course, the reason that one is engaged
in naked call writing might shed some more light on the use of LEAPS for that purpose.
The overriding reason that most strategists sell naked calls is to collect the time
premium before the stock can rise above the striking price. These strategists generally
have an opinion about the stock's direction, believing that it is perhaps trapped in a trad-
ing range or even headed lower over the short term. This strategy does not lend itself well
to using LEAPS, since it would be difficult to project that the stock would remain below
the strike for so long a period of time.
Short LEAPS Instead of Short Stock. Another reason that naked calls are sold is
as a strategy akin to shorting the common stock. In this case, in-the-money calls are sold.
The advantages are threefold:
1. The amount of collateral required to sell the call is less than that required to sell stock
short.
2. One does not have to borrow an option in order to sell it short, although one must
borrow common stock in order to sell it short.
:1. :\.n nptick is not required to sell the option, hut one is required in order to sell stock short.
Chapter
25:Long-Term
For these reasons, one might opt to sell an in-the-money call instea<l of shorting stock.
The profit potentials of the two strategies are <lifferent. The short seller of stock has
a very large profit potential if the stock <leclines substantially, while the seller of an
in-the-money call can collect only the call premium no matter how far the stock <lrops.
Moreover, the call 's price decline will slow as the stock nears the strike. Another way to
express this is to say that the delta of the call shrinks from a number close to 1 (which
means the call mirrors stock movements closely) to something more like 0 ..50 at the strike
(which means that the call is only declining half as quickly as the stock).
Another problem that may occur for the call seller is early assignment, a topic that
is addressed shortly. One should not attempt this strategy if the underlying stock is not
borrowable for ordinan.1 short sales. If the underlying stock is not available for borrowing,
it generally means that extraneous forces are at work; perhaps there is a tender offer or
exchange offer going on, or some form of convertible arbitrage is taking place. In any case,
if the underlying stock is not borrowable, one should not be deluded into thinking that he
can sell an in-the-money call instead and have a worry-free position. In these cases, the
call will normally have little or no time premium and may be subject to early assignment.
If such assignment does occur, the strategist will become short the stock and, since it is
not borrowable, will have to cover the stock. At the least, he will cost himself some com-
missions by this unprofitable strategy; and at worst, he will have to pay a higher price to
buy back the stock as well.
LEAPS calls may help to alleviate this problem. Since they are such long-term calls,
they are likely to have some time value premium in them. In-the-money calls that have
time value premium are not normally assigned. As an alternative to shorting a stock that
is not borrowable, one might try to sell an in-the-money LEAPS call, but only if it has
time value premium remaining. Just because the call has a long time remaining until
expiration does not mean that it must have time value premium, as will be seen in the
following discussion. Finally, if one does sell the LEAPS call, he must realize that if the
stock drops, the LEAPS call will not follow it completely. As the stock nears the strike,
the amount of time value premium will build up to an even greater level in the LEAPS.
Still, the naked call seller would make some profit in that case, and it presents a better
alternative than not being able to sell the stock short at all.
Early Assignment. An American-style option is one that can be exercised at any time
during its life. All listed equity options, LEAPS included, are of this variety. Thus, any in-
the-money option that has been sold may become subject to early assignment. The clue to
whether early assignment is imminent is whether there is time value premium in the
option. If the option has no time value premium-in other words, it is trading at parity or
at a discount-then assignment may be close at hand. The option writer who does not want
to be assigned woul<l want to cover the option when it no longer carries time premiu111.
LEAPS may be subject to early assignment as well. It is possible, albeit far less likely,
that a long-term option would lose all of its time value premium and therefore be subject
to early assignment. This would certainly happen if the underlying stock were being taken
over and a tender offer were coming to fruition. However, it may also occur because of an
impending dividend payment. or more specifically, because the stock is about to go ex-
diviclend. Recall that the call owner, LEAPS calls included, is not entitled to any divi-
dencls paid by the 11nclerlyingstock. So if the call owner wants the dividend, he exercises
his call on the day before the stock goes ex-dividend. This makes him an owner of the
common stock just in the nick of time to get the dividend.
\Vhat econornic factors motivate him to exercise the call? If there is any time value
premium at all in the call, the call holder would be better off selling the call in the open
market and then purchasing the stock in the open market as well. In this manner, he
would still get the dividend, but he would get a better price for his call when he sold it. lf,
howt'ver, there is 110 time vahw premium in the call, he cloes not have to bother with two
transactions in the open market; he merely exercises his call in order to buy stock.
All well and good, but what makes the call sell at parity before expiration? It has to
do with the arbitrage that is available for any call option. In this case, the arbitrage is not
the simple discount arbitrage that was discussed in Chapter 1 when this topic was cov-
erecl. Rather, it is a more complicated form that is discussed in greater detail in Chapter
28. Suffice it to sa:•-'that if the dividend is larger than the interest that can he earned from
a credit balance equal to the striking price, then the time value premium will disappear
from the call.
Example: XYZ is a $:30stock and about to go ex-dividend ,50 cents. The prevailing short-
term interest rate is 5% and there are LEAPS with a striking price of 20.
A .SO-cent quarterly dividend on a striking price of 20 is an annual dividend rate (on
the strike) of 10%. Since short-term rates are much lower than that, arbitrageurs economi-
call~;cannot pa:v out 10% for dividends and earn .So/cfor their credit balances.
In this situation, the LEAPS call would lose its time value premium and would be a
candidate for early exercise when the stock goes ex-dividend.
In actual practice, the situation is more complicated than this, because the price of
the puts comes into play: but this example shows the general reasoning that the arbitra-
geur must go through.
Certain arbitrageurs construct positions that allow them to earn interest on a credit
balance equal to the striking price of the call. This position involves heing short the
1rnder]_,,i11g stock and being long the call. Thus, when the stock goes ex-dividend, the arbi-
tragt'11r \\·ill owt>the di\·idernl. If, howe\·ec the amount of the dividend is more than he
Chapter
25:Long-Term
will earn in intert>st from his <:.:rt>dit

balance, he will merely exercise his call to cover his
short stock. This action will pre\·ent him from having to pay out the diviclemL
The arbitrageur's exercise of the call means that someone is going to be assigned. If
you are a writer of the call, it could be >'Oll. It is not important to understand the arbitrage
completely: its effect will be reflectt'cl in the marketplace in the form of a call trading at
parity or a discount. Tims, cce11a LEAPS call 1cith a substantial amount of time remain-
ing may be assigned if it is trading at parity.
STRADDLESELLING
Straddle selling is equh'alent to ratio writing and is a strategy whereby one attempts to
sell (overpriced) options in order to produce a range of stock prices within which the
option seller can profit. The strategy often involves follow-up action as the stock moves
around, and the strategist feels that he must adjust his position in order to prevent large
losses. LEAPS puts and calls might be used for this strategy. However, their long-term
nature is often not conducive to the aims of straddle selling.
First, consider the effect of time decay. One might normally sell a three-month
straddle. If the stock "behaves" and is relatively unchanged after two months have passed,
the straclclle seller could reasonably expect to have a profit of about 40% of the original
straddle price. However, if one had sold a 2-year LEAPS straddle, and the stock were rela-
tively unchanged after two months, he would only have a profit of about 7% of the original
sale price. This should not be surprising in light of what has been demonstrated about the
decaying of long-term options. It should make the straddle seller somewhat leery of using
LEAPS, however, unless he truly thinks the options are overpriced.
Second, consider follow-up action. Recall that in Chapter 20, it was shown that the
bane of the straddle seller was the whipsaw. A whipsaw occurs when one makes a follow-
up protective action on one side (for instance, he does something bullish because the
underlying stock is rising and the short calls are losing money), only to have the stock
reverse and come crashing back clown. Obviously, the more time left until expiration, the
more likely it is that a whipsaw will occur after any follow-up action, and the more expen-
sive it will be, since there will be a lot of time value premium left in the options that are
being repurchased. This makes LEAPS straddle selling less than attractive.
LEAPS straddles may look expensive because of their large absolute price, and there-
fore may appear to be attractive straddle sale candidates. However, the price is often justified,
and the seller of LEAPS straddles will be fighting sudden stock movements without getting
much benefit from the passage of time. The best time to sell LEAPS straddles is when short-
term rates are high and volatilities are high as well (i.e., the options are overpriced). At least,
in those cases, the seller will derive some real benefit if rates or volatilities should drop.
SPREADS USING LEAPS
Any of the spread strategies previously discussed can be implemented with LEAPS as
well, if one desires. The margin requirements are the same for LEAPS spreads as they
are for ordinary equity option spreads. One general category of spread lends itself well to
using LEAPS: that of buying a longer-term option and selling a short-term one. Calendar
spreads , as well as diagonal spreads, fall into that category.
The combinations are myriad, but the reasoning is the same. One wants to own the
option that is not so subject to time decay, while simultaneously selling the option that is
quite subject to time decay. Of course, since LEAPS are long-term and therefore expen-
sive, one is generally taking on a large debit in such a spread and may have substantial risk
if the stock performs adversely. Other risks may be present as well. As a means of demon-
strating these facts, let us consider a simple bull spread using calls.
Example: The following prices exist in the month of January:
XYZ: 105
April 100 call: 10.50
April 110 call: 5.50
January (2-year) 100 call: 26
January (2-year) 110 call: 21.50
An investor is considering a bull spread in XYZ and is unsure about whether to use
the short-term calls, the LEAPS calls, or a mixture. These are his choices:
Short-termbull spread: Buy April 100 @ 10.50

Sell April 110 @ 5.50
Net Debit: $500
Diagonal bull spread: BuyJanuary LEAPS100 @ 26
Sell April 110 @ 5.50
Net Debit: $2,050
LEAPSbull spread: BuyJanuary LEAPS100 @ 26
Sell January LEAPS110@ 21.50
Net Debit: $450
:\otice that the debit paid for the LEAPS spread is slightly less than that of the short-
term bull sprt'acl. This means that they have approximately the same profit potential at
Chapter
2S:Long-Term
FIGURE 25-7.
Bull spread comparison at April expiration.
t 750
+500
-.-250
~ 0
ct
-250
-500
-750
-1,000
Stock Price
their respective expiration dates. However, the strategist is more concerned with how
these compare directly with each other. The obvious point in time to make this compari-
son is when the short-term options expire.
Figure 25-7 shows the profitability of these three positions at April expiration. It was
assumed that all of the following were the same in April as they had been in January: vola-
tility, short-term rates , and dividend payout.
Note that the short-term bull spread has the farniliar profit graph from Chapter 7, mak-
ing its maximum profit over 110 and taking its maximum loss below 100. (See Table 25-4.)
The LEAPS spread doesn't generate much of either a profit or a loss in only three
months' time . Even if XYZ rises to 120, the LEAPS bull spread will have only a $1.50
profit. Conversely, if XYZ falls to 80, the spread loses only about $200. This price action
is very typical for long-term bull spreads when both options have a significant amount of
time premium remaining in them.
The diagonal spread is different, however. Typically, the maximum profit potential
of a bull spread is the difference in the strikes less the initial debit paid. For this diagonal
spread, that would be $1,000 minus $2,050, a loss! Obviously, this simple formula is not
applicable to diagonal spreads, because the purchased option still has time value premium
when the written option expires. The profit graph shows that indeed the diagonal spread
is the most bullish of the three. It makes its best profit at the strike of the written option-a
TABLE 25-4.
Bull spread comparison at April expiration.
Stock
Price Short-Term Diagonal LEAPS
80 -500 -1,100 -200
90 -500 600 -150
100 -500 50 - 25
110 500 750 50
120 500 550 150
140 500 150 250
160 500 - 50 350
180 500 - 350 450
standard procedure for a11yspread-and that profit it is greater than either of the other
t\rn spreads at April e_\.pimtim1(u11dertlw significant assnmption that volatility and inter-
t'St rates art' 11nchangcd). If XYZ trades higher than 110, the diagonal spread will lose
sou1e of its profit: in fact. if XYZ were to trade at a very high price, the diagonal spread
would actually have a loss (see Table 2,5-4). \ Vhe11everthe purchased LEAPS call loses its
1
time value premium, the diagonal spread will not perform as well.
If the co111rnonstock drops in price, the diagonal spread has the greatest risk in dol-
lar terms hut 11otin percentage terms, because it has the largest initial debit. If XYZ falls
to HOin three months, the spread will lose about $1,100, just over half the initial $2,0.50
debit. Ol)\'iously, the short-term spread would have lost 100% of its initial debit, which is
only $500, at that same point in time.
The diagonal .sprrnclpresents {/II opportunity to rnrn more money if the underlying
co11111w11 is near tlze strike of tlze 1critte11option 1che11the 1critten option expires. How-
e\·er_ if the common u1on"s a great deal in either direction, the diagonal spread is the
worst of the three. This rnea11sthat tht' cliago11alspread strategy is a neutral strategy: One
wants the 1mderl:·i11g common to remain near the written strike until the near-term
option t'\:pires. This is a trne stateme11t e\·en if the diagonal spread is under the guise of a
bullish spread, as in the previous example.
~I any traders are fond oflrnying LEAPS and selling a11out-of-the-money near-term
call as a ht>ch!;e.Be cart>fnl about doing this. If the underlying common rises too fast and/
or intnest rates fall a11d/or rnlatility dt>creases, this could be a poor strategy. There is
rt>all:·11othi11\2;
q11itt'as ps:·chologically da11iagi11gas ht>i11gright about the stock, but being
in tlw \\Trn1g option stratt'g: and tht>rt'fort>losing money. Consider the above examples.
the spreader was lmllish 011XYZ; that's why he chose bull spreads. If XYZ
Oste11sil1l_1,-,
Chapter25:Long-Term
hE'came a \\·ildk lmllish stock and rosE-'fron1 100 to lkO in thret' rno11ths, tht> diagonal
spreader \\'011ld l1a\·t' lost 111ollt';,'·He co11lcl11'thml' lwen liappy-no one wrndd ht>. This is
something to keep in mind when diagonalizing a LEAPS spread.
Tlw deltas of tlw options imoln:>d i11the sprt>ad will gi\'E-'Olle a good chit> as to how
it going to pcrforlll. Recall that a sl1ort-ten11. in-the-rnont>y option acquires a rntl1er high
dPlta. especially as expiration dra\\·s nigh. llcm·e\·er, an i11-the-mont>y LEAPS call will not
ha\·e an E-'xtrernely high delta. hecanst' of tlw \ ast a!llount of time rt>maining. Tl1us, OllE:"' is
short an optioll \\·itl1 a liigli delta and long an optio11 witli a srnallt>r dt>lta. These deltas
indicate tl1at Olle is goi11gto lost> 1no11eyif tht> underlying stock rist's in prict'. Consicler the
following situation:
XYZ
Stock,
120:
Call Position Delta
Long 1 January LEAPS100 call: 0.70
Short 1 April 110 call: -0.90
At this point, if XYZ rises in pricP hy 1 point, the spread can he expected to losE-'20 cents,
since tl1e delta of the short option is 0.20 greater than the delta of the long option.
This pl1e11omenon has ra111ifications for the diagonal spreader of LEAPS. If the two
strike prices of the spread art> too close together, it um:· actually be possible to construct
a hull spread that loses money on the upside. That would be \·ery difficult for most traders
to accept. In the ahm·e example, as depictE-'d in Table :2.S-4,that's what happens. One way
around this is to widen the strike prices out so that there is at least smne profit potential,
e\·en if tl1e stock rises drarnaticalh-. That rnav be difficult to do and still he able to sell the
- -
short-term option for any meaningful amount of premium.
~ote tl1at a diagonal spread could e\·en he considered as a substitute for a covered
write in some special cases. It was shown that a LEAPS call can sometimes be used as a
substitute for the common stock with the im-estor placing the difference between the cost
of the LEAPS call and the cost of the stock in tht> bank (or in T-bills). Suppose that an
im·estor is a covered writer, buying stock and selling reL1tiVt'lyshort-term calls against it.
If that investor were to make a LEAPS call s11bstit11tionfor his stock, he would then lim-e
a diagonal hull spread. Such a diagonal sprt>aclwould probably ha\·e less risk than the one
descrihE-'d ahm·e, since the im·estor presumably chose the LEAPS substit11tio11becanst' it
was "cheap." Still. the potential pitfalls of the diagonal bull spread would appl:,· to this situ-
ation as well. Tims, if one is a cm-ered writer, this cloE-'snot nt>cessarily mean that he can
s11hstit11tl'.LEAPS calls for the long stock without taking cart>. The resultin1.; position rna:·
not resemble a covered write as much as he thought it would.
The "bottom line" is that if one pays a debit greater than the difference in the strike
prices, he may eventually lose money if the stock rises far enough to virtually eliminate
the time value premium of both options. This comes into play also if one rolls his options
clotcn if the underlying stock declines. Eventually, by doing so, he may invert the strikes-
i.e., the striking price of the written option is lower than the striking price of the option
that is owned. In that case, he will have locked in a loss if the overall credit he has
received is less than the difference in the strikes-a quite likely event. So, for those who
think this strategy is akin to a guaranteed profit, think again. It most certainly is not.
Backspreads. LEAPS may be applied to other popular forms of diagonal spreads, such
as the one in which in-the-money, near-term options are sold, and a greater quantity of
longer-term (LEAPS) at- or out-of-the money calls are bought. (This was referred to as a
diagonal backspread in Chapter 14.) This is an excellent strategy, and a LEAPS rnay be
used as the long option in the spread. Recall that the ohject of the spread is for the stock
to be volatile, particularly to the upside if calls are used. If that doesn't happen, and the
stock declines instead, at least the premium captured from the in-the-money sale will be a
gain to offset against the loss suffered on the longer-term calls that were purchased. The
strategy can be established with puts as well, in which case the spreader would want the
underlying stock to fall dramatically while the spread was in place .
Without going into as much detail as in the examples above, the diagonal back-
spreader should realize that he is going to have a significant debit in the spread and could
lose a significant portion of it should the underlying stock fall a great deal in price. To the
upside, his LEAPS calls will retain some time value premium and will move quite closely
with the underlying common stock. Thus, he does not have to buy as many LEAPS as he
might think in order to have a neutral spread.
Example: XYZ is at 10.5and a spreader wants to establish a backspread. Recall that the
quantity of options to use in a neutral strategy is determined by dividing the deltas of the
two options . Assume the following prices and deltas exist:
XYZ:
105inJanuary
Option Price Delta
April 100 call 8 0.75
July 110 call 5 0.50
January (2-year)LEAPS100 call 15 0.60
Two backspreads are aYailable with these options. In the first, one would sell the April
100 calls and buy the July 110 calls. He would be selling 3-month calls and buying
Chapter
25:Long-Term
Option·
Strategies 399
6-rnonth calls. The neutral ratio is 0.75/0.50 or 3 to 2; that is, 3 calls are to be bought for
every 2 sold. Thus , a neutral spread would be:
Buy 6 July 110 calls

Sell 4 April l 00 calls
As a second alternative, he might use the LEAPS as the long side of the spread; he would
still sell the April 100 calls as the short side of the spread. In this case, his neutral ratio
would be 0.75/0.60, or 5 to 4. The resulting neutral spread would be:
Buy 5 January LEAPS110 calls

Sell 4 Apr I l 00 calls
Thus, a neutral backspread involving LEAPS requires buyingfewer calls than a neutral
backspread inwluing a 6-month option on the long side. This is because the delta of the
LEAPS call is larger. The significant point here is that, because of the time value reten-
tion of the LEAPS call, even when the stock moves higher, it is not necessary to buy as
many. If one does not use the deltas, but merely figures that 3 to 2 is a good ratio for any
diagonal backspread, then he will be overly bullish if he uses LEAPS. That could cost
him if the underlying stock declines .
Calendar Spreads. LEAPS may also be used in calendar spreads-spreads in which

the striking price of the longer-term option purchased and the shorter-term option sold
are the same. The calendar spread is a neutral strategy, wherein the spreader wants the
underlying stock to be as close as possible to the striking price when the near-term option
expires. A calendar spread has risk if the stock moves too far away from the striking price
(see Chapter 9 and 22). Purchasing a LEAPS call increases that risk in terms of dollars,
not percentage, because of the larger debit that one must spend for the spread.
Simplistically, calendar spreads are established with equal quantities of options
bought and sold. This is often not a neutral strategy in the true sense. As was shown in
Chapter 9 on call calendar spreads, one may want to use the deltas of the two options to
establish a truly neutral calendar spread, particularly if the stock is not initially right at
the striking price. Out-of-the-money, one would sell more calls than he is buying. Con-
versely, in-the-money, one would buy more calls than he is selling. Both strategies statisti-
cally have merit and are attractive. When using LEAPS deltas to construct the neutral
spread, one need generally buy fewer calls than he might think, because of the higher
delta of a LEAPS call. This is the same phenomenon described in the previous example
of a diagonal backspread.
SUMMAR
LEAPS are nothing more than long-term options. They are usable in a wide variety of
strategies in the same way that any option would be. Their margin and investment
requirements are similar to those of the more familiar equity options. Both LEAPS puts
and calls are traded , and there is a secondary market for them as well.
There are certain differences between the prices of long-term options and those of
shorter-term options, but the greatest is the relatively large effect that interest rates and
dividends have on the price of long-term options. Increases in interest rates will cause
LEAPS to increase in price, while increases in dividend payout will cause LEAPS calls
to decrease in price and LEAPS puts to increase in price. As usual, volatility has a major
effect on the price of an option, and long-term options are no exception. Even small
changes in the volatility of the underlying common stock can cause large price differences
in a two-year option. The rate of decay clue to time is much smaller for long-term options.
Finally, the deltas of LEAPS calls are larger than those of short-term calls; conversely, the
deltas of LEAPS puts are smaller.
Several common strategies lend themselves well to the usage of LEAPS. A LEAPS
may be used as a stock substitute if the cash not invested in the stock is instead deposited
in a CD or T-hill. LEAPS puts can be bought as protection for common stock. Speculative
option buyers will appreciate the low rate of time decay of LEAPS. LEAPS calls can be
written against common stock, thereby creating a covered write, although the sale of
naked LEAPS puts is probably a better strategy in most cases. Spread strategies with
LEAPS may be viable as welL but the spreader should carefully consider the ramifications
of bu~:ing a long-term option and selling a shorter-term one against it. If the underlying
stock moves a great distance quickly, the spread strategy may not perform as expected.
Overall, long-term options are not very different from the shorter-term options to
vvhich traders and investors have become accustomed. Once these investors become
familiar with the way these long-term options are affected by the various factors that
determine the price of an option, they will consider the use of long-term options as an
integral part of a strategic arsenal.
Additional
Considerations
Buying Options
and Treasury Bills
Numerous strategies have been describe<l, ranging from the simple to the complex. Each one
has advantages, but there are disadvantages as well. In fact, some of them may be too complex
for the average investor to seriously consider implementing. The reader may feel that there
should be an easier answer. Isn't there a strategy that might not require such a large invest-
ment or so much time spent in monitoring the position, but woul<lstill have a chance of return-
ing a reasonable profit? In fact, there is a strategy that has not yet been described, a strategy
considered by some experts in the field of mathematical analysis to be the best of them all.
Simply stated, the strateglj consists of putting 90% of one's money in riskjree investments
(mch as short-term TreasurlJ bills)and buying options with the remaining 10% of one'sfunds.
It has previously been pointed out that some of the more attractive strategies are
those that involve small levels of risk with the potential for large profits. Usually, these
types of strategies inherently have a rather large frequency of small losses, and a small
probability of realizing large gains. Their advantage lies in the fact that one or two large
profits can conceivably more than make up for numerous small losses. This Treasury bill/
option strategy is another strategy of this type .
HOW THE TREASURY BILL/OPTION STRATEGY OPERATES
Although there are certain details involved in operating this strategy, it is basically a
simple one to approach. First, the most that one can lose is 10%, less the interest earned
on the fixed-income portion of his portfolio (the remaining 90% of his assets), during
403
404 PartIV:Additional
Considerations
the life of the purchased optiom. It is a simple matter to space out one's commitments
to option purchases so that his m entll risk in a one-year period can be kept down to
ne arly 10%.
Example: An im·estor rnight decide to put :2½% of his money into three-month option
purchases. Tims, in any one :•;ear.he \Ymild be risking 107r.At the same time he ,rnuld be
earning perhaps 69c frorn the m erall interest generated on the fi:.._ed-incomesecurities
that make up the remaining U09c of his assets. This \\·mild keep his m·erall risk down to
appro xima tely 4 .6% p er year.
Tht>rt>are better \\'ays to rnonitor this risk and they are described shortl:·· The poten-
tial profits frorn this strategy are lirnitecl onl:· b:· time. Since one is O\\'ning options-say
call options-he co11klprofit handsomely from a large up,Yard moYe in the stock market.
As with any strategy in which one has limited risk and the potential of large profits, a small
11m11berof large profits could offset a large number of srnall losses. In actual practice, of
course, his profits will ne,·er he m·ern-lH:lming, since only apprmimatel:· 107c of the mone:·
is com m itt ed to opti on purchases.
It should he noted that ,Yhen intert>st rates are extremeh- low, there is no "interest
earned" component from the T-bills-or ,·ery little, at best. In that case, one might
want to consider im·estmt>11tswith slight!:· more risk than T-bills for the 90% of the assets
that are 11ut im·estecl in long options. These might be AAA corporate bonds, or some-
thing similar. Hm,·e,·er, one should not take an:· untoward risk ,,·ith the interest-earning
portion of this strateg:·-suclt as junk bonds, for example . The idea is that the
interest-earning portion is sate, and the option-bu:-ing portion is risk:·· To introduce much
risk into the interest-earning portion would be to change the strateg:··s objectiYes too
radi cally.
In totaL tl1is stmtcg!J !ms greatly reduced risk 1citli the potential lf making abm·c-
accmge JJn~fits.Since the 109c of the mone:· that is im-ested in options gi,·es great leYer-
age. it might he possible for that portion to double or triple in a short time under farnrable
market conditions. This strategy is something like owning a corl\'ertible bond. A com·ert-
ihle bond, since it is com·t>rtihle into the cornmon stock. rnm·es up and do\\'n in price with
the price of the under!: ing stock. Hmw,·er. if the stock should fall a great deaL the bond
,, ill not follm,· it all the "·a:· dmrn. because e,·e11tuall:· its :·ielcl will prm·ide a "floor" for
the price.
:\ strateg:· that is not used ,·ery often is called the "s:·nthetic com·ertible bond." One
buys a ddwntmc and a call option on the sarne stock. If the stock rises in price. the call
does. too. and so the con1hinatiou of the debenture and the call acts much like a c011Yert-
ihle lio11clmmld to the upside. If. on the other hand. the stock falls. the call \\·ill expire
Chapter26: BuyingOptionsandTreasury
Bills 405
\rnrtliles<;: lrnt tlw ime'-tor \\ill rdai11 111ostof l1is imcst111c11t. lwcal!Sc he will still han·
th e debenture plus any interest that the bond has paid.
Tlw 'itrak'.2;:· of placing YW/r of one's 11101ieyinto risk-free. intert'st-ht'aring Ct'rtifi-
cate<; and lrn: i11'.2;optioJJ<, \\·ith tit<' n'111ai11cltTis superior to tl1e COJ1\'Crtihle ho11d or the
"\\·11tl1etic
.
co11\<·rtilil<' lio11cl." since tl1t're is 110 risk of r)rice f-111ct11ationin the larcrest
h
portion of the investment.
Tl1e Treas,ur: hill/option strateg:· is fairly easy to operate. althou,gh one does hm·e
to do srn11(•\\ork en·r: ti111t'llf'\\. options art' p11rcl1ased. Also. periodic adjustments need
to be JJ1aclPt<J kePp tl1e IE->\elof risk apprnxirnately the same at all times. As for v,foch
options to h11:. tl1e reader n1a:· rPcall that specifications wne outlined in Chapters :3 and
lo on how to self•ct tl1f• best option pnrchast's. Tlwse criteria can he summarized briefl:·
as follows:
1. :\.<;s1111w
that <'acl1 11nderlying "tock can ackance or decline in accordance with its
volatility over a fixed time period (30, 60, or 90 days).
2. Estimate the call prices after the advance, or put prices after the decline.
:3. Rank all potential purchases by the highest reward opportunity.
Tfw user of tl1is stmtcf!,y 11eedonlu he interested i11 those option purclwses that
prrnide tlte l1i;!/1estrncard OJJpnrt1111if!J
11nder this ranking method. In the pre\·ious
chapters 011 optioJJ b11ying. it was mentioned tl1at one might want to look at the risk/
reward ratios of his poteJJtial optioJJ p11rcliases in order to hm·e a more consen-ati\·e list.
Howc:n:'r. that is not necessar:· in the Treas11ry hill/option strateg:·- since the m·erall risk
has already bet-n limited. A ranking of option purchases \'ia the foregoing criteria will
gPnerall:· gi\·e a list of at- or sligl1tly 011t-of-the-money options. Tliese are not necessarily
"llnderpriced ,, options: although if an option is truly underpriced, it will hm·e a hetter
d1ance of ranking higher on the st'lection list than one that is ·'m·erpricecl."
A li'>t of potential option purcliases that is constructed with criteria similar to those
outlined ahoH:' is a\·ailablt· frorn many data sen-ices ancl brokerage firms. The strategist
\, ·ho is \\"illir1g to select his option p11rcliases in this manner will find that he does not hm e
to sp<'11da great deal of ti111eon the selection proct'ss. The reader shoulcl note that this
tl)JJP rif07Jtim1purclwse rm1ki11f!.co111plctclu ignores tlic m1tlook_fc)r the 1111derlui11;!_
stock.
If (HIP \Vo11ldrat! 1er make his purchases based on an outlook for tlw 11nclerl:ing stock-
prch·rably a technical ontlook-he will he forced to spend more time on his selection
proces'>. Altl1011~!;l1
tliis may he appealing to some im·t'stors. it \\·ill prohahl:· :·ielcl worse
results in the long rnn than the pre\·io11'il:· described unhiasecl approach to option pur-
chases, unless the strategist is extremely adept at stock selection.
Considerations
KEEPING THE RISK LEVELEQUAL
The second function that the strategist has to perform in th is Treasury bill/option strat-
egy is to keep his risk level approximately equal at all times.
Example: An investor starts the strategy with $90,000 in Treasury bills (T-bills) and
$10,000 in option purchases. After some time has passed, the option purchases may have
worked out well and perhaps he now has $90,000 in T-bills plus $30,000 worth of options,
plus interest from the T-bills. Obviously, he no longer has 90% of his money in fixed-
income securities and 10% in option purchases. The ratio is now 75% in T-bills and 25%
in option purchases. This is too risky a ratio, and the strategist must consequently sell
some of his options and buy T-bills with the proceeds. Since his total assets are $120,000
currently, he must sell out $18,000 of options to bring his option investment down from
the current $30,000 figure to $12,000, or 10% of his total assets. If one fails to adhere to
this readjustment of his funds after profits are made, he may eventually lose those profits.
Since options can lose a great percentage of their worth in a short time period, the inves-
tor is always running the risk that the option portion of his investment may be nearly
wiped out. If he has kept all his profits in the option portion of his strategy, he is con-
stantly risking nearly all of his accumulated profits, and that is not wise.
One must also adjust his ratio of T-bills to options after losses occur.
Example: In the first year, the strategist loses all of the $10,000 he originally placed in
options. This would leave him with total assets of $90,000 plus interest (possibly $6,000
of interest might be earned). He could readjust to a 90:10 ratio by selling out some of the
T-bills and using the proceeds to buy options. If one follows this strategy, he will be risk-
ing 10% of his funds each year. Thus, a series of loss years could depreciate the initial
assets, although the net losses in one year would be smaller than 10% because of the
interest earned on the T-bills. It is recommended that the strategist pursue this method
of readjusting his ratios in both up and down markets in order to constantly provide him-
self with essentially similar risk/reward opportunities at all times.
The individual can blend the option selection process and the adjustment of the T-bill/
option ratio to fit his individual portfolio. The larger portfolio can be diversified into options
with differing holding periods, and the ratio adjustments can be made quite frequently,
perhaps once a month. The smaller investor should concentrate on somewhat longer holding
periods for his options, and would adjust the ratio less often. Some examples might help to
illustrate the way in which both the large and small strategist might operate. It should he
noted that this T-bill/option strategy is quite adaptable to fairly small sums of money, as long
Chapter
26: BuyingOptionsandTreasury
Bills 407
as the 10% that is going to be put into option purchases allows one to be able to participate
in a reasonable manner. A tactic for the extremely small investor is also described below.
ANNUALIZED RISK
Before getting into portfolio size, let us describe the concept of annualized risk. One
might want to purchase options with the intent of holding some of them for 30 days, some
for 90 days, and some for 180 days. Recall that he does not want his option purchases to
represent more than 10% annual risk at any time. In actual practice, if one purchases an
option that has 90 days of life, but he is planning to hold the option only 30 days, he will
most likely not lose 100% of his investment in the 30-day period. However, for purposes
of computing annualized risk easily, the assumption that will be made is that the risk dur-
ing any holding period is 100%, regardless of the length of time remaining in the life of
the option. Thus, a 30-day option purchase represents an annualized risk of 1,200%
(100% risk every 30 days times twelve 30-day periods in one year). Ninety-day purchases
have 400% annualized risk, and 180-day purchases have 200% annualized risk. There is
a multitude of way to combine purchases in these three holding periods so that the over-
all risk is 10% annualized.
Example: An investor could put 2½% of his total money into 90-day purchases four times
a year. That is, 2½% of his total assets are being subjected to a 400% annualized risk;
400% times 2½% equals 10% annualized risk on the total assets. Of course, the remainder
of the assets would be placed in risk-free, income-bearing securities. Another of the many
combinations might be to place 1% of the total assets in 90-day purchases and also place
3% of the total assets in 180-day purchases. Thus, 1% of one's total money would be sub-
jected to a 400% annual risk and 3% would be subjected to a 200% annual risk (.01 times
400 plus .03 times 200 equals 10% annualized risk on the entire assets). If one prefers a
formula, annualized risk can be computed as:
. d .k t· t.c . Percent of total 360

Annua 11ze ns on en 1re por 10 110 = . d x ld' . d
assets mveste Ho mg perm
If one is able to diversify into several holding periods, the annualized risk is merely the
sum of the risks for each holding period.
With this information in mind, the strategist can utilize option purchases of 1 month,
.3 months, and 6 months, preferably each generated by a separate computer analysis simi-
lar to the one described earlier. He will know how much of his total assets he can place
into purchases of each holding period, because he will know his annualized risk.
408 Part IV:Additional
Considerations
Example: Suppose that a very large investor, or pool of investors, has $1 million committed
to this T-bill/option strategy. Further, suppose ½ of 1% of the money is to be committed to
30-<lay option purchases with the idea of reinvesting every 30 days. Similarly, ½ of 1% is to
be placed in 90-day purchases and 1% in 180-day purchases. The annualized risk is 10%:
Total annualized risk = ½% X

36
°+ ½
30
% ·X
36
°+
90
1% X f~~
= .06 + .02 + .02 = 10%
With assets of $1 million, this means that $5,000 would be committed to 30-day pur-
chases; $.S,000 to 90-<lay purchases; and $10,000 to 180-day purchases. This money v,.rould
be reinvested in similar quantities at the end of each holding period.
RISK ADJUSTMENT
The subject of ac{justi11gthe ratio to constantly reflect 10% risk must be addressed at the
end cf each holding period. Although it is correct for the investor to keep his percentage
commitments constant, he must not be deluded into automatically reinvesting the same
amount of dollars each tim e.
Example: At the end of 30 days, the value of the entire portfolio, including potential
option profits and losses, and interest earned, was down to $990,000. Then only½ of 1%
of that amount should be invested in the next 30-day purchase ($4,950).
By operating in this manner-first computing the annualized risk and balancing it

through predetermined percentage commitments to holding periods of various lengths;
and second, readjusting the actual dollar commitment at the end of each holding period-
the overall risk/reward ratios will be kept close to the levels described in the earlier,
simple description of this strategy. This may require a relatively large amount of work on
the part of the strate gist , but large portfolios usually do require work
The smaller investor does not have the luxury of such complete diversification, but
he also does not have to adju st his total position as often.
Example: An investor decided to commit $.50,000 to this strategy. Since there is a 1,200%
amrnalized risk in 30-day purchases, it does not make much sense to even consider pur-
chases that are so short-term for assets of this size. Rather, he might decide to commit 1%
of his assets to a 90-clay purcliase and 3% to a 180-day purchase. In dollar amounts, this
mmld he ~.500 iu a 90-day option and $1,,500 in 180-clay options. Admittedly, this does
not lem·e nmch room for diversification, but to risk more in the short-term purchases
Chapter
26: Buying
OptionsandTreasury
Bills 409
would expose the investor to too much risk. In actual practice, this investor would prob-
ably just invest 5% of his assets in 180-day purchases, also a 10% annualized risk. This
would mean that he could operate with only one option buyer's analysis (the 180-day one)
and could place $2,500 into selections from that list.
His adjustments of the assets committed to option purchases could not be done as
frequently as the large investor, because of the commissions involved. He certainly would
have to adjust every 180 days, but might prefer to do so more frequently-perhaps every
90 days-to be able to space his 180-day commitments over different option expiration
cycles. It should also be pointed out that T-bills can be bought and sold only in amounts of
at least $10,000 and in increments of $5,000 thereafter. That is, one could buy or sell $10,000
or $1.5,000 or $20,000 or $25,000, and so on, but could not buy or sell $.5,000 or $8,000
or $23,000 in T-bills. This is of little concern to the investor with $1 million, since it takes
only a fraction of a percentage of his assets to be able to round up to the next $5,000 incre-
ment for a T-bill sale or purchase. However, the medium-sized investor with a $50,000
portfolio might run into problems. While short-term T-bills do represent the best risk-free
investment, the medium-sized investor might want to utilize one of the no-load, money
market funds for at least part of his income-bearing assets. Such funds have only slightly
more risk than T-bills and offer the ability to deposit and withdraw in any arnount.
The truly small investor might be feeling somewhat left out. Could it be possible to
operate this strategy with a very small amount of money, such as $.5,000? Yes it could, but
there are several disadvantages .
Example: It would be extremely difficult to keep the risk level down to 10% annually with
only $5,000. For example, 5% of the money invested every 180 days is only $250 in each
investment period. Since the option selection process that is described will tend to select
at- or slightly out-of-the-money calls, many of these will cost more than 2½ points for one
option. The small investor might decide to raise his risk level slightly, although the risk level
should never exceed 20% annually, no matter how small the actual dollar investment. To
exceed this risk level would be to completely defeat the purpose of the fixed-income/option
purchase strategy. Obviously, this small investor cannot buy T-bills, for his total investable
assets are below the minimum $10,000 purchase level. He might consider utilizing one of
the money market funds. Clearly, an investor of this small magnitude is operating at a
double disadvantage: His small dollar commitment to option purchases may preclude him
from buying some of the more attractive items; and his fixed-income portion will be earn-
ing a smaller percentage interest rate than that of the larger investor who is in T-hills or
some other form of relatively risk-free, income-bearing security. Consequently, the slllall
investor should carefully consider his financial capahility and tcillingness to adhere
strictly to the criteria of this strategy before actually committing his dollars.
Considerations
* * *
It may appear to the reader that the actual dollars being placed at risk in each option
purchase are quite small in these examples. In fact, they are rather small, but they have
been shown to represent 10% annualized risk. An assumption was made in these examples
that the risk in each option purchase was 100% for the holding period. This is a fairly
restrictive assumption and, if it were lessened, would allow for a larger dollar commitment
in each holding period. It is difficult and dangerous, however, to assume that the risk in
holding a call option is less than 100% in a holding period as short as 30 days. The strate-
gist may feel that he is disciplined enough to sell out when losses occur and thereby hold
the risk to less than 100%. Alternatively, mathematical analysis will generally show that
the expected loss in a fixed time period is less than 100%. One can also mitigate the prob-
ability of losing all of his money in an option purchase by buying in-the-money options.
While they are more expensive, of course, they do have a larger probability of having some
residual worth even if the underlying stock doesn't rise to the trader's expectations. Adher-
ing to any of these criteria can lead one to become too aggressive and therefore be too
heavily committed to option purchases. It is far safer to stick to the simpler, more restric-
tive assumption that one is risking all his money, even over a fairly short holding period,
when he buys an option.
AVOIDING EXCESSIVE RISK
One final word of caution must be inserted. The investor should not attempt to become
"fancy" u;ith the income-bearing portion of his assets. T-bills may appear to be too
"tame" to some investors, and they consider using GNMA's (Government National Mort-
gage Association certificates), corporate bonds, convertible bonds, or municipal bonds for
the fixed-income portion. Although the latter securities may yield a slightly higher return
than do T-bills, they may also prove to be less liquid and they quite clearly involve more
risk than a short-term T-bill does. Moreover, some investors might even consider placing
the balance of their funds in other places, such as high-yield stock or covered call writing.
vVhile high-yield stock purchases and covered call writing are conservative investments,
as most investments go, they would have to be considered very speculative in comparison
to the purchase of a 90-day T-bill. In this strategy, the profit potential is represented by
the option purchases. The yield on short-term T-bills will quite adequately offset the
risks. One should take great care not to attempt to generate much higher yields on
the fixed-income portion of his investment, for he may find that he has assumed risk with
the portion of his money that was not intended to have any risk at all.
A fair amount of rigorous mathematical work has been done on the evaluation of this
stratt>gy. Tlze theoretical papers are quite fawrable. Scholars have generally considered
Chapter
26: Buying
OptionsandTreasury
Bills 411
only the purchase of call options as the risk portion of the strategy. Obviously, the strate-
gist is quite free to purchase put options without harming the overall intent of the strat-
egy. When onl)' call options are purchased, both static and down markets harm the
performance. If some puts are included in the option purchases, only static markets could
produce the wor st results.
There are trade-offs involved as well. If, after purchasing the options, the market
experiences a substantial rally, that portion of the option purchase money that is devoted
to put option purchases will be lost. Thus, the combination of both put and call purchases
would do better in a down market than a strategy of buying only calls, but would do worse
in an up market. In a broad sense, it makes sense to include some put purchases if one has
the funds to diversify, since the frequency of market rallies is smaller than the combined
frequency of market rallies and declines. The investor who owns both puts and calls will
be able to profit from substantial moves in either direction, because the profitable options
will be able to overcome the limited losses on the unprofitable ones .
SUMMARY
In summary, the T-bill/option strategy is attractive from several viewpoints. Its true
adwntage lies in the fact that it has predefined risk and does not have a limit on poten-
tial profits. Some theorists claim it is the best strategy available, if the options are "under-
priced" when they are purchased. The strategy is also relatively simple to operate. It is not
necessary to have a margin account or to compute collateral requirements for uncovered
options; the strategy can be operated completely from a cash account. There are no
spreads involved, nor is it necessary to worry about details such as early assignment
(because there are no short options in this strategy) .
The investor who is going to employ this strategy, however, must not be deluded into
thinking that it is so simple that it does not take any work at all. The concepts and applica-
tion of annualized risk management are very important to the strategy. So are the mechan-
ics of option buying-particularly a disciplined, rational approach to the selection of
which calls and/or puts to buy. In addition, if interest rates are so low that T-bills produce
virtually no income, then one must manage the interest-earning portion of this portfolio
as well-in higher-yielding, but still safe, bonds. Consequently, this strategy is suitable
only for the investor who has both the time and the discipline to operate it correctly.
Arbitrage
Arbitrage in the securities market often connotes that one is buying something in one
marketplace and selling it in another marketplace, for a small profit with little or no risk.
For example, one might buy XYZ at .5.5in New York and sell it at .5.5¼in Chicago. Arbi-
trage, especially option arbitrage, involves a far wider range of tactics than this simple
example. Many of the option arbitrage tactics involve buying one side of an equivalent
position and simultaneously selling the other side. Since there is a large number of equiva-
lent strategies, many of which have been pointed out in earlier chapters, a full-time option
arbitrageur is able to construct a rather large number of positions, most of which have
little or no risk. The public customer cannot generally operate arbitrage-like strategies
because of the commission costs involved. Arbitrageurs are firm traders or floor traders
who are trading through a seat on the appropriate securities exchange, and therefore have
only minimal tran saction costs .
The public rnstomer can benefit from understanding arbitrage techniques, even if
he' does not personallu employ them. The arbitrageurs perform a useful function in the
option marketplace, often making markets where a market might not otherwise exist
(deeply in-the-money options, for example). This chapter is directed at the strategist who
is actually going to be participating in arbitrage. This should not be confusing to the public
customer, for he will better understand the arbitrage strategies if he temporarily places
himself in th e arbitrage u r's shoe s.
It is \·irtuall: ' impossible to perform pure arbitrage on dually listed options; that is,
to buy an option on the CBOE and sell it on the Anwrican exchange in New York for a
profit. Such discrepancies occur so infrequently and in such small size that an option
arbitrageur could never hope to be fully employed in this type of simple arbitrage. Rather,
the more complex forms of arbitrage described here are the ones on which he would nor-
mally concen trate.
412
Chapter
27:Arbitrage 413
BASIC PUT AND CALL ARBITRAGE ("DISCOUNTING")
The basic call and the basic put arbitrages are two of the simpler forms of option arbi-
trage. In these situations, the arbitrage1tr attempts to b1ty the option at a disrnunt 1chile
si11111/ta11eo11sly
taki11ga11opposite positio11in the 1tnderlying stock. He can then exercise
his option immediately and make a profit equal to the amount of the discount.
The basic call arbitrage is described first. This was also outlined in Chapter 1, under
the section on anticipating exercise .
Example: XYZ is trading at 58 and the XYZ July 50 call is trading at 7.90. The call is
actually at a discount from parity of 10 cents. Discount options generally either are quite
deeply in-the-money or have only a short time remaining until expiration, or both. The
call arbitrage would be constructed by:
1. buying the call at 7.90;

2. selling the stock at 58;
3. exercising the call to buy the stock at 50.
The arbitrageur would make 8 points of profit from the stock, having sold it at .58 and
bought it back at 50 via tlte option exercise. He loses the 7.90 points that he paid for the
call option, but this still leaves him with an overall profit of lO cents. Since he is a member
of the exchange, or is trading the seat of an exchange member, the arbitrageur pays only
a small charge to transact the trades.
In reality, the stock is not sold short per se, even though it is sold before it is bought.
Rather, the position is designated, at the time ofits inception, as an "irrevocable exercise:·The
arbitrageur is promising to exercise the call. As a result, no uptick is required to sell the stock.
The nwin goal in the call arbitrage is to be able to b1ty the call at a discount from
th e price at 1chich the stock is sold. The differential is the profit potential of the arbitrage.
The basic put arbitrage is quite similar to the call arbitrage. Again, the arbitrageur is
looking to buy the put option at a discount from parity. The put arbitrage is completed
with a stock purchase and option exercise .
Example: XYZ is at .58 and the XYZ July 70 put is at 11.90. With the put at a 10-cent
discount from parity, the arbitrageur might take the following action:
1. Buy put at 11.90.

2. Buy stock at 58.
3. Exercise put to sell stock at 70.
Considerations
The stock transaction is a 12-point profit, since the stock was bought at 58 and is sold at
70 via the put exercise. The cost of the put-11.90 points-is lost, but the arbitrageur still
makes a 10-cent profit. Again, this profit is equal to the amount of the discount in the
option when the position was established. Generally, the arbitrageur would exercise his
put option immediately, because he would not want to tie up his capital to carry the long
stock. An exception to this would be if the stock were about to go ex-dividend. D ividend
arbitrage is discussed in the next section.
The basic call and put arbitrages may exist at any time, although they will be more
frequent when there is an abundance of deeply in-the-money options or when there is a
very short time remaining until expiration. After market rallies, the call arbitrage may be
easier to establish; after market declines, the put arbitrage will be easier to find. As an
expiration date draws near, an option that is even slightly in-the-money on the last day or
two of trading could be a candidate for discount arbitrage. The reason that this is true is
that public buying interest in the option will normally wane. The only public buyers would
be those who are short and want to cover. Many covered writers will elect to let the stock
be called away, so that will reduce even further the buying potential of the public. This
leaves it to the arbitrageurs to supply the buying interest.
The arbitrageur obviously wants to establish these positions in as large a size as pos-
sible, since there is no risk in the position if it is established at a discount. Usually, there
will be a larger market for the stock than there will be for the options, so the arbitrageur
spends more of his time on the option position. However, there may be occasions when
the option markets are larger than the corresponding stock quotes. When this happens,
the arbitrageur has an alternative available to him: He might sell an in-the-money option
at parity rather than take a stock position.
Example: XYZ is at ,58 and the XYZ July 50 call is at 7.90. These are the same figures as in
the previous example. Furthermore, suppose that the trader is able to buy more options at
7.90 than he is able to sell stock at .58. If there were another in-the-money call that could be
sold at parity, it could be used in place of the stock sale. For example, if the XYZ July 40 call
could be sold at 18 (parity), the arbitrage could still be established. If he is assigned on the July
40 that he is short, he will then be short stock at a net price of 58-the striking price of 40,
plus the 18 points that were brought in from the sale of the July 40 call. Thus, the sale of the
in-the-money call at parity is equivalent to shorting the stock for the arbitrage purpose.
In a similar manner, an in-the-money put can be used in the basic put arbitrage.
Example: With XYZ at ,58and the July 70 put at 11.90, the arbitrage could be established.
l lowen"r, if the trader is having trouble buying enough stock at ,58, he might be able to
Chapter
27:Arbitrage 415
use another in-the-money put. Suppose the XYZ July 80 put coul<l he sol<l at 22. This
would be the same as buying the stock at .58, because if the put were assigned, the arbi-
trageur would be forced to buy stock at 80-the striking price-but his net cost woul<lbe
80 minus the 22 points he received from the sale of the put, for a net cost of 58. Again,
the arbitrageur is able to use the sale of a deeply in-the-money option as a substitute for
the stock trade.
The examples above assumed that the arbitrageur sold a deeper in-the-money option at
parity. In actual practice, if an in-the-money option is at a discount, an even deeper in-the-
money option will generally be at a discount as well. The arbitrageur would normally try to
sell, at parity, an option that was less deeply in-the-money than the one he is discounting.
In a broader sense, this technique is applicable to any arbitrage that involves a stock
trade as part of the arbitrage, except when the dividend in the stock itself is important.
Thus, if the arbitrageur is having trouble buying or selling stock as part of his arbitrage,
he can alu;ays check ichether there is an in-the-money option that could be sold to pro-
duce a position equivalent to the stock position.
DIVIDEND ARBITRAGE
Dividend arbitrage is actually quite similar to the basic put arbitrage. The trader can lock
in profits by buying both the stock and the put, then waiting to collect the dividend on the
underlying stock before exercising his put. In theory, on the day before a stock goes ex-
clividencl, all puts should haue a time value premium at least as large as the dividend
amount. This is true even for deeply in-the-money puts.
Example: XYZ closes at 4,5 and is going to go ex-dividend by $1 tomorrow. Then a put
with striking price of ,50 should sell for at least 6 points (the in-the-money amount plus
the amount of the dividend), because the stock will go ex-dividend and is expected to open
at 44, six points in-the-money .
If, however, the pufs time value premium should be less than the amount of the
dividend, the arbitrageur can take a riskless position. Suppose the XYZ July ,50 put is sell-
ing for 5.90, with the stock at 45 and about to go ex-dividend by $1. The arbitrageur can
take the following steps:
1. Buy the put at 5.90.

2. Buy the stock at 45.
3. Hold the put and stock until the stock goes ex-dividend (1 point in this case).
4. Exercise the put to sell the stock at 50.
Considerations
The trader makes .5points from the stock trade, buying it at 4.5 and selling it at ,50 via the
pnt exercise, and also collects the 1-point dividend, for a total inflow of 6 points. Since he
loses the 5.90 points he paid for the put, his net profit is 10 cents.
Far in advance of the ex-dividend date, a <leeply in-the-money put may trade
very close to parit_':. Tims, it would seem that the arbitrageur could "load up" on these
types of positions and mere].', sit back and wait for the stock to go ex-dividend. There is a
flaw in this line of thinking, however, hecanse the arbitrageur has a carrying cost for the
11w11cythat he 11111st tie up i11the long stock. This carrying cost fluctuates with short-term
interest rates.
Example: If the current rate of carrying charges were 6% annually, this would be equiva-
lent to lo/r e\·ery 2 months. If the arbitrageur were to establish this example position
2 months prior to expiration, he would have a carrying cost of .,507.5point. (His total out-
lay is .50.90 points, 4,5 for the stock and ,5.90 for the options, and he would pay 1% to carry
that stock and option for the two months until the ex-dividend date.) This is more than .50
cents in costs-clearly more than the 10-cent potential profit. Consequently, the arbitra-
geur must he aware of his carrying costs if he attempts to establish a dividend arbitrage
well in ach-ance of the ex-di\·idend date. Of course, if the ex-dividend date is only a short
time awa:·, the carrying cost has little effect, and the arbitrageur can gauge the profit-
ability of his position mostly by the amount of the dividend and the time value premium
in the put option.
The arbitrageur should note that this strategy of buying the put and buying the stock
to pick up the di\·idend might h,ffe a residual, rather profitable side effect. If the underly-
ing stock should rally up to or above the striking price of the put, there could be rather
large profits in this position. Although it is not likely that such a rally could occur, it would
he an added benefit if it did. Even a rather small rally might cause the put to pick up some
ti1ne premium, allowing the arbitrageur to trade out his position for a profit larger than
he could have made by the arbitrage discount.
This form of arhitra 0cre occasionallv. lends itself to a limited form of risk arbitracre.
b
Risk arhitragP is a strategy that is designed to lock in a profit if a certain event occurs. If
ti iat en'nt does not occur, there could he a loss (usually quite limited); hence, the position
lias risk. This risk clc111rntd{ffercntiatcs a risk arhitragc from a standard, no-risk arbi-
tm gc. Risk arbitrage is described more fully in a later section, hut the following example
concerning a special dividend is one form of risk arbitrage.
Example: XYZ has hecn known to declare extra, or special, dividends with a fair amount
of n_,gnlarit:·· There are sen'ral stocks that do so-Eastman Kodak and General Motors,
Chapter
27:Arbitrage 417
for example . In this case, assume that a hypothetical stock, XYZ, has generally declared
a special dividend in the fonrth quarter of each year, hut that its normal quarterly rate is
$1.00 per share. Suppose the special dividend in the fourth quarter has ranged from an
extra $1.00 to $3.00 over the past five years. If the arbitrageur were willing to speculate
on the size of the upcoming dividend, he might be able to make a nice profit. Even if he
overestimates the size of the special cli\·idencl, he has a limited loss. Suppose XYZ is trad-
ing at 5.5 about two weeks before the company is going to announce the dividend for the
fourth quarter. There is no guarantee that there will, in fact, be a special dividend, but
assume that XYZ is having a relati\·ely good year profitwise, an<l that some special divi-
dend seems forthcoming. Furthermore, suppose the January 60 put is trading at 7.50. This
put has 2 ..50 points of time value premium. If the arbitrageur buys XYZ at 5.5 and also
buys the January 60 put at 7.,50, he is setting up a risk arbitrage . He will profit regardless
of how far the stock falls or how much time value premium the put loses, if the special
dividend is larger than $1..50. A special dividend of $1..SO plus the regular dividend of
$1.00 would add up to $2.50, thus covering his risk in the position. Note that $1.50 is in
the low encl of the $1.00 to $3.00 recent historical range for the special dividends, so the
arbitrageur might he tempted to speculate a little by establishing this dividend risk arbi-
trage. Even if the company unexpectedly decided to declare no special dividend at all, it
would most likely still pay out the $1.00 regular dividend. Thus, the most that the arbitra-
geur would lose would he I .,SOpoints (his 2.,50-point initial time value premiurn cost, less
the 1-point dividend). In actual practice, the stock would probably not change in price by
a great deal over the next two weeks (it is a high-yield stock), and therefore the January
60 put would probably have some time value premium left in it after the stock goes ex-
dividend . Thu s, th e pra ctical risk is even less tha n 1.50 points .
While these types of dividend risk arbitrage are not frequently available, the arbitra-
geur who is willing to do some homework and also take some risk may find that he is able
to put on a position with a small risk and a profitability quite a bit larger than the normal
discount dividend arbit rage.
There is really not a direct form (f diuidcnd arbitrage invoicing call options. If a
relatively high-yield stock is about to go ex-dividend, holders of the calls will attempt to
sell. They do so because the stock will drop in price, thereby generally forcing the call to
drop in price as well, because of the dividend. However, the holder of a call does not
receive cash dividends and therefore is not willing to hold the call if the stock is going to
drop by a relatively large amount (perhaps .75 points or more). The effect of these call
holders attempting to sell their calls may often produce a discount option, and therefore
a basic call arbitrage may be possible. The arbitrageur should he careful, however, if he is
attempting to arbitrage a stock that is going ex-dividend on the foll0vving day. Since he
must sell the stock to set up the arbitrage, he cannot afford to wind up the clayhcing short
Considerations
any stock for he will then have to pay out the dividend the following day (the ex-dividend
dat e). Furthermore, his records must be accurate, so that he exercises all his long options
on the day before the ex-dividend date. If the arbitrageur is careless and is still short some
stock on the ex-date, he may find that the dividend he has to pay out wipes out a large
portion of the discount profits he has established.
CONVERSIONS AND REVERSALS
In the introductory material on puts, it was shown that put and call prices are related
through a process known as conversion. This is an arbitrage process whereby a trader may
sometimes be able to lock in a profit at absolutely no risk. A conuersion consists of buying
the underlying entity, and also buying a put option and selling a call option such that
both options have the same terms. This position icill have a locked-in profit if the total
cost of the position is less than the striking price of the options.
It should be noted that the underlying entity and the terms of the options must
agree , if this to be a riskless arbitrage. For example, if the options are for 150 shares of the
underlying stock (presumably a .3-for-2 stock split occurred sometime in the recent past),
then the arbitrage would consist of buying LSOshares of XYZ for each option established.
As another example, if sometime in the recent past, XYZ had spun off 1 share of UVW
stock for each share of XYZ owned, then certain options might be for 100 shares of XYZ
plus 100 shares of UVW. In that case, the arbitrageur would have to buy 100 shares of
XYZ and 100 shares of UVW for each option position established in those options whose
terms included both stocks.
XYZ common, 55;

XYZ January 50 call, 6.50; and
Suppose that these options are for 100 shares of XYZ. The total cost of this conversion is
49.50-.5.5 for the stock plus 1 for the put, less 6.,50 for the call. Since 49.50 is less than
th e striking price of .SO,there is a locked-in profit on this position. To see that such a profit
exists, suppose the stock is somewhere above ,50 at expiration. It makes no difference
how far above ,50 the stock might be; the result will be the same. With the stock above 50,
tlw call will be assigned and the stock will be sold at a price of .50. The put will expire
worthless. Tims, the profit is ,50 cents, since the initial cost of the position was 49.,50 and
Chapter
27:Arbitrage 419
it can eventually be liquidated for a price of 50 at expiration. A similar result occurs if

XYZ is below ,50 at expiration. In this case, the trader would exercise his put to sell
his stock at ,50, and the call would expire worthless. Again, the position is liquidated for
a price of 50 and, since it only cost 49.,50 to establish, the same .SO-cent profit can be
made. No matter where the stock is at expiration, this position has a locked-in-profit of
50 cents.
This example is rather simplistic because it does not include two very important fac-
tors: the possible dividend paid by the stock and the cost of carrying the position until
expiration. The inclusion of these factors complicates things somewhat, and its discussion
is deferred momentarily while the companion strategy, the reversal, is explained.
A reversal (or reverse conversion, as it is sometimes called) is exactly the opposite of
a conversion. In a recersal, the trader sells the underlying entity short, sells a put, and
buys a call. Again, the put and call have the same terms. A reversal will be profitable if
the initial credit (sale price) is greater than the striking price of the options.
Example: A different set of prices will be used to describe a reversal:
XYZ common, 55;

XYZ January 60 put, 7.50.
Suppose that these options are for 100 shares of XYZ. The total credit of the reversal is
60.50-55 from the stock sale, plus 7.50 from the put sale, less the 2-point cost of the call.
Since 60.,50 is greater than the striking price of the options, 60, there is a locked-in profit
equal to the differential of ,50 cents. To verify this, first assume that XYZ is anywhere
below 60 at January expiration. The put will be assigned-stock is bought at 60-and the
call will expire worthless. Thus, the reversal position is liquidated for a cost of 60. A
.SO-cent profit results since the original sale value (credit) of the position was 60.,50. On
the other hand, if XYZ were above 60 at expiration, the trader would exercise his call,
thus buying stock at 60, and the put would expire worthless. Again, he would liquidate
the position at a cost of 60 and would make a 50-cent profit.
Dividends and carrying costs are important in reversals, too; these factors are
addressed, here. The conversion involves buying stock, and the trader will thus receive
any dividends paid by the stock during the life of the arbitrage. However, the converter
also has to pay out a rather large sum of money to set up his arbitrage, and must therefore
deduct the cost of carrying the position from his potential profits. In the example
Considerations
above, the conversion position cost 49.,50 points to establish. If the trader's cost of money
were 6% annually, he woulcl thus lose .06/12 x 49.,50, or .2475 point per month for each
month that he holcls the position. This is nearly 25 cents per month. Recall that the poten-
tial profit in the example is ,50 cents, so that if one helcl the position for more than two
months, his carrying costs woulcl wipe out his profit. It is extremely important that the
arbitrageur compute his carrying costs accurately prior to establishing any conversion
arbitrage.
If one prefers formulae, the profit potentials of a conversion or a reversal can be
stated as:
Conversion profit = Striking price+ Call price - Underlying price - Put price+
Dividends to be received - Carrying cost of position
Reversal profit= Underlying+ Put - Strike - Call+ Carrying cost - Dividends
Note that <luring any one tracling day, the only items iu the formulae that can change are
the prices of the securities involved. The other items, dividends and carrying cost, are
fixecl for the clay.Thus, one could have a small computer program prepared that listed the
fixed charges on a particular stock for all the strikes on that stock.
Example: It is assumed that XYZ stock is going to pay a .SO-cent dividend during the life
of the position, and that the position will have to be held for three months at a carrying
cost of 6% per year. If the arbitrageur were interested in a conversion with a striking price
of 50, and the options are for 100 shares of XYZ, his fixed cost wou ld be:
Conversion fixed cost = Carrying rate x Time held x Striking price -

Dividend to be received
= .06 X ½2 X 50 - .50
= .7,5- .,50 = .25
The arbitrageur would know that if the profit potential, computed in the simplistic man-
ner using only the prices of the securities involved, was greater than 25 cents, he could
establish the conversion for an eventual profit, including all costs. Of course, the carrying
costs would be different if the striking price were 40 or 60, so a computer printout of all
the possible striking prices 011 each stock would be useful in order for the trader to be
able to refer quickly to a table of his fixed costs each day.
Chapter
27:Arbitrage 421
MO RE ON CARRYING COSTS
The computation of carrying costs can be made more involved than the simple method
used above. Simplistically, the carrying cost is computed by multiplying the debit of the
position by the interest rate charged and the time that the position will be held. That is,
it could be formulated as:
Carrying cost = Strike xrxt
where r is the interest rate and t is the time that the position will be held. Relating this
formula for the carrying cost to the conversion profit formula given above, one would get:
Conversion profit = Call - Underlying - Put + Dividend + Strike - Carrying cost

= Call- Underlying- Put+ Dividend+ Strike (1-rt)
In an actuarial sense, the carrying cost could be expressed in a slightly more complex
manner. The simple formula (strike x r x t) ignores two things: the compounding
effect of interest rates and the "present value" concept (the present value of a future
amount). The absolutely correct formula to include both present value and the compound-
ing effect would necessitate replacing the factor strike ( 1-rt) in the profit formula by
the factor
Strike
(1 + rf
Is this effect large? No, not when rand t are small, as they would be for most option cal-
culations. The interest rate per month would normally be less than l %, and the time
would be less than 9 months. Thus, it is generally acceptable, and is the common practice
among many arbitrageurs, to use the simple formula for carrying costs. In fact, this is
often a matter of convenience for the arbitrageur if he is computing the carrying costs on
a hand calculator that does not perform exponentiation. However, in periods of high
interest rates when longer-term options are being analyzed, the arbitrageur who is using
the simple formula should double-check his calculations with the correct formula to
assure that his error is not too large.
For purposes of simplicity, the remaining examples use the simple formula for car-
rying-cost computations. The reader should remember, however, that it is only a conve-
nient approximation that works best when the interest rate and the holding period are
small. This discussion of the compounding effect of interest rates also raises another
interesting point: Any investor using margin should, in theory, calculate his potential
Considerations
interest charge using the compounding formula. However, as a matter of practicality,

extremely few investors do. An example of this compounding effect on a covered call write
is presented in Chapter 2.
BACK TO CONVERSIONS AND REVERSALS
Profit calculation similar to the conversion profit formula is necessary for the reversal
arbitrage. Since the reversal necessitates shorting stock, the trader must pay out any divi-
dends on the stock during the time in which the position is held. However, he is now
bringing in a credit when the position is established, and this money can be put to work
to earn interest. In a reversal, then, the dividend is a cost and the interest earned is a
profit .
Example: Use the same XYZ details described above: The stock is going to pay a .SO-cent
dividend, the position will be held for three months, and the money will earn interest at
a rate of½ of l % per month. If the trader were contemplating an arbitrage with a striking
price of 30, the fixed cost would be:
Reversal fixed cost = Dividend to be paid - Interest rate per month X

Months held X Striking price
= .50- .005X3X30
= .50 - .045 = .005 point
The fixed cost in this reversal is extremely small. In fact, the reader should be able to see
that it is often possible-even probable-that there will be a fixed credit, not a fixed cost,
in a reversal arbitrage. To verify this, rework the example with a striking price of ,50 or 60.
As in a conversion, the fixed cost (or profit) in a reversal is a number that can be used for
the entire trading day. It will not change.
BORROWING STOCK TO SELL SHORT
The above example assumes that the arbitrageur earns the full carrying rate on the short
stock. Only certain arbitrageurs are actually able to earn that rate. When one sells stock
short, he must actually borrow the stock from someone who owns it, and then the seller
goes into the market to sell the stock. When customers of brokerage firms keep stock in a
111arginaccount, they agree to let the brokerage firm loan their stock out without the
Chapter
27:Arbitrage 423
customer's specific approval. Thus, if an arbitrageur working for that brokerage firm
wanted to establish a reversal, and if the stock to he sold short in the reversal were avail-
able in one of the margin accounts, the arbitrageur could borrow that stock and earn the
full carrying rate Oll it. This is called "using box stock," since stock held in margin accounts
is generally referred to as being in the "box."
There are other times, however, when an arbitrageur wants to do a reversal but does
not have access to "'box" stock. He must then find someone else from whom to borrow the
stock. Ob\·iously, there are people who own stock and would loan it to arbitrageurs for a
fee. There are people who specialize in matching up investors with stock to loan and
arbitrageurs who want to borrow stock. These people are said to be in the "stock loan"
business. Generally, the fee for borrowing stock in this manner is anywhere from 10 to
20% of the prevailing carrying cost rate. For example, if the current carrying rate were
10% annually, then one would expect to pay 1 or 2% to the lender to borrow his stock.
This reduces the profitability of the reversal slightly. Since small margins are being worked
with, this cost to borrow the stock may make a significant difference to the arbitrageur.
These variations in the rates that an arbitrageur can earn on the credit balances in
his account affect the marketplace. For example, a particular reversal might be available
in the marketplace at a net profit of .50 cents. Such a reversal may not be equally attractive
to all arbitrageurs. Those who have "box" stock may be willing to do the reversal for 50
cents; those who have to pay l % to borrow stock may want 0.55 for the reversal; and those
who pay 2% to borrow stock may need 0.65 for the reversal. Thus, arbitrageurs who do
conversions and reversals are in competition with each other not only in the marketplace,
but in the stock loan arena as well.
Re'[;ersals are generally easier positions for the arbitrageur to locate than are con-
uersions. This is because the fixed cost of the conversion has a rather burdensome effect.
Only if the stock pays a rather large dividend that outweighs the carrying cost could the
fixed portion of the conversion formula ever be a profit as opposed to a cost. In practice,
the interest rate paid to carry stock is probably higher than the interest earned from being
short stock, but any reasonable computer program should be able to handle two different
interest rates.
The novice trader may find the term "conversion" somewhat illogical. In the over-
the-counter option markets, the dealers create a position similar to the one shown here
as a result of actually converting a put to a call.
Example: When someone owns a conventional put on XYZ with a striking price of 60 and
the stock falls to .50, there is often little chance of being able to sell the put profitably in
the secondary market. The over-the-counter option dealer might offer to convert the put
into a call. To do this, he would buy the put from the holder, then buy the stock itself, and
then offer a call at the original striking price of 60 to the holder of the put. Thus, the
Considerations
dealer would he long the underlying, long the put, and short the call-a conversion. The
customer would then own a call on XYZ with a striking price of 60, due to expire on
the same date that the put was destined to. The put that the customer owned has been
converted into a call. To effect this conversion, the dealer pays out to the customer the
difference between the current stock price, .50, and the striking price, 60. Thus, the cus-
tomer receives $1,000 for this conversion. Also, the dealer would charge the customer for
costs to carrv the stock, so that the dealer had no risk. If the stock rallied back above 60,
the customer could make more money. because he owns the call. The dealer has no risk,
as he has an arbitrage position to begin with. In a similar manner, the dealer can effect a
reverse convt>rsion-converting a call to a put-but will charge the dividends to the cus-
tomer for doing so.
RISKS IN CONVERSIONS AND REVERSALS
Conn:rsions and reversals are generally considered to be riskless arbitrage. That is, the
profit in the arbitrage is fixed from the start and the subsequent movement of the under-
lying makes no difference in the eventual outcome. This is generally a true statement.
Howe\·er, tht>re are some risks, and they are great enough that one can actually lose
mone,· in cml\'ersions and reversals if ht> does not take care. The risks are fourfold in
re, ·prsal arbitrage: An t>xtra di,·idend is declared, the interest rate falls while the reversal
is in plact>. an earl:· assignment is received. or the stock is exactly at the striking price at
t>xpiration. Com t>rters hm·p similar risks: a dividend cut, an increase in the interest rate,
early assignment, or the stock closing at the strike at expiration.
Tht>se risks are first explored from the viewpoint of the reversal trader. If the com-
pany dt>clares an extra dividt>nd. it is highly likely that the reversal will become unprofit-
able. This is so because most t>xtra dividends are rather large-more than the profit of a
re,·ersal. Tlwrt> is little tht> arbitrageur can do to avoid being caught by the declaration of
a truly extra cli\·iclend. However, some companies have a track record of declaring extras
with annual rt>gularity. Tht> arbitrageur should be awart> of which companies these are
and of tht> tirning oftlwse t>xtra dividends. A clue sometimes exists in the marketplace. If
the ff'\·ersal appt>ars m·erly profitable wlwn the arbitrageur is first examining it (before he
actually t>stahlishes it). he sl1ould be somewhat skeptical. Perhaps there is a reason why
the rt>\·prsal looks so tt'mpting. An extra dividend that is heing factored into the opinion
of the marketplace may be the answer.
Tlw st>conclrisk is that of rnriation in interest rates while the reversal is in progress.
Oln-i011sl:··ratt>s can changt> m·pr the life of a reversal, normally :3to 6 months. There are
t,nJ \,·a:s to co11ipt>nsatt> for this. The simplt>st way is to leave some room for rates to move.
Chapter
27:Arbitrage 425
For examplt>, if rates are currently at 12% annually, one might allow for a lllovement of 2
to :3% in rates, depending 011 the length of tinw the reversal is expected to he in place. In
order to allow for a 2% move, the arbitrageur would calculate his initial profit hased on a
rate of 10%, 27r less than the currcntl_v prevailing 12%. He would not establish any rever-
sal that did not at least break even with a 10% rate. The rate at which a reversal breaks
even is often called the "effective rate"-10% in this case. Obviously, if rates average
higher than 107c during the life of the reversal, it will make money. Normally, when one
has an entire portfolio of reversals in place, he should know the effective rate of each set
of reversals c->xpiringat the same time. Thus, he would have an c->ffectiverate for his
2-month reversals, his 3-month ones , and so forth.
Allowing this room for rates to move does not necessarily mean that there will not
be an adverse affect if rates do indeed fall. For example, rates could fall further than the
room allowed. Thus, a further measure is necessary in order to completely protect against
a drop in rates: One should invest his credit balances generated by the reversals in
interest-bc->aring paper that expires at approximately the same time the reversals do, and
that bears interc->stat a rate that locks in a profit for the reversal account. For example,
suppose that an arbitrageur has $.5 million in :3-month reversals at an effective rate of
10%. If he can buy $.5 million worth of :3-rnonth Certificates of Deposit with a rate of
11½%, then he would lock in a profit of 1½% on his $.5million. This method of using paper
to hedge rate fluctuations is not practiced by all arbitrageurs; sollle think it is not worth
it. They believe that hy leaving the credit balances to fluctuate at prevailing rates, they
can make more if rates go up, and that will cushion the effect when rates decline.
The third risk of reversal arbitrage is reception of an early assignment on the short
puts . This forces the arbitrageur to buy stock and incur a debit. Thus, the position does
not earn as much interest as was originally assumed. If the assignment is received early
enough in the life of the reversal (recall that in-the-money puts can be assigned very far
in advance of expiration), the reversal could actually incur an overall loss. Such early
assignments normally occur <luring bearish markets. The only advantage of this early
assignment is that one is left with unhedged long calls; these calls are well out-of-the-
money and normally quite low-priced (.2.5 or less). If the market should reverse and turn
bullish before the expiration of the calls, the arbitrageur may make money on them. There
is no way to hedge completely against a market decline, but it does help if the arbitrageur
tries to establish reversals with the call in-the-money and the put out-of-the-money. That,
plus demanding a better overall return for reversals near the strike, should help cushion
the effects of the bear market.
The final risk is the most common one, that of the stock closing exactly at the strike
at expiration. This presents the arbitrageur with a decision to make regarding exercise of
his long calls. Since the stock is Pxactly at the strilw, he is not sure whether he will he
Considerations
assigned on his short puts at expiration. The outcome is that he may end up with an
unhedged stock position on Monday morning after expiration. If the stock should open on
a gap, he could have a substantial loss that wipes out the profits of many reversals. This
risk of stock closing at the strike may seem minute, but it is not. In the absence of any real
buying or selling in the stock on expiration day, the process of discounting will force a
stock that is near the strike virtually right onto the strike. Once it is near the strike, this
risk materialize s.
There are two basic scenarios that could occur to produce this unhedged stock posi-
tion. First, suppose one decides that he will not get put and he exercises his calls. How-
ever, he was wrong and he does get put. He has bought double the amount of stock-once
via call exercise and again via put assignment. Thus, he will be long on Monday morning.
The other scenario produces the opposite effect. Suppose one decides that he will get put
and he decides not to exercise his calls. If he is wrong in this case, he does not buy any
stock-he didn't exercise nor did he get put. Consequently, he will be short stock on
Monday morning .
If one is truly undecided about whether he will be assigned on his short puts, he
might look at several clues. First, has any late news come out on Friday evening that might
affect the market's opening or the stock's opening on Monday morning? If so, that should
he factored into the decision regarding exercising the calls. Another clue arises from the
price at which the stock was trading during the Friday expiration day, prior to the close.
If the stock was below the strike for most of the day before closing at the strike, then there
is a greater chance that the puts will be assigned. This is so because other arbitrageurs
(discounters) have probably bought puts and bought stock during the day and will exercise
to clean out their positions .
If there is still doubt, it may be wisest to exercise only half of the calls, hoping for a
partial assignment on the puts (always a possibility). This halfway measure will normally
result in some sort of unhedged stock position on Monday morning, but it will be smaller
than the ma ximum exposur e by at least half.
Another approach that the arbitrageur can take if the stock is near the strike of the
reversal during the late trading of the options' life-during the last few days-is to roll
the reversal to a later expiration or, failing that, to roll to another strike in the same expira-
tion. First, let us consider rolling to another expiration. The arbitrageur knows the dollar
price that equals his effective rate for a :3-month reversal. If the current options can be
closed out and new options opened at the next expiration for at least the effective rate,
then the reversal should be rolled. This is not a likely event, mostly due to the fact that
the spread between tlw bid and asked prices on four separate options makes it difficult to
attain the desired price. Nute: This entire four-way order can be entered as a spread order;
it is not necessar y to attempt to "leg" the spread .
Chapter
27:Arbitrage 427
The second action-rolling to another strike in the same expiration month-may be

more arnilable. Suppose that one has the July 4.5 reversal in place (long July 45 call and
short July 45 put). If the underlying stock is near 45, he might place an order to the
exchange floor as a three-way spread: Sell the July 45 call (closing), buy the July 45 put
(closing), and sell the July 40 call (opening) for a net credit of 5 points. This action costs
the arbitrageur nothing except a small transaction charge, since he is receiving a 5-point
credit for rnm·ing the strike by 5 points. Once this is accomplished, he will have moved
the strike approximately 5 points away and will thus have avoided the problem of the stock
closing at the strike .
Overall, these four risks are significant, and reversal arbitrageurs should take care
that they do not fall prey to tJ1em. The careless arbitrageur uses effective rates too close to
current market rates, establishes reversals with puts in-the-money, and routinely accepts
the risk of acquiring an unhedged stock position on the morning after expiration. He will
probably sustain a large loss at some time. Since many reversal arbitrageurs work with small
capital and/or have convinced their backers that it is a riskless strategy, such a loss may have
the effect of putting them out of business. That is an unnecessary risk to take. There are
countermeasures, as described above, that can reduce the effects of the four risks.
Let us consider the risks for conversion traders more briefly. The risk of stock closing
near the strike is just as bad for the conversion as it is for the reversal. The same tech-
niques for handling those risks apply equally well to conversions as to reversals. The other
risks are similar to reversal risks, but there are slight nuances.
The conversion arbitrage suffers if there is a dividend cut. There is little the arbitra-
geur can do to predict this except to be aware of the fundamentals of the company before
entering into the conversion. Alternatively, he might avoid conversions in which the divi-
dend makes up a major part of the profit of the arbitrage.
Another risk occurs if there is an early assignment on the calls before the ex-dividend
date and the dividend is not received. Moreover, an early assignment leaves the arbitra-
geur with long puts, albeit fractional ones since they are surely deeply out-of-the-money.
Again, the policy of establishing conversions in which the dividend is not a major factor
would help to ease the consequences of early assignment.
The final risk is that interest rates increase during the time the conversion is in place.
This makes the carrying costs larger than anticipated and might cause a loss. The best way
to hedge this initially is to allow a margin for error. Thus, if the prevailing interest rate is
12%, one might only establish reversals that would break even if rates rose to 14%. If rates
do not rise that far on average, a profit will result. The arbitrageur can attempt to hedge
this risk by shorting interest-bearing paper that matures at approximately the same time
as the conversions. For example, if one has $5 million worth of 3-month conversions estab-
lished at an effective rate of 14% and he shorts 3-month paper at 12½%, he locks in a
Considerations
profit of 1½%. This is not common practice for conversion arbitrageurs, but it does hedge
the effect of rising interest rates.
SUMMARY OF CONVERSION ARBITRAGE
The JJmctice cf cmnersion and rnersal arbitrage in the listed option markets helps to
keep 7mt and call prices in line. If arbitrageurs are active in a particular option, the prices
of the put ancl call will relate to the underlying price in line with the formulae given
earlier. Note that this is also a valid reason why puts tend to sell at a lower price than calls
do. Tlw cost of money is the determining factor in the difference between put and call
prict's. In essence, the "cost" (although it may sometimes be a credit) is subtracted from
the theoretical put price. Refer again to the formula given above for the profit potential of
a conversion. Assume that things are in perfect alignment. Then the formula would read:
Put pric e = Striking price + Call price - Underlying price - Fixed cost
Furthnmore, if the underlying is at the striking price, the formula reduces to:
Put pric e = Call price - Fixed cost
So, whene\·er the fixed cost, which is equal to the carrying charge less the dividends, is
greattT than zero (and it usually is), the put will sell for less than the call if the underlying
is at the striking price. Only in the case of a large-dividend-paying stock, when the fixed
cost becomes negative (that is, it is not a cost, but a credit), does the reverse hold true.
This is supportive evidence for statements made earlier that at-the-money calls sell for
mort' than at-the-money puts, all other things being equal. The reader can see quite
clearly that it has nothing to clo with supply and demand for the puts and calls, a fallacy
that is sometimes proffered. This same sort of analysis can be used to prove the broader
statement that calls h,ffe a greater time value premium than puts do, except in the case
of a large-dividend-paying stock.
One final word of advice should he offered to the public customer. He may some-
times he able to find conversions or reversals, hy using the simplistic formula, that appear
to han' profit potentials that exceed commission costs. Such positions do exist from time
to tinw, but the rate of return to the public customer will almost assuredly be less than
the short-term cost of money. If it were not, arbitrageurs would be onto the position very
quickl:·· The public option trader may not actually be thinking in terms of comparing the
profit potential of a position with what he could get by placing the money into a hank, hut
lie 1n11stdo so to c011\·i11cehimself that he cannot feasibly attempt conversion or reversal
arbitrages.
Chapter
27:Arbitrage 429
THE "INTEREST PLAY"
In the preceding discussion of reversal arbitrage, it is apparent that a substantial portion

of the arbitrageur's profits may he clue to the interest earned on the credit of the position.
Another type of position is used by many arbitrageurs to take advantage of this interest
earned. The arbitrageur sells the underlying short and simultaneously huys an in-the-
money call that is trading slightly over parity. The actual amount over parity that the
arbitrageur can afford to pay for the call is determined by the interest that he will earn
from his short sale and the dividend payout before expiration. He does not use a put in
this type of position. In fact, this "interest play" strategy is merely a reversal arbitrage
without the short put. This sltght variation has a residual benefit for the arbitrageur: If the
underlying stock should drop dramatically in price, he could make large profits because
he is short the underlying stock. In any case, he tcill make his interest credit less the
amount of time value premium paid for the call less any dividends lost.
Example 1: XYZ is sold short at 60, and a January ,50 call is bought for 10.2.5 points.
Assume that the prevailing interest rate is 1% per month and that the position is estab-
lished one month prior to expiration. XYZ pays no dividend. The total credit brought in
from the trades is $4,97.S, so the arbitrageur will earn $49.7,5 in interest over the course
of 1 month. If the stock is above .SOat expiration, he will exercise his call to buy stock at
.SOand close the position. His loss on the security trades will be $2.S-the amount of time
value premium paid for the call option. (He makes 10 points by selling stock at 60 and
buying at .SO,but loses 10.2.Spoints on the exercised call.) His overall profit is thus $24.7,5.
Example 2: A real-life example may point out the effect of interest rates even more dra-
matically. In early 1979, IBM April 240 calls with about six weeks of life remaining were
over 60 points in-the-money. IBM was not going to be ex-dividend in that time. Normally,
such a deeply in-the-money option would be trading at parity or even a discount when the
time remaining to expiration is so short. However , these calls were trading 3.,50 points
over parity because of the prevailing high interest rates at the time. IBM was at 300, the
April 240 calls were trading at 63 ..50, and the prevailing interest rate was approximately
1% per month. The credit from selling the stock and buying the call was $23,700, so the
arbitrageur earned $36.5.,50 in interest for l ½ months, and lost $3.50-the 3 ..50 points of
time value premium that he paid for the call. This still left enough room for a profit.
In Chapter L it was stated that interest rates affect option prices. The above exam-
ples of the "interest play" strategy quite clearly show why. As interest rates rise, the arbi-
trageur can afford to pay more for the long call in this strategy, thus causing the call price
to increase in times of high interest rates. If call prices are higher, so will pnt prices be,
Considerations
as the relationships necessary for conversion and reversal arbitrage are preserved. Simi-
larly, if interest rates decline, the arbitrageur will make lower bids, and call and put prices
will be lower. They are active enough to give truth to the theory that option prices are
directly related to interest rates.
THE BOX SPREAD
An arbitrage consists of simultaneously buying and selling the same security or eq11iw-
lc11tsernrities at d~[ferent prices. For example, the reversal consists of selling a put and
simultaneously shorting stock and bu:ving a call. The reader will recall that the short
stock/long call position was called a synthetic put. That is, shorting the stock and buying
a call is equivalent to buying a put. The reversal arbitrage therefore consists of selling a
(listed) put and simultaneously buying a (synthetic) put. In a similar manner, the conver-
sion is merely the purchase of a (listed) put and the simultaneous sale of a (synthetic) put.
Many equivalent strategies can be combined for arbitrage purposes. One of the more
common ones is the box spread.
Recall that it was shown that a bull spread or a bear spread could be constructed
with either puts or calls. Thus, if one were to simultaneously buy a (call) bull spread and
buy a (put) bear spread, he could have an arbitrage. In essence, he is merely buying and
selling equi\·alent spreads. If the price differentials work out correctly, a risk-free arbitrage
may be possible.
XYZ common, 55
XYZ January 50 call, 7
XYZ January 50 put , 1
XYZ January 60 call , 2
XYZ January 60 put, 5.50
The arbitrageur could establish the box spread in this example hy executing the fol-
lowing transactions:
Buy a call bull spread:

Buy XYZ January 50 call 7 debit
Sell XYZ January 60 call 2 credit
Net call cost 5 debit
Chapter
27:Arbitrage 431
Buy a put bear spread:

Buy XYZ January 60 put 5.50 debit
Sell XYZ January 50 put credit
Net put cost 4.50 debit
Total cost of position 9.50 debit
No matter where XYZ is at January expiration, this position will be worth 10 points. The
arbitrageur has locked i11a risk-free profit of 50 cents, since he "bought" the box spread
for 9.50 points and will be able to "sell" it for 10 points at expiration. To verify this, evalu-
ate the position at expiration, first with XYZ above 60, then with XYZ between 50 and 60,
and finally with XYZ below .50. If XYZ is above 60 at expiration, the puts will expire
worthless and the call bull spread will be at its maximum potential of 10 points, the dif-
ference between the striking prices. Thus, the position can be liquidated for 10 points if
XYZ is above 60 at expiration. Now assume that XYZ is between .50 and 60 at expiration.
In that case, the out-of-the-money, written options would expire worthless-the January
60 call and the January 50 put. This would leave a long, in-the-money combination consist-
ing of a January 50 call and a January 60 put. These two options must have a total value of
10 points at expiration with XYZ between 50 and 60. (For example, the arbitrageur could
exercise his call to buy stock at ,50 and exercise his put to sell stock at 60.) Finally, assume
that XYZ is below 50 at expiration. The calls would expire worthless if that were true, but
the remaining put spread-actually a bear spread in the puts-would be at its maximum
potential of 10 points. Again, the box spread could be liquidated for 10 points.
The arbitrageur must pay a cost to carry the position, however. In the prior example,
if interest rates were 6% and he had to hold the box for 3 months, it would cost him an
additional 14 cents (.06 x 9.50 x ½2).This still leaves room for a profit.
In essence, a bull spread (using calls) was purchased while a bear spread (using puts)
was bought. The box spread was described in these terms only to illustrate the fact that
the arbitrageur is buying and selling equivalent positions. The arbitrageur who is utilizing
the box spread should not think in terms of bull or bear spread, however. Rather, he
should be concerned with "buying" the entire box spread at a cost of less than the dif-
ferential between the two striking prices. By "buying" the box spread, it is meant that
both the call spread portion and the put spread portion are debit spreads. Wheneuer the
arbitrageur observes that a call spread and a put spread using the same strikes and that
are both debit spreads can be bought for less than the differe11ce in the strikes plus car-
rying costs, he should execute the arbitrage.
* * *
432 PartIV: Additional s
Consideration
Obviously, there is a companion strategy to the one just described. It might sorne-
titnes be possible for the arbitrageur to ·'sell" both spreads. That is, he would establish a
credit call spread and a credit put spread, using the same strikes. If this credit were
greater than the difference in the striking prices, a risk-free profit would be locked in.
Example: Assume that a diff erent set of prices exists:
XYZ common, 75
XYZ April 70 call, 8.50
XYZ April 70 pu t , 1
XYZ April 80 call , 3
XYZ April 80 put, 6
By executing the following transactions , the box spread could be "sold":
Sell a call (bear) spread:

Buy April 80 call 3 debit
Sell April 70 call 8.50 credit
Net credit on calls 5.50 credits
Sell a put (bull) spread:

Buy April 70 put l debit
Sell April 80 put 6 credit
Net credit on puts 5 credit
Total credit of position l 0.50 credit
111this case , no matter where XYZ is at expiration, the position can be bough t back for
10 poi11ts. This means that the arbitrageur has locked in risk-free profit of .50 cents. To
,·erif:· this statement first assume that XYZ is above 80 at April expiration. The puts will
e\pire worthless, and th e call spread will have widened to 10 points-the cost to buy it
back Alternatively , if XYZ were between 70 and 80 at Apr il expiration, the long, out-of-
t he-money options would expire worthless and the in-the-money combination would cost
10 points to Im:· back. (For example. the arbitrageur could let himself he put at 80, buying
stock th t>re.and called at 70. selling the stock there-a net "cost" to liquidate of 10 points.)
Finally . if XYZ \\'ere below 70 at expiration, the calls would expire worthless and the put
spread would han-' widened to 10 points . It could then he closed out at a cost of 10 points.
111eac h case. tlw arbitrageur is able to liquidate the hox spread by buying it back at 10.
Chapter
27:Arbitrage 433
In this sale of a box spread, he would earn interest on the credit received while he
holds the position.
There is an additional factor in the profitability of the box spread. Since the sale of
a box generates a credit, the arbitrageur who sells a box will earn a small amount of money
from that sale. Conversely, the purchaser of a box spread will have a charge for carrying
cost. Since profit margins may be small in a box arbitrage, these carrying costs can have
a definite effect. As a result, boxes may actually be sold for .Spoints, even though the strik-
ing prices are ,5 points apart, and the arbitrageur can still make money because of the
interest earned.
Tlwse box spreads are not easy to find. If one does appear, the act of doing the arbi-
trage will soon make the arbitrage impossible. In fact, this is true of any type of arbitrage;
it cannot be executed indefinitely because the mere act of arbitraging will force the prices
back into line. Occasionally, the arbitrageur will be able to find the option quotes to his
liking, especially in volatile markets, and can establish a risk-free arbitrage with the box
spread. It can he evaluated at a glance. Only two questions need to be answered:
1. If one were to establish a debit call spread and a debit put spread, using the same
strikes, would the total cost be less than the difference in the striking prices plus car-
rying costs? If the answer is yes , an arbitrage exists .
2. Alternatively, if one were to sell both spread-establishing a credit call spread and a
credit put spread-would the total credit received plus interest earned be greater
than the difference in the striking prices? If the answer is yes, an arbitrage exists.
There are some risks to box arbitrage. Many of them are the same as those risks
faced by the arbitrageur doing conversions or reversals. First, there is risk that the stock
might close at either of the two strikes. This presents the arbitrageur with the same
dilemma regarding whether or not to exercise his long options, since he is not sure whether
he will be assigned. Additionally, early assignment may change the profitability: Assign-
ment of a short put will incur large carrying costs on the resulting long stock; assignment
of a short call will inevitably come just before an ex-dividend date, costing the arbitrageur
the amount of the dividend.
There are not many opportunities to actually transact box arbitrage, but the fact that
such arbitrage exists can help to keep markets in line. For example, if an underlying stock
begins to move quickly and order flow increases dramatically, the specialist or market-
markers in that stock's options may be so inundated with orders that they cannot be sure
that their markets are correct. They can use the principles of box arbitrage to keep prit:es
in line. The most active options would be the ones at strikes nearest to the current stock
price. The specialist can quickly add up the markets of the call and put at tht> 1warcst
Considerations
strike above the stock price and add to that the markets of the options at the strike just
below. The sum of the four should add up to a price that surrounds the difference in the
strikes. If the strikes are ,5points apart, then the sum of the four markets should be some-
thing like 4 ..50 bid, ,5..50 asked. If, instead, the four markets add up to a price that allows
box arbitrage to be established, then the specialist will adjust his markets.
VARIATIONS ON EQUIVALENCE ARBITRAGE
Other variations of arbitrage on equivalent positions are possible, although they are rela-
tively complicated and probably not worth the arbitrageur's time to analyze. For example,
one could buy a butterfly spread with calls and simultaneously sell a butterfly spread
using puts. A listed straddle could be sold and a synthetic straddle could be bought-
short stock and long 2 calls. Inversely, a listed straddle could be bought against a ratio
write-long stock and short 2 calls. The only time the arbitrageur should even consider
anything like this is when there are more sizable markets in certain of the puts and calls
than there are in others. If this were the case, he might be able to take an ordinary box
spread, conversion, or reversal and add to it, keeping the arbitrage intact by ensuring that
he is, in fact , buying and selling equivalent positions.
THE EFFECTSOF ARBITRAGE
The arbitrage process serves a useful purpose in the listed options market, because it may
provide a secondary market where one might not otherwise exist. Normally, public inter-
est in an in-the-money option dwindles as the option becomes deeply in-the-money or
when the time remaining until expiration is very short. There would be few public buyers
of these options. In fact, public selling pressure might increase, because the public would
rather liquidate in-the-money options held long than exercise them. The few public buy-
ers of such options might be writers who are closing out. However, if the writer is cov-
erecl, especially where call options are concerned, he might decide to be assigned rather
than close out his option. This means that the public seller is creating a rather larger
suppl:' that is not offset by a public demand. The market created by the arbitrageur, espe-
cially in the basic put or call arbitrage, essentially creates the demand. vVithout these
arbitrageurs, there could conceivably be no buyers at all for those options that are short-
lived and in-the-money, after public writers have finished closing out their positions.
Equi,·cdcnce arbitrage-conversion, reversals, and box spreads-helps to keep the
relati,·e prices of puts ancl calls in line with each other and with the underlying stock price.
This creates a more efficient and rational market for the public to operate in. The
Chapter
27:Arbitrage 435
arbitrageur would help eliminate, for example, the case in which a public customer buys
a calL sees the stock go up, but cannot find anyone to sell his call to at higher prices. If
the call were too cheap, arbitrageurs would do reversals, which involve call purchases, and
would the refore provid e a market to sell into .
Questions hm·e been raised as to whether option trading affects stock prices, espe-
cially at or just before an expiration. If the amount of arbitrage in a certain issue becomes
very large, it could appear to temporarily affect the price of the stock itself. For example,
take the call arbitrage. This involves the sale of stock in the market. The corresponding
stock purchase, via the call exercise, is not executed on the exchange. Thus, as far as the
stock market is concerned, there may appear to be an inordinate amount of selling in
the stock. If large numbers of basic call arbitrages are taking place, they might thus hold
the price of the stock down until the calls expire .
The put arbitrage has an opposite effect. This arbitrage involves buying stock in the
market. The offsetting stock sale via the put exercise takes place off the exchange. If a
large amount of put arbitrage is being done, there may appear to be an inordinate amount
of buying in the stock. Such action might temporarily hold the stock price up.
In a vast majority of cases, however, the arbitrage has no visible effect on the underlying
stock price, because the amount of arbitrage being done is very small in comparison to the
total number of trades in a given stock. Even if the open interest in a particular option is large,
allowing for plenty of option volume by the arbitrageurs, the actual act of doing the arbitrage
will force the prices of the stock and option back into line, thus destroying the arbitrage.
Rather elaborate studies, including doctoral theses, have been written that try to
prove or disprove the theory that option trading affects stock prices. Nothing has been
proven conclusively, and it may never be, because of the complexity of the task. Logic
would seem to dictate that arbitrage could temporarily affect a stock's movement if it has
discount, in-the-money options shortly before expiration. However, one would have to
reasonably conclude that the size of these arbitrages could almost never be large enough
to overcome a directional trend in the underlying stock itself. Thus, in the absence of a
definite direction in the stock, arbitrage might help to perpetuate the inertia; but if there
were truly a preponderance of investors wanting to buy or sell the stock, these investors
would totally dominate any arbitrage that might be in progress .
RISK ARBITRAGE USING OPTIONS
Risk arbitrage is a strategy that is well described by its name. It is basically an arbitrage-
the same or equivalent securities are bought and sold. However, there is generally risk
because the arbitrage usually depends Oil a future event occurring in orderfor the arbi-
trage to he succes.~ful. One form of risk arbitrage was described earlier conct-rning the
Considerations
speculation on the size of a special dividend that an underlying stock might pay. That
arbitrage consisted of buying the stock and buying the put, when the put's time value
premium is less than the amount of the projected special dividend. The risk lies in the
arbitrageur's speculation on the size of the anticipated special dividend.
MERGERS
Risk arbitrage is an age-old type of arbitrage in the stock market. Generally, it concerns
spcrnlation on ichcther a proposed merger or acquisition icill actually go through as
proposed.
Example: XYZ, which is selling for $.SOper share, offers to buy out LMN and is offering
to swap one share of its (XYZ's) stock for every two shares of LMN. This would mean that
LMN should he worth $2,Sper share if the acquisition goes through as proposed. On the
day the takeover is proposed, LMN stock would probably rise to about $22 per share. It
would not trade all the way up to 2.5until the takeover was approved by the shareholders
of LMN stock. The arbitrageur who feels that this takeover will be approved can take
action. He would sell short XYZ and, for every share that he is short, he would buy
2 shares of LMN stock. If the merger goes through, he will profit. The reason that he
shorts XYZ as well as buying LMN is to protect himself in case the market price of XYZ
drops before the acquisition is approved. In essence, he has sold XYZ and also bought the
equivalent of XYZ (two shares of LMN will be equal to one share of XYZ if the takeover
goes through). This, then, is clearly an arbitrage. However, it is a risk arbitrage because, if
the stockholders of LMN reject the offer, he will surely lose money. His profit potential is
equal to the remaining differential between the current market price of LMN (22) and
the takeover price (2.5). If the proposed acquisition goes through, the differential disap-
pears , and the arbitrageur has his profit.
The greatest risk in a merger is that it is canceled. If that happens, stock being
acquired (LMN) will fall in price, returning to its pre-takeover levels. In addition, the
acquiring stock (XYZ) will probably rise. Thus, the risk arbitrageur can lose money on
both sides of his trade. {f either or both <fthe stocks inuafoed in the pro7JOsed takeover
have options , the arbitrageur may be able to work options into his strategy.
In merger situations, since large moves can occur in both stocks (they move in con-
cert), option purchases are the preferable option strategy. If the acquiring company (XYZ)
has in-the-money puts, then the purchase of those puts may be used instead of selling
XYZ short. The advantage is that if XYZ rallies dramatically during the time it takes for
the rnerger to take effect, then the arbitrageur's profits will be increased.
Chapter
27:Arbitrage 437
Example: As above, assume that XYZ is at .SOand is acquiring LMN in a 2-for-l stock
deal. LMN is at 22. Suppose that XYZ rallies to 60 by the time the deal closes. This would
pull LMN up to a price of 30. If one had been short 100 XYZ at .50 and long 200 LMN at
22, then his profit would be $600-a $1,600 gain on the 200 long LMN minus a $1,000
loss on the XYZ short sale .
Compare that result to a similar strategy substituting a long put for the short XYZ
stock. Assume that he buys 200 LMN as before, but now buys an XYZ put. If one could
buy an XYZ July .S.5put with little time premium, say at ,5..50 points, then he would have
nearly the same dollars of profit if the merger should go through with XYZ below .S.S.
However, when XYZ rallies to 60, his profit increases. He would still make the
$1,600 on LMN as it rose from 22 to 30, but now would only lose $.5.50on the XYZ put-a
total profit of $1,050 as compared to $600 with an all-stock position .
The disadvantage to substituting long puts for short stock is that the arbitrageur does
not receive credit for the short sale and, therefore, does not earn money at the carrying
rate. This might not be as large a disadvantage as it initially seems, however, since it is
often the case that it is very expensive-even impossible-to borrow the acquiring stock
in order to short it. If the stock borrmv costs are very large or if no stock can be located
for borrowing, the purchase of an in-the-money put is a viable alternative. The purchase
of an in-the-money put is preferable to an at- or out-of-the-money put, because the amount
of time value premium paid for the latter would take too much of the profitability away
from the arbitrage if XYZ stayed unchanged or declined. This strategy may also save
money if the merger falls apart and XYZ rises. The loss on the long put may well be less
than the loss would be on short XYZ stock. It should be noted, however, that if the stock
is hard to borrow, that fact will be built into the (in-the-money) put prices, and they may
therefore be more expensive than they normally would .
Note also that one could sell the XYZ July .S.Scall short as well as buy the put. This
would, of course, be synthetic short stock and is a pure substitute for shorting the stock.
The use of this synthetic short is recommended only when the arbitrageur cannot borrow
the acquiring stock. If this is his purpose, he should use the in-the-money put and out-of-the-
money call, since if he were assigned on the call, he could not borrow the stock to deli\·er
it as a short sale. The use of an out-of-the-money call lessens the chance of eventual
assignment.
The companion strategy is to buy an in-the-money call instead of buying the com-
pany being acquired (LMN). This has advantages if the stock falls too far, either because
the merger falls apart or because the stocks in the merger decline too far. Additionally,
the cost of carrying the long LMN stock is eliminated, although that is generally built
into the cost of the long calls. The larger amount of time value premium in calls as
Considerations
compared to puts makes this strategy often less attractive than that of buying the puts as
a substitute for the short sale.
One might also consider selling options instead of buying them. Generally this is an
inferior strategy, but in certain instances it makes sense. The reason that option sales are
inferior is that they do not limit one's risk in the risk arbitrage, but they cut off the profit.
For example, if one sells puts on the company being acquired (LMN), he has a bullish situ-
ation. However, if the company being acquired (XYZ) rallies too far, there will be a loss,
became the short puts will stop making money as soon as LMN rises through the strike.
This is especially disconcerting if a takeover bidding war should develop for LMN. The
arbitrageur who is long LMN will participate nicely as LMN rises heavily in price during
tht' bidding war. However, the put seller will not participate to nearly the same extent.
The sale of in-the-money calls as a substitute for shorting the acquiring company
(XYZ) can be beneficial at certain times. It is necessary to have a plus tick in order to sell
stock short. vVlwn many arbitrageurs are trying to sell a stock short at the same time, it
may be difficult to sell such stock short. Morever, natural owners of XYZ may see the
arbitrageurs holding the price clown and decide to sell their long stock rather than suffer
through a possible decline in the stock's price while the merger is in progress. Addition-
ally, buyers of XYZ will become very timid, lowering their bids for the same reasons. All
of this may add up to a situation in which it is very difficult to sell the stock short, even if
it can he borrowed. The sale of an in-the-money call can overcome this difficulty. The call
should be deepl:--·in-the-money and not be too long-term, for the arbitrageur does not
want to see XYZ decline below the strike of the call. If that happened, he would no longer
be hedged; the other side of the arbitrage-the long LMN stock-would continue to
decline, but he would not have any remaining short against the long LMN.
LIMITS ON THE MERGER
There is another type of merger for stock that is more difficult to arbitrage, but options
may pro,·e useful. In some merger situations, the acquiring company (XYZ) promises to
give the shareholders of the company being acquired (LMN) an amount of stock equal to
a set dollar price. This amount of stock would be paid even if the acquiring company rose
or fell moderately in price. If XYZ falls too far, however, it cannot pay out an extraordi-
narily increased number of shares to LMN shareholders, so XYZ puts a limit on the maxi-
mum nmnber of shares that it will pay for each share of LMN stock. Thus, the shareholders
of XYZ are guaranteed that there will be some downside buffer in terms of dilution of
tht'ir c01npany in case XYZ declines, as is often the case for an acquiring company. How-
e\ t'L if XYZ declines too far, then LMN shareholders will receive less. In return for get-
ti11~this clownsicle guarantee, XYZ will usually also stipulate that there is a mi11i11111111
an101mt of shares that the:--·will pay to LMN shareholders, even if XYZ stock rises
Chapter
27:Arbitrage 439
tremendously. Thus, if XYZ should rise tremendously in price, then LMN shareholders
,,,villdo even better than they had anticipated. An example will demonstrate this type of
merger accord .
Example: Assume that XYZ is at 50 and it intends to acquire LMN for a stated price of
$2.5 per share, as in the previous example. However, instead of merely saying that it will
exchange two shares of LMN for one share of XYZ, the company says that it wants the
offer to be worth $2.5 per share to LMN shareholders as long as XYZ is between 45 and
,55. Given this information, we can determine the maximum and minimum number of
shares that LMN shareholders will receive: The maximum is the stated price, 25, divided
by the lower limit, 45, or 0..5.56shares; the minimum is 25 divided by the higher limit, 55,
or 0.455.
This type of merger is usually stated in terms of how many shares of XYZ will be
issued, rather than in terms of the price range that XYZ will be able to move in. In either
case, one can be derived from the other, so that the manner in which the merger deal is
stated is merely a convention. In this case, for example, the merger might be stated as
being worth $2,5 per share, with each share of LMN being worth at least 0.4,5,5shares of
XYZ and at most 0..5.56shares of XYZ. Note that these ratios make the deal worth 25 as
long as XYZ is between 45 and 55: 4.5 times 0.,5,56equals 25, as does 0.45,5 times .5.5.
If the acquiring stock, XYZ, is between 4,5 and ,5,5at the time the merger is com-
pleted, then the number of shares of XYZ that each LMN shareholder will receive is
determined in a preset manner. Usually, at the time the merger is announced, XYZ will
say that its price on the closing date of the merger will be used to establish the proper
ratio. As a slight alternative, sometimes the acquiring company will state that the price to
be used in determining the final ratio is to be an average of the closing prices of the stock
over a stated period of time. This stated period of time might he something like the 10 days
prior to the closing of the merger.
Example: Suppose that the closing price of XYZ on the day that the merger closes is to
be the price used in the ratio. Furthermore, suppose that XYZ closes at 51 on that day. It
is within the prestated range, so a calculation must he done in order to determine how
many shares of XYZ each LMN shareholder will get. This ratio is determined hy dividing
the stated price, 25, by the price in question, 51. This would give a final ratio of 0.490196.
The final ratio is usually computed to a rather large number of decimal points in order to
assure that LMN shareholders get as close to $2.5 per share as possible.
The above two examples explain how this type of merger works. A merger of this
type is said to have "hooks"-the prices at which the ratio steadies. This makes it difficult
Considerations
to arbitrage. As long as XYZ roams around in the 45 to ,5,5range, the arbitrageur does not
want to short XYZ as part of his arbitrage, because the price of XYZ does not affect the
price he will eventually receive for LMN-2.S. Rather, he would buy LMN and wait until
the deal is near closing before actually shorting XYZ. By waiting, he will know approxi-
mately how many shares ofXYZ to short for each share of LMN that he owns. The reason
that he must short XYZ at the end of the merger is that there is usually a period of time
before the physical stock is reorganized from LMN into XYZ. During that time, ifhe were
long LMN, he would be at risk if he did not short XYZ against it.
Problems arise if XYZ begins to fall below 45 well before the closing of the merger,
the lower "hook" in the merger. If it should remain below 45, then one should set up the
arbitrage as being short 0..S.56shares of XYZ for each share of LMN that is held long. As
long as XYZ remains below 4,5 until the merger closes, this is the proper ratio. However,
if, after establishing that ratio, XYZ rallies back above 45, the arbitrageur can suffer dam-
aging losses. XYZ may continue to rise in price, creating a loss on the short side. However,
LMN \Vil!not follow it, because the merger is structured so that LMN is worth 25 unless
XYZ rises too far. Thus, the long side stops following as the short side moves higher.
Ou the other hand, no such problem exists ifXYZ rises too far from its original price
of ,50, going above the upper "hook" of ,5,5.In that case, the arbitrageur would already be
long the LMN and would not yet have shorted XYZ, since the merger was not yet closing.
LMN would merel y follow XYZ higher after the latter had crossed 55.
This is not an uncommon dilemma. Recall that it was shown that the acquiring stock
will often fall in price immediately after a merger is announced. Thus, XYZ may fall close
to, or below, the lower "hook." Some arbitrageurs attempt to hedge themselves by shorting
a little XYZ as it begins to fall near 45 and then completing the short if it drops well below
4.5.The problem with handling the situation in this way is that one ends up with an inexact
ratio. E ssentiall y, he is forcing himself to predict the movements of XYZ.
If the acquiring stock drops below the lower "hook," there may be an opportunity
to establish a hedge without these risks if that stock has listed options. The idea is to buy
puts 011 the acquiring company, and for those puts to have a striking price nearly equal
to the price of the lower "hook." The proper amount of the company being acquired
(LMN) is then purchased to complete the arbitrage. If the acquiring company subse-
quently rallies back into the stated price range, the puts will not lose money past the
striking price and the problems described in the preceding paragraph will have been
overcome .
Example: A merger is announced as clescrihecl in the preceding example: XYZ is to

acquire LMl\' at a stated \';_dueof $25 per share, with the stipulation that each share of
L.\I:'\ \\'ill he worth at lc>ast0.45.S shares of XYZ and at most 0556 shares. ThC"seshare
ratios equate to prices of 45 and 55 on XYZ.
Chapter
27:Arbitrage 441
Suppose that XYZ drops immediately in price after the merger is announced, and
it falls to 40. Furthermore, suppose that the merger is expected to close sometime
during July and that there are XYZ August 45 puts trading at 5.50. This represents only
50 cents time value premium. The arbitrageur could then set up the arbitrage by
buying 10,000 LMN and buying 56 of those puts. Smaller investors might buy 1,000
LMN and buy 6 puts. Either of these is in approximately the proper ratio of 1 LMN to
()..556 XYZ.
TENDER OFFERS
Another type of corporate takeover that falls under the broad category of risk arbitrage is
the tender offer. In a tender offer, the acquiring company normally offers to exchange
cash for sharps of the company to be acquired. Sometimes the offer is for all of the shares
of the company being acquired; sometimes it is for a fractional portion of shares. In the
latter case, it is important to know what is intended to be done with the remaining shares.
These might be exchanged for shares of the acquiring company, or they might be exchanged
for other securities (bonds, most likely), or perhaps there is no plan for exchanging them
at all. In some cases, a company tenders for part of its own stock, so that it is in effect both
the acquirer and the acquiree. Thus, tender offers can he complicated to arbitrage prop-
erly. The use of options can lessen the risks.
In the case in which the acquiring company is making a cash tender for all the shares
(called an "any and all" offer), the main use of options is the purchase of puts as protection.
One would buy puts on the company being acquired at the same time that he bought
shares of that company. If the deal fell apart for some reason, the puts could prevent a
disastrous loss as the acquiring stock dropped. The arbitrageur must be judicious in buying
these puts. If they are too expensive or too far out-of~the-rnoney, or if the acquiring com-
pany might not really drop very far if the deal falls apart, then the purchase of puts is a
waste. However, if there is substantial downside risk, the put purchase may he useful.
Selling options in an "any and all" deal often seems like easy money, but there may
be risks. If the deal is completed, the company being acquired will disappear and its
options would be delisted. Therefore, it may often seem reasonable to sell out-of-the-
money puts on the acquiring company. If the deal is completed, these expire worthless at
the closing of the merger. However, if the deal falls through, these puts will soar in price
and cause a large loss. On the other hand, it may also seem like easy money to sell naked
calls with a striking price higher than the price being offered for the stock. Again, if the
deal goes through, these will be delisted and expire worthless. The risk in this situation
is that another company bids a higher price for the company on which the calls were
written. If this happens, there might suddenly be a large upward jump in price, and the
written calls could suffer a large loss.
Considerations
Options can play a more meaningful role in the tender offer that is for only part of
the stock, especially when it is expected that the remaining stock might fall substantially
in price after the partial tender offer is completed. An example of a partial tender offer
might help to establish the scenario .
Example: XYZ proposes to buy back part of its own stock. It has offered to pay $70 per
share for half the company. There are no plans to do anything further. Based on the fun-
damentals of the company , it is expected that the remaining stock will sell for approxi-
mately $40 per share . Thus, the average share of XYZ is worth ,55 if the tender offer is
completed (one-half can be sold at 70, and the other half will be worth 40). XYZ stock
might sell for $52 or $5:3 per share until the tender is completed. On the day after the
tender offer expires, XYZ stock will drop immediately to the $40 per share level.
There are two ways to make money in this situation. One is to buy XYZ at the cur-
rent price, say 52, and tender it. The remaining portion would be sold at the lower price,
say 40, when XYZ reopened after the tender expired. This method would yield a profit of
$3 per share if exactly 50% of the shares are accepted at 70 in the tender offer. In reality ,
a slightly higher percentage of shares is usually accepted, because a few people make
mistakes and don't tender. Thus, one's average net price might be $56 per share, for a $4
profit from this method. The risk in this situation is that XYZ opens substantially below
40 after the tender at 70 is completed .
Theoretically , the other way to trade this tender offer might be to sell XYZ short at
52 and cover it at 40 when it reopens after the tender offer expires. Unfortunately, this
method cannot be effected because there will not be any XYZ stock to borrow in order to
sell it short. All owners will tender the stock rather than loan it to arbitrageurs. Arbitra-
geurs understand this, and they also understand the risk they take if they try to short stock
at the last minute: They might be forced to buy back the stock for cash, or they may be
forced to give the equivalent of $70 per share for half the stock to the person who bought
the stock from them. For sorne reason, many individual investors believe that they can
"get away" with this strategy. They short stock, figuring that their brokerage firm will find
some way to borrow it for them. Unfortunately , this usually costs the customer a lot of
money.
The use of calls does not provide a more viable way of attempting to capitalize on
the drop of XYZ from ,52 to 40. In-the-money call options on XYZ will normally be selling
at parity just before the tender offer expires. If one sells the call as a substitute for the
short sale. he will probably receive an assignment notice on the day after the tender offer
expires, and therefore find himself with the same problems the short seller has.
The only safe way to play for this drop is to buy puts on XYZ. These puts will be very
expe11sin'. In fact, with XYZ at 52 before the tender offer expires, if the consensus opinion
Chapter
27:Arbitrage 443
is that XYZ will trade at 40 after the offer expires, then puts with a 50 strike will sell for
at least $10. This large price reHects the expected drop in price of XYZ. Thus, it is not
beneficial to buy these puts as downside speculation unless one expects the stock to drop
further than to the $40 level. There is, however, an opportunity for arbitrage by buying
XYZ stock and also buying the expensive puts.
Before giving an example of that arbitrage, a word about short tendering is in order.
Short tendering is against the law. It comes about when one tenders stock into a tender
offer when he does not really own that stock. There are complex definitions regarding
what constitutes ownership of stock during a tender offer. One must be net long all the
stock that he tenders on the day the tender offer expires. Thus, he cannot tender the stock
on the day before the offer expires, and then short the stock on the next day (even if he
could borrow the stock). In addition, one must subtract the number of shares covered by
certain calls written against his position: Any calls with a strike price less than the tender
offer price must be subtracted. Thus, if he is long 1,000 shares and has written 10 in-the-
money calls, he cannot tender any shares. The novice and experienced investor alike must
be aware of these definitions and should not violate the short tender rules.
Let us now look at an arbitrage consisting of buying stock and buying the
expensive puts.
Example: XYZ is at ,52. As before, there is a tender offer for half the stock at 70, with no
plans for the remainder. The July .55 puts sell for 15, and the July 50 puts sell for 10. It is
common that both puts would be predicting the same price in the after-market: 40.
If one buys 200 shares of XYZ at 52 and buys one July 50 put at 10, he has a locked-in profit
as long as the tender offer is completed. He only buys one put because he is assuming that
100 shares will be accepted by the company and only 100 shares will be returned to him.
Once the 100 shares have been returned, he can exercise the put to close out his position.
The following table summarizes these results:
Initial purchase
Buy 200 XYZ at 52 $10,400 debit
Buy 1 July 50 put at 10 1,000 debit
Total Cost $11,400 debit
Closing sale
Sell 100 XYZ at 70 via tender 7,000 credit
Sell 100 XYZ at 50 via put exercise 5,000 credit
Total proceeds $12,000 credit
Total profit: $600
444 PattIV:Additional
Considerations
This strategy eliminates the risk ofloss if XYZ opens substantially below 40 after the
tender offer. The downside price is locked in by the puts.
If more than .50% of XYZ should be accepted in the tender offer, then a larger
profit will result. Also, if XYZ should subsequently trade at a high enough price so that
the July .50 put has some time value premium, then a larger profit would result as well.
(The arbitrageur would not exercise the put, but would sell the stock and the put sepa-
rately in that case .)
Partial tender offers can be quite varied. The type described in the above example
is called a "two-tier" offt>r because the tender offer price is substantially different from
the remaining price. In some partial tenders, the remainder of the stock is slated for pur-
chase at substantially the same price, perhaps through a cash merger. The above strategy
would not he applicable in that case, since such an offer would more closely resemble the
"any and all" offer. In other typt>s of partial tenders, debt securities of the acquiring com-
pany may be issued after the partial cash tender. The net price of these debt securities
may be cliffert'nt from the tender offer price. If they are, the above strategy might work.
In su1muary, thm, one should look at tender offers carefully. One should be careful
not to take extraordinary option risk in an "any and all" tender. Conversely, one should
look to takt' a(h-antage of an:' "two-tit>r" situation in a partial tender offer by buying stock
and buying puts.
PROFITABILITY
Since tht' pott'ntial profits in risk arbitrage situations may be quite large, perhaps 3 or
4 points pt'I" 100 shares, the public can participate in this strategy. Commission charges
will makt' the risk arbitrage less profitable for a public customer than it would be for an
arbitragt>ur. Tht> profit potential is often large enough, however, to make this type of risk
arbitrage viable even for the public customer.
In summary, the risk arbitrageur may ht>able to ust' options in his strategy, either as
a rt>plact>nwntfor the actual stock position or as prott'ction for the stock position. Although
the public cannot normally participate in arbitrage strategies because of the small profit
pott>ntiaL risk arhitragt>s may often offer exceptions. The profit potential can be large
enough to overcome the commission burden for the public customer.
PAIRS TRADING
:\ stock trading strategy that has gai1wd somt' adht>rt'nts in recent :·t'ars is pairs trading.
Simplistically, this strakgy involves trading pairs of stocks-one hel<l long, the other
sl1ort. Thus, it is a ht>dgcd strateg:·, but it is not bona fide arbitrage. The two stocks' price
Chapter
27:Arbitrage 445
movements are related historically. The pairs trader would establish the position when
one stock was expensive with respect to the other one, historically. Then, when the stocks
return to their historical relationship, a profit would result. In reality, some fairly compli-
cated computer programs search out the appropriate pairs .
Tlw interest on the short sale offsets the cost of carry of the stock purchased. There-
fore, the pairs trader doesn't have any expense except the possible differential in dividend
payout.
The bane of pairs trading is a possible escalation of the stock sold short without any
corresponding rise in price of the stock held long. A takeover attempt might cause this to
happen. Of course, pairs traders will attempt to research the situation to ensure that they
don't often sell short stocks that are perceived to be takeover candidates.
Pairs traders can use options to potentially reduce their risk if there are in-the-
money options on both stocks. One would buy an in-the-money put instead of selling one
stock short, and would buy an in-the-rnoney call on the other stock instead of buying the
stock itself. In this option combination, traders are paying very little time value premium ,
so their profit potential is approximately the same as with the pairs trading strategy using
stocks. (One would, however, have a debit, since both options are purchased; so there
would be a cost of carry in the option strategy .)
If the stocks return to their historical relationship, the option strategy will reflect the
same profit as the stock strategy, less any loss of time value premium. One added advan-
tage of the option strategy, however, is that if a takeover occurs, the put has limited liabil-
ity, and the trader's loss would be less.
Another advantage of the option strategy is that if both stocks should experience
large moves, it could make money even if the pair doesn't return to historical norms. This
would happen, for example, if both stocks dropped a great deal: The call has limited loss,
while the put's profits would continue to accrue. Similarly, to the upside, a large move by
both stocks would make the put worthless, but the call would keep making money. In both
cases, the option strategy could profit even if the pair of stocks didn't perform as
predicted.
This type of strategy-buying in-the-money options as substitutes for both sides of
a spread or hedge strategy-is discussed in more detail in Chapter :31on index spreading
and Chapter 35 on futures spreads.
FACILITATION (BLOCK POSITIONING)
Facilitation is the process whereby a trader seeks to aid in making markets for the pur-
chase or sale oflarge blocks of stock. This is not really an arbitrage, and its description is
thus deferred to Chapter 28.
Considerations
Arbitrage involving options can be very profitable, but unless the profit potential is suffi-
ciently large, it is generally a strategy that is for professional traders who are exchange
members-who pay little or no commissions. Various forms of arbitrage are possible,
ranging from riskless (discount, dividend, conversion and reversal arbitrage, interest
plays, boxes, and equivalence arbitrage). While they may entail some risk (underlying
expiring right at the striking price, for example), their risk is small. There are also forms
of arbitrage that involve much more risk-and therefore more profit potential-involving
mergers, takeovers, and tender offers. Regardless, one must be sure in any of the arbi-
trage situations, that the underlying he is trading matches the terms of the options in his
position. Otherwise it will not be a riskless arbitrage; in fact, risk could be quite large.
Mathematical Applications
In previous chapters, many references have been made to the possibility of applying
mathematical techniques to option strategies. Those techniques are developed in this
chapter. Although the average investor-public, institutional, or floor trader-normally
has a limited grasp of advanced mathematics, the information in this chapter should still
prove useful. It will allow the investor to see what sorts of strategy decisions could be
aided by the use of mathematics. It will allow the investor to evaluate techniques of an
information service. Additionally, if the investor is contemplating hiring someone knowl-
edgeable in mathematics to do work for him, the information to be presented may be
useful as a focal point for the work The investor who does have a knowledge of mathemat-
ics and also has access to a computer will be able to directly use the techniques in this
chapter.
THE BLACK-SCHOLES MODEL
Since an option's price is the function of stock price, striking price, volatility, time to
expiration, and short-term interest rates, it is logical that a formula could he drawn up
to calculate option prices from these variables. Many models have been conceived
since listed options began trading in 1973. Many of these have been attempts to
improve on one of the first models introduced, the Black-Scholes model. This model was
introduced in early 1973, very near the time when listed options began trading. It was
made public at that time and, as a result, gained a rather large number of adherents. The
formula is rather easy to use in that the equations are short and the number of variables
is small.
The actual formula is:
447
Considerations
The variables are:
p = stock p1ice
s = striking price
t = time remaining until expiration, expressed as a percent of a year
r = current risk-free interest rate
V = volatility measured by annual standard deviation
ln = natural logarithm
N(x) = cumulative normal density function
An important by-product of the 111odelis the exact calculation of the delta-that is,
the amount by which the option price can be expected to change for a small change in the
stock price. The delta was described in Chapter :3 on call buying, and is more formally
known as the hedge ratio.
The formula is so simple to use that it can fit quite easily on most programmable calcula-
tors . In fact, some of these calculators can be observed on the exchange floors as the more
theoretical floor traders attempt to monitor the present value of option premiums. Of
course, a computer can handle the calculations easily and with great speed. A large num-
ber of Black-Scholes computations can be performed in a very short period of time.
The cumulative normal distribution function can be found in tabular form in most
statistical hooks. However, for computation purposes, it would be wasteful to repeatedly
look up \·alues in a table. Since the normal curve is a smooth curve (it is the "bell-shaped"
cun-e used most commonly to describe population distributions), the cumulative distribu-
tion can be approximated by a formula:
x = l -z (l.330274y 5
- l.821256y 4
+ l.781478y 3
- .356538y 2 + .3193815y)
- 1 and z = .3989423e-O"½
where y - 1 + .2316419 I CJ I
Then N(<J) = x if CJ > 0 or N (CJ)= 1 - x if CJ < 0
Chapter
28:Mathematical
Applications 449
This approximation is quite accurate for option pricing purposes, since one is not really
interested in thousandths of a point where option prices are concerned.
Example: Suppose that XYZ is trading at 4.5 and we are interested in evaluating the July
.50call, which has 60 days remaining until expiration. Furthermore, assume that the vola-
tility of XYZ is 30% and that the risk-free interest rate is currently 10%. The theoretical
value calculation is shown in detail, in order that those readers who wish to program the
model will have something to compare their calculations against.
Initially, determine t, d1, and d2 , by referring to the formulae on the previous page:
t = 60/365 = .16438 years

di = In (45/50) + (.1 + .3 X .3/2) X .16438
.3 X /16438
= -.10536+(.145X.16438) =-_ 67025
.3 X .40544
d 2 =- .67025- .3/16438 =-.67025-(.3X .40544) =-.79189
Now calculate the cumulative normal distribution function for d 1 and d 2 by referring
to the above formulae:
d1 =-.67025
1 1 -
y = l + (.2316419) 1- .670251) 1.15526 - .86,561
Z = .3989423e-(- 67025)X 67025)/2
= .3989423e- 0 ·22462 = .31868
There are too many calculations involved in the computation of the fifth-order poly-
nomial to display them here. Only the result is given:
X = .74865
Since we are determining the cumulative normal distribution of a negative number,
th e distribution is determined by subtracting x from 1.
N(d1) = N(- .67025) = l -x = 1- .74865 = .25134
In a similar manner, which requires computing new values for x, y, and z,
N(d2) = N(-.79189) = 1- .78579 = .21421

Considerations
Now, returning to the formula for theoretical option price, we can complete the
calculation of the July .50 call's theoretical value, called value here for short:
value= 45 X N(d 1) - 50 X e - .Jx. 16438 X N(d 2 )

= 45 X .25134 - 50 X .9837 X .21421
= .7746
Thus , the theoretical value of the July 50 call is just slightly over¾ of a point. Note
that the delta of the call was calculated along the way as N(d 1) and is equal to just over
.25. That is, the July ,50 call will change price about ¼ as fast as the stock for a small price
change by th e stock.
This example should answer many of the questions that readers of the previous edi-
tions have posed. The reader interested in a more in-depth description of the model, pos-
sibly including the actual derivation, should refer to the article "Fact and Fantasy in the Use
of Options. "1 One of the less obvious relationships in the model is that call option prices will
increase (and put option prices will decrease) as the risk-free interest rate increases. It may
also be observed that the model correctly preserves relationships such as increased volatility,
higher stock prices, or more time to expiration, which all imply higher option prices.
CHARACTERISTICS OF THE MODEL
Several aspects of this model are worth further discussion. First, the reader will notice that
the model does not include dividends paid by the common stock. As has been demonstrated,
dividends act as a negative effect on call prices. Thus, direct application of the model will
tend to give inflated call prices , especially on stocks that pay relatively large dividends. There
are ways of handling this. Fisher Black, one of the coauthors of the model, suggested the fol-
lowing method: Adjust the stock price to be used in the formula by subtracting, from the
current stock price, the present worth of the dividends likely to be paid before maturity. Then
calculate the option price. Second, assume that the option expires just prior to the last ex-
dividend date preceding actual option expiration. Again adjust the stock price and calculate
the option price. Use the higher of the two option prices calculated as the theoretical price.
Another, less exact, method is to apply a weighting factor to call prices. The weight-
ing factor would be based on the dividend payment, with a heavier weight being applied
to call options on high-yielding stock. It should be pointed out that, in many of the applica-
tions that are going to be prescribed, it is not necessary to know the exact theoretical price
'Fisher Black, Financial Analysts j ournal, July- August 1975, pp. 36-70.
Chapter
28:Mathematical
Applications 451
of the call. Therefore , th e dividend "correction" might not have to be applied for certain
strate gy decision s.
The model is based cm {I log11omwl distribution ofstock prices. Even though the normal
distribution is part of the model, the inclusion of the exponential functions makes the distri-
bution lognonnal. For those less familiar with statistics , a normal distribution has a bell-
shaped curve. This is the most familiar mathematical distribution. The problem with using a
normal distribution is that it allows for negative stock prices, an impossible occurrence. There-
fore, the lognorrnal distribution is generally used for stock prices, because it implies that the
stock price can have a range only between zero and infinity. Furthermore, the upward (bull-
ish) bias of the lognonnal distribution appears to be logically correct, since a stock can drop
only 100% but can rise in price by more than 100%. Many option pricing models that ante-
date the Black- Scholes model have attempted to use empirical distributions. An empirical
distribution has a different shape than either the normal or the lognormal distribution. Rea-
sonable empirical distributions for stock prices do not differ tremendously from the lognormal
distribution, although they often assume that a stock has a greater probability of remaining
stable than does the lognormal distribution. Critics of the Black-Scholes model claim that,
largely because it uses the lognormal distribution, the model tends to overprice in-the-money
calls and underprice out-of-the-money calls. This criticism is true in some cases, but does not
materially subtract from many applications of the model in strategy decisions. True, if one is
going to buy or sell calls solely on the basis of their computed value, this would create a large
problem. However, if strategy decisions are to be made based on other factors that outweigh
the overpriced/underpriced criteria, small differentials will not matter.
The computation of volatility is always a difficult problem for mathematical applica-
tion. In the Black-Scholes model, volatility is defined as the annual standard deviation of
the stock price. This is the regular statistical definition of standard deviation:
ll
L (Pi-P) 2
(5 2 = _i=_ I __ _ _
n- 1
V = a/P
where
P average stock price of all P;'s

Pi daily stock price
n - number of days ob served
V volatility
When volatility is computed using past stock prices, it is called a historical volatility.
The volatilities of stocks tend to change over time. Certain predictable factors , such as a
Considerations
large stock split increasing the float of the stock, can reduce the volatility. The entry of a
company into a more speculative area of business may increase the volatility. Other, less
well-defined factors can alter the volatility as well. Since the volatility is a very crucial
element of the pricing model, it is important that the modeler use a reasonable estimate
of the current volatility. It has b('comc apparent that an annual standard dedation is not
accurate, because it encompasses too long a period of time. Recent efforts by many mod-
elers hm·e suggested that one should perhaps weight the recent stock price action more
heavily than older price action in arriving at a current volatility. This is a possible approach,
but the computation of such factors may introduce as much error as using the annual
standard deviation does. The problem of accurately computing the volatility is critical,
because the model is so sensitive to it.
Computing Lognormal Historical Volatility. The above calculation does not

give the proper input for the Black-Scholes model because the model assumes that the
logaritlrnzs of changes in price are normally distributed, not the prices themselves. That
is, the term Pi in the above formula should be changed.
Example: XYZ closed at ,51today and at .50yesterday. Thus, its percentage change for the
day is .51/.50= 1.02. The natural logarithm of 1.02 is then based on the volatility formula:
In (51/s
0 ) = In (1.02) = 0.0198
This is similar to saying that arithmetically the stock was up 2% today , but on a log-
normal basis, it was only up 1.98%
If the stock is down, this method will yield a negative number. Suppose that on the
following clay, XYZ declined from .51 back to .50. The number to use in the volatility for-
mula would then be:
In (5½1) = In (0.9804) =-0.0198
A new equation can now he formulated using this concept. It will yield volatilities
that are consistent with the Black-Scholes model:
11
L (X,-X)2
I~ I
V=
n-1
wlwre X, = ln(P/P, 1); P, = closing price on da_vi and X= the average of the X;'s over the
desired number of days.
Chapter
28:Mathematical
Applications 453
So to compute a 10-day historical volatility, one would JH:'ed11 observations. In the

following example, clo not be concerned with the complete details if you do not plan to
comput e the volatilities yourself they are provided for the mathematician or programmer
who needs to check his work:
Day XYZ
Stock P;/P;_
l X;=ln(P/P;_
1) (X;- XF
1 153.875
2 153.625 .9984 -.0016 .000020
3 151 .9829 -.0172 .000405
4 146 .9669 -.0337 .001336
5 144.125 .9872 -.0129 .000250
6 147.25 1.0217 .0215 .000345
7 146.25 .9932 -.0068 .000094
8 149.5 1.0222 .0220 .000365
9 152.5 1.0201 .0199 .000289
10 158.625 1.0402 .0394 .001332
11 158.375 0.9984 -.0016 .000020
AVG:0.0028825 I: 0.004455
The average of the Ins (4th column) over the 10 days is 0.00288.
The difference of each In from the mean, squared, is then summed (5th column).
For example, for day l the term is (- .0016 - .00288)2 = .00002. This is the top number in
the far right-hand column. This process can be computed for each number in the "ln"
column. The sum of all these terms is 0.004455.
Now U = J(.004455/9) = 0.022249

This is a 10-day volatility. To convert it into an annual volatility, we need to multiply
hy the square root of the number of trading days in a year. Since there are approximately
260 trading days in a year , the final volatility would be:
V = 0.022249 X J(260) = 0.3587

Thus, one could say that the volatility of XYZ is 36% on an annualized basis.
This is then the proper way to calculate historical volatility. Obviously, the strategist
can calculate 10-, 20-, and .50-<layand annual volatilities if he wishes-or any other nurn-
ber for that matter. In certain cases, one can discern valuable information about a stock or
future and its options by seeing how the various volatilities compare with one another.
454 Part IV: AdditionalConsiderations
COM PUTIN G COM PO SITE IMPLIED VOLATILITY
There is, in fact, a way in which the strategist can let the market compute the volatility
for him. This is called using the implied volatility; that is, the volatility that the market
itself is implying. This concept makes the assumption that, for options with striking
prices close to the current stock price and for options with relatively large trading vol-
ume, the market is fairly priced. This is something like an efficient market hypothesis. If
there is enough trading interest in an option that is close to the money, that option will
generally be fairly priced. Once this assumption has been made, a corollary arises: If the
actual price of an option is the fair price, it can be fixed in the Black-Scholes equation
u:hile letting wlatility be the unknoicn variable. The volatility can be determined by
iteration. In fact, this process of iterating to compute the volatility can be done for each
option on a particular underlying stock. This might result in several different volatilities
for the stock. If one weights these various results by volume of trading and by distance
in- or out-of-the-money, a single volatility can be derived for the underlying stock. This
volatility is based on the closing price of all the options on the underlying stock for that
given day.
Example: XYZ is at 33 and the closing prices are given in Table 28-1. Each option has a
different implied volatility, as computed by determining what volatility in the Black-
Scholes model would result in the closing price for each option: That is, if .34 were used
as the volatility, the model would give 4½ as the price of the January 30 call. In order to
rationally combine these volatilities, weighting factors must be applied before a volatility
for XYZ stock itself can be arrived at.
The weighting factors for volume are easy to compute. The factor for each option is
merely that option's daily volume divided by the total option volume on all XYZ options
(Table 28-2). The weighting functions for distance from the striking price should probably
not be linear. For example, if one option is 2 points out-of-the-money and another is
4 points out-of-the-money, the former option should not necessarily get twice as much
weight as the latter. Once an option is too far in- or out-of-the-money, it should not be
given much or any weight at all, regardless of its trading volume. Any parabolic function
of the following form should suffice:
2
- (x - a) if xis less than a
Weighting factor - a2
{
=0 if x is greater than a
Chapter
28:Mathematical
Applications 455
TABLE 28-1.
Implied volatilities, closing price, and volume.
Option Implied
Option Price Volume Volatility
January 30 4.50 50 .34
January 35 1.50 90 .28
April 35 2.50 55 .30
April 40 1.50 5 .38
200
TABLE 28-2.
Volume weighting factors.
Option Volume Volume
Weighting
Factor
January 30 50 .25 (50/200)
January 35 90 .45 (90/200)
April 35 55 .275 (55/200)
April 40 5 .025 ( 5/200)
where xis the percentage distance between stock price and strike price and a is the maxi-
mum percentage distance at which the modeler wants to give any weight at all to the
option' s implied volatilit y.
Example: An investor decides that he wants to discard options from the weighting crite-
rion that have striking prices more than 25% from the current stock price. The variable,
a, would then be equal to .2.5. The weighting factors , with XYZ at 33, could thus be com-
puted as shown in Table 28-3. To combine the weighting factors for both volume and
distance from strike, the two factors are multiplied by the implied volatility for that option.
These products are summed up for all the options in question. This sum is then divided
by the products of the weighting factors, summed over all the options in question. As a
formula , this would read:
Implied _ L (Volume factor X Distance factor X Implied volatility)

volatility - L (Volume factor X Distan ce factor )
In our example, this would give an implied volatility for XYZ stock of 29.8% (Table
28-4). Note that the implied volatility, .298, is not equal to any of the individual option 's
implied volatilities. Rather, it is a composite figure that gives the most weight to the heavil~·
Considerations
TABLE 28-3.
Distance weighting factors.
Distance
from Distance
Option Stock
Price Weighting
Factor
January 30 .091 (3/33) .41
January 35 .061 (2/33) .57
April 35 .061 (2/33) .57
Apr il 40 .212 (7/33) .02
TABLE 28-4.
Option's implied volatility.
Volume Distance Option's
Implied
Option Factor Factor Volatility
January 30 .25 .41 .34
January 35 .45 .57 .28
April 35 .275 .57 .30
April 40 .025 .02 .38
Implied .25 X .41 X .34 + .45 X .57 X .28 + .275 X .57 X .30 + .025 X .02 X .38
volatility .25 X .41 + .45 X .57 + .275 X .57 + .025 X .02
= .298
traded, near-the-money options, and very little weight to the lightly traded (.5contracts),
deeply out-of-the-money April 40 call. This implied volatility is still a form of standard
deviation, and can thus be used whenever a standard deviation volatility is called for.
This method of computing colatility is quite accurate and proves to be sensitice to

changes in the wlatility of a stock. For example, as markets become bullish or bearish
(ge1wrating large rallies or declines), most stocks will react in a volatile manner as well.
Option premiums expand rather quickly, and this method of implied volatility is able to
pick up the change quickly. One last bit of fine-tuning needs to be clone before the final
rnlatility of the stock is arrived at. On a day-to-clay hasis, the implied volatility for a
stock-especially one whose options are not too active-may Huctuate more than the
strategist would like. A smoothing effect can he obtained hy taking a moving average of
tht> last 20 or :30 clays· implied volatilities. An alternative that does not require the s,.l\-ing
Chapter Applications
28:Mathematical 457
of man:7 previous da:'s· worth of data is to use a momentum calculation on the implied
volatility For exarnplP, toda:·'s final rnlatilit_Ymigltt he c0111putedhy adding 5% of today's
implied volatility to 95% of :'eStPnla:7'sfinal volatility This method requires saving only one
previous piece of data-yesterday's final volatility-and still preserves a "smoothing" eHect.
Once this implied i:olatiliflj lws bce11co111p11tcd, it can the11be used in the Black.-
Scholes nwdcl (or any other 111odcl)as the colatility variable. Thus one could compute
the theoretical rnhw of each option according tot he Black-Scholes formula, utilizing the
implied \·ulatilit:v for the stock. Since the implied volatility for the stock will most likely be
somewhat different fron1 the implied volatility of this particular option, there will be a
discrepancy between the option's actual closing price and the theoretical price as com-
puted by the model. This differential represents the amount by which the option is theo-
retically overpriced or underpriced, compared to other options on tlzat same stock.
Computing a Volatility Skew
There is not a single, definitive way to calculate a single number for each stock each day
that represents the skew in the options, but this is one acceptable way. Essentially, the
process is this:
1. Calculate the individual implied volatility of each option.

2. Calculate the standard deviation of the series in step l. It is not necessary to weight
these individual implied volatilities as one does in the composite implied volatility
calculation. Rather , merely compute the standard deviation of the set of implied vola-
tilities . Also, note that one may want to eliminate options that are essentially trading
with little or no time value premium from this standard deviation calculation, since
they are not representative of the "normal" options on this stock.
3. Divide the result of step 2 by the composite implied volatility, computed as shown in
the preceding section.
Example: XYZ is trading at 6 .50. It has several listed options, with various individual
implied volatilities.
Option Volatility
Implied
Mar 5 call 85.0%
June 5 call 715%
Mar 15 call 75.0%
June 75 call 70.0%
Considerations
The standard deviation of these four numbers is 6.25. Note that this number does
not take into account the price or the volume of the individual options. However, deeply
in- or out-of-the-money options would not be included if their time value premium is
extremely small.
Furthermore, assuming that the composite implied volatility of the above four
options (which does use volume and distance in- or out-of-the-money), is 75.0%, the "skew
factor " for this stock on thi s day would be :
Skew factor = 6.25 / 75.0 = 8.3%
Similar skew factors would be computed for all stocks, and then ranked. Those with
the highest skew factors are likely to have a distinct volatility skew. One would have to
look at the implied volatilities of the individual options on any particular stock with a large
skew factor to see what is causing the skew.
If an "event" (FDA hearing, lawsuit verdict, earnings report, etc.) is due, that might
cause a horizontal skew-where the implied volatilities of the options expiring just after
the anticipated event are more expensive than all other options. Conversely, in a bearish
market, there might be a vertical skew, where options at lower strikes, for example, have
higher implied volatilities than options at higher strikes. Strategies dealing with these
skews will be discussed in the chapter on Volatility Trading Techniques.
Once the Composite Implied Volatility and the Volatility Skew Factor are computed,
one should consider keeping a database of daily values for every stock, index, ETF, and
futures contract. \Vith this information, one would then be able to compute percentiles
of implied volatility and skew, looking back over time. These are useful statistics to help
one decide if a particular stock's options are indeed expensive or cheap, or if they are
unusually skewed .
EXPECTEDRETURN
Certain investors will enter positions only when the historical percentages are on their side.
\ Vhen one enters into a transaction, he normally has a belief as to the possibility of making
a profit. For example, when he buys stock he may think that there is a "good chance" that
there will he a rally or that earnings will increase. The investor may consciously or uncon-
sciously evaluate the prohabilities, but invariably, an investment is made based on a positive
expectation of profit. Since options have fixed terms, they lend themselves to a more rigor-
ous computation of expected profit than the aforementioned intuitive appraisal. This more
rigorous approach consists of computing the expected return. The expected return is 11oth-
11wretlia11the return that tlie positio11should yield acer a large number of cases.
i11:,!.
Chapter
28:Mathematical
Applications 459
TABLE 28-5.
Calculation of expected returns.
Price
ofXYZin6 Months Chance
ofXYZBeing
atThat
Price
Below 30 20%
31 10%
32 10%
33 10%
34 10%
Above 35 40%
100%
A simple example may help to explain the concept. The crucial variable in computing
expected return is to outline what the chances are of the stock being at a certain price at
some future time.
Example: XYZ is selling at 33, and an investor is interested in determining where XYZ
will be in 6 months. Assume that there is a 20% chance of XYZ being below 30 in
6 months, and that there is a 40% chance that XYZ will be above 3,5 in 6 months. Finally,
assume that XYZ has an equal 10% chance of being at 31, 32, 33, or 34 in 6 months. All
other prices are ignored for simplification. Table 28-5 summarizes these assumptions.
Since the percentages total 100%, all the outcomes have theoretically been allowed for.
Now suppose a February 30 call is trading at 4 and a February 35 call is trading at 2 points.
A bull spread could be established by buying the February 30 and selling the February 3.5.
This position would cost 2 points-that is, it is a 2-point debit. The spreader could make
3 points if XYZ were above 35 at expiration for a return of 150%, or he could lose 100% if
XYZ were below 30 at expiration. The expected return for this spread can be computed by
multiplying the outcome at expiration for each price by the probability of being at that price,
and then summing the results. For example, if XYZ is below 30 at expiration, the spreader loses
$200. It was assumed that there is a 20% chance ofXYZ being below 30 at expiration, so the
expected loss is 20% times $200, or $40. Table 28-6 shows the computation of the expected
results at all the prices. The total expected profit is $100. This means that the expected return
(profit divided by investment) is ,50% ($100/$200). This appears to be an attractive spread,
because the spreader could "expect" to make 50% on his money, less commissions.
What has really been calculated in this example is merely the return that one would
expect to make in the long run if he invested in the same position many tinws throughout
history. Saying that a particular position has an expected return of 8 or 9% is no different
460 Part IV:Additio
nal Considerations
TABLE28-6.
Computation of expected pro fit.
Chance
ofBeing Profit
at Expected
XYZPrice
at atThatPrice ThatPrice Profit:
Expiration (A) , (B) (A)x (B)
Below 30 20 % - $200 -$ 40
31 10% - 100 - 10
32 10% 0 0
33 10% + 100 + 10
34 10% + 200 + 20
Above 35 40% + 300 + 120
--
Total expected profit $100
from saying that common stocks return 8 or 9% in the long run. Of course, in bull markets
stock would do much better , and in hear markets much worse. In a similar manner, this
example bull spread with an expected return of 50% may do as well as the maximum profit
or as poorly as losing 100% in any one case . It is the total return on many cases that has
the expected return of 50% . Mathematical theory holds that, if one constantly inuests in
positions 1cith positiue e'.l.pected returns, he should have a betterclwnce of making money.
As is readily observable, the selection of what percentages to assign to the possible
outcomes in the stock price is a crucial choice. In the example above, if one altered his
assumption slightly so that XYZ had a 30% chance of being below 30 and a 30% chance
of being above 35 at expiration, the expected return would drop considerably , to 25% .
Thus, it is illlportant to lune a reasonably accurate and consistent rnetlwd of assigning
these percentages. Furthermore , the example above was too simplistic , in that it did not
allow for the stock to close at any fractional prices, such as 32.,50. A correct expected
return computation must take into account all possible outcomes for the stock.
Fortunately , there is a straightforward method of computing the expected percent-
age chance of a given stock being at a certain price at a certain point in time. This com-
putation i1wolves using the distribution of stock prices . As mentioned earlier, the
Black-Scholes model assumes a lognormal distribution for stock prices, although many
modelers today use nonstandard (empirical or heuristic) distributions. No matter what the
distribution, the area under the distrilmtion ClLruebetu.,,'ernany two points gives the prob-
ability of being between those two points.
Figure 28-1 is a graph of a typical lognormal distribution. The peak always lies at the
--lllean," or an "rage , of th(:-'distribution. For stock price distributions, under the random
walk ass11rnptio11,the "111ca11" is generally rnnsidered to be the current stock price. The
Chapter
28:Mathematical
Applications 461
FIGURE 28-1.
Typical lognormal distribution.
~
:.a
ct!
.0
e
a..
0 A Mean (current price)

Stock Price at End of Time Period
graph allows one to visualize the probability of being at any given price. Note that there is
a fairly great chance that the stock will be relatively unchanged; there is no chance that the
stock will be below zero; and there is a bullish bias to the graph-the stock could rise
infinitely, although the chances of it doing so are extremely small.
The chance that XYZ will be below the mean at the end of the time period is .50%
in a random walk distribution. This also means that .50% of the area under the graph lies
to the left of the mean and ,50% lies to the right of the mean. Note point A on the graph.
Forty percent of the area under the distribution curve lies to the left of point A and 60%
lies to the right of it. This means that there is a 40% chance that the stock will be below
price A at the end of the time period and a 60% chance that the stock will be above price A.
Consequently, the distribution curve can be used to determine the probabilities necessary
for the expected return computation. The reader should take note of the fact that these
probabilities apply to the end of the time period. They say nothing about the chances that
XYZ might dip below price A at some time during the time period. To compute that per-
centage , an involved computation is necessary .
The height and width of the distribution graph are determined by the volatility of
the underlying stock, when volatility is expressed as a standard deviation. This is consis-
tent with the method of computing volatility described earlier in this chapter. Implied
volatility can, of course, be used. Since the option modeler is generally interested in time
periods other than one year, the annual volatility must be converted into a volatility for
the time period in question. This is easily accomplished by the following formula:
Considerations
where
V = annual volatility
t = time, in years
Vr = volatility for time , t.
As an example, a 3-month volatility would be equal to one-half of the annual volatil-

ity. In this case, t would equal .25 (one fourth of a year), so V2s = vJ25 = .Sv.
Tlw necessary groundwork has been laid for the computation of the probability
necessary in the expected return calculation. The following formula gives the probability
of a stock that is currently at price p being below some other price, q, at the end of the
time period. The lognormal distribution is assumed.
Probability of stock being below price q at end of time period t:
ln(!L))
P (below)= N ( u~
where
N = cumulative normal distribution

p = current price of the stock
q = price in question
In = natural logarithm for the time period in question.
If one is interested in computing the probability of the stock being aboue the given
price, the formula is
P (above) = 1- P (below)
\Vith this formula, the computation of expected return is quickly accomplished with
a computer. One merely has to start at some price-the lower strike in a bull spread, for
example-and work his way up to a higher price-the high strike for a bull spread. At
each price point in between, the outcome of the spread is multiplied by the probability of
being at that price , and a running sum is kept.
Simplistically, the following iterative equation would be used.
P (of being at price x) = P (below x) - P (below y)

Chapter
28:Mathematical
Applications 463
where y is close to but less than x in price. As an example:
P (of being at 32.4) = P (below 32.4) - P (below 32.3)
Thus, once the low starting point is chosen and the probability of being below that price
is determined, one can compute the probability of being at prices that are successively
higher merely by iterating with the preceding formula. In reality, one is using this infor-
mation to integrate the distribution curve. Any method of approximating the integral
that is used in basic calculus, such as the Trapezoidal Rule or Simpson's Rule, would be
applicable here for more accurate results, if they are desired.
A partial example of an expected return calculation follows.
Example: XYZ is currently at 33 and has an annual volatility of 2.5%. The previous bull
spread is being established-buy the February 30 and sell the February 3.5 for a 2-point
debit-and these are 6-month options. Table 28-7 gives the necessary components for com-
puting the expected return. Column (A),the probability of being below price q, is computed
according to the previously given formula, where p = 33 and Vi = .177 (r = .2.5 /½\The
first stock price that needs to be looked at is 30, since all results for the bull spread are
equal below that price-a 100% loss on the spread. The calculations would be performed
for each tenth of a point up through a price of 3.5. The expected return is computed by
multiplying the two right-hand columns, (B) and (C), and summing the results . Note that
column (B) is determined by subtracting successive numbers in column (A). It would not
be particularly enlightening to carry this example to completion, since the rest of the
computations are similar and there is a large number of them .
TABLE 28-7.
Calculation of expected returns.
Priceat Expiration (A) (B) (()
(q) P(belowq) P(ofbeingat q) ProfitonSpread
30 .295 .295 -$200
30.10 .301 .006 - 190
30.20 .308 .007 - 180
30 .30 .316 .008 - 170
Considerations
* * *
In theory , if one had the data and the computer power, he could evaluate a wide
range of strategies every day and come up with the best positions on an expected return
basis. He would probably get a few option buys (puts or calls), some bull spreads, some
naked writes and ratio calendar spreads, fewer straddles and ratio writes, and a few cov-
ered call writes. This theory would be somewhat difficult to apply in practice, because of
the massive numbers of calculations involved and also because of the accuracy of closing
pric e data. It was mentioned previously that a computer will assume that "bad" closing
prices are actually attainable. By a "bad" closing price , it is meant that the option did not
trade simultaneously with the stock later in the day, and that the actual market for the
option is somewhat different in price than is reflected by the closing price for the option.
A daily contract volume "screen" will help alleviate this problem. For example, one may
want to discard any option from his calculations if that option did not trade a predeter-
mined, minimum number of contracts during the previous day. Data that give closing bids
and offers for each option are more expensive but also more reliable, and would alleviate
the problem of "bad" closing prices. In addition to a volume screen, another way of reduc-
ing the calculations required is to limit oneself to strategies in which one has interest, or
which one is reasonably certain will fit in well with his investment objectives. Regardless
of the limitations that one places upon the quantity of computations, some computer
power is necessary to compute expected return. A sophisticated programmable calculator
may be able to provide a real -time calculation, but could never he used to evaluate the
entire option universe and come up with a ranking of the preferable situations each day.
On-line computer systems are also available that can provide these types of calculations
using up-to-the-minute prices. While real-time prices may occasionally be useful, it is not
an absolute necessi ty to have them .
On e other by-product of the expected return calculation is that it could be used as
another model for predicting the theoretical value of an option. All one would have to do
is compute the probabilities of the stock being at each successive price above the striking
price of the option by expiration, and sum them up. The result would be the theoretical
option value. These data are published by some services and generally give a different
theoretical value than would the Black-Scholes model. The reason for the difference most
readily lies in tht> inclusion of the risk-free interest rate in the Black-Scholes model and
its omission in the expec ted return mod el.
Chapter
28:Mathematical
Applications 465
APPLYING THE CALCULATIONS TO STRATEGY DECISIONS
CALL WRITING
One method of ranking covered call writt>s that was dt>scribed in Chapter 2 was to rank all
the writes that pro,,idt>d at least a minimal acceptable level of return by their probability of
not losing money. If one were interested in safety, he might decide to use this approach. Sup-
pose he decided that he would consider any write that provided an annualized total return
(capital gains. divi_dends.and commissions) of at least 12%. This would eliminate many poten-
tial writes, but would leave him with a fairly large number of writing candidates each day. He
knows the downside break-even point at expiration in each write. Therefore, the probability
of the stock being below that break-even point at expiration can be computed quickly. His
final list would rank those 1crites icith the least chance of being belo1c the break-ecen point
at expiration as the best tcrites. Again, this ranking is based on an expected probability and
is, of course, no guarantee that the stock will not, in reality, fall below the break-even point.
However, over time, a list of this sort should provicle the most consenath£ covered 1crites.
Example: XYZ is selling for 43 and a 6-month July 40 call is selling for 8 points. After
including dividends and commission costs for a ,500-share position, the downside break-
even point at expiration is .36. If the annualized volatility of XYZ is 25%, the probability
of making money at expiration can be computed. The 6-month volatility is 17.7% (25%
times the square root of ½ year). The probability of being below 36 can be computed by
using the formula given earlier in this section:
ln( 36))
N ( .l ~~
8
P (below 36 in 6 months)= = N( ~i~~ ) = 0.158
The expected probability of XYZ being below 36 in 6 months is 15.8%. Therefore, this
would be an attractive write on a conservative basis, because it has a large probability of
making money (nearly 85% chance of not being below the break-even point at expiration).
The return if exercised in this example is approximately 20% annualized, so it should be
acceptable from a profit potential viewpoint as well. It is a relatively easy matter to per-
form a similar calculation, with the aid of a computer, on all covered writing candidates.
The ability to measure downside protection in terms of a common denominator-

volatility-can be useful in other types of covered call writing analyses. The writer inter-
ested in writing out-of-the-money calls, which generally have higher profit potential, is
still interested in having an idea of what his downside protection is. He might, for example,
Considerations
decide that he wants to invest in situations in which the probability of making money is at
least 60%. This is not an unusually difficult requirement to fulfill, and will leave many
attractive covered writes with a high profit potential to choose from. A downside require-
ment stated in terms of probability of success removes the necessity of having to impose
arbitrary requirements. Typical arbitrary requirements would be including only calls that
sell for one point or more, or stating that the downside protection must be a certain
percentage of the stock price. These obviously cannot suffice for stocks with different vola-
tilities. Rather, the downside protection criterion should be stated in terms of "probability
of down protection" or, alternatively, in terms of the volatility itself. In this manner, a
uniform comparison can be made between volatile and nonvolatile stocks.
CALL BUYING
The option buyer can also constructively use the measurement of volatility to aid him in
his option buying decisions. In Chapter 3, it was shown that evaluating the profitability
of calls hased on the colatility of the underlying stock is the correct u.:ay to analyze an
option purchase. One specific method of analysis is described. There are certain vari-
ables in this analysis that may be altered to fit the call buyer's individual preferences, but
the general logic is applicable to all cases.
As a first step, one should decide upon a uniform stock mocement for ranking call
purcha ses. One might decide to rank all purchases by how they would perform if the
underlying stock moved up in accordance with its volatility. The phrase "in accordance
with its volatility" must be quantified. For example, one might decide to assume that every
stock could move up one standard deviation, and then rank all call purchases on that
basis. The prospf:'Ctiue call buyer rnust also fix the time period that he wants to use. Gen-
erally, one looks at purchases to be held for 30 days, 60 days, and 90 days.
The exact steps to be followed in the analysis of profitability and risk can be listed
as follows:
1. Specify the distance that underlying stock can move, up or down, in terms of its
volatility.
2. Select the holding period over which the analysis is to take place .
PROFITABILITY
:3. Calculate the stock price that the stock would move up to, when the foregoing
assumptions are implemented .
..!-. Using a pricing model, such as the Black-Scholes model, estimate what the option
price would become after the upward stock movement.
Chapter
28:Mathematical
Applications 467
5. Calculate the percent profit , after deducting commissions.

6. Repeat steps 4 and 5 for each option on the stock.
A final ranking of all potential call buys can be obtained by performing steps 3 through 6
on all stocks, and ranking the purchases by their percentage reward.
RISK
,. Calculate the stock price that the stock could fall to, when the assumptions in steps
1 and 2 are applied.
8. With a model , price the option after the stock's decline .
9. Calculate the percentage loss after commissions.
10. Compute a reward/risk ratio: Divide the percentage profit from step 5 by the per-
centage risk from step 9.
11. Repeat steps 8 through 10 for each option on the stock.
A final ranking of less aggressive option purchases can be constructed by performing

steps 7 through 11 on all stocks, and ranking the purchases by their reward/risk ratio.
The higher profitability list of option purchases will tend to be at- or slightly out-of-
the-money calls. The less aggressive list, ranked by reward/risk potential, will tend to be
in-the-money options.
Example: Steps 1 and 2: Suppose an investor wants to look at option purchases for a
90-day holding period, under the assumption that each stock could move up by one stan-
dard deviation in that time. (There is only about a 16% chance that a stock will move more
than one standard deviation in one direction in a given time period. Therefore, in actual
practice, one might want to use a smaller stock movement in his ranking calculations.)
Furthermore , assume that the following data are known:
XYZ common, 41;

XYZ volatility, 30% annually ;
XYZ January 40 call , 4; and
time to January expiration , 6 months
Step 3: Calculate upward stock potential. This is accomplished by the following

formula:
Considerations
where
p = current stock price

q = potential stock price
V1 = volatility for the time period, t
a = a constant (see below).
The constants, a and t, are fixed under the assumptions in steps 1 and 2. The first con-
stant, a, is the number of standard deviations of movement to be allowed. In our example,
a= 1. That is, the analysis is being made under the assumption that the stock could move
up by one standard deviation. The second constant, t, is .25, since the analysis is for a
90-day holding period, which is 25% of a year. In this example:
Vt= vft = .30 Ji5 = .30X .50 = .15
so
q = 4le· 15 = 41 X 1.16 = 47.64
Thus. this stock would move up to approximately 47.64 if it moved one standard deviation
in exactly 90 days.
Step 4: Using the Black-Scholes model, the XYZ January 40 call can be priced. It
would he worth approximately 8.10 if XYZ were at 47.60 and there were 90 days' less life
in the call.
Step .5:Calculate the profit potential. For this exarnple, commissions will be ignored,
but they should be included in a real-life situation.
Percents profit=
81
· ~-
4
=
4 0
·t
= 103%
Thus, ifXYZ stock moves up bv one standard deviation over the next 90 days, this call would
:·ielcl a projected profit of 10:3o/c.Recall again that there is only about a 16% chance of the
stock actually moving at least this far. If all options on all stocks are ranked under this
same assumption, however, a fair comparison of profitable options will be obtained.
Step 6 is omitted from this example. It would consist of performing a similar profit
anal:·sis (steps 4 and ,5) 011 all other XYZ options, with the assumption that XYZ is at 47.60
after 90 days.
Step 7: Calculate the downside potential of XYZ. The formula for the downside
potential of the stock is near!:· the same as that used in step :3for the upside potential:
Chapter
28:Mathematical
Applications 469
q = pe-av,
15
= 4le-· = 41 X .86 = 35.39
XYZ would fall to approximately 3.5.39 in 90 days if it fell by one standard deviation. Note
that the actual distances that XYZ could rise and fall are not the same. The upward
potential was 6.60 points, while the downward potential is about .5.7.5points. This differ-
ence is due to the use of the lognormal distribution.
Step 8: Using the Black-Scholes model, one could estimate that the XYZ January 40
call would be worth about 1.10 if XYZ were at 35.39 in 90 days.
Step 9: The risk potential in the January 40 call would be:
Percent risk= 4 - l.lO = 2 -90 = 73%

4 4
Step 10: The reward/risk ratio is merely the percentage reward divided by the percentage
risk:
Rewar dins· k ra t·10 103%

= 73
% = 1.41
Step 11: This analysis would be repeated for all XYZ options, and then for all other
optionable stocks. The less aggressive call purchases would be ranked by their reward/
risk ratios, with higher ratios representing more attractive purchases. More aggressive
purchases would be ranked by the potential rewards only (step 5).
This completes the call buying example. Before leaving this section, it should be noted
that the assumption of ranking the purchases after one full standard deviation movement by
the underlying stock is probably excessive. A more moderate assumption would be that the
stock might he able to move .7 standard deviation. There is about a 25% expected chance that
a stock could move up at least .7 standard deviation at the end of a fixed time period.
PRICING A PUT OPTION
Theoretical models for pricing put options have been derived; that is, ones that are sepa-
rate from call pricing models. Black and Scholes presented such a model in their original
paper. However, as has been demonstrated, there is a relationship between put and call
prices in the listed option market due to the conversion and reversal strategies.
One could use the basic call pricing model for tlze purpose of predicting put prices
if lw assumes that arbitrageurs will efficiC'ntly influence the nwrkC't via co11twrsio11s.
Considerations
Theoreticians will argue that such a method of pricing puts assumes that the arbitrage
process is always present and works efficiently, and that this is not true. The "conversion
efficiency" assumption could be a serious fault if one were trying to determine the exact
overpriced or underpriced nature of the put option. However, if one is merely comparing
various put strategies under constant assumptions, the arbitrage model for pricing puts
works quite well.
The listed put's price can be estimated by using the call pricing model and the arbi-
trage formula. Recall that the arbitrageur must include the cost of carrying the position
as well as the dividends to be received.
Theoretical Theoretical + Stn_·ke_ Sto_ck _ Carrving

1
~ ~ + Dividends
put - call price pnce pnce cost
The "theoretical call price" is obtained from the Black-Scholes model. The carrying cost
is the cost of money (interest rate) times the striking price, multiplied by the time to expi-
ration. Recall that this is the approximation formula for carrying cost (see Chapter 27 for
comments on present value and compounding). Consequently, if XYZ were at 41 and a
6-rnonth January 40 call option were valued at 4 points by the Black-Scholes model, the
theoretical put price could be estimated. Assume that the cost of money interest rate is
10% annually, and that the stock will pay $ ..50 in dividends in 6 months (t = ½ year).
Theoretica l put price = 4 + 40 - 41 - (.10 X 40 X ½)+ .50

= 3-2+ .50
= 1.50
This means that if the call could be sold for 4 points, the arbitrageur would be willing to
pay up to 1.,50points for the put to establish a conversion. The arbitrageur's price is used
as the theoretical listed put price estimate.
PUT BUYING
Put option purchases can he ranked in a manner cery similar to that described for call
option buying. Reward opportunities occur when the stock falls in accordance with its vola-
tility. An upward stock movement represents risk for the put buyer. All of the 11 steps in the
pre\·ious section on call buying are applicable to put buying. The pricing of the put neces-
sary for steps 4 and 8 is clone in accordance with the arbitrage model just presented.
If an unclerl_vingstock does not have listed puts trading, the synthetic put can be
Chapter
28:Mathematical
Applications 471
considered. While all U.S.-listed stocks have Loth puts and calls at every strike, there are
still situations with warrants, especially in foreign countries, that are applicable to the
following discussion. Recall that synthetic puts are created for customers by some broker-
age houses. The brokerage sells the stock short and buys a call. The customer can pur-
chase the synthetic put for the amount of the risk involved, plus any dividends to be paid
Ly the underlying stock. The synthetic put pricing formula that would be used in steps 4
and 8 of the option buying analysis is exactly the same as the arbitrage model for listed
puts , except that the carrying costs are omitted:
Theoretical synthetic _ Theoretical + St?ke Stock

+ Dividends
put price - call price pnce price
When the ranking analysis is performed, very few synthetic puts will appear as
attractive put buys. This is because, when the customer buys a synthetic put, he must
advance the full cost of the dividend, but receives no offsetting cost reduction for the
credit being earned by the short stock position. Consequently, synthetic puts are always
more expensive, on a relative basis, than are listed puts. However, if one is particularly
bearish on a stock that has no listed puts, a synthetic put may still prove to be a worth-
while investment. The recommended analysis can give him a feeling for the reward and
risk potential of the investment.
CALENDAR SPREADS
The pricing model can help in determining 1chich neutral calendar spreads are most
attractive. Recall that in a neutral calendar spread, one is selling a near-term call and
buying a longer-term call, when the stock is relatively close to the striking price of the
calls. The object of the spread is to capture the time decay differential between the two
options. The neutral calendar spread is normally closed when the near-term option
expires. The pricing model can aid the spreader by estimating what the profit potential of
the spread is, as well as helping in the determination of the break-even points of the posi-
tion at near-term expiration.
To determine the maximum profit potential of the spread, assume that the near-term
call expires worthless and use the pricing model to estimate the value of the longer-term
call with the stock exactly at the striking price. Since commission costs are relatively large
in spread transactions, it would be best to have the computations include commissions.
Calculating a second profit potential is sometimes useful as well-the profit ~funchanged.
To determine how much profit would Le made if the stock were unchanged at near-term
expiration, assume that the spread is closed with the near-term call equal to its intrinsic
472 /"artIV: Additional
Consideratio
ns
value (zero if the stock is currently below the strike, or the difference between the stock
price and the strike if the stock is initially above the strike). Then use the pricing model
to estimate the value of the longer-term call, which will then have three or six months of
life remaining, with the stock unchanged. The resulting differential between the near-
term call 's intrinsic value and the estimated value of the longer-term call is an estimate of
the price at which the spread could be liquidated. The profit, of course, is that differential
minus the current (initia l) differentia l, less commissions.
In the earlier discussion of calendar spreads, it was pointed out that there is b oth an
upside break-even point and a downside break-even point at near-term expiration. These
break-even points can be estimated with the use of the pricing model. One method of
determination involves estimating the liquidating value of the spread at successive stock
prices. When the liquidating value is found to be equal to the initial value, plus commis-
sions, a break-even point has been located.
Example: If the spread in question is using options with a striking price of 30, one would
begin his break-even point calculations at a price of 30. Estimate the liquidating value of
the spread at 30, 29.90, 29 .80, 29.70, and so forth until the break-even point is found .
Once the downside break-even point has been determined in this manner, the iterations
to locate the upside break-even point should begin again at the striking price. Thus, one
would evaluate the liquidating value at :30, 30.10, 30.20, and so on. This is somew hat of a
brute-force method, but with a computer it is fairly fast. The number of calculations can
be reduced by adopting a more complicated iteration process .
A final useful piece of information can he obtained with the aid of the pricing
model-the theoretical ualue of the spread. Recompute the estimated value of both the
near-term and longer-term calls at the current time and stock price, using the implied
volatility for the underlying stock. The resultant differential between the two estimated
call prices may differ substantially from the actual differential, perhaps highlighting an
attractive calendar spread situation. One would want to establish spreads in which the
theoretical differential is greater than the actual differential (that is, he would want to buy
a "cheap" calendar spread).
Once these pieces of information have been computed, the strategist can rank t he
spread possibilities by whatever criterion he finds most workable. The logical method of
ranking the spreads is by their return if unchanged. The spreads with the highest return
if unchanged at near-term expiration are those in which the stock price and striking price
\\·ere close together initiall}·, a basic requirement of the neutral calendar spread. More
complicated ranking systems should try to include the theoretical value of the spread and
possibly even the maximum potential of the spread. A similar analysis ca11,of course, hr
1corked out _(<H- put rnlrndar spreads, using the arbitrage pricing model for puts.
Chapter
28:Mathematical
Applications 473
RATIO STRATEGIES
Ratio strategies involve selling naked options. Therefore, the strategist has potentially
large risk either to the upside or to the downside or both. He should attempt to get a
feeling for how probable this risk is. The formulae for determining the probability of a
stock being above or below a certain price at some time in the future can give him these
probabilities. For example, in a straddle writing situation, the strategist would want to
compute such arithmetic quantities as maximum profit potential, return if unchanged, col-
lateral required at upside break-even point or at upside action point (recall that the
collateral requirement increases for naked options on an adverse stock movement), and
the break-even points themselves. The probabilities of being above the upper break-even
point at expiration or below the lower break-even point should be computed as well.
Moreover, an expected return analysis could be performed on the position to determine
the general level of profitability of the position with respect to all other positions of
the same type on other stocks. Such an expected return analysis need not assume that
the position is held to expiration. Firm traders, paying little or no commissions, might be
interested in seeing the expected results for a holding period as short as 30 days or less.
Public customers might use a longer holding period, on the assumption that they would
not trade the position as readily because of commission costs. Ratio positions should be
ranked either by return if unchanged or by expected return.
The analyses described for calendar spreads and ratio positions should not be relied
upon as gospel. In the proposed forms of analysis, one is projecting future option prices
and stock prices under the assumption that the volatility of the underlying stock will
remain the same. Although this may be true in some cases, there wnl also be many times
when the volatility of the underlying stock will change during the life of the position. If
the volatility decreases, the projected break-even points for a calendar spread will be too
far away from the striking price. Thus, a loss would result at some prices where the
spreader expected to make money. If the volatility increases, the expected return of a ratio
position will drop, because the probabilities of the stock moving outside the profit range
will increase , thereby increasing the probability of loss.
The effect of a changing volatility can be counteracted, in theory, by continuing to
mon itor the position daily after it has been established. In a straddle write, for example,
if the stock begins to move dramatically, the expected return may become very low. If this
happens, adjustments could be made to the position to improve it. Such monitoring is
difficult to apply in practice for the public customer, because the commission costs
involved in constant position adjustments would mount rapidly. There is no exact method
that would allow for infrequent, periodic adjustments, but by using a follow-up analysis
the puhlic customer may be able to get a better feelingfor the timing of acljusti11ga posi-
tion. For example, suppose that one initially wrote a .5-point straddle when the stock was
474 PartIV: AdditionalConsiderations
at 30. Sometime later, the stock is at ,34.The expected return of writing a .5-point straddle
with a strike of 30 when the stock is at 34 could be computed for the shorter time period
remaining until expiration. If the expected return is negative, an adjustment needs to be
made. Adopting this form of adjusting would keep the number of trades to a minimum,
but would still allow the strategist to determine when his position has become improperly
balanced. Of course, the current volatility would be used in making these determinations.
Another follow-up monitoring technique, using the deltas of the options involved, is pre-
sented later in this chapter, and has been described several times previously.
FACILITATION OR INSTITUTIONAL BLOCK POSITIONING
In this and the following section, the acfoantages of using the hedge ratio are outlined.
These strategies arc primarily member firm, not public customer, strategies, since they
are best applied in the absence of commission costs. An institutional block trader may be
able to use options to help him in his positioning, particularly when he is trying to help a
client in a stock transaction .
Suppose that a block trader wants to make a bid for stock to facilitate a customer's
sell order. If he wants some sort of a hedge until he can sell the stock that he buys, and
the stock has listed options, he can sell some options to hedge his stock position. To deter-
mine the quantity of options to sell, he can use the hedge ratio. The exact formula for the
hedge ratio was given earlier in this chapter, in the section on the Black-Scholes pricing
model. It is one of the components of the formula. Simply stated, the hedge ratio is merely
the delta of the option-that is, the amount by which the option will change in price for
small changes in the stock price. By selling the correct number of calls against his stock
purchase, the block trader will have a neutral position. This position would, in theory,
neither gain nor lose for small changes in the stock price. He is therefore buying himself
tim e until he can unwin d the po sition in the open market.
Example: A trader buys 10,000 shares of XYZ, and a January 30 call is trading with a
hedge ratio of ..SO.To have a neutral position, the trader should sell options against 20,000
shares of stock (10,000 divided by ..50equals 20,000). Thus, he should sell 200 of the Janu-
ary 30's. If the hedge ratio is correct-largely a funct ion of the volatility estimate of the
unclerl:'ing stock-the trader will have greatly eliminated risk or reward on the position
for small stock movements. Of course, if the block trader wants to assume some risk, that
is a different matter. However, for the purposes of this discussion, the assumption is made
that the block trader merely wants to facilitate the trade in the most risk-free manner
possible. In this sample position, if the stock moves up by 1 point, the option should move
11ph:· .SOcents. The trader would make $10,000 on his stock position and would lose
Chapter
28:Mathematical
Applications 475
$10,000 on his 200 short options-he has uo gain or loss. Onc.:ethe trader has the neutral
position established, he can then begin to concentrate 011 unwinding the position.
In actual practice, this hedge ratio may not work exactly, because it tends to change
constantly as the stock price changes. If the trader finds the stock moving more than
fractionally, he may have to add more calls or buy some in, to maintain a neutral hedge
ratio. This would expose him to some risk, but the risk is substantially smaller than if he
had not he>clge<lat all. Of course, there would also be certain cases in which he would
profit by the stock price change. For example, implied volatility could decrease, making
the calls cheaper .
A similar hedge can be established by the block trader who sells stock to accommo-
date a customer buy order. He could buy calls in accordance with the hedge ratio, to set
up a neutral position .
This process of facilitation is quite widely practiced, especially by brokerage houses
that are trying to attract the business of the large institutional customer. Since the intro-
duction of listed call options and their applications for facilitating orders, many quotes for
large blocks of stock have improved considerably. The block trader (who works for the
brokerage house) is willing to make a higher bid or a lower offer if he can use options to
hedge his position. This facilitation with options results in a better market (higher bid or
lower offer) from the point of view of the institutional customer. Without the availability
of such listed options, the block trader would probably make a bid or an offer that was
substantially away from the prevailing market price in order to work out of his stock-only
position with a lessened degree of risk. This would obviously present a poorer market for
the institutional customer.
THE NEUTRAL SPREAD
The hedge ratios (deltas) of two or more options may be used to determine a neutral
spread. This strategy is especially useful to market-makers on the options exchanges who
may want to reduce the risk of options bought or sold in the process of providing a public
market. If the hedge ratios of two options are known, the neutral ratio is determined by
dividing the two hedge ratios.
Example: An XYZ January 35 has a hedge ratio of .25, and an XYZ January 30 has a
hedge ratio of ..50, so a neutral ratio would be 2: 1 (.50 divided by .2,5). That is, one would
sell 2 January 35's against one long January 30, or, conversely, would buy 2 January 35's
against one short January 30. Thus, a market-maker who has just bought 50 January 30's
in an effort to provide a market for a public seller of that call could hedge his position by
selling 100 January 35's. This should keep his risk small, for small stock price changes,
Considerations
until he can unwind the position. The ratio for the neutral spread is not as sensitive to the
volatility estimate of the underlying stock as is the ratio concerning stock and options.
This is because the same volatility estimate is applied to both options, and the resultant
ratio for the spread would not tend to change greatly.
The risk trader can also use the neutral spread ratio to his advantage. This concept
was illustrated several times in previous chapters describing ratio writing, ratio spreads,
and straddle writes. Ratio spreads are quite popular with member firm traders and floor
traders . Recall that a ratio spread consists of buying options at a certain strike, and selling
more options further out-of~the-money. The hedge ratios can, of course, be used by the
trader, or by a public customer, to initially establish a neutral position. Perhaps more impor-
tant , the hedge ratio can also be used as a follow up action to keep the position neutral after
the stock changes in price. This strategy is the "delta spread" described in Chapter 11.
The risk trader is not attempting to establish the spread u;ith the idea of minimi:zing
risk for small stock 11wceme11ts.Rather, he is looking to make a profit, but would prefer
to remain as neutral as possible on the underlying stock. He is implementing a risk strat-
egy that has a neutral outlook on the underlying stock. He is selling much more time value
premium than he is buying.
Example: The purchase of 1.5January 30 calls and the sale of 30 January :35calls-a ratio
call spread-may be a position taken for profit potential. It would be a neutral position if
the deltas were .60 and .30, for example. This spread would do best if the stock were at
exactly 3.5 at expiration. However, if the stock rose quickly before expiration, the spread
ratio would decrease from 2: 1 to perhaps 3:2. That is, the neutral ratio between the Janu-
ar:v 30 call and the January 3.5 call should be 3 short January 3,5's to 2 long January 30's.
If the trader wants to balance his position, he could buy .5 more January 30's, giving him
a total of 20 long versus the :30short January 3.5'sthat he originally sold. Conversely, if the
stock dropped in price, the neutral spread ratio might increase, indicating that more calls
should be sold. For example, if this stock declines, the neutral ratio might be 3:1. In that
case, 1.5more January 3.5'scould be sold, making the position short 4,5 calls versus 1.5long
calls , which would produce the neutral 3:1 ratio.
It 1co11ldnot be proper to arljust the ratio constantly, because the frequent whipsaw
losses on trading 111ow111entswould wipe out the profit potential of the position. However,
the trader may want to pick out points, in ackance, at which he wants to reevaluate his
position before something drastic goes wrong. For example, if the foregoing spread were
established with the stock at a price of 30, the spreader might want to readjust at 33 or 27,
whichever comes first.
By monitoring the spread using the hedge ratio, the trader may also be able to dis-
cern wlwther he has <'Stahlished too bullish or too bearish a position.
Chapter
28:Mathematical
Applications 477
Example: The trader starts with the example described above-long 1.5January 30 calls
and short 30 January 35 calls-when the hedge ratios were .60 and .30, respectively . Some
later time, the stock falls to 27 and the trader needs to reevaluate his position. The hedge
ratios may have become .42 for the January 30 and .14 for the January 35, indicating that
a 3:l ratio would be neutral ( .42/.14 = :3). He now has a bullish position, because his 2: 1
ratio is less than the neutral 3:1 ratio. It is not mandatorv, that the trader act on this infor-
mation. He may actually be bullish on the stock at this point and decide to remain with his
position. The usefulness of the hedge ratio is that it allows him to see that his position is
bullish, so he can make a correct judgment. Without this knowledge , he might still think
his position to be neutral, a critical mistake ifhe indeed wants to be neutral. If the trader's
ratio is greater than the neutral ratio (2:1 vs. 3:2, for example), he is bearishly positioned.
As a final point, it should be noted that the ratio can be adjusted by buying or selling
either option .
Example: If the stock falls and it is desired that the ratio be increased to 3:1, one might
sell more January 3.5'sor might decide to sell out some of his January 30's. A bullish adjust-
ment could be made by buying on either side of the spread in a similar manner. In general,
one should adjust by selling time premium or buying intrinsic value . That is, out-of-the-
moneys are usually sold and in-the-moneys are usually bought, when adjusting.
AIDING IN FOLLOW -UP ACTION
The computer can also be an invaluable aid to the strategist in that it can help him moni-
tor his positions. It is generally necessary for the strategist to have some way of inputting
his positions into an inventory database and also to have some way of identifying different
securities that are grouped within the same trading position. Once this has been done,
the computer can simultaneously read pricing data (either realtime or closing prices)
and the inventory database to generate information concerning the current status of
any position .
A cur rent mark to market (profit and loss) statement is of obvious use in that the
trader can see how he is doing each clay. The computer can also easily generate a set of
warning flags that may be of interest to the trader, and could produce a list summarizing
possible positions that need action. In most of the strategies that were described, it was
shown that the stra tegist should avoid early assignment if at all possible. It is a simple mat-
ter for the computer to calculate the remaining time value premium of any short options ,
and to warn the trader if there is only a small amount of time value premium remaining.
perhaps 0.10 or less. For similar reasons, the trader may want to have a daily list of positions
Considerations
that are nearing maturity, perhaps with less than 1 month of life remaining in the options.
A flag indicating an approaching ex-dividend date might also be useful for this purpose.
If the trader inputs another piece of information into the database, the computer can
help him in another follow-up action. In most strategies that were described, especially
those involving uncovered options, the trader wants to take some sort of follow-up action
based on the price movement of the underlying stock. If the stock rallies too far, he may
want to cover short calls or buy other calls as protection. If the stock declines too far, simi-
lar maneuvers would apply to put options or to rolling down short calls. If the trader
inputs the stock prices at which he would like to take action, the computer can monitor
each day's closing price of the stock and generate a list of positions that have exceeded
their upside or downside action points.
The computer can also do more sophisticated types of position monitoring. Recall
that it was pointed out that the deltas of the options involved in a position can be com-
pared to each other to tell whether the position is bullish or bearish. The Black-Scholes
model can be used to calculate the deltas of the options in one's positions. Then the net
position can be determined by the computer, thereby telling the trader whether his posi-
tion has become "delta long" (bullish), "delta short" (bearish), or neutral. If he sees that a
position is bearish and he does not want to be structured in that way, he can make bullish
adjustments. The delta spread and neutral spread strategies very conveniently lend
themselves to such types of follow-up action, although any of the more complicated strad-
dle writing and protected straddle writing positions can be monitored usefully in this way
as well.
The computation for determining whether a position is net short or net long gener-
ally involves calculating the "equivalent stock position" (ESP). If one owns 10 calls that
have a delta of .45, his equivalent stock position from those calls is 10 x 100 shares per
call x .45 = 450. That is, owning those 10 calls is equivalent to owning 450 shares of the
underlying stock, according to the delta. All puts and calls can be reduced to an ESP and
can then, of course, be combined with any actual long or short stock in the position to
produce an ESP for the entire strategy. The resultant ESP for each of the trader's posi-
tions can be printed form the computer along with the items described above.
Further sophisticated measures can be taken. The computer can generate a table of
results at expiration. If so desired, this could be presented as a graph, but that is not really
necessary. A table suffices quite well, as shown by most of the examples in this book. Such
a picture has meaning only if all options in the position expire at the same time. If they
don't, one may instead want the computer to compose a table of results or a graph at near-
term expiration. Thus, in a calendar spread, for example, one could see what sorts of
profitability he would be looking at when it was time to remove the spread.
Finally. the computer can compute the expected return of a position already in
place. This would give a more dynamic picture of the position, and this expected return
Chapter
28:Mathematical
Applications 479
is usually for a relatively short time period. That time period might be 30 days, or the time
remaining until expiration, whichever is less. The expected return is calculated in much
the same manner as the expected return computation described earlier in this chapter.
First, one uses the stock's volatility to construct a range of prices over which to examine
the position. Second, one uses the Black-Scholes model to calculate the values of the
various options in the position at that future time and at the various stock prices. Some of
the results should be displayed in table form by the computer program. The expected
profit is computed, as described earlier, by summing the multiples of the probabilities of
the stock being at each price by the result of the position at that price. The expected
return is then computed by dividing the expected profit by the expected investment.
Since margin computations can require involved computer programs, it is sufficient to
omit this last step and merely observe the expected profit. The following example shows
how a sample position might look as the computer displays the position itself, the ESP, the
profit at expiration, and the expected profit in 30 days. A complex position is assumed, in
order that the value of these analyses can be demonstrated.
Example: The following position exists when XYZ is at 31.7.5.It is essentially a backspread
combined with a reverse ratio write. It resembles a long straddle in that there is increased
profit potential in either direction if the stock moves far enough by expiration. Initially,
the computer should display the position and the ESP.
Position Delta ESP

Short 4,500 XYZ 1.00 Short 4,500 shares
Short 100 XYZApril 25 calls 0.89 Short 8,900 shares
Long 50 XYZApril 30 calls 0.76 Long 3,800 shares
Long 139 XYZJuly 30 calls 0.74 Long 10,286 shares
Total ESP Long 686 shares
Total money in position: $163,500 credit
The advantage of using the ESP is that this fairly complex position is reduced to a
single number. The entire position is equivalent to being long 686 shares of the common
stock. Essentially, this is close to delta-neutral for such a large position. The next item that
the computer should display is the total credit or debit in the position to date. With this
information, an expiration picture can be drawn if it is applicable. In this position, since
there is a mixture of April and July options, a strict expiration picture does not apply.
Rather, the computer should draw a picture based on the position at April expiration or
on a shorter time horizon.
Assume that April expiration is still some time away, so that the computt-r will
Considerations
instead draw the picture 30 days hence. In order to do so, the computer uses the stock's
volatility to project stock prices 30 days in the future. Seven stock prices are shown in the
next table; they represent points along the distribution curve of the stock, ranging from
minus one and one-half standard deviations to plus one and one-half standard deviations
of movement from the current stock price. While these seven points certainly do not
comprise the entire spectrum of possible stock moves, they are a representative sample.
Stock
Price Standard Expected
in30Days Deviations Results
35.90 +1.5 +$15,847
34.10 +1.0 + 12,355
32 .90 +0.5 + 10,097
31.75 0.0 + 9,443
30 .60 -0.5 + 10,743
29.50 -1.0 + 14,172
28.50 -1.5 + 19,605
Expectedprofit +$11,426
Obviously , this position has had some profitable adjustments made to it in the past. That
is not important at this point, because the trader is interested only in the future. If the
current mark to market of this position were in excess of $11,426, then he should consider
removing the position, since it would be more profitable than the expected profit.
IMPtEMENTAT
ON
Many of the analyses described in this chapter can be obtained from a reliable data ser-
vice or brokerage firm. The strategist who plans to prepare his own analysis, either by
himself or by contracting the programming work out, should be aware that computer
programs should not be written in website languages such as Java Script, PHP, HTML,
etc., because the mathematics are far too complicated. Languages such as Pascal, C, C++,
\'isual Basic, or any high-level structured programming language would suffice, although
Java could he considered as well, keeping in mind that Java's main usage is not for com-
putational purposes. Reliable option pricing data that include dividend information on
the unclerl~·ing stock are also necessary. The larger programmable calculators can handle
calculations such as the Black-Scholes model, computing the hedge ratio, and determin-
ing the prnhahility of a stock being above or below a certain price at some future time.
Chapter
28:Mathematical
Applications 481
However, more involved calculations, such as computing the implied volatility or deter-
mining the expected return of a position, require the use of a computer .
SUMMARY
Two basic mathematical aids have been presented: the pricing model and the ability to
predict the probability of a stock's movement. The hedge ratio and the expected return
analysis are extensions of the basic aids. Any strategy can be evaluated with these tools.
Such an analysis should be able to give the trader or strategist some idea of the relative
attractiveness of establishing the position, and may also aid in making follow-up adjust-
ments to the position. All the analyses rely heavily on one's estimate of the volatility of the
underlying stock. Using the implied volatility seems to be one of the best ways to obtain
an accurate, current volatility estimate, since it is derived from the prices in the market
itself. The applications presented here are not all-inclusive. The strategist who is, or
becomes, familiar with the advantages of rigorous mathematical analysis will be able to
construct many other aids for his trading that utilize the basic mathematics described in
this chapter.
'l.:l"~
'(
"i,,_'f~•~
'
~;;"'
"'- .. -~~
'
-
i!',.---~ ,!f .' - .,..
Index Options
and Futures
Introduction to Index Option
Products and Futures
Since their introduction in 1981, listed index options have proved to be very popular.
Index options are options whose underlying security is not a single stock but rather an
index composed of many stocks. These include options on index futures contracts. Most
popular types of cash settlement options are options on indices or subindices. The strate-
gies employed in trading these options are not substantially different from those used in
trading stock options, with a few notable exceptions. However, the options themselves
tend to be priced differently and to trade differently. It is these differences between stock
options and index options on which we will predominantly concentrate.
Index products-cash-based options, futures-based options, and index futures-will
be the main topic of discussion in this section of the book. We will look at how indices are
constructed, how to use these products to speculate, how to hedge, and how to spread one
index against another. Both futures and options will be used in these strategies. The dis-
cussion of other futures options-currencies, grains, bonds, etc-will be deferred to a
later chapter .
In this chapter, we will be looking at introductory facts about index options and
futures which differentiate them from the equity options that have encompassed the
entire previous part of this book. First, however, we will take an in-depth look at stock
indices and the methods of calculating them. Also in this chapter there will be a discus-
sion of futures contracts and how trading them differs from trading stocks and stock
options .
485
486 Part V:Index OptionsandFutures
IN DICES
Since many cash-based or futures options have an index of stocks underlying the option,
it is useful to understand how indices are calculated, in order that one may be able to
understand how an individual stock's movement within the index affects the overall value
of the index. The indices on which options are traded are generally stock indices-that is,
the items making up the index are stocks. There are two main ways of calculating a stock
inde x: weighted by price or weighted by capital.
CAPITALIZATION-WEIGH TED IN DICES
The capitali::.ation of a stock is the total dollar value of its securities to current market
prices: It is the multiple of the number of shares outstanding (the float) and the current
stock price. In a capitalization-weighted index, the capitalizations of all stocks in the index
are computed and added together to produce the total market value of the index. The price
of each stock in the index is multiplied by the total number of shares of that stock that are
outstanding (the "float"), and their sum is calculated. Finally, this total sum is divided by
another number, termed the "divisor," to produce the final index value. An example will
help to illustrate the concept of calculating the value of a capitalization-weighted index.
Example: Suppose that an index is composed of three stocks whose prices and floats are
given in the following table. The multiple of price times float (capitalization) is also
included in the table .
Stock Price Float Capitalization

A 30 175,000,000 5,250,000,000
B 90 50,000,000 4,500,000,000
C 50 100,000,000 5,000,000 ,000
Total capitalization : 14,750,000,000
Most indices use a divisor since it would be unwieldy to say that the index closed at
14,7.50,000,000 (for example, think of trying to quote the Dow-Jones Industrial Average
as such a large figure). The divisor is generally an arbitrary number that is initially used
to reduce the index value to a workable number. When an index is initiated, the divisor
might he set so that the index starts out at an even number. Suppose that in the sample
index above, we wanted the initial value-as represented by the given prices and floats-
to bt> 100.00. Then we would set the initial divisor to 147,.500,000. Thus the total capital-
ization of the indc>xdi\·ided by the divisor would give a value of 100.00.
Chapter
29: Introduction
to IndexOptionProducts
andFutures 487
The divisor of an index can be changed to provide continuity for the index's value
when changed occur in the individual components. Note that the divisor does not have to
be changed when a stock splits, because the price is adjusted downward automatically by
an amount equal to the increase in the float of the stock that is splitting. Notice that in
the above example, if stock B should split 2-for-l then its price would be 4.5 (90-:- 2) and
its float would double to 100 million shares from .SOmillion. Thus, the capitalization of
stock B remains the same : $4,500,000 ,000.
However, if a stock should alter its capitalization in a manner that is not reflected by
an automatic adjustment in its price, then the divisor must be changed. For example, a
company might issue more stock in a secondary offering-something that would not cause
the exchange where the stock is listed to automatically reduce the price of the stock. To
produce continuity in the value of the index between the day the secondary is issued and
the day after it is issued, the divisor is changed to keep the index value the same. Consider
the following example .
Example: Using the same sample index as before, suppose that the following prices exist
at the closing one day:

A 40 175,000,000 7,000,000,000
B 80 50,000,000 4,000,000,000
C 60 100,000,000 6,000,000,000
Total capitalization
: 17,000,000,000
Divisor: 147,500,000
Indexvalue: 115.25
Now suppose that stock A issues a 2-million-share secondary that evening, giving that
stock a total float of 177 million shares. Such an action would change the value of the
index as follows:

A 40 177,000,000 7,080,000,000
B 80 50,000,000 4,000,000,000
C 60 100,000,000 6,000,000,000
Total capitalization: 17,080,000,000
Divisor: 147,500,000
Index value: 115.80
488 PartV:IndexOptionsandFutures
However, it makes no sense to change the value of the index from 115.25 to 115.80
when nothing actually changed in the marketplace. If investors deem it necessary to lower
the price of stock A in the marketplace because of the secondary issue, so be it. But such
a change in investor philosophy would be reflected in the price of the index as the stock
drops. So, in order to keep the value of the index the same on the morning after the sec-
ondary is issued, the divisor must be changed to reflect the extra 2 million shares of stock
A. The new divisor would be equal to the new total capitalization (17,080,000,000) divided
by the old index value (115.2542373) . This would give the new divisor:
New divisor : 148, 194,117 .6
As this example demonstrates, the divisor of a capitalization-weighted index can

change quite often. Fortunately , there are organizations that are responsible for keeping
the index current and for calculating the divisor every time it needs changing. Thus, an
investor who needs to know the latest divisor can generally find it out by making a phone
call or visiting a website. This is far easier than keeping track of everything by oneself.
In a capitalization-weighted index, the stocks with the largest market value have the
most weight within the index. This means that indices that contain such largely capital-
ized stocks as Apple, Google, IBM, AT&T, General Electric, and Exxon will be domi-
nated by those stocks. In order to compute the percentage that a stock comprises of the
index, it is merely necessary to divide that stock'.') capitalization by the total capitaliza-
tion of the index. Using the previous example, one can see how the percentage is
computed .
Stock Price Float Capitalization Pct

A 40 177,000,000 7,080,000,000 41.5%
B 80 50,000,000 4,000,000,000 23.4%
C 60 100,000,000 6,000,000,000 35.1%
Total capitalization: 17,080,000,000 100.0%
Another interesting statistic to know regarding any index is how many shares of each
stock are in the index. In a capitalization-weighted index, the number of shares of each
float by the divisor of tlze index. In the same
stock is determined by dividing the stock'.c.;
sample index , the following table shows how many shares of each stock are in the index.
Chapt
er 29: Introductionto Index OptionProducts andFutu
res 489
Stock Price Floa

t Capita
lization Shares
A 40 177,000,000 7,080,000,000 1.20
B 80 50,000,000 4,000,000,000 0.34
C 60 l 00,00 0,000 6,000,000,000 0.68
Divisor : 147,500,000
Index value: 115.80
Thus, if stock A goes up by one point, then the value of the index wou ld increase by
1.20 points since there are 1.2 shares of stock A in the index. One can see the value of
computing such a statistic-it readily allows him to see how any individual stock's move-
ment will affect the index movement during a trading day. This is especially useful when
a stock is halted , but the inde x itself keeps trading.
Exam p le: Suppose that , in the above index, stock Chas halted trading. There are 0.68
shares of stock C in the index . Suppose that stock C is indicated 3 points lower, but that
the index is currently trading unchanged from the previous night's close due to the fact
that both stocks A and Bare unchange<l on the day. If one were to try to price the options
on the index , he would be wrong to use the current price of the index since that will soon
change when stock C opens . However , there is not really a problem since one can readily
see that if stock C opens 3 points lower , then the index will drop by 2.04 points (3 x 0.68).
Thus one should price the options as if the index were already trading about 2 points
lower. This kind of anticipation depends, of course, on knowing the number of shares of
stock C in the index .
A similar type of ana lysis is useful when trying to predict longer-term effects of a
stock on an index. If you thought stock Chad a chance of rallying :JOpoints , then one can
see that this would cause the index to rise over 20 points . Given this type of relationship,
th ere are sometimes option spreads between the stock's options and the index's options
that will be profitable based on such an assumption.
It should also be noted tha t the number of shares of stock in a capitalization-
weighted index does not change on a daily basis since it does not depend on the price of
the stocks in the index. However, the percent that each stock comprises of the index does
change each day as prices change. Thus, the number of shares is a more stable statistic to
keep track of, and is also more directly usable to anticipate index value changes as stock
prices change.
Capitalization-weighted indices are the most prevalent type, and most investors are
familiar with several of them: the Standard and Poor's 500, the Standard and Poor's 400,
the Standard and Poor's 100 (also called by its quote symbol, OEX), the New York Stock
Exchange Index , and the American Stock Exchange Index.
PRICE-WEIGHTED INDICES
A price-weighted index contains an equal number of shares of each stock in the index. A
price-weighted index is computed by adding together the prices of the various stocks in
the index and then dividing that sum by the divisor to produce the index value. Again, the
divisor is initially an arbitrary number that is used to produce a desired original index
value-something like 100.00, for example. Let us use the same three stocks we were using
above to construct an example of a price-weighted index. Assume the divisor at the time
of this example is 1.65843 .
Stock Price
A 30
B 90
C 50
Price total : 170
Divisor: 1.65843
Index value: 102.51
Unlike the capitalization-weighted index, the divisor needs to be changed when a

stock's price is adjusted by the exchange where it is listed (as in a stock split or stock divi-
dend) but does not have to be adjusted when the company issues more stock. That is, the
divisor in a price-weighted index is changed when the price of the stock is adjusted, but
not when the stock's capitalization is changed.
If a certain stock issues new stock in a secondary offering, the exchange where its
stock is listed will not automatically adjust the price of the stock downward. Hence, there
is no change to the divisor of any price-weighted index containing that stock because the
closing price of the stock was not adjusted by the exchange.
However, in the above example, if stock B should split 2-for-l, the exchange would
change its closing from 90 to 45. Thus, the sum of the stocks in the price-weighted index
would change without the market even being open. Consequently, the divisor would need
to be changed to reflect the split. The following example sums up the situation after stock
B splits 2-for-l .
Chapter
29: Introduction
andFutures 491
Stock Price
A 30
B 45
C 50
Price total : 125
Old divisor: 1.65843
Previous closing index value: 102.51
New divisor (i.e., the divisor necessary to keep the index
value unchanged): 1.21943
The new divisor is calculated by dividing the new sum of the prices, 125, by the old
closing price, 102.51. Tlms the divisor is reduced in order to produce the same indexvalue-
102.51-even though the sum of the prices of the stocks in the index is now 125 instead
of the previous 170. Note that the new divisor is not dependent on the old divisor.
Another statistic that we looked at with capitalization-weighted indices was the num-
ber of shares of each stock in the index. In a price-weighted index each stock in the index
has the same number of shares and that number is equal to 1 divided by the divisor of the
index. In the last example above, with the divisor equal to 1.21943, there would be
1/1.21943 or 0.82 shares of each stock in the index. Thus any stock that was up by 1 point
during a given clay would be contributing an upward movement of 0.82 points in the
index. Before the split there were 0.60 (1/1.65843) shares of each stock.
Another way to look at the revision of a price-weighted index following a split by one
of its stocks is the following: If one stock splits, then to reestablish the fact that there are
an equal number of shares of each stock in the index, part of the extra (split) shares should
be sold off and used to buy an equal number of shares of each of the remaining stocks.
Note that before the split there were 0.60 shares of each stock, and 0.82 shares after.
When stock B split 2-for-l, it increased its shares from 0.60 to 1.20, so to rebalance the
index it was necessary to sell 0.38 shares of stock B and use the proceeds to buy 0.22
shares of each of stocks A and C .
A price-weighted index's divisor can be subject to fairly frequent revision, just as was
the case with the capitalization-weighted index. These divisors are maintained by the
organizations responsible for originating them, and they can be easily obtained just by
calling the proper organization. The most popular price-weighted indices are the various
Dow-Jones indices.
The stock with the most weight in a price-weighted index is the one with the highest
price, which is substantially different from the capitalization-weightt'd index where the
stock with the most weight is the one with the most markt't value. Thus, in tht' above
492 PartV: Index Options
andFutur
es
examples, the stock with tlie greatest weight in the index wou ld be stock B before the split
and C after the split. Of course , the matter of a stock's volatility has something to do with
wh ich stock has the most weight in the change of the value of the index. Thus, if stock B
was the highest-priced stock at $90 per share , but had a very low volatility , then its price
changes would be small and it might consequently not have as great an influence on the
cha nges in the pri ce of th e index as some lower-priced stock would .
In general, one is far less concerned with a stock's weight in a price-weighted index
than he is in a capitalization-weighted index. That is, one might notice that four or five
large stocks-IBM, AT&T Exxon, Apple , and General Electric, for example-might
make up m·er 307c of the S&P 100 e\·en though they represent only 5% of the stocks in
the index . Howe\·er, the same five stocks in a price-weighted index of 100 stocks would
prohahly account for \·er:-,·near!:-,·So/cof the index because their prices are not substantially
different from those of the other 95 stocks (even though their capitalizations are). So if
one were to notice a large change in the price of IBM, one might figure that capitalization-
weighted indices that contained that stock would also be showing somewhat unusual price
chang es in the same direction that IBM is moving. A price-weighted index that contained
IBl\I would, of cours e, also be affected by IBM's price change, but not extraordinarily so
since IBM wou ld have far less weight in the pr ice -weighted ind ex.
SECTORS
Sector is a term used to refer to an index of stocks in which all the stocks are members of
the same industr:-,· group. Examples of groups on which sectors have been created-and
on which options ha, ·e traded-are computers and technology , international oils, domes-
tic oils, gold, transportation, airlines, and gaming and hotels. These indices are computed
in th e same ways as described above-either price-weighted or capitalization -weighted.
The:-,·generall:-,· consist of fewer stocks than their major counterparts, however. Most
sectors are comprised of between 20 and :30 stocks, since that is about all of the stocks
in an:-,·one specific industr:-,·group. The large indices are usually referred to as "broad -based"
indices, as oppo sed to th e smaller sectors which are often referred to as "narrow-based "
indices.
Options trade on these sectors. The intent of these options is to allow portfolio
manag ers-who often arc group-oriented-to be able to hedge off parts of their portfolio
h:-,·industry group. Th e options on these sectors are usually cash-based options. Strategies
,,·ill ht>discuss ed later, hut there is not much difference in strategy between broad-based
or 1iarrm,·-hast>clindex options. One difference is that broad-based option writers receive
111on-_, farn rnhlc margin tr eatment (that is, th e:-,·are required to put up less collateral) than
narrow-based option writers.

Chapter
29: Introduction
andFutures 493
CASH-BASED OPTIONS
Now that the reader is familiar with indices, let us look at the most popular type of listed
index option, the cash-based option .
Cash-based options do not have any ph:'sical entity underlying the option contract.
Rather, if the option is exercised or assigned, the settlement is <lonewith cash only-there
is no equity inrnkecl. This type of option is generally issued on an index, such as the S&P
,500, for which it would be ,·irtually impossible to actually deliver the underlying securities
in case of assignment or exercise.
Since many investors feel that it is easier to predict the market's movement rather
than that of an individual stock, the cash-based index option has become very popular.
Other indices that underlie cash-based option contracts are the New York Stock Exchange
Index , the S&P .500 Index, the S&P 100 Index (OEX-an index introduced by the CBOE),
the NASDAQ Index (NDX), the Dow-Jones .30 Industrials (DJX), and several other indi-
ces. In each of these cases there are too many stocks in the index, and too many varying
quantities of each of the stocks, to be able to handle the physical delivery of each of the
stocks in the case of exercise or assignment. Some cash-based options are based on sub-
indices (that is, subgroups of the larger indices such as the transportation group).
EXERCISE AND ASSIGNMENT
It is important to understand the ramifications of exercise and assignment when dealing

with this type of option. When a cash-based option is exercised, the ou:ner receives cash
equal to the difference betu;een the index'.s·closing price and the strike price of the option.
The option writer who is assigned must pay out an equal amount. The following example
shows how a call exercise might work. In this and the following examples we will use a
fiction al inde x ZYX (index symbols often end in X).
Example: Suppose an investor buys a ZYX September 160 call option. At a later date, the
ind ex has risen substantially in price and closes at 17,5.24on a particular <lay.The investor
decides it is time to take his profit by exercising his call option. Assuming the ZYX con-
tract is worth $100 per point, just as stock options are, he receives cash in the amount of
$100 times the difference between the index closing price and the strike price:
$100 X (17.5.24 - 160.00) = $1, .524. He has no further position or rights-the option
position disappears from his account by virtue of the exercise and he does not acyuire any
security by the exercise; he gets only cash.
An assignment would work in a similar manner, with the seller of an option having to
pay out of his account cash e<1ual to the difference between the index dosing price and the
494 PartV:IndexOptions
andFutures
option's striking price. As an example, suppose that a trader sells a put option on the ZYX
Index-the October 16,5put. Subsequently, the index drops in price, and one morning the
writer of this put option finds that he has been assigned (as of the previous day, as is the case
with stock options). If the index closed at 1.57.,58on the previous day, then the option writer's
account will be debited an amount equal to $100 X (165.00 - 157..58)= $742.
EUROPEAN VERSUSAMERICAN EXERCISE
Before proceeding with more examples of index option exercise and the accompanying
strategies, it is necessary to introduce two new definitions. American exercise means that
an option may he exercised at any time; European exercise means that an option may be
exercised only on its expiration day. Many of the cash-based index options have the Euro-
pean exercise feature. All stock options and some index options have the American exer-
cise feature.
The European exercise feature was introduced because institutional investors who
might tend to write calls against their portfolio of stocks wanted some assurance that their
protection wouldn't be unexpectedly taken away from them. Thus several index option
series became European exercise. Two major ones are the cash-based index options on
the S&P 500 Index (SPX) and the cash-based options on the Dow-Jones 30 Industrials.
OEX remains an American exercise .
In-the-money European put options will be cheaper than their American counter-
parts. This is because an arbitrageur would have to carry the position all the way to expira-
tion; he could not exercise his puts and liquidate the position immediately. In fact, deeply
in-the-money European puts will trade at a discount; the higher short-term interest rates
are, the deeper the discount will be .
This can affect the full protective capability of long-term European puts. If a port-
folio manager buys puts to protect his portfolio and the market crashes, the puts might be
deeply in-the-money. If these puts have a European exercise feature, they would be sell-
ing at a deep discount and therefore would not have afforded all the price protection that
the portfolio manager had been looking for.
American Exercise Consideration. The primary reason for the holder of an index
option to exercise the option is to take his profit. One might think that, if the holder
wanted to take a profit, he would merely sell his option in the open market. Of course, if
he could, he would. However, many times the deeply in-the-money options sell at a sub-
stantial discount during the trading day. A deep discount is considered to be ½to¼ of
a point, or more. Near the encl of the <lay, these options tend to trade at only slight
clisconnts. In either case, the holder of the option may decide to exercise rather than to
Chapter
29: Introduction
andFutures 495
sell at any discount. Of course, if one is the holder of a call option that is trading at a sub-
stantial discount in the morning of a particular day, and he decides to exercise, he may
lose more by the end of the day (if the market trades clown) than he would have if he had
merely sold at the deep discount in the first place. In fact, some theoreticians feel that the
"job" of a deeply in-the-money cash-based option during the trading day is to try to
predict the market's close. This, of course, is not a "job" that can be consistently done
with accuracy (if it could, the traders doing the predicting would be rich beyond their
wildest dreams).
If the holder of a cash-based call option turned bearish, that would be another reason
to exercise. That's right-if the holder of a cash-based call option is bearish, he should exer-
cise because, by so doing, he liquidates his bullish position and takes his profit. This is
somewhat opposite from an option that has a physical underlying security, such as a stock
option. This presents an interesting scenario: If one turns bearish late in the day, even after
the close, he might conceivably try to exercise his calls to liquidate his position. The
exchanges recognize that such tactics might not be in everyone's best interest-for example,
if one waited to see how the money supply numbers looked on a particular evening before
exercising, he would definitely have an advantage over the writers of those same options.
The writers could no longer viably hedge their positions after the market had closed. In
order to prevent this, cash-based option exercise notices are only acceptable until 5 minutes
after the options close trading on that exchange on any given trading day (except expiration,
of course), in order to allow both holders and writers to be on somewhat equal footing.
There is one more fact regarding exercise of cash-based options that will interest
brokerage customers, retail or institutional. Most brokerage firms will charge a commis-
sion for the cash-based option exercise or assignment. When index options were first
traded, commissions were quite high. Currently, however, one should generally be paying
a commission based upon the equivalent option price .
Example: In the previous example, one exercised a ZYX Sep 160 call at expiration when
the index closed at 175.24. This is a differential of 1.5.24. One should pay a commission as
if he had sold his long calls at a price of 15.24, not on anything more.
For writers of cash-based options, things are not so different from stock options. The
writer is still warned of impending assignment by the fact that the option is trading at a
discount. If it is not trading at a discount, it is probably not in danger of being assigned.
Also, since there is no stock involved and therefore no dividends paid, the writer of a
cash-based put option need only be concerned with whether the put is trading at a dis-
count, not with whether it is trading at a discount to underlying price less the dividend,
as is the case with stock options.
andFutures
Traders doing spreads in cash -based options have special worries, however. vVhat
I/lay seem to be a lirnited-risk spread may acquire more risk than one initially perceived ,
due to early assignlllent of the short options in the spread. Consider the following
example.
Example: Suppose that an investor establishes a bearish call spread in ZYX options-he
buys the November 160 call at a price of 1 and simultaneously sells the November 1.5,5call
at :3.His risk on the spread is $:300 plus commissions ifhe has to pay the maximum, limited
<lebit of $,500 to buy back the spread, or so it appears. However, suppose that the index rises
substantially in price and the spreader is assigned on the short side of his spread with the
index at 17.5.24. He thus is charged a debit of $2,024 to "cover" each short call via the
assignment: $100 times the in-the-money amount, 17.5.24 - 1.5.5.00,or 20.24. He receives
this assignment notice in the morning before the next trading day begins. Note that he
cannot merely exercise his long, since, if he did that, he would then receive the next night's
closing price for his long. Under the worst scenario, suppose the market receives disap-
pointing economic news the next day and opens sharply lower-with the index at 172. If
he sells his long Nov 160 calls at parity ($1,200), he will have paid a debit of $824-larger
than his initial, theoretically "limited" maximum debit of $.500. Thus he loses $624 on
this spread ($824 less the initial credit of $200)-over twice the theoretically limited loss
of $300 .
If the market should open sharply lower and trade down, he could lose more money
than he thought because his long position is now exposed-there is no longer a spread in
place after the short option is assigned. Of course, this could work to his advantage if the
market rallied the next clay. The point is, however, that a spread in cash-based options
acquires more risk than the difference in the strikes (the maximum risk in stock options) if
the short option in the spread becomes a deeply in-the-money option, ripe for assignment.
NAKED MARGIN
\\'hen an index is designated as "broad-based," a lesser margin requirement applies to the

writer of naked options. The SEC determines which indices are broad-based. A broad-based
index receives rnore favorable margin treatment because the underlying index will not
normally change in price as quickly as a stock or subindex. Thus, the naked writer theo-
retically has less of a risk with a nak ed broa d-based ind ex opti on .
Thr rC(fllirernentfor 1criting a broad-based index option naked is 1.5%of the index,
11l11stlir optio11prc>llli11111,
11lir111s if any, that the option is 011t-(fthe-11w11ey.
tlie a/llo1111t,
There is a minimum requirement: for calls, it is 10% of the index value; for puts, it is 10%
of the striking price. Bot h minima are in addition to th e opt ion pr emium .
Chapter
29: Introduction
andFutures 497
Example: Suppose that the ZYX is at 168.00, with a Dec 170 call selling for 6 and a
Dec 170 put selling for .5.The requirement for selling the call naked would be calculated
as follows:
15% of index $2,520

Plus call premium + 600
Lessout-of-money amount - 200
Naked call requirement $2,920
The requirement for writing the Dec 170 put naked would be:
5% of index $2,520
Plus put premium + 500
Naked put requirement $3,020
Both of these requirements are above the minimum of 10% of the index.
Options on narrow-based indices are subject to the same naked requirements as

stock options: 20% of the index plus the premium less an out-of-the-money amount, with
a minimum requirement of 15% of the index.
Other margin requirements are similar to those for stock options. For example, if one
wanted to write the Dec 170 straddle naked, using the same prices as in the last example,
he would have a margin requirement equal to $3,020-the larger of the put or call require-
ment, just as he would for stock options. Spread requirements for index options work in
exactly the same manner as they do for stock options. Those accounts that qualify for
portfolio margin will have reduced requirements and not the requirements stated above.
F.tJTU S
We will now take a look at how futures contracts work. This section will be concerned
only with cash-based index futures; futures for physical delivery are included in a later
chapter. The ordinary stock investor might think that he will be able to employ index
option strategies without getting involved in futures. While it may be possible to avoid
futures, the strategist will realize that they are a necessary part of the entire index-trading
strategy. Thus, in order to be completely prepared to hedge one's positions and to operate
in an optimum manner, the use of index futures or index futures options is a necessar_v
complement to nearly all index strategies.
andFutures
A cornmodities futures contract is a standardized contract calling for the delivery

of a specified quantity of a certain commodity at some future time. The older, more con-
ventional types of commodities contracts were futures on grains, meats, and metals. In
recent years, futures have expanded extensively and have encompassed financial
securities-bonds, T-bills, currencies, etc. In recent decades, futures have been issued
that are cash-based; that is, no actual commodity is deliverable. Rather, the contract
settles for cash. Some of these cash-based futures contracts have stock market indices as
their underlying 'commodity.' It is this latter type of future that will be the subject of the
examples in this section, although the basic facts regarding futures are applicable to all
futures contracts , cash-based or not.
Several types of traders or investors use futures contracts. One is the speculator: He
is able to generate tremendous leverage with futures and may be able to capitalize on
small swings in the price of the underlying commodity. Another is the true hedger: He is
a dealer in the actual underlying commodity and uses futures to hedge his price risk. This
is the more economic function of futures. Examples of hedges for physical commodities
as well as stocks will be presented in later chapters. However, let us look at a simple
example of how one might hedge a stock portfolio with stock index futures.
Example: Suppose that a stock mutual fund operates under the philosophy that investors
cannot outperform a bullish market, so the best investment strategy when one is bullish
is just to "buy the market." That is, this mutual fund actually buys all the stocks in the
Standard & Poor's 500 Index and holds them.
If the manager of this fund turns bearish, he would want to sell out his positions.
However, the commission costs and slippage (difference between bid and asked prices)
for liquidating the entire portfolio would be large. Also, the act of selling so much stock
might actually depress the market, thereby devaluing the remainder of his portfolio before
he can sell it.
This manager might sell S&P 500 futures against his portfolio instead of selling his
stocks. Such a futures contract would move up or clown in line with the S&P 500 Index
as it rises or falls. Suppose that he sold enough futures to hedge the entire dollar value of
his stock portfolio. Then, even if the stock market declined, his futures contracts would
decline also and would theoretically prevent him from having a loss. Of course, he couldn't
make much of a gain if the market went up, since the futures would then lose money.
What this money manager has accomplished is that he has effectively sold his stock port-
folio without incurring stock commission costs (futures comrnissions are normally quite
small).
If he turns bullish again at some later date, he can buy the futures back, and have
his long stocks free to profit if the market rises. Again, he does not spend the stock
Chapter
29: Introduction
andFutures 499
commission nor does he have to go through the tedious process of placing 500 stock orders
to "buy" the S&P 500-he merely places one order in futures contracts .
Futures contracts often trade at preminms to the underlying commodity, due to the
fact that the investor who buys the future does not have to spend the money that one who
buys all the stocks would have to spend. Thus, he saves the carrying costs but forsakes any
dividends . This savings is reflected by the marketplace in that a premium is placed on the
price of the futures contract. As a consequence, longer-term contracts trade at a larger
premium than do near-term contracts, much as is the case with options. In most cases,
however, the index futures trader is concerned with the nearest-term contract, and per-
haps the next one out in time. Short-term interest rates affect the premium on the
cash-based futures. The "fair value" calculations for such contracts are presented in the
next chapter .
TERMS OF THE CONTRACT
There are cash-based index futures on several indices, although some of these futures con-
tracts are not heavily traded. The most heavily traded contract is thee-mini future on the
S&P 500 Index. This contract trades on the Chicago Mercantile Exchange. It has contracts
that expire every 3 months (March, June, September, December) and a I-point move in the
futures contract is worth $.50. There is no particular reason why a I-point move is worth
$50, that is merely how the contract is defined. The '' big" S& P 500 futures contract is worth
$250 per point of movement.
Example: A futures trader buys 1 March e-mini S&P 500 contract at 401.00 (the smallest
unit of trading is 0.25 points). The contract rises in price to 403.50. The trader has a profit
of 2.50 points, or $125 (2.50 points x $50 per point).
The terms of futures contracts can change as the exchanges on which they are traded
attempt to adjust the contracts to be more competitive in the current trading environ-
ment. Consequently, the strategist should check with his broker to determine the exact
terms of any contract before he begins trading it.
FUTURES TRADING
Futures generally trade in electronic markets. Previously, they traded in pits via an open
outcry method, as stocks and options did. But in recent years, most futures pits have been
500 PattV:IndexOptions
andFutures
replaced by electronic markets. This change has been very beneficial to the individual
trader, since he can see the futures markets and the option markets on his trading
screen-just as he can for stock and index options. This was not always the case.
MARGIN, LIMITS, AND QUOTES
Futures contracts are traded on margin and are marked to market every day. Generally,
the amount of margin required is small in comparison to the total size of the contract, so
that there is tremendous leverage in trading futures. Anyone trading the futures must
deposit the initial margin amount in his account on the day he initiates the trade. Then
at the end of each clay, the amount of gain or loss on the contract is computed, and the
account is credited if there is a gain or debited if there is a loss. In case of a loss, if there
is not sufficient margin in the account, the trader must add more cash to his account to
cover the loss. This daily margin computation is known as maintenance margin. Treasury
bills or other securitie s are good collateral for the initial margin.
Example: The S&P .500 futures contract is a cash-based futures contract that trades on
the Chicago Mercantile Exchange. Since the contract is settled in cash, there is no actual
physical commodity underlying the contract. Rather, the contract is based on the value of
the S&P ,500 stock index. At the expiration of the contract, each open contract is marked
to market at the closing price of the S&P ,500 stock index and disappears. All contracts
are settled for cash on their final day and then they no longer exist-they expire. The
terms of the contract specify that each point of movement is worth $250. Thus, if the S&P
.500 Index itself is at 140.S, then the S&P futures contract is a contract on $250 x 1405, or
$3.51,2,50 worth of stocks comprising the index. Assume the initial margin for one of these
contracts is $3 0,000 , although it may vary at specific brokerage houses.
Suppose that a trader buys one December S&P futures contract for his account
s0111etirnein October. With the underlying index at 140,5.00, suppose he pays 1417.50 for
the futures contract. The futures will trade at a premium or at a discount to the index
itself based on the level of risk-free interest rates. The reason regarding this will be dis-
cussed in a later section. Initially, the customer puts up $30,000 as margin, and this may
he in the form of T-bills. On the next clay, however, the market declines and the futures
close at 1406.00. This represents a loss of 11..50 points from the purchase price. At $250
per point, the trader has a loss of $2,87.S (2.50 x 11..50) at this time. He is required to add
82,K,.5 in cash into the account, only if there is not already sufficient collateral in the
account.
If he continued to hold the contract until expiration, this process of adding his daily
gain or subtracting his daily loss from the account would recur each day. Finally, on the
last da_',, the futml's contract settles at the "a.m." settlement price if the S&P ,500 Index
Chapter
29: Introduction
andFutures 501
(see next section) and the variation margin is calculated again at that price. Then the
futures contract is expired, so it is "erased" from his account. He is then left with only the
cash that he made or lost on the trade of his contract.
The leverage produced by small margin requirements (as a percent of the total value
of the contract) is a major factor in making futures very volatile, in dollar terms. In the
preceding example, a $30,000 margin investment controls $:3,51,2.50worth of stocks. Thus
he is leveraged almost 12-to-l in this trade. Due to their volatility, many futures contracts
trade with a limit. That is, the price can only fluctuate a fixed amount above or below the
pre\'ious day's closing price. This concept is intended to prevent traders with large posi-
tions from being able to manipulate the market drastically in either direction.
S&P a nd NYSE Expir a tion. S& P ,500 futures expiration occurs in a somewhat com-
plex way, compared to those indices whose options and futures expire at the last sale on
the final day of trading. Some years ago, in order to attempt to reduce the volatility that
index futures and options expiration was causing in the stock market, the NYSE and the
Chicago Mercantile Exchange (where the S&P .500 futures trade) agreed to change the
expiration of their index products from the encl of trading on the last Friday to the morn-
ing of that day. The effect of expiration on the stock market is discussed in the next chapter.
As a result, the S&P futures and futures options settle in the following manner on
their last day of trading. On expiration day-the third Friday of the month-the "final"
price for purposes of settling futures and options is comprised of taking the opening trade
of each stock and calculating an index price based on those opening prices. There is no
actual trading in the futures and options on that last Friday; they cease trading at the close
of trading on the previous day, Thursday.
The purpose of this change was to give the specialists on the New York Stock
Exchange more time to line up the other side of trades to handle order imbalances. Under
the new rules, index arbitrageurs are forced to enter their buy or sell orders as market
on open orders on that last Friday before 9 am EST The specialist can then take his time
in opening the stock if he needs to; he can solicit orders if there is too much stock to buy
or sell.
The effect of all this is that the "final" index price for settlement purposes is not
known until all the stocks in the index have opened. It may take some time to open all
,500 stocks in the S&P ,500 Index if there is a volatile market that Friday morning (perhaps
caused by news) or if there are severe order imbalances in many of the stocks (caused hy
index arbitrageurs). Index arbitrage is described in Chapter 30.
Limits . Originally, index futures traded without limits. However, the stock market crash
of 1987 changed that. Certain parties felt that if the futures-which Wt'rc leading tlte
market down-had ceased trading for a while, the stock market could han' stabilized. As
502 Part V:IndexOptions and Futures
a result, a series of trading limits now exists for stock index futures. These are designed to
be "circuit breakers"-to prevent a stock market crash. They are not limits in the sense
that other futures have limits , but they are similar .
The levels at which these circuit breakers occur may change from time to time,
based on the volatility of the stock market and the price levels at which the S&P futures
are trading. That is, if the S&P futures are trading at 1.500, one can expect wider circuit
breakers than if they are trading at 600. These circuit breakers only apply to downside
moves by the stock market. The first in the series of circuit breakers usua lly halts trading
for only 10 minutes. After that, if the market trades lower-usually something on the
order of a 10% decline-then a longer circuit breaker is instituted for about 30 minutes
or so. After that they could open again, and if they reached the next limit down-
something probably on the order of 20%-then trading would be halted for a longer time
(two hours or so-again, the details depend on the current regulations). If there is any
time left in the trading day, they can open again, and trade down to a final limit, at which
time trading would be halted for the day. They could not trade any lower that day, although
they could trade lower the next day if need be .
There are similar limits imposed by the NYSE on its trading-based on the
Dow-Jones Industrial Averages. Those limits don't necessarily line up exactly with the
limits on the S&P futures. That fact might cause problems for hedgers should any of these
severe downside limits actually occur .
There are actually other "circuit breakers" designed to prevent runaway stock mar-
kets, but they are not related to limits on futures trading. They will be described along
with index arbitrage and program trading in Chapter 30.
Quotes. While stock and stock options are always quoted in pennies, or sometimes nick-
els, such is not the case with futures. Some futures trade in fractions, while others trade
in cents. In the corning chapters, there will be many examples of the trading details of
futures and options. However, the investor should familiarize himself with the details of
an individual contract before beginning to trade it or its options. One's commodity broker
can easily supply this information, or it can be obtained from the website of the exchange
wher e the future s trade .
OPTIONS ON INDEX FUTURES
As we saw earlier, futures contracts allow a person dealing in a commodity to minimize

profit fluctuations in his commodity. The mutual fund manager who sold the futures
largely removed any possibility of further upside profit or downside loss. Options, however,
Chapter
29: Introduction
andFutures 503
allow a little more leeway than futures do. With the option, a person can lock in one side
of his position, but can leave room for further profits if conditions improve. For example,
the mutual fund manager might buy put options on the S&P ,500 Index to hedge his
downside risk, but still leave room for upside profits if the stock market rises. This is dif-
ferent from the sale of a futures contract, which locks in his profit, but does not leave any
room for further profits if the market moves favorably.
Options trade on many types of futures contracts. The security underlying the option
is the futures contract having the same expiration month, not the entity underlying the
futures contract itself. Thus, if one exercises a listed futures option, he receives a futures
contract position , not the physical commodity.
Example: A trader owns the ZYX futures December 165 call option (165 is the striking
price). Assume the ZYX December future closed at 171.20. Both the calls and the futures
are worth $500 per point. If the call is exercised, the trader then owns one ZYX Decem-
ber (same expiration month as the option) futures contract at a price of 16,5. Since the
current price is 171.20, there is a maintenance margin credit of $3,100 in his account
(500 x 6.20 points). Note that even though the option is an option on a future which is
cash-based, the exercise may provide the holder of the option with a futures contract posi-
tion, not with cash.
At the present time, there are futures options on all of the various index futures
contracts.
EXP.IRATIO DATE'S
Futures options have specifics much the same as stock options do: expiration month
(agreeing with the expiration months of the underlying futures contract), striking price,
etc. If a trader buys a futures option, he must pay for it in full, just as with stock options.
Margin requirements vary for naked futures options, but are generally more lenient than
stock options. Often, the naked requirement is based on the futures margin, which is
much less than the 20% of the underlying stock price as is the case with listed stock
options.
When the futures option has a cash-based futures contract underlying it, the option
and the futures generally expire on the same day. Thus, if one were to exercise a ZYX
option on expiration day, one would receive the future in his account, which would in turn
become cash because the future is cash-settled and expiring as well.
Example: Suppose that a trader owns a ZYX December 165 call option, in which the
trading unit in both the underlying futures and the option is $500 per point. He holds the
andFutures
option through the last day of trading. On that last day, the ZYX Index settles at 174.00.
The call is automatically exercised, and the following sequence occurs:
1. Buy one ZYX future at 165.00 via the call exercise.

2. Mark the future at 174.00, the closing price. This is a variation margin profit of
$4,500 (174.00 - 165.00) X $500
.3. The option is removed from the account because it was exercised, and the future is
removed as well because it expired.
Thus, the exercise of the option generates $4,.500 in cash into the account and leaves behind
no futures or option contracts. \ Ve do not know if this represents a profit or loss for this call
holder, since we <lonot know if his original cost was greater than $4,.500 or not.
It should be noted that futures option expiration dates, in general, arc fairly complex.
They are not normally the third Friday of the expiration month, as stock options are.
Index futures options generally do expire on the third Friday of the expiration month, but
many physical commodity options do not. These differences will be discussed in the later
chapter on futures options .
OPTION PREMIUMS
The dollar amount of trading of a futures option contract is normally the same as that of
the underlying future. That is, since the S&P .500 future is worth $2.50 per point, so are
the S&P 500 futures options .
Example: An investor buys an S&P ,500 December 1410 call for 4.20 with the index at
1409.,50. The cost of the call is $1,0,50 (4.20 x 2.50). The call must be paid for in full, as
with equity options.
An interesting fact about futures options is that the longer-term options have a "dou-
ble premium" effect. The option itself has time value premium and its underlying security,
the future, also has a premium over the physical commodity. This phenomenon can pro-
duce some rather startling prices when looking at calendar spreads.
Example: The ZYX Indt'x is trading at 162.00 sometime during the month of January.
Suppose that tht' March ZYX futures contract is trading at 16.3..50and the June futures
contract at 167..~0. Tlwst' prices are rt'asonahle in that they represent a premium O\'t'r
the inclt'x itst'lf \\·hich is lo:2.00. These prt'miums are related to the amount of time
Chapter
29: Introduction
andFutures 505
remaining until the expiration of the futures contract and the prevailing short-term inter-
est rate.
Now, however, let us look at two options-the March 165 put and the June 165 put.
The March 165 put might be trading at 3 with its underlying security, the March futures
contract , trading at 163.50. The June 165 put option has as its underlying security the June
futures contract. Since the June option has more time remaining until expiration, it will
have more time value premium than a March option would. However, the underlying June
future is trading at 167.50, so the June 165 put option is 2½ points out-of-the-money
and therefore might be selling for 2½. This makes a very strange-looking calendar spread
with the longer-term option selling at 21/1and the near-term option selling for 3. This is
due to the fact, of course, that the two options have different underlying securities. One
is in-the-money and the other is out-of-the-money. These two underlyings-the March
and June futures-have a price differential of their own. So the option calendar spread is
inverted due to this double premium effect.
FUTURES OPTION MARGIN
Most futures exchanges have gone to the form of option margin called SPAN, which
stands for Standard Portfolio ANalysis of Risk. This form of margining is very fair and
attempts to base the margin requirement of an option position on the probability of move-
ment by the underlying futures contract, as well as on the potential change of implied
volatility of the options in question.
The older method of margining option positions is known as the "customer margin"
method. The customer margin method generally results in higher margin requirements.
The reader is referred to the chapter on futures and futures options for an in-depth dis-
cussion of SPAN and other option margin requirements.
OTHER TERMS
Just as futures on differing physical commodities have differing terms, so do options on

those futures. Some options have striking prices 5 points apart while others have strikes
only 1 point apart, reflecting the volatility of the commodity. Specifically, for index futures
options, the S&P 500 options have striking prices 5 points apart.
Futures option symbology is essentially the same as that for stock options now that
the OSI has taken place. Numeric values are used for strikes and expiration dates. How-
ever, there is one major difference: the expiration month for most futures and options still
adheres to the old futures method. Some vendors may translate for you, but many do not:
F ==January, G ==February, H ==March, J==April, K ==May, M ==June, N ==July, Q ==
August, U ==September, V ==October, X ==November, and Z ==December.
506 Part V:IndexOptionsand Futures
There are position limits for some futures options, but they allow for very large posi-
tions. Check with your broker for exact limits in the various futures options.
One factor concerning the trading of futures options can be of major concern to
many customers and salesmen. Salesmen who are registered to sell stocks are not neces-
sarily registered to sell futures-an additional test must be passed in order to sell many
types of futures options. Similarly, many customers-primarily institutions-have
received approval from their constituents to trade in stock options, but would need further
approvals to trade futures or futures options. Neither of these things should stand in the
way of the strategist-if there are opportunities in futures options, then the customer
should find a broker who can trade them. Also if the strategist finds that he requires cer-
tain approvals from within his own institution before he can trade futures, then he should
obtain those approvals.
STANDA RD OPTION STRATEGIESUSING INDEX OPTIONS
Let us return now to a general discussion of index option strategies. These apply to all
index options-whether on equity option exchanges or on futures exchanges. The stock
option strategies described in all of the preceding chapters of this book can be estab-
lished with index options as well. The concepts are normally the same for index options
as they would be for stock options. If one buys a call at one strike and sells a call at a
higher strike, that is a bullish spread; if one sells both a put and a call at the same strike
(a straddle), that is a neutral strategy. One uses deltas to determine how many options to
sell against the ones that he buys in order to establish a delta neutral strategy. Likewise,
he uses the deltas to tell, along the way, how his position is progressing and how to adjust
it to keep it delta neutral.
\Ve will not describe these same strategies over again. They have already been
described in detail. The risk of early assignment removing one side of a position can alter
some strategies. In some cases there are particular advantages or disadvantages with index
options and futures. Thus, we will briefly go over some major option strategies, giving
details pertaining to their usage as index option strategies.
OPTION BUYING
The most common reason for wanting to buy index options is to take advantage of the
di\·ersification that they provide, in addition to the normal advantages that option pur-
chasing pro\·icles: leverage and limited dollar risk. Many people feel that it is easier to
predict the general market direction than it is to predict an individual stock's direction.
This feeling, can, of course, he put to good advantage by buying index options. However,
Chapter
29:Introduction
andFutures 507
sometimes it is not better to buy the index options. In such cases, it may actually be
smarter to purchase a package of individual stock options .
Due to a phenomenon known as volatility skewing, it is possible for index options to
have implied volatilities that are out of line with projected index or stock price move-
ments. This phenomenon is discussed in detail in the chapter on advanced concepts.
For example, suppose that index puts are expensive, as they became after the 1987
stock market crash. \ Vhen this happens it may actually be more profitable for a trader who
is bearish on the market to buy a package of equity puts instead of buying index puts. The
equity puts are forced to reflect the probability of stock price movement because arbitrage
strategies will keep them in line. They will therefore be less expensive than index puts
when this type of volatility skewing is present. Index puts can remain expensive for several
reasons-primarily excessive demand and inflated margin requirements. In such situa-
tions, it is theoretically correct to buy a group of puts on stock options. In fact, one might
even hedge this purchase by selling out-of-the money, overpriced index puts.
SELLING INDEX OPTIONS
In earlier chapters, we saw that many mathematically attractive strategies involve the sale
of naked options-ratio writes, straddles, ratio spreads, etc. Index options present an
even stronger case for these strategies. Recall that the greatest risk in these strategies
with naked options is that the underlying security might move a great distance, thereby
exposing the position to great loss if the movement is in the direction in which the naked
options lie. That is, if one is naked calls and the underlying security rises dramatically,
perhaps on a takeover bid, then large losses-potentially unlimited in the absence of
follow-up action-could occur.
The strategist would, of course, never let the loss run uncontrolled. He would
attempt to take some follow-up action to limit the loss or to neutralize the position. How-
ever, even the best strategist cannot hedge his position if the movement in the underlying
occurs while the market is closed. For example, if the underlying security is a stock, cer-
tain news items might cause a large gap to occur between the closing price of a stock and
its next opening price. Such news might be related to a takeover of the company or to a
drastically negative earnings report, for example.
Index options do not have this particular drawback. An index-especially a
broad-based index-is not as likely to open on a wide gap as a stock is. An index cannot
be the subject of a takeover attempt. It cannot be severely depressed by bad earnings on
one of its components. Thus, index options are more viable candidates for strategics
involving naked option writing than stock options are. Index futures and options may
often open on small gaps of a point or so, due to emotion or possibly due to the fact that
a market that opens earlier (T-Bond futures, for example) has already made a rather large
move by the time the futures open. Such a small gap is normally not extremely damaging
to the naked writer.
One cannot assume that an index can never gap open widely-if something drastic
were to happen in the marketplace that caused opening gaps in many stocks, then a gap
could appear in the index itself. The worst case of such a gap, percentage-wise, was the
stock market crash in 1987 when the major indices such as OEX and S&P .500 opened
down over 20 points. \Vhile that remains the worst down day in history, there have been
many other severe market collapses, such as in the fall of 2008. Therefore, one cannot
assume that naked option writing of index options is a low-risk strategy; however, it is
generally less risky than naked option writing of equity options.
HANDLING EARLYASSIGNMENT OF CASH-BASED OPTIONS
Most index options are European exercise-they cannot be exercised early. However,
there are still a few cash-based American-style indices, and they could be a problem if
early assignment were to occnr. The greatest problem that a spreader of index options has
is the possibility of early assignment. This removes his hedge on one side of his position,
exposing him to much more risk than he had wanted or anticipated.
One can often obtain a clue before early assignment occurs by observing the price
of the in-the-money options. If they are trading at a discount, one can expect assignment
to be more likely.
Example: ZYX is trading at :3.57a few clays before expiration of the January options. The
stock market rallies heavily near the close, and the January 340 calls are trading with a
market of 16.50 to 17.00 after 4 p.m. EST. Since parity is 17 for these calls, it is likely that
a writer will receive an assignment notice in the morning.
The strategist who observes this situation taking place must make a rather quick
decision. Since the market has rallied heavily on the close, it is likely that arbitrageurs or
institntional accounts who are long index options are going to exercise them. The cynic
among us would e\·en think that they might be short stocks as well which they plan to
cm·er in the morning. Notice that the effect of hedged call option sellers (i.e., spreaders)
receiving assignment notices will be to make them all long the market. The short side of
their spread will have heen removed via assignment. and they will be left with only the
long side. Therefore. in order to liquidate or hedge, they will have to sell stocks or index
futures and options in the morning. This would force the market down temporarily and
would be a boon to anyone who was short overnight.
The spreader's first potential choice of action is to notice what is happening near the
close of trading and to try to exercise his long calls since he expects assignment of his short
Chapter
29: Introduction
andFutures 509
calls. The assignment of course, is not certain-he is merely projecting it. Therefore, he
could outfox himself and end up being very short if he did not receive an assignment
notice on his short calls.
Assuming the strategist did not anticipate assignment and therefore did not exercise his
long calls, he has several choices after receiving an assignment notice the next morning. First,
he could do nothing. This would he an overly aggressive bullish stance for someone who was
pre,iously in a hedged position, but it is sometimes done. The strategist who takes this aggres-
sive tack is hanking on the fact that the selling after the assignment will be temporary, and
the market will rebound thereafter, giving him the opportunity to close out his remaining
longs at fa,·orable prices. This is an overl~raggressive strategy and is not recommended.
The most prudent approach to take when one receives an early assignment on a
cash-based option is to immediately try to do something to hedge the remaining position.
The simplest thing to do is to buy or sell futures, depending on whether the assignment
was on a put or call. If one was assigned on a put, a portion of the bullishness (short puts
are bullish) of one's position has been removed. Therefore, one might buy futures to
quickly add some bullishness to the remaining position. Generally, if one were assigned
early on calls, part of the bearishness of his position ,vould have been removed-short
calls being bearish-and he might therefore sell futures to add bearishness to his remain-
ing position. Once hedged, the position can be removed during that trading day, if desired,
by trading out of the hedge established that morning.
One should receive this assignment notice early in the morning, so he can immedi-
ately hedge his position in the overnight markets. If he waits until the day session opens,
he might use futures or options to hedge. One should be particularly careful about placing
market orders in an opening option rotation, especially on index options after a severe
downside move has occurred the previous day. Market-makers are very nervous and are
not willing to sell puts as protection to the public in that situation. Consequently, puts are
notoriously overpriced after a large down clay in the stock market. One should refrain
from buying put options in the opening rotation in such a case. In the future, it is possible
that comparable situations may exist on the upside. To date, however, all gaps and severe
mispricing anomalies have been on the bearish side of the market, the downside.
CONCLUSION
The introduction of index products has opened some new areas for option strategists. The
ideas presented in this chapter form a foundation for exploring this new realm of option
strategies. Many traders are reluctant to trade futures options because futures seem too
foreign. Such should not be the case. By trading in futures options, one can avail himself of
the same strategies available in stock option. Moreover, he may he able to takt' advantage of
certain features of futures and futures options that are not availahlt' with stock options.
andFutures
Trading in index options can be very profitable, but only if one understands the risks
involved-especially the risk of early assignment in cash-based options. The advantages
to being able to "trade the market" as opposed to trading one stock at a time are obvious:
If one is right on the market, his index option strategies will be profitable. This is superior
to stock-oriented buying whereby one might be right on the market, but not make any
money because calls were bought on stocks that didn't follow the market.
The strategist should consider all of his alternatives when trading in these markets.
If he is bullish, should he really be buying SPX calls? Maybe futures calls on the S&P 500
are better. In fact, perhaps all the calls are so expensive that the underlying futures are
the best buy. The ideas presented in this chapter lay the groundwork for the strategist to
explore these questions and make the best decision for his investment strategy.
Finally, keep in mind that the index futures and options comprise a very diverse set of
securities. They can be put to work for the investor, the trader, and the strategist in a multitude
of ways. The only practical limit is in the mind of the user of these derivative securities.
PUT-CALL RATIO
Generally, we have not been concerned with technical trading systems in this book. Not
that they aren't important, they are just in another category of investments other than
option strategies. However, the put-call ratio system is so closely related to options that its
inclusion is worthwhile.
The put-call ratio is simply the number of puts traded divided by the number of
calls traded. It can be computed daily, weekly, or over any other time period. It can be
computed for stock options, index options, or futures options. Sometimes it is computed
using open interest instead of volume. Another way to compute the put call ratio is to divide
the dollars spent on puts (sum of each put price times its trading volume) divided by the
dollars spent on calls (sum of each call price times its trading volume). This is called
the iccighted put-call ratio. If it is calculated daily, one usually averages several days'
worth of figures to smooth out the fluctuations .
Example: The morning paper shows that yesterday the trading activity for SPX options was:
Total SPX Call Volume: 200,000 Contracts

Total SPX Put Volume: 300,000 Contracts
Therefore, th e ratio is:

. 300 000
Index Put-Call Ratio = : OOO= 1.50 for yesterday
200
Chapter
29: Introduction
andFutures 511
This technical indicator is a contrary one. The contrarian thinking is along these lines: if
everyone is buying puts, then everyone must be bearish; if everyone is doing something,
they can't all be right therefore the contrarian must assume a bullish stance.
So, if the put-call ratio is high, too many traders are buying puts; a contrarian would
interpret that as a bullish sign. Conversely, if the put-call ratio is low, too many traders are
buying calls; the contrarian would consider that as a bearish indicator. The theory behind
contrary systems is that the majority of traders are wrong at major turning points in the
market.
Many different ratios can be computed. The total put-call ratio includes all listed
index and equity (but not futures) options. The equity-only put-call ratio includes only
stock options, and not index options or ETFs. In futures, one would compute separate
ratios for each commodity-Gold, Sugar, Corn, etc.-and would not combine them into
one. However, one u;ould combine all the months on any one particular commodity-
April Gold, June Gold, Sept Gold, etc., would all be combined to compute the Gold
put-call ratio .
With the advent of ETFs that follow commodities, one can often use the put-call
ratio of a commodity as a signal for trading the related ETF (Gold options' put-call ratio
for trading GLD , for example).
Obviously, the more highly traded option contracts produce a more reliable put-call
ratio: equity options and index options being very liquid. Gold futures options by them-
selves are not that active and may produce distorted results for a period of time.
The Ratio Itself. Traders and investors almost always buy more calls than puts where
stock options are concerned. Therefore, the equity put-call ratio is normally a number far
less than 1.00. If call buying is rampant, the equity put-call ratio may dip into the 0.30
range on a daily basis. Very bearish days may occasionally produce numbers of 1.00 or
higher. An average day will generally produce a ratio of around 0 ..50.
Index options, however, produce much larger ratios. Many institutional and other
investors are constantly looking to avail themselves of the protective capability of index
puts. Therefore, far more index puts are purchased than are equity puts. An average day
might produce readings of 2.00 for some indice s.
Interpretingthe Ratio. There are several philosophies as to how to interpret the ratio
once it has been calculated. All philosophies are of the contrarian variety, so the general
comments made earlier that high ratios are bullish and low ratios are bearish still hold
true. However, quantifying just what is "high" and what is "low" leaves room for
interpretation .
One school helieves that absolute ratios should be used. An example might he: "if
the 10-clay moving average of the equity put-call ratio is over 0.60, that is a huy signal."
Unfortunately, applying absolute figures to any of the ratios can be counterproductive at

times. If the market is in the grip of a prolonged bearish move, more and more puts will
continue to he purchased, sending the ratio quite high before it can reverse and start
corning back to normal levels. Therefore, it is better to look for the ratios to make a high
or a low before calling a buy or sell signal. This is a more dynamic interpretation; it allows
for buy and sell signals to come at different absolute levels of the put-call ratio.
In general, the put call ratio should be rising when the underlying market is falling
and vice versa. If that is not the case, then it is likely that hedging activity is taking place,
ancl the ratio no longer has value as a contrary indicator until the hedging activity ceases.
So, for example, if the underlying market is rising, but so is the put-call ratio, then one
should ignore an~, signals that occur. That is because it is not normal for the ratio to be
rising-i.e., for there to be heavy put buying-during a rising market. Hence, the put
buying in this case is probably for hedging purposes by traders who are actually long the
underlying market.
In summary, the put-call ratio is an easily calculated one. Daily fluctuations can be
smoothed out into 10-, 20-, or .50-da~,moving averages. The ratio should be interpreted
bullishly when there is too much put buying and bearishly when there is too much call
buying. The phrase '"too much" is not easily interpreted, hut looking for local maxima or
local minima in the chart pattern is a reasonable way to approach the problem. When the
put-call ratio moving average is increasing, a buy signal would not he given until the aver-
age rolls over and begins declining; a sell signal would be generated when the average
which is declining bottoms out.
SUMMARY
There are sevt>ral kinds of indices and several kinds of trading vehicles: cash-based
options, futures options, and futures. These various underlying securities have differing
terms in the way they trade and also in the way their options are designed. This variety
creates many opportunities for astute option strategists.
Stock Index Hedging
Strategies
This chapter is devoted primarily to examining the various ways that one might hedge a
portfolio of stocks with index products. This portfolio might be a small one owned by an
individual investor or it might be as large as the entire S&P ,500 Index. We explore this
strategy from the various viewpoints of the individual investor, the institutional money
manager, and the arbitrageur. This technique of hedging stocks with index products has
become quite popular and has also drawn some attention because of the way it can cause
short-term movements in the entire stock market. The reasons why these movements
occur are also explained. Finally, we look at ways of simulating a broad-based index by
buying a group of stocks whose performance is geared to that of the index itself.
MARKET BASKETS
One of the most popular strategies using index futures and options has been the technique
of buying stocks whose performance simulates the performance of a broader index and
hedging that purchase with the sale of overpriced futures or options based on that index.
The group of stocks that is purchased is commonly known as a "market basket" of stocks.
This chapter describes how these baskets can be used to trade against a very broad index,
such as the S&P .500, or a far narrower index, such as the Dow-Jones 30 Industrials (DJX),
or even one as small as just a few stocks-perhaps a portfolio held by any investor.
The key to determining whether it will be profitable to trade some derivative security-
options or futures-against a set of stocks is generally the level of premium in the futures
513
andFutures
contract itself. That is, if the S&P 500 Index is at 405.00 and the futures are trading at 408.00,
then there is a premium of 3.00-the futures contract is trading 3.00 points higher than the
index itself. The absolute level of the premium is not what is important, but rather the rela-
tionship between the premium and the fair value of the future. We will look at how to deter-
mine fair value shortly.
The futures are the leaders among the derivative securities, especially the S&P ,500
futures. Whenever these become overpriced, other derivative securities will generally
follow suit. In this chapter, when S&P ,500 futures are referred to, it should be understood
that either the "big contract," worth $2.50 per point, or thee-mini contract, worth $50 per
point, could be utilized.
The normal scenario is for most of the index derivative securities-options and
futures-to follow the lead of the S&P 500 futures. When this happens, the only thing
that is fairly priced is the index itself-that is, stocks. Consequently, the logical way to
hedge the derivative security is to do it with stocks. If the index is small enough, such as
the 30-stock DJX, then one might buy all 30 stocks and sell the futures when they are
overpriced. This is a complete hedge and would, in fact, be an arbitrage. In the case of a
larger index such as the S&P .500, it would be possible only for the most professional trad-
ers to buy all .500 stocks, so one might buy a smaller subset of the index in hopes that this
smaller set of stocks will mirror the performance of the index well enough to simulate
having bought the entire index. We take in-depth looks at both types of hedging.
Even if the investor is not planning to use these hedging strategies, it is important
for him to umlerstand how they work. These strategies have certain ramifications for the
way the entire stock market moves. In order to anticipate these movements, a working
knowledge of these hedging strategies is necessary. The first thing that one must know in
order to implement any of these hedging strategies is how to determine the fair value of
a futures contract.
FUTURES FAIR VALUE
The formula for calculating the fair value of the futures contract is extremely simple,
although one of the factors is a little difficult to obtain. First, let's look at the simple
futures fair value formula.
Simple Formula:
Futures fair value= Index X [l + Time X (Rate - Yield)]
\\·here index is the current value of the index itself, rate is the current carrying rate (typi-
call~,,the hrokt>r loan ratt>), yield is the combined annual yield of all the stocks in the
index, and time is the time, in years, remaining until expiration of tlw contract.
Chapter
30: StockIndexHedging
Strategies 515
Example: Suppose the ZYX Index is composed of 500 stocks and is trading at 160.00, the
broker loan rate is 10%, the yield on the 500 stocks is 5%, and there are exactly 3 months
remaining until expiration of the futures contract. The time is .25, expressed in years, so
the formula becomes:
Future fair value= 160.00 X [l + .25 X (.10 - .05)]

= 160.00 X (1 + .0125) = 162.00
Thus, the future should be trading at about 2 points above the value of the index itself.
This premium of the foture over the index represents the savings in not having to pay for
and carry 500 stocks, less the loss of the dividends on the stocks (the future does not pay
dividends). If the future should get very expensive-trading at 3.50 or 4 points over the
index-then it would have to be considered very overvalued, and an arbitrageur could
move in to take advantage of that fact. Similarly, if the future should trade cheaply, at less
than a point over fair value, there might be an arbitrage available in that case as well.
The fair value is really only a function of four things: the value of the index itself, the
time remaining until expiration, the current carrying rate, and the dividends being paid
by the stocks in the index until expiration. Notice that "the dividends paid by the stock in
the index until expiration" is not quite the same as the yield of the ,500 stocks, which we
used in the above simple formula. We will expand more on that difference shortly.
Before doing that, however, let us look at how changes in the variables in the formula
affect the fair value of the futures contract. More important, we are interested in how
changes in the variables affect the premium of the futures contract over the index value.
This is what one is primarily concentrating on when trading market baskets.
As the index wlue itself rises, the fair value premium rises. For example, if 2 points
is the fair premium when the index is at 160, as in the above example, then 4 points would
be the fair premium if the index were at 320 and all the other variables remained the
same. Conversely, as the index falls, the fair value of the premium shrinks.
The premium rises and falls in direct correlation with the carrying rate as well as
with time renwining until expiration. Note that this statement is true for stock options
also, and for the same reason: The carrying costs are greater when rates are higher, or
when one must hold for a longer time, or both. In the above example, if one were to
assume there were 6 months to expiration instead of 3, the fair value of the premium
would increase to 4 points from 2 points. Similarly, if the time were decreased, the fair
value would be smaller.
Some investors, primarily institutional investors, use the short-term T-bill rate rather
than the carrying rate in order to determine the futures fair value. The reason they do
that is to determine whether the money they have in cash is better off in T-bills or in an
arbitrage strategy such as this. More will be said about this use of the T-hill rate later.
Dividends Have an Inverse Correlation to the Premium Value. An increase

in the overall yield of the index will shrink the fair value of the futures contract. This is
because the futures holder does not get the dividends and therefore the future is not as
valuable because of the loss of dividends. Conversely, if dividend yields fall, then the fair
value of the premium increases. This is not the whole story on dividends, however.
Recall that a few paragraphs ago, it was pointed out that the yield and the amount of
dividends are not exactly the same thing. This is because stocks don't pay their dividends
in a uniform manner. Rather than paying a continuous yield as bonds do, stocks normally
pay their dividends in four lump sums a year. This means that the yield variable in the
simple formula shown above should be replaced by the actual amount of dividends remain-
ing until expiration. This fact makes the computation of the fair value of the index a little
more difficult. In order to do it accurately, one must know the dividend amount and
ex-dividend dates of each of the stocks in the index. Knowing all of this information is a far
morc formidable task than knowing the yield of the index, since the yield is published
weekly in sewral places. In fact, the services of a computer are required in order to com-
pute the actual dividend on the larger indices, where 100 or more stocks are involved.
As a result, the actual formula changes slightly from the simple formula shown above.
Actual formula:
Futures fair value= Index X (1 + Time X Rate) - Dividends
In this formula, tlze dicidends are taken to be the present u;orth of all the dividends
remaining until expiration of the future.
Example: In an example similar to the one given for the simple formula, suppose the ZYX
Index is trading at 160.00, the broker loan rate is 10%, the present worth of the dividends
remaining until expiration is $1.89, and there are exactly 3 months remaining until expira-
tion of the futures contract. The time is .25, expressed in years, so the formula becomes:
Future fair value= 160.00 X (1 + .25 X .10) -1.89

= 160.00 X (1 + .025) -1.89 = 162.11
In order to compute the present worth of the dividends of an index, it is necessary
to know the amount of each stock's cli,·icleml as well as the payment elate of the dividend.
To cornpute the index's dividend, one computes the present worth of each dividend and
umltiplies that res11ltby that stock's divisor in the index in order to give the dividend the
proper weight. The inclt>x'stotal cli,·idencl is tht> sum of each of these individual stock
con1p11tations. Each stock's divisor is mert>ly the float of the stock divided by the divisor
Chapter
30:StockIndexHedging
Strategies 517
of the index. In a price-weighted index, it is not necessary to adjust the present worth of
each di,·idend-merel_v add them together and divide by the divisor. As an example, we
will look at a hypothetical index composed of three stocks in order to see how one com-
putes the present worth of an index's dividends.
Example: Suppose a capitalization-weighted index is composed of three stocks: AAA,

BBB, and CCC. Furthermore, suppose that the amount of each of the individual
stocks' dividends and the time remaining until the dividend is paid are given in the
following table, as well as each stock's float. Finally, assume the divisor for the index is
150,000,000.
Dividend DaysUntil
Stock Amount Dividend
Payout Float
AAA 1.00 35 50,000,000
BBB 0.25 60 35,000,000
CCC 0.60 8 120,000,000
Divisor: 150,000,000
In order to compute the present worth of a future amount, one uses the formula:
Future amount
P resen t wo rth = .
(1 + Rate) Time
where rate is the current short-term rate and time is expressed in years.
Assume that the current interest rate is 10%. Then the present worth of AAA's divi-
dend would be:
Present worth AAA = ___ l_.O_O
__
(1 + .10) (35/360)
1.00
(1.10) (.0972)
1.00
1.0093
= 0.9908
The present worth of the dividend is alu;ays less than the actual dividend. The present
worth of an amount is the amount of money that would have to be invested today at the
stated rate (10% in this example) to produce the future amount. That is, 99.08 cPnts
invested at 10% would be worth exactly 1.00 in 35 days.
andFutures
The present worth of the other two dividends is .2461 for BBB and .5987 for CCC.
The reader should verify for himself that these are indeed the correct amounts. Notice
that the present worth of a dividend is not much less than the actual value of the dividend.
However, in a larger index, where one is dealing with several hundred dividends, the pres-
ent worth may be significantly different from the actual sum of the dividends, especially
if short-term rates are high.
Since we made the assumption that this is a capitalization-weighted index, each of
these figures must be adjusted for the capitalization of the stock in order to give each
present worth the proper weight within the index. Thus, for AAA, the adjusted dividend
would be .9908 times .50,000,000(AAA's float), divided by 1.50,000,000,the divisor of the
index. This would result in an adjusted dividend of .3303 for AAA. When similar adjust-
ments are made for BBB and CCC, their adjusted values become .0,574 and .4790,
respectively.
Thus, the present worth of the dividend for the index would be the sum of the three
individual adjusted present worths, or .:3303+ 0..574+ .4790 = $0.8667.
Note: If the index were a price-weighted index, the index's dividend would be the
sum of these three present worths (.9908 + .2461 + .,5987),divided by the divisor of that
inde x.
The above fair value formula can be applied to options as well. For example, the
OEX Index does not have futures. However, the fair value calculations can be done in the
same manner, and the synthetic index then constructed by using puts and calls can be
compared with that fair value.
Example: Suppose that OEX is trading at 364.50 and a September OEX future-if one
existed-would have a fair value of 367.10.That is, the future would command a premium
of 2.60. Not only should a future trade with that theoretical premium, but so should the
"synthetic OEX" composed of puts and calls at the same strike. Hence, the synthetic OEX
constructed with options should trade at about 367.10 also.
That is, if the OEX Sep 36,5call were selling for 4.60 and the Sep 365 put were sell-
ing for 2.,50,then the synthetic OEX constructed by the use of these two options would
be priced at 367.10. Recall that one determines the synthetic cost by adding the strike,
36,5,to the call price, 4.60, and then subtracting the put price: 365 + 4.60 - 2.,50 = 367.0.
This synthetic price of 367.10 is literally the same as the theoretical futures price of
367.10.
The same calculations can be applied to any index with listed options trading. Let
us now return to the broader subject at hand-trading market baskets of stocks against
futures.
Chapter
Strategies 519
PROGRAM TRADING
Two terms that conjure up images of the stock market crash in 1987 and other severe
price drops are ·'program trading" and "index arbitrage." Neither one by itself should
affect the stock market, since they are two-sided strategies-involving buying stocks and
selling futures. This two-sided aspect should have little effect on the market, theoreti-
cally. However, in practice, it is often the case that trades are not executed simultane-
ously, and the stock market takes a jump or a dive.
Program trading is nothing more than trading futures against a general stock
portfolio. Index arbitrage is trading futures against the exact stocks that comprise an
index .
Later discussions will assume that one is trying to create or simulate the index itself
in order to hedge it with futures. This is the arbitrage approach. However, there are many
other types of stock positions that may be hedged with the futures. These might include
a portfolio of one's own construction containing various stocks, or might include a group
of stocks from which one wants to remove "market risk." Normally, one would not own
the makeup of any index, but rather would have a unique combination of stocks in his
portfolio. Such an investor may want to use futures to hedge what he does own.
One reason why an investor who owned stocks would want to sell index products
against them might be that he has turned bearish and would prefer to sell futures rather
than incur the costs involved with selling out his stock portfolio (and repurchasing it later).
Commission charges are quite small on futures transactions as compared to an equal dol-
lar amount of stock. By selling the futures on an index-say, the S&P .500-he removes
the "market risk" from his portfolio (assuming the S&P ,500 represents the "marke t ").
What is left over after selling the futures is the "tracking error." The discrepancy between
the movement of the general stock market and any individual portfolio is called "tracking
error." This investor will still make money if his portfolio outperforms the S&P .500, but
he will find that he did not completely eliminate his losses if his portfolio underperforms
the index. Note that if the market goes up, the investor will not make any money except
for possible tracking error in his favor.
REMOVING THE MARKET RISK FROM A PORTFOLIO
Stock portfolios are diverse in nature, not necessarily reflecting the composition of
the index underlying the futures contracts. The characteristics of the individual stocks
must be taken into account, for they may move more quickly or more slowly than ''the
market." Let us spend a moment to define this characteristic of stocks that is so
import ant.
520 Part V:Inde
x OptionsandFutures
VOLATILITY VERSUS SETA
Recall that when we originally defined volatility for use in the Black-Scholes model, we
stated that Beta was not acceptable because it was strictly a measure of the correlation of
a stock's performance to that of the stock market and was not a measure of how fast the
stock changed in price. Now we are concerned with how the stock's movement relates to
the market's as a whole. This is the Beta.
Unfortunately, Beta is not as readily available to the option strategist as is volatility.
Many option traders merely have to punch a button on their quote machines and they can
recei\·e estimates of volatility. However, Beta estimates are more difficult to obtain, and the
ones that are available are often for very long time periods, such as several years. These
long-term Betas cannot be used for the purposes of the index hedging discussed in this chap-
ter. Therefore, if om' does not have access to shorter-term Beta calculations, then he c8.n
approxi1uate Beta by comparing an individual stock's volatility with the market's volatility.
Example: XYZ is a relatively volatile stock, having both an implied and historical volatility
of :36%. The m·ernll stock market has a volatility of 1.5%.Therefore, one could approximate
the Beta of XYZ as: ·
Beta approximation = 36/15 = 2.40
There are CPrtain situations in which this approximation would not work well, because
the stock has little or no correlation to the overall stock market (e.g., gold or oil stocks). If
one has a portfolio of stocks of that type, then he should make a serious attempt to attain
their Betas, for the Beta estimate method just described will not be accurate. Such stocks
may be rnlatile-that is, they change in price fairly rapidly-but they may go in totally dif-
ferent directions from the overall stock market: They would thus have high volatility, but low
Beta. This is not conducive to the ahove short-cut for approximating Beta from volatility.
The remaining examples in this chapter use the terms Beta and ar{justed wlatility
synonymously. Adjusted volatility is merely the approximation of Beta from volatility as
described above: the stock's volatility divided by the market's volatility.
THE PORTFOLIO HEDGE
l11attempting to hedge a diverse portfolio, it is necessary to use the Beta or adjusted vola-
tilit:· because one does not want to sell too many or too few futures. For example, if the
portfolio were composed of nonvolatile stocks and one sold too many futures against it, one
could lose money if the market rallied, even if his portfolio outperformed the market.
This \\·ould happen because the general market, being more volatile, would rallv further
tlia11 tllt' nom'olatile portfolio. Icleall:·, one should sell only enough futures so that there
\nmld lw no .~ain or loss if the market rallied. There would he 0111'-, trackinab error.
Chapter
Strategies 521
Conversely, if one dot>snot sell enough futures against a volatile portfolio, then there is risk
of loss if the market declines, since tht> portfolio would decline faster than the market.
The Beta or adjusted volatility of each stock is used in order to determine the proper
number of futures to sell against the portfolio. The dollar value (capitalization) of each
stock in the index is adjusted by that stock's volatility to give an ·'adjusted capitalization"
for each stock. Then, when all these are added together, one will have determined how
much "adjusted capitalization" must be hedged with futures. The suggested method,
described in the following example, uses an adjusted volatility for each stock.
The steps to follow in determining how many futures to sell against a diverse port-
folio of stocks are as follows:
l. If you don't know the Beta, divide each stock's volatility by the market's (S&P ,500)
volatility. This is the stock's adjusted volatility.
2. Multiply the quantity of each stock owned by its price and then multiply by the
adjusted volatility from step l. This gives the adjusted capitalization of the stock in
the portfolio .
3. Add the results from step 2 together for each stock to get the total adjusted capitaliza-
tion of the portfolio.
4. Divide the sum from step 3 by the index price of the futures to be used and the unit
of trading for the futures ($2.50 per point for the S&P .500 futures) to determine how
many futures to sell.
Example: Suppose that one owns a portfolio of three diverse stocks: 3,000 COCO, an
over-the-counter technology stock; ,5,000 UTIL, a major public utility stock; and 2,000 OIL,
a large oil company. The owner of this portfolio has become bearish on the market and would
like to sell futures against the portfolio. He needs to determine how many futures to sell.
The prices and volatilities of these stocks are given in the following table. Assume
that the volatility of the fictional ZYX Index is 1.5%. This is the "market's volatility" that
is divided into each stock's volatility to get its adjusted volatility (step L above).
Adjusted Adjusted
Volatility Quantity Capitalization
Stock Vola
tility (Stepl) Price Owned (Step2)
GOGO .60 4.00 25 3,000 $300,000
UTIL .12 0.80 60 5,000 240,000
O IL .30 2.00 45 2,000 180,000
Total adjusted capitalization: $720,000 (step 3)
Now suppose that the ZYX Index is trading at 178.6,5and a 1-point move in the futures is
worth $.500. Step 4 can now be calculated: $720,000-:- .500-:- 178.6.S, or 8.06 futures
contracts. Thus, the sale of 8 futures contracts would adequately hedge this diverse
portfolio.
There is an important nuance in this simple example: The price of the index should
be 11sedin all hedging calculations, as opposed to using the price of the future. There are
many examples of hedging portfolios and market baskets with futures or options in this
chapter and the next. Regardless of the situation, the value of the index should always be
used to determine how much stock to buy or how much of the derivative security to sell.
Note that the actual capitalization of the above example portfolio was only $46.5,000
($7.5,000 for COCO, $300,000 for UTIL, and $90,000 for OIL). However, the portfolio
is more volatile than the general market because of the presence of the two higher-volatility
stocks. It is thus necessary to hedge $720,000 worth of "market," or adjusted capitaliza-
tion , in order to compensate for the higher volatility of the portfolio.
A similar process can be used for far larger portfolios. The estimate of volatility is, of
course, crucial in these calculations, but as long as one is consistent in the source from which
he is extracting his volatilities, he should have a reasonable hedge. There is no way to judge
the future performance of a portfolio of stocks versus the ZYX Index. Thus, one has to expect
a rather large tracking error. In this type of hedge, one hopes to keep the tracking error
down to a few 7-'C'rcent, which could be several points in the futures contracts over a long
enough period of time. Uf course, the tracking error can work in one's favor also. The main
point to recognize here is that the vast majority of the risk of owning the portfolios has been
eliminated by selling the futures contracts. The upside profit potential of the portfolios has
been eliminated as well, but the premise was that the investor was bearish on the market.
Note that if the futures are overpriced when one enacts his bearishly oriented portfolio
hedge, he will gain an additional advantage. This will act to offset some negative tracking
error, should such tracking error occur. However, there is no guarantee that overpriced
futures will be available at the time that the investor or portfolio manager decides to turn
bearish. It is better to sell the futures and establish the hedge at the time one turns bearish,
rather than to wait and hope that they will acquire a large premium before one sells them.
HEDGING PORTFOLIOS WITH INDEX OPTIONS
As mentioned earlier, one could substitute options for futures wherever appropriate. If he
were going to sell futures, he could sell calls and buy puts instead. In this section, we are
also going to take a more sophisticated look at using index options against stock portfolios.
First, let us examine how the investor from the previous example might use index
options to hedge his portfolio.
Chapter 30: StockIndexHedging
Strategies 513
Example: Suppose that an investor owns the sarnt:' portfolio as in the previous example:
3,000 COCO, 5,000 UTIL, and 2,000 OIL. He deciclE.'sto hedge with index UVX, which
has options worth $100 per point. Assume that the volatility of the UVX is 15%. This
investor would then compute his total adjusted capitalization in the same manner as in
the previous example, again arriving at a figure of $720,000.
Suppose that the UVX Index is at 17,5.60.This investor would want to hedge his
$720,000 of adjusted capitalization with 4,100 ·'shares" of UVX ($720,000-:- 175.60). Since
a 1-point move in UVX options is worth $100, this means that one would sell 41 UVX calls
and buy 41 UVX puts. He would probably use the 175strike or possibly the 180 strike, since
those strikes are the ones whereby the calls have the least chance for early assignment.
\Vhere short options are involved, as with the calls in the above example, one must
be aware of the possibility of early assignment exposing the portfolio. Consequently, if the
marketplace has an equal premium on the futures and the "synthetic" UVX, one should
sell the futures in that case, because there is no possibility of unwanted assignment. How-
ever, if the options represent a synthetic price that is more expensive than the futures,
then using the options may be more attractive.
Example: Suppose that our same investor has decided to hedge his portfolio with its
$720,000 of adjusted capitalization. He is indifferent as to whether to use the ZYX futures
or the UVX options. He will use whichever one affords him the better opportunity. The
following table depicts the prices of the securities that he is considering, as well as their
fair values.
Current Fair Index

Security Price Value Price
ZYXJun Future 180.50 180.65 178.65
UVXJun 175 Call 5 5 175.60
UVXJun 175 Put 2 2½ 175.60
UVXJun 180 Call 2½ 2½ 175.60
UVXJun 180 Put 4½ 5 175.60
This investor essentially has three choices: (1) to use the ZYX futures, (2) to use the
UVX options with the 175 strike, or (3) to use the UVX options with the 180 strike. Notice
t hat the ZYX future is trading 1.5cents below its fair value (180..50 vs. 180.65). The UVX
Index fair value, as shown by the fair values of the options, is 177..50.This can be com-
puted by adding the call price to the strike and subtracting the put price. In thE' case of
either strike, the fair values indicate a UVX Inde x fair value of 177.50.
andFutures
Howew-·r, the actual markets are slightly out of line. When using the actual prices,
one sees that he can sell the UVX Index synthetically for 178.00 whether he uses the
17.5'sor the 180's. Thus, by using the UVX options he can sell the UVX "future" syntheti-
cally for 1/:2 point over fair value, while the ZYX futures would have to be sold at
1.5cents under fair value. Thus, the options appear to be a better choice since 6.5 cents
(the .50 cents that the UVX options are overvalued plus the 1.5 cents that the futures
are undervalued) is probably enough of an edge to offset the possibility of early
assignment.
\Vith the futures having been eliminated as a possibility, the investor must now
choose which strike to use. Since he will be selling calls and buying puts, and since either
strike allows him to synthetically sell the UVX "future" at 178, he should choose the 180
strike. This should he his choice because the 180 calls are out-of-the-money and thus less
likely to be the object of an early assignment.
HEDGING WITH INDEX PUTS
Let us now move on to discuss ways of hedging in which a complete hedge is not estab-
lished, hut rather some risk is taken. The main difference between options and futures is
that futures lock in a price, while options lock in a worst-case price (at greater cost) but
leave room for further profit potential. To see this, consider a long stock portfolio hedged
h~·short futures. In this case, one eliminates his upside profit potential except for positive
tracking error. However, if he buys put options instead, he expends money-thereby
incnrring a greater cost to himself than if he had used futures-but he still has profit
potential if the market rallies.
One could hedge a long stock portfolio with options by either buying index puts or
selling index calls. Buying the puts is generally the more attractive strategy, especially if
the puts are cheap. In order to properly establish the hedge, it is not only necessary to
adjust the dollars of stock in accordance with the Beta, but the deltas of the options must
be taken into account as well. The following example will demonstrate the use of puts to
hedge a portfolio of diverse stocks.
Example: Assun1e that an investor has the same portfolio of three stocks that was used in
a pre\·ious example: :3,000COCO, ,5,000UTIL, and 2,000 OIL. He has become somewhat
bearish on the market in general and would like to hedge some of his downside risk. How-
en'r, he decides to use puts for the hedge just in case there is a further rally in the market.
Tht>tahle from the earlier example is reprinted below, showing the adjusted volatili-
ties and capitalizations for each stock in the portfolio. The total adjusted capitalization of
the portfolio is $720,000, as before.
Chapter
Strategies 525
Adjusted Adjusted
Stock Volatility (Stepl) Price Owned (Step2)
GOGO .60 4.00 25 3,000 $300,000
UTIL .12 0.80 60 5,000 240,000
OIL .30 2.00 45 2,000 180,000
Total adjusted capitalization: $720,000 (step 3)
There are two ways that one might want to approach hedging this $720,000 portfolio
with puts.
l. As disaster insurance: Buy enough (out-of-the-money) puts so that the portfolio would
be 100% hedged be low the striking price of the puts.
2. As a hedge against current market movements: Buy enough puts so that all current
portfolio movements are hedged.
Example-Method 1: In this method, the portfolio manager is looking for disaster insur-
ance. He is not so much concerned with hedging current market movements as he is with
preventing a major loss if the market should collapse. The manager often uses an
out-of-the-money put for disaster insurance.
Assume that he is going to use the UVX Index puts, which are worth $100 per point.
The March 170 puts, trading at 1, are going to be used in the hedge. The index is currently
at 178.00.
He would therefore divide his portfolio's adjusted capitalization ($720,000) hy the
value of the striking price of the puts to be used. In this case, the value of the striking
price is $17,000 (100 X 170).
Puts to buy= $720,000 / $17,000 = 42.3
Cost of 42 puts: $4,200

Striking value of 42 puts: $714,000 (42 X $17,000)
The cost of buying 42 puts is $4,200. This can be thought of as an insurance pre-
mium, paid to buy $714,000 worth of insurance. He will have market risk on his portfolio
between the current price of the index (178.00) and the striking price (170.00). The 42
puts would hedge a little of the drop in his portfolio during that 8-point drop in the index,
but their full protective value would not be felt until they were in-the-money. It is not an
andFutures
exact hedge, of course, since the UVX Index may perform differently from the portfolio
once UVX drops below 170. However, this put purchase will definitely remove a great deal
of the market risk of further drops.
Example-Method 2: In this method, the portfolio manager is attempting to hedge the

current value of his portfolio. He wants no further downside losses in his portfolio at all.
He would generally buy at- or in-the-money puts in this case and would use the put's delta
in order to construct a complete hedge.
Again assume that he is going to use the UVX Index puts, which are worth $100 per
point. In this case, however, with the index at 178.00, he is considering the March 180
puts, trading at 4.50, with a delta of -0.60 to be used in the hedge.
In this case, the number of puts is determined by using the same formula as in the
above example and then also dividing by the absolute value of the delta:
Puts to buy= $720,00/(100 X 180)/0.60

= 67
Cost of protection: 67 X $450 = $30, 150
In this case, the portfolio manager is spending much more for the puts, but for his
additional expense, he acquires immediate protection for his portfolio. Furthermore,
there is some intrinsic value to the puts he bought (2 points, or $13,400 on 67 of them).
If the UVX Index drops at all, these puts will immediately begin to hedge his entire
portfolio against loss. Of course, if the market rises, he loses his much more expensive
insurance cost.
When one uses options instead of futures to hedge his position, he must make adjust-
ments when the deltas of the options change. This was not the case when futures were
used; perhaps with futures, one might recalculate the adjusted capitalization of the port-
folio occasionally, but that would not be expected to affect the quantity of futures to any
great degree. With put options, however, the changing delta can make the position delta
short when the market declines, or can make it delta long if the market rises. This situa-
tion is akin to being long a straddle-the position becomes delta short as the market
declines and becomes delta long as the market rises.
Basically, the adjustments would be same as those that a long straddle holder would
make. If the market rallied, the position would be delta long because the delta of the puts
would have shrunk and they would not be providing the portfolio with as much adjusted
dollar protection as it needs. The investor might roll the puts up to a higher strike, a move
that essentially locks in some of his stock profits. Alternatively, he could buy more puts at
the current (low) strike to increase his protection.
Chapter
Strategies 527
Conversely, if the market had declined immediately after the position was established,
the investor will find himself delta short. The delta of the long puts will have increased and
there will actually be too much protection in place. His adjustment alternatives are still the
same as those of a long straddle holder-he might sell some of the puts and thereby take a
profit on them while still providing the required protection for the stock portfolio. Also, he
might roll the puts clown to a lower strike , although that is a less desirable alternative.
H EDGING WITH INDEX CALLS
Another strategy to protect a stock portfolio is to establish a ratio write using short calls
against the long stock. This is the opposite of using puts for protection, in that it is more
equivalent to being short a straddle .
Example: In the last example , the March 180 put had a delta of -0.60. The March 180 call
should then have a delta of 0.40. If the portfolio manager wanted to hedge his portfolio by
ratio writing calls against it, he could use the same formula as in the previous example:
Calls to sell= $720,000/ (100 X 180)/0.40 = 100
He would sell 100 calls to hedge his portfolio .

Adjustments would be made in much the same manner as those that a straddle seller
would make. If the market rises, the delta of the calls will increase and the position will
be delta short. One would probably buy calls in that case. Follow-up action for an actual
short straddle might dictate buying in some of the underlying security rather than buying
the calls, but that is not a realistic alternative in this case, since the sample portfolio is
probably stable .
If, on the other hand, the market declined after the short calls were sold against the
portfolio, the position would become delta long as the delta of the calls shrinks. The nor-
mal action in that case would be to roll the calls down and reestablish the proper amount
of protection for the portfolio .
Overall, hedging the portfolio with short index calls does not present as attractive a
position as hedging with long index puts. This is due mostly to the nature of what the
portfolio manager is trying to accomplish, as opposed to the relative merits of long and
short straddles. As was pointed out in previous chapters, straddle selling, while risky, is an
excellent strategy on a statistical basis. However, in this section we are not dealing with a
strategist who is going to go out and buy stocks and then write index calls against them.
Rather, we have an existing portfolio and the portfolio manager is becoming bearish on
the market. Thus, the stock portfolio is a fixed entity and the index options or futures are
being bui lt around it for prot ection .
andFutures
Long puts serve the purpose of protection far better than short calls, for the follow-
ing reasons. First, the types of adjustments that need to be made by a straddle seller often
involve buying stock or at least buying relatively deep in-the-money calls. A portfolio
manager or investor holding a portfolio stock may not need or want to get involved in a
multi-optioned position. Second, with calls there is large risk to the upside in case of a
large market rally. Someone holding a portfolio of stocks might be willing to forego upside
profits (as in the sale of futures), but generally would be quite upset to sustain large losses
on the upside. Using puts, of course, leaves room for upside profit potential. Third, there
is risk of early assignment with short index calls, although that is of minor significance in
this case since the portfolio of stocks would have been long in any case. Other calls could
be written immediately on the day after the assignment. The only real drawback to using
the puts is that premium dollars are paid out and, if the market stabilizes, the time value
decay will cause a loss on the puts. If one actually suspects that such a stabilization might
occur , he should use futures against his position instead of puts or calls.
DEX ARBITRAGE
As previously stated, index arbitrage consists of buying virtually all of the stocks in an
index and selling futures against them, or vice versa. Whenever the futures on an index
are mispriced, as determined by comparing their actual value with their fair value, there
may be opportunities for arbitrage if the mispricing is large enough. \;\/hen futures are
extremely overpriced: buy stocks, sell futures; or when futures are underpriced: sell
stocks, buy futures. In either case, the arbitrageur is attempting to capture the differen-
tial between the fair value price of the futures contract and the price at which he actually
buys or sells the index. First, we will examine fully hedged situations-ones in which the
entire index is bought or sold. After that, we will examine smaller sets of stocks that are
designed to simulate the performance of the entire index .
Hedging indices which contain fewer stocks is easier than hedging larger indices.
Hedging a price-weighted index is probably the simplest type of hedge. As examples, the
same sample indices that were constructed in the previous chapter will be used.
\Yht>ne\·er futures or index options trade on an index, it is possible to set up market
baskets for arbitrage. The trader should determine, in advance, how many shares of each
stock he will buy or sell in order to duplicate the index. In a price-weighted index, of
cour se, he will buy the same number of shares of each stock. In a capitalization-weighted
ind ex, he will be buying different number of shares of each stock. Let us first look at how
the number of shares to buy is determined. Then we will discuss some of the nuances,
such as monitoring bicls and offers of the indices, order execution, and others.
Chapter
Strategies 529
HOW MANY SHARES TO BUY
In advance of actually trading the stocks and futures or options, one should determine
exactly how many shares of each stock he will be buying in each index he plans to arbi-
trage. Normally, one would decide in advance how many futures contracts or option con-
tracts he will trade at one time. Then the number of shares of stock to be bought as a
hedge can be determined as well. Essentially, one is going to hedge equal dollar amounts-
that is, he will buy enough stocks to offset the total dollar amount represented by the
index.
Example: Suppose that one decides he will set up his market baskets by using 50 ZYX
futures at a time. How much stock should he buy against these ,50 contracts? The futures
contract has a trading unit of $.500 per point. Assume the ZYX Index is trading at 168.89.
Then the total dollar amount represented by 50 contracts is 50 X $,500X 168.89 = $422,225.
The hedger would buy this much stock to hedge 50 futures contracts sold.
Again note that the index price, not the futures price, is used in order to determine
how many futures to sell.
In a price-weighted index, one determines the number of shares to buy by detennin-
ing the total dollar value of the index he plans to trade and then dividing that dollar
amount by the divisor of the index. The resulting number is how many shares of each
stock to buy in order to duplicate the price-weighted index.
Example: Suppose that we have a price-weighted index composed of three stocks, A, B,

and C. The following data describe the index:
Stock Price
A 30
B 90
C 50
Price total: 170
Divisor: 1.65843
Index value: 102.51
The number of shares of each stock that is in the index is l divided by the divisor, or
1/1.6,584.3= 0.60298 shares. Thus, if we were to buy .60298 shares of each of the three
stocks , we would have created the index .
530 Part V:IndexOptionsand Futures
Suppose that futures exist on this index and that the trading unit in these futures is
$2,50 per point. That is, the futures represent a total dollar value of the index times 250.
With this information, it is easy to determine the number of shares of stock to buy to
hedge one futures contract: 250 times the number of shares of each stock, .60298, for a
total of 150.745 shares of each stock.
Normally, one would not merely sell one futures contract and hedge it with stock.
Rather, he would employ larger quantities. Say that he decided to trade in lots of 100
futures contracts versus the stocks. In that case, he would buy the following number of
shares of each stock:
Number of shares= .60298 X $250/point X 100 futures contacts

= 15074.5 shares
Actually he would probably buy 1.5,100shares of each stock against the index, and
on every fourth "round'' (100 futures vs. stock) would buy 1.5,000 shares. This would be a
very close approximation without dealing in odd lots.
The trader might also use index options as his hedge instead of futures. The striking
price of the options does not come into play in this situation. Typically, one would fully
hedge his position with the index options-that is, if he bought stock, he would then sell
calls and buy puts against that stock. Both the puts and the calls would have the same
strike and expiration month. This creates a riskless position. This position is a
conversion.
Example: Suppose that cash-based options trade on this index, and that these options are
worth $100 per point as are normal stock options-that is, an option is essentially an
option on 100 shares of the index. The trader is going to synthetically short the index by
buying 100 June 105 puts and selling 100 June 10.5calls. Assume that the index data is the
same as in the previous example, that 0.60298 shares of each stock comprise the index.
How many shares would one hedge these 100 option synthetics with?
Number of shares = .60298 X 100 contracts X 100 shares/contract

= 6029.8 shares
Note that in the case of a price-\veighted index, neither the current index value nor
the striking price of the options involved (if options are involved) affects the number of
shares of stock to buy. Both of the above examples demonstrate the fact that the number
of shares to buy is strictly a function of the divisor of the price-weighted index and the unit
of tradin g of the option or future .
Chapter
Strategies 531
Hedging a capitalization-weighted index is more complicated, although the technique

revolves around determining the makeup of the index in terms of shares of stock, just as
the price-weighted examples above did. Recall that we could determine the number of
shares of stock in a capitalization-weighted index by dividing the float of each stock by the
divisor of the index . The general formula for the number of shares of each stock to buy is:
Shares of stock N _ Share s of N F . Futur es unit

t o b uy - m .. m d ex X utur es quanbtyX oft ra ding
We will use the fictional capitalization-weighted index from the previous chapter to
illustrate these point s.
Example: The following table identifies the pertinent facts about the fictional index,
including the important data: number of shares of each stock in the index.
Stock Price Float Capitalization Shares

A 40 177,000,000 7,080,000,000 1.20
B 80 50,000,000 4,000,000,000 0.34
C 60 100,000,000 6,000,000,000 0.68
Divisor: 147,500,000
Index value: 115.80
Thus, if one were to buy 1.20 shares of A, ..34 shares of B, and .68 shares of C, he would
duplicate the index. Recall that one determines the number of shares of an individual
stock in a capitalization-weighted index by dividing the float of the stock by the divisor of
the index .
Suppose that a futures contract trades on this index, with one point being worth
$500 in futures profit or loss. Then one would buy an amount of each stock equal to 500
times the number of shares in the index. Further suppose that one decides to trade 5
futures at a time. Thus, the number of shares of each stock that one would have to buy to
hedge the 5-lot futures position would be :
Shares to buy = Share s in ind ex X 5 futures X $500/future
The following table lists that information, as well as totaling the dollar amount of
stock represented by the total. We will verify that the dollar amount of stock purchased
is equal to the dollar amount of inde x represented by the futur es.
532 PartV: IndexOptionsandFutures
Shares toBuyto
Shares SAmountof
Stock inIndex 5 Futures
Hedge Price Bought
Stock
A 1.20 3,000 40 $120,000
B 0.34 850 80 68,000
C 0.68 1,700 60 102,000
$290,000
Thus fb:290,000 worth of stock has been purchased. From an ear lier examp le, we
saw how to compute the total dollar worth of a futures tra de. In this case, th e ind ex is
at 11.5.80, .5 contracts were sold, and each point is worth $500. Thus, the tota l dollar
amount represented by the futures sale is ,5 X 500 X 115.80 = $28 9,50 0 . Th is ver ifies
that our stock purchases hedge the futures sale adequately. Note that the slight di ffer-
ence in the stock purchase a1nount and the futures sale arnount is due to th e fact th at
the number of shar es in the index is carried out to only two deci m al points in this
exampl e.
There is an alternati, ·e method to determine how many shares to buy. In thi s met ho d,
one first determinc>s how much stock he is going to buy in total dolla rs. For exam ple, he
might decide that he is going to buy $10,000,000 worth of the S&P 100 (OE X) In dex.
>!ext , one dc>terrnines what percentage his dollar amount is of the total capita lization of
the index . For examp le, $10,000,000 might be something like .02% of th e total capit aliza-
tion of th e OEX . One would then buy .02% of the total number of sha res outs tandi ng of
each of the stocks in the OEX. After the number of shares of each stock to buy ha s been
detenninecL 011e would have to determined how many futures to sell against this stock-
he wou ld divide $10,000,000 by the index price and also d ivide by th e unit of tradin g for
th e futur es. Th is procedure is demonstrated in the following example .
Example: Suppos e that one wants to set up an arbitrage against the same index as in the
previous example. For purpos es of comparison with that example, we will sup po se tha t
this hedger wants to bu:,: a total of $290,000 worth of stock. In reality, one wou ld pro bably
use a round numh er such as $:300,000 or $500,000 worth of stock. H owever, by ma king
a dir ect comparison, we will be able to more easily demons trate tha t these two meth ods
produ ce th e same answe r.
First, the l1eclger 1nust determin e the percent of the total capita lization th at he
is going to huy. ln this case , he is buying $290,000 worth of stock and the total capitaliza-
tion of thc> index is %17,080,000,000 (refer to the tab le at the b eg in ning of t he
prl', ·ions exampl e). This means that he is buying .0016979% of the tota l cap italiz ation of
th e ind ex.
Chapter
Strategies 533
Next he uses this percentage and 11mltipliesit by the float of each stock. That is, he
is going to bu~, .0016979% of the total m1mber of shares outstanding of each stock in the
index. This results in purchases as shown in the following table: ·
Stock Float Shores

toBuy
A 177,000,000 3,005
B 50,000,000 849
C 100,000,000 1,698
Compare these share purchases with the previous example. The number of shares
to buy is the same, allowing for rounding off in the previous example. Thus, these two
methods of determining how many shares to buy are equivalent.
Before leaving this section, it should be pointed out that arbitrageurs can also estab-
lish an arbitrage when futures are underpriced. They can sell stock short and buy the
underpriced futures. This is a more difficult type of arbitrage to establish because short
sales must be made on plus ticks. However, when futures are unclerpriced for an extensive
period of time-perhaps during extreme pessimism on the part of speculators-it is pos-
sible to set up the arbitrage from this viewpoint.
PROFITABILITY OF THE ARBITRAGE
The key for many arbitrageurs and institutional investors is whether, after costs, there is
enough of a return in this stock versus futures strategy. The method in which we previ-
ously computed the fair value of the futures will he used in determining the overall incre-
mental return of doing the arbitrage.
The major cost in executing the arbitrage is the cost of commissions. Since there are
large quantities of stocks being bought or sold when an entire index is traded, the com-
mission rate is generally quite low. For example, an institutional investor might pay 3 cents
per share or even less. This still could be a substantial cost, especially when a large index
such as the S&P ,500 Index is being purchased. Even professional arbitrageurs may have
to pay commission costs if they are using the services of a computer firm to buy stocks.
These methods of trading stocks are described in the next section.
Once one's rate of commission charges is known, he can convert that into a mn11ber
that represents a portion of the index price. He does so by multiplying his per-share com-
mission rate by the current index value and then dividing that result by the average share
price of the index. The following example describes that method of conversion.
andFutures
Example: Suppose that one is going to buy the entire ZYX Index at a commission rate of
3 cents per share. The index is trading at 18,5.00. Furthermore, assume that the average
price of a share in the index is 4.5 dollars per share. With this information, one can deter-
mine how much he is paying in commissions, in terms of the index itself.
Commission rate
Commission in terms per share X Index value
of index Average price
per share
.03 X 18.5.00
4.5
= .123
Thus, a commission rate of :3cents per share translates into 12.3 cents of index value.
The most difficult factor to determine in the above equation is the average price per
share for a capitalization-weighted index. There is a shortcut that can be used. It is easy
to determine the average price per share for a price-weighted index, such as DJX. The
average price per share for large-capitalization indices such as the OEX and S&P .500 is
about 80% of that of the D JX.
Now that the commission rate has been converted into an index value, one can
determine his net profit from trading the exact index against the futures. One must figure
in his futures commission costs as well. The following example demonstrates the net profit
from executing the arbitrage, including all costs. Once the net profit has been calculated,
a rate of return can be computed.
Example: Suppose that the ZYX Index is trading at 18.5.00 and the futures, which
expire in two months, have a fair value premium of 2.00 points, but are trading at
188 ..50, a premium of 3.,50. The futures are worth $.500 per point. Thus, the futures are
expensive and one might attempt to buy stocks and sell the futures. His net profit con-
sists of the premium over fair value less all costs of entering and exiting the position.
As we saw in the previous example, at 3 cents per share stock commission, we pay
an index value of .123 to enter the position. Similarly, we would pay .123 in index value to
exit the position at a later date. Thus, the net round-turn stock commission is approxi-
mately 25 cents of index value.
Commissions on futures are generally charged only when the position is closed out.
Generally, a futures commission on an S&P .500 contract might be reduced to something
like S10 per contract for this type of hedging. Since 185.00, the index value, represents
l/,500th of the value of the futures contract, we can reduce the futures commission to an
index-related number by dividing the actual dollar commission by .500. Thus, the futures
cornrnission is, in index terms, 10/.500,or .02. The total commission for entering and exiting
Chapter
Strategies 535
the position is thus 0.266 of index value, 0.12:3 each for the purchase and sale of the stocks
and .02 for the futures.
·t Futures Futures fair Commission

N et pro f1 = price value costs
= 188.,50- 187.00 - 0.27
= 1.23
This absolute net profit number can be converted into a rate of return by annualizing the
profit and dividing by the current index price. Suppose that there are two months exactly
remaining until expiration. Then the rate of return is computed as follows:
Incremental Net profit X ( 1/fime remaining)

rate of return = Index price
1.23 X (12/2)
18,5.00
= 3.99%
For the two-month time period, his return is about 2/3 of one percent.
At first glance, a rate of return of almost 4% does not seem like much. But what we
have computed here is an incremental rate of return. That is, this return is over and above
whatever rate we used in determining the fair value of the futures. Thus, if an institution
were going to invest its cash at the prevailing short-term rate, and that rate were used to
determine the futures fair value in the above example, then the institution could earn an
additional 4%, annualized, if it arbitraged the futures rather than put its money in the
short-term money market.
TRADE EXECUTION
Most customers are not concerned with how the trades are executed, for they give
the order to their broker and let him work out the details. However, for those who are
interested in the actual trade execution, a short section dealing with that topic is in order.
Ideally, one should be able to monitor the progress of his index in terms of bid prices,
offer prices, and last sales. There are several modern quote services that allow such mon-
itoring. It is important to know the bids and offers because, when one actually executes
the trades, he generally will be trading on the bid and offer, not the last sale.
Example: Suppose the fair value of the futures contract is represented by a premium of
1.2,5points , but that the actual future is trading with a premium of 2.00 points: The index
is at 16.5.7.5and the futures are 167.7.5(last sale). This might seem like enough "room" to
execute a profitable arbitrage-buy the stocks in the index and sell the futures. However,
the index value of 16,5.7.5is the composite of the last sales of each of the individual stocks
in the index. If one were to look at the offering prices of each stock and then recompute
the index, he might encl up with an index value that was ,50 cents higher. This, then, would
mean that he would be doing the arbitrage for 2,5 cents less costs, which is not enough of
a margin to work with.
Similarly, when one is looking to sell out the stocks he has bought and simultaneously
buy back the futures, he needs to know the bid value of the index in order to see what
kind of premium he is paying to take his position off.
The main method of order entry is completely computerized. The computer knows
the quantity of each stock to buy and, when prompted, sends those buy orders via tele-
communications lines to one of the automatic order execution systems on the exchange
Hoor. Most automatic systems attempt to guarantee the offering price for large quantities
of stock. In this highly sophisticated method of order entry, the entire execution proce-
dure may take place in about one minute for the entire index. This method of order entry
is so quick and accurate that some brokerage firms with this capability offer it for a com-
mission fee to other brokerage firms that do not have the capability.
INSTITUTIONAL STRATEGIES
Holders of large portfolios of stocks can use futures and/or market basket strategies to
their advantage. There are two basic strategies that can be easily used by these large trad-
ers. One is to buy futures instPad of buying stocks, and the other is to sell futures instead
of selling stocks. Both of these strategies will be examined in more detail.
\Vhen one of these large institutions has money to invest in buying stocks, it might
make more sense to buy Treasury bills and futures instead of buying stocks. Of course,
this alternative strategy only makes sense for the institution if the stock purchase were
going to be broad-based-something akin to duplicating the S&P ,500 performance. The
institution does not necessarily have to be intent on purchasing an exact index, but if the
purchase were going to he diversified, the purchase of index futures might help accom-
plish an equivalent result. If, however, the purchase were going to be quite specific, then
this strategy would probably not apply.
This strategy works best when futures are underpriced. If the equivalent dollar
amount of underpricecl futures can be purchased instead of buying stocks, the entire
amount intt>ndecl for stock purchase can he put in Treasury bills instead. Recall that cash
will han· to ht> put into the futures account if the futures mark at a loss (maintenance
margin). fa·en so, there can he substantial savings to the institution if the futures are truly
underpriced. ·
Chapter
Strategies 537
The second institutional strategy is applicable when futures are overpriced and the
institution wants to sell stock. In such a case, it makes more sense to sell the futures than
to sell the stock. First, there are large savings in transaction costs (commissions). Second,
the overpriced nature of the futures actually means that there is additional profitability
in selling them as opposed to selling the stocks. Again, this strategy only makes sense if
one were going to sell a diversified portfolio of stocks, something that is broad-based like
the S&P 500 In dex.
Of course, institutions may want to participate in the arbitrage regardless of their
market stance. That is, if a money manager has a certain amount of money that he is going
to put into short-term instruments (perhaps T-bills), he might instead decide to participate
in this arbitrage of stocks versus futures if the incremental return is high enough. Recall
that we saw how to determine the incremental return in a previous section of this chapter.
If he were going to get a 7½% return from T-bills but could get an 11½% return from
future s arbitrag e, he might opt for the latter .
FOLLOW -UP STRATEGIES
Once any hedge has been established, it must be monitored in case an adjustment needs
to be made. The first and simplest type of monitoring is to take care of spinoffs or other
adjustments in stocks in the market basket that is owned. Of a more serious nature, in
terms of profitability, one also needs to monitor the hedge to see if it should be removed
or if the futures should be rolled forward into a more distant expiration month.
Adjusting one 's portfolio for stock spinoffs is a simple matter which we will address
briefly. In many cases, one of the stocks in the index will spin off a division or segment of
its business and issue stock to its shareholders. Such a spinoff is generally not included in
the price of the index, so that the hedger should sell off such items as soon as he receives
them , for the y do not pertain to his hedg e.
In a similar vein, in any portfolio certain stocks may occasionally be targets of tender
offers or other reorganizations. If one does nothing in such a situation, he will not lose any
money in terms of his portfolio versus the underlying index. However, it is generally wise
for one to tender his stock in such situations and replace it at a lower price after the tender.
Sometimes, in fact, such a tender offer will entirely absorb an index component member.
In that case, one must replace the disappearing stock with whatever stock is announced
as the new member of the index .
Technically, in an arbitrage hedge one should adjust his portfolio every time the
divisor of the index changes. Thus, in a capitalization-weighted hedge he would he adjust-
ing every time one of the components issues new common stock. This is really not neces-
sary in most cases, because the new issue is so small in comparison to the current float of
andFutures
the stock. Such a new issue does not include stock splits, for the divisor of the index does
not change in that case. A more common case is for one of the stocks in a price-weighted
index to split. In this case, one must adjust his portfolio. An example of such an adjustment
was given in Chapter 29. In essence, one must sell off some of the split stock and buy extra
shares of each of the other stocks in the price-weighted index.
Let us now take a look at follow-up methods of removing or preserving the hedge.
ROLLING TO ANOTHER MONTH
As expiration nears, the hedger is faced with a decision regarding taking off the market
basket. If the futures premium is below fair value, he would probably unwind the entire
position, selling the stocks and buying back the futures. However, if the futures remain
expensive-especially the next series-then the hedge might roll his futures. That is, he
would buy back the ones he is short and sell the next series of futures. For S&P 500
futures, this woul<l mean rolling out 3 months, since that index has futures that expire
every 3 months. For index options, there are monthly expirations, so one would only have
to roll out 1 month if so desired.
It is a simple matter to determine if the roll is feasible: Simply compare the fair value
of the spread between the two futures in question. If the current market is greater than
the theoretical value of the spread, then a roll makes sense if one is long stocks and short
futures. If an arbitrageur had initially established his arbitrage when futures were under-
priced, he would be short stocks and long futures. In that case he would look to roll for-
ward to another month if the current market were less than the theoretical value of the
spread.
Example: With the S&P 500 Index at 416.,50, the hedger is short the March future that
is trading at 417.50. The June future is trading at 421..50. Thus, there is a 4-point spread
between the March and June futures contracts.
Assume that the fair value formula shows that the fair value premium for the March
series is 35 cents and for the June series is 3.2.5. Thus, the fair value of the spread is 2.90,
the difference in the fair values.
Consequently, with the current market making the spread available at 4.00, one
should consider buying back his March futures and selling the June futures. The rolling
forward action may be accomplished via a spread order in the futures, much like a spread
order in options. This roll would leave the hedge established for another 3 months at an
overpriced level.
Another way to close the position is to hold it to expiration and then sell out the
stocks as the cash-hasecl index products expire. If one were to sell his entire stock holding
Chapter
Strategies 539
at the time the futures expire, he would be getting out of his hedge at exactly parity. That
is, he sells his stocks at exactly the last sale of the index, and the futures expire, being
marked also to the last sale of the index.
For settlement purposes of index futures and options, the S&P ,500 Index and many
other indices calculate the "last sale" from the opening prices of each stock on the last day
of trading. For some other indices, the last sale uses the closing price of each stock.
Example: In a normal situation, if the S&P ,500 index is trading at 41.5, say, then that
represents the index based on last sales of the stocks in the index. If one were to attempt
to buy all the stocks at their current offering price, however, he would probably be paying
approximately another ,50 cents, or 41.5.,50,for his market basket. Similarly, if he were to
sell all the stocks at the current bid price, then he would sell the market basket at the
equivalent of approximately 414.50.
However, on the last day of trading, the cash-based index product will expire at
the opening price of the index. If one were to sell out his entire market basket of stocks
at the current bid prices at the exact opening of trading on that day, he would sell his
market basket at the calculated last sale of the index. That is, he would actually be creat-
ing the last sale price of the index himself, and would thereby be removing his position at
parity .
There is another interesting facet of the arbitrage strategy that combines the spread
between the near-term future and the next longest one with the idea of executing the
stock portion of the arbitrage at the time the index products expire. Use of this strategy
actually allows one to enter and exit the hedge without having to lose the spread between
last sale and bid or last sale and offer in either case. Suppose that one feels that he would
set up the arbitrage for 3 months if he could establish it at a net price of 1.50 over fair
value. Furthermore, if the fair value of the 3-month spread is 2.10, but it is currently trad-
ing at 3.60, then that represents 1.50 over fair value. One initiates the position by buying
the near-term future and selling the longer-term future for a net credit of 3.60 points. At
expiration of the near-term future, rather than close out the spread, one buys the stocks
that comprise the index at the last sale of the trading day, thereby establishing his long
stock position at the last sale price of the index at the same moment that his long futures
expire. The resultant position is long stocks and short futures that expire in 3 months at a
premium of 3.60. Since the fair value of such a 3-month future should be 2.10, the hedge
is established at 1..50 over fair value. The position can be removed at expiration in the
same manner as described in the previous paragraph, again saving the differential
between last sale and the bids of the stocks in the index. Note that this strategy creates
buying pressure on the stock market at expiration of the near-term side of the spread, and
selling pressure at the latter expiration .
The final way to exit from one's position is to remove it before expiration. Sometimes,
tht>re are opportunities during the last two or three weeks before the futures expire. If
one hedged long stock with short futures, the opportunities to remove the hedge arise
when the futures trade below fair value-perhaps even at an actual discount to parity. If
the futures never trade below fair value , but instead continue to remain expensive, then
rollin g to th e next expiration seri es is ofte n warranted .
MARKET BASKET RISK
There are some uncertainties in this type of hedging, even though the entire index is
being bought. Since one owns the actual index , there is no risk that the stocks one owns
will fail to hedge the futures price movements properly. However, there are other risks.
One is the risk of execution. That is, it may appear that the futures are trading at a pre-
mium of 1..50points when one enters the orders. However, if other hedgers are doing the
same thing at the same time , one may pay more for the stocks than he thought when he
entered his order, and he may sell the futures for less as well. This "execution risk" is gen-
erally small, but if one is too slow in getting his stock orders executed, he may have set up
a hed ge that was not as attracti ve as he first thought.
One major risk is that interest rates might mow against the arbitrageur while the
position is in place. If he is long stocks and short the futures, then he would not want
interest rates to rise. In the previous example, the incremental return for the 2-month
time period that the position was going to be held was 1/.iof one percent. If short-term
rates should rise by more than that, on average, for the 2-month period, the incremental
strategy would be inferior. His carrying costs would have increased to the point of wiping
out th e profit from his arbitrag e.
For institutional arbitrageurs who don't exactly have cost of carry , this situation
would be viewed in the following manner: If rates increase, he may find that he would
have been better off having his money invested in a money market fund at the prevailing
short-term rate than in the incremental arbitrage strategy . Conversely , if the arbitrage was
originally established with short stocks and long futures, the arbitrageur would not want
rat es to drop for similar re ason s.
One might lea\·e a cushion against a movement in rates. If rates are currently 8%,
then one might decide to use a 10% rate in his initial calculations, as a cushion. Hedges
established that are profitable at the higlwr rate level will consequently be able to with-
stan d rates moving up to 10%.
Example: Suppose that one would nonnally use a rate of 71/Hoand would establish the
long stock \·ersus short futures hedge at an incremental rate of return of l 1/2%.This is a
Chapter
Strategies 541
relatively narrow cushion an<l if the hedge is on for a moderate length of time, rates coul<l
move up to such an extent that they advance to 9½% or higher. Suc:h a move would make
the hedge position unprofitable. Instead, one might cakulate the fair value of the futures
using a rate equal to his current prevailing rate plus a c:ushion. That is, if his current rate
is 7½%, he might use 8½% and still demand an incremental return of l ½%. If he estab-
lished the he<lge at these levels, he could suffer a move of 1%, the cushion, against him
and still earn his incremental rate of 1½% .
Another risk that the arbitrageur faces is that of changes in the dividend payout of
the stocks in the index. Suppose that he is long stocks and short futures. If there are
enough cuts in dividend payout, or dividend payments are delayed past the expiration date
of the futures, then he will lose some of his return. Arbitrageurs who are short stocks and
long futures would have similar problems if dividend payout were increased-especially
if a large special dividend were declared by a company that is a major component of the
index-or payment dates were accelerated .
If one holds the arbitrage until expiration, he will be able to unwind it at parity.
However, ifhe decides to remove the arbitrage before expiration, he might incur increased
costs that would harm his projected return. Instead of selling his stocks at the last sale of
the index, as he is able to do on expiration day, he would have to sell them on their bids,
a fact that could cost him a significant portion of his profit.
In a later section, where we discuss hedging the futures with a market basket of
stocks that does not exactly represent the entire index, we will be concerned with the
greatest risk of all, "tracking error"-the difference between the performance of the index
and the performance of the market basket of stocks being purchased.
IMPACT ON THE STOCK MARKET
The act of establishing and removing these hedge positions affects the stock market on a
short-term basis. It is affected both before expiration and also at expiration of the index
products. We will examine both cases and will also address how the strategist can attempt
to benefit from his knowledge of this situation.
IMPACT BEFORE EXPIRATION
When bullish speculators drive the price of futures too high, arbitrageurs will attempt to
move in to establish positions by buying stock and selling futures. This action will cause the
stock market to jump higher, especially since positions are normally established with great
speed and stocks are bought at offering prices. Such acceleration on the upside can mm·c the
market up by a great deal in terms of the Dow-Jones Industrials in a matter of minutes.
andFutures
Conversely, if futures become cheap there is also the possibility that arbitrageurs can
drive the market downward. If positions are already established from the long side (long
stock, short futures), then arbitrageurs might decide to unwind their positions if futures
become too cheap. They would do this if futures were so cheap that it becomes more
profitable to remove the position, even though stocks must be sold on their bid, rather
than hold it to expiration or roll it to another series. When these long hedges are unwound
in this manner, the stock market will decline quickly as stocks are sold on bids. In this
case , the market can fall a substantial amount in just a few minutes.
Once long hedges are unwound, however, cheap futures will not cause the market
to decline. If there is no more stock held long in hedges, then the only strategy that arbi-
trageurs can employ when futures become cheap is to sell stock short and buy futures.
Since stock must be sold short on upticks, this action may put a "lid" on the market, but
will not cause it to decline quickly.
Having long stock and short futures when these large discounts occur is so valuable
to an arbitrageur that some traders will establish the long stock/short futures hedge for no
profit or even a loss. They hope that subsequently futures will plunge to a large discount
and they can unwind their positions for large profits. If that never occurs, they only lose
a few cents of index value. Assume futures fair value is 3.50 over. Such arbitrageurs might
buy stock and sell futures at a net cost of 3.45 over. That is, if they hold the position until
expiration they will lose.Scents, but if a large futures discount ever occurs, they will profit.
Regulatory bodies have become increasingly concerned over the years as to the
effect that program trading and index arbitrage have on the stock market. In reality, when
stocks and futures are executed more or less simultaneously, these strategies should not
overly disturb the stock market.
At one time regulators imposed "program trading curbs," which took effect whenever
the Dow moved 2% from the previous day's close. These were removed in November 2007.
A more definitive restriction does exist though-"circuit breakers." These were
established after the Crash of '87 and remain in effect to this day. At the end of each quar-
ter, the NYSE sets three circuit breakers at levels of 10%, 20%, and 30% of the value of
the Dow Jones Industrials at that time, rounded to the nearest .SO-point interval. For
example, at the end of the second quarter of 2011, these limits were 1200, 2400, and 3600
points. When these limits are hit there are various responses by the NYSE, depending on
the size of the drop and the time of day at which it occurs.
For the smallest limit (down 1200 points, circa 2011), if it is hit prior to 2:00 p.m.,
trading halts for one hour. If it is hit between 2:00 and 2:30 p.m., trading is halted for
30 minutes. If it is hit later in the day than that, trading does not halt because of the first
trading limit.
For the middle limit (down 2400 points, circa 2011), if it is hit prior to 1:00 p.m.,
trading halts for two hours. If it is hit between 1:00 and 2:00 p.m., trading halts for one
Chapter
Strategies 543
hour. If it is hit after 2:00 p.m., trading halts for the day. If the largest limit (down 3600
points, circa 2011) is hit at any time, trading halts for the remainder of the day.
These are huge moves for a single day, and even in the financial crisis of 2008, these
limits \Vere not hit. In fact, the only time that the circuit breaker was ever hit was on Octo-
ber 27, 1997, when the limit was 550 points. That limit was hit late in the day and trading
halted for the remainder of that day. These limits are only in effect during regular NYSE
trading hours.
There are limits on the S&P futures as well, and they are at 5%, 10%, 20%, and 30%.
So they roughly correspond with the Dow limits, but not exactly. In addition, the 5% S&P
limit applies to overnight trading. If it is hit overnight, then trading halts until the next
day, when the day session opens. This 5% limit was hit on January 21, 2008, when, on the
Martin Luther King holiday, markets sold off heavily due to liquidation of a rogue trader's
position at Societe Generale. Once the limit was hit, the Globex session closed until the
next day.
Readers should remember, of course, that the stock market can move independently
of the overpriced or underpriced nature of index products. That is, if futures are over-
priced, the stock market can still decline. Perhaps there is a preponderance of natural
sellers of stocks. Similarly, if futures are cheap, the stock market can still go up if enough
traders are bullish. Thus, one should be cautious about trying to link every movement of
the stock market to index products.
PORTFOLIO INS URAN CE
Portfolio insurance is the generic name used to describe a strategy in which a portfolio
manager uses the index derivatives market to protect his portfolio in case the market
crashes. He could either sell futures, buy puts, or-as will be shown later when volatility
derivatives are discussed-he could also buy volatility products.
The generic concept was put into effect using futures in the mid-1980s. In the form
of the strategy that was being practiced at the time, the portfolio manager did not sell
futures against his entire portfolio right away. Rather, he sold only a few to begin with.
This allowed him to retain a good deal of upside profit potential for his portfolio. If the
market dropped further, then he would sell more. Eventually, if it dropped far enough, he
would keep selling futures until his entire portfolio was properly hedged. There were
computer programs that calculated when to sell the futures and how many to sell in order
for the portfolio manager to eventually end up with the proper amount of insurance at the
right price .
Unfortunately, the concept did not work properly in practice. In fact, it has often
been identified as one of the major factors in the 500-point crash of October 19, 1987.
What happened during the days leading up to that date was that the market was already
going down fast. Futures, as a result, began to trade at a discount. The portfolio insurance
strategy assumes futures are sold at fair value, more or less. Thus, the portfolio insurance
managers did not sell their futures when they had originally intended; or they could not
sell enough without driving the futures to tremendous discounts. In any case, the market
kept going further down without any rebound (essentially from about mid-afternoon on
Thursday, October 1.5,through the close on Monday, October 19), a total of over 6.50
0
points on the Dow-Jones averages. As the market plunged, the portfolio insurance strat-
egy kept demanding that more futures be sold, and they were, but often at prices well
below where the strategy had originally dictated. This continued selling kept futures at a
discount, which triggered even more selling by other program traders and index
arbitrageurs.
As a result, the portfolios were not completely protected-although it should be
noted that they· were somewhat protected since they had been selling some futures.
Hence, the portfolio managers were not pleased. Stock market regulators were not
pleased, either, although nothing illegal hacl been done. The strategy lost most of its
adherents at that time and has not been resurrected in its previous form.
However, the concept is still a valid one, and it is now generally being practiced with
the purchase of put options. The futures strategy was, in theory, superior to buying puts
because the portfolio manager was supposed to be able to collect the premium from sell-
ing the futures. However, its breakdown came during the crash in that it was impossible
to buy the insurance when it was most needed-similar to attempting to buy fire insur-
ance while your house is burning down.
Currently, the portfolio manager buys puts to protect his portfolio. Many of these
puts are bought directly over-the-counter from major banks or brokerage houses, for they
can he tailored directly to the portfolio manager's liking. This practice concerns regulators
somewhat, because the major banks and brokerage houses that are selling the puts are
taking some risk of course. They hedge the sales (with futures or other puts), but regula-
tors are concerned that, if another crash occurred, it would be the writers of these puts
who would he in the market selling futures in a mad frenzy to protect their short put
positions. Hopefully·, the put sellers will be able to hedge their positions properly without
disturbing the stock market to any great degree .
IMPACT AT EXPIRATION-THE RUSH TO EXIT
In tlw early days of index trading, the expiration of futures and options often had a large
effect 011 tlw stock market itself. These effects are diminished today, thanks to "a.m." set-
0
This represented a decline of over 25% from the relatively low levels (mid-2000s) that the index was trading at during
th at time frame.
Chapter
Strategies 545
tlement and European-style exercise for most index products, but have not been com-
pletely eliminated.
The mere act of exiting the position might cause a stock market movement. Consider
the index arbitrageur who is short stocks and long futures. At the instant of expiration, he
cannot just merely do nothing. If he did, his futures would settle for cash, and he would
be left with a large portfolio of short stocks to deal with. Any small upward movement
might completely wipe out his arbitrage profits. Rather, he must buy back all of his stocks
simultaneously on the last "tick" of trading-whether that be the "a.rn." settlement (first
trade of the day) or "p.m." settlement (last trade of the day). That action in effect creates
the settlement price of the index, which then expires for cash at the same price as his
combined stock trades.
This action might move the stock market if it were left unchecked. For example, if a
large number of index arbs were buying back short stocks at the last instant of trading, the
stock market would rise. Conversely, if the arbs were selling out long stocks en masse at
the expiration, then stocks would fall.
The effect of these trades on the stock market has been diminished by requirements
that traders enter their orders in advance, so the NYSE specialists can publish imbalances.
These imbalances create order flow on the other side of the trade.
Example: Due to the fact that there is unwinding of the S&P 500 Index at expiration, the
NYSE specialist observes the order flow-perhaps 30 minutes before the trades are to take
place. He finds that there is more IBM for sale than he can handle. So he publishes that
there is an order imbalance in IBM-that there are 5 million shares of IBM for sale, say.
Mutual fund and institutional managers around the world see that and, more often than
not, there will be willing buyers, because they realize they can buy in size on a downtick.
Thus, while IBM might print down a few cents in this case, it will not print down by a large
amount because of the buy orders drawn in from the order imbalance announcement.
There are clues, of course, as to which way the arbs are set up, but because of the
plethora of index products available, it is often difficult to ascertain beforehand which way
the arbs are positioned. For example, if an arb has a position that is short S&P futures, he
might have offsetting longs in stocks, S&P futures options, SPX options, and/or SPY
options. In fact, if one knew his position in any one of these, it might not mean much
because the aggregate position is all that counts.
The one index that is rather "pure" and doesn't really have many alternatives is the
OEX (S&P 100) Index. There are no futures. There is not an active ETF with options.
Therefore, if one sees that there is a buildup of open interest in OEX options prior to
expiration it might he an accurate clue as to how arbs are positioned in general-in S&P
and other index products .
andFutures
The OEX options are not nearly as liquid or popular as they used to be, so their
informational content has been diminished in recent years, but the process is still the
same. Index arbs own in-the-money OEX options against their positions (if they were
out-of-the-money, they woulcl not be hedged). So it is a simple matter to observe the quan-
tity of expiring in-the-money calls versus the quantity of expiring in-the-money puts.
Suppose that one does that and sees that th ere is a large imbalance of in-the-money calls.
Th e reasonable assumption at expiration is that those are hedged by short stock. Hence,
there is potential buying power at index expiration, for those short stocks need to be cov-
ered. Conversely, if there is a large imbalance of in-the-money puts, one would assume
that they are hedged by long stock and that stock has to be sold at expiration-causing
pressure on the stock market.
These imbala11ces in open interest between expiring OEX in-the-money calls and
puts can often be discerned beforehand, just by knowing how the stock market has been
tradin g. If a strong uptrend has been in place over the last month, say, then there will
certain!:· be a good deal of in-the-money calls and probably not many in-the-money puts.
Hence one would suspect a buying imbalance (short stocks need to be covered) without
e\·er looking at the open interest figures. Conversely, if the stock market has been declin-
ing over the past month, then there will be an excess of in-the-money puts, which will
translate to selling pressure on the stock market.
SIMULATING AN INDEX
The discussion in the previous section assumed that one bought enough stocks to dupli-
cate the entire index. This is unfeasible for mam·, investors for a varietv. of reasons , the
most prominent being that the execution capability and capital required prevent one from
being able to duplicate the indices. Still, these traders obviously would like to take advan-
tage of theoretical pricing discrepancies in the futures contracts. The way to do this, in a
hedged manner , would he to set up a market basket of a small number of stocks, in order
to have some sort of hedge against the futures position.
In this section, we will demonstrate approaches that can be taken to hedge the
futures position with a small number of stocks. This is different from when we looked at
ho\\' to hedge individualized portfolios with index futures or options, because we are now
going to tr:· to duplicate the performance of the entire index, but do it with a subset of
stocks in the index. In either of these cases, a mathematical technique called regression
anal:si<; can be used to measure the performance of these portfolios or small market
baskets. Howen"'r, we will take a simpler approach that does not require such sophisti-
cated calculations , but will produce the desired results.
Chapter
Strategies 547
USING THE HIGH-CAPITALIZATION STOCKS
Recall that in a capitalization-weighted index, the stocks with the largest capitalizations
(price times float) have the most weight. In many such indices, there are a handful of
stocks that carry much more weight than the other stocks. Therefore, it is often possible
to try to create a market basket of just those stocks as a hedge against a futures position.
While this type of basket will certainly not track the index exactly, it will have a definite
positive correlation to the index .
What one essentially tries to accomplish with the smaller market basket is to hedge
dollars represented by the index with the same dollar amount of stocks. No hedge works
in which the total dollars involved are not nearly equal. Listed below are the steps neces-
sary to compute how many shares of each stock to buy in order to create a "mini-index" to
hedge futures or options on a larger index :
1. Determine the percent of the large index to be hedged (OEX, NYSE, S&P 500, etc.)
that each stock comprises. This information is readily available from the exchange on
which the futures or options trade or can be calculated by the methods shown in
Chapter 29.
2. Determin e the percent of the mini-index to be constructed that each stock comprises,
by inflating their relative percentages to total 100%.
3. Decide the total dollar amount of the index to be traded at one time: index value
times futures or option quantity times unit of trading in the futures.
4. Multiply the total dollar amount from step 3 by each individual percentage from step
2 to determine how many dollars of each stock to buy.
5. Divide the result from step 4 by the price of the stock in order to determine how
many shares to buy.
These steps will result in the construction of a mini-index consisting of a small number
of stocks that are grouped together in relative proportion to their weights in the larger index,
and have a total dollar amount sufficient to trade against the desired futures or options trad-
ing lot. This approach ignores volatility. Even without accounting for volatility, this approach
is reasonable when using high-capitalization stocks to hedge a broad-based index.
The examples on the following pages use four fictional large-cap stocks to illustrate
the points (IBN, XON, GN, and CE). At any one point in time, the four largest-capitalization
stocks will be different. GM was at one time the world's largest corporation, for example,
hut is no more. So rather than try to use actual stock symbols in these examples, they will
be generic.
andFutures
Example: Suppose we are attempting to create a hedge for a fictional index, the UVX, by
using IBN, XON, CN, and CE. The following table gives certain information that will be
necessary in computing how many shares of each stock to use in the small basket.
Pctof
Shares
in Index
Stock Float Price Index Capitalization (Step1)
IBN 600,000 130 0.171 78,000,000 13.1%
XON 850,000 40 0.243 34,000,000 5.7%
CE 450,000 70 0.129 31,500,000 5.3%
GN 300,000 85 0.086 25,500,000 4.3%
- -
28.4%
UVX price: 170.25
Divisor: 3,500,000
Total capitalization: 595,875,000 (price times divisor)
Recall how th ese items are calculated: The number of shares of a stock in the index is
that stock's float divided by the divisor of the index. Also, the percent of the index is the stock's
capitalization (float times price) divided by the total capitalization of the index (this is step l
above). Finally, the index value is the index's total capitalization divided by the index divisor.
1
ith this information, we can now construct a mini-index that could be used to hedge
\\
the UVX itself. Notice that these four stocks alone comprise 28.4% of the ent ire UVX index .
\Ve would want each of these four stocks to have the same relative weight within our
mini-index as they do within the UVX itself. The sum of the capitalizations of the four stocks
in the above table as well as their relative percentages are given in the following table.
Pctof Pctof
Index Mini-Index
Stock Capitalization (Step1) (Step2)
IBN 78,000,000 13.1% 46.2%
XON 34,000,000 5.7% 20.1%
CE 31,500,000 5.3% 18.6%
GN 25,500,000 4.3% 15.1%
Total: 169,000,000 28.4% 100.0%
The percent of the mini-index is each of the four stocks' capitalizations as a percent
of tl1P su1n of thPir capitalizations (step 2 frorn abm·e). There are two ways to compute
Chapter
Strategies 549
step 2. First, for IBN one would divide 78 million (its capitalization) by 169 million (the
total capitalization). Second, using the percentages from step 1, divide IBN's percent,
13.1, by 28.4, the total percent. Either method gives the answer of 46.2 percent. \Ve have
now constructed the relative percentages of the mini-index that each stock comprises.
Note that they are in the same relationship to each other as they are in the UVX itself.
Now it is a simple matter to convert that percent into shares of stock, once we decide how
many futures contracts to trade against our mini-index.
\Vhen we know the total dollar amount of futures to hedge and we know the percent
of the mini-index that each stock comprises, we can compute each stock's capitalization
within the mini-index. Finally, we divide by that stock's price to see how many shares of
each stock to buy. Assume that we are going to use UVX options, which are worth $100
per point, in lots of .SOoptions. The total dollar amount of the index with the UVX at
170.2,5would then be $8,51,2.SO(170.2.SX 100 X .SO).This accomplishes step 3. The fol-
lowing table shows the calculations necessary to determine how many shares of stock to
buy against these 50 option contracts.
Capitalization Shares
Pctof inMini-Index toBuy
Stock Mini-Index (Step4) Price (Step5)
IBN 46.2% 393,277 130 3,025
XON 20.1% 171,102 40 4,277
CE 18.6% 158,332 70 2,261
GN 15.1% 128,539 85 1,512
Total: 100.0% 851,250
Note that the capitalization of each stock in the mini-index is determined by multiplying
the desired trading lot ($8.Sl,2.SO)by the percent of the mini-index that that stock
comprises. This completes step 4, and step ,5 follows: The number of shares of each
stock to buy is then determined by dividing that number by the price of the stock. For
example, the calculation for IBN in the above table would be $8.51,2.SOX .462 = $393,277;
then $393,277/130 = 3,02.S.
Thus, one could attempt to hedge .SOUVX option contracts with the above amounts
of each of the four stocks. As a matter of practicality, one would not buy the odd lots, but
would probably round off each stock quantity to round lots: 3,000 IBN, 4,300 XON, 2,300
CE, and 1,.500 GN.
As the prices of the stocks i11the mini-basket change, the mini-basket needs tu he
recalculated. This is because the current prices of the stocks in the index wen:>used to
compute the mini-index. Thus, as the prices of the stocks change, the composition of our
mini-index will begin to deviate from the composition of the UVX.
Example: Suppose that oil stocks do poorly and XON falls to 35 (it was 40 when we con-
structed the mini-index), while the other stocks are the same price as in the previous
example. Finally, suppose that the overall UVX is unchanged at 170.25, even though XON
has changed substantially. We must recalculate step 1: Determine the percent that each
stock is of the UVX. Assume the divisor is unchanged and each stock's float is unchanged,
so the percent is the price times the float divided by the total capitalization (595,875,000).
Pctof Pctof
Float Capitalization Index Mini-Index
Stock Price (000s) (Millions) (Stepl) (Step2)
IBN 130 600 78.00 13.1% 47.3%
XON 35 850 29.75 5.0% 18.1%
CE 70 450 31.50 5.3% 19.1%
GN 85 300 25.50 4 .3% 15.5%
--
Total: 164.75 27.7% 100.0%
Note that the percent that XON comprises of the UVX as well as of the mini-index has
fallen. All three of the other stock's percentages have increased proportionately. These
percentage changes reflect the changes in the stock prices. Since we assumed the UVX is
unchanged, the capitalization of the desired mini-index is still $8.51,2,50 (170.25 x $100
per point x 50 options). Now, if we complete steps 4 and 5, we will see how many shares
of each stock make up the new version of the mini-index.
Capitalization Shares
inMini-Index toBuy
Stock (Step4) Price (Step5)
IBN $402,641 130 3,097
XON 154,076 35 4,402
CE 162,589 70 2,323
GN 131,944 85 1,552
Total: $851,250
Compare the number of shares to be bought in this example with the number of
shares to be bought in the previous example. Actually, we are buying more shares of each
Chapter
Strategies 551
of the stocks. There are two reasons for this. In XON case, we are buying more shares
since the price has dropped more as a percentage of its previous price than its capitaliza-
tion has dropped as a percentage. For the other stocks, we are buying more shares because
the capitalization of each has increased within the mini-index and the price is unchanged.
This example serves to show that as the prices of the stocks in the mini-index change,
the number of shares of each of the stocks might change. This means that the hedger
using this type of hedge should recalculate the makeup of the index rather frequently-at
least once a week. In actual practice, the hedger will know which stocks are underper-
forming and which are outperforming. Hence, he will have some idea of what needs to be
done in advance of actually computing it.
There are many methods of approaching these "mini-indices." Some traders who are
extremely short-term oriented-possibly moving in and out of the futures one or more
times daily-might attempt to hedge the futures with only one stock (generally the
largest-capitalization stock, such as IBN, unless there is some reason to believe that the
general market is moving in a substantially different direction from the largest of all
stocks).
In other cases, hedgers with more capital and more resources but who are unwilling
to hedge the entire index might try to use a larger mini-index to hedge with. In cases such
as these, one is generally not interested in day-trading the futures and stocks, but rather
in attempting to simulate the full hedge against fair value, as described earlier. For exam-
ple, the top 30 capitalization stocks in the OEX make up over 70% of the capitalization of
the index. This provides very accurate tracking, but still does not overly tax the execution
capabilities of even a small trading desk. Such a 30-stock mini-index can be calculated in
exactly the same manner as in the previous examples. Since it represents over 70% of the
index, it will tract the index quite well, although not perfectly of course.
However, if one tried to simulate the S&P 500 Index by buying the top .50 stocks, he
would still not own even 40% of the capitalization of the index. This does not provide as
accurate tracking as one would hope after having bought 50 stocks. As a result, if one were
trying to hedge the S&P ,500 Index, he should use at least 200 stocks.
TRACKING ERROR RISK
In any such simulated index portfolio, there is the largest risk of all with regard to index
hedging, the tracking error. Tracking error is the difference in performance between the
actual index and the simulated index portfolio. There are statistical ways to predict how
closely a certain portfolio of stocks will simulate a given index. This is something akin to
pollsters predicting the margin of victory of an election before the election is held. One
may hear that a certain portfolio has a 98% correlation, say, to an index it is intended to
simulate.
\ Vhat does this measure represent? First, it must be understood that statistics cannot
predict the exact performance of any set of stocks with respect to any other set, just as polls
cannot exactly predict the outcome of an election. What the statistics do tell us is how
probable it is that a certain portfolio will perform nearly the same as another one. The
concept of expected return, which was described earlier in this book, is something like this.
The statistical number does not guarantee that the portfolio will perform like the index
98% of the time or that it will never deviate from the index by more than 2%. It is merely
a comparative measure that says that such a portfolio has a good correlation to the index.
The actual risk that one is taking by using the simulated index instead of the index
itself is not completely measurable. If it were, then we could predict the exact performance
of the simulated index, which we just showed we could not. However, assume an average
performance-that the simulated index deviates from the real index by 2% over the course
of 1 year. If we are speaking of the S&P .500 at 41.5, then 2% would be 9.30 points over a
1-year period, or 2.3:1 points over a 3-rnonth period. That is a substantial amount of move-
ment when one considers that most of our arbitrage examples were assuming profits of not
much more than that. The compensating factor to this risk is that the simulated index may
outperform the actual index and one could make more profits than would be available with
arbitrage. If one had enough capital and enough time to constantly be participating in such
a simulated-index strateg~·, he would, over time, have a tracking error that is relatively small
if his simulated index has a high correlation to the index.
MONITORING THE HEDGE
Once the position has been established, the trader should have some way of monitoring
the position. Ideally, he would have a computer system that could compute his mini-index
in real time. This would allow accurate comparisons between the actual index movement
and the mini-index. Tracking error can, of course, work for or against the trader.
It is not necessary to have a computer system built specifically for index hedging.
Many computerized systems provide for real-time profit and loss calculations on a port-
folio of the user's choosing. Any of these systems would be sufficient for computation of
the relati,·e value of the mini-index. In the course of computing the profit or loss on the
portfolio, the program must compute the net valm"'of the portfolio. As long as this is avail-
ahlt', one can convert it into a mini-index value, suitable for comparison to the larger index.
The "trick" is to use a mini-index multiplier that is a power of 10. That is, the futures unit of
trading times the futures quantity is a power of 10. For example, if the futures unit of trading
is ~2.50 as with the S&P ,500 futures, then a quantity of 40 would result in a power of
10 (IQ.SOX 40 = 10,000). This means that the total capitalization of the mini-index port-
folio shrndcl be able to be read as the "index value" with the mere adjustment of a decimal
point.
Chapter
30: StockIndexHedgi,rg
Strategies 553
Example: If one is trading against futurc--sthat have a trading move of $.500 per point,
then he might choose to use 20 futurc--sagainst his mini-index. That is, the multiplier is
20 X $.500 or $10,000. If he were->hc--dgingagainst an index trading at 170.2.5, he would
then buy 10,000 X 170.2,5 or $1,702, ,500 worth of stock. The total value of the stocks in
his mini-index would total $1,702,500 initially and he could therefore->dc--termiue his
mini-index value to be 170.2500 by moving the decimal point over four places. The fol-
lowing table summarizes how this might be constructed using the four stocks in the most
recent example. Recall that in the previous example, the total capitalization of the
four-stock mini-index was $851,250. In this example we would have had a total mini-index
capitalization of twice that, or $1,702,500. Thus, the capitalization and the number of
shares to buy are doubled from the previous example.
Capitalization
inMini-Index Shares
Stock (Step
4) Price toBuy
IBN $ 805,282 130 6,194
XON 308,152 35 8,804
CE 325,178 70 4,646
GN 263,888 85 3,104
Total: $1,702,500
Later, as the stocks change in value, one's computerized profit and loss system could
readily compute the total capitalization of the mini-index and, by moving the decimal
point over four places, have a "mini-index value" that could be compared against the
actual index (UVX in this case) in order to determine tracking error.
Example: Suppose that the stocks in the mini-index were to increase to have a total value
of $1,761,872 as shown in the following table.
Shares Current
Stock Owned Price Capitalization
IBN 6,194 135 $836,190
XON 8,804 37 325,748
CE 4,646 69 320,574
GN 3,104 90 279,360
Total: $1,761,872
554 Part V:IndexOptionsandFutures
The mini-index value is now 176.1872 (moving the dec imal point over four places), or
176.19. This means that our mini-index increased from a value of 170.25 to 176.19, an
increase of .5.94. This could be compared to the UVX movement during the same period
of time. For example, if the UVX had increased by 6.,50 points over the time period, then
it is easy to see that the mini-index underperformed the UVX by ,56 cents. If, at some
other time, our mini-index had increased faster than the UVX, then we would have track-
ing error in our favor.
USIN G OPTIONS INSTEAD OF FUTURES
As pointed out earlier, one could use options instead of futures when hedging these indi-
ces. Assuming one is creating a fully hedged situation, he would have positions similar to
conversions when he uses options to hedge a long stock market basket position. He would
both sell calls and buy puts with the same striking price in order to create the hedge. This
is similar to a conversion arbitrage.
When attempting to hedge the S&P 500, one could use the S&P 500 futures options
or the S&P 500 cash options, but that would not necessari ly present a more attractive
situation than using the futures. On the other hand, there is not a liquid S&P 100 (OEX)
futures contract, so that when hedging that contract, one generally uses the OEX options.
As mentioned earlier, inter-index option spreads between various indices, including the
S&P 100 and 500, will be discussed in the next chapter.
There is not normally much difference as to which of the two is better at any one
time. However, since a full option hedge requires two executions (both selling the call and
buying the put), the futures probably have a slight advantage in that they involve only a
single execution.
In order to substitute options for futures in any of the examples in these chapters on
indices, one merely has to use the appropriate number of options as compared to the
futures. If one were going to sell OEX calls instead of S&P 500 futures, he would multiply
the futures quantity by .5. Five is the multiple because S&P 500 futures are worth $250
per point vvhile OEX options are worth $100 per point, and because the S&P 500 Index
(SPX) trades at twice the price of OEX (OEX split 2-for-l in November 1997). Thus, if an
example calls for the sale of 20 S&P 500 futures, then an equivalent hedge with OEX
options would require 100 short calls and 100 long puts.
One could attempt to create less fully hedged positions by using the options instead
of the futures. For example, he might buy stocks and just write in-the-money calls instead
of ~elling futures. This would create a covered call write. He would still use the same
techniques to decide how much of each stock to buy, but he would have downside risk if
ht' decided not to buy the puts. Such a position would be most attractive when the calls
are very overpriced.
Chapter
30: StockIndexHedging'
Strategies 555
Similarly, one might try to buy the stocks and buy slightly in-the-money puts without
selling the calls. This position is a synthetic long call; it would have upside profit potential
and would lose if the index fell, but would have limited risk. Such a position might be
established when puts are cheap and calls are expensive.
TRADING THE TRACKING ERROR
Another reason that one might sell futures against a portfolio of stocks is to actually attempt
to capture the tracking error. If one were bullish on oil drilling stocks, for example, and
expected them to outperform the general market, he might buy several drillers and sell S&P
500 futures against them. The sale of the futures essentially removes "the market" from the
package of drilling stocks. What would be left is a position that will reflect how well the drill-
ers perform against the general stock market. If they outperform, the investor will make
money. In this section, we are going to look at ways of implementing these hedging strategies.
This investor is not particularly concerned with predicting whether the market will go up or
down; all he wants to do is remove the "market" from his set of stocks. Then he hopes to
profit if these stocks do, indeed, outperform the broad market. Again, we will not use regres-
sion analysis, but instead will concentrate on methods that are more simply implemented.
Often, investors or portfolio managers think in terms of industry groups. That is, one
may think that the oil drilling stocks will outperform the market, or that the auto stocks will
underperform, for example. In either case, one sells futures to attempt to remove the market
action and capitalize on the performance differential. In some sense, one is creating a hedge
in which he hopes to profit frorn tracking error. In previous discussions, tracking error has
not been considered a particularly desirable thing. In this situation, however, one is going to
attempt to profit by predicting the direction of the tracking error and trading it.
The technique for establishing this hedge is exactly the same as in the examples at
the beginning of this chapter, when we looked at hedging a specific stock portfolio. The
exception is that now one must decide which stocks to buy. Once that is decided, he can
use the four steps outlined previously to decide how many futures to sell against them:
Step 1: Compute each stock's adjusted volatility by dividing its volatility by that of
the market. Use Beta if the group's movement does not correlate well with the
general market.
Step 2: Multiply by the quantity and price of each stock to get an adjusted
capitalization.
Step 3: Add these to get the total capitalization for the portfolio.
Step 4: Determine how many futures to sell by dividing the index price into the
total adjusted capitalization.
Example: Suppose that an investor feels that oil drilling stocks will outperform the mar-
ket. He decides to invest $.500,000 to buy equal dollar amounts of five drilling stocks.
Normally one would buy an equal dollar amount of each stock in this situation. One would
choose five representative stocks. In these examples, the stock symbols will be OSA, OSB,
OSC, OSD, and OSE. The first table shows the price of each stock and how many shares
of each will be purchased; $100,000 is invested in each stock.
Quantity
Stock Price Purchased
OSA 20 5,000
OSB 50 2,000
osc 25 4,000
OSD 10 10,000
OSE 40 2,500
Now, if one obtains the volatilities of these stocks, he can perform the necessary compu-
tations. These computations will tell him how many futures to sell against the portfolio of
drilling stocks. The volatilities and computations are given in the following table, assum-
ing the market volatility is 1.5%. First, dividing the stock's volatility by the market's vola-
tilit~, gives the adjusted volatility (step 1). That result multiplied by the price and quantity
of the stock gives the adjusted capitalization (step 2), and adding these together gives the
total adjusted capitalization (step 3).
Adjusted Adjusted
Stock Volatility (Stepl) Price Owned (Step
2)
OSA .46 3.07 20 5,000 $ 306,667
OSB .30 2.00 50 2,000 200,000
osc .21 1.67 25 4,000 166,667
OSD .50 3.33 10 10,000 333,333
OSE .35 2.33 40 5,000 233,333
Total adjustedcapitalization: $1,240,000 (step3)
Assume that mw wants to hedge with a fictional index, ZYX, and that ZYX futures are
\rnrth 8500 per point. If the ZYX Index is selling at 17.5,then one wonld sell 14 futures
against tliis portfolio of drilling stocks: $1,240,000--:---
$,500per point--:---17.5 is approxi-
mately equa l to 14 (step 4).
Chapter 30: StockIndex Hedging Strategies 557
In a situation such as this, one does not have to be bullish or bearish on the market
in order to establish the hedge. He is rather attempting to time the performance of the
group in question. Similarly, the decision as to when to remove the position is not a matter
of market opinion. Perhaps one has an unrealized profit and decides to take it, or perhaps
something changes fundamentally within the group that leads the investor to believe that
the group no longer has the potential to outperform the market.
If the futures are underpriced when one begins to investigate this strategy, he should
not establish the position. What is gained in tracking error could be lost in theoretical
value of the futures. Since one is establishing both sides of the hedge (stocks and futures)
at essentially the same time, he can afford to wait until the futures are attractively priced.
This is not to say that the futures must be overpriced when the position is established,
although that fact would be an enhancement to the· position.
If one thinks that a particular group will underperform the market, he merely needs
to decide how many shares of each stock to sell short and the n can determine how many
futures to buy against the short sales in order to try to capt ure the tracking error. If one
decides to capture the negative tracking error in this manner, he must be careful not to
buy overpriced futures. Rather, he should wait for the futures to be near fair value in
order to establish the position.
COLLATERALREQUIREMENTS
In any of the portfolio hedging strategies that we have discussed in this sectio n , the re is
no reduction in margin requirements for either the futures or the options. That is, the
stocks must be paid for in full or margined as if they had no protection against them, and
the hedging securi ty-the futures or options-must be margined fully as well. Long puts
would have to be paid for in full, short futures would requ ire their normal margi n and
would be ma rked to the market via variation margin, and short calls would have to be
margined as naked and wou ld also be marked to the market. A trader who has not mar-
gined his stocks could use them as collateral for the naked call requirements if he so
desired.
SUMMARY
Th ere have been two mc~jorimpac ts of index futures and options. One is that they allmv a
trader to "buy the market" without having to select individual stocks. This is important
because many traders have some idea of the direction in which the market is hea<lin~, but
may not he ahle to pick individual stocks well. The other, perhaps more rn,yor, impact is that
large holders of stocks can now hedge their portfr>lios without nearly as much clifficult_Y.
558 Part V:Index Optionsand Futures
The use of these futures and options against actual stock indices-real or simulated-has
introduced a strategy into the marketplace that did not previously exist. The versatility of
these derivative securities is evidenced by the various strategies that were described in this
chapter-hedging an actual index or a simulated one, trading the tracking error, selling the
futures instead of the entire portfolio when one turns bearish, or buying the futures when
they are cheap instead of buying stocks. The owner of a stock portfolio, whether an individual
or a large institution, should understand these strategies because they are often preferable to
merely buying or selling stock.
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Index Spreading
In this chapter, we will look at strategies oriented toward spreading one index against
another. This may be done with either futures or options. In some cases, this is almost an
arbitrage because the indices track each other quite well. In others, it is a high-risk venture
because the indices bear little relationship to each other. In any case , if the futures rela-
tionship between the two indices is out of line , one may have an extra advantage.
INTER-INDEX SPREADING
There are general relationships between many stock indices, both in the United States
and worldwide. The idea behind inter-index spreading is often to capitalize on one's view
of the relationships between the two indices without having to actually predict the direc-
tion of the stock market. Note that this is often the philosophy behind many option
spreads as well.
Sometimes an analyst will say that he expects small-cap stocks to outperform
large -cap stocks. This analyst should consider using an inter-index spread between the
S&P 500 Index and the Value Line Index (which contains many small stocks), or perhaps
between the S&P and a NASDAQ-based index. If he buys the index that is comprised of
smaller stocks and sells the S&P ,500 Index, he will make money if his analysis is right,
regardless of whether the stock market goes up or down. All he wants is for the index he
is long to outperform th e inde x he is short.
Occasionally, the futur~s or options on these indices are mispriced in comparison to
the way the indices are priced. When this happens, one may be able to capitalize on the
pricing discrepancy. At times, the spread between the index products on two indices can
trade at significantly different price levels from the spread between the two indices them-
selves. When this happens, an inter-index spread becomes feasible.
559
andFutures
The margin requirements for these spreads are often reduced because margin rules
recognize that futures on one index can be hedged by futures on another index.
The general rule of thumb as far as selecting a futures spread to establish between
two indices is to compare the price difference in the respective futures to the actual price
difference in the indices themselves. If the difference in the futures is substantially dif-
ferent from the difference in the cash prices of the indices, then one would sell the more
expensive future and buy the cheaper one. Several specific spreads are discussed in this
chapt er.
Regardless of whether one is entering into the spread because he is trying to predict
the relationships between the cash indices, or because he knows the two respective
futures are out of line , he must decide in what ratio he wants to establish the spread.
There are two lines of thinking on this subject. The first is to merely buy one future and
sell one future (on two cliffPrent indices, of course). Many chart books and spread history
charts are graphed in this manner-they compare one index to another index on a
one -for-one basi s.
Example: A spreader wants to buy the ZYX Index futures and sell ABX futures against
them. They are both trading in units of $.500 per point, but ZYX is currently at 175.00
while ABX is at 130.00. Thus, the current differential is 45.00 points. This spreader would
want the spread to widen to something larger in order to make money. The following
profit table shows how he could make a $2,500 profit if the spread widens to 50.00 points,
no matt er which way the market goes.
Market ZYX ZYX ABX ABX Total

Direction Price Profit Price Profit Profit
up 185.00 +$5,000 135.00 -$2,500 +$2,500
neutral 177.00 +1,000 127.00 +1,500 +2,500
down 160.00 -7,500 110.00 +10,000 +2,500
Notice that in each case, the difference in the prices of the indices ZYX and ABX is 50.00
points. The profit is the same regardless of whether the general stock market rose, was
relatively unch anged , or fell.
The $2,.500 profit is the five points of profit that the spreader makes by buying the
spread of 45.00 and selling it at ,50.00 (.5.00 points X $500 per point= $2,500).
The second approach to index spreading is to use a ratio of the two indices. This
approach is often taken when the two indices trade at substantially different prices. For
exarnple , if one index sells for twice the price of the other, and if both indices have similar
Chapter
31:IndexSpreading· 561
volatilities, then a one-to-one spread gives too much weight to the higher-priced index. A
two-to-one ratio would be better, for that would give equal weighting to the spread
between the indices.
Example: UVX is an index of stock prices that is currently priced at 100.00. ZYX, another
index, is priced at 200.00. The two indices have some similarities and, therefore, a spreader
might want to trade one against the other. They also display similar volatilities.
If one were to buy one UVX future and sell one ZYX future, his spread would be too
heavily oriented to ZYX price movement. The following table displays that, showing that if
both indices have similar percentage movements, the profit of the one-by-one spread is domi- .
nated by the profit or loss in the ZYX future. Assume both futures are worth $.500per point.
Market ZYX ZYX uvx uvx Total

Direction Price Profit Price Profit Profit
up 20% 240 -$20,000 120 +$10,000 -$10,000
up 10% 220 - 10,000 110 + 5,000 - 5,000
down 10% 180 + 10,000 90 - 5,000 + 5,000
down 20% 160 + 20,000 80 - 10,000 + 10,000
This is not much of a hedge. If one wanted a position that reflected the movement of the
ZYX index, he could merely trade the ZYX futures and not bother with a spread.
If, however, one had used the ratio of the indices to decide how many futures to buy
and sell, he would have a more neutral position. In this example, he would buy two UVX
futures and sell one ZYX future .
Proponents of using the ratio of indices are attempting strictly to capture any per-
formance difference between the two indices. They are not trying to predict the overall
direction of the stock market.
Technically, the proper ratio should also include the volatility of the two indices,
because that is also a factor in determining how fast they move in relationship to each other.
. VJ p1 U1
Ratio= -X-X-
v2 p 2 U2
where
p 1 and p 2 are the prices of the indices
v1 and v 2 are the respective volatilities
and u 1 and u 2 are the units of trading ($.500per point, for example).
andFutures
Including the volatility ensures that one is spreading essentially equal "volatility dol-
lars" of each index. Moreover, if the two futures don't have the same unit of trading, that
should be factored in as well.
Example: The ZYX Index is not very volatile, having a volatility of 15%. A trader is inter-
ested in spreading it against the ABX Index, which is volatile, having a historical volatility
of 25% . The following data sum up the situation:
Price Volatility Unitof

Trading
ZYX Futures 175.00 15% $250/pt
ABX Futures 225.00 25% $500/pt
.
R t 10 = .25 X 225 .00 X 500
a .15 175.00 250
= 4.286
In round numbers, one would probably trade four ZYX futures against one ABX future.
USING OPTIONS IN INDEX SPREADS
In general, it is easier to spread the indices by using futures rather than options, if futures
exist. However, there are still many applications of options to inter-index spreading. One
might want to create spreads of futures or ETFs that represent the various markets
around the world: SPX, SPY, NASDAQ-100 (NDX, QQQ), Russell 2000 (IWM), China
(FXI), Emerging Markets (EMM ), and so forth .
Whenever both indices have options, as most do, the strategist may find that he can
use the options to his advantage. This does not mean merely that he can use a synthetic
option position as a substitute for the futures position (long call, short put at the same strike
instead of long futures, for example). There are at least two other alternatives with options.
First, he could use an in-the-money option as a substitute for the future. Second, he could
use the options' delta to construct a more leveraged spread. These alternatives are best
used when one is interested in trading the spread between the cash indices-they are not
really amenable to the short-term strategy of spreading the premiums between the futures.
Using in-the-money options as a substitute for futures gives one an additional
advantage: If the cash indices move far enough in either direction, the spreader could still
make money, even if he was wrong in his prediction of the relationship of the cash indices.
Chapter
31:IndexSpreading · 563
ZYX: 175.00
UVX: 150.00
ZYX Dec 185 put : 10½

UVX Dec 140 call : 11
Suppose that one wants to buy the UVX index and sell the ZYX index. He expects
the spread between the two-currently at 25 points-to narrow. He could buy the UVX
futures and sell the ZYX futures. However, suppose that instead he buys the ZYX put and
buys the UVX call .
The time value of the Dec 185 put is ½ point and that of the Dec 140 call is 1 point.
This is a relatively small amount of time value premium. Therefore, the combination
would have results very nearly the same as the futures spread, as long as both options
remain in-the-money; the only difference would be that the futures spread would outper-
form by the amount of the time premium paid .
Even though he pays some time value premium for this long option combination, the
investor has the opportunity to make larger profits than he would with the futures spread. In
fact, he could even make a profit if the cash spread widens, if the indices are volatile. To see
this, suppose that after a large upward move by the overall market, the following prices exist:
ZYX: 200.00
UVX: 170.00
ZYX Dec 185 put : 0 (virtually worthless)

UVX Dec 140 call: 30
The combination that was originally purchased for 21 ½ points is now worth 30, so
the spread has made money. But observe what has happened to the cash spread: It has
widened to 30 points, from the original price of 2,5. This is a movement in the opposite
direction from what was desired, yet the option position still made money.
The reason that the option combination in the example was able to make money,
even though the cash spread moved unfavorably, is because both indices rose so much in
price. The puts that were owned eventually became worthless, but the long call continued
to make money as the market rose. This is a situation that is very similar to owning a long
strangle (long put and call with different strikes), except that the put and call are based
andFutures
on different underlying indices. This concept is discussed in more detail in Chapter 35 on

futures spreads.
The second way to use options in index spreading is to use options that are less
deeply in-the-money. In such a case, one must use the deltas of the options in order to
accurately compute the proper hedge. He would calculate the number of options to buy
and sell by using the formula given previously for the ratio of the indices, which incorpo-
rates both price and volatility, and then multiplying by a factor to include delta.
. . V1 p1 U1 d1
0 pbon Ratio = - X - X- X-
V2 p 2 U2 d2
where
vi is the volatility of indexi
pi is the price of indexi
ui is the unit of trading
and di is the delta of the selected option on index i.
Example: The following data is known:
ZYX: 175.00, volatility= 20%

UVX: 150.00, volatility = 15%
ZYX Dec 175 put: 7, delta = - .45, worth $500/pt.

UVX Dec 150 call: 5, delta= .52, worth $100/pt
Suppose one decides that he wants to set up a position that will profit if the spread
between the two cash indices shrinks. Rather than use the deeply in-the-money options,
he now decides to use the at-the-money options. He would use the option ratio formula
to determine how many puts and calls to buy. (Ignore the put's negative delta for the pur-
poses of this formula.)
0 t . R t·10 .20 X 175.00 X ,500 X .45

P wn a = .15 150.00 100 .52 = 6 ·731
He would buy nearly 7 UVX calls for every ZYX put purchased.
In the previous example, using in-the-money options, one had a very small expense
for time \·c:iluepremium and could profit if the indices were volatile, even if the cash
1
Chapter
31:IndexSpreading 565
spread did not shrink. This position has a great deal of time value premium expense, but
could make profits on smaller moves by the indices. Of course, either one could profit if
the cash indices moved favorably.
Volatility Differential. A theoretical "edge" that sometimes appears is that of volatil-

ity differential. If two indices are supposed to have essentially the same volatility, or at
least a relationship in their volatilities, then one might be able to establish an option
spread if that relationship gets out of line. In such a case, the options might actually show
up as fair-valued on both indices, so that the disparity is in the volatility differential, and
not in the pricing of the options.
OEX and SPX options trade with essentially the same implied volatility. Thus, if one
index's options are trading with a higher implied volatility than the other's, a potential
spread might exist. Normally, one would want the differential in implied volatilities to be
at least 2% apart before establishing the spread for volatility reasons.
In any case, whether establishing the spread because one thinks the cash index
relationship is going to change, or because the options on one index are expensive with
respect to the options on the other index, or because of the disparity in volatilities, the
spreader must use the deltas of the options and the price ratio and volatilities of the indi-
ces in setting up the spread.
Striking Price Differential. The index relationships can also be used by the option
trader in another way. When an option spread is being established with options whose strikes
are not near the current index prices-that is, they are relatively deeply in- or
out-of-the-money-one can use the ratio between the indices to determine which strikes are
equivalent.
Example: ZYX is trading at 250 and the ZYX July 270 call is overpriced. An option
strategist might want to sell that call and hedge it with a call on another index. Suppose
he notices that calls on the UVX Index are trading at approximately fair value with the
UVX Index at 17.5.What UVX strike should he buy to be equivalent to the ZYX 270 strike?
One can multiply the ZYX strike, 270, by the ratio of the indices to arrive at the UVX
strike to use:
UVX strike = 270 X ( 175/250

= 189.00
So he would buy the UVX July 190 calls to hedge. The exact number of calls to lmy
would be determined by the formula given previously for option ratio.
andFutures
SUMMARY
This concludes the discussion of index spreading. The above examples are intended to be
an overview of the most usable strategies in the complex universe of index spreading. The
multitude of strategies involving index-index and intra-index spreads cannot all be fully
described. In fact, one's imagination can be put to good use in designing and implement-
ing new strategies as market conditions change and as the emotion in the marketplace
drives the premium on the futures contracts .
Often one can discern a usable strategy by observation. Watch how two popular
indices trade with respect to each other and observe how the options on the two indices
are related. If, at a later time, one notices that the relationship is changing, perhaps a
spread between the indices is warranted. One could use the NASDAQ-based indices,
such as the NASDAQ-100 (NDX) or smaller indices based on it (QQQ). ETFs and sector
indices can be used as well. The key point to remember is that the index option and
futures world is more diverse than that of stock options. Stock option strategies, once
learned or observed, apply equally well to all stocks. Such is not the case with index
spreading strategies. The diversification means that there are more profit opportunities
that are recognized by fewer people than is the case with stock options. The reader is thus
challenged to build upon the concepts described in this part of the book.
Structured Products
The popularity of derivative instruments and the kinds of risk-reducing, volatility-reducing

effects that they can have on portfolios led to a new type of product in the 1990s. This
new product, termed a structured product, has more appeal for investors than for traders.
In essence, enterprising designers at the major institutional brokerage firms have con-
structed a single security that behaves like a portfolio hedged by options. These designers
structure the combination of derivatives and stocks so that the res ulting product behaves
in a manner that is attractive to many investors, whether institutional or private. In this
chapter, these structured products are examined in detail, to give the reader the back-
ground so that in the future, he may analyze similar products for himself.
Would you like to own an index fund that had no risk? Or, how about owning a pop-
ular stock and getting a dividend payment that is much, much larger than the stock itself
pays? I think everyone would like to do those things. With structured products, one can
own similar investments, but they come with a cost. The two questions asked previously
might then be better restated as follows: Would you like to own an index fund that had
no risk, but that perhaps did not fully participate in all of the upside movement of the
market? It still has downside protection, and unlimited profit potential on the upside. This
is akin to owning the stock or the index and having protected it by buying a put option.
Or, would you like to own that popular stock and receive that huge dividend, but know
that your profit potential is limited to a fixed amount on the upside? This is akin to a cov-
ered call write .
These two questions describe the majority of the listed structured products in exis-
tence today. They are attractive investments in their own right, but one must carefully
assess the products before buying them.
The discussion in this chapter concentrates on the structured products that are listed
and traded on the major stock exchanges. A broader array of products-typically called
exotic options-is traded over-the-counter. These can be very complicated, especially
567
with respect to currency and bond options. It is not our intent to discuss exotic options,
although the approaches to valuing the structured products that are presented in this
chapter can easily be applied to the overall valuation of many types of exotic products.
Also, the comments at the end of the chapter regarding where to find information about
these products may prove useful for those seeking further information about either listed
structured products or exotic options.
11
RISKLESS" OWNERSHIP OF A STOCK OR INDEX
At many of the major institutional banks and brokerages, people are employed who design
structured products. They are often called financial engineers because they take existing
financial products and build something new with them. The result is packaged as a fund
of sorts (or a unit trust, perhaps), and shares are sold to the public. Not only that, but the
shares are then listed on the American or New York Stock Exchanges and can be traded
just like any other stock. These attributes make the structured product a very desirable
investment. An example will show how a generic index structured product might look.
Example: Let's look at the structured index product to see how it might be designed and
then how it might be sold to the public. Suppose that the designers believe there is demand
for an index product that has these characteristics:
1. This "inde x product " will be issued at a low price-say, $10 per share .
2. The product will have a maturity date-say , seven years hence.
3. The owner of these shares can redeem them at their maturity date for the greater of
either a) $10 per share orb) the percentage appreciation of the S&P ,500 index over
that a seven-year time period. That is, if the S&P doubles over the seven years, then
the shares can be redeemed for double their issue price , or $20.
Thus, this product has no price risk! The holder gets his $10 back in the worst case
(except for credit risk , which will be addressed in a minute).
Moreover, these shares will trade in the open market during the seven years, so that
if the holder vvants to exit at any time, he can do so. Perhaps the S&P has rallied drarnati-
call~',or perhaps he needs cash for something else-both might be reasons that the holder
of the shares would want to sell before maturity .
Such a product has appeal to many investors. In fact, if one thought that the stock
rnarkct was a "long-term" buy, this would he a much safer way to approach it than buying
Chapter
32:Structured
Products 569
a portfolio of stocks that might conceivably be much lower in value seven years hence. The
risk of the structured product is that the undencriter might not be able to pay the $10
obligation at maturity. That is, if the major institutional bank or brokerage firm who
underwrote these products were to go out of business over the course of the next seven
years, one might not be able to redeem them. In essence, then, structured products are
really forms of debt (senior debt) of the brokerage firm that underwrote them. Fortu-
nately, most structured products are underwritten by the largest and best-capitalized
institutions, so the chances of a failure to pay at maturity would have to be considered
relatively tiny.
How does the bank create these items'? It might seern that the bank buys stock and
buys a put and sells units on the combined package. In reality, the product is not normally
structured that way. Actually, it is not a difficult concept to grasp. This example shows how
the structure looks from the viewpoint of the bank.
Example: Suppose that the bank wants to raise a pool of $1,000,000 from investors to
create a structured product based on the appreciation of the S&P 500 index over the next
seven years. The bank will use a part of that pool of money to buy U.S. zero-coupon bonds
and will use the rest to buy call options on the S&P 500 index.
Suppose that the U.S. government zero-coupon bonds are trading at 60 cents on the
dollar. Such bonds would mature in seven years and pay the holder $1.00. Thus, the bank
could take $600,000 and buy these bonds, knowing that in seven years, they would mature
at a value of $1,000,000. The other $400,000 is spent to buy call options on the S&P 500
index. Thus, the investors would be made whole at the end of seven years even if the
options that were bought expired worthless. This is why the bank can "guarantee" that
investors will get their initial money back.
Meanwhile, if the stock market advances, the $400,000 worth of call options will gain
value and that money will be returned to the holders of the structured product as well.
In reality, the investment bank uses its own money ($1,000,000) to buy the securities
necessary to structure this product. Then they make the product into a legal entity (often
a unit trust) and sell the shares (units) to the public, marking them up slightly as they
would do with any new stock brought to market.
At the time of the initial offering, the calls are bought at-the-money, meaning the strik-
ing price of the calls is equal to the closing price of the S&P 500 index on the day the prod-
ucts were sold to the public. Thus, the structured product itself has a "strike price" equal to
that of the calls. It is this price that is used at maturity to determine whether the S&P has
appreciated over the seven-year period-an event that would result in the holders receiving
back more than just their initial purchase price .
After the initial offering, the shares are then listed on the AMEX or the NYSE and
they will begin to rise and fall as the value of the S&P ,500 index fluctuates.
* * *
So, the structured product is not an index fund protected by a put option, but rather
it is a combination of zero-coupon government bonds and a call option on an index. These
two structures are equivalent, just as the combination of owning stock protected by a put
option is equivalent to being long a call option.
Structured products of this type are not limited to indices. One could do the same
thing with an individual stock, or perhaps a group of stocks, or even create a simulated bull
spread. There are many possibilities, and the major ones will be discussed in the following
sections. In theory, one could construct products like this for himself, but the mechanics
would be too difficult. For example, where is one going to buy a seven-year option in small
quantity'? Thus, it is often worthwhile to avail oneself of the product that is packaged (struc-
tured) by the investment banker.
In actuality, many of the brokerage firms and investment banks that underwrite
these products give them names-usually acronyms, such as MITTS, TARGETS,
BRIDGES, LINKS, DIN KS, ELKS, and so on. If one looks at the listing, he may see that
they are called notes rather than stocks or index funds. Nevertheless, when the terms are
described, they will often match the examples given in this chapter.
INCOME TAX CONSEQUENCES
There is one point that should be made now: There is "phantom interest" on a structured
product. Phantom interest is what one owes the government when a bond is bought at a
discount to maturity. The IRS techuically calls the initial purchase price an Original Issue
Discount (OID) and requires you to pay taxes annually on a proportionate amount of that
OID. For example, if one buys a zero-coupon U.S. government bond at 60 cents on the dol-
lar, and later lets it mature for $1.00, the IRS does not treat the 40-cent profit as capital
gains. Rather, the 40 cents is interest income. Moreover, says the IRS, you are collecting
that income each year, since you bought the bonds at a discount. (In reality, of course, you
aren't collecting a thing; your investment is simply worth a little more each year because the
discount decreases as the bonds approach maturity.) However, you must pay income tax 011
the "phantom interest" you supposedly receiced each year. Those are the rules, and there
isn't anything you can do about them.
Since some structured products involve the purchase of zero-coupon bonds, the IRS
has ruled that mcners of this type of structured product must pay phantom i11terest each
y<"tlr. Thus, structured products should be bought in a tax-free retirement account (IRA,
SEP, etc.) if at all possible, in order to avoid having to declare phantom interest on your tax
return for each ~;par_vouhold the product. The phantom interest on your tax appiies only
to this t:veof structured product-one on which you are guaranteed to get back a fixed
Chapter 32: Structured Products 571
amount at 1J1atmit:-heca11<,P thi '> i-, tlH· only typc that req11ires b11:·ing a zPro-coupon
bond i11order to e11smc tliat yo11'llgd :<>llf rnori(•y hack if die stock market goes dow11. Tlie
t:
phantom intere '>t co11u·pt does 11ot appl:· to the pc of strnctmed prnd11ct to he discussPd
in the second part cl tlih cliapkr. To !Je cerL::tin. orw <,]io11ldget the necessar: · information
from his brokn or <il1011ldread the prospectus of the strnctmecl procl11ct. Of comse. any
tax '>trate gies <iho11lcl
al'io he di sc11ssed \\·ith a q11alifil'd tax professional.
CASH VALUE
The ca'ih \ alue of the structmed product is what it will he worth at maturity. It is usually
stated in terni<i 'iiJJJilar t(> tli()',e in the preceding example . and a formula is often gi\·er1.
This example will clarify the typ ical nature of this formu la:
Exam p le: A strncturecl product is issued at SlO per share. The terms stipulate that the
holder \,·ill recei\·e back, at rnatmity. either SlO or l()()Clc of the appreciation of the S&P
.SOOindex atJ(Ae a \·allle of 1.24,S.27. Orie would assume that the S&P .SOOcash index
1
closed at 1,2-1.S.27(Jfl the clay the structmecl product was issued.) The prospectus will 11s11-
ally prm·icle a fon nula for the cash smrender \·alue , and it will be stated something like this:
At maturity, the cash value will be equal to the greater of

(a) 810
or (b) $10 + 10 X (Final In dex Value - 1,245. 27)/1,2 4,5.27
where Final Index Value is, say, the closing value of the S&P ,500
index on the maturity date.
T he formula giH:n is rnerdy the aritlnnetic equirnlent of the statement that one will
rece i\ ·e l()(Vi7cof the appreciation of tbe S&P .SOOIndex ab<Ae the strike price of 1,24.S.27.
For those !(Jore adE--"ptat math. the forrnula can be reduced to common terms, in which
case it reads:
Cash Surr en der Value= $10 X Final Value/ 1,245.27
T h is shortened \·ersior1 of the fonrnila on!: · works, though, when the participation
rate is ] ()()C/c,of the increase in the Final Index \'alue ab ove the striking price. Otherwise,
th e longer formu la should be used .
.'\ot all strnctmecl products of this type offor the holder lOOClcof the appreciation of
the index o\·er thf• initial striking price. I n some cases, tlw percentage is smaller raltho11gl1
in the f'arly <ht:·s of i<is11ar1c<·,
son1e prod11cts offrred a percentage apprt'ciation tl1at \\·as
actually greater than 100%). After 1996, options in general became more expensive as the
volatilit y of the stock market increased tremendously. Thus, structured products issued
after 1997 or 1998 tend to include an "annual adjustment factor." Adjustment factors are
discus sed later in the chapter.
Therefore, a more general formula for Cash Surrender Value-one that applies when
the participation rate is a fixed percentage of th e striking price-is:
Cash Surrender Value=

Guarantee+ Guarantee X Participation Rate X (Final Index Value/Striking Price - I)
THE COST OF THE IMBEDDED CALL OPTION
Few structured products pay dividends.* Thus, the "cost" of owning one of these products
is the interest lost Ly not having your money in the bank (or rnoney market fund), but
rather having it tied up in holding the structured product.
Continuing with the preceding example, suppose that you had put the $10 in the
bank instead of buying a structured product with it. Let's further assume that the money
in the hank earns .S%interest, compounded continuously. At the end of seven years, com-
pounded continuously, the $10 would be wor th :
Mone y in th e bank = Guarantee Price X ert

= $10 X e 0 ·05 x 7 - 14.191, in this case
This calculation usually raises some eyebrows. Even compounded annually, the amount
is 14.07. You would make roughly 40% (without considering taxes) just by having your
money in the bank. Forgetting structured products for a moment, this means that stocks
in general would have to increase in value by over 40% during the seven-year period just
for your performanc e to beat that of a bank account.
In this sense, the cost of the imbedded call option in the structured product is this
lost interest-4.19 or so. That seems like a fairly expensive option, but if you consider that ifs
a seven-year option, it doesn't seem quite so expensive. In fact, one could calculate the implied
rnlatility of such a call and compare it to the current options on the index in question.
· Some do pay dividends, though. A structured product existed on a contrived ind ex, called the Dow-Jones Top 10 Yield
index (symbol: XMT). This is a sort of"dogs of the Dow" index. Since part of the reason for owning a "dogs of the Dow"
product is that dividends are part of the performance, the creators of the structured product (Merrill Lynch) stated that
the minimum price one would receive at maturity would be 12.40, not th e 10 that was the initia l offering price. Thus,
this particular structured product had a "dividend" built into it in the form of an elevated minimum price at maturity.
Chapter
32:Structured
Products 573
In this case, with tlw stock at 10, the strike at 10, no dividends, a .5% interest rate,
and seven years until expiration, the implied volatility of a call that costs $4. L9is 28.1%.
Call options on the S&P 500 index are rarely that expensive. So you can see that you are
paying "something" for this call option, even if it is in the form of lost interest rather than
an up-front cost.
As an aside, it is also unlikely that the underwriter of the structured product actually
paid that high an implied volatility for the call that was purchased; hut he is asking you
to pay that amount. This is where his underwriting profit comes from.
The above example assumed that the holder of the structured product is participating
in 100% of the upside gain of the underlying index over its striking price. If that is not the case,
then an adjustment has to be made when computing the price of the imbedded option. In fact,
one must compute what value of the index, at maturity, would result in the cash value being
equal to the "money in the bank" calculation ahove. Then calculate the imbedded call price,
using that value of the index. In that way, the true value of the imbedded call can be found.
You might ask, "Why not just divide the 'money in the bank' formula by the partici-
pation rate?" That would be okay if the participation were always stated as a percentage
of the striking price, but sometimes it is not, as we will see when we look at the more
complicated examples. Further examples of structured products in this chapter demon-
strate this method of computing the cost of the imbedded call.
PRICE BEHAVIOR PRIOR TO MA TURITY
The structured product cannot normally be "exercised" by the holder until it matures. That
is, the cash surrender value is only applicable at maturity. At any other time during the life
of the product, one can compute the cash surrender value, but he cannot actually attain it.
vVhat you can attain, prior to maturity, is the market price, since structured products
trade freely on the exchange where they are listed. In actual fact, the products generally
trade at a slight discount to their theoretical cash surrender value. This is akin to a
closed-end mutual fund selling at a discount to net asset value. Eventually, upon maturity,
the actua l price will be the cash surrender value price; so if you bought the product at a
discount, you would benefit, providing you held all the way to maturity.
Exam p le: Assume that two years ago, a structured product was issued with an initial
offering price of $10 and a strike price of 1,245.27, based upon the S&P 500 index. Since
issuance, the S&P 500 index has risen to 1,522.00. That is an increase of 22.22% for the
S&P .500, so the structured product has a theoretical cash surrender value of 12.22. I say
"theoretical" because that value cannot actually be realized, since the structured product
is not exercisable at the current time-five years prior to maturity.
andFutures
In the real marketplace, this particular structured product might be trading at a

price of 11.75 or so. That is, it is trading at a discount to its theoretical cash surrender
value. This is a fairly common occurrence, both for structured products and for closed-end
mutual funds. If the discount were large enough, it should serve to attract buyers, for if
they were to hold to maturity, they would make an extra 47 cents (the amount of this dis-
count) from their purchase. That's 4% (0.47 divided by 11.75 = 4%) over five years, which
is nothing great, but it's something.
Why does the product trade at a discount? Because of supply and demand. It is free
to trade at any price-premium or discount-because there is nothing to keep it fixed at
the theoretical cash surrender value. If there is excess demand or supply in the open
market, then the price of the structured product will fluctuate to reflect that excess. Even-
tuall y, of course, the discount will disappear, but five years prior to maturity, one will
often find that the product differs from its theoretical value by somewhat significant
amounts. If the discount is large enough, it will attract buyers; alternatively, if there should
be a large premium , that should attract sellers.
SIS
One of the first structured products of this type that came to my attention was one that
traded on the AMEX, entitled "Stock Index return Security" or SIS. It also traded under
the symbol SIS. The product was issued in 1993 and matured in 2000, so we have a com-
plet e history of its movements. The terms were as follows: The underlying index was the
S&P Midcap 400 index (symbol: MID). Issued in June 1993, the original issue price was
$10, and MID was trading at 166.10 on the day of issuance, so that was the striking
pric e. Moreover, buyers were entitled to 11.5%of the appreciation of MID above the
strike price . Thus , the cash value formula was:
Cash Value of SIS = $10 + $10 X 1.15 X (MID - 166.10)/166 .10
where
Guarantee price = $10
Underlying inde x: S&P Midcap 400 (MID)
Striking price : 166.10
Participation rate : 115% of the increase of MID above 166.10
SIS matured seven years later, on June 2, 2000. At the time of issuance, seven-year inter-
est rates were about 5.5%, so the "money in the bank" formula shows that one could have
Chapter
32:Structured
Products 575
made ahout 4.7 points on a $10 investment, just by utilizing risk-free government
securiti es:
Money in the bank= 10 X e 0 ·055 x 7 = 14.70
We can't simply say that the c:ostof the imbedded call was 4.7 points, though, because the
participation rate is not 100%-ifs greater. So we need to find out the Final Value of
MID that results in the cash value being equal to the "money in the bank" result. Using
the cash value formula and inserting all the terms except the final value of MID, we have
the following equation. Note: MID_,fIBstands for the value of MID that results in the
"money in the bank " cash value, as computed above.
14.70 = 10 + 10 X 1.15 X (MlDMrn-166.10)/166.10
Solving for MIDMrn,we get a value of 233.98. Now, convert this to a percent gain of
the striking price :
Imbedded call price = 233.98/166.10 - 1 = 0.4087
Hence, the imbedded call costs 40.87% of the guarantee price. In this example, where
the guarantee price was $10, that means the imbedded call cost $4.087.
Thus, a more generalized formula for the value of the imbedded call can be con-
strued from this example. This formula only works, though, where the participation rate
is a fixed percentage of the strike price .
Im bedded call value = Guarantee p1ice X (Final Index Valuer-.rrn

/ Striking Price - 1)
Final Index Value _,fIB is the final index price that results in the cash value
being equal to the "money in the bank " calculation, where
Money in the bank = Guarantee Price x et
r = risk-free interest rate
t = time to maturity
Thus, the calculated value of the imbedded call was approximately 4.087 points, which is
an implied volatility of just over 26%. At the time, listed short-term options on MID
were trading with an implied volatility of about 14%, so this was an expensive call in
terms of its initial cost.
However, one should rememher that owning SIS gave one more than full participation
in the MID for seven years, with virtually no risk. That has to be worth something.
As it turned out, MID was strong during this seven-year period, and SIS wound up
being worth just over $30 per share. So, in the end, the owner of SIS tripled his money in
seven years and had no risk to begin with. Not a bad scenario.
SIS TRACK RECORD
What SIS also imparts to us, though, is a track record of how it traded during its life. Fig-
ure 32-1 shows the discount at which SIS traded during its lifetime. It is the lower line on
the chart. The upper line is the corresponding cash value on the same dates. Note that
the upper line has the exact same shape as the S&P Midcap 400 (MID) would, since it
is merely MID multiplied by some arithmetic constant. The graph of the discount is
rather "choppy" because it uses last sales of SIS to compute the discount. In reality, since
SIS was a somewhat low-volume security, the last sale was not always representative of
the closing hid-asked market in SIS. Nevertheless, the graph shows that the discount was
greater than 2 points at the left side of the graph (199.t5)and gradually decreased until it
reached zero near maturity (2000).
The graph in Figure 32-1 is useful because it encompasses cases where MID traded
both above and below the striking price of 166.10. No matter whether SIS was in-the-money
(MID above 166.1) or out-of-the-money, SIS traded at a discount. As mentioned previ-
ously, this is akin to a closed-end mutual fund trading at a discount to net asset value.
FIGURE 32-1.
SIS trading at a discount.
Cash Value and SIS Discount

30
20
10
-1
-2
1995 1996 1997 1998 1999 2000

Date
Chapter
32:Structured
Products 577
At a minimum, this discount allows the buyer of SIS to ad<lan additional component
of overall return to his investment. Also, in some cases-when MID was trading below
the striking price-tlw buyer of SIS actually has a guaranteed return, as one might have
with a bond paving interest or a stock paving a dividend. The examples in the next section
examine those situations.
SIS TRADING AT A DISCOUNT TO CASH VALUE
\\'hen SIS is trading at a discount to cash value, the buyer of SIS actually has some down-
side protection.
Example: In late 1996, MID closed at 238.,54 one clay, and SIS closed at 13. The cash
value of SIS for that price of MID is:
Cash Value = 10 + 10 X 1.15 X (238.54/166.10 - 1) = 15.02

Therefore, SIS is trading at almost exactly a 2-point discount to cash value. That is
a fairly large discount of 15.4% (2/13 = .154).
One way to look at this would be to say that an investor is making an "extra" 15.4%
on his investment. That is, if MID were at exactly the same price at expiration, the cash
value would be the settlement price-1.5.02. In other words, the "stock market" as mea-
sured by MID was exactly unchanged. However, the investor would make a return of
15.4% because he bought SIS at a discount.
In fact, no matter where MID is at maturity, the investor feels the positive effect
of having bought at a discount.
Thus, the discount can and should be perceived as adding to the overall return of
owning the structured product. These discounts to net asset value are commonplace with
structured products. However, there is another way to view it: as downside protection.
Example: Using the same prices, MID is at 238 ..54 and SIS is at 13-a 1.5.4%discount to
the cash value of 1.5.02.Another way to view what this discount means is to view it as down-
side protection. In other words, MID could decline in price by maturity and this investor
could still break even. The exact amount of the downside protection can be calculated.
Essentially, one wants to know, at what price for MID would the cash value be 13?
Solving the following equation for MID would give the desired answer:
Cash Value = 13 = 10 + 11.5 X (MID/166.1 - 1)
:3 = 1LS X MID/166.l - 1LS
14.5 X 166.1/11.5 = MID
209.43 = MID
So, if MID were at 209.43, the cash value would be 13-the price the investory is
currently paying for SIS. This is protection of 12.2% down from the current price of
238.54. That is, MID could decline 12.2% at maturity, from the current price of 238.54
to a price of 209.43, and the investor who bought SIS would break even because it would
still have a cash value of 13.
Of course, this discount could have been computed using the SIS prices of 13 and
1.5.02 as well, but many investors prefer to view it in terms of the underlying index-
especially if the underlying is a popular and often-cited index such as the S&P 500 or
Dow-Jones Industrials.
From Figure 32-1, it is evident that the discount persisted throughout the entire life
of the product, shrinking more or less linearly until expiration.
SIS TRADING AT A DISCOUNT TO THE GUARANTEE PRICE
In the previom example, the investor could have bought SIS at a discount to its cash value
computation, but if the stock market had declined considerably, he would still have had
exposure from his SIS purchase price of 13 down to the guarantee price of 10. The dis-
count would have mitigated his percentage loss when compared to the MID index itself,
but it would be a loss nevertheless.
However, there are sometimes occasions when the structured product is trading at
a discount not only to cash value, but also to the guarantee price. This situation occurred
frequently in the early trading life of SIS. From Figure 32-1, you can see that in 1995 the
cash value was near 11, but SIS was trading at a discount of more than 2 points. In other
words, SIS was trading below its guarantee price, while the cash value was actually above
the guarantee price. It is a "double bonus" for an investor when such a situation occurs.
Example: In February 1995, the following prices existed:
MID: 177.,59
SIS: 8.75
For a moment, set aside considerations of the cash value. If one were to buy SIS at
8.7,5and hold it for the 5.5 years remaining until maturity, he would make 1.25 points on
his 8.75 investment-a return of 14.3% for the ,5.,5-yearholding period. As a compounded
rate of interest, this is an annual compound return of 2.43%.
Now, a rate of return of 2.43% is rather paltry considering that the risk-free T-bill
rate was more than twice that amount. However, in this case, you own a call option on
the stock market and get to earn 2.43% per year while you own the call. In other words,
Chapter
32: Structured
Products 579
"they" are paying you to 01c11a call option! Thafs a situation that doesn't arise too often
in the world of listed options.
If we introduce cash value into this computation, the discrepancy is even larger.
Using the MID price of 177.59, the cash value can be computed as:
Cash Value = 10 + 11.5 X (177.59/166.10 - 1) = 10.80
Thus, with SIS trading at 8.75 at that time, it was actually trading at a whopping 19%
discount to its cash value of 10.80. Even if the stock market declined, the guarantee price
of 10 was still there to provide a minimal return.
In actual practice, a structured product will not normally trade at a discount to its guar-
antee price while the cash value is higher than the guarantee price. There's only a narrow
window in which that occurs.
There have been times when the stock market has declined rather substantially
while these products existed. \Ve can observe the discounts at which they then traded to
see just how they might actually behave on the downside if the stock market declined
after the initial offering date . Consider this rather typical example:
Example: In 1997, Merrill Lynch offered a structured product whose underlying index
was Japan's Nikkei index. At the time, the Nikkei was trading at 20,351, so that was the
striking price. The participation rate was 140% of the increase of the Nikkei above
20,3,51-a very favorable participation rate. This structured product, trading under the
symbol JEM, was designed to mature in five years, on June 14, 2002.
As it turned out, that was about the peak of the Japanese market. By October of
1998, when markets worldwide were having difficulty dealing with the Russian debt crisis
and the fallout from a major hedge fund in the U.S. going broke, the Nikkei had plum-
meted to 13,300. Thus, the Nikkei would have had to increase in price by just over 50%
merely to get back to the striking price. Hence, it would not appear that JEM was ever
going to be worth much more than its guarantee price of 10.
Since we have actual price histories of JEM, we can review how the marketplace
viewed the situation. In October 1998, JEM was actually trading at 8.75-only 1.25 points
below its guarantee price. That discount equates to an annual compounded rate of
3.64%. In other words, if one were to buy JEM at 8.75 and it matured at 10 about 40
months later, his return would have been 3.64% compounded annually. That by itself is
a rather paltry rate of return, but one must keep in mind that he also would own a
call option on the Nikkei index, and that option has a 140% participation rate on the
upside .
COMPUTING THE VALUE OF THE IMBEDDED CALL WHEN

THE UNDERLYING IS TRADING AT A DISCOUNT
Can we compute the value of the imbedded call when the structured product itself is
trading at a discount to its guarantee price? Yes, the formulae presented earlier can always
be used to compute the value of the imbedded call.
Example: Again using the example ofJEM, the structured product on the Nikkei index,
recall that it was trading at 8.7,5with a guaranteed price of 10, with maturity 40 months
hence. Assume that the risk-free interest rate at the time was 5.5%. Assuming continuous
compounding, $8.7.5invested today would be worth $10.51 in 40 months.
Money in the bank= 8.75 X ert

where r = 0.05 and t = 3.33 years (40 months)
Money in the bank= 8.75 X e 0 ·055 x 3333 = 10.51
Since the structured product will be worth 10 at maturity, the value of the call is 0..51.
There is another, nearly equivalent way to determine the value of the call. It involves
determining where the structured product would be trading if it were completely a
zero-coupon debt of the underwriting brokerage. The difference between that value and
the actual trading price of the structured product is the value of the imbedded call.
The credit rating of the underwriter of the structured product is an important factor
in how large a discount occurs. Recall that the guarantee price is only as good as the
creditworthiness of the underwriter. The underwriter is the one who will pay the cash
settlement value at maturity-not the exchange where the product is listed nor any sort
of clearinghouse or corporation.
THE ADJUSTMENT FACTOR
In recent years, some of the structured products have been issued with an adjustment
factor. The adjustment factor is generally a negative thing for investors, although the
underwriters try to couch it in language that makes it difficult to discern what is going on.
Simply put the adjustment factor is a multiplier (less than 100%) applied to the underly-
ing index vahw IHfore calculating the Final Cash Value. Adjustment factors seemed to
come into being at about the time that index option implied volatility began to trade at
much higher levels than it ever had (1997 onward).
Chapter
32:Structured
Products 581
Example: A structured product is issued at an initial price of $10. It ostensibly allows one to
participate in the appreciation of the S&P 500 index over a price of 1,100.00. However, upon
closer inspection, what the product really offers is the opportunity for one to participate in
the appreciation of the S&P ,500 index (SPX) over an a~justed value, which is a percentage
of the SPX price-not the actual price itself. The cash value settlement formula is stated as:
Cash settlement value = 10 + 10 X (Adjusted SPX - 1,100.00) / 1, 100.00
The formula looks similar to the "normal" cash settlement value formulae shown
earlier in the chapter, but the term "adjusted SPX" has yet to be defined. In fact, it is
defined as a percentage of the final SPX Price-91.25% in this case. In reality, the pro-
spectus says something to the effect that the final price of SPX will be adjusted down-
ward by an annual adjustment factor of 1.25%. Thus, at the end of the seven-year maturity
period , the total adjustment factor would be seven times 1.25%, or 8.75%. The adjusted
value is then equal to 100%-8 .75%, or 91.25%.
The adjustment factor is an onerous burden for the investor. It means that the final value
of SPX will be reduced by the adjustment factor before it is determined how far, or if at
all, SPX is above the striking price of 1,100.00.
Example: Suppose that SPX exactly doubles in price during the life of the example struc-
tured product. That is, it finishes at 2,200.00-exactly twice the amount of the striking
price . Before the cash settlement value can be determined, SPX must be adjusted:
SPX adjusted value= 0.9125 X 2,200.00 = 2,007.50
So the final cash settlement value is based on the adjusted value of SPX:
Cash settlement value = 10 + 10 X (2,007.50 - 1, 100.00)/1, 100.00 = 18.25
Hence , instead of doubling your money, as you might expect to do since the SPX
Index doubled in price , you "only" make 82.5%.
Another way to view it: If the index doubles, then the structured product "should"
be worth double the initial price, or 20. But instead, it's worth 91.25% of 20, or 18.2,5.
Carrying the example a little further, suppose that SPX had tripled in price by the
maturity date , and was thus at 3,300. In this case, the cash settlement value would be:
SPX adjusted value= 0.9125 X 3,300.00 = 3,011.25

Cash settlement value= 10 + 10 X (3,011.2.5 - 1, 100.00)/1, 100.00 = 27.37.5
Or, thinking in the alternative, if the index triples , then the structured prod-
uct (before adjustment factor) would be triple its initial price, or 30. Then
30 X 91.25% = 27.375.
This example begins to demonstrate just how onerous the adjustment factor is. Notice that
if the underlying doubles, you don't make "double" less 8.75% (the adjustment factor). No,
you make "double" times the adjustment factor-17.5%-less than double. In the case of
tripling, you make 3 X 8.75%, or 26.25%, less than triple (i.e., the structured product is
worth 27.375, not 30, so the percentage increase was 173.75%, not 200%-a difference
of 26.25%, stated in terms of the initial investment). How can that be? It is a result of the
adjustment factor being applied to the SPX price before your profit (cash settlement value)
is computed.
THE BREAK-EVEN FINAL INDEX VALUE
Before discussing the adjustment factor in more detail, one more point should be made:
The owner of the structured product doesn't get back anything more than the base value
unless the underlying has increased by at least a fixed amount at maturity. In others
words, the underlying must appreciate to a price large enough that the final price times
the adjustment factor is greater than the striking price of the structured product. We'll
call this price the break-even final index value.
An example will demonstrate this concept.
Example: As in the preceding example, suppose that the striking price of the structured
product is 1,100 and the adjustment factor is 8.75%. At what price would the final cash
settlement value be something greater than the base value of 10? That price can be solved
for with the following simple equation:
Break-even final index value= Striking price/(! -Adjustment factor)

= 1, 100/(0 .9125) = 1,205.48.
Generally speaking, the underlying index must increase in value by a specific amount
just to break even. In this case that amount is:
1/(1- Adjustment factor ) = 1/0.9175 = 1.0959
In other words, the underlying index must increase in value by more than 9.5% by
maturity just to overcome the weight of the adjustment factor. If the index increases by a
Chapter
32:Structured
Products 583
lesser amount, then the strnctured product holder will merely receive back his base value
(10) at matu rity.
The previous examples all show that the adjustment factor is not a trivial thing. At
first glance, one might not realize just how burdensome it is. After all, one might ask
himself, what does 1.2.5%per year really matter? However, you can see that it does matter.
In fact, our above examples did not even factor in the other cost that any investor has
when his money is at risk-the cost of carry , or what he could have made had he just put
the mone y in the bank
MEASURING THE COST OF THE ADJUSTMENT FACTOR
The magnitude of the adjustment increases as the price of the underlying increases. It is
an unusual concept. We know that the structured product initially had an imbedded call
option. Earlier in this chapter, we endeavored to price that option. However, with the
introduction of the concept of an adjustment factor, it turns out that the call option's cost
is not a fixed amount. It varies, depending on the final value of the underlying index. In
fact, the cost of the option is a percentage of the final value of the index. Thus, we can't
really price it at the beginning, because we don't know what the final value of the index
will be , In fact, we have to cease thinking of this option's cost as a fixed number. Rather,
it is a geometric cost , if you will , for it increase s as the underlying doe s.
Perhaps another way to think of this is to visualize what the cost will be in percent-
age terms. Figure 32-2 compares how much of the percent increase in the index is cap-
tured by the structured product in the preceding example. The x-axis on the graph is the
percent increase by the index. The y-axis is the percent realized by the structured prod-
uct. The terms are the same as used in the previous examples: The strike price is 1,100,
the total adjustment factor is 8.75%, and the guarantee price of the structured product
is 10.
The dashed line illustrates the first example that was shown, when a doubling of the
index value (an increase of 100%) to 2,200 resulted in a gain of 83.5% in the price of the
structured. Thus, the point (100%, 83.5%) is on the line on the chart where the dashed
lines meet.
Figure 32-2 points out just how little of the percent increase one captures if the
underlying index increases only modestly during the life of the structured product. We
already know that the index has to increase by 9..59% just to get to the break-even final
price. That point is where the curved line meets the x-axis in Figure 32-2.
The curved line in Figure 32-2 increases rapidly above the break-even price, and
then begins to flatten out as the index appreciation reaches 100% or so. This depicts the
FIGURE 32-2.
Percent of increase captured by structured product.
90
80
70
60
-0
~
:::J 50
0..
cu
(.)
-;J2_
40
0
Break-even: 9.59% Increase

30
20
10
0 100 200 300 400 500

% Increase by Index
fact that, for small percentage increases in the index, the 8.7.5%adjustment factor-which
is a flat-out downward adjustment in the index price-robs one of most of the percentage
gain. It is only when the index has doubled in price or so that the curve stops rising so
quickly. In other words, the index has increased enough in value that the structured prod-
uct, while not capturing all of the percentage gain by any means, is now capturing a great
deal of it.
After that, the curve in Figure 32-2 flattens dramatically. It eventually flattens out
completely at 91.2,5%.That is, if the index increases enough in value (about 3,000% or
more!), then the structured product final cash value will reflect the full 91.2.5%percent
of appreciation of the index itself. That kind of increase in seven years is virtually unat-
tainable. In reality , the index-if it increases at all-will probably be more in line with
the \·alues shown on the x-axis in Figure 32-2. In those cases, especially for increases of
100% or less, the oppressive weight of the adjustment factor significantly harms the return
from th e structur ed product.
One could visualize the graph in Figure :32-2 another way, if it would help.
Replace the>\·al11eson tlw x-axis with the actual index values: 2,200, :3,300, 4,400, .5,.500,
and o,600 would rc>placc> the figures shown as 100, 200,300,400, and .500.Thus, the x-axis
could then reprc>scnt the final \·alue of the inclc>x(lwfore adjustment). That might help to
Chapter
32: Structured
Products 585
FIGURE 32-3.
Cash value of structured product at maturity.
50
40
Q)
::::,
~ 30
..c:
(J)
ctl
(_)
20
Break-even: 1205.48
10 i-----,r
0 1100 2200 33 0 4400 5500 6600

Index Final Price (Unadjusted)
relate just how far the index would have to rise in order to overcome the downward
adjustment.
Figure 32-3 shows a more conventional look at the comparison between the index
value at maturity and the cash value of the structured product. For example, the dashed
line shows that, with the final value (unadjusted) of the index at 3,300, the structured
product's final cash value would be 27.37,5, as shown in a prior example. The line on Fig-
ure 32-3 looks like that of owning a call-limited risk, with large upside profit potential.
It is much more difficult to tell that the adjustment factor is weighing down the value of
the structured product so dramatically from this chart. Both Figures 32-2 and 32-3 are
mathematically correct. However , only Figure 32-2 depicts the real cost of owning a
structured product with an adjustment factor .
The final graph on this topic , Figure 32-4, shows the cash value of the adjusted
structured product (the same line as was shown in Figure 32-3), compared with an unad-
justed line. For example, the unadjusted line shows a true doubling of the price of the
structured product if the underlying index has doubled. The difference between the two
lines (the shaded area) can be thought of as the cost of the irnbeddecl call-or at least as
the cost of the adjustment factor. You can see from Figure 32-4 how the call's "cost"
increases as the value of the underlying index increases .
FIGURE 32-4.
Comparison of adiusted and unadiusted cash values at maturity.
50
40
Q)
::i
~
-5i30
cu
0
Cost of the
Call Option
20
0 1100 2200 3300 4400 5500 6600

Index Final Price (Unadjusted)
OTHER CONSTRUCTS
The financial engineers who create structured products have come up with a number of dif-
ferent constructs over time. Some resemble spreads, and some have two or three different
products bundled into one. In fact, just about anything is possible. All that is required is that
the underwriter thinks there is enough interest somewhere for him to be able to create the
product, mark it up, and sell it to whomever has interest. In this section, a couple of different
constructs, ones that have been brought to the public marketplace in the past, are discussed.
THE BULL SPREAD
Several structured products have represented a bull spread, in effect. In some cases, the
structured product terms are stated just like those of a call spread in that the final cash
value is defined with both a minimum and a maximum value. For example, it might be
described something like this:
"The final cash value of the (structured) product is equal to a minimum of a base price of
10, plus any appreciation of the underlying index above the striking price, subject to a
maximum price of 20" (where the striking price is stated elsewhere).
Chapter
32:Structured
Products
- 587
* * *
Ifs fairly simple to see how this resembles a bull spread: The worst you can do is to
get back your $10, which is presumably the initial offering price, just as in any of the
structured products described previously in this chapter. Then, above that, you'd get some
appreciation of the index price above the stated striking price-again like the products
discussed earlier. However, in this case, there is a maximum that the cash value can be
worth: 20. In other words, there is a ceiling on the value of this structured product at
maturity. It is exactly like a bull spread with two striking prices, one at 10 and one at 20.
In reality , this structured product would have to be evaluated using both striking prices.
We'll get to that in a minute .
There is another way that the underwriter sometimes states the terms of the struc-
tured product, but it is also a bull spread in effect. The prospectus might say something
to the effect that the structured product is defined pretty much in the standard way, but
that it is callable at a certain (higher) price on a certain date. In other words, someone else
can call your structured product away on that date. In effect, you have sold a call with a
higher striking price against your structured product. Thus, you own an imbedded call
via the usual purchase of the structured product and you have written a call with a higher
strike. That , again , is the definition of a bull spread .
When analyzing a product such as this, one must be mindful that there are two calls
to price, not only in determining the final value, but more importantly in determining
where you might expect the structured product to trade during its life, prior to maturity.
An option strategist knows that a bull spread doesn't widen out to its maximum profit
potential when there is still a lot of time remaining before expiration, unless the underly-
ing rises by a substantial amount in excess of the higher striking price of the spread. Thus,
one would expect this type of structured product to behave in a similar manner.
The example that will be used in the rest of this section is based on actual "bull
spread" structured products of this type that trade in the open marketplace.
Example: Suppose that a structured product is linked to the Internet index. The strike
price, based on index values, is 1.50.If the Internet index is below 150 at maturity, seven
years hence, then the structured product will be worth a base value of 10. There is no
adjustment factor, nor is there a participation rate factor. So far, this is just the same sort
of definition that we've seen in the simpler examples presented previously. The final cash
value formula would be simply stated as:
Final cash value = 10 X (Final Internet inde x value/150)

However, the prospectus also states that this structured product is callable at a price
of 25 during the last month of its life.
This call feature means that there is, in effect, a cap on the price of the underlying.
In actual practice, the call feature may be for a longer or shorter period of time, and may
be callablt' well in advance of maturity. Those factors merely determine the expiration
date of the imbedded call that has been "written."
The first thing one should do is to convert the striking price into an equivalent price
for the underlying index, so that he can see where the higher striking price is in relation
to tlw index price. In this example, the higher striking price when stated in terms of the
structured product is 2.,5times the base price. So the higher striking price, in index terms,
would be 2.5 times the striking price, or 375:
Index call price= (Call price/Base price) X Striking price

= (25/10) X 150
= 375
Hence, if the Internet index rose above 375, the call feature would be "in effect"
(i.e., the written call would be in-the-money). The value at which we can expect the struc-
tured product to trade, at maturity, would be equal to the base price plus the value of the
bull spread with strikes of 10 and 25.
Valuing the Bull Spread. Just as the single-strike structured products have an
imbedded call option in them, whose cost can be inferred, so do double-strike structured
products. The same line of analysis leads to the following:
"Theoretical" cash value= 10 + Value of bull spread - Cost of carry
Cost of carry refers to the cost of carry of the base price (10 in this example).
By using an option model and employing knowledge of bull spreads, one can calcu-
late a theoretical value for the structured product at any time during its life. Moreover,
one can decide whether it is cheap or expensive-factors that would lead to a decision as
to whether or not to buy.
Example: Suppose that the Internet index is trading at a price of 210. What price can we
expect the structured product to be trading at? The answer depends on how much time
has passed. Let's assume that two years have passed since the inception of the structured
product (so there are still five years of life remaining in the option).
\\'ith the Internet index at 210, it is 40% above the structured product's lower
Chapter
32:Structured
Products 589
striking price of 150. Thus, the equivalent price for the structured product would be 14.
Another way to compute this would be to use the cash value formula:
Cash value= 10 X (210 / 150) = 14
Now, we could use the Black-Scholes (or some other) model to evaluate the two calls-
one with a striking price of 10 and the other with a striking price of 2,5. Using a volatility
estimate of 50%, and assuming the underlying is at 14, the two calls are roughly valued as
follows:
Underlying price: 14
Option Theoretical Price

5-year call, strike= 10 7.30
5-year call, strike= 25 3.70
Thus, the value of the bull spread would be approximately 3.60 (7.30 minus .3.70).
The structured product would then be worth 13.60-the base price of 10, plus the value
of the spread:
"Theoretical" cash value= 10 + 3.60 - Cost of carry= 13.60 - Cost of carry
It may seem strange to say that the value of the structured product is actually less
than the cash value, but that is what the call feature does: It reduces the worth of the
structured product to values belou; what the cash value formula would indicate.
Given this information, we can predict where the structured product would trade at any
price or at any time prior to maturity. Let's look at a more extreme example, then, one in
which the Internet index has a tremendously big run to the upside .
Example: Suppose that the Internet index has risen to 525 with four years of life remain-
ing until maturity of the structured product. This is well above the index-equivalent call
price of 37.5. Again, it is first necessary to translate the index price back to an equivalent
price of the structured product, using either percentage gains or the cash value formula:
Cash value= 10 X (52,5/150) = 3,5
Again, using the Black-Scholes model, we can determine the following theoretical
values:
andFutures
Underlying price: 35
Option Theoretical Price
3-year call, strike = 10 25.50·

3-year call, strike = 25 14.70
Now, the value of the bull spread is 10.80 (25.50 minus 14.70). The deepest
in-the-money option is trading near parity, but the (written) option is only 10 points in-
the-money and thus has quite a bit of time value premium remaining, since there are
three years of life left:
"Theoretical,, cash value = 10 + 10.80 = 20.80 - Cost of carry
Hence, even though the Internet index is at 525-far above the equivalent call price
of 37.5-the structured product is expected to be trading at a price well below its maxi-
mum price of 2.5.
Figure 32-,5 shows the values over a broad spectrum of prices and for various
expiration dates. One can clearly see that the structured product will not trade near its
FIGURE 32-5.
Value of bull spread structured product.
At Maturity
25
1 Year Left
20 3Years Left
15
Q)
::i
g
100 150 200 250 300 350 400 450 500 550 600
Price of Index
Chapter
32: Structured
Products 591
maximum price of 25 until time shrinks to nearly the maturity date, or until the underly-
ing index rises to very high prices. In particular, note where the theoretical values for the
bull spread product lie when the index is at the higher striking price of 375 (there is a
vertical line on the chart to aid in identifying those values). The structured product is not
worth 20 in any of the cases, and for longer times to maturity, it isn't even worth 15. Thus,
the call feature tends to dampen the upside profit potential of this product in a dramatic
manner.
The curves in Figure 32-5 were drawn with the assumption that volatility is 50%.
Should volatility change materially during the life of the structured product, then the
values would change as well. A lower volatility would push the curves up toward the "at
maturity" line, while an increase in volatility would push the curves down even further.
MULTIPLE EXPIRATION DATES
In some cases, more than one expiration date is involved when the structured product is
issued. These products are very similar to the simple ones first discussed in this chapter.
However, rather than maturing on a specific date, the final index value-which is used to
determine the final cash value of the structured product-is the average of the underly-
ing index price on two or three different dates.
For example, one such listed product was issued in 1996 and used the S&P 500
index (SPX) as the underlying index. The strike price was the price of SPX on the day of
issuance, as usual. However, there were three maturity dates: one each in April 2001,
August 2002, and December 2003. The final index value used to determine the cash settle-
ment value was specified as the average of the SPX closings on the three maturity dates.
In effect, this structured product was really the sum of three separate structured
products, each maturing on a different date. Hence , the values of the imbedded calls
could each be calculated separately, using the methods presented earlier. Then those
three values could be averaged to determine the overall value of the imbedded call in this
structured product.
OPTION STRATEGIES INVOLVING STRUCTURED PRODUCTS
Since the structured products described previously are similar to well-known option
strategies (long call, bull spread, etc.), it is possible to use listed options in conjunction
with the structured products to produce other strategies. These strategies are actually
quite simple and would follow the same lines as adjustment strategies discussed in the
earlier chapters of this book.
Example: Assume that an investor purchased 15,000 shares of a structured product some
time ago. It is essentially a call option on the S&P 500 index (SPX). The product was
issued at a price of 10, and that is the guarantee price as well. The striking price is 700,
which is where SPX was trading at the time. However, now SPX is trading at 1,200, well
above the striking price . The cash value of the product is:
10 X (1,200/700) = 17.4
Furthermore, assume that there are still two years remaining until maturity of the
structured product, and the investor is getting a little nervous about the market. He is
thinking of selling or hedging his holding in the structured product. However, the struc-
tured product itself is trading at 16.50, a discount of 64 cents from its theoretical cash
value. He is not too eager to sell at such a discount, but he realizes that he has a lot of
exposure between the current price and the guarantee price of 10.
He might consider writing a listed call against his position. That would convert it into
the equivalent of a bull spread, since he already holds the equivalent of a long call via
ownership of the structured product. Suppose that he quotes the SPX options that trade
on the CBOE and finds the following prices for 6-month options, expiring in December:
SPX: 1,200
Option Price
December 1,200 call 85
Suppose that he likes the sale of the December 1,250 call for 62 points. How many
should he sell against his position in order to have a proper hedge?
First, one must compute a nwltiplier that indicates how many shares of the struc-
tured product are equivalent to one "share" of the SPX. That is done in the simple case
by dividing the striking price by the guarantee price :
Multiplier = Striking price/ Base price

= 700/10 = 70
This means that buying 70 shares of the structured product is equivalent to being
Chapter
32:Structured
Products 593
long one share of SPX. To verify this, suppose that one ha<l bought 70 shares of the
structured product initially at a price of 10, when SPX was at 700. Later, assume that
SPX doubles to 1,400. With the simple structure of this product, which has a 100% par-
ticipation rate and no adjustment factor, it should also double to 20. So 70 shares bought
at 10 and sold at 20 would produce a profit of $700. As for SPX, one "share" bought at
700 and later sold at 1,400 would also yield a profit of $700. This verifies that the 70-to-l
ratio is the correct multiplier .
This multiplier can then be used to figure out the current equivalent structured
product position in terms of SPX. Recall that the investor had bought 1.5,000 shares
initially. Since the multiplier is 70-to-l, these 15,000 shares are equivalent to:
SPX equivalent shares = Shares of structured product held/Multiplier

= 15,000/70 = 214.29
That is, owning this structured product is the equivalent of owning 214+ shares
of SPX at current prices. Since an SPX call option is an option on 100 "shares" of
SPX, one would write 2 calls (rounding off) against his structured profit position. Since
the SPX December 1,250 calls are selling for 62, that would bring in $12,400 less
commissions .
Note that the sale of these calls effectively puts a cap on the profit potential of the
investor's overall position until the December expiration of the listed calls. If SPX were
to rise substantially above 1,250, his profits would be "capped" because the two calls were
sold. Thus, he has effectively taken his synthetic long call position and converted it into a
bull spread (or a collared index fund , if you prefer that description) .
In reality, any calls written against the structured product would have to be mar-
gined as naked calls. In a virtual sense, the 15,000 shares of the structured product
"cover" the sale of 2 SPX calls, but margin rules don't allow for that distinction. In
essence, the sale of two calls would create a bull spread. Alternatively, if one thinks of the
structured product as a long index fully protected by a put (which is another way to con-
sider it), then the sale of the SPX listed call produces a "collar."
Of course, one could write nwre than two SPX calls, if he had the required margin
in his account. This would create the equivalent of a call ratio spread, and would have the
properties of that strategy: greatest profit potential at the striking price of the written
calls, limited downside profit potential, and theoretically unlimited upside risk if SPX
should rise quickly and by a large amount.
In any of these option writing strategies, one might want to write out-of-the-money,
short-term calls against his structured product periodically or continuously. Such a strategy
andFutures
would produce good results if the underlying index does not advance quickly while the
written calls are in place. However, if the index should rise through the striking price of
the written calls, such a strategy would detract from the overall return of the structured
product.
Changing the Striking Price. Another strategy that the investor could use if he so
desired is to establish a vertical call spread in order to effectively change the striking price
of the (imbe<lded) call. For example, if the market had advanced by a great deal since the
product was bought, the imbedded call would theoretically have a nice profit. If one could
sell it and buy another, similar call at a higher strike, he would effectively be rolling his
call up. This would raise the striking price and would reduce downside risk greatly (at the
cost of slightly reducing upside profit potential) .
Example: Using the same product as in the previous example, suppose that the investor
who owns the structured product considers another alternative. In the previous example,
he evaluated the possibility of selling a slightly out-of-the-money listed call to effectively
produce a collared position, or a bull spread. The problem with that is that it limits upside
profit potential. If the market were to continue to rise, he would only participate up to the
higher strike (plus the premium received ).
A better alternative might be to roll his imbedded call up, thereby taking some
money out of the position but still retaining upside profit potential. Recall that the struc-
tured product had these terms:
Guarantee price: 10
Underlying index: S&P 500 index (SPX)
Striking price : 700
As in the earlier example, the investor owns 1.5,000shares of the structured product.
Furthermore , assume that there are about two years remaining until maturity of the
structured product, and that the current prices are the same as in the previous example:
Current price of structured product : 16.50

Current price of SPX: 1,200
For purposes of simplicity, let's assume that there are listed two-year LEAPS options
available for the S&P index, whose prices are :
S&P 2-year LEAPS, striking price 700: 550

S&P 2-year LEAPS, striking price 1,200: 210
Chapter
32:Structured
Products
· 595
In reality , S&P LEAPS options are normally reduced-value options, meaning that
they are for one -tenth the value of the index and thus sell for one-tenth the price. How-
ever, for the purposes of this theoretical example, we will assume that the full-value
LEAPS shown her e exist.
It was shown in the previous example that the investor would trade tu.;o of these calls
as an equivalent amount to the quantity of calls imbedded in his structured product. So,
this investor could buy two of the 1,200 calls and sell two of the 700 calls and thereby roll
his striking price up from 700 to 1,200. This roll would bring in 340 points, two times; or
$68 ,000 less commissions.
Since the difference in the striking prices is ,500 points, you can see that he is leaving
something "on the table" by receiving only 340 points for the roll-up. This is common
when rolling up: One loses the time value premium of the vertical spread. However, when
viewed from the perspective of what has been accomplished, the investor might still find
this roll worthwhile. He has now raised the striking price of his call to 1,200, based on
the S&P index , and has taken in $68,000 in doing so. Since he owns 1.5,000 shares of the
structured product, that means he has taken in 4.53 per share (68,000 / 15,000). Now,
for example, if the S&P crashes during the next two years and plummets below 700 at the
maturity date , he will receive $10 as the guarantee price plus the $4.53 he got from the
roll-a total "guarantee" of $14.,53.Thus, he has protected his downside.
Note that his downside risk is not completely eliminated, though. The current
price of the structured product is 16.50 and the cash value at the current S&P price is
17.14 (see the previous example for this calculation), so he has risk from these levels down
to a pric e of $14.53.
His upside is still unlimited, because he is not long two calls-the S&P 2-year
LEAPS calls, struck at 1,200. The two LEAPS calls that he sold, struck at 700, effectively
offsets the call imbedded in the structured product, which is also struck at 700.
This example showed how one could effectively roll the striking price of his struc-
tured product up to a higher price after the underlying had advanced. The individual
investor would have to decide if the extra downside protection acquired is worth the profit
potential sacrificed. That depends heavily, of course, on the prices of the listed S&P
options, which in turn depend on things such as volatility and time remaining until
expiration .
Of course , one other alternative exists for a holder of a structured product who
has built up a good profit, as in the previous two examples: He could sell the product he
owns and buy another one with a striking price closer to the current market value of the
underlying index. This is not always possible, of course, but as long as these products
continue to be brought to market every few months or so by the underwriters , there will
be a wide variety of striking prices to choose from. A possible drawback to rolling to
another structured product is that one might have to extend his holding's maturity date,
but that is not necess arily a bad thing .
A different scenario exists when the underlying index drops after the structured
product is bought. In that case, one would own a synthetic call option that might be quite
far out-of-the-mo11eu. A listed call spread could be used to theoretically lower the call's
striking price , so that upside movement might more readily produce profits. In such a
case, one would sell a listed call option with a striking price equal to the striking price of
the structured product and would buy a listed call option with a lower striking price-one
more in line with current market values. In other words, he would buy a listed call bull
spread to go along with his structured product. Whatever debit he pays for this call bull
spread will increase his downside risk, of course. However, in return he gains the ability
to make profits 1nore quickly if the underlying index rises above the new, lower striking
pric e.
Many other strategies involving listed options and the structured product could be
constructed, of course. However, the ones presented here are the primary strategies that
an investor should consider. All that is required to analyze any strategy is to remember
that this type of structured product is merely a synthetic long call. Once that concept is
in mind, then any ensuing strategies involving listed options can easily be analyzed. For
example , the purchase of a listed put with a striking price essentially equal to that of the
structurt>d product would produce a position similar to a long straddle . The reader is left
to int erpr et and analyze oth er such strategi es on his own.
LISTS OF STRUCTURED PRODUCTS
The descriptions provided so far encompass the great majority of listed structured prod-
ucts. There are man:,.·similar ones involving individual stocks instead of indices (often
called equity-linked notes). The concepts are the same; merely substitute a stock price for
an inde x price in the previous discussions in this chapter .
Some large insurance companies offer similar products in the form of annuities.
The:,.·behave in exactly the same way as the products described above, except that there
is no continuous market for them. However, they still afford one the opportunity to own
an index fond with no risk. Many of the insurance company products, in fact, pay interest
to the annuity holder-something that most of the products listed on the stock exchanges
do not.
~1an:,.·of these structured products are introduced by brokerage firms and shown to
their clients. Some are listed, althoubah far fewer than there used to be. There are maaa- b
zint>s and websites that specialize in listing the available products. Doing a web search for
tlwrn is an Pasy wa:-· to obtain a potential list of current structured products.
Chapter
32: Structured
Products 597
OTHERSTRUCTUREDPRODUCTS
EXCHANGE-TRADED FUNDS
Other listed products exist that are simpler in nature than those already discussed, but
that the exchanges sometimes refer to as structured products . They often take the form
of unit trusts and mutual funds. The general term for these products is Exchange-Traded
Funds (ETFs). In a unit trust , an underwriter (Merrill Lynch, for example) packages
together 10 to 12 stocks that have similar characteristics; perhaps they are in the same
industry group or sector. The underwriter forms a unit trust with these stocks. That is,
the shares are held in trust and the resulting entity-the unit trust-can actually be
traded as shares of its own. The units are listed on an exchange and trade just like stocks.
Example: One of the better-known and popular unit trusts is called the Standard &
Poor's Depository Receipt (SPDR). It is a unit trust that exactly matches the S&P .500
index , divided by 10. The SPDR unit trust is affectionately called Spiders (or Spyders). It
trades under the symbol SPY. If the S&P .500 index itself is at 1,400, for example , then
SPY will be trading near 140. Unit trusts are very active , mostly because they allow any
investor to buy an index fund, and to move in and out of it at will. The bid-asked spread
differential is very tight, due to the liquidity of the product. When a customer trades the
SPY, he pays a commis sion , ju st as he would with any listed stock.
Exchange-traded funds are attractive to all investors who like to trade or invest in index
funds, preferring the diversity provided by an index (passive management of stocks) to an
active role in managing individual stocks. Exchange-traded funds can be sold short as long
as the shares can be borrowed. Some of them don't even require an uptick when executing
the short sale.
Two other large and well-known unit trusts are similar to SPY.One is the NASDAQ-100
tracking stock whose symbol is QQQ. QQQ is ¼oth of the value of the NASDAQ-100 index
(NDX), although it should be noted that NDX has split two-for-one in the past, as has QQQ,
so the relationship could change by a factor of two. The other large, popular unit trust is
linked to the Dow-Jones 30 Industrials; it is called Diamonds and trades under the symbol
DIA. Since this concept has proved to be popular, sector SPDRs were created on a large
number of S&P index sectors-technology, oil, semiconductors, etc. These have proven to
be less popular. There are even ETFs that are equal to one-tenth of the OEX index,
although they have not proven to be liquid.
ETFs are "created '' by institutions in blocks of shares known as Creation Units. A
creation requires a deposit with the trustee of a specified number of shares of a portfolio
of stocks closely approximating the composition of a specific index, and cash equal to
accumulated dividends in return for specific index shares. Similarly, block-sized units of
ETFs can be redeemed in return for a portfolio of stocks approximating the index and a
specified amount of cash. Very large blocks of shares-50,000 or more-are required to
create SPY, QQQ, DIA, and so forth. Slightly smaller blocks of shares are required
to create the sector funds.
A very large segment of ETFs, called iShares, was created by Barclays Global Inves-
tors to track all kinds of index funds. Many of these are not well known to the public, such
as the Russell 2000 Value Fund and the Russell 2000 Growth Fund, but most of them are
understandable upon inspection. There are iShares on funds that track foreign industries,
plus a broad spectrum of funds that track small-cap stocks, value stocks, growth stocks,
or individual sectors such as health care, the Internet, or real estate. The website www
.ishares.com shows all of the currently available iShares. The iShares are all traded on
major stock exchanges.
Another major segment of ETFs are called Holding Company Depository Receipts
(HOLDERS). They were created by Merrill Lynch. A large number of ETFs in recent
years have been added to simulate commodities. These include Crude Oil, Gold, Silver,
Cotton, Natural Gas, Gasoline, and so forth. These will be discussed in more detail in
Chapter 34s and 35.
Options on ETFs.Options are listed on many ETFs. QQQ options, for example, are
listed on all of the option exchanges and are some of the most liquid contracts in existence.
Things can always change, of course: Witness OEX, which at one time traded a million
contracts a day and now barely trades one-thirtieth of that on most days.
The options on ETFs can be used as substitutes for many expensive indices. This
brings index option trading more into the realm of reasonable cost for the small individual
investor .
Example: The PHLX Semiconductor index (SOX) has been a popular index since its
inception , especially during the time that tech stocks were roaring. The index, whose
options are expensive because of its high statistical volatility, traded at prices between 500
and 1,300 for several years. During that time, both implied and historical volatility was /
near 70%. So, for example, if SOX were at 1,000 and one wanted to buy a three-month
at-the-money call, it would cost approximately 135 points. That's $13,500 for one call
option . For many investors, that's out of the realm of feasibility.
However, there are HOLDRS known as Semiconductor HOLDRS (symbol: SMH).
The Semiconductor HOLDERS are composed of 20 stocks (in differing quantities, since
it is a capitalization-weighted unit trust) that behave in aggregate in much the same man-
ner as the Semiconductor index (SOX) does. However, SMH has traded at prices between
40 and 100 over the same period of time that SOX was trading between 500 and 1,300.
Chapter
32:Structured
Products 599
The implied volatility of SMH options is 70%-just like SOX options-because the same
stocks are involved in both indices. However, a three-month at-the-money call on the $100
SMH, say, would cost only 13.50 points ($1,350)-a much more feasible option cost for
most investors and trader s.
Thus, a strategy that most option traders should keep in mind is one in which ETFs are
substituted when one has a trading signal or opinion on a high-priced index. Similarities
exist among many of them. For example, the Morgan Stanley High-Tech index (MSH) is
well known for the reliability of its put-call ratio sentiment signals. However, the index is
high-priced and volatile, much like SOX. Upon examination, though, one can discover
that QQQ trades almost exactly like MSH. So QQQoptions and "stock" can be used as a
substitute when one wants to trade MSH.
STRUCT
UREDPRODUCT SUMMARY
Structured products can and should be utilized by investors looking for unique ways to
protect long-term holdings in indices or individual stocks.
The number of these products is constantly evolving and changing. Analytical tools
are available on the web as well. For example, the site www.derivativesmodels.com has
over 40 different models especially designed for evaluating options and structured prod-
ucts. They range from the simple Black-Scholes model to mode ls that are designed to
evaluate extremely complicated exotic options .
All of these products have a place, but the most conservative seem to be the struc-
tured products that provide upside market potential while limiting downside risk-the
products discussed at the beginning of the chapter. As long as the creditworthiness of the
underwriter is not suspect, such products can be useful longer-term investments for nearly
everyone who bothers to learn about and understand them .
Mathematical Considerations
for Index Products
In this chapter, we look at some risk less arbitrage techniques as they apply to index
options. Then a summary of mathematical techniques, especially modeling, is presented.
ARBITR GE
Most of the normal arbitrage strategies have been described previously . We will review
them here, concentrating on specific techniques not described in previous chapters on
hed ging (market baskets) and inde x spre ading.
DISCOU N TING
Discounting is only applicable to index options that are American-style - that can be
exercised 011 any trading day. Most index options are European-style , meani ng they can
only be exercised at th e end of their life.
We saw that discounting in cash-based index options is done with in-the-money
options as it is with stock options. However, since the discounter cannot exactly hedge the
cash-based index options , he will normally do his discounting near the close of the day so
that th ere is as little time as possible between the time the option is bought and the close
of the market. This reduces the risk that the underlying index can move too far before the
close of trading.
600
Chapter
33:Mathematical
Considerations
forIndexProducts 601
Example: OEX is trading at 673.,53 and an arbitrageur can buy the June 690 puts for 16.
That is a discount of 0.47 since parity is 16.47. Is this enough of a discount? That is, can
the discounter buy this put, hold it unhedged until the close of trading, and exercise it; or
is there too great a chance that OEX will rally and wipe out his discount?
If he buys this put when there is very little time left in the trading day, it might be
enough of a discount. Recall that a one-point move in OEX is roughly equivalent to 1.5points
on the Dow (while a one-point move in SPX is about 7..5 Dow points). Thus, this OEX
discount of 0.47 is about equal to 7 Dow points. Obviously, this is not a lot of cushion,
because the Dow can easily move that far in a short period of time, so it would be suffi-
cient only if there are just a few minutes of trading left and there were not previous indica-
tions of large orders to buy "market on close."
However, if this situation were presented to the discounter at an earlier time in the
trading day, he might defer because he would have to hedge his position and that might
not be worth the trouble. If there were several hours left in the trading day, even a dis-
count of a full point would not be enough to allow him to remain unhedged (one full OEX
point is about 30 Dow points). Rather, he would, for example, buy futures, buy OEX calls,
or sell puts on another index. At the end of the day, he could exercise the puts he bought
at a discount and reverse the hedge in the open market.
CONVERSIONS AND REVERSALS
Conversions and reversals in cash-based options are really the market basket hedges
(index arbitrage) described in Chapter 30. That is, the underlying security is actually all
the stocks in the index. However, the more standard conversions and reversals can be
executed with futures and futures options .
Since there is no credit to one's account for selling a future and no debit for buying
one, most futures conversions and reversals trade very nearly at a net price equal to the
strike. That is, the value of the out-of-the-money futures option is equal to the time pre-
mium of the in-the-money option that is its counterpart in the conversion or reversal.
Example: An index future is trading at 179.00. If the December 180 call is trading for
5.00, then the December 180 put should be priced near 6.00. The time value premium of
the in-the-money put is 5.00 (6.00 + 179.00 - 180.00), which is equal to the price of the
out-of-the-money call at the same strike.
If one were to attempt to do a conversion or reversal with these options, he would
have a position with no risk of loss but no possibility of gain: A reversal would he estab-
lished, for example, at a "net price" of 180. Sell the future at 179, add the premium of the
put, 6.00, and subtract the cost of the call, 5.00: 179 + 6.00 - ,5.00 = 180.00. As we know
from Chapter 27 on arbitrage, one unwinds a conversion or reversal for a "net price" equal
to the strike. Hence, there would be no gain or loss from this futures reversal.
For index futures options, there is no risk when the underlying closes near the strike,
since they settle for cash. One is not forced to make a choice as to whether to exercise his
calls. (See Chapter 27 on arbitrage for a description of risks at expiration when trading
reversals or conversions.)
In actual practice, floor traders may attempt to establish conversions in futures
options for small increments-perhaps 5 or 10 cents in S&P futures, for example. The
arbitrageur should note that futures options do actually create a credit or debit in the
account. That is, they are like stock options in that respect, even though the underlying
instrument is not. This means that if one is using a deep in-the-money option in the con-
version, there will actually be some carrying cost involved.
Example: An index future is trading at 179.00 and one is going to price the December
190 conversion, assuming that December expiration is 50 days away. Assume that the
current carrying cost of money is 10% annually. Finally, assume that the December 190
call is selling for 1.00, and the December 190 put is selling for 11.85. Note that the put
has a time value premium of only 85 cents, less than the premium of the call. The reason
for this is that one would have to pay a carrying cost to do the December 190 conversion.
If one established the 190 conversion, he would buy the futures (no credit or
debit to the account), buy the put (a debit of 11.85), and sell the call (a credit of 1.00).
Thus, the account actually incurs a debit of 10.85 from the options. The carrying cost for
10.8,5 at 10% for 50 days is 10.85 X 10% X 50/365 = 0.15. This indicates that the con-
verter is willing to pay 15 cents less time premium for the put (or conversely that the
reversal trader is willing to sell the put for 15 cents less time premium). Instead of the put
trading with a time value premium equal to the call price, the put will trade with a pre-
mium of 15 cents less. Thus, the time premium of the put is 85 cents, rather than being
equal to the price of the call, 1.00.
BOX SPREADS
Recall that a "box" consists of a bullish vertical spread involving two striking prices, and
a bearish vertical spread using the same two strikes. One spread is constructed with puts
and the other with calls. The profitability of the box is the same regardless of the price of
the underlying security at expiration.
Box arbitrage with equity options involves trying to buy the box for less than the
difference in the striking prices, for example, trying to buy a box in which the strikes are
,5points apart for 4.7,5. Selling the box for more than 5 points would represent arbitrage
Chapter
33:Mathematical
Considerations
as well. In fact. even selling the box at exactly .5 points would produce a profit for the
arbitrageur , since he earns interest on the credit from the sale.
These same strategies apply to options on futures. However, boxes on cash-based
options involve another consideration. It is often the case with cash-based options that the
box sells for more than the difference in the strikes. For example, a box in which the
strikes are 10 points apart might sell for 10..50, a substantial premium over the striking
price differential. The reason that this happens is because of the possibility of early assign-
ment. The seller of the box assumes that risk and, as a result, demands a higher price for
the box.
If he sells the box for half a point more than the striking price differential, then he
has a built-in cushion of ..50of index movement if he were to be assigned early. In.general,
box strategies are not particularly attractive. However, if the premium being paid for the
box is excessively high, then one should consider selling the box. Since there are four com-
missions involved, this is not normally a retail strategy.
MATHEMATICAL APPLICATIONS
The following material is intended to be a companion to Chapter 28 on mathematical

applications . Index options have a few unique properties that must be taken into account
when trying to predict their value via a model.
The Black-Scholes model is still the model of choice for options, even for index
options. Other models have been designed, but the Black-Scholes model seems to give
accurate results without the extreme complications of most of the other models.
FUTURES
Modeling the fair value of most futures contracts is a difficult task. The Black-Scholes
model is not usable for that task. Recall that we saw earlier that the fair value of a future
contract on an index could be calculated by computing the present value of the dividend
and also knowing the savings in carrying cost of the futures contract versus buying the
actual stocks in the index.
CASH-BASED INDEX OPTIONS
The futures fair value model for a capitalization-weighted index requires knowing the
exact dividend, dividend payment date, and capitalization of each stock in the index (for
price-weighted indices, the capitalization is unnecessary). This is the only way of getting
andFutures
the accurate dividend for use in the model. The same dividend calculation must be done
for any other index before the Black-Scholes formula can be applied.
In the actual model, the dividend for cash-based index options is used in much the
same way that dividends are used for stock options: The present value of the dividend is
subtracted from the index price and the model is evaluated using that adjusted stock price.
With stock options, there was a second alternative-shortening the time to expiration to
he equal to the ex-date-but that is not viable with index options since there are numer-
ous ex-dates.
Let's look at an example using the same fictional dividend information and index that
were used in Chapter 30 on stock index hedging strategies.
Example: Assume that we have a capitalization-weighted index composed of three stocks:

AAA, BBB, and CCC. The following table gives the pertinent information regarding the
dividends and floats of these three stocks:
Dividend Days
until
Stock Amount Dividend Float
AAA 1.00 35 50,000,000
BBB 0.25 60 35,000,000
CCC 0.60 8 120,000,000
Divisor:150,000,000
One first computes the present worth of each stock's dividend, multiplies that
amount Lythe float, and then divides by the index divisor. The sum of these computations
for each stock gives the total dividend for the index. The present worth of the dividend
for this index is $0.8667.
Assume that the index is currently trading at 17,5.63 and that we want to evaluate
the theoretical value of the July 17.5call. Then, using the Black-Scholes model, we would
perform the following calculations:
1. Subtract the present worth of the dividend, 0.8667, from the current index price of
175.63, giving an adjusted index price of 174.7633.
2. EYalnate the call's fair value using 174.76,33as the stock price. All other variables are
as they are for stocks, including the risk-free interest rate at its actual value (10%, for
example).
The theoretical Yalue for puts is computed in the same way as for equity options, by
11sing the arbitrage model. This is sufficient for cash-based index options because it is
Chapter
33:Mathematical
Considerations
possible-albeit difficult-to hedge these options by buying or selling the entire index.
Thus, the options should reflect the potential for such arbitrage. The put value should, of
course, reflect the potential for dividend arbitrage with the index. The arbitrage valuation
model presented in Chapter 28 on modeling called for the dividend to be used. For these
inde x puts, one would use the present worth of the dividend on the index-the same one
that was used for the call valuation, as in the last example.
THE IMPLIED DIVIDEND
If one does not have access to all of the dividend information necessary to make the
"present worth of the dividends" calculation (i.e., if he is a private individual or public
customer who does not subscribe to a computer-based dividend "service"), there is still a
way to estimate the present worth of the dividend. All one need do is make the assump-
tion that the market-makers know what the present worth of the dividend is, and are thus
pricing the options accordingly. The individual public customer can use this information
to deduce what the dividend is.
Example: SPX is trading at 1400, the June options have 30 days of life remaining, the
short -term interest rate is 10%, and the following prices exist:
June 1400 call: 38.00

June 1400 put: 30.00
One can use iterations of the Black-Scholes model to determine what the SPX '"divi-
dend" is. In this case , it turns out to be something on the order of $2.50
Briefly, these are the steps that one would need to follow in order to determine this
dividend:
1. Assume the dividend is $0.00.

2. Using the assumed dividend, use the Black-Scholes model to determine the implied
volatility of the call option, whose price is known (38.00 in the above example).
3. Using the implied volatility determined from step 2 and the assumed dividend, is the
arbitrage put value as derived from the Black-Scholes calculations at the end of step 2
roughly equal to the market value of the put (30.00 in the above example)'? If yes, you
are done. If not, increase the assumed dividend by some nominal amount, say $0.10,
and return to step 2.
Thus, without having access to complete dividend information, one can use tlw
information provided to him by the marketplace in order to imply the dividend of an
andFutures
index option. The only assumption one makes is that the market-makers know what the
dividend is (they most assuredly do). Note that the implied volatility of the options is
determined concurrently with the implied dividend (step 2 above). A very useful tool, this
simple "implied dividend calculator" can be added to any software that employs the
Black-Scholes model.
'EUROPEA EXERCISE
To account for European exercise, one basically ignores the fact that an in-the-money put
option's minimum value is its intrinsic value. European exercise puts can trade at a dis-
count to intrinsic value. Consider the situation from the viewpoint of a conversion arbi-
trage. If one buys stock, buys puts, and sells calls , he has a conversion arbitrage. In the
case of a European exercise option, he is forced to carry the position to expiration in order
to remove it: He cannot exercise early, nor can he be called early. Therefore , his carrying
costs will always be the maximum value to expiration. These carrying costs are the
amou nt of the discount of th e put value.
For a deeply in-the-money put, the discount will be equal to the carrying charges
required to carry th e stri king price to expiration :
Less deeply in-the-money puts, that is, those with deltas less than -1.00, would not
require the full discounting factor. Rather, one could multiply the discounting factor by
the absolute value of the put's delta to arrive at the appropriate discounting factor.
FUTURES OPTIONS
A modified Black-Scholes model, called the Black Model, can be used to evaluate futures
options . See Chapter 29 on futures for a futures discussion. Essentially, the adjustment is
as follows: Use 0% as the risk-free rate in the Black-Scholes model and obtain a theoreti-
cal call value; th en disco unt th at result.
Black model:
Call value = e -rt X Black-S chole s call valu e [using r = 0%]
where
r is the risk-free interest rate
and t is the time to expira tion in years.
Chapter
33:Mathematical
Considerations
The relationship between a futures call theoretical value and that of a put can also
be discussed from th e model :
Call = Put + e -rt if - s)
where
f is th e futu res pr ice
and s is the str iking price .
ZYX Cash Index : 174.49

ZYX December future : 177.00
There are 80 days remaining until expiration, the volatility of ZYX is 15%, and the
risk-free intere st rate is 6%.
In order to evaluate the theoretical value of a ZYX December 18,5call, the following
steps would be taken :
1. Evaluate the regular Black-Scholes model using 185 as the strike, 177.00as the stock
price, LS% as the volatility, 0.22 as the time remaining (80/36,5),and 0% as the inter-
est rate . Note that the futures price, not the index price, is input to the model as stock
price .
Suppose that thi s yields a result of 2.05.
2. Discount the result from step 1:
Black Model call value = e-co 6

xo.zzJX 2.05
= 2.02
In this case, the difference between the Black model and the Black-Scholes model
is small (:3cents). However, the discounting factor can be large for longer-term or deeply
in-the-money options .
The other items of a mathematical nature that were discussed in Chapter 28 on
mathematical applications are applicable, without change , to index options. Expected
return and implied volatility have the same meaning. Implied volatility can be calculated
by using the Black- Scholes formulas as specified above.
Neutral positioning retains its meaning as well. Recall that any of the above theoreti-
cal value computations gives the delta of the option as a by-product. These deltas can he
used for cash-based and futures options just as they are used for stock options to maintain
a neutral position. This is done, of course, by calculating the equivalent stock position (or
equivalent "inde x" or "futur es" position, in these cases).
FOLLOW-UP ACTION
The various types of follow-up action that were applicable to stock options are available
for index options as well. In fact, when one has spread options on the same underlying
index, these actions are virtually the same. However, when one is doing inter-index
spreads, there is another type of follow-up picture that is useful. The reason for this is
that the spread will have different outcomes not only based on the price of one index, but
also based on that index's relationship to the other index.
It is possible, for example, that a mildly bullish strategy implemented as an inter-index
spread might actually lose money even if one index rose. This could happen if the other
index performed in a manner that was not desirable. If one could have his computer
"draw" a picture of several different outcomes, he would have a better idea of the profit
potential of his strategy.
Example: Assume a put spread between the ZYX and the ABX indices was established.
An ABX June 180 put was bought at 3.00 and a ZYX June 17.5put was sold at 3.00, when
the ZYX was at 17,5.00and the ABX Index was at 178.00. This spread will obviously have
different outcomes if the prices of the ZYX and the ABX move in dramatically different
patterns .
On the surface, this wonld appear to be a bearish position-long a put at a higher
strike and short a put at a lower strike. However, the position could make money even in
a rising market if the indices move appropriately: If, at expiration, the ZYX and ABX are
both at 179.00, for example, then the short option expires worthless and the long option
is still worth 1.00. This would mean that a 1-point profit, or $.500, was made in the spread
($1,500 profit on the short ZYX puts less a $1,000 loss on the one ABX put).
Conversely, a downward movement doesn't guarantee profits either. If the ZYX falls
to 170.00 while the ABX declines to 175.00, then both puts would be worth .5at expiration
and there would be no gain or loss in the spread.
\Vhat the strategist needs in order to better understand his position is a "sliding scale"
picture. That is, most follow-up pictures give the outcome (say, at expiration) of the posi-
tion at various stock or index prices. That is still needed: One would want to see the
outcome for ZYX prices of, say, 165 up to 18.5 in the example. However, in this spread
Chapter
33:Mathematical
Considerations
somethin g else is needed: The outcome shonld also take into account how the ZYX
matches up with the ABX. Thus, one might need three (or more) tables of outcomes, each
of which depicts the results as ZYX ranges from 16.5 up to 18.5at expiration. One might
first show how the results would look if ZYX were, say, .5points below ABX; then another
table would show ZYX and ABX unchanged from their original relationship (a :3-point
differential); finall_\',another table would show the results if ZYX and ABX were equal at
expiration.
If the relationship between the two indices were at :3points at expiration, such a
table might look like this:
Price
at Expiration
ZYX 165 170 175 180 185
ABX 168 173 178 183 188
ZYXJune 175P 10 5 0 0 0
ABXJune 180P 12 7 2 0 0
Profit +$1,000 +$1,000 +$1,000 0 0
This picture indicates that the position is neutral to bearish, since it makes money
even if the indices are unchanged. However, contrast this with the situation in which the
ZYX falls to a level .5points below the ABX by expiration.
Price
at Expiration
ZYX 165 170 175 180 185
ABX 170 175 180 185 190
ZYXJune 175P 10 5 0 0 0
ABXJune 180P 10 5 0 0 0
Profit 0 0 0 0 0
In this case , the spread has no potential for profit at all, even if the market collapses.
Thus, even a bearish spread like this might not prove profitable if there is an adverse
movement in the relationship of the indices .
Finally , observe what happens if the ZYX rallies so strongly that it catches up to the
ABX .
ofExpiration
Price
ZYX 165 170 175 180 185
ABX 165 170 175 180 185
ZYXJune175P 10 5 0 0 0
ABXJune180P 15 10 5 0 0
Profit +$2,500 +$2,500 +$2,500 +$2,500 +$2,500
These tables can be called "sliding scale" tables, because what one is actually doing
is showing a different set of results by sliding the ABX scale over slightly each time while
keeping the ZYX scale fixed. Note that in the above two tables, the ZYX results are
unchanged , but the ABX has been slid over slightly to show a different result. Tables like
this are necessary for the strategist who is doing spreads in options with different underly-
ing indices or is trading inter-index spreads .
The astute reader will notice that the above example can be generalized by drawing a
three-dimensional graph. The X axis would be the price of ZYX; the Y axis would be the
dollars of profit in the spread; and instead of "sliding scales," the Z axis would be the price of
A BX. There is software that can draw 3-dimensional profit graphs, although they are some-
what difficult to read. The previous tables would then be horizontal planes of the
three-dimensional graph.
This concludes the chapter on riskless arbitrage and mathematical modeling. Recall
that arbitrage in stock options can affect stock prices. The arbitrage techniques outlined
here do not affect the indices themselves. That is done by the market basket hedges. It
was also known that no new models are necessary for evaluation. For index options, one
merely has to properly evaluate the dividend for usage in the standard Black-Scholes
model. Future options can be evaluated by setting the risk-free interest rate to 0% in the
Black-Scholes model and discounting the result, which is the Black model.
Futures and Futures Options
In the previous chapters on index trading, a particular type of futures option-the index
option-was described in some detail. In this chapter, some background information on
futures themselves is spelled out, and then the broad category of futures options is inves-
tigated. In recent years, options have been listed on many types of futures as well as on
some physical entities. These include options on things as diverse as gold futures and
cattle futures, as well as options on currency and bond futures.
Much of the information in this chapter is concerned with describing the ways
that futures options are similar to, or different from, ordinary equity and index options.
There are certain strategies that can be developed specifically for futures options as well.
However , it should be noted that once one understands an option strategy, it is generally
applicable no matter what the underlying instrument is. That is, a bull spread in gold
options entails the same general risks and rewards as does a bull spread in any stock's
options-limited downside risk and limited upside profit potential. The gold bull spread
would make its maximum profit if gold futures were above the higher strike of the spread
at expiration, just as an equity option bull spread would do if the stock were above the
higher strike at expiration. Consequently, it would be a waste of time and space to go over
the same strategies again, substituting soybeans or orange juice futures, say, for XYZ stock
in all the examples that have been given in the previous chapters of this book. Rather, the
concentration will be on areas where there is truly a new or different strategy that futures
options provide.
Before beginning, it should be pointed out that futures contracts and futures options
have far less standardization than equity or index options do. Most futures trade in differ-
ent units. Most options have different expiration months, expiration times, and striking
price intervals. All the different contract specifications are not spelled out here. One
should contact his broker or the exchange where the contracts are traded in order to
611
receive complete details. However, whenever examples are used , full details of the con-
tracts used in those examples are given.
FUTURES CONTRACTS
Before getting into options on futures , a few words about futures contracts themselves
may prove beneficial. Recall that a futures contract is a standardized contract calling for
the delivery of a specified quantity of a certain commodity at some future time. Future
contracts are listed on a wide variety of commodities and financial instruments. In some
cases, one must make or take delivery of a specific quantity of a physical commodity
(50,000 bushels of soybeans, for example). These are known as futures on physicals. In
others, the futures settle for cash as do the S&P 500 Index futures described in a previous
chapter; there are other futures that have this same feature (Volatility Index [VIX]futures ,
for example). These types of futures are cash-based, or cash settlement, futures.
In terms of tot al numbers of contracts listed on the various exchanges, the more
common type of futures contract is one with a physical commodity underlying it. These
are sometimes broken down into subcategories, such as agricultural futures (those on
soybeans, oats, coffee, or orange juice) and financial futures (those on U.S. Treasury
bonds, bills, and notes).
Traders not familiar with futures sometimes get them confused with options. There
really is very little resemblance between futures and options. Think of futures as stock
with an expiration date.
That is, future s contracts can rise dramatically in price and can fall all the way to
nearly zero (theoretically), just as the price of a stock can. Thus, there is great potential
for risk. Conversely, with ownership of an option, risk is limited. The only real similarity
between futures and options is that both have an expiration date. In reality, futures behave
much like stock and the novice should understand that concept befor e moving on.
HEDGING
The primary economic function of futures markets is hedging-taking a futures position

to offset the risk of actually owning the physical commodity. The physical commodity or
financial instrument is known as the "cash." For index futures, this hedging was designed
to remove the risk from owning stocks (the "cash market" that underlines index futures ).
A portfolio manager who owned a large quantity of stocks could sell index futures against
the stock to remove much of the price risk of that stock ownership. Moreover, he is able
to establish that hedge at a much smaller commission cost and with much less work than
Chapter
34:Futures
andFutures
Options 613
would be required to sell thousands of shares of stock. Similar thinking applies to all the
cash markets that underlie futures contracts. The ability to hedge is important for people
who must deal in the "cash,, market, because it gives them price protection as well as
allowing them to be more efficient in their pricing and profitability. A general example
may be useful to demonstrate the hedging concept.
Example: An international businessman based in the United States obtains a large con-
tract to supply a Swiss manufacturer. The manufacturer wishes to pay in Swiss francs, but
the payment is not due until the goods are delivered six months from now. The U.S. busi-
nessman is obviously delighted to have the contract, but perhaps is not so delighted to
have the contract paid in francs six months from now. If the U.S. dollar becomes stronger
relative to the Swiss franc, the U.S. businessman will be receiving Swiss francs which will
be worth fewer dollars for his contract than he originally thought he would. In fact, if he
is working on a narrow profit margin, he might even suffer a loss if the Swiss franc becomes
too weak with respect to the dollar.
A futures contract on the Swiss franc may be appropriate for the U.S. businessman.
He is "long" Swiss francs via his contract (that is, he will get francs in six months, so he is
exposed to their fluctuations during that time). He might sell short a Swiss franc futures
contract that expires in six months in order to lock in his current profit margin. Once he
sells the future , he locks in a profit no matter what happens.
The future's profit and loss are measured in dollars since it trades on a U.S. exchange.
If the Swiss franc becomes stronger over the six-month period, he will lose money on the
futures sale, but will receive more dollars for the sale of his products. Conversely, if
the franc becomes weak, he will receive fewer dollars from the Swiss businessman, but
his futures contract sale will show a profit. In either case, the futures contract enables him
to lock in a future price (hence the name "futures") that is profitable to him at today's
level.
The reader should note that there are certain specific factors that the hedger must
take into consideration. Recall that the hedger of stocks faces possible problems when he
sells futures to hedge his stock portfolio. First, there is the problem of selling futures below
their fair value; changes in interest rates or dividend payouts can affect the hedge as well.
The U.S. businessman who is attempting to hedge his Swiss francs may face similar prob-
lems . Certain items such as short-term interest rates, which affect the cost of carry, and
other factors may cause the Swiss franc futures to trade at a premium or discount to the
cash price. That is, there is not necessarily a complete one-to-one relationship between the
futures price and the cash price. However , the point is that the businessman is able to
substantially reduce the currency risk, since in six months there could he a large change in
andFutures
the relationship between the U.S. dollar and the Swiss franc. While his hedge might not
eliminate every bit of the risk, it will certainly get rid of a very large portion of it.
SPECULATING
While the hedgers provide the economic function of futures, speculators provide the
liquidity. The attraction for speculators is leverage. One is able to trade futures with very
little margin. Thus, large percentages of profits and losses are possible.
Example: A futures contract on cotton is for 50,000 pounds of cotton. Assume the March
cotton h1ture is trading at 60 (that is, 60 cents per pound). Thus, one is controlling $30,000
worth of cotton by owning this contract ($0.60 per pound X 50,000 pounds). However,
assume the exchange minimum margin is $1,500. That is, one has to initially have only
$1,500 to trade this contract. This means that one can trade cotton on 5% margin
($1,500/$30,000 = 5%).
What is the profit or risk potential here? A one-cent move in cotton, from 60 to 61,
would generate a profit of $.500. One can always determine what a one-cent move is worth
as long as he knows the contract size. For cotton, the size is 50,000 pounds, so a one-cent
move is 0.01 X 50,000 = $500.
Consequently, if cotton were to fall three cents, from 60 to ,57,this speculator would
lose 3 X $500, or $1,.500-his entire initial investment. Alternatively, a 3-cent move to the
upside would generate a profit of $1,500, a 100% profit.
This example clearly demonstrates the large risks and rewards facing a speculator in
futures contracts. Certain brokerage firms may require the speculator to place more ini-
tial margin than the exchange minimum. Usually, the most active customers who have a
sufficient net worth are allowed to trade at the exchange minimum margins; other cus-
tomers may have to put up two or three times as much initial margin in order to trade.
This still allows for a lot of leverage, but not as much as the speculator has who is trading
with exchange minimum margins. Initial margin requirements can be in the form of cash
or Treasury bills. Obviously, if one uses Treasury bills to satisfy his initial margin require-
ments, he can be earning interest on that money while it serves as collateral for his initial
margin requirements. If he uses cash for the initial requirement, he will not earn interest.
(:--Jote:Some large customers do earn credit on the cash used for margin requirements in
their futures accounts, but most customers do not.)
A speculator will also be required to keep his account current daily through the use
of maintenance margin. His account is marked to market daily, so unrealized gains and
losses art' taken into account as well as are realized ones. If his account loses monev, he
must add casli into the account or sell out some of his Treasury bills in order to cover the
Chapter34:Futures
andFutures"
Options 615
loss, on a daily basis. However, if he makes money, that unrealized profit is available to be
withdrawn or used for another investment.
Example: The cotton speculator from the previous example sees the price of the March
cotton futures contract he owns fall from 60.00 to 59.20 on the first day he owns it. This
means there is a $400 unrealized loss in his account, since his holding went down in price
by 0.80 cents and a one-cent move is worth $500. He must add $400 to his account, or
sell out $400 worth of T-bills.
The next day, rumors of a drought in the growing areas send cotton prices much
higher. The March future closes at 60.90, up 1.70 from the previous day's close. That
represents a gain of $850 on the day. The entire $850 could be withdrawn, or used as
initial margin for another futures contract, or transferred to one's stock market account
to be used to purchase another investment there.
Without speculators, a futures contract would not be successful, for the speculators
provide liquidity. Volatility attracts speculators. If the contract is not trading and open
interest is small, the contract may be delisted. The various futures exchanges can delist
futures just as stocks can be delisted by the New York Stock Exchange. However, when
stocks are delisted, they merely trade over-the-counter, since the corporation itself still
exists. When futures are delisted, they disappear-there is no over-the-counter futures
market. Futures exchanges are generally more aggressive in listing new products, and
delisting them if necessary , than are stock exchanges.
TERMS
Futures contracts have certain standardized terms associated with them. However,
trading in each separate commodity is like trading an entirely different product. The
standardized terms for soybeans are completely different from those for cocoa, for exam-
ple, as might well be expected. The size of the contract (50,000 pounds in the cotton
example) is often based on the historical size of a commodity delivered to market; at other
times it is merely a contrived number ($100,000 face amount of U.S. Treasury bonds, for
example).
Also, futures contracts have expiration dates. For some commodities (for example,
crude oil and its products, heating oil and unleaded gasoline), there is a futures contract
for every month of the year. Other commodities may have expirations in only .5 or 6 cal-
endar months of the year. These items are listed along with the quotes in a good financial
newspaper , so they are not difficult to discover.
The number of expiration months listed at any one time varies from one market to
another. Eurodollars, for example, have futures contracts with expiration dates that extend
up to ten years in the future. T-bond and 10-year note contracts have expiration dates for
only about the next year or so. Soybean futures, on the other hand, have expirations going
out about two years , as do S&P futures.
The day of the expiration month on which trading ceases is different for each
commodity as well. It is not standardized, as the third Friday is for stock and index
options .
Trading hours are different, even for different commodities listed on the same
futures exchange. For example, U.S. Treasury bond futures, which are listed on the Chi-
cago Board of Trade, have very long trading hours (currently 8:20 a.m. to .3p.m. and also
7 p.m. to 10:,'30p.m. every day, Eastern time). But, on the same exchange, soybean futures
trade a very short day (10:30 a.m. to 2:15 p.m., Eastern time). Some markets alter their
trading hours occasionally, while others have been fixed for years. For example, as the
foreign demand for U.S. Treasury bond futures increases, the trading hours might expand
even further. However, the grain markets have been using these trading hours for decades,
and there is little reason to expect them to change in the future .
Units of trading vary for different futures contracts as well. Grain futures trade in
eighths of a point, .30-year bond futures trade in thirty-seconds of a point, while the S&P
,500 futures trade in 10-cent increments (0.10). Again, it is the responsibility of the trader
to familiarize himself with the units of trading in the futures market if he is going to be
trading there .
Each futures contract has its own margin requirements as well. These conform to
the type of margin that was described with respect to the cotton example above: An initial
margin may be advanced in the form of collateral, and then daily mark-to-market price
movements are paid for in cash or by selling some of the collateral. Recall that mainte-
nance margin is the term for the daily mark to market.
Finally , futures are subject to position lim its. This is to prevent any one entity
from attempting to corner the market in a particular delivery month of a commodity. Dif-
ferent futures have different position limits. This is normally only of interest to hedgers or
very large speculators. The exchange where the futures trade establishes the position
limit.
TRADING LIMITS
Most futures contracts have some limit on their maximum daily price change. For index
futures, it was shown that the limits are designed to act like circuit breakers to prevent
the stock market from crashing. Trading limits exist in many futures contracts in order to
help ensure that the market cannot be manipulated by someone forcing the price to move
tremendously in one direction or the other. Another reason for having trading limits is
Chapter
34:Futures
andFutures
Options 617
ostensibly to allow only a fixed movc->,approximately c->qualto or slightly less than the
amount covered by the initial margin requirement, so that maintenance margin can be
collected if need be. However, limits have been applied to all futures, some of which don't
really seem to warrant a limit-U.S. Treasury bonds, for example. The bond issue is too
large to manipulate, and there is a liquid '"cash" bond market to hedge with.
Regardless, limits are a fact of life in futures trading. Each individual commodity
has its own limits, and those limits may change depending on how the exchange views
the volatility of that commodity. For example, when gold was trading wildly at a price of
more than $700 per ounce, gold futures had a larger daily trading limit than they do
at more stable levels of $300 to $400 an ounce (the current limit is a $1.5move per day).
If a commodity reaches its limit repeatedly for two or three days in a row, the exchange
will usually increase the limit to allow for more price movement. The Chicago Board of
Trade automatically increases limits by 50% if a futures contract trades at the limit three
days in a row.
Whenever limits exist there is always the possibility that they can totally destroy
the liquidity of a market. The actual commodity underlying the futures contract is called
the "spot" and trades at the "spot price." The spot trades without a limit, of course.
Thus, it is possible that the spot commodity can increase in price tremendously while the
futures contract can only advance the daily limit each day. This scenario means that
the futures could trade "up or down the limit" for a number of days in a row. As a conse-
quence, no one would want to sell the futures if they were trading up the limit, since the
spot was much higher. In those cases there is no trading in the futures-they are merely
quoted as bid up the limit and no trades take place. This is disastrous for short sellers.
They may be wiped out without ever having the chance to close out their positions. This
sometimes happens to orange juice futures when an unexpected severe freeze hits Flor-
ida. Options can help alleviate the illiquidity caused by limit moves. That topic is covered
later in this chapter.
Dl:IJVERY
Futures on physical commodities can be assigned, much like stock options can be
assigned. When a futures contract is assigned, the buyer of the contract is called upon to
receive the full contract. Delivery is at the seller's option, meaning that the owner of the
contract is informed that he must take delivery. Thus, if a corn contract is assigned, one
is forced to receive ,5,000 bushels of corn. The old adage about this being dumped in your
yard is untrue. One merely receives a warehouse receipt and is charged for storage. His
broker makes the actual arrangements. Futures contracts cannot he assigned at any time
during their life, as options can. Rather, there is a short period of time before they expire
618 andFutures
PartV:IndexOptions
during which one can take delivery. This is generally a 4- to 6-week period and is called
the "notice period"-the time during which one can be notified to accept delivery. The
first day upon which the futures contract may be assigned is called the "first notice day,"
for logical reasons. Speculators close out their positions before the first notice day, leaving
the rest of the trading up to the hedgers. Such considerations are not necessary for
cash-based futures contracts (the index futures), since there is no physical commodity
involved.
It is always possible to make a mistake , of course, and receive an assignment when
you didn't intend to. Your broker will normally be able to reverse the trade for you, but it
will cost you the warehouse fees and generally at least one commission.
The terms of the futures contract specify exactly what quantity of the commodity
must be delivered, and also specify what form it must be in. Normally this is straight-
forward, as is the case with gold futures: That contract calls for delivery of 100 troy
ounces of gold that is at least 0.995 fine, cast either in one bar or in three one-kilogram
bars.
However, in some cases, the commodity necessary for delivery is more complicated,
as is the case with Treasury bond futures. The futures contract is stated in terms of a
nominal 8% interest rate. However, at any time , it is likely that the prevailing interest rate
for long-term Treasury bonds will not be 8%. Therefore, the delivery terms of the futures
contract allow for delivery of bonds with other interest rates .
Notice that the delivery is at the seller's option. Thus, if one is short the futures and
doesn't realize that first notice day has passed, he has no problem, for delivery is under
his control. It is only those traders holding long futures who may receive a surprise deliv-
ery notice.
One must be familiar with the specific terms of the contract and its methods of
delivery if he expects to deal in the physical commodity. Such details on each futures
contract are readily available from both the exchange and one's broker. However, most
futures traders never receive or deliver the physical commodity; they close out their
futures contracts before the time at which they can be called upon to make delivery.
PRICING OF FUTURES
It is beyond the scope of this book to describe futures arbitrage versus the cash commod-
ity. Suffice it to say that this arbitrage is done, more in some markets (U.S. Treasury
bonds, for example) than others (soybeans). Therefore, futures can be overpriced or
unclerpriced as well. The arbitrage possibilities would be calculated in a manner similar
to that described for index futures, the futures premium versus cash being the determin-
ing factor.
Chapter
34:Futures
andFutures
Options 619
OPTIONS ON FUTURES
The reader is somewhat familiar with options on futures, having seen many examples of
index futures options. The commercial use of the option is to lock in a worst-case price as
opposed to a future price. The U.S. businessman from the earlier example sold Swiss
franc futures to lock in a future price. However, he might decide instead to buy Swiss
franc futures put options to hedge his downside risk, but still leave room for upside profits
if the currency markets move in his favor.
DESCRIPTION
A futures option is an option on the futures contract, not on the cash commodity. Thus,
if one exercises or assigns a futures option, he buys or sells the futures contract. The
options are always for one contract of the underlying commodity. Splits and adjustments
do not apply in the futures markets as they do for stock options. Futures options generally
trade in the same denominations as the future itself (there are a few exceptions to this
rule , such as the T-bond options, which trade in sixty-fourths while the futures trade in
thirty-seconds).
Example: Soybean options will be used to illustrate the above features of futures options.
Suppose that March soybeans are selling at 575.
Soybean quotes are in cents. Thus, 575 is $5.75-soybeans cost $5.75 per bushel. A
soybean contract is for 5,000 bushels of soybeans, so a one-cent move is worth $50
(5,000X .01).
Suppose the following option prices exist. The dollar cost of the options is also shown
(one cent is worth $50).
Option Price Dollar

Cost
March 525 put 5 $ 250
March 550 call 35½ $1,775
March 600 call 8¼ $ 412.50
The actual dollar cost is not necessary for the option strategist to determine the
profitability of a certain strategy. For example, if one buys the March 600 call, he needs
March soybean futures to be trading at 608.25 or higher at expiration in order to have a
profit at that time. This is the normal way in which a call buyer views his break-even point
at expiration: strike price plus cost of the call. It is not necessary to know that soybean
options are worth $,50 per point in order to know that 608.2.S is the break-even price at
expiration.
If the future is a cash settlement future (Eurodollar, S&P .500, and other indices),
then the options and futures generally expire simultaneously at the end of trading on the
last trading day. (Actually, the S&P's expire on the next morning's opening.) However,
options on physical futures will expire before the first notice day of the actual futures
contract, in order to give traders time to close out their positions before receiving a deliv-
ery notice. The fact that the option expires in advance of the expiration of the underlying
future has a slightly odd effect: The option often expires in the month preceding the
month used to describe it.
Example: Options on March soybean futures are referred to as "March options." They
do not actually expire in March-however, the soybean futures do.
The rather arcane definition of the last trading day for soybean options is "the last
Friday preceding the last business day of the month prior to the contract month by at least
.Sbusiness days"!
Thus, the March soybean options actually expire in February. Assume that the last
Friday of February is the 2.3rd. If there is no holiday during the business week of February
19th to 23rd, then the soybean options will expire on Friday, February 16th, which is .S
business days before the last Friday of February.
However, if President's Day happened to fall on Monday, February 19th, then there
would only be four business days during the week of the 19th to the 23rd, so the options
would have to expire one Friday earlier, on February 9th.
Not too simple, right? The best thing to do is to have a futures and options expiration
calendar that one can refer to. Futures Maga;::,inepublishes a yearly calendar in its Decem-
ber issue, annually, as well as monthly calendars which are published each month of the
:'ear. Alternatively, your broker should be able to provide you with the information. The
website of the appropriate exchange where the futures trade has all the information
regarding expiration dates for futures and options.
In any case, the March soybean futures options expire in February, well in advance
of the first notice day for March soybeans, which is the last business day of the month
preceding the expiration month (February 28th in this case). The futures option trader
must be careful not to assume that there is a long time between option expiration and first
notice clay of the futures contract. In certain commodities, the futures first notice day is
the day after the options expire (live cattle futures, for example).
Tims, ~fone is long calls or short puts and, therefore, acquires a long futures con-
t met ria exercise' or assignment, respccticely, he should be aware of when the first notice
Chapter
34:Futures
andFutures
Options 621
day <f the fut11res is; he could receii;c o delii;cry notice 011his lo11gf11tures7Jositim1 1me:x-
pectedly if he is not paying attention.
OTHERTERMS
Striking Price Intervals. Just as futures 011differing physical commodities have dif-
fering terms, so do options on those futures. Striking price intervals are a prime example.
Some options have striking prices ,5 points apart, while others have strikes only 1 point
apart, reflecting the volatility of the futures contract. Specifically, S&P ,500 options have
striking prices .Spoints apart, while soybean options striking prices are 2.5 points (2.5cents)
apart, and gold options are 10 points ($10) apart. Moreover, as is often the case with stocks,
the striking price differential for a particular commodity may change if the price of the
commodity itself is vastly different.
Example: Gold is quoted in dollars per ounce. Depending on the price of the futures
contract, the striking price interval may be changed. The current rules are:
Striking
Price
Interval Price
ofFutures
$10 below $500/oz.
$20 between $500 and $1,000/oz.
$50 above $1,000/oz.
Thus, when gold futures are more expensive, the striking prices are further apart.
Note that gold has never traded above $1,000/oz., hut the option exchanges are all set if
it does.
This variability in the striking prices is common for many commodities. In fact, some
commodities alter the striking price interval depending on how much time is remaining
until expiration, possibly in addition to the actual prices of the futures themselves.
Realizing that the striking price intervals may change-that is, that new strikes will he
added when the contract nears maturity-may help to plan some strategies, as it will give
more choices to the strategist as to which options he can use to hedge or adjust his position.
Automatic Exercise. All futures options are subject to automatic exercise as are stock
options. In general, a futures option will be exercised automatically, even if it is one tick
in the money. You can give instructions to not have a futures option automatically exer-
cised if you wish.
SERIAL OPTIONS
Serial options are futures options whose expiration month is not the same as the expira-
tion month of their corresponding underlying futures.
Example: Gold futures expire in February, April, June, August, October, and December.
There are options that expire in those months as well. Notice that these expirations are
spaced two months apart. Thus, when one gold contract expires, there are two months
remaining until the next one expires.
Most option traders recognize that the heaviest activity in an option series is in the
nearest-term option. If the nearest-term option has two months remaining until expira-
tion, it will not draw the trading interest that a shorter-term option wou ld .
Recognizing this fact, the exchange has decided that in addition to the regular
expiration, there will be an option contract that expires in the nearest non-cycle month,
that is, in the nearest month that does not have an actual gold future expiring. So, if it
were currently January 1, there might be gold options expiring in February, March,
April, etc .
Thus, the March option would be a serial option. There is no actual March gold
future . Rather, the March options would be exercisable into April futures.
Serial options are exercisable into the nearest actual futures contract that exists after
the options' expiration date. The number of serial option expirations depends on the
underlying commodity. For example, gold will always have at least one serial option trad-
ing, per the definition highlighted in the example above. Certain futures whose expira-
tions are three months apart (S&P 500 and all currency options) have serial options for
the nearest two months that are not represented by an actual futures contract. Sugar,
on the other hand, has only one serial option expiration per year-in December-to span
the gap that exists between the normal October and March sugar futures expirations.
Strategists trading in options that may have serial expirations should be careful in
how they evaluate their strategies. For example, June S&P 500 futures options strategies
can be planned with respect to where the underlying S&P 500 Index of stocks will be at
expiration, for the June options are exercisable into the June futures, which settle at the
same price as the Index itself on the last day of trading. However, if one is trading April
S&P 500 options, he must plan his strategy on where the June futures contract is going to
be trading at April expiration. The April options are exercisable into the June futures at
April expiration. Since the June futures contract will still have some time premium in it
in April, the strategist cannot plan his strategy with respect to where the actual S&P ,500
Inde x will be in April.
Chapter
34: Futures
andFutures.Options 623
Example: The S&P 500 Stock Index (symbol SPX) is trading at 1410.,50. The following
prices exist:
Options
Cash (SPX):1410.50 April 1415 call: 5.00
June futures: 1415.00 June 1415 call: 10.00
If one buys the June 1415 call for 10.00, he knows that the SPX Index will have to
rise to 1425.00 in order for his call purchase to break even at June expiration. Since the
SPX is currently at 1410.50, a rise of 14.50 by the cash index itself will be necessary for
break -even at June expiration.
However, a similar analysis will not work for calculating the break-even price for the
April 1415 call at April expiration. Since 5.00 points are being paid for the 1415 call, the
break-even at April expiration is 1420. But exactly what needs to be at 1420? The June
future , since that is what the April calls are exercisable into.
Currently, the June futures are trading at a premium of 4.50 to the cash index
(1415.00 - 1410.50). However, by April expiration, the fair value of that premium will have
shrunk. Suppose that fair value is projected to be 3.50 premium at April expiration. Then
the SPX would have to be at 1416.50 in order for the June futures to be fairly valued at
1420.00 (1416.50 + 3.50 = 1420.00).
Consequently, the SPX cash index would have to rise 6 points, from 1410.50 to
1416.50, in order for the June futures to trade at 1420 at April expiration. If this happened,
the April 1415 call purchase would break even at expiration.
Quote symbols for futures options have improved greatly over the years. Most ven-
dors use the convenient method of stating the striking price as a numeric number. The
only "code" that is required is that of the expiration month. The codes for futures and
futures options expiration months are shown in Table 34-1. Thus, a March (2002) soybean
600 call would use a symbol that is something like SH2C600, where S is the symbol for
soybeans, H is the symbol for March, 2 means 2002, C stands for call option, and 600 is
the striking price. This is a lot simpler and more flexible than stock options. There is no
need for assigning striking prices to letters of the alphabet, as stocks do, to everyone's
great consternation and confusion. ·
Bid-Offer Spread. The actual markets-bids and offers-for most futures options are
not generally available from quote vendors (options traded on the Chicago Mere are usu-
ally a pleasant exception). The same is true for futures contracts themselves. One can
TABLE 34-1.
Month symbols for futures or futures options.
Options
orFutures
Futures Symbol
Month
Month
Expiration
January F
February G
March H
April J
May K
June M
July N
August Q
September u
October V
November X
December z
always request a market from the trading floor, but that is a time-consuming process and
is impractical if one is attempting to analyze a large number of options. Strategists who
are used to dealing in stock or index options will find this to be a major inconvenience.
The situation has persisted for years and shows no sign of improving.
Commissions. Futures traders generally pay a commission only on the closing side of
a trad e. If a speculator first buys gold futures, he pays no commission at that time. Later,
when he sells what he is long-closes his position-he is charged a commission. This is
referred to as a "round-tum" commission, for obvious reasons. Many futures brokerage
firms treat future options the same way-with a round-tum commission. Stock option
trad ers are used to paying a commission on every buy and sell, and there are still a few
futures option brokers who treat futures options that way, too. This is an important dif-
ference . Consider the following example.
Example: A futures option trader has Leen paying a commission of $1.5per side-that is,
he pays a commission of $1.5per contract each time he buys and sells. His broker informs
him one clay that they are going to charge hi1n $30 per round turn, payable up front,
rather than $1.5per side. That is the way most futures option brokerage firms charge their
con1111issionsthese days. Is this the same thing, $1.5per side or $30 round turn, paid up
fronf:-l Xo, it is not! \\That happens if you buy an option and it expires worthless? You have
Chapter
34:Futures
andFutures
Options 625
already paid the commission for a trade that, in eHect, never took place. Nevertheless,
there is little you can do about it, for it has become the industry standard to charge
round-turn commission on futures options.
In either case, commissions are negotiated to a flat rate by many traders. Discount
futures commission merchants (i.e., brokerage houses) often attract business this way. In
general, this method of paying commissions is to the customer's benefit. However, it does
have a hidden effect that the option trader should pay attention to. This effect makes it
potentially more profitable to trade options on some futures than on others.
Example: A customer who buys corn futures pays $30 per round turn in option commis-
sions. Since corn options are worth $50 per one point (one cent), he is paying 0.60 of a
point every time he trades a corn option (30/50 = 0.60).
Now, consider the same customer trading options on the S&P 500 futures. The S&P
500 futures and options are worth $2.S0per point. So, he is paying only 0.12 of a point to
trade S&P 500 options (30/250 = .12).
He clearly stands a much better chance of making money in an S&P ,500 option than
he does in a corn option. He could buy an S&P option at .5.00 and sell it at .S.20 and make
.08 points profit. However, with corn options, if he buys an option at 5, he needs to sell it
at .5%to make money-a substantial difference between the two contracts. In fact, if he
is participating in spread strategies and trading many options, the differential is even
more important.
Position lirnits exist for futures options. While the limits for financial futures are
generally large, other futures-especially agricultural ones-may have small limits. A
large speculator who is doing spreads might inadvertently exceed a smaller limit. There-
fore, one should check with his broker for exact limits in the various futures options before
acquiring a large position.
OPTION MARGIN S
Fut ures option margin requirements are generally more logical than equity or index
option requirements. For example, if one has a conversion or reversal arbitrage in place,
his requirement would be nearly zero for futures options, while it could be quite large for
equity options. Moreover, futures exchanges have introduced a better way of margining
futures and futures option portfolios.
SPAN Marg in. The SPAN margin system (Standard Portfolio ANalysis of Risk) is used
by nearly all of the exchanges. SPAN is designed to determine the entire risk of a portfolio,
including all futures and opt ions. It is a unique system in that it bases the option require-
ments on projected movements in the futures contracts as well as on potential changes in
andFutures
implied volatility of the options in one's portfolio. This creates a more realistic measure of
the risk than the somewhat arbitrary requirements that were previously used (called the
"customer margin" system) or than those used for stock and index options.
Not all futures clearing firms automatically put their customers on SPAN margin.
Some use the older customer margin system for most of their option accounts. As a strate-
gist, it would be beneficial to be under SPAN margin. Thus, one should deal with a broker
who will grant SPAN margin.
The main advantages of SPAN margin to the strategist are twofold. First, naked
option margin requirements are generally less; second, certain long option requirements
are reduced as well. This second point may seem somewhat unusual-margin on long
options? SPAN calculates the amount of a long option's value that is at risk for the current
clay.Obviously, if there is time remaining until expiration, a call option will still have some
value even if the underlying futures trade down the limit. SPAN attempts to calculate this
remaining value. If that value is less than the market price of the option, the excess can
be applied toward any other requirement in the portfolio! Obviously, in-the-money options
would have a greater excess value under thi s system.
How SPAN Works. Certain basic requirements are determined by the futures exchange,
such as the amount of movement by the futures contract that must be margined (mainte-
nance margin). Once that is known, the exchange's computers generate an array of potential
gains and losses for the next day's trading, based on futures movement within a range of
prices and based on volatility changes. These results are stored in a "risk array." There is a
different risk array generated for each futures contract and each option contract. The clearing
member (your broker) or you do not have to do any calculations other than to see how the
quantities of futures and options in your portfolio are affected under the gains or losses in the
SPAN risk array. The exchange does all the mathematical calculations needed to project the
potential gains or losses. The results of those calculations are presented in the risk array.
There are 16 items in the risk array: For seven different futures prices, SPAN pro-
jects a gain or loss for both increased and decreased volatility; that makes 14 items. SPAN
also projects a profit or loss for an "extreme " upward move and an "extreme" downward
move. The futures exchange determines the exact definition of ''extreme ,'' and defines
"increased" or "de crease d " volatilit y.
SPAN "margin " applies to futures contracts as well, although volatility consider-
ations don't mean anything in terms of evaluating the actual futures risk. As a first exam-
ple, consider how SPAN wou ld evaluate the risk of a futur es cont ract.
Example: The S&P .500 futures will be used for this example. Suppose that the Chicago
Mc->rcantileExchange determines that the required maintenance margin for the futures
is 810,000 , which repres ents a 40-point move by the futures (recall that S&P futures
Chapter
34:Futures
andFutures
Options 627
are worth $2.50 per point). Moreover, the exchange determines that an "extreme" move is
28 points, or $7,000 of risk.
Long1
Future
Potential
Scenario Ph/Loss
Futures unchanged; volatility up 0
Futures unchanged; volatility down 0
Futures up one-third of range; volatility up + 3,330
Futures up one-third of range; volatility down + 3,330
Futures down one-third of range; volatility up - 3,330
Futures down one-third of range; volatility down - 3,330
Futures up two-thirds of range; volatility up + 6,670
Futures up two-thirds of range; volatility down + 6,670
Futures down two-thirds of range; volatility up - 6,670
Futures down two-thirds of range; volatility down - 6,670
Futures up three-thirds of range; volatility up + 10,000
Futures up three-thirds of range; volatility down + 10,000
Futures down three-thirds of range; volatility up -10,000
Futures down three-thirds of range; volatility down - 10,000
Futures up "extreme" move + 7,000
Futures down "extreme" move - 7,000
The 16 array items are always displayed in this order. Note that since this array is for a
futures contract, the "volatility up" and "volatility clown" scenarios are always the same, since
the volatility that is referred to is the one that is used as the input to an option pricing model.
Notice that the actual price of the futures contract is not needed in order to generate
the risk array. The SPAN requirement is always the largest potential loss from the array.
Thus, if one were long one S&P 500 futures contract, his SPAN margin requirement
would be $10,000, which occurs under the "futures down three-thirds" scenarios. This
will always be the maintenance margin for a futures contract.
Now let us consider an option example. In this type of calculation, the exchange uses
the same moves by the underlying futures contract and calculates the option theoretical
values as they would exist on the next trading clay.One calculation is performed for vola-
tility increasing and one for volatility decreasing.
andFutures
Example: Using the same S&P ,500 futures contract, the following array might depict the
risk array for a long December 1400 call. One does not need to know the option or futures
price in order to use the array; the exchange incorporates that information into the model
used to generate the potential gains and losses.
l
Long
Dec
1400call
Potential
Scenario Ph/Loss
Futures unchanged; volatility up + 460
Futures unchanged; volatility down 610
Futures up one-third of range; volatility up + 2,640
Futures up one-third of range; volatility down + 1,730
Futures down one-third of range; volatility up - 1,270
Futures down one-third of range; volatility down - 2,340
Futures up two-thirds of range; volatility up + 5,210
Futures up two-thirds of range; volatility down + 4,540
Futures down two-thirds of range; volatility up - 2,540
Futures down two-thirds of range; volatility down - 3,430
Futures up three-thirds of range; volatility up + 8,060
Futures up three-thirds of range; volatility down + 7,640
Futures down three-thirds of range; volatility up - 3,380
Futures down three-thirds of range; volatility down -3,990
Futures up "extreme" move + 3,130
Futures down "extreme" move - 1,500
The items in the risk array are all quite logical: Upward futures movements produce
profits and downward futures movements produce losses in the long call position. More-
m·er, worse results are always obtained hy using the lower volatility as opposed to the
higher one. In this particular example, the SPAN requirement would be $3,990 ("futures
dmrn three-thirds; volatility down"). That is, the SPAN system predicts that you could
lose s:umo of your call rnhw if futures fell by their entire range and volatility decreased-
a worst-case scenario. Therefore, that is the amount of margin one is required to keep for
this long option position.
\\.hile the exchange does not tell us how much of an increase or decrease it uses
in tcrn1s of rnlatilit:·, one can get something of a feel for the magnitude by looking at the
Chapter
34: Futures
andFutures
Options 629
first two lines of the table. The exchange is say'ing that if the futures are unchanged tomor-
row, but volatility "increases," then the call will increase iu value by $460 (1.84 points
at $2,50/point), if it "decreases," however, the call will lose $610 (2.44 points) of value.
These are large price changes, so one can assume that the volatility assumptions are
significant.
The real ease of use of the SPAN risk array is when it comes to evaluating the risk
of a more complicated position, or E'ven a portfolio of options. All one needs to do is to
combine the risk array factors for each option or future in the position in order to arrive
at the total requirement.
Example: Using the above two examples, one can see what the SPAN requirements
would be for a covered write: long the S&P future and short the Dec 1400 call.
Shortl
Dec1400call
Long
l S&P Potential Covered
Scenario Future Pft/Loss Write
Futuresunchanged; vol. up 0 - 460 - 460
Futuresunchanged; vol. down 0 + 610 + 610
Futuresup 1/3 of range; vol. up + 3,330 - 2,640 + 690
Futuresup 1/3 of range; vol. down + 3,330 - 1,730 + 1,600
Futuresdown 1/3 of range; vol. up - 3,330 + 1,270 - 2,060
Futuresdown 1/3 of range; vol. down - 3,330 + 2,340 - 990
Futuresup 2/3 of range; vol. up + 6,670 - 5,210 + 1,460
Futuresdown 2/3 of range; vol. up - 6,670 + 2,540 - 4,130
Futuresdown 2/3 of range; vol. down - 6,670 + 3,430 - 3,240
Futuresup 3/3 of range; vol. up + 10,000 - 8,060 + 1,940
Futures down 3/3 of range; vol. up -10,000 +3,380 -6,620
Futuresdown 3/3 of range; vol. down - 10,000 + 3,990 - 6,010
Futuresup "extreme" move + 7,000 - 3,130 + 3,870
Futuresdown "extreme" move - 7,000 + 1,500 - 5,500
As might be expected, the worst-case projection for a covered write is for the stock
to drop, hut for the implied volatility to increase. The SPAN system projects that this
covered writer would lose $6,620 if that happened. Thus, "futures down 3/3 of range; vola-
tility up" is the SPAN requirement , $6,620.
As a means of comparison, under the older "customer margin" option requirements,
the requirement for a covered write was the futures margin, plus the option premium, less
one-half the out-of-the-money amount. In the above example, assume the futures were at
408 and the call was trading at 8. The customer covered write margin would then be more
than twice the SPAN requirement:
Futures margin $10,000

Option premium + 4,000
½ out-of-money amount - 1,000
$13,000
Obviously, one can alter the quantities in the use of the risk array quite easily. For
example, if he had a ratio write oflong 3 futures and short 5 December 1400 calls, he could
easily calculate the SPAN requirement by multiplying the projected futures gains and losses
by 3, multiplying the projected option gains and losses by ,5,and adding the two together to
obtain the total requirement. Once he had completed this calculation, his SPAN require-
ment would be the worst expected loss as projected by SPAN for the next trading day.
In actual practice, the SPAN calculations are even more sophisticated: They take
into account a certain minimum option margin (for deeply out-of-the-money options);
they account for spreads between futures contracts on the same commodity (different
expiration months); they add a delivery month charge (if you are holding a position past
the first notice day); and they even allow for slightly reduced requirements for related, but
different , futures spreads (T-bills versus T-bonds , for example).
If you are interested in calculating SPAN margin yourself, your broker may be able
to provide you with the software to do so. More likely, though, he will provide the service
of calculating the SPAN margin on a position prior to your establishing it. The details for
obtaining the SPAN margin requirements should thus be requested from your broker.
PHYSICAL CURRENCY OPTIONS
From time to time, foreign currency options have had listed options. Occasionally these
have required physical delivery. There is a large over-the-counter market in foreign cur-
rency options. Since the physical commodity underlying the option is currency, in some
sense of the word, these are cash-based options as well. However, the cash that the
options are based in is not dollars, but rather may be European Euros, Swiss francs,
Chapter
34:Futures
andFutures
·options 631
British pounds, Canadian dollars, or Japanese yen. Futures trade in these same curren-
cies on the Chicago Mercantile Exchange. Hence, many traders of the physical options
use the Chicago-based futures as a hedge for their positions.
Unlike stock options, currency options do not have standardized terms-the amount
of currency underlying the option contract is not the same in each of the cases. The strik-
ing price intervals and units of trading are not the same either. However, since there are
only the six different contracts and since their terms correspond to the details of the
futures contracts, these options have had much success. The foreign currency markets are
some of the largest in the world, and that size is reflected in the liquidity of the futures
on these currencies.
The Japanese yen contract will be used to illustrate the workings of the foreign cur-
rency options. The other types of foreign currency options work in a similar manner,
although they are for differing amounts of foreign currency. The amount of foreign cur-
rency controlled by the foreign currency contract is the unit of trading, just as 100 shares
of stock is the unit of trading for stock options. The unit of trading for the Japanese yen
option is 62,500 Japanese yen. Normally, the currency itself is quoted in terms of U.S.
dollars. For example, a Japanese yen quote of 0.50 would mean that one Japanese yen is
worth 50 cents in U.S. currency.
Note that when one takes a position in foreign currency options (or futures), he is
simultaneously taking an opposite position in U.S. dollars. That is, if one owns a Japanese
yen call, he is long the yen (at least delta long) and is by implication therefore short U.S.
dollars.
Striking prices in yen options are assigned in one-cent increments and are stated in
cents, not dollars. That is, if the Japanese yen is trading at 50 cents, then there might be
striking prices of 48, 49, 50, 51, and 52. Given the unit of trading and the striking price
in U.S. dollars, one can compute the total dollars involved in a foreign currency exercise
or assignment.
Example: Suppose the Japanese yen is trading at 0.50 and there are striking prices of 48,
,50, and 52, representing U.S. cents per Japanese yen. If one were to exercise a call with a
strike of 48, then the dollars involved in the exercise would be 125,000 (the unit of trad-
ing) times 0.48 (the strike in U.S. dollars), or $60,000.
Option premiums are stated in U.S. cents. That is, if a Japanese yen option is quoted
at 0.7,5, its cost is $.0075 times the unit of trading, 125,000, for a total of $937.,50. Premi-
ums are quoted in hundredths of a point. That is, the next "tick" from 0.7,5would be 0.76.
Thus, for the Japanese yen options, each tick or hundredth of a point is equal to $12.,50
(.0001 X 12,5,000).
Actual cldivery of the security to satisfy an assignment notice must occur within the
country of origin. That is, the seller of the currency must make arrangements to deliver
the currency in its country of origin. On exercise or assignment, sellers of currency would
be put holders who exercise or call writers who are assigned. Thus, if one were short Japa-
nese yen calls and he were assigned, he would have to deliver Japanese yen into a bank in
Japan. This essentially means that there have to be agreements between your firm or your
broker and foreign banks if you expect to exercise or be assigned. The actual payment for
the exercise or assignment takes place between the broker and the Options Clearing
Corporation (OCC) in U.S. dollars. The OCC then can receive or deliver the currency in
its country of origin, since OCC has arrangements with banks in each country.
ETF-BASEDFUTURES
Exchange-traded funds (ETFs) were described in Chapter :32. A number of ETFs are
directly related to futures. This allows investors who can't or don't have futures accounts
to participate in the movement of certain commodity futures.
There are two ways that these futures-related ETFs are constructed. In the first
way, the ETF actually owns the physical commodity. That is the way the Gold ETF
(GLD) works, for example. As a result, this type of ETF exactly adheres to the cash price
of gold.
The second way that commodity ETFs are constructed is that they buy the under-
lying futures rather than the physical commodity. There are a number of them that are
constructed this way. Some examples are the Crude Oil ETF (USO), the Natural Gas
ETF (UNG), and the Volatility ETF (VXX). These ETFs might not match the perfor-
mance of the underlying cash market for they might have to pay a time value to continue
to hold and roll the futures contracts.
The problem arises from the fact that-when the longer-term contracts are more
expensive than the near-term contracts-the ETF pays the differential.
Example: The front-month Crude Oil futures are expiring, and thus are near the spot/
cash price at expiration. Let's assume that price is 75. The USO ETF sells out their posi-
tion in the front month futures, and buys the next month out-at a price of 76.50, say.
A month later, assume that the cash market is still unchanged at 75. The now-expiring
futures that cost 76 ..50 are now trading at 75. So the ETF has a loss of 1..50on these con-
tracts, e\·en though the spot/cash market is unchanged. Moreover, it must now buy the
next month, presumably at a price near 76.50.
On'r time, the cumulati\·e effect of all these rolls forward into futures trading at
higher prices puts a "drag" on the performance of the fund, with respect to the cash mar-
ket. Fmthermore, the ETF has only a limited amount of assets, and eventually these
losses could actually cause the ETF to theoretically run out of cash.
34:Futures
Chapter Options
andFutures 633
FUTURES OPTION TRADING STRATEGIES
The strategies described here are those that are unique to futures option trading. Although
there may be some general relationships to stock and index option strategies, for the most
part these strategies apply only to futures options. It will also be shown-in the back-
spread and ratio spread examples-that one can compute the profitability of an option
spread in the same manner , no matter what the underlying instrument is (stocks, futures ,
etc.) by breaking everything down into "points " and not "dollars. "
Before getting into specific strategies, it might prove useful to observe some relationships
about futures options and their price relationships to each other and to the futures contract
itself. Carrying cost and dividends are built into the price of stock and index options, because
th e underlying instrument pays dividends and one has to pay cash to buy or sell the stock Such
is not the case ,vith futures. The "investment" required to buy a futures contract is not initially
a cash outlay. Note that the cost of carry associated with futures generally refers to the carry-
ing cost of owning the cash commodity itself. That carrying cost has no bearing on the price
of a futures option other than to determine the futures price itself. Moreover, the future has
no dividends or similar payout. This is even true for something like U.S. Treasury bond options,
because the interest rate payout of the cash bond is built into the futures price; thus, the
option, which is based on the futures price and not directly on the cash price, does not have
to allow for carry, since the future itself has no initial canying costs associated with it.
Simplistically , it can be stated that:
Futures Call = Futures Put + Futures Price - Strike Price
Example: April crud e oil futures closed at 18.74 ($18.74 per barrel). The following prices
exist:
Strike Call
April Put
April Put+ Futures
Price Price Price - Strike
17 1.80 0.06 1.80
18 0.96 0.22 0.96
19 0.35 0.61 0.35
20 0.10 1.36 0.10
Note that, at every strike, the above formula is true (Call = Put+ Futures - Strike).
These are not theoretical prices; they were tak en from actual settlement prices on a particu-
lar trading day.
In reality, where deeply in-the-money or longer-term options are involved, this sim-
ple formula is not correct. However, for most options on a particular nearby futures con-
tract, it will suffice quite well. Examine the current quotes to verify that this is a true
statement.
A subcase of this observation is that when the futures contract is exactly at the strik-
ing price, the call and put tcith that strike will both trade at the same price. Note that in
the above formula, if one sets the futures price equal to the striking price, the last two
terms cancel out and one is left with: Call price = Put price.
One final observation before getting into strategies: For a put and a call with the
same strike
Net change call - Net change put = Net change futures
This is a true statement for stock and index options as well, and is a useful rule to
remember. If the last sales don't conform to the rule above, then at least one of the last
sales is probably not representative of the true market in the options.
DEITA
While we are on the subject of pricing, a word about delta may be in order as well. The delta
of a futures option has the same meaning as the delta of a stock option: It is the amount by
which the option is expected to increase in price for a one-point move in the underlying
futures contract. As we also know, it is an instantaneous measurement that is obtained by
taking the first derivative of the option prking model.
In any case, the delta of an at-the-money stock or index option is greater than 0 ..50;
the more time remaining to expiration, the higher the delta is. In a simplified sense, this
has to do with the cost of carrying the value of the striking price until the option expires.
But part of it is also due to the distribution of stock price movements-there is an upward
bias, and with a long time remaining until expiration, that bias makes call movements
more pronounced than put movements.
Options on futures do not have the carrying cost feature to deal with, but they do
have the positive bias in their price distribution. A futures contract, just like a stock, can
increase by more than 100%, but cannot fall more than 100%. Consequently, deltas of
at-the-money futures calls will be slightly larger than 0 ..50. The more time remaining until
expiration of the futures option, the higher the at-the-money call delta will be.
Many traders erroneously believe that the delta of an at-the-money futures option is
O..SO,since there is no carrying cost involved in the futures conversion or reversal arbi-
trage. That is not a true statement, since the distribution of futures prices affects the delta
as well.
Chapter
34:Futures
andFutures
Options 635
As always, for futures options as well as for stock and index options, the delta of a
put is related to the delta <fa call u;itli the same striking price and expiration date:
Delta of put = 1 - Delta of call
Finally, the concept of equivalent stock position applies to futures option strategies,
except, of course, it is called the equirnlent futures position (EFP). The EFP is calculated
by the simple formula:
EFP = Delta of option X Option quantity
Thus, if one is long 8 calls with a delta of 0.75, then that position has an EFP of
6 (8 X 0.75). This means that being long those 8 calls is the same as being long 6 futures
contracts.
Note that in the case of stocks, the equivalent stock position formula has another
factor-shares per option. That concept does not apply to futures options, since they are
always options on one futures contract.
MATHEMATICAL CONSIDERATIONS
This brief section discusses modeling considerations for futures options and options on
physicals .
Futures Options. The Black model (see Chapter 33 on mathematical considerations

for index options) is used to price futures options. Recall that futures don't pay dividends,
so there is no dividend adjustment necessary for the model. In addition, there is no car-
rying cost involved with futures, so the only adjustment that one needs to make is to use
0% as the interest rate input to the Black-Scholes model. This is an oversimplification,
especially for deeply in-the-money options. One is tying up some money in order to buy
an option. Hence, the Black model will discount the price from the Black-Scholes model
price. Therefore, the actual pricing model to be used for theoretical evaluation of futures
options is the Black model, which is merely the Black-Scholes model, using 0% as the
interest rate, and then discounted:
Call Theoretical Price= e-rt X Black-Scholes formula [r = OJ
Recall that it was stated above that:
Futures call = Futures put + Future price - Strike price

andFutures
The actual relationship is:
Futures call= Futures put+ e-rr (Futures price - Strike price)
where
r = the short-term interest rate,

t = the time to expiration in years , and
e -rr = the discounting factor.
The short-term interest rate has to he used here because when one pays a debit for
an option, he is theoretically losing the interest that he could earn if he had that money
in the bank instead, earning money at the short-term interest rate.
The difference between these two formulae is so small for nearby options that are
not deeply in-the-money that it is normally less than the bid-asked spread in the options,
and the first equation can be used.
Example: The table below compares the theoretical values computed with the two for-
mulae, where r = 6% and t = 0.25 (1/4 of a year). Furthermore, assume the futures price
is 100. The strike price is given in the first column, and the put price is given in the second
column. The predicted call prices according to each formula are then shown in the next
two columns.
Put Formula
1 Formula2
Strike Price (Simple) e-11)
(Using
70 0.25 30.25 29.80
80 1.00 21.00 20.70
90 3.25 13.25 13.10
95 5.35 10.35 10.28
100 7.50 7.50 7.50
105 10.70 5.70 5.77
110 13.90 3.90 4.05
120 21.80 1.80 2.10
For options that are 20 or 30 points in- or out-of-the-money, there is a noticeable

differential in tlwse three-month options. However, for options closer to the strike, the
differential is small.
Chapter
34:Futures
andFutures
Options 637
If the time remaining to expiration is shorter than that used in the example above,
the differences are smallec if the time is longer, the differences are magnified.
Options on Physicals. Determining the fair value of options on physicals such as

currencies is more complicated. The proper way to calculate the fair value of an option on
a physical is quite similar to that used for stock options. Recall that in the case of stock
options, one first subtracts the present worth of the dividend from the current stock price
before calculating the option value. A similar process is used for determining the fair
value of currency or any other options on physicals. In any of these cases, the underlying
security bears interest continuously, instead of quarterly as stocks do. Therefore, all one
needs to do is to subtract from the underlying price the amount of interest to be paid until
option expiration and then add the amount of accrued interest to be paid. All other inputs
into the Black-Scholes model would remain the same, including the risk-free interest rate
being equal to the 90-day T-bill rate.
Again, the practical option strategist has a shortcut available to him. If one assumes
that the various factors necessary to price currencies have been assimilated into the
futures markets in Chicago, then one can merely use the futures price as the price of the
underlying for evaluating the physical delivery options in Philadelphia. This will not work
well near expiration, since the future expires one week prior to the PHLX option. In addi-
tion, it ignores the early exercise value of the PHLX options. However, except for these
small differentials, the shortcut will give theoretical values that can be used in
strategy-making decisions.
Example: It is sometime in April and one desires to calculate the theoretical values of the
June Euro physical delivery options in Philadelphia. Assume that one knows four of the
basic items necessary for input to the Black-Scholes formula: 60 days to expiration, strike
price of 68, interest rate of 10%, and volatility of 18%. But what should be used as the
price of the underlying Euro? Merely use the price of the June Euro futures contract in
Chicago.
STRATEGIES REGARDING TRADING LIMITS
The fact that trading limits exist in most futures contracts could be detrimental to both
option buyers and option writers. At other times, however, the trading limit may present
a unique opportunity. The following section focuses on who might benefit from trading
limits in futures and who would not.
Recall that a trading limit in a futures contract limits the absolute number of points
that the contract can trade up or clown from the previous close. Thus, if the trading limit
in T-honds is .3points and they closed last night at 742 1/:i:2, then the highest they can trade
on the next day is 772½2, regardless of what might be happening in the cash bond market.
Trading limits exist in many futures contracts in order to help ensure that the market
cannot be manipulated by someone forcing the price to move tremendously in
one direction or the other. Another reason for having trading limits is ostensibly to allow
only a fixed move, approximately equal to the amount covered by the initial margin, so
that maintenance margin can be collected if need be. However, limits have been applied
in cases in which they are unnecessary. For example, in T-bonds, there is too much liquid-
ity for anyone to be able to manipulate the market. Moreover, it is relatively easy to arbi-
trage the T-bond futures contract against cash bonds. This also increases liquidity and
would keep the future from trading at a price substantially different from its theoretical
value .
Sometimes the markets actually need to move far quickly and cannot because of the
trading limit. Perhaps cash bonds have rallied 4 points, when the limit is 3 points. This
makes no difference-when a futures contract has risen as high as it can go for the day,
it is bid there (a situation called "limit bid") and usually doesn't trade again as long as the
underlying commodity moves higher. It is, of course, possible for a future to be limit bid,
only to find that later in the day, the underlying commodity becomes weaker, and traders
begin to sell the future, driving it down off the limit. Similar situations can also occur on
the downside, where, if the future has traded as low as it can go, it is said to be "limit
offered. "
As was pointed out earlier, futures options sometimes have trading limits imposed
on them as well. This limit is of the same magnitude as the futures limit. In other markets,
options are free to trade, even though futures have effectively halted because they are up
or down the limit. However, even in the situations in which futures options themselves
have a trading limit, there may be out-of-the-money options available for trading that have
not reached their trading limit.
When options are still trading, one can use them to imply the price at which the
future s would be trading, were they not at their trading limit .
Example: August soybeans have been inflated in price due to drought fears, having
closed on Friday at 6.50 ($6 ..50 per bushel). However, over the weekend it rains heavily in
the Midwest, and it appears that the drought fears were overblown. Soybeans open
down 30 cents, to 620, down the allowable 30-cent limit. Furthermore, there are no buy-
ers at that level and the August bean contract is locked limit down. No further trading
ensues.
One may he able to use the August soybean options as a price discovery mechanism
to see where August soybeans would be trading if they were open.
Suppose that the following prices exist, even though August soybeans are not trading
because they are locked limit down:
Chapter
34:Futures
andFutures·
Options 639
LostSole NetChange
Option Price fortheDoy
August 625 call 19 -21
August 625 put 31 +16
An option strategist knows that synthetic long futures can be created by buying a
call and selling a put, or vice versa for short futures. Knowing this, one can tell what price
futures are projected to be trading at:
Implied Futures Price = Strike Price + Call Price - Put Price

= 625 +19- 31 = 613
With these options at the prices shown, one can create a synthetic futures position at a
price of 613. Therefore, the implied price for August soybean futures in this example is 613.
Note that this formula is merely another version of the one previously presented in
this chapter.
In the example above, neither of the options in question had moved the 30-point
limit, which applies to soybean options as well as to soybean futures. If they had, they
would not be useable in the formula for implying the price of the future. Only options
that are freely trading-not limit up or do1cn-can he used in the ahoue formula.
A more complete look at soybean futures options on the day they opened and stayed
down the limit would reveal that some of them are not tradeable either:
Example: Continuing the above example, August soybeans are locked limit down 30 cents
on the day. The following list shows a wider array of option prices. Any option that is either
up or down 30 cents on the day has also reached its trading limit, and therefore could not be
used in the process necessary to discover the implied price of the August futures contract.
Lost
Sole NetChange
August550 call 71 -30
640 Part V:IndexOptionsandFutures
August 550 put 4 +3

August 575 put 9 +6
The deeply in-the-money calls, August 5.S0's and August 575's , and the deeply
in-the-money August 675 puts are all at the trading limit. All other options are freely trad-
ing and could be used for the above computation of the August future's implied price.
One may ask how the market-makers are able to create markets for the options when
the future is not freely trading. They are pricing the options off cash quotes. Knowing the
cash quote, they can imply the price of the future (613 in this case), and they can then
make option markets as well.
The real value in being able to use the options when a future is locked limit up or
limit down, of course, is to be able to hedge one 's position. Simplistically , if a trader came
in long the August soybean futures and they were locked limit down as in the example
above , he could use the puts and calls to effectively close out his position.
Example: As before , August soybeans are at 620, locked down the limit of 30 cents.
A trader has come into this trading clay long the futures and he is very worried. He
cannot liquidate his long position, and if soybeans should open down the limit again
tomorrmv, his account will be wiped out. He can use the August options to close out his
position.
Recall that it has been shown that the following is true:
Long put+ Short call is equivalent to short stock.
It is also equivalent to short futures, of course. So if this trader were to buy a put and
short a call at the same strike, then he would have the equivalent of a short futures posi-
tion to offset his long futures position.
Using the following prices, which are the same as before , one can see how his risk is
limited to the effective futures price of 61.3.That is, buying the put and selling the call is
the same as selling his futures out at 613, down 37 cents on the trading day.
Chapter
34:Futures
andFutures
Options 641
Current prices:
LostSole NetChange
August 625 call 19 -21
Position:
Buy August 625 put for 19

Sell August 625 call for 31
AugustFutures NetProfit
at Option orLoss
on
Expiration PutPrice PutP/L CollPrice CollP/L Position
575 50 +$1,900 0 +$1,900 +$3,800
600 25 - 600 0 + 1,900 + 1,300
613 12 - 1,900 0 + 1,900 0
625 0 - 3,100 0 + 1,900 - 1,200
650 0 - 3,100 25 - 600 - 3,700
This profit table shows that selling the August 625 call at 19 and buying the August
625 put at 31 is equivalent to-that is, it has the same profit potential as-selling the
August future at 613. So, if one buys the put and sells the call, he will effectively have sold
his future at 613 and taken his loss.
His resultant position after buying the put and selling the call would be a conversion
(long futures, long put, and short call). The margin required for a conversion or reversal
is zero in the futures market. The margin rules recognize the riskless nature of such a
strategy. Thus, any excess money that he has after paying for the unrealized loss in the
futures will be freed up for new trades.
The futures trader does not have to completely hedge off his position if he does not
want to. He might decide to just buy a put to limit the downside risk. Unfortunately, to do
so after the futures are already locked limit down may be too little, too late. There are
many kinds of partial hedges that he could establish-buy some puts, sell some calls,
utilize different strikes, etc.
The same or similar strategies could be used by a naked option seller who cannot
hedge his position because it is up the limit. He could also utilize options that are still in
free trading to create a synthetic futures position.
Futures options generally have enough out-of-the-money striking prices listed that
andFutures
some of them will still be free trading, even if the futures are up or down the limit. This
fact is a boon to anyone who has a losing position that has moved the daily trading limit.
Knowing how to use just this one option trading strategy should be a worthwhile benefit
to many futures traders .
COMMONPLACE MISPRICING STRATEGIES
Futures options are sometimes prone to severe mispricing. Of course, any product's options
may be subject to mispricing from time to time. However, it seems to appear in futures
options more often than it <loes in stock options. The following discussion of strategies
concentrates on a specific pattern of futures options mispricing that occurs with relative
frequency. It generally manifests itself in that out-of-the-money puts are too cheap, and
out-of-the-money calls are too expensive. The proper term for this phenomenon is "volatil-
ity skewing" and it is discussed further in Chapter 36 on advanced concepts. In this chap-
ter , we concentrate on how to spot it and how to attempt to profit from it.
Occasionally, stock options exhibit this trait to a certain extent. Generally, it occurs in
stocks when speculators have it in their minds that a stock is going to experience a sudden,
substantial rise in price. They then bid up the out-of-the-money calls, particularly the
near -term ones, as they attempt to capitalize on their bullish expectations. When takeover
rumors abound, stock options display this mispricing pattern. Mispricing is, of course, a sta-
tistically related term; it does not infer anything about the possible validity of takeover rumors.
A significant amount of discussion is going to be spent on this topic, because the
futures option trader tcill have ample opportunities to see and capitalize on this mispric-
ing pattern; it is not something that just comes along rarely. He should therefore be pre-
pared to make it work to his advantage.
Example: January soybeans are trading at 583 ($5.83 per bushel). The following prices exist:
January beans: 583
Call Put
Strike Price Price
525 ½
550 3¼
575 19½ 12
600 11 28
625 5¼
650 3½
675 2¼
Chapter
34:Futures
andFutures
Options 643
Suppose one knows that, according to historic patterns, the "fair values" of these
options are the prices listed in the following table .
Call Put
Call Theo. Put Theo.
Strike Price Value Price Value
525 ½ 1.6
550 3¼ 5.4
575 19½ 21.5 12 13.7
600 11 10.4 28 27.6
625 5¾ 4.3
650 3½ 1.5
675 21/4 0.7
Notice that the out-of-the-money puts are priced well below their theoretical value,
while the out-of-the-money calls are priced above. The options at the 57.Sand 600 strikes
are much closer in price to their theoretical values than are the out-of-the-money options.
There is another way to look at this data, and that is to view the options' implied vola-
tility. Implied volatility was discussed in Chapter 28 on mathematical applications. It is
basically the volatility that one would have to plug into his option pricing model in order
for the model's theoretical price to agree with the actual market price. Alternatively, it is
the volatility that is being implied by the actual marketplace. The options in this example
each have different implied volatilities, since their mispricing is so distorted. Table 34-2
TABLE 34-2.
Volatility skewing of soybean options.
Call Put Implied
Strike Price Price Volatility Delta
Call/Put
525 ½ 12% /-0.02
550 3¼ 13% /-0.16
575 19½ 12 15% 0.59/-0.41
600 11 28 17% 0.37/-0.63
625 5¾ 19% 0.21
650 3½ 21% 0.13
675 2¼ 23% 0.09
andFutures
gives those implied volatilities. The deltas of the options involved are shown as well, for
they will be used in later examp les.
These implied volatilities tell the same story: The out-of-the-money puts have
the lowest implied volatilities, and therefore are the cheapest options; the out-of-the-
money calls have the highest implied volatilities, and are therefore the most expensive
options.
So, no matter which way one prefers to look at it-through comparison of the option
price to theoretical price or by comparing implied volatilities-it is obvious that these
soybean options are out of line with one another.
This sort of pricing distortion is prevalent in many commodity options. Soybeans,

sugar, coffee , gold, and silver are all subject to this distortion from time to time. The dis-
tortion is endemic to some-soybeans, for example-or may be present only when the
speculators turn extremely bullish.
This precise mispricing pattern is so prevalent in futures options that strategists
should constantly be looking for it. There are two major ways to attempt to profit from this
pattern. Both are attractive strategies, since one is buying options that are relatively less
expensive than the options that are being sold. Such strategies, if implemented when the
options are mispriced, tilt the odds in the strategist's favor, creating a positive expected
return for the position.
The two theoretically attractive strategies are:
1. Buy out-of-the-money puts and sell at-the-money puts; or

2. Buy at-the-money calls and sell out-of-the-money calls.
One might just buy one cheap and sell one expensive option-a bear spread with the
puts, or a bull spread with the calls. However, it is better to implement these spreads with
a ratio between the number of options bought and the number sold. That is, the first
strateg~· invoking puts would be a backspread, while the second strategy involving calls
would be a ratio spread. By doing the ratio, each strategy is a more neutral one. Each
strategy is examined separately.
BACKSPREADING THE PUTS
The hackspreacl strategy works best when one expects a large degree of volatility. Imple-
rnc>ntingthe strategy with puts means that a large drop in price by the underlying futures
wo11klhe most profitable, although a limit<:d profit could be made if futures rose. Note
that a 111oderak drop in price hy expiration would be the worst result for this spread.
Chapter
34:Futures
andFutures
Options 645
Example: Using prices from the above c>xample,suppose that one decides to establish a
backspread in the puts. Assume that a nc>utral ratio is obtained in the following spread:
Buy 4 January bean 550 puts 3¼ 13 DB

Sell 1 January bean 600 put at 28 28 CR
Net position: 15 Credit
The deltas (see Table 34-2) of the options are used to compute this neutral ratio.
Figure 34-1 shows the profit potential of this spread. It is the typical picture for a
put backspread-limited upside potential with a great deal of profit potential for large
downward moves. Note that the spread is initially established for a credit of 1.5cents. If
January soybeans have volatile movements in either direction, the position should profit.
Obviously, the profit potential is larger to the downside, where there are extra long puts.
However, if beans should rally instead, the spreader could still make up to 15cents ($750),
the initial credit of the position.
Note that one can treat the prices of soybean options in the same manner as he
would treat the prices of stock options in order to determine such things as break-even
points and maximum profit potential. The fact that soybean options are worth $.50
per point (which is cents when referring to soybeans) and stock options are worth
$100 per point do not alter these calculations for a put backspread.
FIGURE 34-1.
January soybean, backspread.
60
50
40-
-
'5
30-
20
ct
0
Cl) 10
c
·o o'
Cl.
525 550 600 625
-10
-20
-30
Futures Price
Maximum upside profit potential= Initial debit or credit of position

= 15 points
Maximum risk = Maximum upside - Distance between strikes

X Number of puts sold short
= 15-50X l
=-35 points
Downside break -even point = Lower strike

- Points of risk/Number of excess puts
= 550-35/3
= 538.3
Thus , one is able to analy:.e a futures option position or a stock option position in
the same manner-by reducing everything to be in terms of points, not dollars. Obvi-
ously, one will eventually have to convert to dollars in order to calculate his profits or
losses. However, note that referring to everything in "points" works very wel l. Later , one
can use the dollars per point to obtain actual dollar cost. Dollars per point would be $.50
for soybeans options, $100 for stock or index options, $400 for live cattle options, $37.5 for
coffee options, $1,120 for sugar options, etc. In this way, one does not have to get hung up
in the nomenclature of the futures contract; he can approach everything in the same fash-
ion for purposes of analyzing the position. He will, of course, have to use proper nomen-
clature to enter the order , but that comes after the analysis is done .
RATIO SPREADING THE CALLS
Returning to the subject at hand-spreads that capture this particular mispncmg

phenomenon of futures options-recall that the other strategy that is attractive in such situ-
ations is the ratio call spread. It is established with the maximum profit potential being some-
what above the current futures price, since the calls that are being sold are out-of-the-money.
Example: Again using the January soybean options of the previous few examples, suppose
that one establishes the following ratio call spread. Using the calls' deltas (see Table 34-2),
the following ratio is approximately neutral to begin with:
Buy 2 January bean 600 calls at 11 22 DB

Sell 5 January bean 650 calls at 3½ 17½ CR
Net position: 4½ Debit
Chapter
34:Futures
andFutures
Options 647
FIGURE 34-2.
January soybean, ratio spread.
90
80
70
60
-
'5
a:
50
40
30
0 20
Cf)
c 10
·o
a.. 0
-10 575 625 650 700
-20
At Expiration
-30
Futures Price
Figure 34-2 shows the profit potential of the ratio call spread. It looks fairly typical
for a ratio spread: limited downside exposure, maximum profit potential at the strike of
the written calls, and unlimited upside exposure.
Since this spread is established with both options out-of-the-money, one needs some
upward movement by January soybean futures in order to be profitable. However, too
much movement would not be welcomed (although follow-up strategies could be used to
deal with that). Consequently, this is a moderately bullish strategy; one should feel that
the underlying futures have a chance to move somewhat higher before expiration.
Again, the analyst should treat this position in terms of points, not dollars or cents of
soybean movement, in order to calculate the significant profit and loss points. Refer to Chap-
ter 11 on ratio call spreads for the original explanation of these formulae for ratio call spreads:
Maximum downside loss= Initial debit or credit

=- 4 ½ (it is a debit)
Point s of maximum profit = Maximum downside loss

+ Difference in strikes
X Number of calls owned
=-4½ + 50X2
=95½
Upside break-even price = High er striking price

+ Maximum profit/Net number of naked calls
= 650 + 95112/3
= 681.8
These are the significant points of profitability at expiration. One does not care what
the unit of trading is (for example, cents for soybeans) or how many dollars are involved
in one unit of trading ($,50for soybeans and soybean options). He can conduct his analysis
strictly in terms of points, and he should do so.
Before proceeding into the comparisons between the backspread and the ratio
spread as they apply to mispriced futures options, it should be pointed out that the serious
strategist should analyze how his position will perform over the short term as well as at
expiration. These analyses are presented in Chapter ,'36on advanced concepts.
WHICH STRATEGY TO USE
The profit potential of the put backspread is obviously far different from that of the
call ratio spread. They are similar in that they both offer the strategist the opportunity to
benefit from spreading mispriced options. Choosing which one to implement (assuming
liquidity in both the puts and calls) may be helped by examining the technical picture
(chart) of the futures contract. Recall that futures traders are often more technically oriented
than stock traders, so it pays to be aware of basic chart patterns, because others are watch-
ing them as well. If enough people see the same thing and act on it, the chart pattern will
he correct if 0111:· from a "self-fulfilling prophecy" vitwpoint if nothing else.
Consequently, if the futures are locked in a (smooth) downtrend, the put strategy is
the strategy of choice because it offers the best downside profit. Conversely, if the futures
are in a smooth uptrend , the call strategy is best.
The worst result will be achieved if the strategist has established the call ratio
sprt'ad, and the futures have an explosi,·e rally. In certain cases, ,·ery bullish rurnors-
weatlwr predictions such as drought or El Nino, foreign labor unrest in the fields or mines,
Russian lm:·ing of grain-will produce this mispricing phenomenon. The strategist should
he let'r:· of using the call ratio spread strategy in such situations, even though the
011t-of-the-rnoney calls look and art' ridiculously expensive. If the rumors prove true, or if
there :lrt' too urnn:· shorts heing squeezed, the futures can move too far, too fast and seri-
011sl:-llllrt tl1c sprt>ader who !ms the ratio call spread in place. His margin requirements
"·ill escalate quick!:· as tht' futures price mm·es higher. The option premiums will remain
Ii i.\.;hor possibly t'H'll expand if the futmt's rally quickly, thereby overriding the potential
Chapter
34:Futures
andFutures
Options 649
benefit of time decay. Moreo\'er, if the fundamentals change immediately-it rains; the
strike is settled: no grain credits are offered to the Russians-or rumors prove false, the
futures can come crashing back down in a hurry .
Consequently, {[ ru111ors of fundamentals hm:e introduad uolatility in the
futures market, i111pleme11tthe strategy 1vith the put back.spread. The put backspreacl is
geared to taking advantage of volatility, and this fundamental situation as described is cer-
tainly volatile. It may seem that because the market is exploding to the upside, it is a waste
of time to establish the put spread. Still, it is the wisest choice in a volatile market, and there
is always the chance that an explosive advance can turn into a quick decline, especially when
the advance is based on rumors or fundamentals that could change overnight.
There are a few ''don'ts" associated with the ratio call spread. Do not be tempted to
use the ratio spread strategy in volatile situations such as those just described; it works
best in a slowly rising market. Also, do not implement the ratio spread with ridiculously
far out-of-the-money options, as one is wasting his theoretical advantage if the futures do
not have a realistic chance to climb to the striking price of the written options. Finally, do
not attempt to use overly large ratios in order to gain the most theoretical advantage. This
is an important concept , and the next example illustrates it well.
Example: Assume the same pricing pattern for January soybean options that has been
the basis for this discussion. January beans are trading at 583. The (novice) strategist sees
that the slightly in-the-money January 575 call is the cheapest and the deeply
out-of-the-money January 67.5 call is the most expensive. This can be verified from either
of two previous tables: the one showing the actual price as compared to the "theoretical"
price , or Table 34-2 showing the implied volatilities.
Again, one would use the deltas (see Table 34-2) to create a neutral spread. A
neutral ratio of these two would involve selling approximately six calls for each one
purchased.
Buy 1 January bean 575 call at 19½ 19½ DB

Sell 6 January bean 675 calls at 2¼ 13½ CR
Net position: 6 Debit
Figure 34-3 shows the possible detrimental effects of using this large ratio. While one
could make 94 points of profit if beans were at 67.5at January expiration, he could lose that
profit quickly if beans shot on through the upside break-even point, which is only 693.8.
The previous formulae can be used to verify these maximum profit and upside break-even
point calculations. The upside break-even point is too close to the striking price to allow
andFutures
FIGURE 34-3.
January soybean, heavily ratioed spread.
90
60
30
0
e
a.. -30
575 625 650 675 725
0
en
c -60
·5
a..
-90
At Expiration
-120
-150
- 180
Futures Price
for reasonable follow-up action. Therefore, this would not be an attractive position from a
practical viewpoint, even though at first glance it looks attractive theoretically.
It would seem that neutral spreading could get one into trouble if it "recommends"
positions like the 6-to-l ratio spread. In reality, it is the strategist who is getting into
trouble if he doesn't look at the whole picture. The statistics are just an aid-a tool. The
strategist must use the tools to his advantage. It should be pointed out as well that there
is a tool missing from the toolkit at this point. There are statistics that will clearly show
the risk of this type of high-ratio spread. In this case, that tool is the gamma of the option.
Chapter 40 covers the use of gamma and other more advanced statistical tools. This same
example is expanded in that chapter to include the gamma concept.
FOLLOW-UP ACTION
The same follow-up strategies apply to these futures options as did for stock options. They
will not be rehashed in detail here; refer to earlier chapters for broader explanations. This
is a summary of the normal follow-up strategies:
Ratio calf spread:

Follow-up action in strategies with naked options, such as this, generally involves taking or
limiting losses. A rising market will produce a negative EFP.
Chapter
34:Futures
andFutur~s
Options 651
Neutralize a negative EFPby:

Buyingfutures
Buying some calls
limit upside losses by placing buy stop orders for futures at or near the upside break-even point.
Putbackspread:
Follow-up action in strategies with an excess of long options generally involves taking or
protectingprofits.A falling marketwill produce a negative EFP.
Neutralize a negative EFPby:
Buyingfutures
Selling some puts
The reader has seen these follow-up strategies earlier in the book. However, there
is one new concept that is important: The mispricing continues to propagate itself no
matter tchat the price of the underlying futures contract. The at-the-money options will
always be about fairly priced; they will have the average implied volatility.
Example: In the previous examples, January soybeans were trading at 583 and the
implied volatility of the options with striking price ,575 was 15%, while those with a 600
strike were 17%. One could, therefore, conclude that the at-the-money January soybean
options would exhibit an implied volatility of about 16%.
This would still be true if beans were at 52.5 or 67.5. The mispricing of the other
options would extend out from what is now the at-the-money strike. Table 34-3 shows
what one might expect to see if January soybeans rose 75 cents in price, from 583 to 658.
Note that the same mispricing properties exist in both the old and new situations:
The puts that are 58 points out-of-the-money have an implied volatility of only 12%, while
the calls that are 92 points out-of-the-money have an implied volatility of 23%:
TABLE34 -3 .
Propagation of vo lat ility skewing.
Original
Situation NewSituation
Januarybeans:
583 January
beans:
658
Implied
Strike Volatility Strike
525 12% 600
550 13% 625
575 15% 650
andFutures
600 17% 675

625 19% 700
650 21% 725
675 23% 750
Tl1is example is not meant to infer that the volatility of an at-the-money soybean
futures option will always be 16o/c.It could be anything, depending on the historical and
impli ed volatility of the futures contract itself. However, the volatility skewing will still
persist even if the futures rally or decline.
This fact will affect how these strategies behave as the underlying futures contract
moves. It is a benefit to both strategies. First, look at the put backspread when the stock
falls to the striking price of the purchased puts.
Example: The put backspread was established under the following conditions:
Put Theoretical Implied

Strike Price PutPrice Volatility
550 3¼ 5.4 13%
600 28 276 17%
If Januar:· soybean futures should fall to .550, one would expect the implied volatility
of the Januar:· .550 puts that are owned to be about 16% or 17%, since they would be
at-the-money at that time. This makes the assumption that the at-the-money puts will have
about a 17% implied volatility, which is what they had when the position was established.
Since the strategy involves being long a large quantity of January 550 puts, this
increase in implied \·olatility as the futures drop in price will be of benefit to the spread.
Note that the implied volatility of the January 600 puts would increase as well, which
would lw a small negative aspect for the spread. However, since there is only one put short
and it is quite deeply in-the-money with the futures at .5.50,this negative cannot outweigh
the positi\·e effect of the expansion of volatilit:· on the long January 550 puts.
In a similar manner, the call spread would benefit. The implied volatility of the writ-
ten options would actual!:· drop as the futures rallied, since they would be less far
out-of-tlw-mone:· than they originally were when the spread was established. While the
same can be said of the long options in the spread, the fact that there are extra, naked,
options means the spread will benefit overall.
Chapter
34:Futures
andFuture~
Options 653
In short, the futures option strategist should he alert to mispricing situations like
those described above. They occur freqm.,ntly in a few commodities and occasionally in
others. The put hackspreacl strategy has limited risk and might therefore be attractive to
more individuals: it is best used in downtremling and/or volatile markets. However, if the
futures are in a smooth uptrend, not a volatile one, a ratio call spread would be better. In
either case, the strategist has established a spread that is statistically attractive because
he has sold options that are expensive in relation to the ones that he has bought.
SUMMARY
This chapter presented the basics of futures and futures options trading. The basic differ-
ences between futures options and stock or index options were laid out. In a certain
sense, a futures option is easier to utilize than is a stock option because the effects of divi-
dends, interest rates, stock splits, and so forth do not apply to futures options. However,
the fact that each underlying physical commodity is completely different from most other
ones means that the strategist is forced to familiarize himself with a vast array of details
involving striking prices, trading units, expiration dates, first notice days, etc.
More details mean there could be more opportunities for mistakes, most of which
can be avoided by visualizing and analyzing all positions in terms of points and not in
dollars.
Futures options do not create new option strategies. However, they may afford one
the opportunity to trade when the futures are locked limit up. Moreover, the volatility
skewing that is present in futures options will offer opportunities for put backspreads and
call ratio spreads that are not normally present in stock options.
Chapter 3.S discusses futures spreads and how one can use futures options with
those spreads. Calendar spreads are discussed as well. Calendar spreads with futures
options are different from calendar spreads using stock or index options. These are impor-
tant concepts in the futures markets-distinctly different from an option spread-and are
therefore significant for the futures option trader.
Futures Option Strategies
for Futures Spreads
A spread with futures is not the same as a spread with options, except tha t one item is
bought while another is simultaneously sold. In this manner, one side of the spread hedges
the risk of the other. This chapter describes futures spreading and offers ways to use
options as an adjunct to those spreads.
The concept of calendar spreading with futures options is covered in this chapter as
well. This is the one strategy that is very different when using futures options, as opposed
to using stock or index options.
FUTU RES SPREADS
Before getting into option strategies, it is necessary to define futures spreads and to exam-
ine some common futures spreading strategies.
FUTURES PRICING DIFFERENTIALS
It has already been shown that, for any particular physical commodity, there are, at any
one time, se\·eral futures that expire in different months. Oil futures have month ly expi-
rations; sugar futures expire in only five months of any one calendar year. The frequency
of expiration months depends on which futures contract one is discussing.
F11tures 011 the same underlying commodity will trade at different prices. The dif-
ferential is clue to several factors, not just time, as is the case with stock options. A major
654
Chapter
35: Futures
OptionStrategiesforFutures
Spreads 655
factor is carrying costs-how much one would spend to buy and hold the physical com-
modity until futures expiration. However, other factors may enter in as well, including
supply and demand considerations. In a normal carrying cost market, futures that expire
later in time are more expensive than those that are nearer-term.
Example: Gold is a commodity whose futures exhibit forward or normal carry. Suppose
it is March 1st and spot gold is trading at 13,51.Then, the futures contracts on gold and
their respective prices might be as follows:
Expiration
Month Price
April 1352.50
June 1354.70
August 1356.90
December 1361.00
June of following year 1366.90
Notice that each successive contract is more expensive than the previous one. There
is a 2.20 differential between each of the first three expirations, equal to 1.10 per month
of additional expiration time. However, the differential is not quite that great for the
December, which expires in 9 months, or for the June contract, which expires in 15
months. The reason for this might be that longer-term interest rates are slightly lower than
the short-term rates, and so the cost of carry is slightly less.
However, prices in all futures don't line up this nicely. In some cases, different
months may actually represent different products, even though both are on the same
underlying physical commodity. For example, wheat is not always wheat. There is a sum-
mer crop and a winter crop. While the two may be related in general, there could be a
substantial difference between the July wheat futures contract and the December con-
tract, for example, that has very little to do with what interest rates are.
Sometimes short-term demand can dominate the interest rate effect, and a series of
futures contracts can be aligned such that the short-term futures are more expensive. This
is known as a reverse carrying charge market, or contango.
INTRAMARKETFUTURESSPREADS
Some futures traders attempt to predict the relationships between various expiration
months on the same underlying physical commodity. That is, one might buy July soybean
futures and sell September soybean futures. When one both buys and sells differing
futures contracts, he has a spread. \Vlzen botli contracts are on the same underlying
physical commodity, he has an intramarket spread.
The spreader is not attempting to predict the overall direction of prices. Rather, he
is trying to predict the differential in prices between the July and September contracts.
He doesn't care if beans go up or down, as long as the spread between July and September
goes his way.
Example: A spread trader notices that historic price charts show that if September soy-
beans get too expensive with respect to July soybeans, the differential usually disappears
in a month or two. The opportunity for establishing this trade usually occurs early in the
year-February or March.
Assume it is February 1st, and the following prices exist:
July soybean futures: 600 ($6.00/bushel)

September soybean futures: 606
The price differential is 6 cents. It rarely gets worse than 12 cents, and often reverses to
the point that July futures are more expensive than the September futures-some years
as much as 100 cents more expensive.
If one were to trade this spread from a historical perspective, he would thus be risking
approximat ely 6 cents, with possibilities of making over 100 cents. That is certainly a good
risk/reward ratio, if historic price patterns hold up in the current environment.
Suppose that one establishes the spread:
Buy one July future @ 600

Sell one September future @ 606
At some later date , the following prices and, hence , profits and losses, exist.
Futures
Price Prof
it/Loss
July: 650 +50 cents
September: 630 -24 cents
Total Profit: 26 cents ($1,300)
The spread has inverted, going from an initial state in which September was 6 cents
more expensive than Jnl:·, to a situation in which July is 20 cents more expensive. The
sprt>aclerwon kl thus make 26 cents. or $1,:100. since 1 cent in beans is worth $.50.
Chapter
35: Futures
Spreads 657
Notice that the same profit would have been made at any of the following pairs of
prices, because the price differential between July and September is 20 cents in all cases
(with July being the more expensive of the two).
JulyFutures September
Futures JulyProfit September
Profit
420 400 -180 +206
470 450 -130 +156
550 530 -50 +76
600 580 0 +26
650 630 +50 -24
700 680 +100 -74
800 780 +200 -174
Therefore, the same 26-cent profit can be made whether soybeans are in a severe
bear market, in a rousing bull market, or even somewhat unchanged. The spreader is only
concerned \-'.:ithwhether the spread widens from a 6-cent differential or not.
Charts, some going back years, are kept of the various relationships between one
expiration month and another. Spread traders often use these historical charts to deter-
mine when to enter and exit intramarket spreads. These charts display the seasonal ten-
dencies that make the relationships between various contracts widen or shrink. Analysis
of the fundamentals that cause the seasonal tendencies could also be motivation for estab-
lishing intramarket spreads.
The margin required for intramarket spread trading (and some other types of futures
spreads) is smaller than that required for speculative trading in the futures themselves. The
reason for this is that spreads are considered less risky than outright positions in the futures.
However, one can still make or lose a good deal of money in a spread-percentage-wise as
well as in dollars-so it cannot be considered conservative; it's just less risky than outright
futures speculation.
Example: Using the soybean spread from the example above, assume the speculative
initial margin requirement is $1,700. Then, the spread margin requirement might be
$.500. That is considerably less than one would have to put up as initial margin if each side
of the spread had to be margined separately, a situation that would require $3,400.
In the previous example, it was shown that the soybean spread had the potential to
widen as much as 100 points ($1.00), a move that would be worth $.5,000 if it occurred.
While it is unlikely that the spread would actually widen to historic highs, it is certainly
possible that it could widen 2.5 or 30 cents, a profit of $1,2.50 to $1,,500.
andFutures
That is certainly high leverage on a $500 investment over a short time period, so one
must classify spreading as a risk strategy.
INTERMARKETFUTURESSPREADS
Another type of futures spread is one in which one buys futures contracts in one market
and sells futures contracts in another, probably related , market. When the futures spread
is transacted in tu;o different markets, it is knou;n as an intennarket spread. Intermarket
spreads are just as popular as intramarket spreads.
One type of intermarket spread involves directly related markets. Examples include
spreads between currency futures on two different international currencies; between
financial futures on two different bond, note, or bill contracts; or between a commodity
an<l its products-oil, unleaded gasoline , and heating oil, for example .
Example: Interest rates have been low in both the United States and Japan. As a result,
both currenc:ies are depressed with respect to the European currencies, where interest
rates remain high. A trader believes that interest rates will become more uniform world-
wide, causing the Japanes e yen to appreciate with respect to the Euro foreign currency.
However, since he is not sure whether Japanese rates will move up or Euro rates will
move down, he is reluctant to take an outright position in either currency. Rather, he
decides to utilizP an intermarket spread to implement his trading idea.
Assume he establi shes the spread at the following prices:
Buy 1 June yen future : 147.00

Sell l June Euro futur e: 130 .00
This is an initial differential of 17.00 between the two currency futures. He is hoping
for the differential to get larger. The dollar trading terms are the same for both futures:
One point of movement (from 130.00 to 1.31.00, for example) is worth $1,2.50. His profit
and loss potenti al would therefore be :
SpreadDifferential
at a LaterDate Prof
it/Loss
14.00 -$3,750
16.00 -$1,250-
18.00 +l,250
20.00 +3,750
Chapter
35: Futures
Spreads 659
In some cases, the exchanges recognize frequently traded intermarket spreads

as being eligible for reduced margin requirements. That is, the exchange recognizes
that the two futures are hedges against one another if one is sold and the other is bought.
These spreads between currencies, called cross-currency spreads, are so heavily
traded that there are other specific vehicles-both futures and warrants-that allow the
speculator to trade them as a single entity. Regardless, they serve as a prime example of
an intermarket spread when the two futures are used .
In the example above, assume the outright speculative margin for a position in either
currency future is $1,700 per contract. Then, the margin for this spread would probably
be nearly $1,700 as well, equal to the speculative margin for one side of the spread. This
position is thus recognized as a spread position for margin purposes. The margin treat-
ment isn't as favorable as for the intramarket spread (see the earlier soybean example), but
the spread margin is still only one-half of what one would have to advance as initial mar-
gin if both sides of the spread had to be margined separately.
Other intennarket spreads are also eligible for reduced margin requirements, although
at first glance they might not seem to be as direct a hedge as the two currencies above were.
Example: A common intermarket spread is the TED spread, which consists of Treasury
bill futures on one side and Eurodollar futures on the other. Treasury bills represent the
safest investment there is; they are guaranteed. Eurodollars, however, are not insured,
and therefore represent a less safe investment. Consequently, Eurodollars yield more than
Treasury bills. How much more is the key, because as the yield differential expands or
shrinks, the spread between the prices of T-bill futures and Eurodollar futures expands
or shrinks as well. In essence, the yield differential is small when there is stability and
confidence in the financial markets, because uninsured deposits and insured deposits are
not that much different in times of financial certainty. However, in times of financial
uncertainty and instability, the spread widens because the uninsured depositors require
a comparatively higher yield for the higher risk they are taking.
Assume the outright initial margin for either the T-bill future or the Eurodollar
future is $800 per contract. The margin for the TED spread, however, is only $400. Thus,
one is able to trade this spread for only one-fourth of the amount of margin that would be
required to margin both sides separately.
The reason that the margin is more favorable is that there is not a lot of volatility in
this spread. Historically , it has ranged between about 0.30 and 1.70. In both futures con-
tracts, one cent (0.01) of movement is worth $2.5. Thus, the entire 140-cent historic range
of the spread only represents $3,500 (140 X $25).
More will be said later about the TED spread when the application of futures
options to intermarket spreads is discussed. Since there is a liquid option market on both
futures, it is sometimes more logical to establish the spread using options instead of futures.
andFutures
One other comment should be made regarding the TED spread: It has carrying cost.
That is, if one buys the spread and holds it, the spread will shrink as time passes, causing
a small loss to the holder. \Vhen interest rates are low, the carrying cost is small (about
0.0,5 for 3 months). It would be larger if short-term rates rose. The prices in Table 35-1
show that the spread is more costly for longer-term contracts.
TABLE 35-1.
Carrying costs of the TED spread.
Month T-Bill
Future Eurodollar
Future TED
Spread
March 96.27 95.86 0.41
June 96.15 95.69 0.46
September 95.90 95.39 0.51
Many intnmarket sprt>acls have some sort of carrying cost built into them; the
spreader should be aware of that fact, for it may figure into his profitability.
Ont> final, and more complex, example of an intermarket spread is the crack spread.
Thert' art' two major ,trt'as in which a basic commodity is traded, as well as two of its products:
crude oil, unleaded gasoline, and heating oil; or soybeans, soybean oil, and soybean meal. A
crack spread involves trading all three-the base commodity and both by-products.
Example: The crack spread in oil consists of buying two futures contracts for crude oil
and selling one contract each for heating oil and unleaded gasoline.
The units of trncling are not the same for all three. The crude oil future is a contract for
L000 barrels of oiL it is traded in units of dollars per barrel, so a $1 increase in oil prices-
from $18.00 to $19.00, say-is worth $1,000 to the futures contract. Heating oil and unleaded
gasoline futures contracts have similar terms, but they are different from crude oil. Each of
these futures is for 42,000 gallons of the product, and they are traded in cents. So, a one-cent
mm·e-gasoline going from 60 cents a gallon to 61 cents a gallon-is worth $420. This infor-
mation is summarized in Table 8,5-2by showing how much a unit change in price is worth.
TABLE 35-2.
Terms of oil production contract.
Initial Subsequent Gainin
Contract Price Price Dollars
Crude Oil 18.00 19.00 $1,000
Unleaded Gasoline .6000 .6100 $ 420
Heating Oil .5500 .5600 $ 420
Chapter
35: Futures
OptionStra_tegies
forFutures
Spreads 661
The following formula is generally used for the oil crack spread:
(Unleaded gasoline+ Heating oil) X 42 - 2 X Crude

Crack=
2
(.6000 + .5500) X 42 - 2 X 18.00
2
= (48.3 - 36)/2
= 6.15
Some traders don't use the divisor of 2 and, therefore, would arrive at a value of
12.30 with the above data .
In either case, the spreader can track the history of this spread and will attempt to buy
oil and sell the other two, or vice versa, in order to attempt to make an overall profit as the
three products move. Suppose a spreader felt that the products were too expensive with
respect to crude oil prices. He would then implement the spread in the following manner:
Buy 2 March crude oil futures @ 18.00

Sell l March heating oil future @ 0.5500
Sell 1 March unleaded gasoline future @ 0.6000
Thus, the crack spread was at 6.1.5when he entered the position. Suppose that he
was right, and the futures prices suhsequently changed to the following:
March crude oil futures: 18.50

March unleaded gas futures : .6075
March heating oil futures: .5575
The profit is shown in Table 35-3.
TABLE 35-3.
Profit and loss of crack spread.
Initial Subsequent Gainin
Contract Price Price Dollars
2 March Crude 18.00 18.50 +$1,000
l March Unleaded .6000 .6075 -$315
l March Heating Oil .5500 .5575 -$315
Net Profit (before commissions) +$370
One can calculate that the crack spread at the new prices has shrunk to 5.965.
Thus, the spreader was correct in predicting that the spread would narrow, and he profited.
Margin requirements are also favorable for this type of spread, generally being
slightly less than the speculative requirement for two contracts of crude oil.
The above examples demonstrate some of the various intermarket spreads that are
heavily watched and traded by futures spreaders. They often provide some of the most
reliable profit situations without requiring one to predict the actual direction of the mar-
ket itself. Only the differential of the spread is important.
One should not assume that all intermarket spreads receive favorable margin treat-
ment. Only those that have traditional relationships do.
USING FUTURES OPTIONS IN FUTURES SPREADS
After viewing the above examples, one can see that futures spreads are not the same as
what we typically know as option spreads. However, option contracts may be useful in
futures spreading strategies. They can often provide an additional measure of profit
potential for very little additional risk. This is true for both intramarket and intermarket
spreads.
The futures option calendar spread is discussed first. The calendar spread with
futures options is uot the same as the calendar spread with stock or index options. In fact,
it may best be viewed as an alternative to the intramarket futures spread rather than as
an option spread strategy.
CALENDAR SPREADS
A calendar spread with futures options would still be constructed in the familiar
manner-buy the May call, sell the March call with the same striking price. However,
there is a major difference between the futures option calendar spread and the stock
option calendar spread. That difference is that a calendar spread using futures options
inwlves tu;o separate underlying instruments, u;hile a calendar spread using stock
options does not. When one buys the May soybean 600 call and sells the March soybean
600 call, he is buying a call on the May soybean futures contract and selling a call on the
March so_vbean futures contract. Thus, the futures option calendar spread involves two
separate, but related, underlying futures contracts. However, if one buys the IBN May
100 call and sells the IBN March 100 call, both calls are on the same underlying instru-
nwnt, IB:'.\J.This is a major difference between the two strategies, although both are
called "calen dar spreads."
Chapter
35: Futures
Spreads 663
To the stock option trader who is used to visualizing calendar spreads, the futures
option variety may confound him at first. For example, a stock option trader may conclude
that if he can buy a four-month call for ,5points and sell a two-month call for 2 points, he
has a good calendar spread possibility. Such an analysis is meaningless with futures
optiom. If one can buy the May soybean 600 call for .5 and sell the March soybean 600
call for 3, is that a good spread or not'? Ifs impossible to tell, unless you know the relation-
ship between May and March soybean futures contracts. Thus, in order to analyze the
futures option calendar spread, one must not only analyze the options' relationship, but
the two futures contracts' relationship as well. Simply stated, when one establishes a
futures option calendar spread, he is not only spreading time, as he does with stock
options, he is also spreading the relationship between the underlying futures.
Example: A trader notices that near-term options in soybeans are relatively more expen-
sive than longer-term options. He thinks a calendar spread might make sense, as he can
sell the overpriced near-term calls and buy the relatively cheaper longer-term calls. This
is a good situation, considering the theoretical value of the options involved. He estab-
lishes the spread at the following prices:
Soybean
Contract Initial
Price Trading
Position
March 600 call 14 Sell 1
May 600 call 21 Buy 1
March future 594 none
May future 598 none
The May/March 600 call calendar spread is established for 7 points debit. March
expiration is two months away. At the current time, the May futures are trading at a
4-point premium to March futures. The spreader figures that if March futures are approx-
imately unchanged at expiration of the March options, he should profit handsomely,
because the March calls are slightly overpriced at the current time, plus they will decay
at a faster rate than the May calls over the next two months.
Suppose that he is correct and March futures are unchanged at expiration of the
March options. This is still no guarantee of profit, because one must also determine where
May futures are trading. If the spread between May and March futures behaves poorly (May
declines with respect to March), then he might still lose money. Look at the following table
to see how the futures spread between March and May futures affects the profitability of
the calendar spread. The calendar spread cost 7 debit when the futures spread was +4
initially.
664 PartV: IndexOptionsandFutures
Futures r
Calenda
Prices
Futures Spread May600Call Spread
March/May Price Price Profit/Loss
594/570 - 24 4 -3 cents
594/580 - 14 6½ -½
594/590 -4 10 +3
594/600 +6 14½ +7½
Thus, the calendar spread could lose money even with March futures unchanged, as
in the top two lines of th e table. It also could do better than expected if the futures spread
wid ens, as in the bottom line of the tabl e.
Tlie profitahiliflj cf the calendar spread is heauil1Jlinked to the futures spread

p rice. !11the above example , it was possible to lose money even though the March futures
contract was unchanged in price from the time the calendar spread was initially established.
This would never happen with stock options. If one placed a calendar spread on IBN and
the stock were unchanged at the expira tion of the near- term option, the spread would make
mone: · ,·irtuall:· all of th e time (unless implied volatility had shrunk dramatically).
The futures option calendar spreader is therefore trading two spreads at once. The
first oue has to do with the relative pricing differentials (impl ied volatilities , for examp le)
of th e two options in question , as well as the passage of time . The second one is the rela-
tionship between the two underlying futures contracts. As a resu lt, it is difficu lt to draw
th e ordinary profit picture . Rather, one must approach the problem in this manner:
1. Use the horizontal axis to represe nt the futures spread price at the expiration of the
ne ar-term opt ion .
2. Draw several profit curv es, one for each price of the near-term future at near-term
expiration.
Examp le: Expanding on the above examp le, this method is demonstrated here.
Figure 3.5-1 shows how to approach the problem. The horizonta l axis depicts the
spread between March and May soybean futur es at the expiration of the March futures
options. The vertical axis represents the profit and loss to be expected from the calendar
sprea d , as it always does.
Tlie major differenc e betw een this profit graph and standard ones is th at there are
now se,·eral sets of profit curv es. A separate one is drawn for each price of the March
f11t11rcs that one w,u1ts to con sider in his analysis. The previous example showed the profit-
ahilit: for onl:· one pric e of the March futur es-unchanged at ,594. However, one cannot
Chapter
35:FuturesOptionStrategiesforFuturesSpreads 665
FIGURE 35-1.
Soybean futures calendar spreads, at March expiration.
20
March= 604
March= 594
16
March= 614
12 March= 584
CJ)
CJ)
.3 8
~ March= 574
'§
ct 4
0
CJ)
~o~-~~-~~~-~~~~~-~~~~-~-~
~ 12 16
-8
March/May Spread
TABLE35-4.
Profit and loss from soybean call calendar.
AllPrices
atMarch
Option
Expiration
Futures Calendar
SpreadProfit
Spread March
Future Future
(May-March) Price
: 574 584 594 604 614 Spread
Profit
-24 -5.5 -4.5 -3 -4.5 -11.5 -28
-14 -4.5 -3 -0.5 -1 -7 -18
-4 -2.5 0 +3 +3.5 -1 - 8
6 0 +3 +7.5 +9 +5.5 + 2
16 +7 +11 +17 +19 +13 +12
rely on the March futures to remain unchanged, so he must view the profitability of the
calendar spread at various March futures prices.
The data that is plotted in the figure is summarized in Table :35-4. Several things are
readily apparent. First, if the futures spread improves in price, the calendar spread will gener-
ally make money. These are the points on the far right of the figure and on the bottom line
of Table :35-4. Second, if the futures spread behaves miserably, the calendar spread will
almost certainly lose money (points on the left-hand side of the figure, or top line of the table).
666 Part V:Index Optionsand Futures
Third, if March futures rise in price too far, the calendar spread could do poorly. In
fact, if March futures rally and the futures spread worsens, one could lose more than his
initial debit (bottom left-hand point on figure). This is partly due to the fact that one is
buying the March options back at a loss if March futures rally, and may also be forced to
sell his May options out at a loss if May futures have fallen at the same time.
Fourth, as might be expected, the best results are obtained if March futures rally
slightly or remain unchanged and the futures spread also remains relatively unchanged
(point s in the upper right-hand quadrant of the figure ).
In Table .3.5-4,the far right-hand column shows how a futures spreader would have
fared if he had bought May and sold March at 4 points May over March, not using any
option s at all.
This example demonstrates just how powerful the influence of the futures spread is.
The calendar spread profit is predominantly a function of the futures spread price. Thus,
even though the calendar spread was attractive from the theoretical viewpoint of the
option's prices, its result does not seem to reflect that theoretical advantage, due to the
influence of the futures spread. Another important point for the calendar spreader used
to dealing with stock options to remember is that one can lose more than his initial debit
in a futures calendar spread if the spread between the underlying futures inverts.
There is another way to view a calendar spread in futures options, however, and that
is as a substitute or alternative to an intramarket spread in the futures contracts them-
selves. Look at Table :3.5-4again and notice the far right-hand column. This is the profit
or loss that would be made by an intramarket soybean spreader who bought May and sold
March at the initial prices of .598 and .594, respectively. The calendar spread generally
outperforms the intramarket spread for the prices shown in this example. This is where
the true theoretical advantage of the calendar spread comes in. So, if one is thinking of
establishing an intramarket spread, he should check out the calendar spread in the
futures options first. If the options have a theoretical pricing advantage, the calendar
spread may clearly outperform the standard intramarket spread .
Study Table :3.5-4for a moment. Note that the intrarnarket spread is only better when
prices drop but the spread widens (lower left corner of table). In all other cases, the cal-
endar spread strategy is better. One could not always expect this to be true, of course; the
results in the example are partly due to the fact that the March options that were sold
were relatively expensive when compared with the May options that were bought.
In summary, the futures option calendar spread is more complicated when com-
pared to the simpler stock or index option calendar spread. As a result, calendar spreading
with futures options is a less popular strategy than its stock option counterpart. However,
this does not mean that the strategist should overlook this strategy. As the strategist
knows, he can often find the best opportunities in seemingly complex situations, because
Chapter
35: Futures
Spreads 667
there may be pricing inefficiencies present. This strategy 's main application may be for
the intramarket spreader who also understands the usage of options.
LONG COMBINATIONS
Another attractive use of options is as a substitute for two instruments that are being
traded one against the other. Since intermarket and intramarket futures spreads involve
two instruments being traded against each other, futures options may be able to work well
in these types of spreads. You may recall that a similar idea was presented with respect to
pairs trading, as well as certain risk arbitrage strategies and index futures spreading.
In any type of futures spread, one might be able to substitute options for the actual
futures. He might buy calls for the long side of the spread instead of actually buying futures.
Likewise , he could sell calls or buy puts instead of selling futures for the other side of the
spread. In using options, however, he wants to avoid two problems. First, he does not want
to increase his risk. Second, he does not want to pay a lot of time value premium that could
waste away, costing him the profits from his spread.
Let's spend a short time discussing these two points. First, he does not want to
increase his risk. In general, selling options instead of utilizing futures increases one's risk.
If he sells calls instead of selling futures, and sells puts instead of buying futures, he could
be increasing his risk tremendously if the futures prices moved a lot. If the futures rose
tremendously , the short calls would lose money, but the short puts would cease to make
money once the futures rose through the striking price of the puts. Therefore, it is not a
recommended strategy to sell options in place of the futures in an intramarket or inter-
market spread. The next example will show why not.
Example: A spreader wants to trade an intramarket spread in live cattle. The contract is
for 40,000 pounds, so a one-cent move is worth $400. He is going to sell April and buy
June futures, hoping for the spread to narrow between the two contracts.
The following prices exist for live cattle futures and options:
April future: 78.00

June future: 74.00
April 78 call: 1.25
June 74 put: 2.00
He decides to use the options instead of futures to implement this spread. He sells
the April 78 call as an alternative to selling the April future; he also sells the June 74 put
as an alternative to buying the June future .
Sometime later , the following prices exist:
April future : 68.00

June future : 66.00
April 78 call: 0.00
June 74 put: 8.05
The futures spread has indeed narrowed as expected-from 4.00 points to 2.00.
However, this spreader has no profit to show for it; in fact he has a loss. The call that he
sold is now virtually worthless and has therefore earned a profit of 1.25 points; however,
the put that was sold for 2.00 is now worth 8.05-a loss of 6.05 points. Overall, the
spreader has a net loss of 4.80 points since he used short options, instead of the 2.00-point
gain he could have had if he had used futures instead.
The second thing that the futures spreader wants to ensure is that he does
not pay for a lot of time value premium that is wasted, costing him his potential
profits. If he buys at- or out-of-the-money calls instead of buying futures, and if he buys
at- or out-of-the-money puts instead of selling futures, he could be exposing his spread
profits to the ravages of time decay. Do not substitute at- or out-of-the-money options
for the f11tures in intramarket or intermarket spreads. The next example will show
why not.
Example: A futures spreader notices that a favorable situation exists in wheat. He wants
to buy July and sell May. The following prices exist for the futures and options:
May futures: 410

July futures: 390
May 410 put: 20
July 390 call: 25
This trader decides to buy the May 410 put instead of selling May futures; he also
buys the July 390 call instead of buying July futures.
Later , the following prices exist:
May futures: 400

July futures: 400
May 410 put: 25
July 390 call: 30
Chapter
35: Futures
Spreads 669
The futures spread would have made 20 poiuts, since they are now the same price.
At least this time, he has made mouey in the option spread. He has made .Spoiuts on each
option for a total of 10 points overall-only half the money that could have been made
with the futures themselves. Note that these sample option prices still show a good deal
of time value premium remaining. If more time had passed and these options were trad-
ing closer to parity , the result of the option spread would be worse.
It might be pointed out that the option strategy in the above example would work
better if futures prices were volatile aud rallied or declined substantially. This is true to a
certain extent. If the market had moved a lot, one option would be very deeply
in-the-money and the other deeply out-of-the-money. Neither one would have much time
value premium, and the trader would therefore have wasted all the money spent for the
initial time premium. So, unless the futures moved so far as to outdistance that loss of
time \'alue premium, the futures moved so far as to outdistance that loss of time value
premium, the futures strategy would still outrank the option strategy.
However, this last point of volatile futures movement helping an option position is a
valid one. It leads to the reason for the only favorable option strategy that is a substitute
for futures spreads-that is, using in-the-money options. If one buys in-the-money calls
instead nf buyingfutures, and buys in-the-money puts instead of sellingfutures, he can
often create a position that has an adcantage over the intramarket or intermarketfutures
spread. In-the-money options avoid most of the problems described in the two previous
examples. There is no increase of risk, since the options are being hought, not sold. In
addition, the amount of money spent on time value premium is small, since hoth options
are in-the-money. In fact, one could buy them so far in the money as to virtually eliminate
any expense for time value premium. However, that is not recommended, for it would
negate the possible advantage of using moderately in-the-money options: If the underlying
futures behave in a volatile manner, it might be possible for the option spread to make
money, even if the futures spread does not behave as expected.
In order to illustrate these points, the TED spread, an intennarket spread, will be
used. Recall that in order to buy the TED spread, one would buy T-bill futures and sell
an equal quantity of Eurodollar futures.
Options exist on both T-bill futures and Eurodollar futures. If T-bill calls were
bought instead of T-bill futures, and if Eurodollar puts were bought instead of selliug
Eurodollar futures, a similar position could be created that might have some advantages
over buying the TED spread using futures. The advantage is that if T-bills ancl/or Euro-
dollars change in price by a large enough amount, the option strategist can make money,
even if the TED spread itself does not cooperate.
One might not think that short-term rates could be volatile enough to make this
a worthwhile strategy. However, they can move substantially in a short period of time,
andFutures
especiall:' if the Federal Resen-e is acti\·e in lowering or raising rates. For example. suppose
the Fed continues to lower rates and both T-bills and Eurodollars substantiall:· rise in price.
fa·entually, the puts that were purchased on the Eurodollars will become worthless, but the
T-bill calls that are owned will continue to grow in \·alue. Thus. one could make mone:·-e\·en
if the TED spread was unchanged or shrunk as long as short-term rates dropped far enough.
Similarly, if rates were to rise instead, the option spread could make mone:· as the
puts gained in value (rising rates mean T-bills and Eurodollars will fall in price) and the
calls eventually became worthless.
Example: The following prices for June T-bill and Eurodollar futures and options exist
in January. All of these products trade in units of 0.01, which is worth $:25. So a \\·hole
point is worth $2,500.
June T-bill futures: 94.75

June Euro$ futures: 94.15
June T-bill 9450 calls: 0.32
June Euro$ 9450 puts: 0.40
The TED spread, basis June, is currently at 0.60 (the difference in price of the hrn
futures). Both futures have in-the-money options with only a small amount of time value
premium in them.
The June T-bill calls with a striking price of 94.,50 are 0.:25 in the mone:· and are
selling for 0.32. Their time value premium is only 0.07 points. Similarl:·- the June Euro-
dollar puts with a striking price of 94.50 are 0.35 in the mone:· and are selling for 0.-10.
Hence, their time value premium is 0.05.
Since the total time rnlue premiurn-0.1:2 ($300)-is small. the strategist decides
that the option spread may have an advantage over the futures intermarket spread, so he
establishes the following position:
Cost
Buy one JuneT-bill call @ 0.40 $1,000
Buy one June Euro$ put @ 0.32 $ 800
Total cost: $1,800
Later. financial conditions in the world are very stable and the TED spread begins
to shrink. Howe\·er, at the same time, rates are being lowered in the United States. and
T-hill and Eurodollar prices begin to rally substantiall:·· In ~lay. when the June T-hill
options expire, the following prices exist:
Chapter
35: Futures
Spreads 671
June T-bill futur es: 95.50

Jun e Euro $ futur es: 95 .10
Jun e T-bill 9450 calls: 1.00
June Eu ro$ 9450 puts: 0.01
The TED spread has shrunk from 0.60 to only 0.40. Thus, any trader attempting to
buy the TED spread using only futures would have lost $500 as the spread moved against
him by 0.20 .
However_ look at the option position. The options are now worth a combined value
of 1.01 points ($2,525), and they were bought for 0.72 points ($1,800). Thus, the option
strategy has turned a profit of $72,5,while the futures strategy would have lost money.
Any traders who used this option strategy instead of using futures would have
enjoyed profits, because as the Federal Reserve lowered rates time after time, the prices
of both T-bills and Eurodollars rose far enough to make the option strategist's calls more
profitable than the loss in his puts. This is the advantage of using in-the-money options
instead of future s in futur es spr eading strat egies.
In fairness, it should be pointed out that if the futures prices had remained relatively
unchanged, the 0.12 points of time value premium ($300) could have been lost, while the
futures spread may have been relatively unchanged. However, this does not alter the rea-
soning behind wanting to use th is opti on strat egy.
Another consideration that might come into play is the margin required. Recall that
the initial margin for implementing the TED spread was $400. However, if one uses the
option strategy, he must pay for the options in full-$1,800 in the above example. This
could conceivably be a deterrent to using the option strategy. Of course, if by investing
$1,800, one can make money instead of losing money with the smaller investment, then
the initial margin requirement is irrelevant. Therefore, the profit potential must be con-
sidered th e more important factor .
FOLLOW-UP CONSIDERATIONS
When one uses long option combinations to implement a futures spread strategy, he
may find that his position changes from a spread to more of an outright position. This would
occur if the markets were volatile and one option became deeply in-the-money , while the
other one was nearly worthless. The TED spread example above showed how this could
occur as the call wound up being worth 1.00, while the put was virtually worthless.
As one side of the option spread goes out-of-the-money, the spread nature begins to
disappear and a more outright position takes its place. One can use the deltas of the options
in order to calculate just how much exposure he has at any one time. The following
andFutures
examples go through a series of analyses and trades that a strategist might have to face. The
first example concerns establisliing an intermarket spread in oil products.
Example: In late summer, a spreader decides to implement an intermarket spread. He

projects that the coming winter may be severely cold; furthermore, he believes that gas-
oline prices are too high, being artificially buoyed by the summer tourist season, and the
high prices are heing carried into the future months by inefficient market pricing.
Therefore, he wants to buy heating oil futures or options and sell RBOB gasoline
futures or options (at the current time, this is the main gasoline futures contract, having
replaced unleaded gasoline futures in that role in 2006). He plans to be out of the trade,
if possible, hy early December, when the market should have discounted the facts about
the winter. Therefore, he decides to look at January futures and options. The following
prices exist:
TimeValue
Future
orOption Price Premium
January heating oil futures: .6550
January RBOB gasoline futures: .5850
January heating oil 60 call: 6.40 0.90
January RBOB gas 62 put: 4.25 0.75
The differential in futures prices is .07, or 7 cents per gallon. He thinks it could grow
to 12 cents or so hy early \vinter. However, he also thinks that oil and oil products have
the potential to be very volatile, so he considers using the options. One cent is worth $420
for each of these items.
The time value premium of the options is 1.6,5 for the put and call combined. If he
pays this amount ($693) per combination, he can still make money if the futures widen
by 5.00 points, as he expects. Morem,er, the option spread gives him the potential for
profits if oil products are volatile, even if he is wrong about the futures relationship.
Therefore, he decides to buy five combinations:
Position Cost
Buy 5 January heating oil 60 calls @ 6.40 $13,440
Buy 5 January RBOB 62 puts @ 4.25 8,925
Total cost: $22,365
This initial cost is substantially larger than the initial margin requirement for five
Chap
ter 35: Futures
Spreads 673
futures spreads, which would he about $7,000. Moreover, the option cost must be paid for
in cash, while the futures requirement could be taken care of with Treasury bills, which
continue to earn money for the spreader. Still, the strategist believes that the option posi-
tion has more potential, so he establishes it.
Notice that in this analysis, the strategist compared his time value premium cost to the
profit potential he expected from the futures spread itse(f This is often a good way to evaluate
whether or not to use options or futures. In this example, he thought that, even if futures
prices remained relatively unchanged, thereby wasting away his time premium, he could still
make money-as long as he was correct about heating oil outperforming RBOB gasoline.
Some follow-up actions will now be examined. If the futures rally, the position
becomes long. Some profit might have accrued, but the whole position is subject to losses
if the futures fall in price. The strategist can calculate the extent to which his position has
become long by using the delta of the options in the strategy. He can then use futures or
other options in order to make the position more neutral , if he wants to .
Example: Suppose that both RBOB gasoline and heating oil have rallied some and that
the futures spread has widened slightly. The following information is known:
Net
Future
orOption Price Change Profit/Loss
January heating oil futures: .7100 +.055
January RBOB gasoline futures: .6300 +.045
January heating oil 60 call: 11.05 +4.65 +$9,765
January RBOB gas 62 put: 1.50 -2.75 -5,775
Total profit: +$3,990
The futures spread has widened to 8 cents. If the strategist had established the
spread with futures, he would now have a one-cent ($420) profit on five contracts, or a
$2,100 profit. The profit is larger in the option strategy.
The futures have rallied as well. Heating oil is up ,5½ cents from its initial price,
while RBOB is up 4½ cents. This rally has been large enough to drive the puts
out-of-the-money. When one has established the intermarket spread with options, and the
futures rally this much, the profit is usually greater from the option spread. Such is the
case in this example, as the option spread is ahead by almost $4,000.
This example shows the most desirable situation for the strategist who has imple-
mented the option spread. The futures rally enough to force the puts out-of-the-money,
andFutures
or alternatively fall far enough to force the calls to be out-of-the-money. If this happens
in advance of option expiration, one option will generally have almost all of its time value
premium disappear (the calls in the above example). The other option, however, will still
have some time value (the puts in the example).
This represents an attractive situation. However, there is a potential negative, and
that is that the position is too long now. It is not really a spread anymore. If futures should
drop in price, the calls will lose value quickly. The puts will not gain much, though,
because they are out-of-the-money and will not adequately protect the calls. At this junc-
ture, the strategist has the choice of taking his profit-closing the position-or making
an adjustment to make the spread more neutral once again. He could also do nothing, of
course, but a strategist would normally want to protect a profit to some extent.
Example: The strategist decides that, since his goal was for the futures spread to widen
to 12 cents, he will not remove the position when the spread is only 8 cents, as it is now.
However, he wants to take some action to protect his current profit, while still retaining
the possibility to have the profit expand.
As a first step, the equivalent futures position (EFP) is calculated. The pertinent
data is shown in Table 35-5.
TABLE 35-5.
EFP of long combination.
Future
orOption Price Delta EFP
January RBOBgasolinefutures: .6300
January heatingoil 60 call: Long5 11.05 0.99 +4.95
January RBOBgas 62 put: Long5 1.50 -0.40 -2.00
Total EFP: +2.95
Overall, the position is long the equivalent of about three futures contracts. The
position's profitability is mostly related to whether the futures rise or fall in price, not to
how the spread between heating oil futures and RBOB gas futures behaves.
The strategist could easily neutralize the long delta by selling three contracts. This
would leave room for more profits if prices continue to rise (there are still two extra long
calls). It would also provide downside protection if prices suddenly drop, since the ,5 long
puts plus the 3 short futures \,vould offset any loss in the ,5 in-the-money calls.
Which futures should the strategist short? That depends on how confident he is in
his original analysis of the intermarket spread widening. If he still thinks it will widen
Chapter
35: Futures
Spreads 675
further, then he should sell RBOB gasoline futures against the deeply in-the-money heat-
ing oil calls. This would give him an additional profit or loss opportunity based on the
relationship of the tvvo oil products. However, if he decides that the intermarket spread
should have widened more than this by now, perhaps he will just sell 3 heating oil futures
as a direct hed ge against the heating oil calls.
Once one finds himself in a profitable situation, as in the above example, the most
consercative course is to hedge the in-the-money option with its own underlyingfuture.
This action lessens the further dependency of the profits on the intennarket spread. There
is still profit potential remaining from futures price action. Furthermore, if the futures
should fall so far that both options return to in-the-money status, then the intermarket
spread comes back into play. Thus, in the above example, the conservative action would
be to sell three heating oil futures against the heating oil calls.
The more aggressive course is to hedge the in-the-money option with the future
underlying the other side of the intermarket spread. In the above example, that would
entail selling the RBOB gasoline futures against the heating oil calls.
Suppose that the strategist in the previous example decides to take the conservative
action, and he therefore shorts three heating oil futures at .7100, the current price. This
action preserves large profit potential in either direction. It is better than selling
out-of-the-money options against his current position.
He would consider removing the hedge if futures prices dropped, perhaps when the
puts returned to an in-the-money status with a put delta of at least -0.7,5 or so. At that
point, the position would be at its original status, more or less, except for the fact that he
would have taken a nice profit in the three futures that were sold and covered.
Epilogue . The above examples are taken from actual price movements. In reality, the
futures fell back, not only to their original price, but far below it. The fundamental reason
for this reversal was that the weather was warm, hurting demand for heating oil, and gaso-
line supplies were low. By the option expiration in December, the following prices existed:

January RBOB gas futures: .5200
Not only had the futures prices virtually crashed, but the intermarket spread had
been decimated as well. The spread had fallen to zero! It had never reached anything near
the 12-cent potential that was envisioned. Any spreader who had established this spread
with futures would almost certainly have lost money; he probably would not have held it
until it reached this lowly level, but there was never much opportunity to get out at a profit.
The strategist who established the spread with options, however, most certainly
would have made money. One could safely assume that he covered the three futures sold
andFutures
in the previous example at a nice profit, possibly 7 points or so. One could also assume
that as the puts became in-the-money options, he established a similar hedge and bought
three RBOB gasoline futures when the EFP reached -3.00. This probably occurred with
RBOB gasoline futures around .5700-5 cents in the money .
Assuming that these were the trades, the following table shows the profits and
losses.
Initial Final NetProfit/

Position Price Price Loss
Bought 5 calls 6.40 0 -$13,440
Bought 5 puts 4.25 10.00 +12,075
Sold 3 heating oil futures .7100 .6400 +8,820
Bought 3 RBOB gas futures .5700 .5200 -6,300
Total profit : +$1,155
In the final analysis, the fact that the intennarket spread collapsed to zero actually
aided the option strategy, since the puts were the in-the-money option at expiration. This
was not planned, of course, but by being long the options, the strategist was able to make
money when volatility appeared.
INTRAMARKET SPREAD STRATEGY
It should be obvious that the same strategy could be applied to an intramarket spread as
well. If one is thinking of spreading two different soybean futures, for example, he could
substitute in-the-money options for futures in the position. He would have the same attri-
butes as shown for the intennarket spread: large potential profits if volatility occurs. Of
course, he could still make money if the intramarket spread widens, but he \Vould lose the
time value premium paid for the options .
SPREADING FUTURES AGAINST STOCK SECTOR INDICES
This concept can be carried one step further. Many futures contracts are related to
stocks-usually to a sector of stocks dealing in a particular commodity. For example,
there are crude oil futures or the crude oil ETF (USO) and there is an Oil & Gas Sector
Index (XOI). There are gold futures or the gold ETF (GLD) and there is a Gold & Silver
Index (XAU). If one charts the history of the commodity versus the price of the stock sec-
Chapter
35: Futures
Spreads 677
tor, he can often find tradeable patkrns in terms of the rdationship between the two .
That relationship can be traded via an i11terrnarket spread using options.
For example, if one thought crude oil was cheap with respect to the price of oil stocks
in general, he could bu_vcalls on crude oil futures or USO and buy puts on the Oil & Gas
(XOI) Index. One would have to be certain to determine the number of options to trade
on each side of the spread, by using the ratio that was presented in Chapter :31 on
inter-index spreading. (In fact, this formula should be used for futures intermarket spread-
ing if the two underlying futures don't have the same terms.) Only now, there is an extra
component to add if options are used-t he delta of the options:
Ratio= ~x~x_!!_l_x_fu_
V2 p 2 U2 A2
where vi = volatility
pi = price of the underlying
ui = unit of trading of the option
~ = delta of the option
Example: Suppose that one indeed wants to buy crude oil calls and also buy puts on the
XOI Index because he thinks that crude oil is cheap with respect to oil stocks. The follow-
ing prices exist:
July crude futures : 16.35 XOI:256.50

Crude July 1550 call: 1.10 June 265 put : 14½
Volatility: 25% Volatility: 17%
Call delta: 0.74 Put delta: 0.73
The unit of trading for XOI options is $100 per point, as it is with nearly all stock and
index options. The unit of trading for crude oil futures and options is $1,000 per point.
With all of this information, the ratio can be computed:
Crude= 1,000 X 0.25 X 16.35 X 0.74

XOI = 100X0.17X256.50X0.73
Ratio = Crude/XO! = 0.91
Therefore, one would buy 0.91 XOI put for every 1 crude oil call that he bought. For small
accounts, this is essentially a 1-to-l ratio, but for large accounts, the exact ratio could be
used (for example, buy 91 XOI puts and 100 crude oil calls). The resultant quantities
encompass the various differences in these two markets-mainly the price and volatility
of the underlyings, plus the large differential in their units of trading (100 vs. 1,000).
SUMMARY
Futures spreading is a very irnportant and potentially profitable endeavor. Utilizing

options in these spreads can often improve profitability to the point that an originally
mistaken assumption can be overcome by volatility of price movement.
Futures spreads fall into two categories-intermarket and intramarket. They are
important strategies because many futures exhibit historic and/or seasonal tendencies that
can be traded without regard to the overall movement of futures prices.
Options can be used to enhance these futures spreading strategies. The futures
calendar spread is closely related to the intramarket spread. It is distinctly different from
the stock or index option calendar spread.
Using in-the-money long option combinations in lieu of futures can be a very attrac-
tive strategy for either intermarket or intramarket spreads. The option strategy gives the
spreader two ways to make money: (1) from the movement of the underlying futures in
the spread; or (2) if the futures prices experience a big move, from the fact that one option
can continually increase in value while the other can drop only to zero. The option strat-
egy also affords the strategist the opportunity for follow-up action based on the equivalent
futures position that accumulates as prices rise or fall.
The concepts introduced in this chapter apply not only to futures spreads, but to
intermarket spreads between any two entities. An example was given of an intermarket
spread between futures and a stock sector index, but the concept can be generalized to
apply to any two related markets of any sort.
Traders who utilize futures spreads as part of their trading strategy should give seri-
ous consideration to substituting options when applicable. Such an alternative strategy will
often improve the chances for profit.
Measuring and
Trading Volatility
680 PartVI:Measuring
andTrading
Volatility
Even though a myriad of strategies and concepts have been presented so far, a common
thread among them is lacking. The one thing that ties all option strategies together and
allows one to make comparative decisions is volatility. In fact, volatility is the most impor-
tant concept in option trading. Oh, sure, if you're a great picker of stocks, then you rnight
be able to get by without considering volatility. Even then, though, you'd be operating
without full consideration of the main factor influencing option prices and strategy. For
the rest of us, it is mandatory that we consider volatility carefully before deciding what
strategy to use. In this section of the book, an extensive treatment of volatility and volatil-
ity trading is presented. The first part defines the terms and discusses some general con-
cepts about how volatility can-and should-be used. Then, a number of the more
popular strategies, described earlier i11the book, are discussed from the vantage point of
how they perform when implied volatilities change. After that, volatility trading strategies
are discussed-and these arE:'some of the most important concepts for option traders. A
discussion is presented on how stock prices actually behave, as opposed to how investors
pcrccicc them to behave, and then specific criteria and methodology for both buying and
selling volatility are introduced.
The information to be presented here is not overly theoretical. All of the concepts
should be understandable hy most option traders. Whether or not one chooses to actually
"trade volatility," it is nevertheless important for an option trader to understand the con-
cepts that underlie the basic principles of volatility trading.
WHY TRADE 11 THE MARKET"?
The "game'' of stock market predicting holds appeal for many because one who can do it
seems powerful and intelligent. Everyone has his favorite indicators, analysis techniques,
or "black box" trading systems. But can the market really be predicted? And if it can't,
what does that say about the time spent trying to predict it? The answers to these ques-
tions are not clear, and even if one were to prove that the market can't be predicted, most
traders would refuse to believe it anyway. In fact, there may be more than one way to
"predict" the market, so in a certain sense one has to qualify exactly what he is talking
about before it can be determined if the market can be predicted or not.
Tlw astute option trader knows that market prediction falls into two categories:
( l) the prediction of the short-term movement of prices, and (2) the prediction of volatility
of the underl:-,·ing. These are not independent predictions. For example, anyone who is
using a "target" is trying to predict both. That's pretty hard. Not only do you have to be
right about the direction of prices, hut :-,·oualso have to be able to predict how volatile the
underlying is going to be so that you can set a reasonable target. In certain cases, the first
PartVI:Measuring
andTrading
Volatility 681
prediction can be made with some degree of accuracy, but the second one is extremely
difficult.
Nearly every trader uses something to aid him in determining what to buy and when
to buy it. Many of these techniques, especially if they are refined to a trading S!JStern,seem
worthwhile. In that sense, it appears that the market can be predicted. However, this type
of predicting usually involves a lot of work including not only the initial selection of the
position, but money management in determining position size, risk management in plac-
ing and watching (trailing) stops, and so on . Thus , it's not easy.
To make matters even worse, most mathematical studies have shown that the market
can 't really be predicted. They tend to imply that anyone who is outperforming an index
fund is merely "hot''-has hit a stream of winners. Can this possibly be true? Consider
this example. Have you ever gone to Las Vegas and had a winning day? How about a week-
end? \Vhat about a week? You might be able to answer "yes" to all of those, even though
you know for a certainty that the casino odds are mathematically stacked against you.
What if the question were extended to your lifetime: Are you ahead of the casinos for your
entire life? This answer is most certainly "no" if you have played for any reasonably long
period of time.
Mathematicians have tended to believe that outperforming the broad stock market
is just about the same as beating the casinos in Las Vegas-possible in the short term, but
virtually impossible in the long term. Thus, when mathematicians say that the stock mar-
ket can't be predicted, they are talking about consistently beating the "index"-say, the
S&P 500-over a long period of time .
Those with an opposing viewpoint, however, say that the market can be beat. They
say the "game" is more like poker-where a good player can be a consistent winner through
money management techniques-than like casino gambling, where the odds are fixed. It
would be impossible to get everyone to agree for sure on who is right. There's some cred-
ibility in both viewpoints, but just as it's very hard to be a good poker player, so it is difficult
to beat the market consistently with directional strategies. Moreover, even the best direc-
tional traders know that there are large swings or draw downs in one's net worth during the
year. Thus, the consistency of returns is generally erratic for the directional trader.
This inconsistency of returns, the amount of work required, and the necessity to
have sufficient capital and to manage it well are all factors that can lead to the demise of
a directional trader. As such, short-term directional trading probably is not really a "com-
fortable" trading strategy for most traders-and if one is trading a strategy that he is not
comfortable with, he is eventually going to lose money doing it.
So, is there a better alternative? Or should one just pack it in, buy some index funds,
and forget it? As an option strategist, one should most certainly believe that there's some-
thing better than buying the index fund. The alternative of volatility trading offers signifi-
cant advantages in terms of the factors that make directional trading difficult.
andTrading
Volatility
If one finds that he is able to handle the rigors of directional trading, then stick with
that approach. You might want to add some volatility trading to your arsenal, though, just
to be safe. However, if one finds that directional trading is just too time-consuming, or
you have trouble utilizing stops properly , or are constantly getting whipsawed, then it's
time to concentrate more heavily on volatility trading, preferably in the form of straddle
buying.
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...~.rn-rim'k$.,,
....
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¼'
The Basics of
Volatility Trading
Volatility trading first attracted mathematically oriented traders who noticed that the mar-
ket's prediction of forthcoming volatility-for example, implied volatility-was substantially
out of line with what one might reasonably expect should happen. Moreover, many of these
traders (market-makers, arbitrageurs, and others) had found great difficulties with keeping
a "delta neutral" position neutral. Seeking a better way to trade without having a market
opinion on the underlying security, they turned to volatility trading. This is not to suggest
that volatility trading eliminates all market risk, turning it all into volatility risk, for example.
But it does suggest that a certain segment of the option trading population can handle the
risk of volatility with more deference and aplomb than they can handle price risk.
Simply stated, it seems like a much easier task to predict volatility than to predict
prices. That is said notwithstanding the great bull market of the 1990s, in which every
investor who strongly participated certainly feels that he understands how to predict prices.
Remember not to confuse brains with a bull market. Consider the chart in Figure 36-1.
This seems as if it might be a good stock to trade: Buy it near the lows and sell it near the
highs, perhaps even selling it short near the highs and covering when it later declines. It
appears to have been in a trading range for a long time, so that after each purchase or sale,
it returns at least to the midpoint of its trading range and sometimes even continues on to
the other side of the range. There is no scale on the chart, but that doesn't change the fact
that it appears to be a tradeable entity. In fact, this is a chart of implied volatility of the
options on a major U.S. corporation. It really doesn't matter which one (it's IBM), because
the implied volatility chart of nearly every stock, index, or futures contract has a similar
pattern-a trading range. The only time that implied volatility will totally break out of its
683
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tility
FIGURE 36-1.
A sample chart.
Buy at these points.
"normal" range is if something material happens to change the fundamentals of the way
the stock moves-a takeover bid, for example, or perhaps a major acquisition or other
dilution of the stock.
So, many traders observed this pattern and have become adherents of trying to
predict volatility. Notice that if one is able to isolate volatility, he doesn't care where the
stock price goes-he is just concerned with buying volatility near the bottom of the range
and selling it when it gets back to the middle or high end of the range, or vice versa. In
real life, it is nearly impossible for a public customer to be able to isolate volatility so spe-
cifically. He will have to pay some attention to the stock price, but he still is able to estab-
lish positions in which the direction of the stock price is irrelevant to the outcome of the
position. This quality is appealing to many investors, who have repeatedly found it difficult
to predict stock prices. Moreover, an approach such as this should work in both bull and
bear markets. Thus, volatility trading appeals to a great number of individuals. Just
remember that, for you personally to operate a strategy properly, you must find that it
appeals to your own philosophy of trading. Trying to use a strategy that you find uncom-
fortable will only lead to losses and frustration. So, if this somewhat neutral approach to
option trading sounds interesting to you, then read on.
DEFINITIONS OF VOLATILITY
Volatility is rnerel:· the term that is used to describe how fast a stock future, or index
changes in price. \\Then one speaks of volatility in connection with options, there are two
Chapter
36: TheBasicsof VolatilityTrading 685
types of volatility that are important. The first is historical volatility, which is a measure
of how fast the underlying instrument has been changing in price. The other is implied
volatility, which is the option market's prediction of the volatility of the underlying over
the life of the option. The computation and comparison of these two measures can aid
immensely in predicting the forthcoming volatility of the underlying instrument-a cru-
cial matter in determining today's option prices .
Historical volatility can be measured with a specific formula, as shown in the chapter
on mathematical applications. It is merely the formula for standard deviation as contained
in most elementary books on statistics. The important point to understand is that it is an
exact calculation, and there is little debate over how to compute historical volatility. It is not
important to know what the actual measurement means. That is, if one says that a certain
stock has a historical volatility of 20%, that by itself is a relatively meaningless number to
anyone but an ardent statistician. However, it can be used for comparative purposes.
The standard deviation is expressed as a percent. One can determine that the his-
torical volatility of the broad stock market has usually been in the range of 15% to 20%.
A very volatile stock might have an historical volatility in excess of 100%. These numbers
can be compared to each other, so that one might say that a stock with the latter historical
volatility is five times more volatile that the "stock market." So, the historical volatility of
one instrument can be compared with that of another instrument in order to determine
which one is more volatile. That in itself is a useful function of historical volatility, but its
uses go much further than that.
Historical volatility can be measured over different time periods to give one a sense of
how volatile the underlying has been over varying lengths of time. For example, it is com-
mon to compute a 10-day historical volatility, as well as a 20-day, .SO-day,and even 100-day.
In each case, the results are annualized so that one can compare the figures directly.
Consider the chart in Figure 36-2. It shows a stock (although it could be a futures
contract or index, too) that was meandering in a rather tight range for quite some time. At
the point marked "K on the chart, it was probably at its least volatile. At that time, the
10-day volatility might have been something quite low, say 20%. The price movements
directly preceding point A had been very small. However, prior to that time the stock had
been more volatile, so longer-term measures of the historical volatility would have shown
higher numbers. The possible measures of historical volatility, then at point A, might have
been something like:
l 0-day historical volatility: 20%

20-day historical volatility : 23%
50-day historical volatility: 35%
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FIGURE 36-2.
Sample stock chart.
A pattern of historical volatilities of this sort describes a stock that has been slowing
down lately.
Its price movements have been less extreme in the near term.
Again referring to Figure 36-2, note that shortly after point A, the stock jumped
much higher over a short period of time. Price action like this increases the implied vol-
atility dramatically. And, at the far right edge of the chart, the stock had stopped rising
but was swinging back and forth in far more rapid fashion than it had been at most other
points on the chart. Violent action in a back-and-forth manner can often produce a higher
historical volatility reading than a straight-line move can; it's just the way the numbers work
out. So, by the far right edge of the chart, the 10-day historical volatility would have
increased rather dramatically, while the longer-term measures wouldn't be so high
because they would still contain the price action that occurred prior to point A.
At the far right edge of Figure 36-2 , these figures might apply:

20-day historical volatility : 75%
With this alignment of historical volatilities, one can see that the stock has been
more rnlatile recently than in the more distant past. In Chapter 38 on the distribution of
Chapter
36: TheBasicsof Volatility
Trading 687
stock prices, we will discuss in some detail just which one, if any, of these historical vola-
tilities one should use as "the" historical volatility input into option and probability mod-
els. We need to be able to make volatility estimates in order to determine whether or not
a strategy might be successful, and to determine whether the current option price is a
relatively cheap one or a relatively expensive one. For example, one can't just say, "I think
XYZ is going to rise at least 18 points by February expiration." There needs to be some
basis in fact for such a statement and, lacking inside information about what the company
might announce between now and February, that basis should be statistics in the form of
volatility projections .
Historical volatility is, of course, useful as an input to the (Black-Scholes) option
model. In fact, the volatility input to any model is crucial because the volatility component
is such a major factor in determining the price of an option. Furthermore, historical vol-
atility is useful for more than just estimating option prices. It is necessary for making stock
price projections and calculating distributions, too, as will be shown when those topics
are discussed later. Any time one asks the question, "What is the probability of the stock
moving from here to there, or of exceeding a particular target price?" the answer is heavily
dependent on the volatility of the underlying stock (or index or futures).
It is obvious from the above example that historical volatility can change dramatically
for any particular instrument. Even if one were to stick with just one measure of historical
volatility (the 20-day historical is commonly the most popular measure), it changes with
great frequency. Thus, one can never be certain that basing option price predictions or
stock price distributions on the current historical volatility will yield the "correct" results.
Statistical volatility may change as time goes forward, in which case your projections would
be incorrect. Thus, it is important to make projections that are on the conservative side.
ANOTHER APPROACH: GARCH
GARCH stands for Generalized Autoregressive Conditional Heteroskedasticity, which is

why it's shortened to GARCH. It is a technique for forecasting volatility that some ana-
lysts say produces better projections than using historical volatility alone or implied vola-
tility alone. GARCH was created in the 1980s by specialists in the field of econometrics.
It incorporates both historical and implied volatility, plus one can throw in a constant
("fudge factor"). In essence, though, the user of GARCH volatility models has to make
some predictions or decisions about the weighting of the factors used for the estimate. By
its very nature, then, it can be just as vague as the situations described in the previous
section.
The model can "learn,'' though, if applied correctly. That is, if one makes a volatility
prediction for today (using GARCH, let's say), but it turns out that the actual volatility was
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lower, then when you make the volatility prediction for tomorrow, you'll probably want to
adjust it downward, using the experience of the real world, where you see volatility declin-
ing. This also incorporates the common-sense notion that volatility tends to remain the
same; that is, tomorrow's volatility is likely to be much like today's. Of course, that's a little
bit like saying tomorrow's weather is likely to be the same as today's (which it is, two-thirds
of the time, according to statistics). It's just that when a tornado hits, you have to realize
that your forecast could be wrong. The same thing applies to GARCH volatility projec-
tions. They can be wrong, too.
So, GARCH does not do a perfect job of estimating and forecasting volatility. In fact,
it might not even be superior, from a strategist's viewpoint, to using the simple minimum/
maximum techniques outlined in the previous section. It is really best geared to predict-
ing short-term volatility and is favored most heavily by dealers in currency options who
must adjust their markets constantly. For longer-term volatility projections, which is what
a position trader of volatility is interested in, GARCH may not be all that useful. How-
ever, it is considered state-of-the-art as far as volatility predicting goes, so it has a follow-
ing among theoretically oriented traders and ana lysts.
MOVING AVERAGES
Some traders try to use moving averages of daily composite implied volatility readings, or
use a smoothing of recent past historical volatility readings to make volatility estimates.
As mentioned in the chapter on mathematical applications, once the composite daily
implied volatility has been computed, it was recommended that a smoothing effect be
obtained by taking a moving average of the 20 or 30 days' implied volatilities. In fact, an
exponential moving average was recommended, because it does not require one to keep
accessing the last 20 or 30 days' worth of data in order to compute the moving average.
Rather, the most recent exponential moving average is all that's needed in order to com-
pute the next one.
IMPLIED VOLATILITY
Implied volatility has been mentioned many times already, but we want to expand on its
concept before getting deeper into its measure and uses later in this section. Implied vol-
atility pertains only to options, although one can aggregate the implied volatilities of the
\ arious options trading on a particular underlying instrument to produce a single num-
ber, which is often referred to as the composite implied volatility of the underlying.
36: TheBasicsal VolatilityTrading
Chapter 689
At any one point in time, a trader knows for certain the following items that affect
an option's price: stock price, strike price, time to expiration, interest rate , and dividends.
The only remaining factor is volatility-in fact, implied volatility. It is the big "fudge fac-
tor " in option trading. If implied volatility is too high, options will be overpriced. That is,
they will be relatively expensive . On the other hand, if implied volatility is too low, options
will be cheap or underpriced. The terms "overpriced" and "underpriced" are not really
used by theoretical option traders much anymore, because their usage implies that one
knows what the option should be worth. In the modern vernacular, one would say that
the options are trading with a "high implied volatility" or a "low implied volatility," mean-
ing that one has some sense of where implied volatility has been in the past, and the cur-
rent measure is thu s high or low in comparison.
Essentially , implied volatility is the option market's guess at the forthcoming statis-
tical volatility of the underlying over the life of the option in question. If traders believe
that the underlying will be volatile over the life of the option, then they will bid up the
option, making it more highly priced. Conversely, if traders envision a nonvolatile period
for the stock, they will not pay up for the option, preferring to bid lower; hence the option
will be relatively low-priced. The important thing to note is that traders normally do not
know the future. They have no way of knowing, for sure, how volatile the underlying is
going to be during the life of the option .
Having said that, it would be unrealistic to assume that inside information does not
leak into the marketplace. That is, if certain people possess nonpublic knowledge about a
company's earnings, new product announcement, takeover bid, and so on, they will
aggressively buy or bid for the options and that will increase implied volatility. So, in cer-
tain cases, when one sees that implied volatility has shot up quickly, it is perhaps a signal
that some traders do indeed know the future-at least with respect to a specific corporate
announcement that is about to be made .
However, most of the time there is not anyone trading with inside information. Yet,
every option trader-market-maker and public alike-is forced to make a "guess" about
volatility when he buys or sells an option. That is true because the price he pays is heavily
influenced by his volatility estimate (whether or not he realizes that he is, in fact, making
such a volatility estimate). As you might imagine, most traders have no idea what volatility
is going to be during the life of the option . They just pay prices that seem to make sense ,
perhaps based on historical volatility. Consequently, today's implied volatility may bear no
resemblance to the actual statistical volatility that later unfolds during the life of the
option.
For those who desire a more mathematical definition of implied volatility, consider
this:
Opt price= f(Stock price, Strike price, Time , Risk-free rate , Volatility, Dividends)
690 Part VI:Measurin
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Furthermore , suppose that one knows the following information :
XYZ price: 52
April 50 call price: 6
Time remaining to April expiration: 36 days
Dividends: $0 .00
Risk-freeinterest rate: 5%
This information, which is available for every option at any time, simply from an option quote,
gives us everything except the implied volatility. So what volatility would one have to plug in
the Black-Scholes model (or whatever model one is using) to make the model give the answer
6 (the current price of the option)? That is, what volatility is necessary to solve the equation?
6 =f (52, 50, 36 days, 5%, Volatility , $0.00)
Whatever volatility is necessary to make the model yield the current market price (6) as
its value, is the implied volatility for the XYZ April 50 call. In this case, if you're inter-
ested, the implied volatility is 75.4%. The actual process of determining implied volatility
is an iterative one. There is no formula, per se. Rather, one keeps trying various volatility
estimates in the model until the answer is close enough to the market value.
THE VOLAT ILITY O F VO LATILITY
In order to discuss the implied volatility of a particular entity-stock, index, or futures

contract-one generally refers to the implied volatility of individual options or perhaps the
composite implied volatility of the entire option series. This is generally good enough for
strategic comparisons. However, it turns out that there might be other ways to consider
looking at implied volatility. In particular, one might want to consider how wide the range
of implied volatility is-that is, how volatile the individual implied volatility numbers are.
It is often conventional to talk about the percentile of implied volatility. That is a way
to rank the current implied volatility reading with past readings for the same underlying
instru ment .
However, a fairly important ingredient is missing when percentiles are involved. One
can 't really tell if "cheap" options are cheap as a practical matter. That's because one
doesn't know how tightly packed together the past implied volatility readings are. For
e:-,,:ample, if one were to discover that the entire past range of implied volatility for XYZ
str etched only frorn 39% to 4,5%, then a current reading of 40%, while low, might not
Chapter
Trading 691
seem all that attractive. That is, if the first percentile of XYZ options were at an implied
volatility reading of 39% and the 100th percentile were at 4.5%, then a reading of 40% is
really quite mundane. There just wouldn't be much room for implied volatility to increase
on an absolute basis. Even if it rose to the 100th percentile, an individual XYZ option
wouldn't gain much value, because its implied volatility would only be increasing from
about 40% to 4.5%.
However, if the distribution of past implied volatility is wide, then one can truly say
the options are cheap if they are currently in a low percentile. Suppose, rather than the tight
range described above, that the range of past implied volatilities for XYZ instead stretched
from 3.5% to 90%-that the first percentile for XYZ implied volatility was at 3.5% and the
100th percentile was at 90%. Now, if the current reading is 40%, there is a large range above
the current reading into which the options could trade, thereby potentially increasing the
value of the options if implied volatility moved up to the higher percentiles.
What this means, as a practical matter, is that one not only needs to know the cur-
rent percentile of implied volatility, but he also needs to know the range of numbers over
which that percentile was derived. If the range is wide, then an extreme percentile truly
represents a cheap or expensive option. But if the range is tight, then one should probably
not be overly concerned with the current percentile of implied volatility.
Another facet of implied volatility that is often overlooked is how it ranges with
respect to the time left in the option. This is particularly important for traders of LEAPS
(long-term) options, for the range of implied volatility of a LEAPS option will not be as
great as that of a short-term option. In order to demonstrate this, the implied volatilities
of OEX options, both regular and LEAPS, were charted over several years. The resulting
scatter diagram is shown in Figure 36-3.
Two curved lines are drawn on Figure 36-3. They contain most of the data points.
One can see from these lines that the range of implied volatility for near-term options is
greater than it is for longer-term options. For example, the implied volatility readings on
the far left of the scatter diagram range from about 14% to nearly 40% (ignore the one
outlying point). However, for longer-term options of 24 months or more, the range is about
17% to 32%. While OEX options have their own idiosyncracies, this scatter diagram is
fairly typical of what we would see for any stock or index option .
One conclusion that we can draw from this is that LEAPS option implied volatilities
just don't change nearly as much as those of short-term options. That can be an important
piece of information for a LEAPS option trader especially if he is comparing the LEAPS
implied volatility with a composite implied volatility or with the historical volatility of the
underlying.
Once again, consider Figure 36-3. While it is difficult to discern from the graph
alone, the 10th percentile of OEX composite implied volatility, using all of the data points
given, is 17%. The line that marks this level (the tenth percentile) is noted on the right
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FIGURE 36-3.
Implied volatilities of OEX options over several years.
50
45
40
~ 35
~ 30
~ 25
"C
-~
0. 20
E
15
10
5
0
0 10 20 30 40
Time to Expiration (months)
side of the scatter diagram. It is quite easy to see that the LEAPS options rarely trade at
that low volatility level.
In Figure 36-3, the distance between the curved lines is much greater on the left
side (i.e., for shorter-term options) than it is on the right side (for longer-term options).
Thus, it's difficult for the longer-term options to register either an extremely high or
extremely low implied volatility reading, when all of the options are considered. Conse-
quently, LEAPS options will rarely appear "cheap" when one looks at their percentile of
implied volatility, including all the short-term options, too.
One might say that, if he were going to buy long-term options, he should look only
at the size of the volatility range on the right side of the scatter diagram. Then, he could
make his decision about whether the options are cheap or not by only comparing the cur-
rent reading to past readings of long-term options. This line of thinking, though, is some-
what fallacious reasoning, for a couple of reasons: First, if one holds the option for any
long period of time, the volatility range will widen out and there is a chance that implied
rnlatility could drop substantially. Second, the long-term volatility range might be so small
that, even though the options are initially cheap, quick increase in implied volatility over
se,·eral deciles might not translate into much of a gain in price in the short term.
Ifs important for anyone using implied volatility in his trading decisions to under-
stand that the range of past implied volatilities is important, and to realize that the volatil-
ity range expands as time shrinks.
Chapter
Trading 693
IS IMPLIED VOLATILITY A GOOD PREDICTOR OF ACTUAL VOLATILITY?
The fact that one can calculate implied volatility does not mean that the calculation is a
good estimate of forthcoming volatility. As stated above, the marketplace does not really
know how volatile an instrument is going to be, any more than it knows the forthcoming
price of the stock. There are clues, of course, and some general ways of estimating forth-
coming volatility, but the fact remains that sometimes options trade with an implied vol-
atility that is quite a bit out of line with past levels. Therefore, implied volatility may be
considered to be an inaccurate estimate of what is really going to happen to the stock
during the life of the option. Just remember that implied volatility is a forward-looking
estimat e, and since it is based on traders' suppositions, it can be wrong-just as any esti-
mate of future events can be in error.
The question posed above is one that should probably be asked more often than it
is: "Is implied volatility a good predictor of actual volatility?" Somehow, it seems logical
to assume that implied and historical (actual) volatility will converge. That's not really
true, at least not in the short term. Moreover, even if they do converge, which one was
right to begin with-implied or historical? That is, did implied volatility move to get more
in line with actual movements of the underlying, or did the stock's movement speed up
or slow down to get in line with implied volatility?
To illustrate this concept, a few charts will be used that show the comparison
between implied and historical volatility. Figure 36-4 shows information for the OEX
Index . In general, OEX options are overpriced. See the discussion in Chapter 29. That is,
implied volatility of OEX options is almost always higher than what actual volatility turns
out to be. Consider Figure 36-4. There are three lines in the figure: (a) implied volatility,
(b) actual volatility, and (c) the difference between the two. There is an important distinc-
tion here , though , as to what comprises these curves:
(a) The implied volatility curve depicts the 20-day moving average of daily composite
implied volatility readings for OEX. That is, each day one number is computed as a
composite implied volatility for OEX for that day. These implied volatility figures are
computed using the averaging formula shown in the chapter on mathematical appli-
cations, whereby each option's implied volatility is weighted by trading volume and
by distance in- or out-of-the-money, to arrive at a single composite implied volatility
reading for the trading day. To smooth out those daily readings, a 20-day simple
moving average is used. This daily implied volatility of OEX options encompasses all
the OEX options, so it is different from the Volatility Index (VIX), which uses only
the options closest to the money. By using all of the options, a slightly different vola-
tility figure is arrived at, as compared to VIX, but a chart of the two would show
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FIGURE 36-4.
OEX implied versus historical volatility.
10
Implied minus Actual 1999 Date
similar patterns. That is, peaks in implied volatility computed using all of the OEX
options occur at the same points in time as peaks in VIX.
(b) The actual volatility on the graph is a little different from what one normally thinks
of a historical volatility. It is the 20-day historical volatility, computed 20 days later
than the date of the implied volatility calculation. Hence , points on the implied vola-
tility curve are matched with a 20-day historical volatility calculation that was made
20 days later. Thus, the two curves more or less show the prediction of volatility and
what actually happened over the 20-day period. These actual volatility readings are
smoothed as well, with a 20-day moving average.
(c) The difference between the two is quite simple, and is shown as the bottom curve
on the graph. A "zero" line is drawn through the difference.
When this "difference line" passes through the zero line, the projection of volatility
and what actually occurred 20 days later were equal. If the difference line is above the
zero line, then implied volatility was too high; the options were overpriced. Conversely, if
the difference line is below the zero line, then actual volatility turned out to be greater
than implied volatility had anticipated. The options were underpriced in that case. Those
latter areas are shaded in Figure .36-4. Simplistically, you would want to own options dur-
ing the shaded periods on the chart, and would want to be a seller of options during the
non-shaded areas.
Note that Figure .36-4 indeed confirms the fact that OEX options are consistently
overpriced. Very few charts are as one-dimensional as the OEX chart, where the options
Chapter
36: TheBasicsol Volatility
Trading 695
were so consistently overpriced. Most stocks find the difference line oscillating back and
forth about the zero mark. Consider Figures 36-5 and 36-6. Figure 36-,5 shows a chart
similar to Figure 36-4, comparing actual and implied volatility, and their difference, for
a particular stock. Figure 36-6 shows the price graph of that same stock, overlaid on
implied volatility, during the period up to and including the heavy shading.
The volatility comparison chart (Figure 36-5) shows several shaded areas, during
which the stock was more volatile than the options had predicted. Owners of options
profited during these times, provided they had a more or less neutral outlook on the stock.
Figure 36-6 shows the stock's performance up to and including the March-April 1999
period-the largest shaded area on the chart. Note that implied volatility was quite low
before the stock made the strong move from 10 to 30 in little more than a month. These
graphs are taken from actual data and demonstrate just how badly out of line implied vol-
atility can be. In February and early March 1999, implied volatility was at or near the
lowest levels on these charts. Yet, by the end of March, a major price explosion had begun
in the stock, one that tripled its value in just over a month. Clearly, implied volatility was
a poor predictor of forthcoming actual volatility in this case .
What about later in the year? In Figure 36-5, one can observe that implied and
actual volatility oscillated back and forth quite a few times during the rest of 1999. It
might appear that these oscillations are small and that implied volatility was actually
FIGURE 36-5.
Implied versus historical volatility of a stock.
150
140 Actual
130
120
110
100
90
80
70
60
50
40
30
20
10
0 /-""~TS~~:T2~~TT1-------w-~77~"'~'/~TI
- 10
-20
-30 -o
-40 cu
-50 a>
-60
-70
a.
Cf)
-80
1999 Implied minus Actual Date
696 Part VI: Measuring
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FIGURE 36-6.
The price graph of the stock.
29.000
27.000
25.000
23.000
21.000
19.000
17.000
15.000
13.000
11.000
9.000
7.000
5.000
98 0 N D F M A M 99
doing a pretty good job of predicting actual volatility, at least until the final spike in
December 1999. However, looking at the scale on the left-hand side of Figure 36-5, one
can see that implied volatility was trying to remain in the ,50% to 60% range, but actual
volatility kept bolting higher rather frequently.
One more example will be presented. Figures :36-7 and 36-8 depict another stock
and its volatilities. On the left half of each graph, implied volatility was quite high. It was
higher than actual volatility turned out to be, so the difference line in Figure 36-7 remains
above the zero line for several months. Then, for some reason, the option market decided
to make an adjustment, and implied volatility began to drop. Its lowest daily point is
marked with a circle in Figure 36-8, and the same point in time is marked with a similar
circle in Figure 36-7. At that time, options traders were "saying" that they expected the
stock to be very tame over the ensuing weeks. Instead, the stock made two quick moves,
one from 1.5down to 11, and then another back up to 17. That movement jerked actual
volatility higher, but implied volatility remained rather low. After a period of trading
between 13 and 1.5,during which time implied volatility remained low, the stock finally
exploded to the upside, as evidenced by the spikes on the right-hand side of both Figures
,16-7 and 36-8. Thus, implied volatility was a poor predictor of actual volatility for most of
the time on these graphs. Moreover, implied volatility remained low at the right-hand side
of the charts (January 2000) even though the stock doubled in the course of a month.
Chapter
Trading 697
FIGURE 36-7.
Implied versus historical volatility of a stock.
120
110
100
90
80
70
60
50
40
30
20
10
01------------'-----.,.,-,-+---\r.,-===-~=
10 -o
cu
20 ~
0.
-30 CJ) F M A M J J A S O N o_
Date
Implied minus Actual 1999
FIGURE 36-8.
The price graph of the stock.
27.000
25.000
23.000
21.000
19.000
17.000
15.000
13.000
11.000
9.000
7.000
5.000
J F MAM J JASON DJ
1999
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The important thing to note from these figures is that they clearly show that implied
volatility is really not a very good predictor of the actual volatility that is to follow. If it
were, the difference line would hover near zero most of the time. Instead, it swings back
and forth wildly, with implied volatility over- or underestimating actual volatility by quite
wide levels. Thus, the current estimates of volatility by traders (i.e., implied volatility) can
actually be quite wrong.
Conversely, one could also say that historical volatility is not a great predictor of vol-
atility that is to follow, either, especially in the short term. No one really makes any claims
that it is a good predictor, for historical volatility is merely a reflection of what has hap-
pened in the past. All we can say for sure is that implied and historical volatility tend to
trade within a range .
One thing that does stand out on these charts is that implied volatility seems to fluc-
tuate less than actual volatility. That seems to be a natural function of the volatility pre-
dictive process. For example, when the market collapses, implied volatilities of options rise
only modestly. In other words, option traders and market-makers are predicting volatility
when they price options, and one tends to make a prediction that is somewhat "middle of
the road," since an extreme prediction is more likely to be wrong. Of course, it turns out
to be wrong anyv1ay,since actual volatility jumps around quite rapidly.
The few charts that have been presented here don't constitute a rigorous study upon
which to draw the conclusion that implied volatility is a poor predictor of actual volatility,
but it is this author's firm opinion that that statement is true. A graduate student looking
for a master 's thesis topic could take it from here .
VOLATILITY TRADING
As a result of the fact that implied volatility can sometimes be at irrational extremes,
options may sometimes trade with implied volatilities that are significantly out of line
with what one would normally expect. For example, suppose a stock is in a relatively non-
volatile period, like the price of the stock in Figure 36-2, just before point A on the graph.
During that time, option sellers would probably become more aggressive while option
buyers, who probably have been seeing their previous purchases decaying with time,
hecome more timid. As a result, option prices drop. Alternatively stated, implied volatility
drops. When implied volatilities are decreasing, option sellers are generally happy (and
may often become more aggressive), while option buyers are losing money (and may often
tend to become more timid). This is just a function of looking at the profit and loss state-
ments in one's option account. But anyone who took a longer backward look at the vola-
tility of the stock in Figure 36-2 would see that it had been much more volatile in the
Chapter
36: TheBasicsof VolatilityTrading 699
past. Consequently, he might decide that the implied volatility of the options had gotten
too low and he would be a buyer of options .
It is the volatility trader's objective to spot situations when implied volatility is possibly
or probably erroneous and to take a position that would profit when the error is brought to
light. Thus, the volatility trader's main objective is spotting situations when implied volatil-
ity is overvalued or undervalued, irrespective of his outlook for the underlying stock itself.
In some ways, this is not so different from the fundamental stock analyst who is attempting
to spot overvalued or undervalued stocks, based on earnings and other fundamentals.
From another viewpoint, volatility trading is also a contrarian theory of investing.
That is, when everyone else thinks the underlying is going to be nonvolatile, the volatility
trader buys volatility. When everyone else is selling options and option buyers are hard to
find, the volatility trader steps up to buy options. Of course, some rigorous analysis must
be done before the volatility trader can establish new positions, but when those situations
come to light, it is most likely that he is taking positions opposite to what "the masses" are
doing. He will be buying volatility when the majority has been selling it (or at least, when
the majority is refusing to buy it), and he will be selling volatility when everyone else is
panicking to buy options , making them quite expensive .
WHY DOES VOLATILITY REACH EXTREMES?
One can't just buy every option that he considers to be cheap. There must be some con-
sideration given to what the probabilities of stock movement are. Even more important,
one can't just sell every option that he values as expensive. There may be valid reasons
why options become expensive, not the least of which is that someone may have inside
information about some forthcoming corporate news (a takeover or an earnings surprise,
for example).
Since options offer a good deal of leverage, they are an attractive vehicle to anyone
who wants to make a quick trade, especially if that person believes he knows something
that the general public doesn't know. Thus, if there is a leak of a takeover rumor-whether
it be from corporate officers, investment bankers, printers, or accountants-whoever pos-
sesses that information may quite likely buy options aggressively, or at least bid for them.
Whenever demand for an option outstrips supply-in this case, the major supplier is prob-
ably the market-maker-the options quickly get more expensive. That is, implied volatility
increas es.
In fact, there are financial analysts and reporters who look for large increases in
trading volume as a clue to which stocks might be ready to make a big move. Invariably,
if the trading volume has increased and if implied volatility has increased as well, it is a
700 PartVI:Measuring and Tra
ding Volatility
good warning sign that someone with inside information is buying the options. In such a
case, it might not he a good idea to sell volatility, even though the options are mathemat-
ically expensive.
Sometimes, e\·en more minor news items are known in advance by a small segment
of the investing comrnm1ity. If those items will he enough to move the stock even a couple
of points, those who possess the information may try to buy options in advance of the
news. Such minor news items might include the resignation or firing of a high-ranking
corporate officer, or perhaps some strategic alliance with another company, or even a new
product announcement.
The seller of rnlatility can watch for two things as warning signs that perhaps the
options are "predicting" a corporate event (and hence should be avoided as a "volat ility
sale"). Those two things are a dramatic increase in option volume or a sudden jump in
implied rnlatilit:; of the options. One or both can be caused by traders with inside infor-
mation trying to obtain a leveraged instrument in advance of the actual corporate news
item being made public.
A SUDDEN INCREASE IN OPTION VOLUME OR IM PLIED VOLATILITY
The s:'mptoms of insider trading, as e\·idenced bv a large increase in option trading activ-
ity, can he recognized. ~vpically, the majority of the increased volu me occurs in th e
near-term option series, particular!:· the at-the-money strike and perhaps the next st rike
ont-of~the-money. The activity doesn't cease there, however. It propagates out to other
option series as rnarket-makers (who by the nature of their job function are short the
near-term options that those with insider knowledge are buying) snap up everything on
the hooks that they can find. In addition, the market-makers may try to entice ot hers,
perhaps institutions, to sell some expensive calls against a portion of their instituti ona l
stock holdings. Acti\·it:· of this sort should be a warning sign to the rnlatility seller to stand
aside in this situation.
Of course, 011 any gi\·en day there are many stocks whose options are extraordinar ily
acfo e, but the increase in activity doesn't have anything to do with insider trading. This
might include a large covered call vvrite or maybe a large put pnrchase established by an
institution as a hedge against an existing stock position, or a relatively large conversion or
re\·ersal arbitrage established h:' an arbitrageur, or en"n a large spread transaction initi-
ated hy a hedge f11nd. l11any of tlit'se cases, option volume would jump dramatically, but
it \\'Onldn't rnea11that a11:·rn1chad inside knowledge about a forthcoming corporate event.
H.atlwr_the i11creasl's in option trading vol11rneas described in this paragraph are merely
functions of the normal workings of the marketplace.
\ \'l1at distinguishes these arbitrage and hedging activities from the machinations of
insid('r trading is: 1 I) Tliere is little propagation of option \·olmne iHto other series in the
Chapter
Trading 701
"benign" case, and (2) the stock price itself may languish. However, when true insider
activity is present, the market-makers react to the aggressive nature of the call buying.
These market-makers know they need to hedge themselves, because they do not want to
be short naked call options in case a takeover bid or some other news spurs the stock dra-
matically higher. As mentioned earlier, they try to buy up any other options offered in "the
book," but there may not be many of those. So, as a last result, the way they reduce their
negative position delta is to buy stock. Thus, if the options are active and expensive, and
if the stock is rising too, you probably have a reasonably good indication that "someone
knows something." However, if the options are expensive but none of the other factors are
present, especially if the stock is declining in price-then one might feel more comfort-
able with a strategy of selling volatility in this case .
However, there is a case in which options might be the object of pursuit by someone
with insider knowledge, yet not be accompanied by heavy trading volume. This situation
could occur with illiquid options. In this case, a floor broker holding the order of those
with insider information might come into the pit to buy options, but the market-makers
may not sell them many, preferring to raise their offering price rather than sell a large
quantity. If this happens a few times in a row, the options will have gotten very expensive
as the floor broker raises his bid price repeatedly, but only buys a few contracts each time.
Meanwhile , the market-maker keeps raising his offering price .
Eventually, the floor broker concludes that the options are too expensive to bother
with and walks away. Perhaps his client then buys stock. In any case, what has happened
is that the options have gotten very expensive as the bids and offers were repeatedly
raised, but not much option volume was actually traded because of the illiquidity of the
contracts. Hence the normal warning light associated with a sudden increase in option
volume would not be present. In this case, though, a volatility seller should still be careful,
because he does not want to step in to sell calls right before some major corporate news
item is released. The clue here is that implied volatility exploded in a short period of time
(one day, or actually less time), and that alone should be enough warning to a volatility
seller.
The point that should be taken here is that when options suddenly become very
expensive, especially if accompanied by strong stock price movement and strong stock
volume, there may very well be a good reason why that is happening. That reason will prob-
ably become public knowledge shortly in the form of a news event. In fact, a major
market-maker once said he believed that most increases in implied volatility were eventually
justified-that is, some corporate news item was released that made the stock jump.
Hence, a volatility seller should avoid situations such as these. Any sudden increase in
implied volatility should probably be viewed as a potential news story in the making.
These situations are not what a neutral volatility seller wants to get into.
On the other hand, if options have become expensive as a result of corporate news,
andTrading
Volatility
then the volatility seller can feel more comfortable making a trade. Perhaps the company
has announced poor earnings and the stock has taken a beating while implied volatility
rose. In this situation, one can assess the information and analyze it clearly; he is not deal-
ing with some hidden facts known to only a few insider traders. With clear analysis, one
might be able to develop a volatility selling strategy that is prudent and potentially
profitable .
Another situation in which options become expensive in the wake of market action
is during a bear market in the underlying. This can be true for indices, stocks, and futures
contracts. The Crash of '87 is an extreme example, but implied volatility shot through the
roof during the crash. Other similar sharp market collapses-such as October 1989, Octo-
ber 1997, and August-September 1998-caused implied volatility to jump dramatically.
In these situations, the volatility seller knows why implied volatility is high. Given that
fact, he can then construct positions around a neutral strategy or around his view of the
future. The time when the volatility seller must be careful is when the options are expen-
sive and no one seems to know why. That's when insider trading may be present, and that's
when the volatility seller should defer from selling options.
CHEAP OPTIONS
When options are cheap, there are usually far less discernible reasons why they have
become cheap. An obvious one may be that the corporate structure of the company has
changed; perhaps it is being taken over, or perhaps the company has acquired another
company nearly its size. In either case, it is possible that the combined entity's stock will
be less volatile than the original company's stock was. As the takeover is in the process of
being consummated, the implied volatility of the company's options will drop, giving the
false impression that the y are cheap.
In a similar vein, a company may mature, perhaps issuing more shares of stock, or
perhaps building such a good earnings stream that the stock is considered less volatile than
it formerly was. Some of the Internet companies will be classic cases: In the beginning they
were high-flying stocks with plenty of price movement, so the options traded with a rela-
tively high degree of implied volatility. However, as the company matures, it buys other
Internet companies and then perhaps even merges with a large, established company
(America Online and Time-\Varner Communications, for example). In these cases, actual
(statistical) volatility will diminish as the company matures, and implied volatility will do
the same. On the surface, a buyer of volatility may see the reduced volatility as an attractive
buying situation, but upon further inspection he may find that it is justified. If the decrease
in implied volatility seems justified, a buyer of volatility should ignore it and look for other
opportunities .
Chapter
Trading 703
All volatility traders should be suspicious when volatility seems to be extreme-

either too expensive or too cheap. The trader should investigate the possibilities as to why
volatility is trading at such extreme levels. In some cases, the supply and demand of the
public just pushes the options to extreme levels; there is nothing more involved than that.
Those are the best volatility trading situations. However, if there is a hint that the volatility
has gotten to an extreme reading because of some logical (but perhaps nonpublic) reason,
then the volatility trader should be suspicious and should probably avoid the trade. Typi-
cally this happens with expensive options .
Buyers of volatility really have little to fear if they miscalculate and thus buy an
option that appears inexpensive but turns out not to be, in reality. The volatility buyer
might lose money if he does this, and overpaying for options constantly will lead to ruin,
but an occasional mistake will probably not be fatal.
Sellersof volatility, however, have to be a lot more careful. One mistake could be the
last one. Selling naked calls that seem terrifically expensive by historic standards could be
ruinous if a takeover bid subsequently emerges at a large premium to the stock's current
price. Even put sellers must be careful, although a lot of traders think that selling naked puts
is safe because it's the same as buying stock. But who ever said buying stock wasn't risky? If
the stock collapses-falling from 80, say, to 1.5or 20, as Oxford Health did, or from 30 to 2
as Sunrise Technology did-then a put seller will be buried. Since the risk ofloss from naked
option selling is large, one could be wiped out by a huge gap opening. That's why it's impera-
tive to study why the options are expensive before one sells them. If ifs known, for example,
that a small biotech company is awaiting FDA trial results in two weeks, and all the options
suddenly become expensive, the volatility seller should not attempt to be a hero. It's obvious
that at least some traders believe that there is a chance for the stock to gap in price dramati-
cally. It would be better to find some other situation in which to sell options.
The seller of futures options or index options should be cautious too, although there
can't be takeovers in those markets, nor can there be a huge earnings surprise or other
corporate event that causes a big gap. The futures markets, though, do have things like
crop reports and government economic data to deal with, and those can create volatile
situations, too. The bottom line is that volatility selling-even hedged volatility selling-
can be taxing and aggravating if one has sold volatility in front of what turns out to be a
news item that justifies the expensive volatility.
SUMM~RY
Volatility trading is a predictable way to approach the market, because volatility almost
invariably trades in a range and therefore its value can be estimated with a great deal
andTrading
Volatility
more precision than can the actual prices of the underlyings. Even so, one must be care-
ful in his approach to volatility trading, because diligent research is needed to determine
if, in fact, volatility is "cheap" or "expensive." As with any systematic approach to the mar-
ket, if one is sloppy about his research, he cannot expect to achieve superior results. In
the next few chapters , a good deal of time will be spent to give the reader a good under-
standing of how volatility affects positions and how it can be used to construct trades with
positive expecte d rates of ret urn .
How Volatility Affects
Popular Strategies
The previous chapter addressed the calculation or interpretation of implied volatility, and
how to relate it to historical volatility. Another, related topic that is important is how implied
volatility affects a specific option strategy. Simplistically, one might think that the effect
of a change in implied volatility on an option position would be a simple matter to discern;
but in reality, most traders don't have a complete grasp of the ways that volatility affects
option positions. In some cases, especially option spreads or more complex positions, one
may not have an intuitive "picture" of how his position is going to be affected by a change
in implied volatility. In this chapter, we'll attempt a relatively thorough review of how
implied volatility changes affect most of the popular option strategies.
There are ways to use computer analysis to "draw'' a picture of this volatility effect,
of course, and that will be discussed momentarily. But an option strategist should have
some idea of the general changes that a position will undergo if implied volatility changes.
Before getting into the individual strategies, it is important that one understands some of
the basics of the effect of volatility on an option's price.
VEGA
Technically speaking, the term that one uses to quantify the impact of volatility changes
on the price of an option is called the ucga of the option. In this chaptC'r, the rC'fr'rences
will he to vega, but the emphasis here is on practicality, so the descriptions of how rnla-
tility affects option positions will he in plain English as well as in the rnmT rnatlwrnatical
705
andTrading
Volatility
realm of vega. Having said that, let's define vega so that it is understood for later use in
the chapter.
Simply stated, vega is the amount by which an option's price changes when volatility
changes by one percentage point.
Example: XYZ is selling at .50, and the July .50 call is•trading at 7.2.5.Assume that there is
no dividend, that short-term interest rates are .5%, and that July expiration is exactly three
months away. With this information, one can determine that the implied volatility of the
Jul} .50 call is 70%. That's a fairly high number, so one can surmise that XYZ is a volatile
1
stock. What would the option price be if implied volatility were to rise to 71%?Using a model,
one can determine that the July ,50call would theoretically be worth 7.35 if that happened.
Hence, the vega of this option is 0.10 (to two decimal places). That is, the option price
increased by 10 cents, from 7.2.5to 7.35, when volatility rose by one percentage point. (Note
that "percentage point" here means a full point increase in volatility, from 70% to 71%.)
\ Vhat if implied rnlatilit}· had decreased instead? Once again, one can use the model
to determine the change in the option price. In this case, using an implied volatility of
69% and keeping en'rything else the same, the option would then theoretically be worth
7.15-again, a 0.10 change in price (this time, a decrease in price).
This example points out an interesting and important aspect of how volatility affects
a call option: {f implied r;olatilit!J increases, the price of the option will increase, and if
implied rnlatility decreases, the price of the option will decrease. Thus, there is a direct
relationship between an option's price and its implied volatility.
Mathematically speaking, vega is the partial derivative of the Black-Scholes model
(or whate\·er model you're using to price options) with respect to volatility. In the above
example, the vega of the July .50 call, with XYZ at 50, can be computed to be 0.098-very
near the value of 0.10 that one arrived at by inspection.
\'ega also has a direct relationship with the price of a put. That is, as implied volatil-
ity rises , the price of a put will rise as well.
Example: Using the same criteria as in the last example, suppose that XYZ is trading at
50, that July is three months away, that short-term interest rates are 5%, and that there is
110 cli\·idencl. In that case, the following theoretical put and call prices would apply at the
stated implied volatilities:
Stock
Price July50call July50put Implied
Volatility Put'sVega
50 715 6.54 69% 0.10
725 6.64 70% 0.10
735 6.74 71% 0.10
Chapter
37: HowVolatility
AffectsPopular
Strategies 707
Thus , the put's vega is 0.10, too-the same as the call's vega was.
In fact, it can he stated that a call ancl a put wit h the same terms have the same vega.
To prove this, one need only refer to the arbitrage equation for a conversion. If the call
increases in price and everything else remains equal-interest rates, stock price, and
striking price--then the put price must increase by the same amount. A change in implied
volatility will cause such a change in the call price, and a similar change in the put price.
Hence , the vega of the put and the call must be the same.
It is also important to know how the vega changes as other factors change, particu-
larly as the stock price changes, or as time changes. The following examples contain sev-
eral tables that illustrate the behavior of vega in a typically fluctuating environment.
Example: In this case, let the stock price fluctuate while holding interest rate (5%),
implied volatility (70%), time (.3months), dividends (0), and the strike price (50) constant.
See Table 37-1.
In these cases, vega drops when the stock price does, too, but it remains fairly con-
stant if the stock rises. It is interesting to note, though, that in the real world, when the
underlying drops in price-especially if it does so quickly, in a panic mode-implied vola-
tility can increase dramatically. Such an increase may be of great benefit to a call holder,
serving to mitigate his losses, perhaps. This concept will be discussed further later in this
chapter.
The above example assumed that the stock was making instantaneous changes in
price . In reality, of course, time would be passing as well, and that affects the vega, too.
Table .37-2 shows how the vega changes when time changes, all other factors being equal.
Example: In this example, the following items are held fixed: stock price (50), strike price
(50), implied volatility (70%), risk-free interest rate (5%), and dividend (0). But now, we let
time fluctuate.
Table .37-2 clearly shows that the passage of time results not only in a decreasing call
TABLE 37-1.
Implied
Volatility Theoretical
Stock
Price July50CallPrice CallPrice Vega
30 70% 0.47 0.028
40 2.62 0.073
50 725 0.098
60 14.07 0.092
70 22.35 0.091
708 PartVI:Measuring Volatility
andTrading
TABLE 37-2.
Implied Time Theoretical
Price
Stock Volatility Remaining CallPrice Vega
50 70% One year 14.60 0.182
Six months 10.32 0.135
Three months 7.25 0.098
Two months 5.87 0.080
One month 4.16 0.058
Two weeks 2.87 0.039
One week 1.96 0.028
One day 0.73 0.010
pric e>.but in a decreasin,g n,ga as wel l. This makes sense, of cour se, since one cannot
e\pt><:t an inc-rt>ast' in irnplied rnlatility to hm·e much of an effect on a very short-term
option-certainly not to the extent that it would affect a LEAPS option.
S0111t'readers 1niglit bt> wondering how changes in implied volati lity itself would
affect the, ega. This might lw called the "veg,l of the vega," although I've never actually
heard it referred to in that manner. The next table explores that concept.
Example : Again, some factors will be kept const,mt-the stock price (,50),th e time to July
t>xpiration (:3 months), the risk-free interest rate (.5%), and the dividend (0). Table 37-3
allows implied rnlatilit:-,· to fluctuate and shows what the theoretical price of a July .50call
would be , as well as its vega, at those volatilities.
Thus, Table :17-:1shows that ,·ega is surprisingly constant over a ,vide range of implied
rnlatilities. That's the- real reason why no one bothers with "vega of the vega." Vega begins
to decline onl:-,·if implied volatility gets e:xceedingly high, and implied volatilities of that
magnitude are relatively rare.
One can also comp11te the distance a stock would need to rise in order to overcome
a decr ease- in rnlatilit:-,·. Co11sidt'r Figme :17-1, which shows the theoretical price of a
G-111011th call option with diffrring implied rnlatilities. Suppose ont' buys an op tion th at
c11rrentl:-,·has implinl rnlatility of 1707r (the->top c11n-e on the graph). Later, investor per-
and the option is trading with an implied volatility of 140%.
ceptions of rnlatilit:-,· cli111i11ish,
That 111ea11s that tlit· option is now "residing" 011th e second curve frolll the top of the list.
Jmlgi11g frnlll tlie gt·iieral distance between those two cuf\'es, the option has probably lost
between 5 and 8 points of value due to the drop in implied volatility.
Here 's another way to think about it. Again, suppose one buy s an at-the-money
option (stock price= 10()) \\·lwn its i111pliecl,obtilit:-, is 1701¼.Tliat option rnlue is marked
as point:-\ on tl1t' graph in Figmc :17-1.Later, tht' option's implit'd rnlatility drops to 140%.
Chapter
37: HowVolatility
AllectsPopular
Strategies 709
TABLE37-3.
Stock Implied Theoretical
Price Volatility CallPrice Vega
50 10% 1.34 0.097
30% 3.31 0.099
50% 5.28 0.099
70% 7.25 0.098
100% 10.16 0.096
150% 14.90 0.093
200% 19.41 0.088
FIGURE 37-1.
Theoretical option prices at differing implied volatilities (6-month calls).
80
70
Q) 60
u
ct 50
C:
0
E. 40
0
30
20
10
Stock Price
60 80 100 C 120 140
How much does the stock have to rise in order to overcome the loss of implied volatility?
The horizontal line from point A to point B shows that the option value is the same on
each line. Then, dropping a vertical line from B down to point C, we see that point C is
at a stock price of about 109. Thus, the stock would have to rise 9 points just to keep the
option value constant, if implied volatility drops from 170% to 140%.
andTrading
Volatility
IMPLIED VOLATILITY AND DELTA
Figure 37-1 shows another rather unusual effect: When implied volatility gets very high,
the delta of the option doesn't change much. Simplistically, the delta of an option mea-
sures how much the option changes in price when the stock moves one point. Mathemat-
ically, the delta is the first partial derivative of the option model with respect to stock
price. Geometrically, that means that the delta of an option is the slope of a line drawn
tangent to the curve in the preceding chart.
The bottom line in Figure 37-1 (where implied volatility= 20%) has a distinct cur-
vature to it when the stock price is between about 80 and 120. Thus the delta ranges from
a fairly low number (when the stock is near 80) to a rather high number (when the stock
is near 120). Now look at the top line on the chart, where implied volatility = 170%. It's
almost a straight line from the lower left to the upper right! The slope of a straight line is
constant. This tells us that the delta (which is the slope) barely changes for such an expen-
siue option-whether the stock is trading at 60 or it'.c;trading at 150! That fact alone is
usually surprising to many.
In addition, the value of this delta can be measured: Ifs 0.70 or higher from a stock
price of 80 all the way up to 1.50.Among other things, this means that an out-of-the-money
option that has extremely high implied volatility has a fairly high delta-and can be
expected to mirror stock price movements more closely than one might think, were he not
privy to the delta.
Figure ,37-2 follows through on this concept, showing how the delta of an option
varies with implied volatility. From this chart, it is clear how much the delta of an option
varies when the implied volatility is 20%, as compared to how little it varies when implied
volatility is extremely high.
That data is interesting enough by itself, but it becomes even more thought-provoking
when one considers that a change in the implied volatility of his option (vega) also can
mean a significant change in the delta of the option. In one sense, it explains why, in the
first chart (Figure 37-1), the stock could rise 9 points and yet the option holder made noth-
ing, becaus e implied volatility declined from 170% to 140%.
EFFECTSON NEUTRALITY
A popular concept that uses delta is the "delta-neutral" spread-a spread whose profit-
ability is supposedly ambivalent to market movement, at least for short time frames and
limited stock price changes. Anything that significantly affects the delta of an option can
affect tliis neutralit~', thus causing a delta-neutral position to become unbalanced (or,
Chapter
37: HowVolatility
AffectsPopular
Strategies 711
FIGURE 37-2.
Value of delta of a 6-month option at differing implied volatilities.
60 80 100 120 140

Stock Price
more likely, causing one's intuition to be wrong regarding what constitutes a delta-neutral
spread in the first place ).
Let's use a familiar strategy, the straddle purchase , as an example. Simplistically,
when one buys a straddle, he merely buys a put and a call with the same terms and doesn't
get any fancier than that. However, it may be the case that, due to the deltas of the options
involved, that approach is biased to the upside, and a neutral straddle position should be
established instead.
Example: Suppose that XYZ is trading at 100, that the options have an implied volatility
of 40%, and that one is considering buying a six-month straddle with a striking price of
100. The following data summarize the situation, including the option prices and the
deltas:
XYZ Common: 100; Implied Volatility: 40%

Option Price Delta
XYZ October l 00 call 12.00 0.60
XYZ October l 00 put 10.00 -0.40
andTrading
Volatility
Notice that the stock price is equal to the strike price (100). However, the deltas are
not at all equal. In fact, the delta of the call is 1.5 times that of the put (in absolute value).
One must buy three puts and tu;o calls in order to have a delta-neutral position.
Most experienced option traders know that the delta of an at-the-money calls is some-
what higher than that of an at-the-money put. Consequently, they often estimate, without
checking, that buying three puts and two calls produces a delta-neutral "straddle buy."
However, consider a similar situation, but with a much higher implied volatility-11 Oo/c,say.
AAA Common: 100; Implied Volatility: 110%

Option Price Delta
AAA October 100 call 31.00 0.67
AAA October l 00 put 28.00 -0.33
The delta-neutral ratio here is two-to-one (67 divided by 33), not three-to-two as in
the earlier case-even though both stock prices are 100 and both sets of options have six
months remaining. This is a big difference in the delta-neutral ratio, especially if one is
trading a large quantity of options. This shows how different levels of implied volatility
can alter one's perception of what is a neutral position. It also points out that one can't
necessarily rely on his intuition; it is always best to check with a model.
Carrying this thought a step further, one must be mindful of a change in implied vola-
tility if he wants to keep his position delta-neutral. If the implied volatility of AAA options
should drop significantly, the 2-to-l ratio will no longer be neutral, even if the stock is still
trading at 100. Hence, a trader wishing to remain delta-neutral must monitor not only
changes in stock price, but changes in implied volatility as well. For more complex strategies,
one will also find the delta-neutral ratio changing due to a change in implied volatility.
The preceding examples summarize the major variables that might affect the vega
and also show how vega affects things other than itself, such as delta and, therefore, delta
neutrality. By the way, the vega of the underlying is zero; an increase in implied volatility
does not affect the price of the underlying instrument at alL in theory. In reality, if options
get very expensive (i.e., implied volatility spikes up), that usually brings traders into a stock
and so the stock price will change. But that's not a mathematical relationship, just a mar-
ket cause-and-effect relationship.
POSITION VEGA
As can be done with delta or with any other of the partial derivatives of the modeL one can
compute a position i:cga-the \'ega of an entire position. The position vega is determined
Chapter
37: HowVolatility
AffectsPopular
Strategies 713
by multiplying the individual option vegas hy the quantity of options bought or sold. The
"position vega" is merely the quantity of options held, times the vcga, tirnes the shares per
options (which is normally 100).
Example: Using a simple call spread as an example, assume the following prices exist:
Security Position Vega Position

Vega
XYZ Stock No position
XYZ July 50 call Long 3 calls 0.098 +0.294
XYZ July 70 call Short 5 calls 0.076 -0.380
Net Position Vega: -0.086
This concept is very important to a volatility trader, for it tells him if he has con-
structed a position that is going to behave in the manner he expects. For example, suppose
that one identifies expensive options, and he figures that implied rnlatility will decrease,
eventually becoming more in line with its historical norms. Then he would want to con-
struct a position with a negatii;e position Gcga. A negative position vega indicates that the
position will profit if implied rnlatility decreases. Conversely, a buyer of volatility-one
who identifies some underpriced situation-would want to construct a position with a
positive position cega, for such a position will profit if implied \'Olatility rises. In either
case, other factors such as delta, time to expiration, and so forth will have an effect on the
position's actual dollar profit, hut the concept of position vega is still important to a vola-
tility trader. It does no good to identify cheap options, for example, and then establish
some strange spread with a negative position vega. Such a construct would be at odds with
one's intended purpose-in this case , buying cheap options.
OUTRIGHT OPTION PURCHASES AND SALES
Let us now begin to investigate the affects of implied volatility on various strategies,
beginning with the simplest strategy of all-the outright option purchase. It was already
shown that implied volatility affects the price of an individual call or put in a dirC'Ctman-
ner. That is, an increase in implied volatility will cause the option price to rise, while a
decrease in volatility will cause a decline in the option price. That piece of information is
the most important one of all, for it imparts what an option trader needs to know: An
explosion in implied volatility is a boon to an option owntT, hut can he a de\·astating detri-
ment to an option seller, especially a naked option seller.
A couple of PxamplPs might dt'1nonstrate more clearly just how pmwrfol the cfft'ct of
714 PartVI: Measuring
andTrading
Volatility
implied volatility is, even when there isn't much time rema inin g in the life of an option. One
should understand the notion that an increase in implied volatility can overcome days, even
weeks, of time decay. This first example attempts to quantify that statement somew hat.
Example: Suppose that XYZ is trading at 100 and one is interes ted in analyzing a 3-month
call with striking price of 100. Furthermore, suppose that implied volatility is currently
at 20%. Given these assumptions, the Black-Scholes model tells us that the call would be
trading at a price of 4.64.
Stock Price: 100

Strike Price: 100
Time Remaining: 3 months
Implied Volatility: 20%
Theoretical Call Value: 4.64
Now, suppose that a month passes. If implied volatility remained the sam e (20%),
the call would lose nearly a point of value due to time decay. However, how much would
implied volatility have had to increase to completely counteract the effect of that time
decay? That is, after a month has passed, what implied volatility will yield a call price of
4 .64? It turns out to be just under 26% .
Stock Price: 100

Strike Price: 100
Implied Volatility: 25.9%
\Vhat would happen after another month passes? There is, of course, some implied
volatility at which the call would still Le worth 4.64, but is it so high as to be unreason-
able? Actually, it turns out that if implied volatility increases to about 38%, the call will
still be worth 4 .64 , even with only one month of life remaining:
Stock Price: 100

Strike Price: 100
Time Remaining: 1 month
Chapter
37: HowVolatility
AffectsPopular
Strategies 715
So, if implied volatility increases from 20% to 26% over the first month, then this
call option would still be trading at the same price-4.64. That's not an unusual increase
in implied volatility; increases of that magnitude, 20% to 26%, happen all the time. For it
to then increase from 26% to 38% over the next month is probably less likely, but it is cer-
tainly not out of the question. There have been many times in the past when just such an
increas e has been possible-during any of the August, September, or October bear mar-
kets or mini-crashes, for example. Also, such an increase in implied volatility might occur
if there were takeover rumors in this stock, or if the entire market became more volatile,
as was the case in the latter half of the 1990s.
Perhaps this example was distorted by the fact that an implied volatility of 20% is a
fairly low number to begin with. What would a similar example look like if one started out
with a much higher implied volatility-say, 80%?
Example: Making the same assumptions as in the previous example, but now setting the
implied volatility to a much higher level of 80%, the Black-Scholes model now says that
the call would be worth a price of 16.45:
Stock Price: 100

Strike Price: 100
Implied Volatility: 80%
TheoreticalCall Value: 16.45
Again, one must ask the question: "If a month passes, what implied volatility would
be necessary for the Black-Scholes model to yield a price of 16.45?" In this case, it turns
out to be an implied volatility of just over 99%.
Stock Price: 100

Strike Price: 100
Finally, to be able to completely compare this example with the previous one, it is
necessary to see what implied volatility would have to rise to in order to offset the effect
of yet another month's time decay. It turns out to be over 140%:
andTrading
Volatility
Stock Price: 100

Strike Price: 100
Time Remaining: 1 month
Table 37-4 summarizes the results of these examples, showing the levels to which
implied volatility would have to rise to maintain the call's value as time passes.
Are the volatility increases in the latter example less likely to occur than the ones in
the former example? Probably yes-certainly the last one, in which implied volatility
would have to increase from 80% to nearly 141% in order to maintain the call's value.
However, in another sense, it may seem more reasonable: Note that the increase in vola-
tility from 20% to 26% is a 30% increase. That is, 20% times 1.30 equals 26%. That's
what's required to maintain the call's value for the lower volatility over the first month-
an increase in the magnitude of implied volatility of 30%. At the higher volatility, though,
an increase in magnitude of only about 2.5% is required (from 80% to 99%). Thus, in those
terms , the two appear on more equal footing.
What makes the top line of Table 37-4 appear more likely than the bottom line is
merely the fact that an experienced option trader knows that many stocks have implied
volatilities that can fluctuate in the 20% to 40% range quite easily. However , there are far
fewer stocks that have implied volatilities in the higher range. In fact, until the Internet
stocks got hot in the latter portion of the 1990s, the only ones with volatilities like those
were very low-priced, extremely volatile stocks. Hence one's experience factor is lower
with such high implied volatility stocks, but it doesn't mean that the volatility fluctuations
appearing in Table 37-4 are impossible.
If the reader has access to a software program containing the Black-Scholes model,
he can experiment with other situations to see how powerful the effect of implied volatil-
ity is. For example, without going into as much detail, if one takes the case of a 12-month
option whose initial implied volatility is 20%, all it takes to maintain the call 's value over
TABLE 37-4.
Initial
Implied Volatility
Level
Required
toMaintain
CallValue...
Volatility ... AfterOneMonth . . . After
Two
Months
20% 26% 38%
80 % 99% 141%
Chapter
37: HowVolatility
AffectsPopular
Strategies 717
a 6-month time period is an increase in implied volatility to 27%. Taken from the view-
point of the option seller, this is perhaps most enlightening: If yon sell a one-year (LEAPS)
option and six months pass, during which time implied volatility increases from 20% to
27%-certainly quite possible-you will have made nothing! The call will still Le selling
for the same price, assuming the stock is still selling for the same price.
Finally, it was mentioned earlier that implied volatility often explodes during a mar-
ket crash. In fact, one could determine just how much of an increase in implied volatility
would be necessarv in a market crash in order to maintain the call's value. This is similar
to the first example in this section, but now the stock price will be allowed to decrease as
well. Table 37-5, then, shows what implied volatility would be required to maintain the
call's initial value (a price of 4.64), when the stock price falls. The other factors remain the
same: time remaining (3 months), striking price (100), and interest rate (.5%).Again, this
table shows instantaneous price changes. In real life, a slightly higher implied volatility
would be necessary , because each market crash could take a day or two.
Thus, from Table 37-5, one could say that even if the underlying stock dropped 20
points (which is 20% in this case) in one day, yet implied volatility exploded from 20% to
67% at the same time, the call's value would be unchanged! Could such an outrageous
thing happen? It has: In the Crash of '87, the market plummeted 22% in one day, while
the Volatility Index (VIX) theoretically rose from 36% to 150% in one day. In fact, call
buyers of some OEX options actually broke even or made a little money due to the explo-
sion in implied volatility, despite the fact that the worst market crash in history had
occurred.
If nothing else, these examples should impart to the reader how important it is to be
aware of implied volatility at the time an option position is established. If you are buying
options, and you buy them when implied volatility is "low," you stand to benefit if implied
volatility merely returns to "normal" levels while you hold the position. Of course, having
the underlying increase in price is also important.
TABLE 37-5.
Stock
Price Implied
Volatility
Necessary
forCalltoMaintain
Value
100 20% (the initial parameters)
95 33%
90 44%
85 55%
80 67%
75 78%
70 89%
andTrading
Volatility
Conversely, an option seller should be keenly aware of implied volatility when the
option is initially sold-perhaps even more so than the buyer of an option. This pertains
equally well to naked option writers and to covered option writers. If implied volatility is
"too low" when the option writing position is established, then an increase (or worse, an
explosion) in implied volatility will be very detrimental to the position, completely over-
coming the effects of time decay. Hence , an option writer should not just sell options
because he thinks he is collecting time decay each day that passes. That may be true, but
an increase in implied volatility can completely dominate what little time decay might
exist, especiall y for a longer-term option.
In a similar manner, a decrease in implied volatility can be just as important. Thus, if
the call buyer purchases options that are "too costly," ones in which implied volatility is "too
high, " then he could lose money even if the underlying makes a modest move in his favor.
In the next chapters, the topic of just how an option buyer or seller should measure
implied volatility to determine what is "too low" or "too high" will be discussed. For now,
suffice it to grasp the general concept that a change in implied volatility can have substan-
tial effects on an option's price-far greater effects than the passage of time can have.
In fact , all of this calls into question just exactly what time value premium is. That
part of an option 's value that is not intrinsic value is really affected much more by volatility
th an it is by tim e dec ay, yet it carrie s the term "time value premiu m."
Many (perhaps novice) option traders seem to think of time as the main antagonist to an
option buyer. However , when one really thinks about it, he should realize that the portion
of an option that is not intrinsic value is really much more related to stock price movement
and/or volatility than anything else, at least in the short term. For this reason, it might be
ben eficial to more closely analyze just what the "excess value " portion of an option repre-
sents and why a buyer should not primarily think of it as time value premium.
An option 's price is composed of two parts: (1) intrin sic value, which is the "real" part
of the option's value - the distance by which the option is in-the-money, and (2) "excess
valu e"-often called tim e value premium. There are actually five factors that affect the
"excess value" portion of an option. Eventually , time will dominate them all, but the longer
the life of the opti on , the more th e oth er factors influen ce th e "excess value ."
The five factors in fluencing excess value are:
1. stock price movements,

2. changes in implied volatility,
3. the passage of time ,
Chapter
37: HowVolatility
AffectsPopular
Strategies 719
4. changes in the dividend (if any exist), and

5. changes in interest rates.
Each is stated in terms of a movement or change; that is, these are not static things.
In fact, to measure them one uses the "greeks": delta, vega, theta (there is no "greek" for
dividend change), and rho. Typically, the effect of a change in dividend or a change in
intere st rate is small (although a large dividend change or an interest rate change on a very
long-ter m option can produce visible changes in the prices of options).
If everything remains static, then time decay will eventually wipe out all of the
excess value of an option. That's why it's called time value premium. But things don't ever
remain static, and on a daily basis, time decay is small, so it is the remaining two factors
that are most important.
Example: XYZ is trading at 82 in late November. The January 80 call is trading at 8. Thus,
the intrinsic value is 2 (82 minus 80) and the excess value is 6 (8 minus 2). If the stock is
still at 82 at January expiration, the option will of course only be worth 2, and one will say
that the 6 points of excess value that was lost was due to time decay. But on that day in
late November, the other factors are much more dominant.
On this particular day, the implied volatility of this option is just over 50%. One can
determ ine that the call's greeks are:
Delta: 0.60
Vega: 0.13
Theta: -0.06
This means, for example, that time decay is only 6 cents per day. It would increase
as time went by, but even with a day or so to go, theta would not increase above about
20 cents unless volatility increased or the stock moved closer to the strike price.
From the above figures, one can see-and this should be intuitively appealing-that the
biggest factor influencing the price of the option is stock price movement (delta). Ifs a
little unfair to say that, because it's conceivable (although unlikely) that volatility could
jump by a large enough margin to become a greater factor than delta for one day's move
in the option. Furthermore, since this option is composed mostly of excess value, these
more dominant forces influence the excess value more than time decay does.
There is a direct relationship between vega and excess value. That is, if implied vola-
tility increases, the excess value portion of the option will increase and, if implied volatil-
ity decreases , so will excess value .
andTrading
Volatility
The relationship between delta and excess value is not so straightforward. The far-
ther the stock moves away from the strike, the more this will have the effect of shrinking
the excess value. If the call is in-the-money (as in the above example), then an increase in
stock price will result in a decrease of excess value. That is, a deeply in-the-money option
is composed primarily of intrinsic value, while excess value is quite small. However, when
the call is out-of-the-money, the effect is just the opposite: Then, an increase in call price
will result in an increase in excess value, because the stock price increase is bringing the
stock closer to the option's striking price.
For some readers, the following may help to conceptualize this concept. The part of
the delta that addresses excess value is this:
Out-of-the-money call : 100% of the delta affects the excess value.

In-the-money call:" 1.00 minus delta" affects the excess value. (So, if a call is very deeply
in-the-money and has a delta of 0.9.5, then the delta only has 1.00-0.9.5, or 0.0.5,
room to increase. Hence it has little effect on what small amount of excess value
remains in this deeply in-the-money call.)
These relationships are not static, of course. Suppose, for example, that in the same
situation of the stock trading at 82 and the January 80 call trading at 8, there is only one
u:cck renwining until expiration! Then the implied volatility would be 1.5.5%(high, but
not unheard of in volatile times). The greeks would bear a significantly different relation-
ship to each other in this case , though:
Delta: 0.59
Vega: 0.044
Theta: -0.51
This very short-term option has about the same delta as its counterpart in the previous
example (the delta of an at-the-money option is generally slightly above 0 ..50). Meanwhile,
\·ega has shrunk. The effect of a change in volatility on such a short-term option is actually
about a third of what it was in the previous example. However, time decay in this example
is huge , amounting to half a point per day in this option.
So now one has the idea of how the excess value is affected by the "big three" of
stock price movement, change in implied volatility, and passage of time. How can one use
this to his advantage? First of all, one can see that an option's excess value may be due
11111cl1 more to the potential volatility of the underlying stock, and therefore to the option's
implied volatility , than to time .

As a result of the above information regarding excess value, one shouldn't think that
he can easily go around selling what appear to be options with a lot of excess value and then
Chapter
37: HowVolatility
AffectsPopular
Strategies 721
expect time to bring in the profits for him. In fact, there may he a lot of volatility-both
actual and implied-keeping that excess value nearly intact for a fairly long period of time.
In fact, in the coming chapters on volatility estimation, it will be shown that option buyers
have a much better chance of success than conventional wisdom has maintained.
VOLATILITY AND THE PUT OPTION
While it is obvious that an increase in implied volatility will increase the price of a put
option , much as was shown for a call option in the preceding discussion, there are certain
differences between a put and a call, so a little review of the put option itself may be use-
ful. A put option tends to lose its premium fairly quickly as it becomes an in-the-money
option. This is due to the realities of conversion arbitrage. In a conversion arbitrage, an
arbitrageur or market-maker buys stock and buys the put, while selling the call. If he car-
ries the position to expiration, he will have to pay carrying costs on the debit incurred to
establish the position. Furthermore, he would earn any dividends that might be paid
while he holds the position. This information was presented in a slightly different form in
the chapter on arbitrage , but it is recounted here:
In a perfect world, all option prices would be so accurate that there would be no
profit available from a conversion. That is, the following equation (1) would apply:
( 1) Call price+ Strike price - Stock p1ice - Put price+ Dividend - Carrying cost =0
where carrying cost = strike price/ (1 + r) t
t = time to expiration
r = interest rate
Now, it is also known that the time value premium of a put is the amount by which its
value exceeds intrinsic value. The intrinsic value of an in-the-money put option is merely
the difference between the strike price and the stock price. Hence, one can write the
following equation (2) for the time value premium (TVP) of an in-the-money put option:
(2) Put TVP = Put price - Strike price+ Stock price
The arbitrage equation, (1), can be rewritten as:
(3) Put price - Strike price+ Stock price = Call price+ Dividends - Carrying cost
and substituting equation (2) for the terms in equation (3), one arrives at:
(4) Put TVP = Call price + Dividends - Carrying cost

722 PartVI:Measurin
g and TradingVolatility
In other u;ords, the time value premium of an in-the-rnoney put is the same as the
(out-of-the-nwney) call price, plus any dividends to be earned until expiration, less any
carrying costs over that same time period.
Assuming that the dividend is small or zero (as it is for most stocks), one can see that
an in-the-money put would lose its time value premium whenever carrying costs exceed
the value of the out-of-the-money call. Since these carrying costs can be relatively large
(the carrying cost is the interest being paid on the entire debit of the position-and that
debit is approximately equal to the strike price), they can quickly dominate the price of
an out-of-the-money call. Hence, the time value premium of an in-the-money put disap-
pears rather quickly.
This is important information for put option buyers, beca use they must understand
that a put won't appreciate in value as much as one might expect, even when the stock
drops, since the put loses its time value premium quickly. It's even more important infor-
mation for put sellers: A short put is at risk of assignment as soon as there is no time value
premium left in the put. Thus, a put can be assigned well in advance of expiration-even
a LEAPS put!
Now, returning to the main topic of how implied volatility affects a position, one can
ask himself how an increase or decrease in implied volatility would affect equation (4)
above. If implied volatility increases, the call price would increase, and if the increase
were great enough, might impart some time value premium to the put. Hence, an increase
in implied wlatility also may increase the price of a put, but if the put is too far
in-the-money, a nwdest increase in implied volatility still u;on't budge the put. That is,
an increase in implied volatility would increase the value of the call, but until it increases
enough to be greater than the carrying costs, an in-the-money put will remain at parity,
and thus a short put would still remain at risk of assignment.
STRADDLE O R STRA N GLE BUYING AND SELLING
Since owning a straddle involves owning both a put and a call with the same terms, it is
fairly evident that an increase in implied volatility will be very beneficial for a straddle
buyer. A sort of double benefit occurs if implied volatility rises, for it will positively affect
both the put and the call in a long straddle. Thus, if a stradd le buyer is careful to buy
straddles in situations in which implied volatility is "low," he can make money in one of
two ways. Either (1) the underlying price makes a move great enough in magnitude to
exceed the initial cost of the straddle, or (2) implied volatility increases quickly enough to
overcome th e deleterious effects of time decay.
Conversely, a straddle seller risks just the opposite-potentially devastating losses if
implied rnlatility should increase dramatically. However, the straddle seller can register
Chapter
37: HowVolatility
AffectsPopular
Strategies 723
gains faster than just the rate of time decay would indicate if implied volatility decreases.
Thus, it is very important when selling options-and this applies to covered options as
well as to naked ones-to sell only when implied volatility is "high."
A strangle is the same as a straddle, except that the call and put have different strik-
ing prices. Typically, the call strike price is higher than the put strike price. Naked option
sellers often prefer selling strangles in which the options are well out-of-the-money, so that
there is less chance of them having any intrinsic value when they expire. Strangles behave
much like straddles do with respect to changes in implied volatility.
The concepts of straddle ownership will be discussed in much more detail in the
following chapters. Moreover, the general concept of option buying versus option selling
will receive a great deal of attention.
CALL BULL SPREADS
In this section, the bull spread strategy will be examined to see how it is affected by
changes in implied volatility. Let's look at a call bull spread and see how implied volatility
changes might affect the price of the spread if all else remains equal. Make the following
assumptions:
Assumption
Set1:
StockPrice: 100
Time to Expiration:4 months
Position:LongCall Struckat 90
ShortCall Struckat 110
Ask yourself this simple question: If the stock remains unchanged at 100, and implied
volatility increases dramatically, will the price of the 90-110 call bull spread grow or
shrink? Answer before reading on.
The truth is that, if implied volatility increases, the price of the spread will shrink.
I would suspect that this comes as something of a surprise to a good number of readers.
Table 37-6 contains some examples, generated from a Black-Scholes model, using the
assumptions stated above, the most important of which is that the stock is at 100 in all
cases in this table.
One should be aware that it would probably be difficult to actually trade the spread
at the theoretical value, due to the bid-asked spread in the options. Nevertheless, the
impact of implied volatility is clear.
One can quantify the amount by which an option position will change for each per-
andTrading
Volatility
TABLE 37-6.
Stock = l 00
Price
90-110Call
Implied Bull
Spread
Volatility (Theoretical
Value)
20% 10.54
30% 9.97
40% 9.54
50% 9.18
60% 8.87
70% 8.58
80% 8.30
centage point of increase in implied volatility. Recall that this measure is called the vega
of the option or option position. In a call bull spread, one would subtract the vega of the
call that is sold from that of the call that is bought in order to arrive at the position vega
of the call bull spread. Table 37-7 is a reprint of Table 37-6, but now including the vega.
Since these \·egas are all negative, they indicate that the spread will shrink in value
if implied volatility rises and that the spread will expand in value if implied volatility
decreases. Again, these statements may seem contrary to what one would expect from a
bullish call po sition.
Of course, it's highly unlikely that implied volatility would change much in the
course of just one day while the stock price remained unchanged. So, to get a better
handle on what to expect, one really needs to look at what might happen at some future
TABLE 37-7.
90-110Call
Implied Bull
Spread Position
Value) Vega
20% 10.54 -0.67
30% 9.97 -0.48
40 % 9.54 -0.38
50% 9.18 -0.33
60% 8.87 -0 .30
70% 8.58 -0 .28
80% 8.30 -0.26
Chapter
37: HowVolatility
AffectsPopular
Strategies 725
time (say a couple of weeks hence) at various stock prices. The graph in Figure 37-3 begins
the investigation of these more complex scenarios.
The profit curve shown in Figure 37-3 makes certain assumptions: (1) The bull
spread assumes the details in Assumption Set 1, above; (2) the spread was bought with an
impli ed rnlatility of 20% and remained at that level when the profit picture above was
drawn; and (3) 30 days have passed since the spread was bought. Under these assump-
tions, the profit graph shows that the bull spread conforms quite well to what one would
expect; that is, the shape of this curve is pretty much like that of a bull spread at expira-
tion, although if you look closely you'll see that it doesn't widen out to nearly its maximum
gain or loss potential until the stock is well above 110 or below 90-the strike prices used
in the spread.
Now observe what happens if one keeps all the other assumptions the same, except
one . In this case, assume implied volatility was 80% at purchase and remains at 80% one
month later. The comparison is shown in Figure 37-4. The 80% curve is overlaid on top
of the 20% curve shown earlier. The contrast is quite startling. Instead of looking like a
bull spread, the profit curve that uses 80% implied volatility is a rather flat thing, sloping
only slightly upward-and exhibiting far less risk and reward potential than its lower
implied volatility counterpart. This points out another important fact: For volatile stocks,
one cannot expect a 4-month bull spread to expand or contract rnuch during the _first
month of life, even if the stock makes a substantial move. Longer-term spreads have even
less movement.
FIGURE 37-3.
Bull spread profit picture in 30 days, at 20% IV.
1000
500
Cl)
Cl)
3 01-1---+----t------+----t----+---+-
~ 70 80 90 100 110 120 130 140
e
! ~00 /
-1000~ Stock Price

andTrading
Volatility
FIGURE 37-4.
Bull spread profit picture in 30 days.
1000
500
(/)
(/)
0
...J
-.;:, 0
'5 70 801 90 100
a:
J20%
~/
ti'}
-500
-1000
Stock
As a corollary, note that if implied volatility shrinks while the stock rises, the profit
outlook will improve. Graphically, using Figure 37-4, if one's profit picture moves from
the 80% curve to the 20% curve on the right-hand side of the chart, that is a positive
development. Of course, if the stock drops and the implied volatility drops too, then one's
losses would be worse-witness the left-hand side of the graph in Figure 37-4.
A graph could be drawn that would incorporate other implied volatilities, but that
would be overkill. The profit graphs of the other spreads from Tables 37-6 or 37-7 would
lie between the two curves shown in Figure 37-4.
If this discussion had looked at bull spreads as put credit spreads instead of call debit
spreads, perhaps these conclusions would not have seemed so unusual. Experienced
option traders already understand much of what has been shown here, but less experi-
enced traders may find this information to be different from what they expected.
Some general facts can be drawn about the bull spread strategy. Perhaps the most
important one is that, if used on a volatile stock, you won't get much expansion in the
spread even if the stock makes a nice move upward in your favor. In fact, for high implied
volatility situations, the bull spread won't expand out to its maximum price until expiration
draws nigh . That can be fru strating and disappointing .
Often, the hull spread is established because the option trader feels the options are
"too expensive" and thus the spread strategy is a way to cut down on the total debit
invested. However, the ultimate penalty paid is great. Consider the fact that, if the stock
Chapter
37: HowVolatility
AffectsPopular
Strategies 727
FIGURE 37-5.
Call buy versus bull spread in 30 days; IV = 80%.
2500
2000
Outright Call Buy/
/
1500
Cl)
2
...J
-;:,
ea..
1000
500
/
~-------- Bull Spread
(fl
O 70 80 ~ -:-- 120 130 140

-500~ ,,,../
/%'
-1000 ~ Stock
rose from 100 to 130 in 30 days, any reasonable four-month call purchase (i.e., with a
strike initially near the current stock price) would make a nice profit, while the bull spread
barely ekes out a 5-point gain. To wit, the graph in Figure :37-5compares the purchase of
the at-the-money call with a striking price of 100 and the 90-110 call bull spread, both
having implied volatility of 80%. Quite clearly, the call purchase dominates to a great
extent on an upward move. Of course, the call purchase does worse on the downside, but
since these are bullish strategies, one would have to assume that the trader had a positive
outlook for the stock when the position was established. Hence, what happens on the
downside is not primary in his thinking.
The bull spread and the call purchase have opposite position vegas, too. That is, a
rise in implied volatility will help the call purchase but will harm the bull spread (and vice
versa). Thus, the call purchase and the bull spread are not very similar positions at all.
If one wants to use the bull spread to effectively reduce the cost of buying an expen-
sive at-the-money option, then at least make sure the striking prices are quite wide apart.
That will allow for a reasonable amount of price appreciation in the bull spread if the
underlying rises in price. Also, one might want to consider establishing the bull spread
with striking prices that are both out-of-the-money. Then, if the stock rallies strongly, a
greater percentage gain can be had by the spreader. Still, though, the facts described
ahove cannot be overcome; they can only possibly be mitigated by such actions.
andTrading
Volatility
A FAMILIAR SCENARIO?
Often , one may be deluded into thinking that the two positions are more similar than
they are. For example , one does some sort of analysis-it does not matter if it's fundamen-
tal or technical-and comes to a conclusion that the stock (or futures contract or index) is
ready for a bullish move. Furthermore, he wants to use options to implement his strategy.
But, upon inspecting the actual market prices, he finds that the options seem rather
expensive . So, he thinks , "Why not use a bull spread instead? It costs less and it's bull-
ish , too."
Fairly quickly, the underlying moves higher-a good prediction by the trader, and a
timely one as well. If the move is a violent one , especially in the futures market, implied
volatility might increase as well. If you had bought calls, you'd be a happy camper. But if
you bought the bull spread, you are not only highly disappointed, but you are now facing
the prospect of having to hold the spread for several more weeks (perhaps months) before
your spread widens out to anything even approaching the maximum profit potential.
Sound familiar? Every option trader has probably done himself in with this line of
thinking at one time or another. At least, now you know the reason why: High or increas-
ing implied volatility is not a friend of the bull spread, while it is a friendly ally of the
outright call purchase. Somewhat surprisingly , many option traders don't realize the dif-
ference between these two strategies, which they probably consider to be somewhat sim-
ilar in natur e.
So, be careful when using bull spreads. If you really think a call option is too expen-
sive and want to reduce its cost, try this strategy: Buy the call and simultaneously sell a
credit put spread (bull spread) using slightly out-of-the-money puts. This strategy reduces
the call's net cost and maintains upside potential (although it increases downside risk, but
at least it is still a fixed risk).
Example: With XYZ at 100, a trader is bullish and wants to buy the July 100 calls, which
expire in two months. However, upon inspection, he finds that they are trading at 10-an
implied volatilit y of .59%. He knows that, historically , the implied volatility of this stock's
options range from approximately 40% to 60%, so these are very expensive options. If he
buys them now and implied volatility returns to its median range near .50%, he will suffer
from th e decrease in implied volatilit y.
As a possible rem edy, he considers selling an out-of-the-money put credit spread at
the same time that he buys the calls. The credit from this spread will act as a means of
rt'd ucing the net cost of the calls. If he's right and the stock goes up, all will be well. How-
(_'\·e
r, th e introduction of the put spread into the mix has introduced some additional
downside risk.
Chapt
er 37: HowVolat
ility AffectsPopular
Strategies 729
Suppos e the following price s exist:

XYZ: 100
July 100 call : 10 (as stated above)
July 90 put: 5
July 80 put: 2
The entire bullish position would now consist of the following:

Buy l July 100 call at 10
Buy 1 July 80 put at 2
Sell 1 July 90 put at 5
Net expenditure : 7 point debit (plus commission)
Figure 37-6 shows the profitability, at expiration, of both the outright call purchase
and the bullish position constructed above.
First, one can see that the bullish spread position has a total risk of 17 points, if XYZ
is below 80 (the lower striking price of the put spread) at expiration. That, of course, is
more than the IO-point cost of the July 100 call by itself, but if one is using a trading stop
of any sort, he probably would not be at risk for the entire 17 points, since he wouldn't
FIGURE 37-6.
Profitabil ity at exp iration .
~
2000
Bullish Spread
//
1000
<I)
<I)
0 Outright Call Purchase
_j
:;::, 87
e
a.
0
70 80 90 100 ~ 100 120
Y,
,,__,,_______...,___,,//
-1000
~ Stock
- 2000-
andTrading
Volatility
FIGURE 37-7.
Results of the two positions in 30 days.
Spread
1000
Outright Call Purchase
Cf)
Cf)
0 95
....J
:;::, O 70
'§ 80 90 120
ct
(;/3-
-1000
-2000- Stock
hold on while the stock fell all the way to 80 and below. Note also that the bullish spread
position would have a loss of 10 points (the same as the call) at a price of 87 for the com-
mon at expiration. Hence , the combined position actually has less risk than the outright
call purchase as long as XYZ is 87 or higher at expiration. Since one is supposedly bullish
initially when establishing this strategy, it seems likely that he would figure the stock
would be 87 or higher at expiration .
Figure .37-7offers another comparison, that of the two positions after .30 days have
passed. Note that the spread position once again does better on the upside and worse on
the downside. The crossover point between the two curves is at about a price of 95. That
is, if XYZ is above 95 in 30 clays, the bullish spread position will outperform the call buy.
One final point should be made regarding the investment required. The outright call
purchase requires an investment of $1,000-the cost of the long call. The bullish spread
position requires that $1,000, plus $700 for the spread (10-point difference in the strikes,
less the 3-point credit received for selling the spread). That's a total of $1,700, the risk of
the bullish spread position. Hence, the rate of return might favor the outright call pur-
chase, dependi ng on how far the stock rallies.
Overall, the bullish spread position is an attractive alternative to an outright call
purchase, especially when the call is overpriced. The spread does risk a greater amount
of mone y if the underlying stock should collapse heavily. Still, if one is truly bullish, and
Chapter
37: HawVolatility
AffectsPopular
Strategies 731
if one employs a reasonably tight downside stop on his entire position, this spread can
perform better than the outright purchase of an overpriced call.
VERTICAL PUT SPREADS
Also of interest is the effect that implied volatility has on put spreads. One of the more
popular strategies involving puts is the sale of a credit spread-a bull spread with puts.
Assume that a stock is selling at 100, and one is going to sell a put with a 110 strike and
buy a put 1cith a .90strike. That is a put credit (bull) spread. Also assume that the options
have four months of life remaining. (See Table 37-8.)
One would not rationally sell this credit spread if implied volatility were as low as
20%, because at that low level of volatility, the in-the-money December llO put is trading
for 10 dollars-parity-and thus would immediately be at risk of early assignment. But
one can see that an increase in implied volatility increases the value of the spread. Now,
if one had sold this spread to begin with, he would thus be losing money when implied
volatility increased. This was proven with call bull spreads, too: They lose money when
implied volatility increases. Conversely, of course, the put credit spread makes money
when implied volatility decreases.
What happens after thirty days have passed? Figure 37-8 shows just two cases-
implied volatility at 30% and implied volatility at 80%. One can surmise that other levels
of implied volatility between 30% and 80% would have profit graphs that lie between the
two shown in Figure 37-8.
First, one can observe that a bull put spread does not widen out to anywhere near its
maximum potential if implied volatility increases. The same thing was seen with the call
TABLE 37-8.
90-110
Implied PutBull
Spread
Value)
20% 9.15 er*
30% 9.70 er
40% 10.12 er
50% 10.46 er
60% 10.78 er
70% 11.05 er
80% 11.33 er
*Short option trading at parity
andTrading
Volatility
FIGURE 37-8.
Put credit (bull) spread profit in 30 days.
1000
500
(J)
(J)
0
_J
-;::,
20.... O 70 80 90 110 120 130 140
U)- //'
IV= 30%
./ ...
,,··(:j'
.<~··
..
-1000 Stock
Assignment Risk Area
bull spread in the pre\-ious section. But a put bull spreader is caught in another trap: If
implied rnlatility falls and the stock falls too. the risk of early assignment materializes
quickly. Note the shaded area at the lower left of the graph, extending from a price of about
94 on clown. After thirty clays (so there would be three months' life remaining at that point
in tirne). if illlplied rnlatility is :30o/c,the 110 put (the short put) would he trading at parity
for stock prices of 94 and below. Thus, it would be at risk of early assignment. If implied
rnlatility were ew'n lower, the puts would be at parity for much higher stock prices.
Now, in and of itself, earl: assignment on an equity or futures put spread is not nec-
1
essarily a terrible thing. There will be a request for additional margin (because the stock
has to be paid for or the futures contract nmrgined), but the risk is still the same in dollar
terms. Of course, the rt'quest for extra margin could be backbreaking for a stock trader if
he can't afford to fully pay for the stock and the early assignment would probably incur
additional commission costs. too. Howe\'er, with cash-hasecl index options there is a more
serious increase in risk after an early assigurnent, because one is left with only the long
side of the spread. If that option happens to have substantial value, then there is consider-
able risk if the underl:·ing should quickly move higher. In fact, by the time one unwinds
tlll' spread. he might actuall:· encl up losing lllore than his original lilllited risk amount-
all due to the earl:· assignrncnt. (This could happen if the underlying first plunges in price,
placing hoth options deepl:· in-the-money. after which one gets assigned on the short put
option, followed by the underlying then dramatically rising in price.)
Chapter
37: HowVolatility
AffectsPopular
Strategies 733
The lesson to be learned is this: If one is considering using bull spreads in which at
least one of the options is at- or in-the-money, then a call bull spread is a superior choice
over a put hull spread. Early assignment is not really a consideration for most call spreads.
In both cases, however, a more serious problem exists, and that is that the spread
does not widen out much even when the stock makes a nice bullish move. Thus, once
again it is actually better to buy a call option in most cases than to use the bull spread,
because profits are larger and an increase in implied volatility is a favorable thing for an
outright call buyer.
Note that these effects are similar, but much less pronounced, for out-of-the-money
put credit spreads. Still, it should be noted that an increase in implied volatility will harm
an out-of-the-money put credit spread, too. Hence, if the underlying goes into a rapid fall
(crash, plunge), then implied volatility usually increases quickly and dramatically. So an
out-of-the-money credit spreader is hit with the double whammy of expanding implied
volatility and the fact that the underlying is fast approaching the strike price of his options,
thereby expanding the price of the spread.
PUT BEAR SPREADS
What about the put spread in a bearish situation? In a vertical put spread one buys the put
with the higher strike and sells the put with the lower strike to construct a simple put bear
spread. Actually, a sudden increase in implied volatility is of help to the bear put spread.
That is, the spread will widen out slightly. To verify this, look at Table 37-8 again, only now
imagine that one is buying the spread for a debit. Note that the smallest debit is at the
lower implied volatility-9. 1.5debit with IV at 30%. If implied volatility were to instanta-
neously jump to 80%, the spread would widen out to 11.33 debit. A very quick profit could
be had. So there's a difference right away between a debit call bull spread (which loses
money when implied volatility suddenly increases) and a debit put bear spread.
Unfortunately, the other major drawback-that the spread doesn't widen out much
if the underlying makes a favorable move-is still true. Figure 37-9 shows a bear put
spread, 30 days hence, for two different implied volatilities. Once again, the lower-volatility
spread widens out more quickly, because both options tend to go to parity in that case. In
fact, one can see on the graph that there is early assignment risk in the low-volatility case,
below a price of about 77 on the stock. That is not a problem, though, since the spread
would have widened to its maximum potential in that case ancl could just be removed
when the risk of early assignment materialized .
When implied volatility remains high, though, the spread doesn't widen out much,
even when the stock drops a lot after 30 days. Since it is common for implied volatility to
rise (even skyrocket) when the underlying drops quickly, the put hear spread prohahly
andTrading
Volatility
FIGURE 37-9.
Bear put spread profit in 30 days.
1000
~IV=30%
~ Assignment
Risk
Area
Cf)
Cf)
0
....J
-;::,
ea.. 0
70 80 .110 120 130 140
(h
-~80%
"~
-1000 Stock
won't widen out much. That may not be a psychologically pleasing strategy, because one
won't make the level of profits that he had hoped to when the underlying fell quickly.
Once again, it seems that the outright purchase of an option is probably superior to
a spread. In these cases, it is true with respect to puts, much as it was with call options.
Spreading often unnecessarily complicates a trader's outlook.
CALENDAR SPREADS
In the earlier chapter on calendar spreads, it was mentioned that an increase in implied
volatility will cause a calendar spread to widen out. Both options will become more
expensive, of course, since the increase in implied volatility affects both of them, but the
absolute price change will be greatest in the long-term option. Therefore, the calendar
spread will widen. This may seem somewhat counterintuitive, especially where highly
volatile stocks are concerned , so some examples may prove useful.
Example: Suppose that XYZ is trading at 100, and one is interested in a calendar spread
in which an August (.5-month) call is bought and a May (2-month) call is sold. For the
purpose of this example, it will be assumed that these are both at-the-money options.
First the \·egas of the two options will he examined, assuming that implied volatility is
40 %:
Chapter
37: HowVolatility
AffectsPopular
Strategies 735
Stock:
100
Implied
Volatility:
40%Option Theoretical
Price Vega
Sell May 100 call 6.91 0.162
Buy August 100 call 11.22 0.251
In theory, this spread should be worth 4.31-the difference in the theoretical values.
Perhaps more important, it has volatility exposure of 0.089-the difference between the
vega of the long call and that of the short call. Since vega is positive, this means that an
increase in implied volatility will be beneficial to the spread. In other words, one can
expect the spread to widen if implied volatility rises, and can expect the spread to shrink
if implied volatility declines.
The following table can also be constructed, showing the theoretical value of the
spread at various levels of implied volatility. This table makes the assumption that very
little time has passed (only one week) before the implied volatility changes take place. It
also assumes that the stock is still at 100.
Stock
Price:
l 00
Oneweekafterthespreadhasbeenestablished:
Implied
Volatility Theoretical
Spread
Value
20% 2.58
30% 3.52
40% 4.46
50% 5.40
60% 6.33
80% 8.16
100% 12.92
From the above data, it is quite obvious that implied volatility levels have a huge effect on
the value of a calendar spread. The actual initial contribution of time decay is rather small in
comparison. For example, note that if volatility remains unchanged at 40%, then the spread
will have widened only slightly-to 4.46 from 4.31-after the passage of one week's time.
That is small in comparison to the changes dictated by volatility expansion or contraction.
A common mistake that calendar spreaders make is to think that such a spread looks
overly attractive on a very volatile stock. Consider the same stock as above, still trading at
andTrading
Volatility
100, but for some reason implied volatility has skyrocketed to 80% (perhaps a takeover
rumor is present).
Stock:
100
Implied
Volatility:
80%
Call Theoretical
Value
May 100 call 12.55
June 100 call 16.81
On the surface, this seems like a very attractive spread. There are two months of life
remaining in the May options (and three months in the Junes) and the spread is trading at
4.36. However, both options are completely composed of time value premium, and most
certainly the June 100 call would be worth far more than 4.36 when the May expires, if the
stock is still near 100. The fact that many traders miss when they think of the calendar
spread this way is that the June call will only be worth "far more than 4.36" if implied vola-
tility holds up. If implied volatility for this stock is normally something on the order of 40%,
say, then it is probably not reasonable to expect that the 80% level will hold up. Just for
comparison , note that if the stock is at 100 at May expiration-the maximum profit poten-
tial for such a calendar spread-the June 100 call, with implied volatility now at 40%, and
with one month of life remaining, would be worth only 4.77. Thus the spread would only
have made a profit of a few cents (4.36 to 4.77), and if the underlying stock were farther
from the strike price at expiration, there would probably be a loss rather than a profit.
The point to be remembered is that a calendar spread is a "long volatility" play (and
a reverse calendar spread is just the opposite). Evaluate the position's risk with an eye to
what might happen to implied volatility, and not just to where the stock price might go or
how much time decay there might be in the position.
RATIO SPREADS AND BACKSPREADS
The previous descriptions in this chapter describe fairly fully and accurately what the
effect of volatility changes are. More complicated strategies are usually nothing more
than combinations of the strategies presented earlier, so it is easy to discern the effect
tlrnt changes in implied volatility would have; just combine the effects on the simpler
strategies. For example, a ratio call write is really just the equivalent of a straddle sale-a
strategy whose volatility ramifications are fairly simp le to understand.
Ratio spreads, on the other hand, might not be as intuitive to interpret, but they are
fairly simple nonetheless. A call ratio spread is really just the combination of some call bull
Chapter
37: HowVolatility
AffectsPopular
Strategies 737
spreads and some naked call options. For example, a call ratio sprt>ad might consist of
buying an XYZ July 100 call and selling two XYZ July 120 calls. If ont' wert' to break it
down into its components, this spread is rt>allylong one XYZ July l00-120 call bull spread,
plu s an additional n aked July 120 call.
\Ve already know that an increase in implied volatility is very detrimental to a naked
call option. In addition, it was shown earlier than an increase in implied volatility actually
harms the value of an at-the-money call bull spread. So, for a ratio call spread, both com-
ponents are harmed by an increase in implied volatility. Com·ersely, a decrease in implied
volatility would be beneficial to a ratio spread, but where naked options are concerned,
one should be more mindful of his risk than of thi s reward .
It was also shown previously that a call bull spread does not widen out much if the
underlying stock makes a quick upward move. The spread won't widen out to its maximum
profit potential until expiration draws nigh or the stock is well above the upper strike in
the spread. This scenario also does not bode well for the ratio call spread. Suppose that
the underlying stock suddenly jumps upv-1ardand implied volatility increases at the same
time. That combination is seen quite frequently, especially if the stock were previously
"dull" or if there is some sort of active corporate (takeover) rumor. The call ratio spread
will fare miserably under these conditions, because the increase in stock price certainly
harms the naked call position and the bull spread is not widening out much to compensate
for it. In addition, the increase in implied volatility is working against both components.
The same sort of thing happens with put ratio spreads. They are really the combina-
tion of a put bear spread plus some additional naked put options. If the underlying falls
in price, while implied volatility increases-a very common occurrence in all markets-
then the put ratio spread will fare poorly. In fact, implied volatility sometimes explodes if
the underlying falls very rapidly (crashes), so the ratio put spreader should clearly assess
his risk in this light.
In summary, a trader utilizing ratio spread strategies should clearly understand and
attempt to analyze the risks of an increase in implied volatility. This includes not only
assessing the vega risk of the spread, but also using a probability calculator with some
inflated volatility estimates to see just \vhat the chances are of the spread getting into real
trouble .
BACKSPREADS
A call backspread is merely the opposite of a call ratio spread. Thus, any of the earlier
commentary about how an increase in implied volatility is detrimental to a ratio spread
can be reversed when discussing the backsprea<l. An increase in implied volatilit:' will he
beneficial to a backspread strategy, while a decrease in implied volatility will he slightly
harmful to the spread. However, since risk is limited in a hackspreacL such a clccrt'ase in
andTrading
Volatility
implied volatility would not have catastrophic consequences unless one had overcommit-
ted his funds to one position.
SUMMARY
In general, one can always determine the exposure of his position to volatility by comput-
ing the vega of this position. However, it is also useful for a strategist to have some general
feeling for how implied volatility will affect his positions and strategies. Thus, this chapter
was designed to point out the most common effects that changes in implied volatility will
have on the basic types of option strategies. Once one has a feeling for his exposure to
volatility, he can then assess whether an adverse volatility movement is likely. For exam-
ple, if an increase in implied volatility would be harmful, and the strategist sees that cur-
rent levels of implied volatility are quite low in comparison to historical norms, then
perhaps he should remove or adjust the position.
Volatility and the price of the underlying are the two major components affecting
profitability for most option positions. Time decay is only most pertinent as expiration
approaches. Yet, many traders concentrate greatly on potential price movements of the
underlying, often while ignoring what changes in implied volatility could do. That is a
mistake, for the most knowledgeable option traders plan for volatility risk at all times.
Understanding and handling that risk can have a positive effect on an option trader's
profits.
The Distribution of
Stock Prices
Much of the work that has been done in statistics and related areas regarding the stock
market has made the assumption that stock prices are distributed normally , or more spe-
cifically, lognonnally. In actual practice, this is usually an incorrect assumption. For the
option strategist, this means that some of the things one might believe about certain
option strategies having an advantage over certain other option strategies might be incor-
rect. In this chapter, a number of facts concerning stock price distribution will be brought
to light , including how it might affect th e option strategist.
MISCONCEPTIONS ABOUT VOLATILITY
Statistics are used to estimate stock price movement (and futures and indices as well) in
many areas of financial analysis. Many authors have written extensively about the use of
probabilities to aid in choosing viable option strategies. Stock mutual fund managers
often use volatility estimates to help them determine how risky their portfolios are. The
uses are myriad. Unfortunately , almost all of these applications are wrong! Perhaps ummg
is too strong a word, but almost all estimates of stock price movement are overly conser-
vative. This can be very dangerous if one is using such estimates for the purposes of, say,
writing naked options or engaging in some other such strategy in which volatile stock
pric e movement is unde sirable .
As a review for those not familiar with mathematical distributions, the lognorrnal
distribution is what's commonly used to describe stock prices because its shape is
739
andTrading
Volatility
intuitively similar to the way stocks behave-they can't go below zero, they can rise to
infinity , and most of the time they don't go much of anywhere. On top of that, the distri-
bution's shape is based on the l1istorical rolatilif!J of the underlying instrument. In a
lognonnal distribution (and normal distribution, too), stocks remain within 3 standard
deviations of their current price 99.74% of the time. A standard deviation (sigma) is a
statistical measure whose absolute distance grows larger with time, and it is something
that can be easily calculated for any individual stock or futures contract, using historical
prices .
There are great differences between the way stocks really behave and the assump-
tions that 1nany mathematical models make about the way stocks theoretically behave.
The problem lies in assuming that normal or lognormal distribution predicts stock price
movements. Such an assumption does not allow for the occasional wild days that many
stocks, some futures, and the relatively rare index undergo. The normal distribution pretty
much says that a stock can't rist' or fall bymore than 3 standard deviations. In fact, accord-
ing to math, tht' probability of something that behaves according to the normal distribu-
tion (the "classic" bell cun-t' is a normal distribution) moving three standard deviations is
0.001:3 (or just a little mort' than one tenth of one percent). So, if there are 2,.500 option-
able stocks, say, then one would expect maybe 3 of them to move three standard devia-
tions on any given day.
Howe,·er, in real market trading, there are routinely moves in stocks of more than 3
stand ard de,·iations-some as much as .Sstandard deviations or more. Statistically (if the
lognorrnal distribution were correct), one would only expect to see moves of that size
maybe once in his lifetime, yet there are five or ten each day! Specifically, the normal
distribution's probability of something being able to move 8 standard deviations is
0.000000000000000629. This number is so small that Ollt' would expect to see only one
such occmTence in the known life of the universe, if prices were truly distributed via the
normal distribution. If the normal distribution were the correct format for stock prices,
such a small probability would indicate that one would not see an 8-stanclard deviation
rnove until billions of trading days had passed. However, one can find several such moves
on nearl>· any trading day, and it is not necessary to use some low-priced, oddball stock
that dropped from 1 to .7,5or some such nonsense as an example.
If thost' numbers don't convince you that stocks aren't lognormally distributed, per-
haps the following study will. Table ,'38-1lists moves that occurred on Monday, April .S,
1999-a day that was somewhat volati le (the Dow was up 174 points).
Thert' Wt'JT1rnm:' otht'r substantial moves that day. In the list in Table 38-1, all three
that fell in prict' were 011 earnings warnings, and the two that rose were just swept up in
that da:·'s ,·t'rsion of the Intt'rnt't mania. All in all, ,58 stocks had moves of greater than
r standard ch..,,
_/<)I[ iations on that da>·!It \\'as not an>·sort of special day, although it did fall
Chapter
38: TheDistribution
ol StockPrices 741
TABLE 38-1.
Stock · Last
Sale Change Standard
Deviations
AspectDevt(ASDV) 8 -14.38 -31.2
Axent(ANT) 8 -12 - 11.2
Ameritrade(AMTD) 91.63 +29.13 +8.6
CheckPoint
(CHKP) 28.75 -10.75 -8.4
SabreGp. (TSG) 55 +8.50 +8.0
during earnings warnings season and in the midst of the Internet mania. But the fact that
the market is somewhat volatile shouldn't justify all of these huge moves, if one still
adheres to the belief that lognormal is the correct distribution .
So, just to make sure that wasn't a bad sample, a low-volatility period was chosen to
sample. Since the inception of the CBOE 's Volatility Index (VIX) trading, its lowest mar-
ket volatility readings were in January and July of 1993. The lowest single day was July 25,
1993. On that day, twelve stocks had moves of more than four standard deviations. They
includ ed some big names, like Adaptec (ADPT), Bethlehem Steel (BS), U.S. Steel (X),
Chiquita Brands (CQB), and Novell (NOVL).
The only way to tell how many standard deviations a stock has moved is to use its
historical volatility-say, the 20-day historical volatility, for example-in the measure-
ment. Thus, a 4-point move for a nonvolatile stock like Bethlehem Steel in 1993 pales in
comparison to Ameritrade's 29-point gain in 1999 (Table 38-1), but both were large moves
in terms of standard deviations, determined by using each stock's historical volatility.
As another test, prices from October 8, 1998-the day the market bottomed after a
severe and rather swift decline brought on by Russian debt problems (it was a very volatile
day after several volatile weeks of trading)-were tested to see how many stocks had
moves of four standard deviations or more. There were 33, but that seemingly low number
reflects the fact that many stocks' 20-day historical volatilities were already well inflated
by October 8, 1998. On that day, the Utility Index (UTY) fell over 14 points, which was
about 5.5 standard deviations. American Power Conversion (APCC) was up over six points
that day, to 36.88-a gain of over five standard deviations.
Perhaps you might think that these one-day moves overstate things, that over a more
prolonged period of time, the lognormal distribution fits better. A study was constructed
to measure the volatility over a slightly longer time period. The results of the study not
only confirmed our suspicions, but actually were somewhat startling in quantifying just
how volatile certain individual issues can be .
The first example comprised the 30-day trading period hetwPen October 22, 1999,
andTrading
Volatility
and December 7, 1999. There is nothing magical about these dates; that just happened to
be the most recent 30-day period for which data was available when the study was
conducted.
This particular period started out as a rather normal one in the market-in fact,
prices had perhaps been a little less volatile than normal leading into that period. To sup-
port that statement, it should be noted that on October 22, the CBOE's Volatility Index
(VIX) stood at about 23-a relatively middle-of-the-range level. So it wasn't as if this was
an extremely volatile period.
The example is simple enough. The performance of 2,900 optionable stocks was
measured to see if, beginning on October 22, 1999, any of them experienced moves of
greater than three standard deviations at any time during the 30-day period. The stan-
dard deviation was based on the 20-day historical volatility of each individual stock. Obvi-
ously, a stock would have to make a much greater move to exceed the 3-standard deviation
limit if it waited until the end of the 30-day period to do it, as opposed to making a big
move on the first day. So, before reading on, take a guess: How many of the stocks do you
think exceeded three standard deviation moves at some point during the 30 days? Remem-
ber that the lognonnal distribution would predict virtually no moves of that size. The
answer is in the next paragraph.
There were more stocks that had large upside moves than there were that had large
downside moves over the period in question. That isn't too surprising, since the market
moved up during that time. The final total showed this: Of the 2,900 stocks, nearly
6.50 experienced moves of 3 standard deviations or more during the life of the study,
including 6.5 that moved more than six standard deviations. If the lognormal distribution
were correct, the two lines in Table 38-2 would be filled with zeroes. This clearly shows
stocks during this period didn't conform to the "normal" expectations. The study results
are shown in Table 38-2. (Note that "a" is the greek letter sigma, which mathematicians
traditionally use to denote standard deviations, so 3a means three standard deviations.)
TABLE 38-2.
Stock price movements.
Total
Stocks:
2,888 Dates
: 10/22/99-12/7/99
3o 4o So >60 Total
Upside Moves : 309 116 44 47 516
Downside Moves: 69 29 15 19 132
Total numberof stocksmoving >=3o: 648 (22% of the stocksstudied)
The largest move was registered by a stock that jumped from a price of .Sto nearly 12 in
ahout si\ tradillg days. One of the bigger downside movers was a stock that fell from about
Chapter
38: TheDistribution
of StockPrices 743
20 to 8 in a matter of a couple of weeks, with most of the damage occurring in a two-day

time period.
Lest you think that this example was biased by the fact that it was taken during a
strong run in the NASDAQ market, here's another example, conducted with a different
set of data-using stock prices between June 1 and July 18, 1999 (also 30 trading days in
length). At that time, there were fewer large moves; about 2.50 stocks out of 2,500 or so
had moves of more than three standard deviations. However, that's still one out of ten-
way more than you've been led to expect if you believe in the normal distribution. The
results are shown in Table 38-3.
Finally, one more example was conducted, using the least volatile period that we had
in our database-July of 1993. Those results are in Table 38-4.
At first glance, it appears that the number of large stock moves diminished dramati-
cally during this less volatile period in the market-until you realize that it still represents
10% of the stocks in the study. There were just a lot fewer stocks with listed options in
1993 than there were in 1999, so the database is smaller (it tracks only stocks with listed
options). Once again, this means that there is a far greater chance for large standard
deviations moves-about one in ten-than the nearly zero percent chance that the log-
normal distribution would indicate.
TABLE38-3.
More stock price movements.
Total
Stocks
: 2,447 Dotes:
6/1/99-7/18/99
3cr 4cr Scr >6cr Total
Upside Moves: l 04 28 13 12 157
Downside Moves: 54 19 7 14 94
Total number of stocks moving >=3cr: 251 (10% of the stocks studied)
TABLE 38-4.
Stock price movements during a nonvolatile period.
Total
Stocks:
588 Dotes:
7/1/93-8/17/93
3cr 4cr Sa >6cr Total
Upside Moves: 14 5 21
Downside Moves : 28 5 3 4 40
Total number of stocks moving >=3cr: 61 (10% of the stocks studied)
andTrading
Volatility
VOLA TILITY BUYER'S RULE!
The point of the previous discussion is that stocks move a lot fart her than you might
expect. Moreover , when they make these moves, it tends to be with rapidity, generally
including gap moves. There are not always gap moves, though, over a study of this length.
Sometimes, there will be a more gradual transition. Consider the fact that one of the
stocks in the study moved .5.8 sigma in the 30 days. There weren't any huge gaps during
that time , but anyone who was short calls while the stock made its run surely didn't think
it was a gra dua l advance.
So, what does thi s information mean to the average option trader'? For one , you
should certainly think twice about selling stock options in a potentially volatile market (or
any market, for that matter, since these large moves are not by any means limited to the
volatile market periods). This statement encompasses naked option selling, but also
includes many forms of option selling, because of the possibilities of large moves by the
und erlying sto cks.
For example , covered call writing is considered to be "conservative ." However, when
the stock has the potential to make these big moves, it will either cause one to give up
large upside profits or to suffer large downside losses. (Covered call writing has limited
profit potential and relatively large downside risk, as does its equivalent strategy , naked
put selling.) When these large stock moves occur on the upside , a covered writer is often
disappointed that he gave up too much of the upside profit potential. Conversely , if the
stock drops quickly, and one is assigned on his naked put, he often no longer has much
appetite for acquiring the stock (even though he said he "wouldn't mind" doing so when
he sold th e put s to b egin with) .
Even spreading has problems along these lines. For example , a vertical spread limits
profits so that one can't participate in these relatively frequent large stock moves when
th ey occur.
\Vhat can an option seller do'? First, he must carefully analyze his position and allow
for much larger stock movements than one would expect under the lognonnal distribu-
tion. Also, he must be careful to sell options only when they are expensive in terms of
implied volatilit y, so that any decrease in implied will work in his favor. Probably most
judicious , though , is that an option seller should really concentrate on indices (or perhaps
certain future s contracts), because they are statistically much less volatile than stocks.
Hard as it is to believe, futures are less volatile than stocks (although the leverage available
in futur es can make th em a riskier investm ent overall ).
Th ese example s of stock price movement are interesting, but are not rigorously com-
plete enough to be able to substantiate the broad conclusion that stock prices don't behave
lognormally. Thu s, a more complete study was conducted. The following section presents
the results of this research.
Chapter
38: TheDistribution
of StockPrices 745
THE DISTRIBUTION OF STOCK PRICES
The earlier examples pointed out that, at least in those specific instances, stock price
movements don't conform to the lognonnal distribution, which is the distribution used in
many mathematical models that are intended to describe the behavior of stock and option
prices. This isn't new information to mathematicians; papers dating back to the mid-1960s
have pointed out that the lognonnal distribution is flawed. However, it isn't a terrible
description of the way that stock prices behave, so many applications have continued to
use the lognormal distribution.
Since 1987, the huge volatility that stocks have exhibited-especially on certain
explosive down days such as the Crash of '87 or the mini-crash of April 14, 2000-has
alerted more people to the fact that something is probably amiss in their 11sualassump-
tions about the way that stocks move. The lognormal distribution "says" that a stock really
can't move farther than three standard deviations (whether it's in a day, a week, or a year).
Actual stock price movements make a mockery of these assumptions, as stocks routinely
move 4, .5,or even 10 standard deviations in a day (not all stocks, mind you, but some-
many more than the lognormal distribution would allow for).
In order to further quantify these thoughts, computer programs \Vere written to ana-
lyze our database of stock prices, going back over six years. As it turns out, that is a short
period of time as far as the stock market is concerned. \!Vhile it is certainly a long enough
time to provide meaningful analysis (there are over 2..5 million individual stock "trading
days" in the study), it is a biased period in that the market was rising for most of that time.
THE NBIG" PICTURE
The first part of the analysis shows that the total distribution of stock prices conforms
pretty much to what the expectations were for the study, and-not surprisingly-to what
others have written about the "real" distribution of stock prices. That is, there is a much
greater chance of a large standard deviation move than the lognonnal distribution would
indicate . The high probabilities on the ends of the distribution are called "fat tails" by most
mathematicians and stock market practitioners alike. These "tails" are what get option
writers in trouble-and perhaps even leveraged stock owners-because margin buyers
and naked writers figure that they will never occur. It is not intuitively obvious to them and
to many other stock market participants that stock prices behave in this manner.
The graphs in Figure .'38-1show this total distribution. The top graph is that of the
lognormal distribution and the actual distribution, using the data from September 199:3
to April 2000-overlaid upon each other. The actual distribution was drawn using :30-da~·
moves (i.e., the number of standard deviations was computed by looking at the stock price
on a certain clay, and then where it was :30 calt'mlar days later). The .\-axis (hottorn axis)
andTrading
Volatility
shows the number of standard deviations moved. Note that the curves have the shape of
a 11ornwl distribution rather than a lognormal distribution, because the x-axis denotes
number of standard deviations moved rather than stock prices themselves. For this rea-
son, the term '"normal" will be used in the remainder of this section; it should be under-
stood that it is the distribution of standard deviations that is "normal," while the
distribution of the stock prices measured by those standard deviation moves is "lognor-
mal." The y-axis (left axis) shows the "counf'-the number of times out of the 2.5 million
data points computed that each point on the x-axis actually occurred (in the case of the
"actual" distribution) or could be expected to occur (in the case of the "normal" distribu-
tion). The notation 011 the y-axis shows the actual count divided by 10. So, for example,
th e highest point (0 standard de\·iations moved) for the "normal" distribution shows that
about 95,000 times out of 2.,5 million, you could expect a stock to be unchanged at the
end of 30 calendar days.
At first glance, it appears that the two curves have almost identical shapes. Upon
closer inspection, howen·r, it is clear that they do not, and in fact some rather startling
differences are evident.
Fat Tails
Figure :38-1 shows the fat tails quite clearly. Magnified views of the fat tails are provided
to show ~·ou the stark differences between the theoretical ("normal") distribution and
actual stock price rnm·ernents. Consider the downside (the lower left circled graph in
Figure :38-1). First, note that both the "actual" and "normal" graphs lift up at the end-
th e leftmost point. This is because tl1e graph was terminated at -4.0 standard deviations,
and all moves that were greater than that were accumulated and graphed as the leftmost
data point. You can see that the "normal" distribution expects fewer than 200 moves out
of 2.5 million to be of -4.0 standard deviations or more (yes, the "normal" distribution
docs allow for mon:'S greater than 3 standard de\·iations; they just aren't very probable).
On the other hand, actual stock prices-even during the bull market that was occurring
during the term of the data in this study-fell more than -4.0 standard deviations nearly
2}500 times out of 2.5 million. Thus, in reality, there was really more than 12 times the
chance (2,,500 \'S. 200) that stocks could suffer a severely dramatic fall, when comparing
actual to theoretical distribution. Also notice in that lower left circle that the actual dis-
tribution is greater than the normal distribution all along the graph.
Tht> upside fat tail shows much the same thing: Actual stock prices can rise farther
than the normal distribution would indicate. At the extreme-moves of +4.0 standard
dt>\iations or rnore-thert' were about 2,000 such rnm·es in actual stock prices, compared
\\ it h fewer than 100 expected hy the normal distribution. Again, a very large discrepancy:
twenty-to-one .
Chapter
38: TheDistribution
of StockPrices 747
FIGURE 38-1.
Stock price distribution is not "normal."
Normal Stock Price Distribution

vs. Actual Stock Distribution (30-Day Moves)
9000
8000
7000
0
6000
£C
:J
0
5000
0
4000
3000
2000
1000
240 Includes All Moves

220 0 160
210 below-4 .0
200
£C 140
:J
120
0 180 0 100
£C 160 0 80
140
:J 60
0 120
0 40
100
20
80
60 0
40 • 3.0
20
0
-4.0
Sigmas
andTrading
Volatility
Inflection Points
If the actual distribution is higher at both ends, it must be lower than the normal distribu-
tion so111eu)1ere,because there are only a total of 2.,5 million data points plotted. It turns
out in this case that the normal distribution is higher (i.e., is expected to occur more
often than it actually does) between -2.,5 standard deviations and +0.5 standard devia-
tions. Those are the points where the two curves cross over each other-the inflection
points. Outside of that range, the actual distribution is more frequent than it was expected
to be.
It is probably the case that this data reflected an overly bullish period. That is, actual
stock prices rose farther than they were expected to, not necessarily at the tails, but in the
intermediate ranges, say between +0.,5 and +LS standard deviations. This does not change
tlw results of the study as far as the tails go, but one may not always be able to count on
interme diate up side moves being more frequent than predicted.
SIDE BENEFITSOF THIS STUDY
In the course of doing these analyses, a lot of smaller distributions were calculated along
the wa:,'·One of these is the distribution on any individual trading day that was involved in
the stud:,'· Nmv, one must understand that one day's trading yields only about 3,000 data
points (there were about :1,000 stocks in the database), so the resulting curve is not going
to be as smooth as the 011esshown in Figure :38-1.Nevertheless, some days could be inter-
esting. For example , consider the clay of the mini-crash, Friday, April 14, 2000. The
Dow-Jones Industrials were down 617 that day; the S&P ,500 index was down 83 points;
aucl the NASDAQ-100 was down 346. Except for the Crash of 1987, these were the largest
single-da:,· declines in history at the time. The distribution graph is shown in Figure 38-2.
First of alL notice how heavily the distribution is skewed to the left; that agrees with
one's intuition that the distribution should be on the left when there is such a serious down
day as 4/14/2000. Also, notice that the leftmost data point-representing all moves of -4.0
standard de\·iations and lower, shows that about 750 out of the 2,984 stocks had moves of
that size! That is unbelie\·able, and it really points out just how dangerous naked puts and
long stock on margin can he on clays like this. No probability calculator is going to give
1rnH.:hlikelihood to a day like this occurring, hut it did occur and it benefited those holding
long puts great ly, while it seriously hurt other s.
In addition to distributions for individual dates, distributions for individual stocks
were c.TPateclfor the time period in question. The graph for IBM, using data from the
sallle st11d:,·as ahm·e (September 1mnto April 2000) is shown in Figure 38-3. In the next
graph , Figure 3,~-4. a longer price history of IBM is used to draw the distribution: 1987
to 2000. Both graphs depict 30- day movement s in IBM .
Chapter
38: TheDistribution
of StockPrices 749
FIGURE 38-2.
Stock price distribution for 4/14/2000 - 2,984 Stocks in Study.
0
£C
::,
0
0
-4.0 -3.0 -2.0 -1.0 0.0 + 1.0 +2.0 +3.0 +4.0

Sigmas
FIGURE 38-3.
Stock price distribution, IBM, 7-year.
7
~ r-\
r,,
6
~ I ,:
M \! I ·,
5 /,,,J.
I,, 'vli f 1
I/ '11I
0
£C 4 I
11
~ .~
·-·
y \,;
·' \\
::,
0
0
3 r~ I
/,\
I
2 r'
,.j -
~
I
e
~
',
~
Ir,,i
)1
' ,
0
. -4.0 -3 .0 2.0 -1.0 0.0 + 1.0 +2.0 +3.0 +4.0
Sigmas
Figure 38-:3 perhaps shows eveu more starkly how the bull market affected things
over the six-plus year period, from 1993 to 2000. Tlwre are over 1,600 data points for IBM
(i.e., daily reaclillgs) in Figme 38-3, yet the whole distribution is skewed to tlic right. It
apparently was able to move np quite easily throughout this time period. In fact the worst
andTrading
Volatility
FIGURE 38-4.
Actual stock price distribution, IBM, 13-year.
0
£C:
13
12
11
10
9
8
}.\
7
\\
:::,
0 6
u 5
4
j
/
\
3
2
0
-4.0 -3.0 -2.0 - 1.0 0.0 +1.0 +2.0 +3.0 +4.0
Sigmas
move that occurred was one move of -2.,5 standard deviations, while there were about ten
moves of +4.0 standard deviations or more.
For a longer-term look at how IBM behaves, consider the longer-term distribution
of IBM price s, going back to March 1987, as shown in Figure 38-4.
From Figure 38-4, it's clear that this longer-term distribution conforms more closely
to the normal distribution in that it has a sort of symmetrical look, as opposed to Figure
38-3 , which is clearly biased to the right (upside).
These two graphs have implications for the big picture study shown in Figure 38-1.
The database used for this study had data for most stocks only going back to 1993 (I BM
is one of the exceptions); but if the broad study of all stocks were nm using data all the
way back to 1987, it is certain that the "actual" price distribution would be more evenly
centered, as opposed to its justification to the right (upside). That's because there would
be more bearish periods in the longer study (1987, 1989, and 1990 all had some rather
nasty periods). Still, this doesn't detract from the basic premise that stocks can move far-
ther than the normal distribution would indicate.
WHAT THIS MEANS FOR OPTION TRADERS
The most ob\·ious thing that an option trader can learn from these distributions and stud-
ies is that hu:,:ing options is probably a lot more feasible than conventional wisdom would
Chapter
38: TheDistribution
of StockPrices 751
have you believe. The old thinking that selling an option is "'best" because it wastes away
every day is false. In reality, when you have sold an option, you are exposed to adverse
price movements and adverse movements in implied volatility all during the life of the
option. The likelihood of those occurring is great, and they generally have more influence
on the price of the option in the short run than does time decay .
You might ask "But doesn't all the volatility in 1999 and 2000 just distort the figures,
making the big moves more likely than they ever were, and possibly ever will be again?"
The answer to that is a resounding, "No!" The reason is that the current 20-day historical
volatility was used on each day of the study in order to determine how many standard
deviations each stock moved. So, in 1999 and 2000, that historical volatility was a high
number and it therefore means that the stock would have had to move a very long way to
move four standard deviations. In 1993, however, when the market was in the doldrums,
historical volatility was low, and so a much smaller move was needed to register a
4-standard deviation move. To see a specific example of how this works in actual practice,
look carefully at the chart of IBM in Figure 38-4, the one that encompasses the crash of
'87. Don't you think it's a little strange that the chart doesn't show any moves of greater
than rninus 4.0 standard deviations? The reason is that IBM's historical volatility had
already increased so much in the days preceding the crash day itself, that when IBM fell
on the day of the crash, its move was less than minus 4.0 standard deviations. (Actually,
its one-day move was greater than -4 standard deviations, but the 30-day move-which
is what the graphs in Figure 38-3 and 38-4 depict-was not.)
STOCK PRICE DISTRIBUTION SUMMARY
One can say with a great deal of certainty that stocks do not conform to the normal dis-
tribution. Actually, the normal distribution is a decent approximation of stock price move-
ment most of the time, but it's these "outlying" results that can hurt anyone using it as a
basis for a nonvolatility strategy.
Scientists working on chaos theory have been trying to get a better handle on
this. An article in Scientific American magazine ("A Fractal Walk Down Wall Street,"
February 1999 issue) met some criticism from followers of Elliott Wave theory, in that they
claim the article's author is purporting to have "invented" things that R. N. Elliott discov-
ered years ago. I don't know about that, but I do know that thP, article addresses these
same points in more detail. In the article, the author points out that chaos theory was
applied to the prediction of earthquakes. Essentially, it concluded that earthquakes can't
be predicted. Is this therefore a useless analysis? No, says the author. It means that
humans should concentrate on building stronger buildings that can withstand the earth-
(1uakes, for no one can predict when they may occur. Relating this to the option market,
andTrading
Volatility
this means that one should concentrate on building strategies that can withstand the
chaotic movements that occasionally occur, since chaotic stock price behavior can't be
predicted either.
It is important that option traders, above all people, understand the risks of making
too conservative an estimate of stock price movement. These risks are especially great for
the writer of an option (and that includes covered writers and spreaders, who may be giv-
ing away too much upside by writing a call against long stock or long calls). By quantifying
past stock price movements, as has been done in this chapter, my aim is to convince you
that "conventional" assumptions are not good enough for your analyses. This doesn't mean
that ifs okay to buy overpriced options just because stocks can make large moves with a
greater frequency than most option models predict; but it certainly means that the buyer
of underpriced options stands to benefit in a couple of ways. Conversely, an option seller
must certainly concentrate his efforts where options are expensive, and even then should
be acutely aware that he may experience larger-than-expected stock price movements
while the option position is in place.
So what does this mean for option strategies? On the surface, it means that if one uses
the normal (or lognormal) distribution for estimating the probability of a strategy's success,
he may get a big move in the stock that he didn't originally view as possible. If one were
long straddles, that ·s great. However, if he is short naked options, then there could be a
nasty surprise in store. That's one reason why extreme caution should be used regarding
selling naked options on stocks; they can make moves of this sort too often. At least with
indices, such moves are far less frequent, although the Dow drop of over .5.50points in
October 1997 was a move of seven standard deviations, and the crash of '87 was about a
16-stanclard de,·iation move-vvhich Professor Mark Rubenstein of the University of Cali-
fornia at Berkeley says was something that should occur ahout once in ten times the life of
our current 11nicerse!That's according to lognorrnal distribution, of course, which we know
understates things somewhat, but ifs still a big number under any distribution.
There are two approaches that one can take, then, regarding option strategies. One
is to invent another method for estimating stock price distributions. Suffice it to say that
that is not an easy task, or someone would have made it well-known already. There have
been many attempts, including some in which a large history of stock price movements is
obsen-ed ancl then a distribution is fitted to them. The problem with accounting for these
occasional large price moves is that it is perhaps an even more grievous error to oceresti-
mate the probabilities of such moves than to underestimate them.
The second approach is to continue to use the normal distribution, because ifs fast
and accessible in a lot of places. Then, either rely on option buying strategies (straddles,
for example) where implied volatility appears to be low-knowing that y·ou have a chance
at better results than the statistics might indicate-or adjust your calculations nwntally
for tlwse large potential rnovenwnts if you are using option selling strategies.
Chapter
38: TheDistribution
of StockPrices 753
THE PRICING OF OPTIONS
The extrerne movements of the fat tail distribution should be figured into the pricing of
an option, but they really are not, at least not by most models. The Black-Scholes model,
for example, uses a lognormal distribution. Personally, this author believes that the Black-
Scholes model is an excellent tool for analyzing options and option strategies, but one
must understand that it may not be affording enough probability to large moves by the
underlying.
Does this mean that most options are underpriced, since traders and market-makers
are using the Black-Scholes model (or similar models) to price them? Without getting too
technical, the answer is that yes, some options-particularly out-of-the-money options-
are probably underpriced. However, one must understand that it is still a relatively rare
occurrence to experience one of these big moves-it's just not as rare as the lognormal
distribution would indicate. So, an out-of-the-money option might be slightly underpriced,
but often not enough to make any real difference .
In fact,futures options in grains, gold, oil, and other markets that often experience
large and sudden rallies display a distinct volatility skew. That is, out-of-the-money call
options trade at significantly higher implied volatilities than do at-the-money options.
Ironically, there is far less chance of one of these hyper-standard-deviation moves occur-
ring in commodities than there is in stocks, at least if history is a guide. So, the fact that
some out-of-the-money futures options are expensive is probably an incorrect overadjust-
ment for the possibility of large moves.
THE PROBABILITY OF STOCK PRICE MOVEMENT
The distribution information introduced in this chapter can be incorporated into some-
what rigorous methods of determining probabilities. That is, one can attempt to assess the
chances of a stock, futures contract, or index moving by a given distance, and those
chances can incorporate the fat tails or other non-lognormal behavior of prices.
The software that calculates such probabilities is typically named a "probability cal-
culator." There are many such software programs available in the marketplace. They range
from free calculators to completely overpriced ones selling for more than $1,000. In real-
ity, high-level probability calculation software can be created by someone with a good
understanding of statistics, or a program can be purchased for a rather nominal fee-
perhaps $100 or so.
Before getting into these various methods of probability estimation, it should he
noted that all of them require the trader to input a volatility estimate. There are only a
few other inputs, usually the stock price, target price(s), and length of time of the stud~--
andTrading
Volatility
The volatility one inputs is, of course, an estimate of future volatility-something

that cannot be predicted with certainty. Nevertheless, any probability calculator requires
this input. So, one must understand that the results one obtains from any of these prob-
ability calculators is an estimate of what might happen. It should not be relied on as
"gospel."
Additionally, probability calculators make a second assumption: that the volatility
one inputs will remain constant over the entire length of the study. We knoic this is incor-
rect, for volatility can change daily. However, there really isn't a good way of estimating
how volatility might change in the course of the study, so we are pretty much forced to
live with this incorrect assumption as well.
There is no certain way to mitigate these volatility "problems" as far as the probabil-
ity calculator is concerned, but one helpful technique is to bias the volatility projection
against your objectives. That is, be overly conservative in your volatility projections. If
things turn out to be better than you estimated, fine. However, at least you won't be over-
stating things initially. An example may help to demonstrate this technique.
Example: Suppose that a trader is considering buying a straddle on XYZ. The five-month
straddle is selling for a price of 8, with the stock currently trading near 40. A probability
calculator will help him to determine the chances that XYZ can rise to 48 or fall to 32 (the
break-even points) prior to the options' expiration. However, the probability calculator's
answer will depend heavily on the volatility estimate that the trader plugs into the prob-
ability calculator. Suppose that the following information is known about the historical
volatility of XYZ:

l 00-day historical volatility 33%
Which volatility should the trader use? Should he choose the 100-day historical volatility
since this is a five-month straddle, which encompasses just about 100 trading days until
expiration? Should he use the 20-day historical volatility, since that is the "generally
accepted" measure that most traders refer to? Should he calculate a historical volatility
based exactly on the number of days until expiration and use that?
To he most conservative, none of those answers is right, at least not for the right
reasons. Since one is buying options in this strategy, he should use the lowest of the above
historical volatility measures as his volatility estimate. By doing so, he is taking a conser-
\·atin_•approach. If the straddle buy looks good under this conservative assumption, then
Chapter
38: TheDistribution
of StockPrices 755
he can feel fairly certain that lw has not m·erstated the possibilities of success. If it turns
out that volatility is higher during the life of the position, that will be an added benefit to
this position consisting of long options. So, in this example, he should use the 20-clay
historical volatility because it is the lo1cest of the four choices that he has.
Similarly, if one is considering the sale of options or is taking a position with a nega-
tive vega (one that will be harmed if volatility increases), then he should use the highest
historical volatility when making his probability projections. By so doing, he is again being
conservative. If the strategy in question still looks good, even under an assumption of high
volatility , then he can figure that he won't be unpleasantly surprised by a higher volatility
during the life of the position.
There have been times when a 100-day lookback period was not sufficient for deter-
mining historical volatility. That is, the underlying has been performing in an erratic or
unusual manner for over 100 clays. In reality, its true nature is not described by its move-
ments over the past 100 days. Some might say that 100 clays is not enough time to deter-
mine the historical volatility in any case, although most of the time the four volatility
measures shown above will be a sufficient guide for volatility.
vVhen a longer lookback period is required, there is another method that can be
used: Go back in a historical database of prices for the underlying and compute the
20-day , .SO-day,and 100-day historical \'Olatilities for all the time periods in the database,
or at least during a fairly large segment of the past prices. Then use the median of those
calculations for your volatility estimates.
Example: XYZ has been behaving erratically for several months, due to overall market
volatility being high as well as to a series of chaotic news events that have been affecting
XYZ. A trader wants to trade XYZ's options, but needs a good estimate of the "true" vol-
atility potential of XYZ, for he thinks that the news events are out of the way now. At the
current time, the historical volatility readings are:
20-day historical: 130%

50-day historical 100%
l 00-day historical 80%
However, when the trader looks farther back in XYZ's trading history, he sees that
it is not normally this volatile. Since he suspects that XYZ's recent trading history is not
typical of its true long-term performance, what volatility should he use in either an option
model or a probability calculator?
Rather than just using the maximum or minimum of the above three 1mmhers
andTrading
Volatility
(depending on whether one is buying or selling options), th e trader decides to look back
over the last 1,000 trading days for XYZ. A 100-day historical volatility can be computed,
using 100 consecutive trading days of data, for 901 of those days (beginning with the
100th clay ancl continuing through the l,000th day, which is presumably the current trad-
ing clay).Admittedly, these are not completely unique time periods; there would only be
ten non-overlapping (independent) consecutive 100-day periods in 1,000 days of data.
However, let's assume that the 901 periods are used. One can then arrive at a distribution
of 100-day histor ical volatilities. Suppo se it looks something like this :
Percentile l00-Day
Historic
al
Qth 34%
1Qth 37%
2Qth 43%
JQth 45%
4Qth 46%
5Qth 48%
6Qth 51%
7Qth 58%
8Qth 67%
9Qth 75%
lQQth 81%
In other words, the 901 historical volatilities (100 days in each) are sorted and then th e
percentiles are determined. The above table is just a snapshot of where the percentiles
lie. Th e range of those 901 rnlatilities is from 34% on the low side to 81% on the high side.
Notice also that there is a \·ery flat grouping from about the 20th percentile to the 60th
percentile: The 100-day historical volatility was between 43% and ,51% over that entire
range. The 111cdia11 of the above figures is 48%-the 100-day volatility at the 50th
percentile.
Referring to the early part of this example, the current 100-day historical is 80% , a
\·ery high reading in comparison to what the measures were over the past 1,000 days, and
certainly much higher than the me dian of 48%.
One could perform similar analyses 011 the 1,000 days of historical data to determine
when :' the 10-da:·, :20-day, and ,50-day historical volatilities were over that time. Those,
too. could he sorted and arranged in percentile format , using the ,50th percentile (median)
Chapter
38: TheDistribution
of StockPrices 757
as a good estimate of volatility. After such computations, the trader might then have this
information :
Using 1,000 days of data :
Median l 00-day historical volatility : 48%

Median 50 -day historical volatility: 49%
Median 20-day historical volatility: 52%
Median l 0-day historical volatility: 49%
If these were all the data that one had, then he would probably use a volatility estimate
of 48% or so in his option models or probability calculators. Of course, this is starkly dif-
ferent from the current levels of historical volatility (shown at the beginning of this exam-
ple). So, one must be careful in assessing whether he expects the stock to perform more
in line with its longer-term (1,000 trading days) characteristics or if there is some reason
to think that the stock's behavior patterns have changed and the higher, more recent vola-
tilities should b e used .
The pertinent volatilities to consider, then, in a strategy analysis are the medians as
well as the current figures. If the trader were going to be buying options in his strategy,
should he use the minimum of the volatilities shown, 48%? Probably. However, if he's a
seller of options, should he use the maximum, 130%? That might be a little too much of
a penalty, but at least he would feel safe that if his volatility selling position had a positive
expected return with that high a volatility projection, then it must truly be an attractive
position .
In an analysis like that shown in this example, there is nothing magical about using
1,000 trading days. Perhaps something like 600 trading days would be better. The idea is
to use enough trading days to bring in some historic data to counterbalance the recent,
erratic behavior of the stock.
Among other things, this example also shows that volatilities are unstahle, no matter
how much work and mathematics one puts into calculating them. Therefore, they are at
best a fragile estimate of what might happen in the future. Still, ifs the best guess that
one can make. The trader should realize, though, that when volatilities are this disparate
when comparing recent and more distant activity, the results of any mathematical projec-
tions using those volatilities should not be relied upon too heavily. Those results will he
just as tenuous as the volatility projections themselv es.
Of course, in any case, the actual volatility that occurs while the position is in place
may he even more unfavorable than the one the trader used in his initial analysis. There
758 PartVI:Measuring and TradingVola
tility
is nothing that one can do about that. But if you choose what appears to be a somewhat
unfavorable volatility , and the position still looks good under those assumptions, then it is
likely that the trader will be pleasantly surprised more often than not-that actual volatil-
ity during the life of the position will tend to be more in his favor than not.
In a recent chapter , the various methods of trying to predict volatility were outlined,
using either historical volatility , implied volatility , a moving average of either of those, or
even GAR CH volatility. None of these will predict with certainty what is going to happen
in the future . Hence, the prediction of volatility is necessarily vague at best.
In addition to the vagaries of estimating volatility, the probability calculators will
return an answer that represents the probability of something happening "in the long
run." That is, if the same scenario were to arise many , many times, the answer is relevant
to how many times the stock would move to the indicated target price. This is small solace
if one happens to be caught in the vortex of the Crash of '87, for example. So, just remem-
ber that these probability calculators are tools that can help you in assessing the relative
risks of similar positions (evaluating various naked option sales , say), but the resulting
stock movement in any one case can be quite different from what any probability calcu-
lator descri bes as the chances of th at move actually happenin g.
THE ENDPOINT CALCULATION
The following paragraphs describe how the various probability calculation mechanisms
work. The simplest and most straightforward probability calculation has already been pre-
sented in Chapter 28 on mathematical applications. It was included in the section on
"expected returns., in that chapter. The formula is presented here again, for completeness.
The formula gives the probability of a stock, which is currently at price p, being
below some other price , q, at the end of the time period. The lognormal distribution is
assum ed .
Probabilit y of stock bein g below pric e q at end of time p eriod , t
ln( J_))
P (below) = N ( v~
whe re
N cumul ative nor mal distribution

p curren t price of the stock
q price in questio n
In natural logari th m for the time pe riod in questi on
Chapter
38: TheDistribution
of StockPrices 759
If one is interested in computing tht> probability of the stock being above the given
price, the formula is
P(above) = 1- P(below)
In the abm·e formula, Vi= v/t where t is time to expiration in years and u is
annual volatility, as usual.
This formula is quite elementary for predictive purposes, and it is used by many
traders. This calculator can be found for free at the website www.optionstrategist.com. Its
main problem is that it gives the probability of the stock being above or below the target
price at the end of the time period, t. That's not a totally realistic way of approaching prob-
ability analysis. Most option traders are very concerned with what happens to their posi-
tions during the life of the option, not just at expiration.
Example: Suppose a trader is a seller of naked put options. He sells OEX October 550
puts naked, with OEX currently trading at 600. He would not normally just walk away
from this position until October expiration, because of the large risk involved with the sale
of a naked option. There are essentially three scenarios that can occur:
1. OEX might neuer fall to 550 by expiration. In this case, he would have a very
comfortable trade that was never in jeopardy, and the options would expire
worthless.
2. OEX n1ight fall below 550 and remain there until expiration. In this case, he would
surely have a loss unless OEX were just a tiny bit below 550.
3. OEX might fall below 550 at some time between when the trade was established
and when expiration occurred, but then subsequently rally back above 550 by the
time expiration arrived.
An experienced option trader would almost certainly adjust if scenario 3 arose, in

order to prevent large losses from occurring. He might roll his naked puts down and out
to another strike, or he might just close them out altogether. However, it is unlikely that
he would do nothing.
The simple probability calculator formula shown above does not take into account
the trader's third scenario. Since it is only concerned with where the stock is at expiration
of the options, only scenarios 1 and 2 apply to it. Hence the usage of this simple calculator
is not really descriptive of what might happen to a trade during its lifetime.
Let's assign some numbers to the above trade, so that you might see the differ-
ence. Suppose that the volatility estimate is 2.5%, there are :10 clays until expiration, and
andTrading
Volatility
the prices are as stated in the previous example: OEX is at 600, and the striking price
of the naked put being sold is .5,50.The resulting probabilities might be something like
this:
Scenario Actual
Probability
ofOccurrence
1. OEX never falls below 550 67%
2. OEX falls below 550 and remains there 19%
3. OEX falls below 550 but rallies later 14%
The probabilities stated above are the "real" probabilities of the three various sce-
narios occurring. Howe\'er, if one were using the simple probability calculator presented
above , he would only have the following information:
Probability of OEX being above 550 at expiration: 81%

Probability of OEX being below 550 at expiration: 19%
So, with the simple calculator, it looks like there's an 81% chance of a worry-free trade.
Just sit back and relax and let the option expire worthless. However, in real life-as
shown by the pre\'ious set of probabilities, there's only a 67% chance of a worry-free
trade . The difference-the other 14%-is the probability of the third scenario occurring
(OEX falls below .S.50,but rallies back above it by expiration). The simple probability cal-
culator doesn't account for that scenario at all.
Hence, most serious traders don't use the simple model. Does that mean it's not use-
ful at all? No, it is certainly viable as a comparative tool; for example, to compare the
chances of the OEX put expiring worthless versus those of another put sale being consid-
erecl, perhaps something in a stock option. However, better analyses can be undertaken.
Before leaving the scenario of the simple probability calculator, one more point
should be made. It has been mentioned earlier in this book that the delta of an option is
actually a fairly good estimate of the probability of the option being in-the-money at its
expiration date. Thus, the delta and the simple endpoint probability calculator shown
above attempt to convey the same information to a trader. In reality, because of the fact
that implied rnlatility might be different for various strikes (a volatility skew), especially
in index options, the delta of the option might not agree exactly with the probability cal-
culator. Even so, the delta is a quick and dirty way of estimating the probability of the
stock being above tlw strike price (in the case of call options) or below the strike price (in
the case of put options) at expiration.
Chapter
38: TheDistribution
al Stacie
Prices 761
THE 11 EVER" CALCULATOR
Having seen the frailties of the endpoint calculator, the next step is to try to design a
calculator that can estimate the probability of the stock ever hitting the target price(s) at
any time during the life of the probability study, usually the life of an option. It turns out
that there are a couple of ways to approach this problem. One is with a Monte Carlo
analysis, whereby one lets a computer run a large number of randomly generated sce-
narios (say, 100,000 or so) and counts the number of times the target price is hit. A Monte
Carlo analysis is a completely valid way of estimating the probability of an event, but it is
a somewhat complicated approach.
In reality, there is a way to create a single formula that can estimate the "ever" prob-
ability, although it is not any easy task either. In the following discussion, I am borrowing
liberaily from correspondence with Dr. Stewart Mayhew, Professor of Mathematics at the
University of Georgia. For proprietary reasons, the exact formula is not given here, but
the following description should be sufficient for a mathematics or statistics major to
encode it. If one is not interested in implementing the actual formula, the calculation can
be obtained through programs sold by McMillan Analysis Corp. at www.optionstrategist
.com.
This discussion is quite technical, so readers not interested in the description of the
mathematics can skip the next paragraph and instead move ahead to the next section on
Monte Carlo studies.
These are the steps necessary in determining the formula for the "ever" probability
of a stock hitting an upside target at any time during its life. First, make the assumption
that stock prices behave randomly, and perform at the risk-free rate, r Mathematicians
call random behavior "Brownian motion." There are a number of formulae available in
statistics books regarding Brownian motion. If one is to estimate the probability of reach-
ing a maximum (upside target) point, what is needed is the known formula for the cumu-
lative density function (CDP) for a running maximum of a Brownian motion. In that
formula, it is necessary to use the lognormal function to describe the upside target. Thus,
instead of using the actual target price in the CDF formula, one substitutes In(qlp), where
q is the target price and p is the current stock price .
The "ever" probability calculator provides much more useful information to a trader
of options. Not only does a naked option seller have a much more realistic estimate of the
probability that he's going to have to make an adjustment during the life of an option, but
the option buyer can find the information useful as well. For example, if one is buying an
option at a price of 10, say, then he could use the "ever" probability calculator to estimate
the chances of the stock trading 10 points above the striking price at any time during the
life of the option. That is, what are the chances that the option is going to at least break
even'? The option buyer can, of course, determine other things too, such as the probahilit:'
andTrading
Volatility
that the option doubles in price (or reaches some other return on investment, such as he
might deem appropriate for his analysis).
THE MONTE CARLO PROBABILITY CALCULATOR
Up to this point, the calculators we have discussed are subject to the limitations described
earlier-mainly, that they rely heavily on one's volatility estimate, that they assume the
volatility will remain constant over time, and that they assume a lognormal distribution.
The early part of this chapter was spent explaining that the lognormal distribution is not
the real distribution that stock prices adhere to. So, what we'd like to see in a probability
calculator is one that could adjust for various volatility scenarios as time passed and one
in which the assumed distribution of stock prices was not lognormal.
·when one starts to make these sorts of assumptions, I do not believe there is a single
formula that can he derived for the probability calculations. Rather, what is known as a
Monte Carlo simulation must be undertaken. Essentially, one "tells" the computer what
he is trying to simulate. It could be any number of things in real life, perhaps the rocket
engine components in a NASA space shuttle, or the operation of an internal combustion
engine, or the movement of a stock. As long as the process can be described, it can be
simulated by a computer. Then, the computer can run a large number of those simulations
to determine the answers to such things as "What is the failure rate of the NASA engine
components?" or "How long can the internal combustion engine go without an oil change?"
or "What is the probability of the stock trading at a certain target price?" The Monte Carlo
simulation technique can be thought of as letting the computer run through the simulation
a lot of times and counting how many times a certain outcome occurs. If the number of
trials (simulations) is large enough and the model is good enough, then the resulting count
divided by the number of trials undertaken is a good probability estimate of the said event
occurring. The reason one nms a lot of trials is that over a large number of trials, the fre-
quency· with which an event occurs will approximate the actual probability of its occur-
renc e for a single trial-the single trial being your trade , for example .
The next three paragraphs describe the general process necessary for constructing
a stock probability calculator using a Monte Carlo simulation. Again, this is fairly techni-
cal, so if the reader is not interested in the background behind the mathematics, then skip
ahead three paragraphs. In the case of a stock probability calculator, the Monte Carlo
simulation can be undertaken as follows.
\ Ve know what the distribution of stock prices looks like. The fat tails can be built
into the distribution if one wants to simulate real life. See Figure .38-1 for both the log-
normal distribution and the actual distribution. Ifs a simple matter to tell the computer
this information. For example, recall that 2 ..5 million points went into making up Figure
:v.;-J. In tlte actual distribution in Figure :38-L about 92,000 (or .3.68%) of them resulted
Chapter
38: TheDistribution
of StockPrices 763
in the stock being unchanged. Also, only about 2,.500 of them, or 1/lOth of one percent,
resulted in a move of -4.0 standard deviations or more. Those percentages, along with all
of the others, would be built into the computer, so that the total distribution accounts for
100% of all possible stock movements.
Then, we tell the computer to allow a stock to move randomly in accordance with
whatever volatility the user has input. So, there would he a fairly large probability that it
wouldn't move very far on a given day, and a very small probability that it would move
three or more standard deviations. Of course, with the fat tail distribution, there would
be a larger probability of a movement of three or more standard deviations than there
would be with the regular lognormal distribution. The Monte Carlo simulation progresses
through the given number of trading <lays,moving the stock cumulatively as time passes.
If the stock hits the break-even price, that particular simulation can be terminated and
the next one begun. At the encl of all the trials (100,000 perhaps), the number in which
the upside target was touched is divided by the total number of trials to give the probabil-
ity estimate.
Is it really worth all this extra trouble to evaluate these more complicated probability
distributions? It seems so. Consider the following example:
Example: Suppose that a trader is considering selling naked puts on XYZ stock, which is
currently trading at a price of 80. He wants to sell the November 60 puts, which expire in
two months. Although XYZ is a fairly volatile stock, he feels that he wouldn't mind owning
it if it were put to him. However, he would like to see the puts expire worthless. Suppose
the following information is available to him via the various probability calculators:
Simple "end point" probability of XYZ < 60 at expiration: 10%

Probability that XYZ ever trades < 60 (using the log normal distribution): 20%
Probability that XYZ ever trades < 60 (using the fat tail distribution): 22%
If the chances of the put never needing attention were truly only 10%, this trader would
probably sell the puts naked and feel quite comfortable that he had a trade that he wouldn't
have to worry too much about later on. However, if the true probability that the put will need
attention is 22%, then he might not take the trade. Many naked option sellers try to sell
options that have only probabilities of 1.5%or less of potentially becoming troublesome.
Hence, the choice of which probability calculation he uses can make a difference in
whether or not a trade is established.
Other strategies lend themselves quite well to probability analysis as well. Credit
spreaders-sellers of out-of~the-rnoney put spreacls-mually attempt to quantif)' the
andTrading
Volatility
probability of having to take defensive action. Any action to adjust or remove a deeply
out-of-the-money put credit spread usually destroys most or all of its profitability, so an
accurate initial assessment of the probabilities of having to make such an adjustment is
important.
Option buyers, too, would benefit from the use of a more accurate probability esti-
mate. This is especially true for neutral strategies, such as straddle or strangle buying,
when the trader is interested in the chances of the stock being able to move far enough to
hit one or the other of the straddle's break-even points at some time during the life of the
straddle.
The Monte Carlo probability calculation can he expanded to include other sorts of
distributions. In the world of statistics, there are many distributions that define random
patterns. The lognonnal distribution is but one of them (although it is the one that most
closely follows stock prices movements in general). Also, there is a school of thought that
says that each stock's individual price distribution patterns should be analyzed when look-
ing at stratt>gies on that stock as opposed to using a general stock price distribution accu-
mulated over the entire market. There is much debate about that, because an individual
stock's trading pattern can change abruptly; just consider any of the Internet stocks in the
late 1990s and earl~-:2000s. Thus, a probability estimate based on a single stock's behavior,
even if that behavior extends back several years, might be too unreliable a statistic upon
which to base a probability estimate.
In summary, then, one should use a probability calculator before taking an option
position, even an outright option buy. Perhaps straight stock traders should use a proba-
bility calcutor as well. In doing so, though, one should be aware of the limitations of the
estimate: It is heavily biased by the volatility estimate that is input and by the assumption
of what distribution the underlying instrument will adhere to during the life of the posi-
tion. \ Vhile neither of those limitations can be overcome completely, one can mitigate the
problems by using a conservative volatilit~· estimate. Also, he can look at the results of
the probability calculation under several distributions (perhaps lognormal, fat tail, and the
distribution using only the past price behavior of the underlying instrument in question)
and see how they differ. In that case, he would at least have a feeling for what could hap-
pen during the life of the option position.
EXPECTEDRETURN
The concept of expected return was described in the chapter on mathematical applica-
tions. In short t>xpected return is a position's expected profit divided by its i1l\"estment (or
npcctcd i1l\"estment if the investrnent \'aries with stock price, as in a naked option posi-
tion or a futures position). The crucial component, though, is expected profit.
Chapter
38: TheDistribution
of StockPrices 765
Expected profit is computed by calculating the profitability of a position at a certain

stock price times the probabilitlj of the stock being at that price, an<l summing that mul-
tiple over all possible stock pric.:es.vVhen the concept was first introduced, the "probability
of the stock being at the price" was given as what we now know is the "endpoint" proha-
bilit~--In reality. a much better measure of the expected profit of a position can he obtained
by using one of the more advanced probability estimation models presented above.
In generalized expected return studies done using the fat tails Monte Carlo simula-
tion , certain general conclusion s can be drawn about some strate gies.
• A bull spread is an inferior strategy when the options are fairly priced, no matter
which distribution is assumed. This more or less agrees with observations that have
been made previously regarding the disappointments that traders often encounter
when using vertical spreads.
• \Vhile covered writing might seem superior to stock ownership under the lognormal
distribution , the two are about equal under a fat tail distribution.
• Most startling, though, is the fact that option buying strategies fare much, much better
under a fat tail distribution than a lognormal one. This most clearly demonstrates the
"power" of the fat tail distribution: A limited-risk investment with unlimited profit
potential can be expected to perform very well if the fat tails are allowed for.
Using the lognormal distribution more or less represents the conventional wisdom regard-
ing option strategies-the one that many brokers promote: "Don't buy options, don't mess
with spreads, either buy stocks or do covered call writes." The fat tail distribution column
stands much of that advice on its head. In real life (as demonstrated by the fat tail distri-
bution), strategies with limited profit potential and unlimited or large risk potential are
inferior strategies .
One should be aware that the phrase "expected return" is used in many quasisophis-
ticated option analyses (and even in analyses not using options). Many investors accept
these "returns" on blind faith, figuring that if they're generated by a computer, they must
be correct. In reality, they may not be representative, even for comparisons.
SUMMA Y
This chapter has demonstrated that probability analysis is an inexact science, because
markets behave in ways that are very difficult to describe mathematically. However, prob-
ability analysis is also necessaru for the option strategist; without it he would ht' in the
clark as to the likelihood of profitable outcomes for his strategy. Overall, in a di\'('rsificd
set of positions, tlie option strategist should use the fat tail distribution in a Monte Carlo
andTrading
Volatility
simulation to estimate probabilities. However , if that is not available, he can use the nor-
mal or lognormal distribution with the proviso that he understands it is not "gospel." He
should require very stringent criteria on any strategies that are antivolatility strategies,
such as naked option writing of stock options, for there is a greater than normal chance
of a large move by the underlying, especially if the underlying is stock.
The sophisticated trader may want to view his probabilities in the light of more than
one proposed distribution of prices. Of course, this type of analysis (using several distribu-
tions) puts the onus on the investor to choose the distribution that he wants to use in order
to analyze his investment. However, such an approach should be extremely illustrative in
that he can compare returns from different strategies and have a reasonable expectation
as to which ones might perform the best under different market conditions.
Volatility Trading Techniques
The previous three chapters laid the foundation for volatility trading. In this chapter, the
actual application of the technique will be described. It should be understood that vola-
tility trading is both an art and a science. It's a science to the extent that one must be
rigorous about determining historical volatility or implied volatility, calculating probabil-
ities, and so forth. However, given the vagaries of those measurements that were described
in some detail in the previous chapters, volatility trading is also something of an art. Just
as two fundamental analysts with the same information regarding earnings, sales projec-
tion, and so on might have two different opinions about a stock's fortunes, so also can two
volatility traders disagree about the potential for movement in a stock.
However, volatility traders do agree on the approach. It is based on comparing
today'.5;implied volatility with what one expects volatility to do in the future. As noted
previously, one's expectations for volatility might be based on volatility charts, patterns of
historical volatility and implied volatility, or something as complicated as a GARCH
forecasting model. None of them guarantees success. However, we do know that volatility
tends to trade in a range in the long run. Therefore, the approach that traders agree upon
is this: If implied volatility is "low," buy it. If it's "high," sell it with caution. So simple: Buy
low, sell high (not necessarily in that order). The theory behind volatility trading is that
it's easier to buy low and sell high (or at least to determine what's "low" and "high") when
one is speaking about volatility, than it is to do the same thing when one is talking about
stock prices.
Most of the time, implied volatility will not be significantly high or low on any par-
ticular stock, futures contract, or index. Therefore, the volatility trader will have little
interest in most stocks on any given day. This is especially true of the big-cap stocks, the
ones whose options are most heavily traded. There are so many traders watching the sit-
uation for those stocks that they will rarely let volatility get to the extremes that one would
consider "too high" or "too low." Yet, with the large number of optionahle stocks, futures,
767
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Volatility
and indices that exist, there are always some that are out of line, and that's where the
independent volatility trader will concentrate his efforts.
Once a volatility extreme has been uncovered, there are different methods of trad-
ing it. Some traders-market-makers and short-term traders-are just looking for very
fle-eting trades, and expect volatility to fall back into line quickly after an aberrant move.
Others prefer more of a position traders' approach: attempting to determine volatility
extremes that are so far out of line with accepted norms that it will probably take some
time to move back into line. Obviously, the trader's own situation will dictate, to a certain
extent, which strategy he pursues. Things such as commission rates, capital requirements,
and risk tolerance will determine whether one is more of a short-term trader or a position
trader. The techniques to be described in this chapter apply to both methods, although
the emphasis will be on position trading.
TWO WAYS VOLATILITY PREDICTIONS CAN BE WRONG
\Vhen traders determine the implied volatility of the options on any particular underlying
instrument, they may generally be correct in their predictions; that is, implied volatility
will actually be a fairly good estimate of forthcoming volatility. However, when they're
u:rong, they can actually be wrong in two ways: either in the outright prediction of volatil-
ity or in the path of their volatility predictions. Let's discuss both. When they're wrong
about the absolute level of volatility, that merely means that implied volatility is either
·'too low" or "too high." In retrospect, one could only make that assessment, of course,
after having seen what actual volatility turned out to be over the life of the option. The
second way they could be wrong is by making the implied volatility on sorne of the options
on a particular underlying instrument. This is called a volatility skew and it is usually an
incorrect prediction about the way the underlying will perform during the life of the
options.
The rest of this chapter will be divided into two main parts, then. The first part will
deal with volatility from the viewpoint of the absolute level of implied volatility being
"wrong " (which we'll call ·'trading the volatility prediction"), and the second part will deal
with trading the volatility skew.
TRADING THE VOLATILITY PREDICTION
Tht> \ olatility tradt>r must haw some way of determining when implied volatility is suffi-
cit>ntk out of line that it warrants a trade. Then he must decide what trade to establish.
Fnrtlwrrnorc. as with any strategy-especially option strategies-follow-up action is
Chapter
39: Volatility
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Techniques 769
important, too. \Ve will not be introducing any new strategies, per se, in this chapter.
Those strategies have already been laid out in the previous chapters of this book. How-
ever, we will briefl~· re\·iew important points about those strategies and their follow-up
actions where it is appropriate.
First. one must try to find situations in which implied volatility is out of line. That is
not the end of the analysis, though. After that, one needs to do some probability work and
needs to see how the underlying has behaved in the past. Other fine-tuning measures are
often useful, too . These will all be described in this chapter.
DETERMINING WHEN VOLATILITY IS OUT OF LINE
There is much disagreement among volatility traders regarding the best method to use
for determining if implied volatility is "out of line." Most favor comparing implied with
historical volatility. However, it was shown two chapters ago that implied volatility is not
necessarily a good predictor of historical volatility. Yet this approach cannot be discarded;
however it must be used judiciously. Another approach is to compare today's implied vol-
atility with where it has been in the past. This concept relies heavily on the concept of the
percentile of implied volatility. Finally, there is the approach of trying to "read" the charts
of implied and historical volatility. This is actually something akin to what GARCH tries
to do, but on a short-term horizon. So the approaches are :
l. Compare implied volatility to its own past levels (percentile approach).

2. Compare implied volatility to historical volatility.
3. Interpret the chart of volatility.
In addition, we will examine two lesser-used methods: comparing current levels of his-
torical volatility to past measures of historical volatility, an<l finally, using only a probabil-
ity calculator an<l trading the situation that has the best probabilities of success.
THE PERCENTI LE APPROACH
In this author's opinion, there is much merit in the percentile approach. When one says
that volatility tends to trade in a range, which is the basic premise behind volatility trad-
ing, he is generally talking about implied volatility. Thus, it makes sense to know where
implied volatility is within the range of the past readings of implied volatility. If volatility
is low with respect to where it usually trades, tlwn we can say the options are cheap. Con-
versely, if it's high with respect to those past values, then we can say the options are
expensive. These conclusions do not draw on historical volatility.
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The percentile of implied rnlatilit:· is generall:· used to describe just \,·here the cur-
rent implied rnlatility reading lies \,·ith respect to its past Yalues. The "implied rnlatilit:· ..
reading that is being used in this case is the composite reading-the one that takes into
account all the options on an underl:-ing instrument. \\·eighting them b:· their distance
in- or out-of-the-mone:· ~at-the-mone:· gets more \,·eight) and also \\·eighting them b:· their
trading rnlume. This technique has been referred to man:· times and \ms first described
in Chapter 2S on mathematical applications. That composite implied \·obtilit:· reading can
be stored in a database for each underl:-ing instrument e\·er:· da:·· Such databases are
an.ilable for purchase from firms that specialize in option data. A.lso. snapshots of such
data are available to members of www.optionstrategist.com.
In general. most underl:·ing imtruments \rnuld hm·e a composite implied \·olatilit:·
reading some\\·here near the ,30th percentile on an:· gi\·en da:·· Hm,·e\·er. it is not uncom-
mon to see sonu' underl:·ings \\·ith percentile readings near zero or 10oc;-on a gi\·en da:··
These are the ones that \\·oulcl interest a rnlatilit:· trader. Those \\·ith readings in the 10th
percentile or less. sa:·· \rnuld be considered "cheap": those in the 90th percentile or higher
would be considered expensive.
In reedit:. the percentile of implied rnlatility is going to be affected b:· \,·hat the
broad market is doing. For e:-,,:ample.during a se\-ere market slide. implied rnlatilities \,-ill
increase across the board. Then. one may find a large number of stocks \\·hose options are
in the 90th percentile or higher. C011\'ersel:·· there ha\·e been other times \,·hen m·erall
implied rnlatility has declined substantiall:·: 199:3. for e:-,,:mnple.and the summer of :?.001.
for another. A.t those times. \Ye often find a great number of stocks \,·hose options reside
in the 10th percentile of implied rnlatilit:· or lm,·er. The point is that the distribution of
percentile readings is a d:·narnic thing. not something static like a lognormal distribution.
Yes. perhaps m·er a long period of time and taking into account a great number of cases.
we might find that the percentiles of implied rnlatility are nonnall:· distributed. but not
on any given day.
The trader has some discretion m·er this percentile calculation. Foremost. he must
decide how man:· da:·s of past history he \rnnts to use in determining the percentiles.
There are about 2,5,Strading da:·s in a :·ear. So. if he \\·anted a t\rn-:·ear histor:·· he \rnuld
record the percentile of toda:··s composite implied rnlatility \\·ith respect to the .S10 dail:·
readings m-er the past t\,·o :·ears. This author t:picall:· uses 600 da:·s of implied \·olatilit:·
history for the purpose of determining percentiles. but a case could be made for other
length s of time. The purpose is to use enough implied rnlatility histor:· to giw one a good
perspecfo·e. Then. a reading of the 10th percentile or the 90th percentile \,·ill truh- be
significant and \rnulcl therefore be a good starting point in determining \,·hether the
options are cheap or expensive.
In addition to the actual percentile. the trader should also be m,·are of the 1cidth of
the implied rnlatilit:· distribution. This \\·as discussed in an earlier chapter. but essentialh-
Chapter
39: Volatility
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Techniques 771
the concept is this: If the first percentile is an implied volatility of 40% and the 100th
percentile is an implied volatility of 4.5%, then that entire range is so narrow as to be
meaningless in terms of whether one could classify the options as cheap or expensive.
The adrnntage of buying options in a low percentile of implied volatility is to give
oneself two ways to make money: one, via movement in the underlying (if a straddle were
owned, for example), and two, by an increase in implied volatility. That is, if the options
were to return to the .SOth percentile of implied volatility, the volatility trader who has
bought "cheap" options should expect to make money from that movement as well. That
can onl:: happen if the .SOthpercentile and the 10th percentile are sufficiently far apart
to allow for an increase in the price of the option to be meaningful. Perhaps a good rule
of thumb is this: If the option rises from the current (low) percentile reading to the 50th
perce11tile in a month, tcill the increase in implied volatility be equal to or greater than
the time decay ouer that periodr Alternatively stated, with all other things being equal,
will the option Le trading at the same or a greater price in a month, if implied volatility
rises to the .50th percentile at the end of that timer If so, then the width of the range of
implied volatilities is great enough to produce the desired results.
The attractiveness to this method for determining if implied volatility is out of line
is that the trader is "forced" to buy options that are cheap (or to sell options that are
expensive), on a relative basis. Even though historical volatility has not been taken into
consideration, it will be later on when the probability calculators are brought to bear.
There is no guarantee, of course, that implied volatility will move toward the .SOthper-
centile while the position is in place, but if it does, that will certainly be an aid to the
position.
In effect this method is measuring what the option trading public is "thinking" about
volatility and comparing it with what they've thought in the past. Since the public is wrong
(about prices as well as volatility) at major turning points, it is valid to want to be long
volatility when "everyone else" has pushed it down to depressed levels. The converse may
not necessarily be true: that we would want to be short volatility when everyone else has
pushed it up to extremely high levels. The caveat in that case is that someone may have
inside information that justifies expensive options. This is another reason why selling vol-
atility can be difficult: You may be dealing with far less information than those who are
actually making the implied volatility high.
COMPARING IMPLIED AND HISTORICAL VOLATILITY
The most common way that traders determine which options are cheap or expensive is Ly
comparing the current composite implied volatility with various historical volatility mea-
sures. However, just because this is the conventional wisdom does not necessarily mean
that this method is the preferred one for determining which options are hest for rnlatilit:·
772 PartVI:Measurin
g andTrading Volatility
trades. In this author 's opinion, it is inferior to the percentile method (comparing implied
to past measures of implied), but it does have it<;merits. The theory behind using this
method is that it is a virtual certainty that implied and historical volatility will eventually
converge with each other. So, if one establishes volatility trading positions when they are
far apart, there is supposedly an advantage there.
However, this argument has plenty of holes in it. First of all, there is no guarantee
that the two will converge in a timely manner, for example, before the options in the trad-
er's position can become profitable. Historical and implied volatility often remain fairly
far apart for weeks at a time.
Second, even if the convergence does occur, it doesn't necessarily mean one will
make money. As an example, consider the case in which implied volatility is 40% and his-
torical volatility is 60%. That's quite a difference, so you'd want to buy volatility. Further-
more, suppose the two do converge. Does that mean you'll make money? No, it does not.
What if they converge and meet at 40%? Or, worse yet, at 30%? You'd most certain ly lose
in those cases as the stock slowed down while your option lost time value .
Another problem with this method is that implied volatility is not necessarily low
when it is bought, nor high when it is sold. Consider the example just cited. \Ve merely
knew that implied volatility was 40% and that historical volatility was 60%. We had no
perspective on whether 40% was high, medium, or low. Thus, it is also necessary to see
what the percentile of implied wlatility is. If it turns out that 40% is a relatively high
reading for implied rnlatility, as determined by looking at where implied volatility has
been over the past couple of years, then we would probably not want to buy volatility in
this situation, even though implied and historical volatility have a large discrepancy
between them.
Many market-makers and floor traders use this approach. However, they are often
looking for an option that is briefly mispriced, figuring that volatilities will quickly revert
back to where they were. But for a position trader, the problems cited above can be
troublesome.
Having said that, if one looks to implement this method of trying to determine when
options are out of line, something along the following lines should be implemented. One
should ensure that implied volatility is significantly different from all of the pertinent his-
torical rnlatilities. For example, one might rec1uire that implied volatility is less than 80%
of each of the 10-, 20-, .50-, ancl 100-day historical volatility calcula tions. In addi tion, the
cnrrent percentile of implied volatility should be noted so that one has some relative basis
for determining if all of the rnlatilities, historical and implied, are very high or very low.
One would 11otwant to buy options if the:' were all in a very high percentile, nor sell them
if the y were all in a very low percentile.
Often, a rnlatility chart shmving both the implied and certain historical volatilities
Chapter
39: Volatility
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Techniques 773
will be a useful aid in making these decisions. One can not only quickly tell if the options
are in a high or low percentile, but he may also he able to see what happened at similar
times in the past when implied and historical volatility deviated substantially.
Finally, one needs some measure to ensure that, if convergence between implied and
historical volatility does occur, he will be able to make money. So, for example, if one is
buying a straddle, he might require that if implied rises to meet historical (say, the lmcest
of the historicals) in a month, he will actually make money. One could use a different time
frame, but be careful not to make it something unreasonable. For example, ifimplied vola-
tility is currently 40% and historical is 60%, it is highly unlikely that implied would rise to
60% in a day or two. Using this criterion also ensures that the absolute difference between
implied and historical volatility is wide enough to allow for profits to be made. That is, if
implied is 10% and historical is 13%, that's a difference of 30% in the two-ostensibly a
"wide" divergence between implied and historical. However, if implied rises to meet his-
torical, it will mean only an absolute increase of 3 percentage points in implied volatility-
probably not enough to produce a profit, after costs, if any length of time passes.
If all of these criteria are satisfied, then one has successfully found "mispriced"
options using the implied versus historical method, and he can proceed to the next step
in the volatility analysis: using the probability calculator.
READING THE VOLATILITY CHART
Another technique that traders use in order to determine if options are mispriced is to
actually try to analyze the chart of volatility-typically implied volatility, but it could be
historical. This might seem to be a subjective approach, except that it is really not much
different from the GARCH approach, which is considered to be highly advanced. When
one views the volatility chart, he is not looking for chart patterns like technical analysts
might do with stock charts: support, resistance, head-and-shoulders, flags, pennants, and
so on. Rather, he is merely looking for the trend of volatility to change.
This is a valid approach in the use of many indicators, particularly sentiment indica-
tors, that can go to extreme levels. By waiting for the trend to change, the user is not
subjecting himself to buying into the midst of a downtrend in volatility, nor selling into
the midst of a steep uptrend in volatility.
Example: Suppose a volatility trader has determined that the current level of implied
volatility for XYZ stock is in the 1st percentile of all past readings. Tims, the options are
as cheap as they've ever been. Perhaps, though, the overall market is experiencing a very
dull period, or XYZ itself has been in a prolonged, tight trading range-either of which
might cause implied volatility to decline steadily and substantially. Having found these
andTrading
Volatility
cheap options, he wants to buy volatility. However, he has no guarantee that implied vola-
tility won't continue to decline, even though it is already as cheap as it's ever been.
If he follows the technique of waiting for a reversal in the trend of implied volatility,
then he would keep an eye on XYZ's implied volatility daily until it had at least a modest
increase, something to indicate that option buyers have become more interested in XYZ's
options. The chart in Figure 39-1 shows how this situation might look.
There are a number of items marked on the chart, so it will be described in detail.
There are two graphs in Figure 39-1: The top line is the implied volatility graph, while on
the bottom is the stock price chart. The implied volatility chart shows that, near the first
of June, it made new all-time lows near 28% (i.e., it was in the 0th percentile of implied
volatility). Hence, one might have bought volatility at that point. However, it is obvious
that implied volatility was in a steep downtrend at that time, so the volatility trader who
reads the charts might have decided to wait for a pop in volatility before buying. This
turned out to be a judicious decision, because the stock went nowhere for nearly another
month and a half, all the while volatility was dropping. At the right of the chart, implied
volatilit y has dropped to nearly 20%.
The solid lines 011 the two graphs indicate the data that is known about the implied
rnlatilit~' and price history of XYZ. The dotted lines indicate a scenario that might unfold.
FIGURE 39-1.
Chart of the trend of implied volatility.
XYZ
34. 000
32.000
30.000
28.000
26.000
24.000
22. 000
:CO.ODO
Chapter
39: Volatility
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If implied volatility were to jump (and the stock price might jump, too), then one might
think that the trend of implied volatility was no longer down, and he would then buy
volatility .
The reason that this approach has merit is that one never knows how low volatility
can go, and more important, how high it can get. It was mentioned that the same sort of
approach works well for other sentiment indicators, the put-call ratio, in particular. Dur-
ing the bull market of the 1990s, the equity-only put-call ratio generally ranged between
about 30 and 5,5. Thus, some traders became accustomed to buying the market when the
put-call ratio reached numbers exceeding 50 (high put-call ratio numbers are bullish
predictors for the market in general). However, when the bull market ended, or at least
faltered, the put-call ratios zoomed to heights near 70 or 75. Thus, those using a static
approach (that is, "Buy at 50 or higher") were buried as they bought too early and had to
suffer while the put-call ratios went to new all-time highs. A trend reversal approach
would have saved them. It is a more dynamic procedure, and thus one would have let the
put -call ratio continue to rise until it peaked. Then the market could have been bought.
This is exactly what reading the volatility chart is about. Rather than relying on past
data to indicate where the absolute maxima and minima of movements might occur, one
rather notes that the volatility data is at extreme levels (1st percentile or 100th percentile)
and then watches it until it reverses direction. This is especially useful for options sellers,
because it avoids stepping into the vortex of massive option buying, where the buyers per-
haps have inside information about some forthcoming corporate event such as a takeover.
True, the options might be very expensive (100th percentile), but there is a reason they
are, and those with the inside information know the reason, whereas the typical volatility
trader might not. However, if the volatility trader merely waits for a downturn in implied
volatility readings before selling these options, he will most likely avoid the majority of
trouble because the options will probably not lose implied volatility until news comes out
or until the buyers give up (perhaps figuring that the takeover rumor has died).
Volatility buyers don't face the same problems with early entry that volatility sellers
do, but still it makes sense to wait for the trend of volatility to increase (as in Figure 39-1)
before trying to guess the bottom in volatility. Just as it is usually foolhardy to buy a stock
that is in a severe downtrend, so it may be , too, with buying volatility.
A less useful approach would be to apply the same techniques to historical volatility
charts, for such charts say nothing about option prices. See the next section for expansion
on these thoughts .
COMPARING HISTORICAL VERSUS HISTORICAL
The above paragraphs summarize the three major ways that traders attempt to find
options that are out ofline. Sometimes, another method is mentioned: comparing c11ITent
andTrading
Volatility
levels of historical volatility with past levels of the same measure, historical volatility. This
method will he described, but it is generally an inferior method because such a compar-
ison doesn't tell us anything about the option prices. It would do little good, for example,
to find that current historical volatility is in a very low percentile of historical volatilities,
only to learn later that the options are expensive and that perhaps implied volatility is
even higher than historical volatility. One would normally not want to buy options in that
case, so the initial analysis of comparing historical to historical is a wasted effort.
Comparing current levels of historical volatility with past measures of historical vol-
atility is sort of a backward-looking approach, since historical volatility involves strictly the
use of past stock prices. There is no consideration of implied volatility in this approach.
Moreover, this method makes the tacit assumption that a stock's volatility characteristics
<lo not change, that it will revert to some sort of "normal" past price behavior in terms of
volatility. In reality, this is not true at all. Nearly every stock can be shown to have con-
siderable changes in its historical volatility patterns over time.
Consider the historical volatilities of one of the wilder stocks of the tech stock boom,
Rambus (RMBS). Historical volatilities had ranged between ,50% and ll0%, from the
listing of RMBS stock, through February 2000. At that time, the stock averaged a price
of about $20 per share.
Things changed mightily when RMBS stock began to rise at a tremendous rate in
February 2000. At that time, the stock blasted to 11.5,pulled back to 35, made a new high
near 135, and then collapsed to a price near 20. Hence, the stock itself had completed a
wild round-trip over the two-year period. See Figures 39-2 and 39-3 for the stock chart
and the historical volatility chart of RMBS over the time period in question.
As this happened, historical volatility skyrocketed. After February 2000, and well
into 200 L historical volatility was well above 120%. Thus it is clear that the behavior pat-
terns of Rambus changed greatly after February 2000. However, if one had been compar-
ing historical volatilities at any time after that, he would have erroneously concluded that
RMBS was about to slow clown, that the historical volatilities were too high in comparison
with where they'd been in the past. If this had led one to sell volatility on RMBS, it could
have been a very expensive mistake.
\Vhile RMBS may be an extreme example, it is certainly not alone. Many other
stocks experienced similar changes in behavior. In this author's opinion, such behavior
debunks the usefulness of comparing historical volatility with past measures of historical
volatility as a valid way of selecting volatility trades.
What this method may be best used for is to complement the other methods
described previously, in order to give the volatility trader some perspective on how volatile
he can expect the underlying instrument to be; but it obviously has to be taken only as a
general guideline .
39: Volatility
Chapter Techniques
Trading 777
FIGURE 39 -2 .
Historical volatilities of RMBS.
RMBS 19.000 17. 250 18. 875 20010410
·····t·····-···,····t·····,
39 M A MJ J A sb N b J F MAMJ J A sb N b J F Mi
FIGURE 39-3 .
Stock chart of RMBS.
19.000 17.25 0 18.875 20010410
RMBS ··r 134.000

126.000
119. 000
l l l. 000
1]2.000
94.000
86.000
78.000
70. 000
62. 000
54.0[10
~6.000
38.000
: : ' : : : : : :
30.000
:'2. 000
b~~H~i 14.000
. . ... . 6.000
'l'l r1 i\ ~1 J .1 A soN o J t i1 ;,; ~1 J J i\ s t, N b .1 r hi
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CHECK THE FUNDAMENTALS
Once these mispriced options have been found, it is always imperative to check the news
to see if there is some fundamental reason behind it. For example, if the options are
extremely cheap and one then checks the news stories and finds that the underlying stock
has been the beneficiary of an all-cash tender offer, he would not buy those options. The
stock is not going to go anywhere, and in fact will disappear if the deal goes through as
planned.
Similarly, if the options appear to be v-ery expensive, and one checks the news and
finds that the underlying has a product up for review before a governmental agency (FDA,
for example), then the options should not be sold because the stock may be about to
undergo a large gap move based on the outcome of FDA hearings. There could be any
number of similar corporate events that would make the options very expensive. The
seller of volatility should not try to intercede when such events or rumors are occurring.
However, if there is no news that would seem to explain why the options are so
cheap or so expensive, then the volatility trader can continue on to the rest of his
analyses.
SELECTINGTHE STRATEGYTO USE
In general, when one wants to trade volatility, a simple approach is best, especially if one
is huying volatility. If there is a volatility skew involved, then there may be other strate-
gies that are superior, and they are discussed in the latter part of this chapter. However,
when one is interested in the straight trading of volatility because he thinks implied vola-
tility is out of line, then only a few strategies apply.
If volatility is too low, then either a straddle or a strangle should be purchased. One
would normally choose a straddle if the underlying instrument is currently trading near
an available striking price. However, if the underlying is currently trading between two
striking prices, then a strangle might be the better choice. In either case, a position trader
would want to buy a straddle with several months of life remaining, in order to improve
his chances of making a profit. There is no ''best" time length to use , so one should use a
prohabilit~, calculator to aid in that decision. The use of probability calculators will be
discussed shortly.
Example: XYZ is trading at :30.60 and a volatility trader has determined that he wants to
buy rnlatilit:·· With this information, he should attempt to buy a straddle with a striking
of 40 for both the put and the call.
SupposP that the cmTent elate is in December, and the available expiration months
for XYZ arl' Jarniar:·· February. April, Jul:·, and October, plus LEAPS for January of the
Chapter
39: Volatility
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next year. Then he would anal~'ze each straddle (January 40, February 40, April 40, etc.)
to see which is the best one to buy It generally seems to work out that the midrange
straddles han" the best probabilities of success, given the way that option prices are usu-
ally structured. Of course, the actual prices of each straddle would he considered when
using the probability calculator. In this case, then, the July 40 or October 40 straddle
would probably be the best choices from a statistical viewpoint for a position trader.
If XYZ had been trading at a price of 37..50, say, then the trader would probably want
to consider buying a strangle: buying a call with a striking price of 40 and a put with a
striking price of 3,5. From the viewpoint of buying strangles, it does not make sense to
separate the strikes by more than one striking price unit-.S points for stock options, for
example. This just makes the position more neutral to begin with.
Speaking of neutrality, one can also use the deltas of the options in question to alter
the ratio of puts to calls, making the position initially as neutral as possible. This is the sug-
gested approach, since the volatility buyer does not care whether the stock goes up or
down. He is merely interested in stock movement and/or an increase in implied volatility.
Example: XYZ is again trading at :39.60, and the trader wants a neutral position. He
should use the deltas of the options to construct a neutral position. Consider the October
40 straddle, for example. Assume the volatility used for the probability calculations is
40%. Under those conditions (and the ones assumed in the previous example), the Octo-
ber 40 call has a delta of 0.60 and the October 40 put has a delta of-0.40. Thus a ratio of
buying 2 calls and 3 puts is a neutral ratio. If the call is selling for 6 and the put is selling
for .5,then the break-even points for a 2-by-3 position would be ,53..5 on the upside and 31
on the downside . This information is summarized as follows:
Delta of October 40 call: +0.60

Delta of October 40 put: -0.40
Delta-neutral ratio: buy 2 calls and 3 puts
Price of October 40 call: 6.00

Price of October 40 put: 5.00
Net cost of 2-by-3 position: 27 points
Break-even points: Upside= 40 + 27/2 = 53.50

Downside= 40 - 27/3 = 31.00
780 PartVI: Measuring Volatility
andTrading
TABLE 39-1.
January February April July ber
Octo aryLEAP
Janu
Call price 1.25 2.25 3.50 5.00 6 .00 7 15
Put price 1.50 2.35 3.35 4.35 5.00 5.55
Call delta 0.48 0.52 0.55 0.58 0.60 0 .62
Put delta -0.52 -0.48 -0.45 -0.42 -0.40 -0.38
Neutral ~1-to-l ~1-to-1 ~l-to -1 ~2-to-3 ~2-to-3 ~2-to-3
Debit 2.75 4 .60 6 .85 23.05 2700 30.95
Upside break-even 42.75 44.60 46.85 51.57 53.50 55.47
Downsidebreak-even 3725 35.40 33.15 32.30 31.00 29.68
So, the prohahility cak11lations would endeavor to determine what the chances are of the
stock erer trading at either ,5:3..50 or :31.00 at any time prior to expiration. In fact, since
there are straddles arnilable in several expiration months, the stra tegist woul d wan t to
anal:·ze each of tlwrn in a similar fashion. Table :39-l shows how his choices might look.
If one were considering bu:·ing a strangle, similar calculations could be made using the
deltas of the put and the call, where the call strike is higher than t he put str ike.
Another simple strateg_\' that can be used when volatility is low is th e calendar
spread. because it has a positi, ·e vega. That is, it can be expected to expan d if implied vol-
atilit_\' increases. For n1ost traders, though, the limited profit nature of the cale ndar sprea d
is too much of a burden. either psychologically or in terms of commissions, and so thi s
strnteg:· is only modestly used by volatility traders. Some traders w ill use th e calend ar
spread if the:· don't see immediate prospects for an increase in impl ied volatility. They
perhaps buy a call calendar slightly out-of-the-money and also buy a put calenda r with
slight].',-out-of-the-rnoney puts. Then, if not much happens over the short term, th e options
that were sold expire worthless, and the remaining long straddle or strangle is even more
attracti,·e than e,·er. Of course, this strategy has its drawback in that a quick move by th e
unclerl:·ing may result in a loss, sonwthing that would not have happened had a simp le
straddle or strangle been purchased.
SELLING VOLATILITY
If one were selling rnlatilit: · (i.e.. volatility is too high), his choices are more comp lex.
\'irt11all:· c.ll1_\!me who has E'YET sold ,olatilit.' ,.has had a bad experience or two with either
e\ploclin~ stock prices or exploding rnlatility. Some of the concerns regarding the sale of
rnlatilit:· will lw discussed at length later in this chapter. For now, the simp ler strategies
Chapter
39: Volatility
Trading
Techniques 781
will be considerecl, in keeping with the discussion involving the creation of a volatility
trading position.
Simplistically, a volatility seller would generally have a choice between one of two
strategies (although there is a more complicated strategy that can be introduced as well).
The simplest strateg:· is just to sell both an out-of-the-money put and an out-of-the-money
call. The striking prices chosen should be far enough away from the current underlying
price so that the probabilities of the position getting in trouble (i.e., the probabilities that
the underlying actually trades at the striking prices of the naked options during the life
of the position) are quite small. Just as the option buyer above outlined several expiration
months, then computed the break-even prices, so should a volatility seller. Generally he
will probably want to sell short-term options, but all expiration months should be consid-
erecl, at least initially. Also, he may want to try different strike prices in order to get a
balance between a low probability of the stock reaching the striking price of the naked
options and taking in enough premium to make the trade worthwhile. To this author, the
sale of naked options at small fractional prices does not appear attractive.
Of course, merely selling such a put and a call means the options are naked, and that
strategy is not suitable for all traders. The next best choice then, I suppose, is a credit spread.
The problem with a credit spread is that one is both selling expensive options and also buy-
ing expensive options as protection. The ramifications of volatility changes on the credit
spread strategy were detailed two chapters previously, so they won't be recounted here,
except to say that if volatility decreases, the profits to be realized by a credit spreader are
quite small (perhaps not even enough to overcome the commission expense of rernoving the
position), whereas a naked option seller would benefit to a greater and more obvious extent.
The choice between naked writing and credit spreading should he made based
largely on the philosophy and psychological makeup of the trader himself. If one feels
uncomfortable with naked options, or if he doesn't have the ability to watch the market
pretty much all the time (or have someone watch it for him), or if he doesn't have the
financial wherewithal to margin the positions and carry them until the stock hits the
break-even point, then naked writing is not for that trader .
Another factor that might affect the choice of strategy for the option seller is what
type of underlying instrument is being considered. Index options are by far the best choices
for naked option selling. Futures are next, and stocks are last. This is because of the ways
those various instruments behave; stocks have by far the greatest capability of making huge
gap moves that are the bane of naked option selling. So, if one has found expensive stock
or futures options, that might lend more credence to the credit spread strategy.
There is one other strategy that can be employed, upon occasion, when options are
expensive. It is called the volatility backspread, but its discussion will be>cleferrc>duntil
later in the chapter.
782 Part VI:Measuring and TradingVolatility
USING A PROBABILITY CALCULATOR
No matter which method is used to find options that are out of line, and no matter which
strategy is preferred by the trader, it is still necessary to use a probability calculator to get
a meaningful idea of whether or not the underlying has the ability to make the move to
profitability (or not make the move into loss territory , if you're selling options). This is
where historical volatility plays a big part, for it is the input into the probability calculator.
In fact, no probability calculator will give reasonable predictions wit hout a good estimate
of volatility. Please refer to tl1e previous chapter for a more in-depth discussion of prob-
abilit y calculator s an d stock pric e distributio ns.
The use of probability analysis also mitigates some of the problems inherent in the
method of selection that compares implied and historical volatilities. If the probabilities
are good for success , then we might not care so much whether the options are currently
in a low percentile of implied volatility or not (although we still would not want to buy
volatility when the options were in a high percentile of implied volatility and we would
not want to sell option s th at are in a low perc entile ).
In using the probability calculator, one first selects a strategy (straddle buying, for
example, if options are cheap) and then calculates the break-even points as demonstrated
in the previous section. Then the probability calculator is used to determine what the
chances are of the underlying instrument euer trading at one or the other of those
break -even prices at any time during the life of the option position. It was shown in the
previous chapter that a Monte Carlo sirnulation using the fat tail distribution is best used
for th is process.
An attractive volatility buying situation should have probabilities in excess of 80% of
the underlying ever exceeding the break-even point , while an attractive volatility selling
situation should have probabilities of le~s than 2.5% of ever trading at prices that would
cause losses. The volatility seller can, of course, heavily influence those probabilities by
choosing options that are well out-of-the-money. As noted above, the volatility seller
should. in fact, calculate the probabilities on several different striking prices, striving to
find a balance between high probability of success and the ability to take in enough pre-
mium to make the risk wort hwh ile.
Example: The OEX Index is trading at 6.50. Suppose that one has determined that vola-
tilities are too high and wants to analyze the sale of some naked options. Furthermore,
suppose that the choices have been narrowed down to selling the September options, which
expir e in about fh·e weeks . The main choices under consideration are those in Table 39-2.
The option prices in this example, being index options, reflect a volatility skew (to be dis-
cussed later) to make the example realis tic.
The>two right-han d column s should be rejected because the probabilities of the
Chapter
39: Volatility
Trading
Techniques 783
TABLE 39-2.
September September September September
800coll 750coll 730coll 700coll
September September September September
Naked
sale: 500put 550put 570put 600put
Call price 0.20 1.50 3.50 8.80
Putprice 0.40 2.00 3.70 8.50
Probabilityof call strike 4% 17% 30% 44%
Probability of put strike 1% 11% 20% 40%
stock hitting one or the other of the striking prices prior to expiration are too high-well
in excess of the 25% guideline mentioned earlier. That leaves the September 500-800
strangle or the September .550-750 strangle to consider. The probabilities are best for the
farthest out-of-the-mon ey options (September 500-800 strangle) , but the options are sell-
ing at such small prices that they will not provide much of a return even if they expire
worthless. Remember that one is required to establish the position with margin of at least
10% of the index price for naked index options , which would be $6,500 in this case. In
fact, it has been recommend ed that one margin the position at the striking price itself
(15% of 800, or $12,000 in this case). So, taking in only $60, less commissions , for the sale
of the September 500-800 strangle doesn't seem to provide enough of a reward. Thus, the
best choice seems to be the September .550-750 strangle . One would be making about
$320 after commissions if the options expired worthl ess, and the recommended margin
would be 15% of 750 (the higher strike ), or $11,250-a return of about 2.8% for one
month. One cannot annualize these returns, for he has no idea if the same option pricing
structure will exist in five weeks , when the se option s expire .
Other probabilities can be calculated as well. For example, suppose one has decided
to buy a straddle. He might want to know what the odds are not only of breaking even ,
but also of making at least a certain percentage return-say 20% . One could also calculate
the probability of the stock moving 20% past the break-even points. That distance-20%-
is a reasonable figure to use because one would most likely be taking some partial profits
or adjusting his position if the stock did indeed move that far.
USING STOCK PRICE HISTORY
All of the work done so far-determining which options are expensive, selecting a strat-
egy, and calculating the probabilities of success-has been somewhat th eoretical in that
we haven't clone any "back testing" with regard to the volatility of th e underlying
andTrading
Volatility
instruments. At this point, one should look at past prices to see if the stock has been able
to make large moves (whether or not such a move is desired).
Example: A trader is considering the purchase of the XYZ October 40 straddle for 11
points, with the stock at .39.60. The options are cheap and the probabilities of success
appear to be good, according to the probability calculator. The question that now needs
to be asked and answered is this: "In the past, has this stock been able to move 11 points
in 10 months (the time remaining in the straddle's life)?" Or, more importantly, since 11
divided by 39.60 is about 28%, "Has this stock been able to make moves of 28% over 10
months, in the past?" The answers to these questions can be readily obtained if stock price
history data is available. One could even look at a chart of the stock and attempt to answer
the questions himself without the aid of a computer, but computer analysis of the price
history is more rigorous and is therefore encouraged.
The answers can be expressed in the form of probabilities, much as the results of the
probability calculator are .
Suppose one determines that the stock has been able to move 11 points in 10 months
77% of the time in the past. That's okay, but not great. However, when one looks at the
price chart of XYZ, he sees that it traded at much lower prices-near $10 a share-for a
long time before rising to its current levels. It would be very hard to expect a $10 stock
to move 11 points in 10 months. That's why the second figure, the one involving the 28%
move, is the more significant one. In this case, one might find that XYZ has been able to
move 28% in 10 months over 90% of the time in the past. Nau; one has what appears to
be a decent-looking straddle buy.
This analysis of past prices can be done in a more sophisticated manner. Rather than just
asking whether or not the stock has moved the required distance in the past, one might
want to see just how the stock's movements "look." That is, there are a couple of scenarios
under which the past movements might look attractive, but upon closer examination, one
would not be so sanguine .
For example, what ifXYZ had repeatedly movecl 28%, but never much more in most
of the IO-month periods that comprise its stock history? Then, one would be less inclined
to want to own this straddle.
Another scenario of past movements might be that XYZ had made moves that one
could not reasonably expect to be repeated. Perhaps there was a huge gap down on an
earnings shortfall, or if it was an Internet stock around the turn of the millennium, it had
a huge rnuve upward, followed by a huge move downward. That would be another non-
repeating type of move, because absent the Internet mania, the stock might have been a
rather range-bound item both prior to and after the one huge, round-trip move.
These problems could be addressed by merely looking at the chart, but the naked
Chapter
39: Volatility
Trading
Techniques 785
FIGURE 39-4.
Histogram of XYZ movements. (Testing 28% move in ten months.)
1596
"'
~
"'
c_5 1096 X
""'
0
xx
=
~
...
I.I
XXX
X XXX
XX XXX
~ 596 xxxxxxx
xxxxxxx X X
X XXXXXXXX X X X X
XXX XXXXXXXX XXX XX X XXXX
xxxxxxxxxxxxxxxx xxxxxxxxxxxxxxxxxxx
-3 -2 -1 0 1 2 3
Movement
eye can be deceiving in many cases. Rather, a more rigorous approach would be to con-
struct a histogram of these past stock movements and analyze the histogram.
Figure 39-4 shows such a histogram. The x-axis shows the magnitude of each
IO-month move that is in the database ofXYZ stock prices. A move to 'T' would mean that
it moved the 28% and no farther over the 10-month period. A move to "-2" indicates
that it fell 56% (twice the required distance) during the IO-month period. The y-axis
(left-hand scale) shows the percentage of times that the move occurred. The sample his-
togram shown in Figure 39-4 is actually a very favorable one. Notice that the stock was
always able to move at least 28%. Furthermore, it moved two or three times that far with
great frequency. Finally, there is a continuity to the points on the histogram: There are
some y-axis data points at almost all points on the x-axis (between the minimum and
maximum x-axis points). That is good, because it shows that there has not been a cluster-
ing of movements by XYZ that might have dominated past activity.
As for what is not a "good" histogram, we would not be so enamored of a histogram
that showed a huge cluster of points near and between the "-1" and "l" points on the
x-axis. We want the stock to have shown an ability to movefarther than just the break-even
distance, if possible. As an example , see Figure 39-5, which shows a stock whose move-
ments rarely exceed the "-1" or "+l" points, and even when they do, they don't exceed it
by much. Most of these would be losing trades because, even though the stock might have
moved the required percentage, that was its nwxi1num move during the 10-mouth period,
and there is no way that a trader would know to take profits exactly at that time. The
straddles described hy the histogram in Figure 39-5 should not be bought, regardless of
what the previous analyse s might have shown .
786 PartVI:Measu
ring and TradingVolatility
FIGURE 39-5.
Example of poor movement.
15%
X
10%
X X
5% XXX
xxxx
xx xxxx X
xxxx XXX X
xx --------,:,0------::-'
XXXXX X XXX
2
-3 -2 3
Nor would it be desirable for the histogram to show a large number of movements
above the "+3" level on the histogram, with virtually nothing below that. Such a histogram
would most likely be reflective of the spiky, Internet-type stock activity that was referred
to earlier as being unreasonable to expect that it might repeat itself. In a general sense, one
doesn't want to see too many open spaces on the histogram's x-axis; continuity is desired.
If the histogram is a favorable one, then the volatility analysis is complete. One
would have found mispriced options, with a good theoretical probability of profit, whose
past stock movements verify that such movements are feasible in the future.
ANOTHER APPROACH?
After having considered the descriptions of all of these analyses, one other approach
comes to mind: Use the past movements exclusicely and ignore the other analyses alto-
gether. This sounds somewhat radical, but it is certainly a valid approach. It's more like
giving some rigor to the person who "knows" IBM can move 18 points and who therefore
wants to buy the straddle. If the histogram (study of past movements) tells us that IBM
does, indeed, have a good chance of moving 18 points, what do we really care about the
relationship of implied and historical volatility, or about the current percentiles of either
type of volatility or what a theoretical probability calculator might say? In some sense,
this is like comparing implied volatility (the price of the straddle) with historical volatility
(the history of stock price movements) in a strictly practical sense, not using statistics.
In reality, one would have to be mindful of not buying overly expensive options (or
st'lling mwly cllt'ap Oilt's), because implied volatility cannot he ignored. However, the
Chapter
39: Volatility
Trading
Techniques 787
price of the straddle itself which is what determines the x-axis on the histogr~m, does
reflect option prices, and therefore implit'd volatility, in a nontt'clmical sense. This author
suspects that a list of volatility trading candidates generated only by using past movements
would be a rather long list. Therefore, as a practical matter, it may not be useful.
MORE THOUGHTS ON SELLING VOLATILITY
Earlier, it was promised that another, more complex volatility selling strategy would be dis-
cussed. An option strategist is often faced with a difficult choice when it comes to selling
(overpriced) options in a neutral manner-in other words, "selling volatility." Many traders
don't like to sell naked options, especially naked elfllity options, yet many forms of spreads
designed to limit risk seem to force the strategist into a directional (bullish or bearish) strat-
egy that he doesn't really want. This section addresses the more daunting prospect of trying
to sell volatility with protection in the equity and futures option markets.
The quandary in trying to sell volatility is in trying to find a neutral strategy that
allows one to benefit from the sale of expensive options without paying too much for a
hedge-the offsetting purchase of equally expensive options. The simple strategy that
most traders first attempt is the credit spread. Theoretically, if implied volatility were to
fall during the time the credit spread position is in place, a profit might he realized. How-
ever, after commissions on four different options in and possibly out (assuming one sold
both out-of-the-money put and call spreads), there probably wouldn't be any real profit
left if the position were closed out early. In sum, there is nothing really wrong with the
credit spread strategy, but it just doesn't St'ern like anything to get too excited about. What
other strategy can be used that has limited risk and would benefit from a decline in
implied volatility? The highest-priced options are the longer-term ones. If implied volatil-
ity is high, then if one can sell options such as these and hedge them, that might be a good
strategy.
The simplest strategy that has the desired traits is selling a calendar spread-that
is, sell a longer-term option and hedge it by buying a short-term option at the same strike.
True, both are expensive (and the near-term option might even have a slightly higher
implied volatility than the longer-term one). But the longer-term one trades with a far
greater absolute price, so if both become cheaper, the longer-term one can decline quite
a bit farther in points than the near-term one. That is, the ucga of the longer-term option
is greater than the vega of the shorter-term one. When one sells a calendar spread, it is
called a reuerse calendar spread. The strategy was described in the chapter on reverse
spreads. The reader might want to review that chapter, not only for the description of the
strategy, but also for the description of the margin problems inherent in reverse spreads
on stocks and indices.
One of the problems that most traders have with the rt'wrst' calt'll(lar spread is that
andTrading
Volatility
it doesn't produce very large profits. The spread can theoretically shrink to zero after it is
sold , but in realitv it will not do so, for the longer-term option will retain some amount of
tirne value premi~1rneven if it is very deeply in- or out-of-the-money. Hence the spread will
never really shrink to zero.
Yet, there is another approach that can often provide larger profit potential and still
retain the potential to make money if implied volatility decreases. In some sense it is a
modification of the re\'erse calendar spread strategy that can create a potentially even
more desirable position. The strategy, known as a wlatility backspread, involves selling a
long-term at-the-money option (just as in the reverse calendar spread) and then buying a
greater number of nearer term out-of-the-money options. The position is generally con-
structed to he delta-neutral and it has a negative vega, meaning that it will profit if implied
volatility decreases.
Example: XYZ is trading at 11.Sin early June. Its options are very expensive. A trader
would like to construct a volatility backspread using the following two options:
CallOption Price Delta Vega

July 130 call: 2.50 0.26 0.10
October 120 call: 13 0.53 0.27
A delta-neutral position would be to buy 2 of the July 130 calls and sell one of the
October 120 calls. This would bring in a credit of 8 points. Also, it would have a small
negati\·e position \·ega, since two times the vega of the July calls minus one times the vega
of the October call is -0.07. That is, for each one percentage point drop in implied volatil-
ity of XYZ options in general, this position would make $7-not a large amount, but it is
a small position.
The profitability of the position is shown in Figure 39-6. This strategy has limited
risk because it does 110! involve naked options. In fact, if XYZ were to rally by a good
distance, one could mah:> large profits because of the extra long call. Meanwhile , on the
downside, if XYZ falls hem'ily, all the options would lose most of their value and one would
hm·e a profit approaching the amount of the initial credit received. Furthermore, a
decrease in implied rnlatilit~, produces a small profit as well, although time decay may not
lit' in the trader's farnr. depending on exactly which short-term options were bought. The
biggest risk is that XYZ is exactly at 130 at July expiration, so any strategist employing this
strateg_'· should plan to close it out in advance of the near-term expiration. It should not
be allowed to deteriorate to the point of maximum loss .
.\lodifications to the strateg-'· can be considered. One is to sell even longer-term
Chapter
39: Volatility
Trading
Techniques 789
FIG URE 39-6.

Volatility backspread neutral position.
(/)
(/)
0
...J
~
'5 80 90 160
a:
ti¼
Underlying Price
options and of course hedge them with the purchase of the near-term options. The
longer-term the option is, the higger its \'ega will be, so a decrease in implied volatility will
cause the heftier-priced long-term option to decline more in price. This modification is
somewhat tempered, though, hy the fact that whe11options get really expensive, there is
often a tendency for the near-term options to be skewed. That is, the near-term options
will be trading with a much higher implied volatility than will the longer-term options.
This is especially true for LEAPS options. For that reason, one should make sure that he
is not entering into a situation in which the shorter-term options could lose volatility while
the longer-term ones rnore or less retain the same implied volatility, as LEAPS options
often do. This concept of differing volatility between near- and long-term options was
discussed in more detail in Chapter 36 on the basics of volatility trading. As a sort of gen-
eral rule, if one finds that the longer-term option has a much lou.:erimplied volatility than
the one you were going to buy, this strategy is not recommended. As a corollary, then, it
is unlikely that this strategy will work well with LEAPS options.
One other thing that you should analyze when looking for this type of trade is
whether it might he better to use the puts than the calls. For one thing, you can establish
a position in which the heavy profitability is on the downside (as opposed to the upside,
as in the XYZ example above). Then, of course, having considered that, it might actually
behoove one to establish both the call spread and tht> put spread. If you do both, though,
you create a "good news, bad news" situation. The good news is that thf' maximum risk is
reduced; for example, if XYZ goes exactly to 1:10(the worst point for the call spread), the
companion put spread's credit would reduce that risk a little. I lowcvcr, the had news is
790 Part VI:Measuringand Trading Volatility
that there is a much wider range over which there is not profit, since there are two spots
where losses are more or less maximized (at the strike price of the long calls and again at
the strike price of the long puts ).
Margin will be discussed only briefly, since it was addressed in the chapter on reverse
spreads. For both index and stock options, this strategy is considered to have naked
options-a preposterous assumption, since one can see from the profit graph that the
position is fully hedged until the near-term options expire. This raises the capital require-
ment for nonmember traders. The margin anomaly is not a problem with futures options,
however. For those options, one need only margin the difference in the strikes, less any
credit received, because that is the true risk of the position. In summary, the volatility
trader who wants to sell volatility in equity and futures options markets needs to be
hedged, because gaps are prevalent and potentially very costly. This strategy creates a
more neutral, less price-dependent way to benefit if implied volatility decreases, especially
when compared with simple credit spreads .
SUM MAR Y: TRADING THE VOLATILITY PREDICTIO N
Attempting to establish trades when implied volatility is out of line is a theoretically

attractive strategy. The process outlined above consisted of a few steps, employing both
statistical and theoretical analysis. In any case, though, probability calculators must "say"
that a volatility trade has good probabilities of success. Ifs merely a matter of what criteria
we apply to limit our choices before we run the probability analysis. So, it might be more
useful to view volatility trading analysis in this light :
Step 1: Use a selection criterion to limit the myriad of volatility tradi ng choices. Any of
these could be used as the first criterion , but not all of them at once:
a. Require implied volatility to be at an extreme percentile .
b. Require historical and implied volatility to have a large discrepancy between
them.
c. Int erpr et th e chart of implied volatility to see if it has reversed trend .
Step 2: Use a prohability calculator to project whether the strategy can be expected to
be a success.
Step 3: Using past price histories, determine whether the underlying has been able to
create profitable trades in the past. (For example, if one is considering buying a
straddle, ask the question, "Has this stock been able to move far enough, with
great enough frequency, to make this straddle purchase profitable?") Use histo-
grams to ensure that the past distrihution of stock prices is smooth, so that an
aberra nt , nonrep eatable move is not overly influencing the results.
Chapter
39: Volatility
Trading
Techniques 791
Each criterion from Step 1 would produc.:ea different list of viable volatility trading
candidates on any given day. If a particular candidate were to appear on more than one
of the lists , it might be the best situation of all.
TRADING THE VOLATILITY SKEW
In the early part of this chapter, it was mentioned that there are two ways in which volatil-
ity predictions could be ·'wrong." The first was that implied volatility was out of line. The
second is that individual options on the same underlying instrument have significantly
different implied volatilities. This is called a volatility skew, and presents trading oppor-
tunities in its own right.
DIFFERING IMPLIED VOLATILITIES ON THE SAME UNDERLYING SECURITY
The implied volatility of an option is the volatility that one would have to use as input to
the Black-Scholes model in order for the result of the model to be equal to the current
market price of the option. Each option will thus have its own implied volatility. Gener-
ally, they will be fairly close to each other in value, although not exactly the same. How-
ever , in some cases, there will be large enough discrepancies between the individual
implied volatilities to warrant the strategist's attention. It is this latter condition of large
discrepancies that will be addressed in this section.
Example: XYZ is trading at 45. The following option prices exist, along with their implied
volatilities:
Option Actual
Price Implied
Volatility
January 45 call 2.75 41%
February 45 call 3.50 38%
February50 call 4.00 45%
Note that the implied volatilities of the individual options range from a low of 38%
to a high of .53%. This is a rather large discrepancy for options on the same underlying
security, but it is useful for exemplary purposes.
A neutral strategy could be established by buying options with lower implied volatili-
ties and simultanPously selling ones with higlwr volatilities, such as Luy 10 February 45
792 Part VI:Measuri
ng andTradi
ng Volatility
calls and sell 20 January 50 calls. Examples of neutral spreads will be expanded upon in
the next chapter, when more exact measures for determining how many calls to buy and
sell are discussed.
Before jumping into such a position, the strategist should ask himself if there is a
valid reason why the different options have such different implied volatilities. As a gener-
alization, it might be fair to say that out-of-the-money options have slightly higher implieds
than at-the-money ones, and that longer-term options have lower implieds than short-term
ones. But there are many instances in which such is not the case, so one must be careful
not to overgeneralize.
Speculators often desire the lowest dollar-cost option available. Thus, in a takeover
rumor situation, they would buy the out-of-the-moneys as opposed to the higher-priced
at- or in-the-moneys. If the out-of-the-moneys are extremely expensive because of a take-
over rumor, then the strategist must be careful, because the neutral strategy concept may
lead him into selling naked calls. This is not to say he should avoid the situation altogether;
he may be able to structure a position with enough upside room to protect himself, or he
may believe the rumors are false .
Returning to the general topic of differing implied volatilities on the same underly-
ing stock the strategist might ask how he is to determine if the discrepancies between the
individual options are significantly large to warrant attention. A mathematical approach
is presented at the end of the next chapter in a section on advanced mathematical con-
cepts. Suffice it to sa:· that there is a way that the differences in the various implieds can
he reduced to a single number-a sort of "standard deviation of the implieds" that is easy
for the strategi-;t to use. A list of these numbers can be constructed, comparing which
stocks or futures might be candidates for this type of neutral spreading. On a given day,
the list is usually quite short-perhaps 20 stocks and 10 futures contracts will qualify.
The concept of the implied rnlatilities of rnrious options on the same underlying
stock remaining out of line with each other is one that needs more discussion. In the fol-
lowing section. the idea of semipermanent distortion between the volatilities of different
striking prices is discuss ed.
VOLATILITY SKEWING
After the stock market crashed in 1987, index options experienced what has since proven
to be a permanent distortion: Out-of-the-money puts have remained more expensive than
out-of-the-rnone:, calls. Furthermore. out-of-the-money puts are more expensive than
at-the-1noney puts: out-of-the-money calls are cheaper than at-the-money calls. This dis-
torted effect is due to several factors, hut it is so deep-seated that it has remained through
Chapter
39: VolatilityTrading
Techniques 793
all kinds of up-and-down markets since then. Other markets, particularly futures markets,
have also experienced a long-lasting distortion between the implied volatilities at various
strikes.
The proper name given to this phenomenon is volatility skewing: the long-lasting
effect ichcreby options at different striking prices trade tcith differing implied volatilities.
It should be noted that the calls and puts at the same strike must trade for the same
implied volatility; otherwise, conversion or reversal arbitrage would eliminate the differ-
ence. However, there is no true arbitrage between different striking prices. Hence, arbi-
trage cannot eliminate volatility skewing.
Example: Volatility skewing exists in OEX index options. Assume the average volatility
of OEX and its options is 16%. With volatility skewing present, the implied volatilities at
the various striking prices might look like this:
OEX: 580
Strike Implied
Volatility
ofBoth
PutsandCalls
550 22%
560 19%
570 17%
580 16%
590 15%
600 14%
610 13%
In this form of volatility skewing, the out-of-the-money puts are the most expensive
options; the out-of-the-money calls are the cheapest. This pattern of implied volatilities is
called a reverse volatility skew or, alternatively, a negative volatility skew.
The causes of this effect stem from the stock market's penchant to crash occasionally.
Investors who want protection buy index puts; they don't sell index futures as much as they
used to because of the failure of the portfolio insurance strategy during the 1987 crash. In
addition, margin requirements for selling naked index puts have increased, especially for
market-makers, who are the main suppliers of naked puts. Consequently, demand for index
puts is high and supply is low. Therefore, out-of-the-money index puts are overly expensive.
This does not entirely explain why index calls are so cheap. Part of the reason for
that is that institutional traders can help finance the cost of those expcnsi\·e index puts hy
andTrading
Volatility
selling some out-of-the-money index calls. Such sales would essentially be covered calls if
the institution owned stocks, which it most certainly would. This strategy is called a
collar.
This distortion in volatilities is not in accordance with the probability distribution of
stock prices. These distorted implied volatilities define a different probability curve for
stock movement. They seem to say that there is more chance of the market dropping than
there is of it rising. This is not true; in fact, just the opposite is true. Refer to the reasons
for using lognormal distribution to define stock price movements. Consequently, there are
opportunities to profit from volatility skewing, if one is able to hold the position until
expiration.
It was shown in previous examples that one would attempt to sell the options with
higher implied volatilities and buy ones with lower implieds as a hedge. Hence, for OEX
traders, three strategies seem relevant:
1. Buy a bear put spread in OEX.

Example: Buy 10 OEX June 560 puts
Sell 10 OEX June 540 puts
2. Buy OEX puts and sell a larger number of out-of-the-money puts-a ratio write of
put options.
Example: Buy 10 OEX June 560 puts
Sell 20 OEX June 550 puts
3. Sell OEX calls and buy a larger number of out-of-the-money calls-a backspread of
call options.
Example: Buy 20 OEX June 590 calls
Sell 10 OEX June 580 calls
In all three cases, one is selling the higher implied volatility and buying options with
lower implied volatilities. The first strategy is a simple bear spread. While it will benefit
from the fact that the options are skewed in terms of implied volatility, it is not a neutral
strategy. It requires that the underlying drop in price in order to become profitable. There
is nothing wrong with using a directional strategy like this, but the strategist must be
aware that the skew is unlikely to disappear (until expiration) and therefore the index
price movement is going to be necessary for profitability.
Tht>SE:-'concl
strategy would be best suited for moderately bearish investors, although
a St'\'t'rE:' market decline might drive the index so low that the additional short puts could
cause se\·ne losses. However, statistically this is an attractive strategy. At expiration, the
er 39: Volatility
Chapt Techniques
Trading 795
volatility skewing must disappear: the markets will ltave moved in line with their real
probabilit_vdistribution, not the false 011ebeing implied by the skewed options. This makes
for a potentially profitable situation for the strategist.
The backspread strategy would vvorkbest for bullish investors , although some back-
spreads can be created for credits, so a little money could also be made if the index fell.
In theory, a strategist could implement both strategies simultaneously, which would give
him an edge over a wide range of index prices. Again, this does not mean that he cannot
lose money; it merely means that his strategy is statistically superior because of the way
the options are priced. That is, the odds are in his favor.
In reality, though, a neutral trader would choose either the ratio spread or the back-
spread-not both. As a general rule of thumb, one would use the ratio spread strategy if
the current level of implied volatility were in a high percentile. The backspread strategy
would be used if implied volatility were in a low percentile currently. In that way, a move-
ment of implied volatility back toward the 50th percentile would also benefit the trade
that is in place .
Another interesting thing happens in these strategies that may be to their benefit:
The volatility skewing that is present propagates itself throughout the striking prices as
OEX moves around. It was shown in the previous section's example that one should prob-
ably continue to project his profits using the distorted volatilities that were present when
he establishes a position. This is a conservative approach, but a correct one. In the case of
these OEX spreads, it may be a benefit.
Assuming that the skewing is present wherever OEX is trading means that th e
at-the-money strike will have 16% as its implied volatility regardless of the absolute price
level; the skewing will then extend out from that strike. So, if OEX rises to 600, then the
600 strike would have a volatility of 16%; or if it fell to .560, then the ,560 puts and calls
would have a volatility of 16%. Of course, 16% is just a representative figure; the "average"
volatility of OEX can change as well. For illustrative purposes, it is convenient to assume
that the at-the-money strike keeps a constant volatility.
Example: Initially, a trader establis hes a call backspread in OEX options in order to take
advantage of the volatility skewing:
In itial situation: OEX: 580
Option Volatility
Implied Delta
June 590 call 15% 0.40
June 600 call 14% 0.20
A neutral spread would be:

796 Part VI:Measuring andTrading Volatility
Buy 2 June 600 calls

Sell l June 590 call
since the deltas are in the ratio of 2-to-l.
Now, suppose that OEX rises to 600 at a later date, but well before expiration. This
is not a particularly attractive price for this position. Recall that, at expiration, a back-
spread has its worst result at the striking price of the purchased options. £\·en prior to
expiration, one would not expect to hm·e a profit with the index right at 600.
Howe\·er, the statistical advantage that the strategist had to begin with might be able
to help him out . The present situation would probably look like this:
Option Implied
Volatility
June 590 call 17%
June 600 call 16%
The .June 600 call is now the at-the-monev. call, since OEX has risen to 600. As such,
its implied rnlatility will be 169c (or whate\·er the '\t\·erage" volatility is for OEX at that
time-the assumption is made that it is still 16o/c ). The June .590 call has a slightly higher
volatility (17%)because volatility skewing is still present.
Thus, the options that are long in this spread have had their implied volatility
incr('ase: that is a benefit. Of course, the options that are short had theirs increase as well,
but the overall spread should benefit for two reasons:
1. Twice as many options are owned as were sold.

:2. The effect of increased volatility is greatest on the at-the-mone:· option: the
in-the-money will be affected to a lesser degree .
All index options exhibit this rnlatility skewing. Volatility skewing exists in other
markets as well. The other markets where rnlatility skewing is prevalent are usually
futures option markets. In particular, gold, siker, sugar, soybeans, and coffee options will
from time to time display a form of \·olatilit:· skewing that is the opposite of that displayed
by index options. In these futures markets, the cheapest options are out-of-the-money
puts , while the most expensive options are out-of-the-money calls.
Example: Ja1mar:, so: beans are trading at .580 (S.S.80per bushel). The following table of
irnplied rnlatilities shm,·s how rnlatilit:· skewing that is present in the so:·hean market is
the opposite of that shown by the OEX market in the previous examples:
Chapter
39: Volatility
Trading
Techniques 797
January beans : 580
Strike Implied
Volatility
525 12%
550 13%
575 15%
600 17%
625 19%
650 21%
675 23%
Notice that the out-of-the-money calls are now the more expensive items, while
out-of-the-money puts are the cheapest. This pattern of implied volatilities is called for-
ward volatility skew or, alternatively, positive volatility skew.
The distribution of soybean prices implied by these volatilities is just as incorrect as

the OEX one was for the stock market. This soybean implied distribution is too bullish. It
implies that there is a much larger probability of the soybean market rising 100 points
than there is of it falling 50 points. That is incorrect, considering the historical price
movement of soybeans.
A strategist attempting to benefit from the forward (or positive) volatility skew in this
market has essentially three strategies available. They are the opposite of the three recom-
mended for the OEX, which had a reverse (or negative) volatility skew. First would he a
call bull spread, second would be a put backspread, and third would he a call ratio spread.
In all three cases, one would be buying options at the lou;er striking price and selling
options at the higher striking price. This would give him the theoretical advantage.
The same sorts of comments that were made about the OEX strategies can be
applied here. The bull spread is a directional strategy and can probably only be expected
to make money if the underlying rises in price, despite the statistical advantage of the
volatility skew. The put backspread is best established when the overall level of implied
volatility is in a low percentile. Finally, the call ratio spread has a great deal of risk to the
upside (and futures prices can fly to the upside quickly, especially if bad fundamental
conditions develop, such as weather in the grain markets). The call ratio spread would best
be used when implied volatilities are already in a high percentile .
As a general comment, it should be noted that if the volatility skew disappears while
the trader has the position in place, a profit will generally result. It would nonnall~, behom,e
the strategist to take the profit at that time. Otherwise, follow-up action should adlwre to the
general kinds of action rec0111111endedfor the strategies in question: protectiw action to
798 PartVI:Measuri
ngandTradin
g Volat
ility
pre\'ent large losses in the case of the ratio spreads, or the taking of partial profits and pos-
sibly rolling the long options to a more at-the-money strike in the case of the backspread
strategies.
SUMMARY OF VOLATILITY SKEWING
\Vhenever volatility skewing exists-no matter what market-opportunities arise for the
neutral strategist to establish a position that has advantages. These advantages arise out
of the fact that normal market movements are different from what the options are imply-
ing. Moreo\'E'r, the options are wrong when there is skewing at all strikes, from the lowest
to the highest. The strategist should be careful to project his profits prior to expiration
using the same skewing, for it may persist for some time to come. However, at expiration,
it must of course disappear. Therefore, the strategist who is planning to hold the position
to expiration will find that volatility skewing has presented him with an opportunity for a
po sitive expec ted return.
SUM MARY OF VOLATILITY TRADING
The theoretical trading of options, mostly in a neutral manner, has evolved into one large
branch-\'Olatility trading. This part of the book has attempted to lay out the foundations,
structures, and practices prevalent in this branch of trading. As the reader can see, there
are some sophisticated techniques being applied-not so much in terms of strategy, but
in terms of the ways that one looks at volatility and in the ways that stocks can move.
Statistical methods are used liberally in trying to determine the ways that either
\'Olatility can move or stocks can mm·e. The probability calculators, stock price distribu-
tions, and related topics are all statistical in nature. The volatility trader is intent on find -
ing situations in which current market implied volatility is incorrect, either in its absolute
rnlue or in the skew that is prevalent in the options on a particular underlying instrument.
Upon finding such discrepancies, the trader attempts to take advantage by constructing a
more or less neutral position, preferring not to predict price so much, but rather attempt-
ing to pre dict volatilit y.
Most volatility traders attempt to buy volatility rather than sell it, for the reasons that
tht> strategies inherent in doing so have limited risk and large potential rewards, and don't
require one to n1onitor them continuously. If one owns a straddle , any major market move-
ments resulting in gaps in prices are a benefit. Hence, monitoring of positions as little as
just once a cla~·is sufficient, a fact that means that the volatility buyer can have a life apart
frrn11watching a trading screen all day long. In addition, volatility buyers of stock options
Chapter
39: Volatility
Trading
Techniques 799
can avail themselves of the chaotic movements that stocks can make, taking advantage of
the occasional fat tail movements.
However, since volatility and prices are so unstable, one cannot predict their move-
ments with any certainty. The vagaries of historical volatility as compared to implied vol-
atility, the differences between the implied volatility of short- and long-term options, and
the difficulty in predicting stock price distributions all complicate the process of predict-
ing volatility. Hence, volatility trading is not a '"lock," but its practitioners normally believe
that it is by far the best approach to theoretical option trading available today. Moreover,
most option professionals primarily trade volatility rather than directional positions.
Advanced Concep ts
As the option markets have matured, strategists have been forced to rely more on mathe -
matics in order to select new positions as well as to discern how their positions will behave
in fluctuating markets. These techniques can be used 011 simple strategies, such as bull
spreads or ratio spreads, or on far more complex portfolios of options.
First, the concept of implied volatility will be examined in more detail, primarily as
an aid in choosing new positions that have a positive expected return. Then, the concept
of risk managernent will be explored. In effect, one can reduce his option position into
st'\·eral components of risk measurement that can be readily understood. This chapter
describes the techniques used to evaluate one's position, and shows how to use this infor-
rnation to reduce the risk in the position. The actual mathematical calculations required
to perform these analyses are included at the end of the chapter.
NEUTRALITY
In many of the examples in previous chapters, it was generally assumed that one would
take a "neutral --position in order to capture the pricing or volatility differential. Why this
concentration on neutralit-'? Neutrality, as it applies to option positions, means that one
is noncommittal with respect to at least one of the factors that influence an option's price.
Si1npl:· put, this means that one can design an option position in which he can profit, no
matter which way the underlying security moves.
~lost option strategies fall into one of two categories: as a hedge to a stock or futures
stratt>g_\·(for example, bu:·ing puts to protect a portfolio of stocks), or as a profit venture
1111toitself. Tilt' latter category is where most traders find themselves, and thev often
approach it in a fairly speculative manner-either by buying options or by being a pre-
800
Chapter
40:Advanced
Concepts 801
mium seller (covered or tmcm·ered). In such strategies, the tra<ler is taking a view of the
market; he needs certain price action from the underlying security in order to profit. Even
covered call writing, which is considered to be a conservative strategy, is subject to large
losses if the underlying stock drops drastically.
It doesn't have to be that way. Strategies can be devised that will have a chance to
profit regardless of price changes in the underlying stock, as well as heca11seof them. Such
strategies are neutral strategies and they always require at least two options in the
position-a spread, straddle, or some other combination. Often, when one constructs a
neutral strategy, he is neutral with respect to price changes in the underlying security. It
is also possible, and often wise, to be neutral with respect to the rate of price change of
the underlying security, with respect to the i:,olatility of the security, or with respect to
time decay. This is not to imply that any option spread that is neutral will automatically
be a moneymaker; rather, one looks for an opportunity-perhaps an overpriced series of
options-and attempts to capture that overpricing by constructing a neutral strategy
around it. Then, regardless of the movement of the underlying stock, the strategist has a
chance of making money if the overpricing disappears.
Note that the neutral approach is distinctly different from the speculator's, who, upon
determining that he has discovered an underpriced call, would merely buy the call, hoping
for the stock to increase in price. He would not make money if XYZ fell in price unless
there was a huge expansion in implie<l volatility-not something to count on. The next sec-
tion of this chapter deals with how one determines his neutrality. In effect, if he is not
neutral, then he has risk of some sort. The following sections outline various measures of
risk that the strategist can use to establish a new position or manage an existing one.
The most important of these risk measurements is how much market exposure the
position currently has. This has previously been described as the "delta." Of nearly equal
importance to the strategist is how much the option strategy will change with respect to
the rate of change in the price of the underlying security. Also of interest are how changes
in volatility, in time remaining until expiration, or even in the risk-free interest rate will
affect the position. Once the components of the option position are defined, the strategist
can then take action to reduce the risk associated with any of the factors, should he so
desire.
THE " GREEKS"
Risk measurements have generally been given the names of actual or contrived Greek
letters. For example, "delta" was discussed in previous chapters. It has bt>come corn111011
practice to refer to the exposure of an option position nwrely hy describing it in tt>nns of
andTrading
Volatility
this "Greek" nomenclature. For example, "delta long 200 shares" means that the entire
option position behaves as if the strategist were merely long 200 shares of the underlying
stock. In all, there are six components, but only four are heavily used.
The first risk measurement that concerns the option strategist is how much current expo-
surC' his option position has as the underlying security moues. This is called the "delta."
In fact, the term delta is commonly used in at least two different contexts: to express the
amount by which an option changes for a 1-point move in the underlying security, or to
describe the equivalent stock position of an entire option portfolio.
Reviewing the definition of the delta of an individual option (first described in Chap-
ter :3), recall that the delta is a number that ranges between 0.0 and 1.0 for calls, and
between -1.0 and 0.0 for puts. It is the amount by which the option will move if the
underl ying stock moves 1 point; stated another way, it is the percentage of any stock price
change that will be reflected in the change of price of the option.
Example: Assume an XYZ January .50 call has a delta of 0.,50 with XYZ at a price of 49.
This means that the call will move .50% as fast as the stock will move. So, if XYZ jumps
to ,51,a gain of 2 points, then the January .50 call can be expected to increase in price by
1 point (50% of the stock increase).
In another context, the delta of a call is often thought of as the probability of the
call being in-the-money at expiration. That is, if XYZ is 50 and the January ,55 call has a
delta of 0.40, then there is a 40% probability that XYZ will be over 5,5 at January
expiration.
Put deltas are expressed as negative numbers to indicate that put prices move in the
opposite direction from the underlying security. Recall that deltas of out-of-the-money
options are smaller numbers, tending toward O as the option becomes very far
out-of-the-money. Conversely, deeply in-the-money calls have deltas approaching 1.0,
while deeply in-the-money puts have deltas approaching -1.0. Note: Mathematically, the
delta of an option is the partial derivative of the Black-Scholes equation (or whatever
formula one is using) with respect to stock price. Graphically, it is the slope of a line that
is tangent to the option pricing curve.
Let us 110w take a look at how both volatility and time affect the delta of a call option.
~Iuch of the data to he presPntecl in this chapter will be in both tabular and graphical
form, since some readers prefer one style or the other.
The rnlatility of the underlying stock has an effect 011 delta. If the stock is not vola-
tile. tlwn in-the-nHme:-,·options hm·e a higher delta, and out-of-the-money options have a
Chapter
40:Advanced
Concepts 803
lower delta. Figure 40-1 and Table 40-1 depict the deltas of various calls on two stocks
with differing volatilities. The deltas are shown for various strike prices, with the time
remaining to expiration equal to 3 months and the underlying stock at a price of ,50 in all
cases. Note that the graph confirms the fact that a low-volatility stock's in-the-money
FIGURE 40-1.
Delta comparison, with XYZ = 50.
100
75
.lB
a5 50
0 ''
''
''
Low-Volatility Stock
' ' ',
25 ' ',,, High-Volatility Stock
',
',,
.............
.........
oLL ________ L_ _______ ...::::t:==--...1--
40 45 50 55 60 65
Strike Price
TABLE40-1.
Delta comparison for different volatilities with XYZ = 50 and
time = 3 months.
Delta
Strike
Price Low-Volatility
Stock Hi9h-Volatility
Stock
40 100 94
45 93 78
50 51 53
55 11 29
60 l 13
65 0 5
804 PartVI:Measuring andTrading
Volatility
options have the higher delta. The opposite holds true for out-of-the-money options: The
high-volatility stock's options have the higher delta in that case. Another way to view this
data is that a higher-volatility stock's options will always have more time value premi u m
than the low-volatility stock's. In-the-money, these options with more time value wi ll not
track the underlying stoek price movement as closely as ones with little or no time value.
Thus, in-the-money, the low-volatility stock's options have the higher delta, since they
track the underlying stoek price movements more closely. Out-of-the-money, the entire
priee of the option is composed of time value premium. The ones with higher time value
(the ones on the high-volatility stock) will move more since they have a higher price. Thus,
out-of-the-money, the higher-volatility stock's options have the greater delta.
Time also affects delta. Figures 40-2 (see Table 40-2) and 40-4 show the relation-
ships between time and delta. Figure 40-2's scales are similar to those in Figure 40 -2,
delta vs. rnlatility: The deltas are shown for various striking prices, with XYZ assumed to
be equal to .SOin all cases. Notice that in-the-money, the shorter-term options have the
higher delta. Again, this is because tlwy have the least time value premium.
Out-of-the-money, the opposite is true: The longer-term options have t he h igher deltas,
since these options have the most time value premium.
Figure 40-:3 (see Table 40-3) depicts the delta for an XYZ January .SOcall with XYZ
equal to ,50. The horizontal a:,.,:isin this graph is "weeks until expiration." Note that the
delta of a longer-term at-the-money option is larger than that of a shorter -term option. In
fact, the delta shrinks more rapidly as expiration draws nearer. Thus, even if a stock
remains unehanged and its volatility is constant, the delta of its options will be alte red as
time passes. This is an important point to note for the strategist, since he is constantly
monitoring the risk characteristics of his position. He cannot assume that his position is
the same just because the stock has remained at the same price for a period of time.
Pos ition Delta. Another usage of the term delta is what has previously been referred
to as the equivalent stock position (ESP); for futures options, it would be referred to as
EFP (equivalent futures position). To differentiate between the two terms, the de lta of
the option is generally r<?ferred to as "option delta," while the ESP or EFP is called "posi-
tion delta." Recall that the position delta is computed aceording to the following simp le
equation:
Position delta= Option's delta X Shares per option X Option quantity
For futures options, the term "shares per option'' would be replaced by "shares per
contract" which is always 1. This is the risk measurement of how much market exposure
the options position has. Whether called position delta, ESP, or EFP, one uses the deltas
of tlH' indi\·idual options in his portfolio to calculate the overall exposure. By summing
Chapter
40:Advanced
Concepts 805
FIGURE 40-2.
Delta comparison, with XYZ = 50.
100
75
$
ai 50
0
25
.................t = 6 months
0
40 45 50 55 60 65
Strike Price
TABLE40-2.
Delta comparison-varying time remaining with XYZ = 50.
Delta
Strike
Price t = 1year t =6 months t =3 months
40 92 97 99
45 79 83 90
50 61 57 55
55 41 30 18
60 25 12 3
65 14 4 0
the calculations for each item in a position, or even in an entire option portfolio, one can
approximate how much market exposure the entire option position has. The next example,
reprinted from the chapter on mathematical applications, shows how one computes tht>
net expo sur e of a complicated position .
andTrading
Volatility
FIGURE 40-3.
Delta as a function of time.
2 4 6 8 10 12 14 16 18 20
Weeks Remaining
TABLE40-3.
Delta as a function of time.
Weeks
Remaining Delta
20 .566
18 .562
15 .557
13 .553
10 .547
8 .543
6 .538
4 .531
2 .521
.515
Example: The following position exists when XYZ is at :31.7,5.It resembles a long straddle
(or hackspread), in that there is increased profit potential in either direction if the stock
n1m·es far enough hv expiration. Many market-makers and professional traders attempt to
strncture these (q)es of positions, if possible, in order to take advantage of the sudden
volatility that is inherent in today's markets.
Chapter
40:Advanced
Concepts 807
Position
Position Delta Delta
Short 4,500 XYZ 1.00 - 4,500
Short l 00 XYZ April 25 calls 0.89 - 8,900
Long 50 XYZ April 30 calls 0.76 + 3,800
Long 139 XYZ July 30 calls 0.74 +10,286
Total ESP: + 686
This position, though complicated to the naked eye, reduces to being long only
approximately 700 shares of XYZ. This is commonly referred to as being "delta long 700
shares." Thus, the terms "delta," when referring to the sum of the deltas of a whole posi-
tion , and "equivalent stock position" are synonymous.
This position has some exposure to the market since it is delta long. If the position
delta were zero, it would be referred to as being delta neutral and would, theoretically,
have no exposure to the market at that time .
Note that one can derive some general characteristics of his delta by just examining
his portfolio by eye: Short calls or long puts will introduce negative delta into the position;
long calls or short puts will introduce positive delta. Furthermore, it is obvious that being
long the underlying security adds to the long delta of the position, while being short
the underlying security places more negative delta in the position. The use of this infor-
mation to adjust the delta of one's position will be discussed in a later section of this
chapter .
Obviously, the delta of this entire position will change as the stock price moves up
or clown as time passes. The figure given is merely an instantaneous look at how the posi-
tion is structured. It is the need to know how the position will change when other factors
change that has led strategists to employ the following concepts.
GAMMA
Simply stated, the gamma is how fast the delta changes with respect to changes in the
underlying stock price. It is known that the delta of a call increases as the call moves from
out-of-the-money to in-the-money. The gamma is merely a precise measurement of how
fast the delta is increasing.
Example: With XYZ at 49, assume the January ,50 call has a delta of 0.50 and a gamma
of 0.0.5. If XYZ moves up one point to .50, the delta of the call will increase by the amount
of the gamma: It will increase from 0.50 to 0.55.
andTrading
Volatility
As with the delta, the gamma can also be expressed as a percentage. But in this case,
th e increase or decr ease appli es to the delta .
Example: Again, with XYZ at 49, assume the January ,50 call has a delta of 0.,50 and a
gamma of 0.05. If XYZ moves up 2 points to 51, the delta of the call will increase by 5%
of the stock 11wce, because the gamma is 0.0,5, or 5 percent. Five percent of the stock
111ou' is 0.0,5x 2, or 0.10. Thus, the delta will increase by 0.10, from 0.50 to 0.60.
Ob\·iousl::, the delta cannot keep increasing by 0.0,5 each time XYZ gains another
point in price , for it will e\·entually exceed 1.00 by that calculation, and it is known that
the delta has a maximum of 1.00. Thus, it is obvious that the gamma changes. In general,
tlic gmmna is at its 111m.:i11111m JJOint1chen the stock is near the strike of the option. As the
stock moves away from the strike in either direction, the gamma decreases, approaching
its min imum value of zero .
Conceptually , this means that a deeply in-the-money or deeply out-of-the-money
option has a gr111111w of nearly zero. This makes sense-it implies that the delta of a deep
in- or deep out-of-the-!lloney option does not change very much at all, even if the stock
moves by one point.
Example: Assullle XYZ is 2,5, and the January ,50 call has a delta of virtually zero. If XYZ
moves up one point to 26, the call is still so far out-of-the-money that the delta will still
be zero. Thus, the ga!llma of this call is zero, since the delta does not change when the
stock increases in pri ce by a poi nt.
In a silllilar manner, the January 45 put on XYZ would have a delta of -1.0 with XYZ
at 2.5. If XYZ moved up one point to 26, the pufs delta would not change; it is still so far
in-the-mone_,: that it would still be -1.0. Thus, the gamma of this deeply in-the-money
option is also zero, since the delta remains unchanged in the face of a I-point rise in the
un de rlying security.
Note that the gamma of any option is expressed as a positive number, whether the
opt ion is a put or a call.
Other properties of gamma are useful to know as well. As expiration nears, the
gamma of at-the-money options increases dramatically. Consider an option with a day or
two oflife re1naining. If it is at-the-rnmH:>
:·, the delta is approximately 0..50. However, if the
stock were to rnm·e 2 points higher, the delta of the option would jump to nearly 1.00
because of tlie short time remaining until expiration. Thus, the gamma would be roughly
0.2,5 (the delta increased b:' 0.,50when the stock moved 2 points), as compared to much
smaller \·c.dnesof ga111111a for at-the-money options with several weeks or months of life
Chapter
40:Advanced
Concepts 809
remainin g. The same 2-point rise in the underlying stock would not result in much of an
increase in the delta of longer-term options at all.
Out-of-the-money options display a different relationship between gamma and time
remaining. An out-of~the-moncy option that is about to expire has a very small delta, and
hence a very small gamma. However, if the out-of-the-money option has a significant
amount of time remaining, then it will have a larger gamma than the option that is close
to expiration.
Figure 40-""1(see Table 40-4) depicts the gammas of three options \Vith varying
amounts of time remaining until expiration. The properties regarding the relationship of
gamma and time can he observed here. Notice that the short-term options have very low
gammas deeply in- or out-of the-money, but have the highest gamma at-the-money (at .50).
Conversely, the longest-term, one-year option has the highest gamma of the three time
periods for deeply in- or out-of-the-money options. The data is presented in Table 40-4.
This table contains a slight amount of additional data: the gamma for the at-the-money
option at even shorter periods of time remaining until e:,,:piration.Notice how the gamma
explodes as time decreases, for the at-the-money option. With only one week remaining,
the gamma is over 0.28, meaning that the delta of such a call would, for example, jump
from 0.50 to 0.78 if the stock merely moved up from 50 to 51.
Gamma is dependent on the volatility of the underlying security as well. At-the-money
options on less volatile securities will have higher gammas than similar options on more
volatile securities. The following example demonstrates this fact.
Example: Assume XYZ is at 49, as is ABC. Moreover, XYZ is a more volatile stock (30%
implied) as compared to ABC (20%). Then, similar options on the two stocks would have
significantly different gammas.
XYZGammas ABCGammas
Option (Volatility
= 30%) (Volatility
= 20%)
January 50 .066 .097
January 55 .045 .039
January 60 .019 .0053
February 50 .055 .081
February 60 .024 .011
Note that the at-the-money options (January ,SO'sand Felmrnry .SO's)on ABC, the
less volatile stock, have larger gammas than do their XYZ counterparts. However, look
one strike higher (January 5.5's), and notice that the mort' volatilt> options have a slightly
andTrading
Volatility
FIGURE 40-4.
Gamma comparison, with XYZ = 50.
8
7
0 6
0
T"""
X 5
co
E 4
E
co 3
C)
2 t = 1 year
t= 6 months
L......L...------'--------'-------'----~--____. 1_t_
=_3 months
0
40 45 50 55 60 65
Strike Price
TABLE40-4.
Gamma comparison-various amounts of time remaining
{with XYZ = 50).
TimeRemaining StrikePrice
40 45 50 55 60 65
l year .015 .029 .039 .04 .033 .023
6 months .011 .037 .058 .051 .030 .013
3 months .003 .039 .086 .057 .015 .002
2 months .108
l month .166
l week .288
higher gamma. Look two strikes higher and the more volatile options have a vastly higher
gamma, both for the January 60's and the February 60's.
This concept makes sense if one thinks about the relationship between volatility and
dl'lta. On nonrnlatile stocks, one finds that the delta of even a slightly in-the-money option
increases rapid!:•;.This is because, since the stock is not volatile, buyers are not willing to
Chapter
40:Advanced
Concepts 811
pay much time premium for the option. As a result, the gamma is high as well, because as
the stock moves into-the-money , the increase in delta will be more dramatic than it would
be for a volatile stock. Out-of-the-money options are an entirely different story. Since the
nonvolatile stock will have difficulty moving fast enough to reach an out-of-the-money
striking price, the delta of the out-of-the-money option is small and it will not change
quickl y (that is, th e gamma is small also).
These concepts are summarized in Figure 40-5 (see Table 40-5), which depicts the
gammas for similar options on stocks with differing volatilities. For the purposes of these
graphs, XYZ is equal to 50 and there are three months remaining until expiration.
Notice that for a \'ery volatile stock, the gamma is quite stable over nearly all striking
prices when there are 3 months remaining until expiration. This means that the deltas of
all options on such a volatile stock will be changing quite a bit for even a 1-point move in
the underlying stock. This is an important point for neutral strategists to note , because a
position that starts out as delta neutral may quickly change if the underlying stock is very
volatile. As this table implies, the deltas of the options in that "neutral" spread may be
altered quickly, thereby rendering the spread quite unneutral. This concept will be dis-
cus sed in greater detail later in thi s chapt er.
As delta was used to construct the equivalent stock position of an entire option posi-
tion or portfolio, gamma can be used in a similar manner. An example of this follows,
using the same securities from the preceding example on the delta of a position. An
important point to note is that the gamma of the underlying security itself is zero. This is
FIGURE 40-5.
Gamma comparison, with XYZ = 50, t = three months.
7
Low Volatility
0 6
0
X 5
ctS
E 4
E
ctS
0 3
2
Very High Volatility
0
40 45 50 55 60 65
Strike Price
andTrading
Volatility
TABLE40-5.
Gamma comparison for varying volatilities (XYZ = SO, t = 3 months).
Gamma Very
Strike Low
Volatility High
Volatility High
Volatility
40 .003 .013 .017
45 .039 .039 .022
50 .086 .057 .024
55 .057 .049 .025
60 .015 .028 .023
65 .002 .012 .020
true because the delta of the underlying security (which is always 1.0) never changes-
hence tht> gamma is zero. The gamma is measuring the amount of change of the delta; if
the delta of the underlying security never changes, the gamma of the underlying security
must be zero.
Example: The following position exists when XYZ is at 31.7.5.Recall that it resembles a
long straddle (or backspread) in that there is increased profit potential in either direction
if the stock moves far Pnough by expiration. In addition to the delta previously listed, the
gamma is now shown as well. Note that since gamma is a small absolute number, it is
sometimes calculat ed out to three or four decimal places.
Option Position Option Position

Position Delta Delta Gamma Gamma
Short 4,500 XYZ 1.00 -4,500 0.0000 0
Short l 00 XYZ April 25 calls 0.89 - 8,900 0.0100 -100
Long 50 XYZ April 30 calls 0.76 + 3,800 0.0300 +150
Long 139 XYZ July 30 calls 0.74 +10,286 0.0200 +278
--
Totals: + 686 +328
As hefort>, the position still has a delta long of almost 700 shares. In addition, one
can now set' that it has a positive gamma of over 300 shares. This means that the delta
can be expected to changt> b~,328 shares for each point that XYZ moves: If it moves up l
point tlw dt>lta will increase to + 1,014 (tlw current delta, 686, plus the gamma of :328).
Howe\-eL iL\.YZ 1non·s down by l point, then the delta will decrease to +3.58 (the current
delta, 686, less the gamma of 328).
Chapter
40:Advanced
Concepts 813
* * *
Note that, in the abm·e example, if XYZ continues higher, the gamma will remain
positi\·e (although it will eventually shrink some), and the delta will continue to increase.
This means the position is getting longer and longer-a fact that makes sense when one
notes that there are extra long calls and they would be getting deeper in-the-money as the
stock mm·es up. Conversely, if XYZ continues to move lower, the delta will continue to
decrease ancl will quickly become negative, meaning that the position would become
short overall. Hence, the position does indeed resemble a long straddle: It gets longer as
the market moves up and it gets shorter as the market moves down.
Long options, n:hetlicr puts or calls, hace positiue gamma, ichile sliort options have
negatice gamma. Thus, a strategist with a position that has positive gamma has a net long
option position and is generally hoping for large market movements. Conversely, if one has
a position with negative gamma, it means he has shorted options and wants the market to
remain fairly stable .
Note that it is possible to be delta neutral, but to have a significant gamma. (For example,
if one owns puts and calls with offaetting deltas, he would he delta neutral, but would have
positive gamma since both options are long.) If one is delta neutral, he knows he has no market
exposure at this time, but his gamma will show him what exposure his position will acquire as
the market moves. These concepts will be discussed in greater detail later in this chapter.
VEGA OR TAU
There is no letter in the Greek alphabet called "vega." Thus, some strategists, being pur-
ists, prefer to use a real Greek letter, "tau," to refer to this risk measurement. The term
"vega" will be used in this book, but the reader should note that "tau" means the same
thing. Vega is the amount by ichich the optio11 price cha11ges ichen the colatility changes.
Vega is always expressed as a positive number, whether it refers to a put or a call.
It is known that more volatile stocks have more expensive options. Thus, as volatility
increases, the price of an option will rise. If volatility falls, the price of the option will fall
as well. The vega is merely an attempt to quantify how much the option price will increase
or decrease as the volatility moves , all other factors being equal.
Before considering an example, a review of the term volatility is in order. Volatility is a
measure of how quickly the underlying security moves around. Statistically, it is usually cal-
culated as the standard deviation of stock prices over some period of time, generally annual-
ized. This statistical measure is expressed as a percent, although relating that percent to
actual stock movements can be complicated. Suffice it to say that a stock that has a ,50% vola-
tility is more volatile than a stock with .'30%volatility. The stock market generally has a volatil-
ity of about 1.5%overall, although that may change from time to time (crashes, for example).
andTrading
Volatility
Example: Again, assume XYZ is at 49, and the January 50 call is selling for 3.50. The vega
of the option is 0.25, and the current volatility of XYZis 30%.
If the volatility increases by one percentage point or 1% to 31%, then the vega indi-
cates that the option will increase in value by 0.25, to 3.75.
If the volatility had instead decreased by 1 percent to 29%, then the January 50 call
would have decreased to 3.25 (a loss of 0.25, the amount of the vega).
If the implied volatility of an option increases, the option price will increase as well.
Consequently, even though XYZ stock may be exhibiting the same historic movement that
it always has, and therefore its (historical) volatility would be unchanged, if option buyers
appear in sufficient quantity, they may drive the implied volatility ofXYZ's options higher.
Likewise, an excess of option sellers could drive the implied volatility lower, even though
the historical volatility does not change. So, it must be concluded that vega measures how
much the option price changes as implied volatility changes.
Vega is related to time. Figure 40-6 (see Table 40-6) shows the vegas for options with
differing times remaining until expiration. The underlying stock is assumed to be 50 in
all cases. Notice that the more time that remains, the higher the vega is. It is interesting
to note that, for very long-term options, the vega of the slightly out-of-the-money calls
(strike= 55) is actually higher than that of the at-the-money. However, this discrepancy
disappears as time passes. Not shown, but equally true, is that the vega of a slightly
out-of-the-money option on a very volatile stock may be higher than that of the
at-the-money.
As with the measurements of risk discussed already, vega can refer to the option
itself ("option vega") or to the position as a whole ("position vega"). Since vega is expressed
as a positive number, if one is long options, then his position vega will be positive. This
means he has exposure if volatilities decrease, or can make money if volatilities increase.
Example: Again, assume that we have the same backspread position as before, with XYZ
at 31.75.
Option Position
Position Vega Vega
Short 4,500 XYZ 0.00 0
Short l 00 XYZ April 25 calls 0.02 - 200
Long50 XYZ April 30 calls 0.05 + 250
Long 139 XYZJuly 30 calls 0.07 + 973
Total Vega: +l,023
Chapt
er 40: Advanc
ed Concepts 8 15
FIGURE 40 -6 .
Vega compariso n, XY Z = SO.
20
18
16
14
0
0 12
?""
X
10
cu
Cl
~ 8
6
t = 3 months
4
2
45 50 55 60 65
Strike Price
TABLE40 -6.
Vega comparison for different time per iods (w ith XYZ = 50 ).
Vega
Strik
e Price t = 1Year t = 6 Months t = 3 Months
40 0.12 0.06 0.02
45 0.16 0.11 0.06
50 0.19 0.13 0.09
55 0.20 0.13 0.08
60 0.18 0.11 0.05
65 0.16 0.07 0.02
The vega is a positive 10.23 points ($1,023 since each point for these equity options
is worth $100). The fact that the position has a positive vega means that it is exposed to
variations in volatility. If volatility decreases, the position will lose money: $1,023 for each
one percentage point decrease in volatility. However, if volatility increases, the position
will benefit.
andTrading
Volatility
* * *
Vega is greatest for at-the-money options and approaches zero as the option is deeply
in- or out-of-the-money. Again, this is common sense, since a deep in- or out-of-the-money
option will not be affected much by a change in volatility. In addition, for at-the-money
options, longer-term options have a higher vega than short-term options. To verify this,
think of it in the extn"'me: An at-the-money option with one day to expiration will not be
overly affected by any change in volatility, due to its pending expiration. However, a
three-month at-the-money option will certainly be sensitive to changes in volatility.
Vega does not directly correlate with either delta or gamma. One could have a posi-
tion with no delta and no gamma (delta neutral and gamma neutral) and still have expo-
sure to volatility. This does not mean that such a position would be undesirable; it merely
means that if one had such a position, he would have removed most of the market risk
from his position and would be concerned only with volatility risk.
In later sections, the use of volatility to establish positions and the use of vega to
monitor them will be discussed.
THETA
Theta measures the time decay of a position. All option traders know that time is the
enemy of the option holder, and it is the friend of the option writer. Theta is the name
gi\·en to the risk measurement of time in one's position. Theta is generally expressed as a
negative number, and it is expressed as the amount by which the option value will change.
Thus, if an option has a theta of -0.12, that means the option will lose 12 cents, or about
an eighth of a point, per day. This is true for both puts and calls, although the theta of a
put and a call with the same strike and expiration date are not equal to each other.
Very long-term options are not subject to much time decay in one clay's time. Thus,
the theta of a long-term option is nearly zero. On the other hand, short-term options,
especially at-the-money ones, have the largest absolute theta, since they are subject to the
ravages of time on a daily basis. The theta of options on a highly volatile stock will be
higher than the theta of options on a low-volatility stock. Obviously , the former options
are more expensive (have more time value) and therefore have more time value to lose on
a daily basis, thereby implying that they have a higher theta. Finally, the decay is not
linear-an option will lose a greater percent of its daily value near the end of its life.
Figure 40-7 (see Table 40-7) depicts the relationships of thetas for various striking
prices and for differing volatilities on options with three months of life remaining. Again,
notice that for very volatile stocks, the out-of-the-money options have thetas as large as
tl1t>at-the-rnone:·s. This is saying that as each day passes, the probability of the stock
Chapter
40:Advanced
Concepts 817
FIGURE 40-7 .
Theta comparison, with XYZ = SO, t = three months.
-16
Very High Volatility
-14
0
-1 2
0
Cll
-10
~
~
Low Volatility
-8
-6
0
40 45 50 55 60 65
Strike Price
TABLE 40-7.
Theta comparison for differing volatilities (XYZ = SO, t = 3 months).
Strike lowVolatility Medium
Volatility High
Volatility
40 -0.005 -0.008 -0.013
45 -0.007 -0.010 -0.014
50 -0.008 -0.010 -0.015
55 -0.007 -0.010 -0.016
60 -0.006 -0.009 -0.016
65 -0.004 -0.008 -0.015
reaching that out-of-the-money strike drops and causes the option to lose value. This does
not change the fact that, for very short-term options, the theta is largest at-the-money.
Normally, the theta of an individual option is of little interest to the strategist. He
generally would be more concerned with delta or garnma. However, as with the other risk
measures, theta can be computed for an entire portfolio of options. This measure, the
"position theta," can he quite important because it gives the strategist a good idea of how
andTrading
Volatility
much gain or loss he can expect on a daily basis, due to time erosion. The following
example demonstrates this point. Note that the underlying security itself has a theta of
zero, since it cannot lose any value due to time decay.
Example : With XYZ at 49, the strategist has the following position in February, so that
the April calls are nearer to expirat ion than the July calls. Th is position is similar to a large
calendar spread position.
Option Positi
on
Positi
on Theta Theta
Short4,000 XYZ 0.00 0
Short 150 XYZApril 50 calls -0.04 +600
Long 150 XYZApril 30 calls -0.02 -300
Short 78 XYZJuly 30 puts -0.02 +156
TotalTheta: +456
This position is expected to make $4.56 per day due to time decay. Note that short
optio ns, whether puts or calls, have a positice position theta, while long options have a
negative position theta. A negative position theta means the position has risk due to time,
while a positive position theta means time is working for the position.
Rho is the name given to the price change of an option'.c.;value due to a change in interest
rates. Recall that one of the components that contributes to an option's price is interest
rates. As interest rates rise, call prices will rise, but put prices will fall. The opposite is
true as well: As interest rates fall, call prices decline and put prices rise. Rho measures
the amount by which these prices rise or fall.
This behavior of puts and calls with respect to interest rates may not be immediately
obvious, but recall that the arbitrage that can be established with in-the-money calls (the
"interest play," discussed in Chapter 27 on arbitrage) demonstrates that arbitrageurs are
·willing to pay more for an in-the-money call as interest rates rise because they will be
earning more interest on the stock that they sell short against that in-the-money call.
Thu s, rising interest rates cause call prices to increase .
The opposite is true for puts: Rising interest rates cause put prices to decline. Again,
an arbitrage can be used to demonstrate the point. Recall that in a reversal arbitrage, the
arbitrageur is selling the stock and the put while buying the call. We have just demon-
strated that, as interest rates rise, he is willing to pay more for the call since he can earn
Chapter
40:Advanced
Concepts 819
extra interest on the short sale of his stock. This automatically means that he will be will-
ing to sell the put for less.
Rho is expressed as a positive number for calls and a negative one for puts. Rho is
smallest for deeply out-of-tlze-111oney options and is large for deeply in-the-money
options. It is larger for longer-term options and is nearly :::.ero
for fiery short-term options.
The following table of option prices may help to demonstrate these relationships:
Example: With XYZ at 49, the following options have the rho indicated (January is the
near -ter m expirati on):
Month/Strike Coll
Rho PutRho
January 35 0 .05 - 0.01
January 50 0.03 -0.03
January 60 0.00 -0.05
July 35 0 .18 - 0.02

July 50 0 .14 -0 .15
July 60 0.07 -0.18
Note that the in-the-money calls (3,5strike) have larger rho than the out-of-the-money
60's, in both January and July. Similarly, the in-the-money puts (the 60's) have larger rho
on an absolute basis than the out-of-the-money 35's. Again, this is true for both January
and July.
Furthermore, note that the longer-term July rhos are all larger (again as absolute
numbers ) than their shorter-term January counterpa rts .
Rho can also be calculated for an entire portfolio to obtain a "position rho," similar
to previous examples. Generally, one would not be overly concerned with his position rho
unless his portfolio contained quite a few long-term options and/or deeply in-the-money
ones. Thus, rho is more important as a consideration when one is trading LEAPS or war-
rants, both of which may be extremely long-term vehicles. Of the risk measures discussed
so far, rho is the least used, since many traders tend to have relatively short-term options
in their positions .
THE GAMM A OF THE GAMMA
Occasionally, one may hear reference to the "six measures of risk." This is the sixth one
an<l it is the most arcane. At any point, one knows the delta and gamma of an option. As
andTrading
Volatility
the stock moves, the delta changes (by the amount of the gamma), but so does the gamma.
Some traders are interested in knowing how much the gamma will change when the stock
moves. Hence, they will compute the gamma of the gamma, which is the amount by
ichich the grmzma n:ill change when the stock price changes. This concept will be dis-
cussed at tht> end of this chapter. It is most important for strategists involved in positions
on highly volatile stocks, for if the stock moves far enough, the gamma (and therefore the
delta) may change dramatically. Thus, one might want to know how this risk measure
affects his profitability .
:SUMMARY
Delta: Positi\ e delta indicates that a position is currently bullish; if the underlying
security goes up in price, the position should make money. A negative delta
indicates a bearish slant.
Gamma: Positi\·e gamma means that the delta will increase if the underlying security
rises in price. Positive gamma generally implies that there is a preponderance
of long options in the position, either puts or calls; negative gamma indicates
written or naked options in the position.
Theta: Negative theta means that the position will lose money as time passes (typi-
cal of positions with long options); positive theta implies that time is working
for the position (positions with written options).
Vega: Positive vega means that an increase of (perceived) volatility will benefit the
position-usually true of positions with long options in them; negative vega
means that a decrease of volatility would be beneficial.
STRATEGY CONSIDERATIONS: USING THE "GREEKS"
Before looking at how one operates a particular strategy using delta, gamma, etc., it might be
beneficial to see how these factors relate to the individual strategies that have been described
throughout this hook. Table 40-8 is a general guide to how the various strategies are exposed
to \·arious market factors. It is not an all-purpose or specific table, because as the stock moves
higher or lower, some of the risk measurement factors will certainly he affected.
A ft>wassumptions wt>re made in constructing the table. First, it was assumed that
the strategit>s where dt>lta is noted as being zero are established in a neutral stance. The
hull spread and hear sprt>acl strategies assumed that the stock was midway between
th e striking price s. Two other spread strategies-ratio call and ratio put-assumed the
stock was at the striking price of the option that was sold. In all other cases, there is only
rnw striking prict> irn·oh·ecL and it was assumed that the stock was at the strike.
Chapter
40:Advanced
Concepts 821
TABLE40-8 .
General risk exposure of common strategies.
Strategy Delta Gamma Theta Vega Rho
Buy stock + 0 0 0 0
Sell stock short 0 0 0 0
Call buy + + + +
Put buy + +
Straddle buy 0 + + +
Covered write + +
Naked call sale +
Naked put sale + + +
Ratio write (straddle sale) 0 +
Calendar spread 0 + +
Bull spread + +
Bear spread +
Ratio call spread 0 +
Ratio put spread 0 + +
The table may help to clarify some of the concepts concerning the risk measurement
factors. First, notice that stock or futures-or any underlying security-have only delta.
None of the other factors pertains to the underlying security itself.
As might he expected, spread strategies involving both long and short options are
less easily quantified than outright buys or sells. The calendar spread strategy is one in
which the spreader does not want a lot of stock movement-he would prefer the underly-
ing security to remain near the striking price, for that is the area of maximum profit
potential. This is reflected by the fact that gamma is negative. Also, for calendar spreads,
the passage of time is good, a fact that is reflected by the fact that theta is positive. Finally,
since an increase in implied volatilities or interest rates would boost prices and widen the
spread (creating a profit), vega is positive and rho is negative .
A bull spread has positive delta, reflecting the bullish nature of the spread, but it has
negative gamma. The reason gamma is negative is that the position becomes less bullish
as the underlying security rises, since the profit potential, and hence the bullishness of
the position, is limited. For similar reasons, a bear spread has negative delta (reflecting
bearishness) and negative gamma (reflecting limited bearishness). Both the hull spread
and the hear spread are the same with respect to the other risk measurements: Theta is
negative, reflecting the fact that timt' decay can hurt the spread. Less obvious is tlw fact
822 Part VI:Measuring and TradingVolatility
that these spreads are hurt by an increase in perceived volatility; a negative vega tells us
this is true , however.
These risk measurement tools are important in that they can quite graphically depict
the risk and reward characteristics of an option position or option portfolio. They are useful
in establishing a new position, because one can see how much exposure he is taking on. In
addition, they are extremely useful for follow-up action, since one can see how his position's
characteristics have developed in the current marketplace at the present time. In the fol-
lowing sections, the use of the risk measurement tools as aids in establishing a position or
in following up on a position will be discussed in detail.
DELTANEUTRAL
One popular type of neutral position is to be delta neutral-that is, to have the equivalent
stock position (ESP) or equivalent futures position (EFP) be zero. A delta neutral position
is one in u;hich the sum of the projected price changes of the long options in the spread is
essentially off;et by the projected price cha11gesof the short options in the same spread.
Example: XYZ is trading at 50. The following three options are trading with the prices
and deltas indicated. Furthermore, the "theoretical value" of each option is shown:
XYZ: 50
"Theoretical
Option Price Delta Value"
January 50 call 3.00 0.55 3.50
January 55 call 1.50 0.35 1.48
February 50 put 3.50 -0.40 3.44
Assuming that one can rely upon these "theoretical values" (a big assumption, by the
way), it is obvious that the January 50 call is cheap with respect to the other options: They
are close to their values, while the January 50 is 50 cents under. The neutral strategist
would want to buy the January 50 call and hedge his purchase with one of the other two
options presented. One choice would be to establish a spread wherein the January .50calls
are bought and a number of January ,5,S'sare sold. To determine how many are to be
bought and sold, one merely has to divide the deltas of the two options:
Delta neutral spread ratio= 0.55/0 .35 = 11-to-7
Thus, a delta neutral ratio spread would consist of buying 7 January .S0'sand selling
11 January 5.S's.To verify that this spread is neutral with respect to the change in price of
Chapter
40:Advanced
Concepts 823
XYZ, notice that if XYZ moves up in price 1 point , the January ,50 will increase in price
by 0.55; so seven of them will increase by 7 X 0.55, or 3.85 points total. Similarly, the
January 55 will increase in price by 0.35, so eleven of them would increase in price by
11 X 0.35, or 3.85 points total. Hence, the long side of the spread would profit by 3.85
point s, while th e short side loses 3.85 point s-a neutral situation .
The resulting position is a ratio spread. The profitability of the spread occurs between
about 51 and 62 at expiration as shown in Figure 40-8 , but that is not the major point. The
real attractiveness of the spread to the neutral trader is that if the underpriced nature of
the January 50 call (vis-a-vis the January 55 call) should disappear, the spread should
produce a profit, regardless of the short-term market movement ofXYZ. The spread could
then be closed if this should occur .
To illustrate this fact, suppose that XYZ actually falls to 49, but the January 50 call
return s to "fair value":
XYZ : 49
"Theoretical
Option Price Delta Value"
January50 call 3.00 0.52 3.00
January55 call 1.10 0.34 1.13
February50 put 3.90 - 0.42 3.84
Notice that the theoretical values in this table are equal to the theoretical values
from the previous table, less the amount of the delta. Since the XYZ January 50 call is no
longer underpriced, the position would be removed, and the strategist would make noth-
ing on his January 50's, but would make .40 on each of the eleven short January 55's, for
a profit of $440 less commissions.
This example leans heavily on the assumption that one is able to accurately estimate
the th eoretical value and delta of the options. In real life, this chore can be quite difficult,
since the estimate requires one to define the future volatility of the common stock. This
is not easy. However, for the purposes of a spread, the ratio of the two deltas is used.
Moreover, the example didn't require that one know the exact theoretical value of each
option; rather, the only knowledge that was required was that one of the options was
cheap with respect to the oth er option s.
As an alternative to a ratio spread, another type of delta neutral position could be estab-
lished from the previous data: Buy the January ,50call (this is the basis of the position since it
is supposedly the cheap option) and buy the February 50 put-the only other choice from the
andTrading
Volatility
FIGURE 40-8.
XYZ ratio spread.
3000
2000
CJ)
CJ)
..:l
~
1000
ea..
~
40 45 5 55 60
At Expiration
Stock Price
data given. This position is a long straddle of sorts. Recall that the delta of a put is negative; so
again, the delta neutral ratio can be calculated by dividing the absolute value of two deltas:
Delta neutral straddle ratio= 0.55/I- 0.401= 11-to-8
Thus, a delta neutral straddle position would consist of buying 8 January ,50calls and
buying 11 February ,50puts. The straddle has no market exposure, at least over the short
term. Note that the delta neutral straddle has a significantly different profit picture from
the delta neutral ratio spread, but they are both neutral and are both based on the fact
that the January 50 call is cheap. The straddle makes money if the stock moves a lot, while
the other makes money if the stock moves only a little. (See Figure 40-9.)
Can these two vastly different profit pictures be depicting strategies in which the same
thing is to be accomplished (that is, to capture the underpriced nature of the XYZ January
.50call)'?Yes. but in order to decide which strategy is "best," the strategist would have to take
other factors into consideration: the historical volatility of the underlying security, for exam-
ple. or how much actual time remains until January expiration, as well as his own psycho-
logical attitude toward selling uncovered calls. A more precise definition of the other risks
of thesP two positions can be obtained by looking at their position gammas.
Delta Neutral ls Not Entirely Neutral. In fact, delta neutral means that one is
neutral 011lfJu:ith respect to small price changes in the underlying security. A delta
nP11tralposition ma:· have seriously unneutral characteristics when some of the other risk
Chapter
40:Advanced
Concepts 825
FIGURE 40-9.
XYZ straddle buy.
8000
7000
6000
5000
4000
en
en
0
....J
3000
~
e 1000
c..
2000
Y}
0
- 1000
- 2000
- 3000 At January Expiration
Stock Price
measurements are considered. Consequently, one cannot blithely go around establishing

delta neutral positions and ignoring them, for they may have significant market risk as
certain factors change.
For example, it is obvious to the naked eye that the two positions described in the
previous section-the ratio spread and the long straddle-are not alike at all, but both
are delta neutral. If one incorporates the usage of some of the other risk measurements
into his position , he will be able to quantify the differences between "neutral" strategies.
The sale of a straddle will be used to examine how these various factors work.
Positions with naked options in them have negative position gamma. This means that
as the underlying security moves, the position will acquire traits opposite to that move-
ment: If the security rises, the position becomes short; if it falls, the position becomes
long. This description generally fits any position with naked options, such as a ratio spread,
a naked straddle, or a ratio write.
Example: XYZ is at 88. There are three months remaining until July expiration, and the vola-
tility of XYZ is 30%. Suppose 100 July 90 straddles are sold for 10 points-the put and the
call each selling for .5.Initially, this position is nearly delta neutral, as shown in Table 40-9.
However, since both options are sold, each sale places negative gamma in the position.
The usefuln ess of calculating gamma is shown by this example. Tlw initial position
andTrading
Volatility
TABLE 40-9.
Position delta and gamma of straddle sale. XYZ = 88.
Option Position Option Position
Position Delta Delta Gamma Gamma
Sell 100 July 90 calls 0.505 -5,050 0.03 -300
Sell 100 July 90 puts 0.495 +4,950 0.03 -300
--
Totalshares - 100 -600
is NET short only 100 shares of XYZ, a very small delta. In fact, a person who is a trader
of small amounts of stock might actually be induced into believing that he could sell these
100 straddles, because that is equivalent to being short merely 100 shares of the stock.
Calculating the gamma quickly dispels those notions. The gamma is large: 600
shares of negative gamma. Hence, if the stock moves only 2 points lower, this trader's
straddle position can be expected to behave as if it were now long 1,100 shares (the origi-
nal 100 shares short plus 1,200 that the gamma tells us we can expect to get long)! The
position might look like this after the stock drops 2 points:
XYZ: 86
Option Position
Sold 100 July 90 calls 0.44 -4,400
Sold 100 July 90 puts 0.55 +5,500
+1,100 shares
Hence, a 2-point drop in the stock means that the position is already acquiring a
"long" look. Further drops will cause the position to become even "longer." This is cer-
tainl y not a position-being short 100 straddles-for a small trader to be in, even though
it might have erroneously appeared that way when one observed only the delta of the
position. Paying attention to gamma more fully discloses the real risks.
In a similar manner, if the stock had risen 2 points to 90, the position would quickly
have become delta short. In fact, one could expect it to be short 1,300 shares in that case:
the original short 100 shares plus the 1,200 indicated by the negative gamma. A rise to
90, then , would make the position look like this:
Chapter
40:Advanced
Concepts 827
XYZ: 90
Option Position
Sold 100 July90 calls 0.56 -5,600
Sold 100 July90 puts 0.43 +4,300
-1,300 shares
These examples demonstrate how quickly a large position, such as being short 100
straddles, can acquire a large delta as the stock moves even a small distance. Extrapolating
the moves is not completely correct, because the gamma changes as the stock price
changes, but it can give the trader some feel for how much his delta will change.
It is often useful to calculate this information in advance, to some point in the near
future . Figure 40-10 depicts what the delta of this large short straddle position will be,
two weeks after it was first sold. The points on the horizontal axis are stock prices. The
quickness with which the neutrality of the position disappears is alarming. A small move
up to 93-only one standard deviation-in two weeks makes the overall position short
FIGURE 40-1 O.
Proiected delta, in 14 days.
6000
4500
3000
en
Q) 1500 -
cu
..c
CJ)
c 0
Q)
co 80 85 95
> XYZStock Price
·s -1500
CY
w
-3000
-4500
andTrading
Volatility
the equivalent of about 3,300 shares ofXYZ. Figure 40-10 really shows nothing more than
the effect that gamma is having on the position, but it is presented in a form that may be
preferable for some traders.
\Vhat this means is that the position is "fighting" the market: As the market goes
up , this position becomes shorter and shorter. That can be an unpleasant situation, both
from the point of view of creating unrealized losses as well as from a psychological view-
point. The JJOsition delta and gamma can be used to estinwte the amount of 1mrralized
loss that tcill occur. Just how much can this position be expected to lose if there is a quick
move in the underlying stock? The answer is quickly obtained from the delta and gamma:
With the first point that XYZ moves, from 88 to 89, the position acts as if it is short 100
shares (the position delta), so it would lose $100. \ Vith the next point that XYZ rises, from
89 to 90, the position will act as if it is short the original 100 shares (the position delta),
plus another 600 shares (the position gamma). Hence, during that second point of mm·e-
ment by XYZ, the entire position will act as if it is short 700 shares, and therefore lose
another $700. Therefore, an immediate 2-point jump in XYZ will cause an unrealized loss
of $800 in the position . Summar izing:
Loss, first point of stock movement = position delta

Loss, second point of stock movement = position delta + gamma
Total loss for 2 points of stock movement
= 2 X position delta + position gamma
Using the example data:
Loss, XYZ moves from 88 to 89: -$100 (the position delta)

Loss, XYZ moves from 89 to 90: -$100 (delta) -$600 (gamma)
: -$700
Total loss, XYZ moves from 88 to 90: -$100 X 2 -$600 = -$800
This can be verified by looking at the prices of the call and put after XYZ has jumped
from 88 to 90. One could use a model to calculate expected prices if that happened.
However , there is another way. Consider the following statements:
If the stock goes up by 1 point , the call will then have a price of:
p 1 =Po+ delta
,5.50,5= 5.00 + 0.505 (if XYZ goes to 89 in the example)
If tlw stock goes up 2 points, the call will hm·e an increase of the abm·e amount plus
a similar increase for the next point of stock mon·ment. The delta for that second point of
Chapter
40:Advanced
Concepts 829
stock movement is the original delta plus the garnma, since gamma tells one how much
his delta is going to change.
p 2 = p 1 + delta + gamma , or sub stitutin g from above

p2 = (p O + delt a) + delta + gamma
=Po+ 2 X delta+ gamm a
6.04 = 5.00 + 2 X 0.505 + 0.03 (in the example if XYZ = 90)
By the same calculation, the put in the example will be priced at 4.04 ifXYZ immediately
jumps to 90:
4.04 = 5.00 - 2 X 0.495 + 0.03
So, overall, the call will have increased by 1.04, but the put will only have decreased by
0.96. The unrealized loss would then be computed as -$10,400 for the 100 calls, offset by a
gain of$9,600 on the sale of 100 puts , for a net unrealized loss of $800. This verifies the result
obtained above using position delta and position gamma. Again, this confirms the logical fact
that a quick stock movement will cause unrealized losses in a short straddle position.
Continuing on, let us look at some of the other factors affecting the sale of this straddle .
The straddle seller has time working in his favor. After the position is established, there will
not be as much decay in the first two-week period as there will be when expiration draws near.
The exact amount of time decay to e>,.'Pectcan be calculated from the theta of the position:
XYZ:88
Option Position
Position Theta Theta
Sold 100 July 90 calls -0 .03 +$300
Sold 100 July 90 puts -0 .03 +$300
+$600
This is how the position looked with respect to time decay when it was first established
(XYZat 88 and three months remaining until expiration). The theta of the put and the call
are essentially the same , and indicate that each option is losing about 3 cents of value each
day. Note that the theta is expressed as a negative number, and since these options are sold,
the position theta is a positive number. A positive position theta means time decay is work-
ing in your favor. One could expect to make $.'300per day from the sale of the 100 calls. He
830 PartVI: Measuring
andTrading
Volatility
could expect to make another $300 per day from the sale of the 100 puts. Thus, his overall
position is generating a theoretical profit from time decay of $600 per day.
The fact that the sale of a straddle generates profits from time decay is not
ear th-shattering. That is a well-known fact. However, the amount of that time decay is
quantified by using theta. Furthermore, it serves to show that this position, which is delta
neutral, is not neutral with respect to the passage of time.
Finally, let us examine the position with respect to changes in volatility. This is done
by calculating the position vega.
XYZ: 88
Opti
on Posi
tion
Position Vega Vega
Sold 100 July 90 calls 0.18 -$1,800
Sold 100 July 90 puts 0.18 -$1,800
-$3,600
Again, this information is displayed at the time the position was established,
three months to expiration, and with a volatility of 30% for XYZ. The vega is quite large.
The fact that the call's vega is 0.18 means that the call price is expecte d to increase by
18 cents if the implied volatility of the option increases by one percentage point, from 30%
to 31%. Since the position is short 100 calls, an increase of 18 cents in the price of the call
would translate into a loss of $1,800. The put has a similar vega, so the overall position would
lose $3,600 if the options trade with an increase in volatility of just one percentage point.
Of course, the position would make $3,600 if the volatility decreased by one percentage
point, to 29%.
This volatility risk, then, is the greatest risk in this short straddle position. As before,
it is obvious that an increase in volatility is not good for a position with naked options in it.
The use of vega quantifies this risk and shows how important it is to attempt to sell over-
priced options when establishing such positions. One should not adhere to any one strategy
all the time. For example, one should not always be selling naked puts. If the implied vola-
tilities of these puts are below historical norms, such a strategy is much more likely to
encounter the risk represented by the position vega. There have been several times in the
recent past-mostly during market crashes-when the implied volatilities of both index
and equity options have leaped tremendously. Those times were not kind to sellers of
options. However, in almost every case, the implied volatility of index options was quite low
before the crash occurred. Thus, any trader who was examining his vega risk would not
have been inclined to sell naked options when they were historically "cheap."
Chapter
40:Advanced
Concepts 831
In summary then, this "neutral" position is, in reality, much more complex when one
considers all the other factors.
Position summary
RiskFactor Comment
Position delta = -100 Neutral; no immediate exposure to small
market movements; lose $ 100 for 1
point move in underlying.
Position gamma = -600 Fairly negative; position will react
inversely to market movements, causing
losses of $700 for second point of
movement by underlying.
Position theta = +$600 Favorable; the passage of time works in
the position's favor.
Position vega = -$3,600 Very negative; position is extremely
subject to changes in implied volatility.
This straddle sale has only one thing guaranteed to work for it initially: time decay.
(The risk factors will change as price, time, and volatility change.) Stock price movements
will not be helpful, and there will always be stock price movements, so one can expect to
feel the negative effect of those price changes. Volatility is the big unknown. If it decreases,
the straddle seller will profit handsomely. Realistically, however, it can only decrease by a
limited amount. If it increases, very bad things will happen to the profitability of the posi-
tion. Even worse, if the implied volatility is increasing, there is a fairly likely chance that
the underlying stock will be jumping around quite a bit as well. That isn't good either.
Thus, it is imperative that the straddle seller engage in the strategy only when there is a
reasonable expectation that volatilities are high and can be expected to decrease. If there
is significant danger of the opposite occurring, the strategy should be avoided.
If volatility remains relatively stab le, one can anticipate what effects the passage of
time will have on the position. The delta will not change much, since the options are
nearly at-the-money. However, the gamma will increase, indicating that nearer to expira-
tion, short-term price movements will have more exaggerated effects on the unrealized
profits of the position. The theta will grow even more, indicating that time will be an even
better friend for the straddle writer. Shorter-term options tend to decay at a faster rate
than do longer-term ones. Finally, the vega will decrease some as well, so that the effect
of an increase in implied volatility alone will not be as damaging to the position when
there is significantly less time remaining. So, the passage of time generally will improve
andTrading
Volatility
most aspects of this naked straddle sale. However , that does not mitigate the current situ-
ation, nor does it imply that there will be no risk if a little time passes.
The type of analysis shown in the preceding examples gives a much more in-depth
look than merely envisioning the straddle sale as being delta short 100 shares or looking
at how the position will do at expiration. In the previous example, it is known that the
straddle writer will profit if XYZ is between 80 and 100 in three months, at expiration.
However, what might happen in the interim is another matter entirely. The delta, gamma,
th eta, and vega are useful for the purpose of defining how the position will behave or
misbehave at the current point in time.
RefPr back to the table of strategies at the beginning of this section. Notice that ratio
writing or straddle selling (they are equivalent strategies) have the characteristics that
have been described in detail: Delta is 0, and several other factors are negative. It has
been shown how those negative factors translate into potential profits or losses. Observing
other lines in the same table, note that covered writing and naked put selling (they are
also equivalent, don't forget) have a description very similar to straddle selling: Delta is
positive, and the other factors are negative. This is a worse situation than selling naked
straddles, for it entails all the same risks, but in addition will suffer losses on immediate
downward moves by the underlying stock. The point to be made here is that if one felt
that straddle selling is not a particularly attractive strategy after he had observed these
examples, he then should feel even less inclined to do covered writing, for it has all the
same risk factors and isn't even delta neutral.
An examp le that was given in the chapter on futures options trading will be expanded
as promised at this time. To review, one may often find volatility skewing in futures
options, but it was noted that one should not normally buy an at-the-money call (the
cheapest one) and sell a large quantity of out-of-the-money calls just because that looks
like the biggest theoretical advantage. The following example was given. It will now be
expanded to include the concept of gamma.
Example: Hem-y volatility skewing exists in the prices of January soybean options: The
out-of-the-money calls are much more expensive than the at-the-money calls.
The following data is known:
January soybeans: 583
Option Price Implied

Volatility Delta Gamma
575 call 19.50 15% 0.55 .0100
675 call 2.25 23% 0.09 .0026
Chapter
40:Advanced
Concepts 833
Using deltas , the following spread appears to be neutral:
Buy 1 January bean 575 call at 19.50 19.50 DB

Sell 6 January bean 675 calls at 2.25 13.50 CR
Net position: 6 Debit
At the time the original example was presented, it was demonstrated through the use
of the profit picture that the ratio was too steep and problems could result in a large rally.
Now that one has the concept of gamma at his disposal, he can quantify what those
problems are.
The position gamma of thi s spread is quite negativ e:
Position gamma = .01 - 6 X .0026 = - 0 .0056
That is, for every 10 points that January soybeans rally, the position will become short
about½ of one futures contract. The maximum profit point, 67.5, is 92 points above the cur-
rent price of ,58.3.While beans would not normally rally 92 points in only a few days, it does
demonstrate that this position could become very short if beans quickly rallied to the point
of maximum profit potential. Rest assured there would be no profit if that happened.
Even a small rally of 20 cents (points) in soybeans-less than the daily limit-would
begin to make this tiny spread noticeably short. If one had established the spread in some
quantity, say buying 100 and selling GOO,he could become seriously short very fast.
A neutral spreader would not use such a large ratio in this spread. Rather, he would
neutralize the gamma and then attempt to deal with the resulting delta. The next section
deals with ways to accomplish that.
CREATING M ULTIFACETEDNEUTRALITY
So what is the strategist to do? He can attempt to construct positions that are neutral with
respect to the other factors if he perceives them as a risk. There is no reason why a posi-
tion cannot be constructed as vega neutral rather than delta neutral, if he wants to elimi-
nate the risk of volatility increases or decreases. Or, maybe he wants to eliminate the risk
of stock price movements, in which case he would attempt to he gamma neutral as well
as delta neutral.
This seems like a simple concept until one first attempts to establish a position that
is neutral with respect to more than one risk variable. For example, if Ollt' is attempting
to crea te a spread that is neutral with respect to hoth gamma and delta, he could attempt
it in the following way:
834 PartVI: Measu
ringandTrading
Volatility
Example: XYZ is 60. A spreader wants to establish a spread that is neutral with respect
to both gamma and delta , using the following prices:
Option Delta Gamma

October 60 call 0.60 0.050
October 70 call 0.25 0.025
The secret to dctcrllli11i11g

a spread that is neutral u;ith respect to both risk measures
is to 11c11tmli:.egr111111w_first,for
delta can alicays be ncutrali:.ed by taking an offsetting
position i11the 1111derlyi11g security. 1chctlzer it be stock or futures. First, determine a
gamma neutral spread by dividing the two gammas:
Gamma neutral ratio = 0.050/0.025 = 2-to-l
So. bu~'ing one October 60 and selling two October 70 calls would be a gamma
neutral spread. Now, the position delta of that spread is computed:
Position Delta Posi

tionDelta
Long 1 October 60 call 0.60 +60 shares
Short 2 October 70 calls 0.25 -50 shares
Net position delta: +10 shares
Hence, this gamma neutral ratio is making the position delta long by 10 shares
of stock for each l-by-2 spread that is established. For example, if one bought 100
October 60 calls and sold 200 October 70 calls, his position delta would be long 1,000
shares.
This position delta is easily neutralized by selling short 1,000 shares of the stock. The
resulting position is both gamma neutral and delta neutral:
Option Posi
tion Opti
on Position
Position Delta Delta Gamma Gamm
a
Short 1,000 XYZ 1.00 -1,000 0 0
Long 100 October 60 calls 0.60 +6,000 0.050 +500
Short 200 October 70 calls 0.25 -5,000 0.025 -500
--
Net Position: 0 0
Chapter
40:Advanced
Concepts 835
Hence, it is always a simple matter to create a position that is both gamma and <lelta neu-
tral. In fact, it is just as simple to create a position that is neutral with respect to delta an<l
any other risk measure, because all that is necessary is to create a neutral ratio of the
other risk measure (gamma, vega, theta, etc.) and then eliminate the resulting position
delta by using the underlying.
In theory, one could construct a position that was neutral with respect to all five risk
measures (or six, if you really want to go overboard and include "gamma of the gamma" as
well). Of course, there wouldn't be much profit potential in such a position, either. But such
constructions are actually employed, or at least attempted, by traders such as market-makers
who try to make their profits from the difference between the bid and offer of an option
quote , and not from assuming market risk
Still, the concept of being neutral with respect to more than one risk factor is a valid
one. In fact, if a strategist can determine what he is really attempting to accomplish, he
can often negate other factors and construct a position designed to accomplish exactly
what he wants. Suppose that one thought the implied volatility of a certain set of options
was too high. He could just sell straddles and attempt to capture that volatility. However,
he is then exposed to movements by the underlying stock. He would be better served to
construct a position with negative vega to reflect his expectation on volatility, but then also
have the position be delta neutral and gamma neutral, so that there would be little risk to
the position from market movements. This can normally be done quite easily. An example
will demonstrate how.
Example: XYZ is 48. There are three months to expiration, and the volatility of XYZ and
its options is 35%. The following information is also known:
XYZ: 48
Option Price Delta Gamma Vega

April 50 call 2.50 0.47 0.045 0.08
April 60 call 1.00 0.17 0.026 0.06
For whatever reasons-perhaps the historical volatility is much lower-the strategist

decides that he wants to sell volatility. That is, he wants to have a negative position vega
so that when the volatility decreases, he will make money. This can probably be accom-
plished by buying some April 50 calls and selling more April 60 calls. However, he does
not want any risk of price movement, so some analysis must be done .
First, he should determine a gamma neutral spread. This is done in much the same
andTrading
Volatility
manner as determining a delta neutral spread, except that gamma is used. Merely divide
the two gammas to determine the neutral ratio to be used. In this case, assume that the
April 50 call and the April 60 call are to be used:
Gamma neutral ratio:0.045/0.026 = 1.73-to-l
Thus , a gamma neutral position would be created by buying 100 April ,S0'sand selling 173
April 60's. Alternatively, buying 10 and selling 17 would be close to gamma neutral as
well. The larger position will be used for the remainder of this example.
Now that this ratio has been chosen, what is the effect on delta and vega?
Position Option Position Position

Position Option
Delta Delta Gamma Gamma Option
Vega Vega
Long 100 April 50 0.47 +4,700 0.045 +450 0.08 +$800
Short 173 April 60 0.17 -2,941 0.026 -450 0.06 -1,038
Total: +1,759 0 -$238
The position delta is long 1,7.59shares ofXYZ. This can easily be "cured" by shorting
1,700 or 1,800 shares ofXYZ to neutralize the delta. Consequently, the complete position,
including the short 1,700 shares, would he neutral with respect to both delta and gamma,
and would have the desired negative vega.
The actual profit picture at expiration is shown in Figure 40-11. Bear in mind,
howeYer, that the strategist would normally not intend to hold a position like this until
FIGURE 40-11.
Spread with negative vega; gamma and delta neutral.
40000.,,
•1"'4
30000 ~
~
20000
10000
4 J··-...___ 5 0 / 55 6 rJ
-----~'----✓
XVZ Stock Price
Chapter
40:Advanced
Concepts 837
expiration. He would close it out if his expectations mi volatility decline were fulfilled (or
proved false).
One other point should be made: The fact that gamma and delta are neutral to begin
with does not mean that they will remain neutral indefinitely as the stock moves (or even
as volatility changes). However. there will be little or no effect of stock price rnovements
on the position in the short run .
In sununary, then, one can ahcays create a position that is neutral with respect to
both gamma and delta by first choosing a ratio that makes the gamma :::,ero,and then
using a position in the underlying security to neutrali:::,ethe delta that is created by the
chosen ratio. This type of position would always involve two options and some stock. The
resulting position will not necessarily be neutral with respect to the other risk factors.
THE MATHEMATICAL APPROACH
The strategist should be aware that the process of determining neutrality in several of the
risk variables can be handled quite easily by a computer. All that is required is to solve a
series of simultaneous equations.
In the preceding example, the resulting vega was negative: -$238. For each decline
of 1 percentage point in volatility from the current level of 35%, one could expect to make
$238. This result could have been reached by another method, as long as one were willing
to spell out in advance the amount of vega risk he wants to accept. Then, he can also
assume the gamma is zero and solve for the quantity of options to trade in the spread. The
delt a would be neutralized, as above , by using the common stock.
Example: Prices are the same as in the preceding example. XYZ is 48. There are three
months to expiration, and the volatility ofXYZ and its options is 35%. The following infor-
mation is also the same:
Option Price Delta Gamma Vega

April 50 call 2.50 0.47 0.045 0.08
April 60 call 1.01 0.17 0.026 0.06
A spreader expects volatility to decline and is willing to set up a position whereby he

will profit by $250 for each one percentage decrease in volatility. Moreover, he wants to
be gamma and delta neutral. He knows that he can eventually neutralize any delta by
using XYZ common stock, as in the previous example. How many options should be
spread to achieve the desired result?
To answer the question, one must create two equations in two unknowns. x and y.
andTrading
Volatility
The unknowns represent the quantities of options to be bought and sold, respectively. The
constants in the equations are taken from the table above.
The first equation represents gamma neutral:
0.045x + 0.026y ==0,
where
xis the number of April .S0'sin the spread and y is the number of April 60's. Note that the
constants in the equation are the gammas of the two calls involved.
The second equation represents the desired vega risk of making 2.5 points, or $2.50, if the
volatility decreases:
0.08x + 0.06y = -2.5,
where
x and y are the same quantities as in the first equation, and the constants in this equation
are the gammas of the options. Furthermore, note that the vega risk is negative, since the
spreader wants to profit if volatility decreases.
Solving the two equations in two unknowns by algebraic methods yields the follow-
ing results:
Equations:
0.045x + 0.026y = 0
0.08x + 0.06y =-2.5
Solutions:
X = 104.80
y =-181.45
This means that one would buy 10.5April .50 calls, since x being positive means that the
options would be bought. He would also sell 181 April 60 calls (y is negative, which
implies that the calls would be sold). This is nearly the same ratio determined in the pre-
vious example. The quantities are slightly higher, since the vega here is -$2.50 instead of
the -$238 achieved in the previous example.
Chapter
40:Advanced
Concepts 839
Finally, one would again determine the amount of stock to buy or sell to neutralize
the delta by computing the position delta:
Position delta= 105 X 0.47 -181 X 0.17 = 18.58
Thus 1,858 shares of XYZ would be shorted to neutralize the position.

Note: All the equations cannot be set equal to zero, or the solution will be all zeros.
This is easily handled by setting at least one equation equal to a small, nonzero quantity,
such as 0.1. As long as at least one of the risk factors is nonzero, one can determine the
neutral ratio for all other factors merely by solving these simultaneous equations. There
are plenty of low-cost computer programs that can solve simultaneous equations such as
these .
This concept can be carried to greater lengths in order to determine the best spread
to create in order to achieve the desired results. One might even try to use three different
options, using the third option to neutralize delta, so that he wouldn't have to neutralize
with stock. The third equation would use deltas as constants and would be set to equal
zero, representing delta neutral. Solving this would require solving three equations in
three unknowns , a simple matter for a computer .
As long as at least one of the risk factors is nonzero, one can determine the neutral ratio
for all other factors merely by solving these simultaneous equations. Even more importantly,
the computer can scan many combinations of options that produce a position that is both
gamma and delta neutral and has a specific position vega (-$238, for example). One would
then choose the "best" spread of the available possibilities by logical methods including, if
possible, choosing one with positive theta, so time is working in his favor.
To summarize, one can neutralize all variables, or he can specify the risk that he
wants to accept in any of them. Merely write the equations and solve them. It is best to
use a computer to do this, but the fact that it can be done adds an entirely new, broad
dimension to option spreading and risk-reducing strategies .
EVALUATING A POSITION USING THE RISK MEASURES
The previous sections have dealt with establishing a new position and determining its
neutrality or lack thereof. However, the most important use of these risk measures is to
predict how a position will perform into the future. At a minimum, a serious strategist
should use a computer to print out a projection of the profits and losses and position risk
at future expected prices. Moreover, this type of analysis should be done for several
future times in order to give the strategist an idea of how the passage of time and the
resultant larger movements by the underlying security would affect the position.
andTrading
Volatility
First, one would choose an appropriate time period-say, 7 days hence-for the
first analysis. Then he should use the statistical projection of stock prices (see Chapter 28
on mathematical applications) to determine probable prices for the underlying security
at that time. Obviously, this stock price projection needs to use volatility , and that is
somewhat variable. But, for the purposes of such a projection, it is acceptable to use the
current volatility. The results of as many as 9 stock prices might be displayed: every one-half
standard deviation from - 2 through +2 (-2 .0, -1.5 , -1.0 , -0.5 , 0, 0.5, 1.0, 1.5, 2 .0).
Example: XYZ is at 60 and has a volatility of 35% . A distribution of stock prices 7 days
into the future would be det ermined using the equation:
Future Pric e = Current Pri ce X e av✓ i
where
a corre sponds to th e con stants in the following table : (-2 .0 . . . 2 .0):
#Standard
Deviations Projected
Stock
Price
-2 .0 54.46
-1.5 55.79
-1.0 5716
-0.5 58.56
0 60.00
0.5 61.47
1.0 62.98
1.5 64.52
2.0 66.11
Again, refer to Chapter 28 on mathematical applications for a more in-depth discus-

sion of th is pri ce det erminati on equ ation.
Note that the formula used to project prices has time as one of its components. This
means that as we look further out in time, the range of possible stock prices will expand-
a necessary and logical cornponent of this analysis. For example, if the prices were being
clf'terrni11ecl14 clays into the future, the range of prices would he from 52.31 to 68.82. That
is, XYZ has the same probability of being at 54.46 in 7 clays that it has of being at ,52.31 in
14 clays. At e\:piration, some 90 clays hence, the range would be quite a bit wider still. Do
not 111akethe rnistnke <f trying to ('WfurzfC' tlic position at the sarnc prices for each time
period 7'd(lys. 1-Jd(l!J-'>.
1 1 111011th,
cxpimtion, etc.). Such an analysis would be wrong.
Chapter
40:Advanced
Concepts 841
Once the appropriate stock prices have been determined, the following quantities
would be calculated for each stock price: profit or loss, position delta, position gamma,
position theta, and position vega. (Position rho is generally a less important risk measure
for stock and futures short-term options.) Armed with this information, the strategist can
he prepared to face the future. An important item to note: A model will necessarily be
used to make these projections. As was shown earlier, if there is a distortion in the current
implied volatilities of the options involved in the position, the strategist should use the
curr ent i111pliedsas i11p11tto the model for future option price projections. If he does not,
the position ma~· look m·erly attractive if expensive options are being sold or cheap ones
are being bought. A truer profit picture is obtained by propagating the current implied
volatility structure into the near future.
Using an example similar to the previous one-a ratio spread using short stock to
make it delta neutral-the concepts will be described.
Initial Position. XYZ is at 60. The .Januarv 70 calls, which have three months until
,
expiration, are expensive with respect to the January 60 calls. A strategist expects this
discrepancy to disappear when the implied volatility of XYZ options decreases. He there-
fore established the following position, which is both gamma and delta neutral.
Position Delta Gamma Theta Vega

Long 100 January 60 calls 0.565 0.0723 -0.020 0.109
Short 240 January 70 calls 0.204 0.0298 -0.019 0.080
Short 800 XYZ
The risk measures for the entire position are:
Position delta: -46 shares (virtually delta neutral)

Position gamma: +8 shares (gamma neutral)
Position theta: +$256
Position vega: -$830
Thus, the position is both gamma and delta neutral. Moreover, it has the attractive
feature of making $256 per day because of the positive theta. Finally, as was the intention
of the spreader, it will make money if the volatility of XYZ declines: $830 for each per-
centage point decrease in implied volatility. Two equations in two unknowns (gamma and
vega) were solved to obtain the quantities to buy and sell. The resulting position delta was
neutralized by selling 800 XYZ.
The following analyses will assume that the relative expensiveness of the April 70
andTrading
Volatility
calls persists. These are the calls that were sold in the position. If that overpricing should
disappear , the spread would look more favorable, but there is no guarantee that they will
cheapen-especially over a short time period such as one or two weeks.
How would the position look in 7 days at the stock prices determined above?
Stock
Price P&L Delta Gamma Theta Vega
54.46 1905 - 7.40 1.62 0.94 - 1.57
55.79 1077 - 4.90 2.07 1.18 - 1.96
57.16 606 - 1.97 2.13 1.53 - 2.90
58.56 528 0.74 1.65 2.00 - 4.62
60.00 771 2.38 0.56 2.63 - 7.22
61.47 1127 2.07 -1.01 3.38 -10.63
62.98 1252 - 0.87 -2.85 4 .22 -14.56
64.52 702 - 6.73 - 4.67 5.07 -18.6 1
66.11 -1019 -15.42 -6.21 5.85 -22.31
In a similar manner, the position would have the following characteristics after 14
days had passed:
Stock
52.31 4221 - 9.10 0.69 0.55 - 0.98
54.14 2731 - 6.93 1.69 0.75 - 0.89
56.02 1782 - 2.87 2.51 1.06 - 1.21
57.98 1717 2.17 2.44 1.61 - 2.69
60.00 2577 5.85 1.00 2.51 - 6.00
62.09 3839 5.29 -1 .63 3.73 - 11.05
64 .26 4361 - 1.55 -4.61 5.09 - 16.90
66.50 2631 -14.80 -7.02 6.31 - 22.17
68.82 -2799 -32.83 -8.32 7.18 -25.72
The same information will be presented graphically in Figure 40-13 so that those
who prefer pictures instead of columns of numbers can follow the discussions easily.
First the profitability of the spread can be examined. This profit picture assumes that
the rnlatilit:,· of XYZ remains unchanged. Note that in 7 days, there is a small profit if the
Chapter
40:Advanced
Concepts 843
stock remains unchanged. This is to bt>expected, since theta was positive, and therefore time
is working in favor of this spread. Likewise, in 14 days, there is an even bigger profit if XYZ
remains relatively unchanged-again due to the positive theta . Overall , there is an expected
profit of $800 in 7 days, or $2,600 in 14 days, from this position. This indicates that it is an
attractive situation statistically, but, of course, it does not mean that one cannot lose money.
Continuing to look at the profit picture, the downside is favorable to the spread since
the short stock in the position vvould contribute to ever larger profits in the case that XYZ
tumbles dramatically (see Figure 40-12). The upside is where problems could develop. In
7 days, the position breaks even at about 65 on the upside; in 14 days, it breaks even at
about 67.50.
The reader may he asking, "Why is there such a dramatic risk to the upside? I thought
the position was delta neutral and gamma neutral." True, the position was originally neutral
with respect to both those variables. That neutrality explains the flatness of the profit curves
about the current stock price of 60. However, once the stock has moved l..50 standard devia-
tions to the upside, the neutrality begins to disappear. To see this, let us look at Figures 40-13
and 40-14 that show both the position delta and position gamma 7 days and 14 days after the
spread was established. Again, these are the same numbers listed in the previous tables.
First, look at the position delta in 7 days (Figure 40-1.3). Note that the position
remains relatively delta neutral with XYZ between ,57 and 63. This is because the gamma
was initially neutral. However, the position begins to get quite delta short if XYZ rises
FIGURE 40-12.
XYZ ratio spread, gamma and delta neutral.
4300
3400
2500
1600
'E 700
ct
0
-200 61 63
53 55 57 59
-1100
-2000
Stock Price
andTrading
Volatility
FIGURE 40-13.
XYZ ratio spread, position delta.
200 l-------r-----.---..,,,,C....--,,tC---r-----.------""-c-.------+-r----;-,--
67
-300
-800
Q..
Cf) -1300
w
-1800
-2300
-2800
Stock Price
FIGURE 40-14.
XYZ ratio spread, position gamma.
100
0 I I
57 61 63 65 67
-100
co
E
E - 300
co
CJ
-500
In 14 Days
-700
Stock Price
Chapter
40:Advanced
Concepts 845
above 63 or falls below ,57 in 7 clays. What is happening to gamma while this is going on?
Since we just obseffed that the delta t>ventually changes, that has to mean that the posi-
tion is acquiring some gamma.
Figure 40-14 depicts the fact that gamma is not \'ery stable, considering that it
started at nearly zero. If XYZ falls, gamma increases a little, reHecting the fact that the
position will get some\,vhat shorter as XYZ falls. But since there are only calls coupled with
short stock in this position, there is no risk to the downside. Positive gamma, even a small
positive gamma like this one , is beneficial to stock movement.
The upside is another matter entirely. The gamma begins to become seriously neg-
ative above a stock price of 63 in 7 days. Recall that negative gamma means that one's
position is about to react poorly to price changes in the market-the position will soon be
'·fighting the market." As the stock goes even higher, the gamma becomes even more neg-
ative. These observations apply to stock price movements in either 7 days or 14 days; in
fact the effect on gamma does not seem to be particularly dependent on time in this
example, since the two lines on Figure 40-15 are very close to each other.
The above information depids in detailed form the fact that this position will not
behave well if the stock rises too far in too short a time. However, stable stock prices will
produce profits, as will falling prices. These are not earth-shattering conclusions since, by
simple observation, one can see that there are extra short calls plus some short stock in
the position. However, the point of calculating this information in advance is to be able
to anticipate where to make adjustments and how much to adjust.
Follow-Up Action. How should the strategist use this information? A simplistic
approach is to adjust the delta as it becomes non-neutral. This won't do anything for
gamma, however, and may therefore not necessarily be the best approach. If one were
to adjust only the delta, he would do it in the following manner: The chart of delta
(Figure 40-1:3) shows that the position will be approximately delta short 800 shares if
XYZ rises to 64.,50 in a week. One simple plan would be to cover the 800 shares of XYZ
that are short if the stock rises to 64 ..50. Covering the 800 shares would return the position
to delta n'eutral at that time. Note that if the stock rises at a slower pace, the point at which
the strategist would cover the 800 shares moves higher. For example, the delta in 14 days
(again in Figure 40-1:3)shows that XYZ would have to be at about 6.5..50 for the position
to be delta short 800 shares. Hence, if it took two weeks for XYZ to begin rising, one
could wait until 6.5..50 before covering the 800 shares and returning the position to delta
neutral.
In either case, the purchase of the 800 shares does not take care of tlw negative
gamma that is creeping into the position as the stock rises. The only 1cay to c0111lfff ncg-
atiuc gamma is to buy options, not stock. To return a position to neutrality with respt>ct
846 PartVI:Measuring andTra
dingVolatility
to more than one risk variable requires one to approach the problem as he did when the
position was established: Neutralize the gamma first, and then use stock to adjust the
delta. Note the difference between this approach and the one described in the previous
paragraph. Here, we are trying to adjust gamma first, and will get to delta later.
In order to add some positive gamma, one might want to buy back (cover) some of
the January 70 calls that are currently short. Suppose that the decision is made to cover
when XYZ reaches 65.,50 in 14 days. From the graph above, one can see that the position
would be approximately gamma short 700 shares at the time. Suppose that the gamma of
the January 70 calls is 0.07. Then, one would have to cover 100 January 70 calls to add 700
shares of positive gamma to the position, returning it to gamma neutral. This purchase
would, of course, make the position delta long, so some stock would have to be sold short
as well in order to make the position delta neutral once again.
Thus, the procedure for follow-up action is somewhat similar to that for establishing
the position: First, neutralize the gamma and then eliminate the resulting delta by using
the common stock. The resulting profit graph will not be shown for this follow-up adjust-
ment, since the process could go on and on. However, a few observations are pertinent.
First, the purchase of calls to reduce the negatir;e gamma hurts the original thesis of the
position-to have negative vega and positive theta, if possible. Buying calls will add vega
to and subtract theta from the position, which is not desirable. However, it is more desir-
able than letting losses build up in the position as the stock continues to run to the upside.
Second, one might choose to remor;e the position if it is profitable. This might happen if
the volatility did decrease as expected. Then, when the stock rallies, producing negative
gamma, one might actually have a profit, because his assumption concerning volatility had
been right. If he does not see much further potential gains from decreasing volatility, he
might use the point at which negative gamma starts to build up as the exit point from his
position. Third, one 1night choose to accept the acquired gamma risk. Rather than jeop-
ardize his initial thesis, one may just want to adjust the delta and let the gamma build up.
This is no longer a neutral strategy, but one may have reasons for approaching the position
this way. At least he has calculated the risk and is aware of it. If he chooses to accept it
rather than eliminate it, that is his decision.
Finally, it is obvious that the process is dynamic. As factors change (stock price, vol-
atility, time), the position itself changes and the strategist is presented with new choices.
There is no absolutely correct adjustment. The process is more of an art than a science at
times. Moreover, the strategist should continue to recalculate these profit pictures and
risk measures as the stock moves and time passes, or if there is a change in the securities
involved in the position. There is one absolute truism and that is that the serious strategist
should be mcare cf the risk lzis position has u;ith respect to at least the four basic 11iea-
sures cf delta, gamma, theta, and r;ega. To he ignorant of the risk is to be delinquent in
the management of the position.
Chapter
40:Advanced
Concepts 847
TRADING GAMMA FROM THE LONG SIDE
The strategist who is selling overpriced options and hedging that purchase with other
options or stock will often have a position similar to the one described earlier. Large stock
movements-at least in one direction-will typically be a problem for such positions. The
opposite of this strategy would be to have a position that is long gamma. That is, the posi-
tion does better if the stock moves quickly in one direction. While this seems pleasing to
the psyche, these types of positions have their own brand of risk.
The simplest position with long gamma is a long straddle, or a backspread (reverse ratio
spread). Another way to construct a position with long gamma is to invert a calendar
spread-to buy the near-term option and to sell a longer-term one. Since a near-term option
has a higher gamma than a longer-term one with the same strike, such a position has long
gamma. In fact, traders who expect violent action in a stock often construct such a position
for the very reason that the public will come in behind them, bid up the short-term calls
(increasing their implied volatility), and make the spread more profitable for the trader.
Unfortunately, all of these positions often involve being long just about everything
else, including theta and vega as well. This means that time is working against the position,
and that swings in implied volatility can be helpful or harmful as well. Can one construct
a position that is long gamma, but is not so subject to the other variables? Of course he can,
but what would it look like? The answer, as one might suspect, is not an ironclad one.
For the following examples , assume these prices exist:
XYZ: 60
Option Price Delta Gamma Theta Vega

March 60 call 3.25 0.54 0.0510 0.033 0.089
June 60 call 5.50 0.57 0.0306 0.021 0.147
Example: Suppose that a strategist wants to create a position that is gamma long, but is
neutral with respect to both delta and vega. He thinks the stock will move, but is not sure
of the price direction, and does not want to have any risk with respect to quick changes
in volatility. In order to quantify the statement that he "wants to be gamma long," let us
assume that he wants to be gamma long 1,000 shares or 10 contracts.
It is known that delta can always be neutralized last, so let us concentrate on the
other two variables first. The two equations below are used to determine the quantities to
buy in order to make gamma long and vega neutral:
0.0510x + 0.0306y = 10 (gamma, expressed in# of contracts)

0.089x + 0.147y = 0 (vega)
andTrading
Volatility
The solution to these equations is:
X = 308, y =-186
Thus, one would buy 308 March 60 calls and would sell 186 June 60 calls. Th is is the
reverse calendar spread that was discussed: Near-term calls are bought and longer-term
calls are sold.
Finally, the delta must be neutralized. To do this, calculate the position delta using
the quantities just determined:
Position delta = 0.54 X 308 - 0.57 X 186 = 60.30
So, the position is long 60 contra cts, or 6,000 shares. It can be made delta neutral by sell-
ing short 6,000 shares of XYZ .
The overall position would look like this:
Position Delta Gamma Veg

a
Short 6,000 XYZ 1.00 0 0
Long 308 March 60 calls 0.54 0.0510 0.089
Short 186 June 60 calls 0.57 0.0306 0.147
Its risk measurements are :

Position delta : long 30 shares (neutra l)
Position vega: $7 (neutral)
Position gamma: long 1,001 shares
This position then satisfies the initial objectives of wanting to be gamma long 1,000
shares , but delta and vega neutral.
Finally, note that theta = -$625. The position will lose $625 per day from tim e
decay.
The strategist must go further than this analysis, especially if one is dealing with
positions that are not simple constructions. He should calculate a profit picture as well as
look at how the risk measures behave as time passes and th e stock pr ice changes.
Figure 40- 1.5 (see Tables 40-10, 40-11, and 40-12) shows the profit potential in
7 clays, in 14 days, and at March expiration. Figure 40-16 shows the position vega at the
7- and 14-day time intervals. Before discussing these items, the data will be presented in
tabular form at three different times: in 7 days, in 14 days, and at March expiration.
Chapter
40:Advanced
Concepts 849
FIGURE 40-15.
Trading long gamma, profit picture.
80,000
60,000
40,000
20,000
'5 0
a::
50
-20 ,000 -
- 40,000
-60,000
Stock Price
TABLE40-10.
Risk measures of long gamma position in 7 days.
Stock
54.46 12259 -58.72 8.28 4.15 -5.74
55.79 5202 -46.60 9.78 5.20 -4.18
5716 - 224 -32.45 10.80 6.09 -2.85
58.56 - 3670 -16.91 11.25 6.73 -1.94
60.00 - 4975 -0.80 11.08 704 -1.63
61.47 - 3901 15.01 10.32 6.98 -1.96
62.98 - 507 29.69 9.09 6.57 -2.89
64.52 5105 42.56 754 5.87 -4 .29
66.l l 12717 53.17 5.86 4.97 -5.96
The data in Table 40-10 depict the position in 7 days.

Table 40-11 represents the results in 14 days.
Finally, the position as it looks at March expiration should be known as well (see
Table 40-12).
andTrading
Volatility
TABLE 40-11.
Risk measures of long gamma position in 14 days.
Stock
52.31 24945 -79.34 4.75 2.10 - 9.91
54.14 11445 -6768 8.00 3.91 - 787
56.02 277 -49.79 10.79 5.76 - 5.56
5798 - 7263 -26.87 12.42 721 - 3.73
60.00 - 10141 - 1.44 12.47 788 - 3.04
62.09 - 7784 23.32 10.99 760 - 3.78
64.26 - 347 44.47 8.45 6.47 - 5.71
66.50 11491 60.12 5.55 4.82 - 8.20
68.82 26672 69.81 2.92 3.09 - 10.4 8
TABLE 40-12 .
Risk measu res of long gamma position at March expiration.
Stock
Price P&L Delta Gam ma Theta Vega
46.19 81327 - 75.69 -3.65 -1.32 - 6.88
49.31 55628 - 89.84 -5.39 -2.25 -11.43
52.64 22378 -110.50 -6.89 -3.33 -16.50
56.20 -21523 -136.65 -762 -4.28 -20.67
60.00 -78907 144.68 -729 -4.79 -22.49
64.06 -25946 11744 -6.03 -4.70 -21.26
68.39 19787 95.03 -4.31 -4.10 -17.44
73.01 59732 79.05 -2.67 -3.24 -12.43
7795 96062 69.19 -1.43 -2.4 1 - 769
In each case, note that the stock prices are calculated in accordance with the
stat istical formula shown in the last section . The more time tha t passes, the furt her it is
possible for the stock to roam from the curren t price.
The profit picture (Figure 40-1.5) shows tha t this position looks much like a long
straddle would: It makes large, symmetric profits if the stock goes either way up or way
down. Moreover, the losses if the stock remains relatively unchanged can be large. These
losses tend to mount right away, becoming significant even in 14 days. Hence, if one enters
this type of position, he had better get the desired stock movement quickly, or be pre-
pared to cut his losses and exit the position.
Chapter
40:Advanced
Concepts 851
FIGURE 40-16.
Trading long gamma, position vega.
55 60 65
0 i----------------,...._ _____ ....._
___ _
-2
-4
-6
-8
-10
Stock Price
The most startling thing to note about the entire position is the devastating effect
of time on the position. The profit picture shows that large losses will result if the stock
movement that is expected does not materialize. These losses are completely due to time
decay. Theta is negative in the initial position ($62.S of losses per day), and remains
negative-and surprisingly constant-until March expiration (when the long calls expire).
Time also affects vega. Notice how the vega begins to get negative right away and keeps
getting much more negative as time passes. Simply, it can be seen that as time passes, the
position becomes vulnerable to increases in implied volatility.
This relationship between time and volatility might not be readily apparent to the
strategist unless he takes the time to calculate these sorts of tables or figures. In fact, one
may be somewhat confounded by this observation. What is happening is that as time
passes , the options that are owned are less explosive if volatility increases, but the options
that were sold have a lot of time remaining, and are therefore apt to increase violently if
volatility spurts upward.
Figures 40-17 and 40-18 provide less enlightening information about delta and
gamma. Since gamrna was positive to start with, the delta increases dramatically as the
stock rises, and decreases just as fast if the stock falls (Figure 40-18). This is standard
behavior for positions with long gamma; a long straddle would look very similar.
Notice that gamma remains positive throughout (Figure 40-17), although it falls to smaller
levels if the stock moves toward the end of the pricing ranges used in the analyses. Again,
this is standa rd action for a long straddle .
andTrading
Volatility
FIGURE 40-17.
Trading long gamma, position gamma.
1200
1000
800
(fJ
~ 600
s::.
Cf)
400
200
55 60 65
Stock Price
FIGURE 40-18.
Trading long gamma, position delta.
6000
4000
2000
(fJ
~ 01-----..-------------------.-----
.c
Cf)
-2000
-4000
-6000
-8000
So_ is this a good position'? That is a difficult question to answer unless one knows
what is going to happen to tlw underlying stock. Statistically, this type of position has a
11e~atin' e:\pectecl rdnrn and would generally produce losses over the long run. However,
in sit1rations in which the near-term options are destined to get overheated-perhaps
Chapter
40:Advanced
Concepts 853
because of a takem·er rumor or just a leak of material information about a company-

many sophisticated traders establish this type of position to take advantage of the expected
explosion in stock price.
Other Variations. Without going into as much detail, it is possible to compare the
above position with similar ones. The purpose in doing so is to illustrate how a change in
the strategist's initial requirements would alter the established position. In the preceding
position, the strategist wanted to be gamma long, but neutral with respect to delta and vola-
tility. Suppose he not only expects price movement (meaning he wants positive gamma),
but also expects au increase in volatility. If that were the case, he would want positive vega
as well. Suppose he quantifies that desire by deciding that he wants to make $1,000 for
every one percentage increase in volatility. The simultaneous equations would then be:
0.050lx+ 0.0306y = 10 (gamma)

0.089x + 0.147y = 10 (vega)
The solution to these equations is:
X = 24:3, Y = - 80
Furthermore, 8J500 shares would have to be sold short in order to make the position delta
neutral. The resulting position would then be:
Short 8,500 XYZ Delta: neutral

Long 243 March 60 calls Gamma: long 1,000 shares
Short 80 June 60 calls Vega: long $1,000
Theta : long $630
Recall that the position discussed in the last section was vega neutral and was:

Long 308 March 60 calls Gamma : long 1,000 shares
Short 186 Jun e 60 calls Vega: neutral
Theta: long $625
Notice that in the new position, there are over three times as many long March GO
calls as there are short June 60 calls. This is a much larger ratio than in the vega neutral
position, in which ahout 1.6 calls were bought for each one sold. This even greater
andTrading
Volatility
preponderance of near-term calls that are purchased means the newer position has an
even larger exposure to time decay than did the previous one. That is, in order to acquire
the positive vega, one is forced to take on even more risk with respect to time decay. For
that reason, this is a less desirable position than the first one; it seems overly risky to want
to be both long gamma and long volatility.
This does not necessarily mean that one would never want to be long volatility. In
fact, if one expected volatility to increase, he might want to establish a,position that was
delta neutral and gamma neutral, but had positive vega. Again, using the same prices as
in the previous examples, the following position would satisfy these criteria:

Short 64 March 60 calls Gamma: neutral
Long 106 June 60 calls Vega: long $1,000
Theta: long $11
This position has a more conventional form. It is a calendar spread, except that more
long calls are purchased. Moreover, the theta of this position is only $11-it will only lose
$11 per day to time decay. At first glance it might seem like the best of the three choices.
Unfortunately , when one draws the profit graph (Figure 40-19), he finds that this position
has significant downside risk: The short stock cannot compensate for the large quantity of
FIGURE 40-19.
Trading long gamma, "conventional" calendar.
7500
5000
2500
CJ)
CJ)
0
...J
~ 0
ea.. 45 50 75
-2500
-5000 At March Expiration
-7500
Stock Price
Chap
ter 40:AdvancedConcepts 855
June 60 calls. Still, the position does make money on the upside, and will also make money
if volatility increases. If the near-term March calls were overpriced with respect to the June
calls at the time the position was established, it would make it even more desirable.
To summarize, defining the risks one wants to take or avoid specifies the construc-
tion of the eventual position. The strategist should examine the potential risks and
rewards, especially the profit picture. If the potential risks are not desirable, the strategist
should rethink his requirements and try again. Thus, in the example presented, the strat-
egist felt that he initially wanted to be long gamma, but it involved too much risk of time
decay. A second attempt was made, introducing positive volatility into the situation, but
that didn't seem to help much. Finally, a third analysis was generated involving only long
volatility and not long gamma. The resulting position has little time risk, but has risk if the
stock drops in price. It is probably the best of the three. The strategist arrives at this con-
clusion through a logical process of analysis.
ADVANCED MATHEMATICAL CONCEPTS
The remainder of this chapter is a short adjunct to Chapter 28 on mathematica l applications.

It is quite technical. Those who desire to understand the basic concepts behi nd the risk mea-
sures and perhaps to utilize them in more advanced ways will be interested in what follows.
CALCULATING THE '' GREEKS"
It is known that the equation for delta is a direct by-product of the Black-Scholes model
calculation:
11= N(dl)
Each of the risk measures can be derived mathematically by taking the partial deriv-
ative of the model. However, there is a shortcut approximation that works just as well. For
example, the formula for gamma is as follows:
(i+ r)']/v/t+ vf
x= 1n[sx
e <-x2/2)
r--~=
-pv/2iit.
There is a simpler, yet correct, way to arrive at the gamma. The delta is the partial
derivative of the Black-Scholes model with respect to stock price-that is, it is the amount
hy which the opt ion's price changes for a change in stock price . The gamma is the change
856 Part VI: Measu
ring andTradingVolatili
ty
in delta for the same change in stock price. Thus, one can approx imate the gamma by the
following steps:
1. Calculate the delta with p = Current stock price .

2. Set p = p + 1 and recalculate the delta.
3. Gamma= delta from step 1- delta from step 2.
The same procedure can be used for the other "greeks":
Vega: 1. Calculate the option price with a particular volatility.

2. Calculate another option price with volatility increased by 1%.
3. Vega= difference of the prices in steps 1 and 2.
Theta: 1. Calculate the option price with the current time to expiration.
2. Calculate the option price with 1 day less time remaining to expiration.
3. Theta= difference of the prices in steps 1 and 2.
Rho: 1. Calculate the option price with the current risk-free interest rate.
2. Calculate the option price with the rate increased by 1%.
3. Rho = difference of the prices in steps 1 and 2.
THE GAM MA OF THE GAMMA
The discussion of this concept was deferred from earlier sections because it is somewhat
difficult to grasp. It is included now for those who may wish to use it at some time. Those
readers who are not interested in such matters may skip to the next section.
Recall that this is the sixth risk measurement of an option position. The garmna of
tlie gamma is the amount by u;hich the gamma will change when the stock price changes.
Recall that in the earlier discussion of gamma, it was noted that gamma changes.
This example is based on the same example used earlier.
Example: With XYZ at 49, assume the January 50 call has a delta of 0.50 and a gamma
of 0.0,5. If XYZ moves up 1 point to .SO,the delta of the call will increase by the amount
of the gamma: It will increase from 0.,50 to 0.5,5. Simplistically, if XYZ moves up another
point to 51, the delta will increase by another 0.05 , to 0.60.
Obviously, the delta cannot keep increasing by 0.0,5 each time XYZ gains another
point in price. for it will eventually exceed 1.00 by that calcu lation, and it is known that
the delta has a maximum of 1.00. Thus, it is obvious that the gamma changes.
Chapter
40:Advanced
Concepts 857
In reality, the gamma decreases as the stock moves away from the strike. Thus, with
XYZ at .51, the gamma might only be 0.04. Therefore, if XYZ moved up to ,52, the call's
delta would only increase by 0.04, to 0.64. Hence, the gamma of the gamma is -0.01, since
the gamma decreased from .05 to .04 when the stock rose by one point.
As XYZ moves higher and higher, the gamma will get smaller and smaller. Eventu-
ally, with XYZ in the low 60's, the delta will be nearly 1.00 and the gamma nearly 0.00.
This change in the gamma as the stock moves is called the gamma of the gmnma. It
is probably referred to by other names, but since its use is limited to only the most sophisti-
cated traders, there is no standard name. Generally, one would use this measure on his
entire portfolio to gauge how quickly the portfolio would be responding to the position
gamma.
Example: With XYZ at 31.7.S as in some of the previous examples, the following risk
measures exist:
Option Option Option Position

Position Delta Gamma Gamma/Gamma
Gamma/Gamma
Short 4,500 XYZ 1.00 0.00 0.0000 0
Short 100 XYZ April 25 calls 0.89 0.01 -0.0015 -15
Long 50 XYZ April 30 calls 0.76 0.03 -0.0006 -3
Long 139 XYZ July 30 calls 0.74 0.02 -0.0003 -4
Total Gamma of Gamma: -22
Recall that, in the same example used to describe gamma, the position was delta
long 686 shares and had a positive gamma of 328 shares. Furthermore, we now see that
the gamma itself is going to decrease as the stock moves up (it is negative) or will increase
as the stock moves dowll. In fact, it is expected to increase or decrease by 22 shares for
each point XYZ moves.
So, if XYZ moves up by 1 point , the following should happen:
a. Delta increases from 686 to 1,014, increasing by the amount of the gamma.
b. Gamma decreases from ,328 to 306, indicating that a further upward move by XYZ
will result in a smaller increase in delta.
One can huild a general picture of how the gamma of the gamma changes over
different situations-in- or out-of-the-money, or with more or less time remaining m1til
expiration. The following table of two index calls, the January 3,50 with one month of life
andTrading
Volatility
remaining and the December 350 with eleven months of life remaining, shows the delta,
gamma , and gamm a of the gamma for variou s stock prices .
January
350call December
350call
IndexPrice Delta Gamma Gamma/Gamma Delta Gamma Gamma/Gamma
310 .0006 .0001 .0000 .3203 .0083 .0000
320 .0087 .0020 .0004 .3971 .0082 .0000
330 .0618 .0100 .0013 .4787 .0080 - .0000
340 .2333 .0744 .0013 .5626 .0078 -.0001
350 .5241 .0309 - .0003 .6360 .0073 - ;0001
360 .7957 .0215 -. 0014 .6984 .0067 -.0001
370 .9420 .0086 - .0010 .7653 .0060 - .0001
380 .9892 .0021 - .0003 .8213 .0052 -.0001
Several conclusions can be drawn, not all of which are obvious at first glance. First
of all, the gamma of the gamma for long-term options is very small. This should be
expected, since the delta of a long-term option changes very slowly. The next fact can best
be observed while looking at the shorter-term January 350 table. The gamma of the
gamma is near zero for deeply out-of-the-money options. But, as the option comes closer
to being in-the-money , the gamma of the gamma becomes a positive number, reaching its
maximum while the option is still out-of-the-money. By the time the option is at-the-money ,
the gamma of the gamma has turned negative. It then remains negative, reaching its most
negative point when slightly in-the-money. From there on, as the option goes even deeper
into-the-money, the gamma of the gamma remains negative but gets closer and closer to
zero, eventually reaching (minus) zero when the option is very far in-the-money.
Can one possibly reason this risk measurement out without making severe mathe-
matical calculations? Well, possibly. Note that the delta of an option starts as a small
number when the option is out-of-the-money. It then increases, slowly at first, then more
quickly, until it is just below 0.60 for an at-the-money option. From there on, it will con-
tinue to increase , but much more slowly as the option becomes in-the-money . This move-
ment of the delta can be observed by looking at gamma: It is the change in the delta, so
it starts slowly, increases as the stock nears the strike, and then begins to decrease as the
option is in-the-money, always remaining a positive number, since delta can only change
in the positive direction as the stock rises. Finally, the gamma of the gamma is the change
in the gamma, so it in turn starts as a positive number as gamma grows larger; but then
when gamma starts tapering off, this is reflected as a negative gamma of the gamma.
In general , the gamma of the gamma is used by sophisticated traders on large option
positions where it is not obvious what is going to happen to the gamma as the stock
Chapter
40:Advanced
Concepts 859
changes in price. Traders often have some feel for their delta. They may even have some
feel for how that delta is going to change as the stock moves (i.e., they have a feel for
gamma). However, sophisticated traders know that even positions that start out with zero
delta and zero gamma may eventually acquire some delta. The gamma of the gamma tells
the trader how much and how soon that eventual delta will be acquired.
MEASURING THE DIFFERENCE OF IMPLIED VOLATILITIES
Recall that when the topic of implied volatility was discussed, it was shown that if one
could identify situations in which the various options on the same underlying security had
substantially different implied volatilities, then there might be an attractive neutral
spread available. The strategist might ask how he is to determine if the discrepancies
between the individual options are significantly large to warrant attention. Furthermore,
is there a quick way (using a computer , of course ) to determine this?
A logical way to approach this is to look at each individual implied volatility and com-
pute the standard deviation of these numbers. This standard deviation can be converted to
a percentage by dividing it by the overall implied volatility of the stock. This percentage, if
it is large enough, alerts the strategist that there may be opportunities to spread the options
of this underlying security against each other. An example should clarify this procedure.
Example: XYZ is trading at 50, and the following options exist with the indicated implied
volatilities. We can calculate a standard deviation of these implieds, called implied devia-
tion , via the formula:
Implied deviation = sqrt (sum of differences from mean) 2/(# options -1)
XYZ: 50
Implied Difference
Option Volatility fromAverage
October 45 call 21% -9.44
November 45 call 21% -9.44
January 45 call 23% -7.44
October 50 call 32% . +1.56

November 50 call 30% -0.44
January 50 call 28% -2 .44
October 55 call 40% +9.56

November 55 call 37% +6 .56
January 55 call 34% +3 .56
andTrading
Volatility
Average: 30 .44 %
Sum of (difference from avg) 2 = 389.26
Implied devi ation= sqrt (sum of diff) 2 / (# option s - 1)
= sqrt (389.26/8)
= 6 .98
This figure represents the raw standard deviation of the implied volatilities. To con-
vert it into a useful number for comparisons, one must divide it by the average implied
volatilit y.
Implied deviation
Percent deviation = A . . d
verage imp 11e
= 6.98/30.44
=23%
This "percent dniation" number is usually sig11{ficant{fit is larger than 15%. That
is, if the \·arious options have implied volatilities that are different enough from each other
to produce a result of 1.5%or greater in the above calculation, then the strategist should
take a look at establishing neutral spreads in that security or futures contract.
The concept presented here can be refined further by using a weighted average of
the implieds (taking into consideration such factors as volume and distance from the strik-
ing price) rather than just using the raw average. That task is left to the reader.
Recall that a computer can perform a large number of Black-Scholes calculations in
a short period of time. Thus, the computer can calculate each option's implied volatility
and then perform the "percent deviation" calculation even faster. The strategist who is
interested in establishing this type of neutral spread would only have to scan down the
list of percent deviations to find candidates for spreading. On a given day, the list is usually
qui te short-p erhaps 20 stock s and 10 future s contracts will qualify .
SUMMARY
In today's highly competitive and volatile option markets, neutral traders must be extremely
aware of their risks. That risk is not just risk at expiration, hut also the current risk in the
market. Furthermore, they sho11lclhm·e an idea of how the risk will increase or decrease
as the 11nderl:·i11gstock or futures contract moves up and down in price. Moreover, the
passage of time or the \olatility that the options are being assigned in the marketplace-
Chapter
40:Advanced
Concepts 861
the implied volatility-are important considerations. Even changes in short-term interest

rates can be of interest, especially if longer-term options (LEAPS) are involved.
Once the strategist understands these concepts, he can use them to select new posi-
tions, to adjust existing ones, and to formulate specific strategies to take advantage of
them. He can select a specific criteria that he wants to exploit-selling high volatility, for
example-and use the other measures to construct a position that has little risk with
respect to any of the other variables. Furthermore, the market-maker or specialist, who
does not want to acquire any market risk if he can help it, will use these techniques to
attempt to neutralize all of the current risk , if possible .
Volatility Derivatives
At the beginning of listed opt ion trad ing in 1973, when a "new" stock was added to the
list of those with options, only call options were listed. Eventually, in 1976, puts were
listed on a few stocks. At that time, option industry officials envisioned that all stocks
with listed options would have both puts and calls (visionary at the time!). Of course, we
know that today any stock that is added to the list of those with options immediately has
puts and calls listed at all available striking prices.
Eventually, in 1983, listed index options came into being, and their popularity has
been immense. However, options traders were still missing an important tool to effectively
hedge a portfolio of stocks and other instrumen ts; there was no direct way to address vol-
atility. Sure, there are strategies with puts and calls designed to profit from-and perhaps,
in a general sense, hedge-volatility, but they are clumsy at best, for they have many other
components contributing to their risk-reward characteristics, other than mere volati lity.
Many sophisticated option traders and trading desks designed and tracked volatility
measures since the beginning of listed option tra ding, but in 1993, the CBOE forma lly
published the Volatility Index, VIX-the first, and still the foremost, index of volatility in
existence.
But the mere publication of VIX was just something traders could observe; they
could not trade it. In fact, the calculation of VIX was changed in 2003, and shortly there-
after (2004) listed futures on VIX were introduced. The CBOE created its own futures
exchange, the CBOE Futures Exchange (CFE) for this purpose. Futures were listed on
both realized volatility (variance futures) and on implied volatility (VIX futures). Variance
futnres have not proven to be very popular with the populace who trades listed deriva-
tives, but VIX futures have .
It took some trips back and forth to the drawing board, but eventually listed options
on VIX were introduced in 2006. This has been one of the most successful new products
862
Chapter
41: Volatility
Derivatives 863
ever introduced in listed options, and its popularity continues to grow among both specu-
lators and hedgers looking to protect stock portfolios.
These options and futures-for the first time-allowed listed option traders to
address volatility directly (over-the-counter institutional traders have had the ability for
some time to trade both realized and implied volatility).
In this section of the book, we are going to take an in-depth look at listed volatility
derivatives-from their definition, to their uses in speculation and strategy, and finally at
their use for portfolio protection .
HISTORICAL AND IMPLIED VOLATILITY
Historical volatility measures how fast an entity (a stock, for example) has been moving
around in the past. Implied volatility, on the other hand, is the option markets' estimate
of how volatile the underlying is going to be during the life of the option. It is a
forward-looking measure.
In Chapter 28, "Mathematical Applications," we described how volatility is
calculated-both historical and implied. Recall that historical volatility is the standard
deviation of daily percentage price changes in the stock, index, futures contract, or other
entity you are monitoring. Variance is volatility squared. Historica l volatility is a
backward-looking measure because it uses past prices in its calculation.
Generally, actual volatility declines in bull markets and increases in bear markets. One
reason is that, in bull markets, stocks tend to advance almost every day. But in bear markets,
declines are often punctuated with sharp, short-lived rallies, and so the standard deviation
of the daily price changes is much greater. In fact, novice investors and certain members of
the media interchange the terms volatility and price decline. They might say "the market is
volatile," when what they mean is "the market is down." This is incorrect, of course.
The general statement regarding volatility and price movement is not true in all
markets, however. For example, in the tech stock bull market of 1995-2000, volatility
generally increased even as prices were rising, for large gains in tech stocks were often
punctuated with isolated, but significant, days of selling. As a general rule, on a daily basis,
volatility moves oppos ite to the direction of the underlying entity about 75% of the time-
certainly a significant amount of the time, but not all of the time.
Implied volatility, however, is strictly a component of option pricing, and is a
forward-looking measure. It is the volatility that one would have to use in a theoretical
model (such as the Black-Scholes model) in order for the model's estimate of "fair value"
to be equal to the current market price of the option. There is not a specific formula for
calcu lating implied volatility; rather, it is an iterative process.
andTrading
Volatility
As has been shown in many other places in this book, implied volatility is a very
major determinant of what strategies are best used in certain situations. In general, high
implied volatility means options are expensive and low implied volatility means they are
cheap. But that is too general of a statement, for we have no real way of knowing what is
"high" or "low," except by looking at past measures of volatility. When options were first
listed, and the Black-Scholes model was introduced, many mathematically based traders
(including this author) thought it would be a simple matter to determine if options were
cheap or expensive, and buy or sell them accordingly. What was not realized initially was
that there is no such thing as "fair value." It completely depends on your volatility esti-
mates and how they relate to the eventual volatility of the underlying entity.
It is often the case that options seem to be trading with a volatility that is "too high,"
but it is usually justified. There may be an ei;e11t on the horizon that will have significant
bearing on a gap in the stock price-such as an FDA hearing, or an earnings report, or a
takeover rumor. Even a sharp drop in the price of the underlying may cause implied vol-
atility to rise, for traders fear further price drops and thus pay higher prices for puts.
CALCULATION OF VIX
The original CBOE Volatility Index calculation was released in 1993, with backdated
data to 1986. The actual formula was designed hy Dr. James Whaley, of Duke University.
It used four series of OEX options, centered about the current OEX price-one strike
above the OEX price, one below, in each of the first two expiration months. The implied
volatilities of these options were weighted to come up \vith one number-the VIX.
At the time (1993), OEX options were still the most liquid and most popular index
options. However, as time passed, S&P ,500 options (SPX) began to take over that role,
espe cially due to their popularity with large, institutional traders. Furthermore, option
traders had known, since the Crash of Ki, that deeply out-of-the-money puts on the indi-
ces were far more expensive-in terms of implied volatility-than at-the-money options
were. Simultaneously, deeply out-of-the-money call options were less expensive than
at-the-money options. Eventually, there was some demand for a new volatility calculation
that would take these things into account.
So, in 2003, the CBOE revamped the calculation of VIX. The "old" VIX remains-
its symbol was merely changed to VXO. The "new" VIX was based on SPX options, and
incorporated all of the strikes trading in the first two expiration months. Actually, not all
of the strikes are included , but nearly all are-all the ones with both bid and offer prices
for the options. In the vernacular, it is said that the "new" VIX is based on the "strips" of
options expiring in the first two months. The actual formula, which is complicated, can
be found on the CBOE website , along with other papers on the subject.
Chapter
41: Volatility
Derivatives 865
Both the old and new VIX are :30-day volatility measures. As you will see later in
this section, that is ver:-,·important, for longer-term derivatives, expiring many months in
the future will not track VIX well, for this very reason. VVhatthis :30-day estimate means,
in mathematical terms, is that the tvvo strips of SPX options that are used in the VIX cal-
culation have a different weighting each day. As time passes from one month to the next,
the strip of SPX options in the "near" month gets less weight and the strip in the "far"
month gets more.
The VIX calculation is versatile. It can be applied to any set of options where con-
tinuous markets (bids and offers) are being made in the two strips of options in the two
front-months. As a result, a VIX-like calculation of volatility can be made for nearly every
listed stock, index, or futures contract.
In order to trade VIX options on any entity, it is first necessary to create a volatility,
or VIX index, for that product. Regular listed puts and calls trade on the underlying stock
(index or future), but VIX options can't trade on the stock price; rather, they must trade
on a VIX index created from the puts and calls on that stock. So, first a VIX-like index is
created; then, options can trade on it. As an example, SPX had listed puts and calls for
years, then those options were used to calculate the original VIX for several months, and
finally VIX futures and options were created, based on the VIX index.
Originally, VIX was the term and symbol for the CBOE Volatility Index. But the
term has-in everyday usage-evolved more to describe the process of calculating vola-
tility. As an example, consider Xerox. Originally it was the name of a company (and still
is), but eventually the word Xerox evolved to mean "to copy" or even a "copying machine,"
no matter who manufactured it. This appears to be what is happening to VIX. Xerox actu-
ally tried a lawsuit to stop the generic use of its name, but was unsuccessful in that
attempt.
In 2010 and 2011, the CBOE introduced VIX calculations on gold, crude oil, and
the Euro (foreign currency). These used the options of the popular ETFs GLD, USO, and
FXE, respectively. Later, VIX calculations were being broadcast on more ETFs and on
certain individual stocks as well. Even the futures exchanges entered the fray, introducing
a VIX calculation on gold and crude oil, based on the listedfittures options that trade.
Since then, VIX calculations are being broadcast by the CBOE on a number of other
ETFs and some individual stocks-which, at this time, include Apple (AAPL), Amazon
(AMZN), Goldman Sachs (GS), Google (GOOG), and IBM (IBM), and the following
ETFs: Emerging Markets (EEM), China (FXI), Brazil (EWZ), Gold Miners (GDX), Silver
(SLY), and Energy (XLE). There are individual symbols for these volatility (VIX) calcula-
tions on each of these stocks and ETFs.
This seems very similar to 1976, when puts were introduced. At the time, it seemed
hard to envision that every stock with listed options would have both pnts and calls, but
eventually that became the norm. \Ve may now he on the verge of a future wh('re e\·er:-,·
866 PartVI:Measurin
g andTrad
ing Volatility
entity with listed options has puts, calls, and VIX options. Clearly , we are early in the
process, but it is cert ainly po ssible .
It will become necessary, if it isn't already, to qualify which VIX one is talking about.
For years, VIX meant the calculation based on the SPX options. But it really is likely to
be called "SPX \ 'IX" as time progresses, to differentiate it from "Gold VIX," "Apple VIX,"
and so fort h .
There is an annual seasonality of volatility that can sometimes be useful to traders.
It is important to understand the general path that volatility takes during the course of a
year. There may he \·,uiations in any individual year, but most years conform to the gen-
eral patt ern in some form or another .
Figure 41-1 shows the composite of the "old VIX" (VXO) for the 22-year period from
1989 through 2010. That is, the average \'XO on the first day of each of the 22 years was
plotted (ifs about 20.7.5).Then the second day and third day, etc. VXO was used because
it has a longer backdated historical data set. VIX and VXO move in tandem, so the con-
clusions below apply to VI X as well.
The pattern in Figure 41-1 is thus a 22-year auemge VXO for each trading day of the
year. Volatility seems to rise slightly in January and then peaks in March. From there it
falls during the spring into the yearly low, very near the first of July. Then a major increase
FIGURE 41-1.
Seasonality of volatility.
VXO Compos ite by Trading Day ofYear-21 -Year Composite Spread: 1989-2010
26
F
25
24
23
22
21
20
19
18 C
J [ F [ M [ A [ M [ J [ J [ A [ S IO IN ID
Chapter
41: Volatility
Derivatives 867
in volatility takes place, throughout the latter part of the summer (contrary to conven-
tional wisdom that holds that August is a nonvolatile month), increasing rapidly through
September and into October.
Of course, the stock market often falls sharply in September and October, thus cre-
ating the rise in volatility that is seen in Figure 41-1. About the time of this peak, the
"average" trader might think that he has finally figured out what is going on with
volatility-it is increasing. And even though he missed buying it during the summer he
decides to buy it in October, figuring that even more volatile times lie ahead. Such is the
lot of the individual investor, who is a contrarian indicator. But instead of rallying further,
volatility begins to decrease during the fall of the year, retreating so dramatically that, by
the end of the year , it is nearly back to the July lows!
This pattern doesn't hold for every year, of course. But in some years that seemingly
don't fit the pattern, there is a distinct similarity. Consider 2010, for example. That was
the year of the "flash crash" in May, followed by a sharp market decline. Therefore, VIX
spiked from its yearly low in April to its yearly high in May. From there it generally
declined throughout the rest of the year. In other words, the graph in Figure 41-1 was sort
of "squashed" to the left for 2010. That happened in a few other years as well.
This seasonal data is not necessarily information that you would use to set up a spe-
cific strategy, but it does make clear that "buying" volatility in the late spring or early
summer is a plausible approach, while selling it in the fall might also be useful.
LISTED VOLATILITY FUTURES
In 2004, the CBOE created its futures exchange-the CFE-with only two products in
mind: listed futures on historical and implied volatility. Implied volatility futures-or
VIX futures, as they are commonly known-have proven to be the far more popular
product.
Futures were discussed in Chapter 34. If you are not at all familiar with futures, you
may want to review that chapter, although the following information should suffice for
understanding VIX futures. Do not skip this section if you are planning on trading any
derivative volatility products. Even if you think that you might have no interest in trading
VIX futures-only options on VIX-you must understand the futures on VIX in order to
understand the options on VIX. Therefore this section is required reading.
A futures contract has an expiration date but no striking price. That is one major
distinction between futures and options. Another is that futures trade with very high
leverage, so that one does not have limited risk when trading a futures contract. On the
contrary, his initial margin requirement may be wiped out by a fairly small, adverse move
(say 10%) in the price of the futures contract.
andTrading
Volatility
VIX futures are quoted in price terms, much like VIX . For example, if VIX itself is
trading near 20, then the \·arious futures will be trading at prices slightly above 20, most
likely. A VIX futures contract is worth $1,000 for every one point move it makes. So if one
buys the July VIX futures contract at 21 and sells it at 22, he makes $1,000 less
commissions.
The margin required hy the futures broker can vary, depending on the price of the
future s and on general market volatility. The exchanges are always allowed to raise margin
pricc>sto curb speculation if they so see fit. At this time, the exchange minimum margin for
trading one VIX futures contract is $4,000. We will discuss spread margins later. Thus, the
VIX futures contract has tremendous le\·erage, as do most futures contracts. A four-point
move in the contract could double your money or wipe out your initial margin equity.
VIX FUTURES EXPIRATION DATE
VIX futures are listed for se\·eral months-at least the next seven contiguous months
going forward from the>current date. Each futures contract has an expiration date. At first
glance, VIX expiration dates seem rather arcane, but there is actually a physical reason
for the way these expiration elates are determined, as is the case with many futures expi-
ration dates on all kinds of commodities and financial products.
The expiration of VIX futures in any given month is .30 days prior to the SPX option
expiration in the next month. This is always a \Vednesday. It may sometimes be the
Wednesday blforc "regular" option expiration (which takes place on the third Friday of
the month) , or the Wednesday after. Those are the only two possibilities.
Example: July SPX options expire on Friday the 19th (the normal third Friday of the
month). June VIX futures will thus expire .30 calendar days prior. That means back up 19
days in July, and 11 in June. Since June has .30 days in all, backing up 11 days from the
end of the month puts the expiration date as Wednesday , June 19.
\\'hy this :10-day "look-back"? Why not just have VIX futures expire on the third
Friday , like all other stock and index options? Let's digress for a moment and discuss liquid-
ity. No derirnti,·es product will be liquid-or successful-without the ability to arbitrage
it. For example, market-makers in puts and calls can hedge off equivalent positions by
positioning stock against the options. This is what the regulators in October 2008 didn't
realize when they wanted to ban short selling. Without the ability to sell short the under-
lying, option market-makers would be reluctant to take on long calls and/or short puts.
That ban was qnickly lifted for option market-makers (which effectively removed that ban
for en:>r:-,·onebecause en"ryone else could buy puts and let the market-makers short stock
to hedge the puts that the market-makers sold).
Chapter
41: Volatility
Derivatives 869
This 30-day look-back is necessary for market-makers to be able to hedge their

futures positions. At first, designers of the VIX derivatives were having a hard time decid-
ing how they could make the product hedgeable. Then they hit upon this idea. Recall that
the VIX calculation requires the weighting of the two strips of SPX options, and that
weighting changes each day. A market-maker in the futures, who takes down a big pos-
ition in futures and wishes to hedge it with SPX options, would, in pure theory, have to
establish positions in all of the SPX options in the two monthly strips, and then change
his quantities in those two strips of options each day, as long as he held the arbitrage in
place. This is preposterous, of course, and figuring out how to allow market-makers to
effectively hedge large futures positions was what delayed the initial introduction of the
product for some time .
Eventually, an ingenious solution was conceived. What if, on expiration day only, the
VIX calculation for expiration futures only involved one strip of options-the one that
expires 30 days hence? Then market-makers could take down a big position in futures,
perhaps simultaneously hedging it with the options in one strip of SPX options, and hold
the position in place without having to change SPX options quantities daily. This solved
the problem , for the most part.
The actual expiration of the VIX futures takes place on the Wednesday morning of
expiration, and a VIX calculation is done, using just the SPX options that are trading with
an expiration of 30 days hence. There are rules governing exactly what price to use for the
SPX options-an average of the bid and offer, or the last sale-that can be found on the
CBOE website.
Once this "expiration-day-only" VIX computation is made, the VIX futures expire
and settle for cash at that price.
Example: Continuing with the above example, on expiration day, Wednesday, June 19,
the June VIX futures do not actually trade. Rather, when the July SPX options are opened
for trading that morning, the first posted market or trade in each pertinent option in the
whole strip is used in a VIX-like calculation (according to the regular VIX formula), and
a "settlement VIX" is determined. This VIX settlement price is disseminated by the
CBOE under the symbol VRO (quoted as an index). Thus, June futures are marked to that
price and expire. They are removed from each customer's account at that price, and the
resulting gain or loss is booked as realized. This is similar to the process whereby other
cash-based financial futures-such as S&P 500 futures-expire .
Suppose that an account had bought June VIX futures at a price of 2:3.2.5and held
them until expiration. Furthermore, suppose that at expiration, VRO is determined to be
20.84. Then a realized loss of 2.41 points, or $2,410 dollars, would be booked into his
account, and the futures position would be removed from the account. In reality. the
andTrading
Volatility
futures would have been marked to market daily in his account, so that $2,410 loss would
have been accumulating for some time .
There have been some accusations of chicanery surrounding VIX expiration-
rumors that traders of the SPX options are putting up prints in out-of-the-money options
at illogical prices in order to make VRO jump at expiration. These generally fall into the
category of urban legend-more fiction than fact. There are procedures in place to throw
out truly outlying SPX opt ion prices at expiration.
Nevertheless, there have been many instances ofVRO jumping by a great deal from
the previous night's closing VIX price. These are generally due to overnight market move-
ments, which cause SPX to gap open the next day. As a result, it is probably good practice
to close out your VIX derivative positions prior to expiration rather than merely holding
th em all the way into expiration.
FUTURES COMPARED TO VIX: PREMIUMS OR DISCOUNTS
If a futures contract is trading at a higher price than VIX, it is said to be trading at a pre-
mium. Conversely, if a futures contract is trading at a lower price than VIX , it is said to
be trading at a discount. In other words-as is the case with S&P futures and many other
futures contracts-the terms premium or discount refer to the relationship of the futures
with respect to VIX, not the other way around. That is, one would not say "VIXis trading
at a discount to the futures contract," but would instead say "the futures contract is trad-
ing at a premium to VIX." ·
It is useful to traders of volatil ity to pay attention to the premium of the futures. But
it is insufficien t to merely use the premium on the front-month futures contract. When
time gets very short for the front-month futures, it is not as important as the next futures
contract is. Therefore, it is useful to compute a blended premium, using th e two
front -month futures contracts.
Since VIX is a 30-day weighted average of the two front-month strips of options, and
this refers to calendar days, we can use the two front-month futures prices to directly
compute this blended premium.
Example: The following prices exist on the first day after the June VIX futures have
become the front-month contract. Assume that there are 4 weeks (i.e., 20 trading days)
between June and July VIX derivatives expiration.
VIX: 23.05
June VIX futures: 25.00
July VIX futures : 27.50
Therefore the premiums are:
Chapter
41: Volatility
Derivatives 871
Jun e premium : 25.00 - 23.05 = 1.95

July pr emium : 27.50 - 23.05 = 4.45
Since there are 20 days between the two expirations , and there are 19 days remain-
ing until July expiration, June has a weight of 95% and July 5%. So the blended premium
would be :
0.95 X June+ 0.05 X July=

0.95 X 1.95 + 0.05 X 4.45 = 2.125
The next day, the weights would be 0.90 and 0.10, and on the next .85 and .15, and so
forth. When there are fice weeks between the two VIX expirations, that means there are
25 trading days between them, so the weights could change by 0.04 each day (i.e., on the
first day the weights would be 0.96 and 0.04, then 0.92 and 0.08 the next day, and so forth).
If one computes the VIX premium in this manner, there will always be a smooth
transition right through VIX expiration. Otherwise, if one used only the front-month
futures contract, there would be a jump or gap each time the futures expired, for the
front-month future has very little premium as it is about to expire-no matter how much
traders are paying for the next month .
THETERMSTRUCTURE
When one talks about the collective status of the premiums on all the futures contracts,
he is said to be referring to the term structure of the futures. It is usually the case that
the various futures contracts-extending out seven months in time , or more-trade in a
pattern. One pattern that is fairly common is to see larger and larger premiums on the
futures , as one looks farther out in time .
Example: This is an example of a positive-sloping term structure:
VIX: 17.86
June VIX futures : 19.00
July VIX futures : 19.60
August VIX future s: 20.55
September VIX futur es: 21.75
October VIX futures: 22.60
November VIX futures: 23.15
December VIX futures : 23.35
Januar y VIX future s: 24 .25
andTrading
Volatility
See how each futures contract is trading at a slightly higher price than its predeces-
sor? That is a positive slope to the term structure. We will be discussing and referring to
the term strncture quite a bit in this chapter , but it really means that traders are paying a
higher implied volatility for SPX options expiring farther out in time than they are willing
to pay for short-term SPX option s.
\Ve have addressed this concept before, in Chapter 36, "The Basics of Volatility
Trading." Figure .16-3 showed the implied volatility of OEX options. Since that graph will
be referred to several times in this chapter, it is reproduced here as Figure 41-2. These
futures prices arc points on that graph. For example, if all the futures were priced along
the lower boundary in Figure 41-2, there would be an upward-sloping term structure. If
they were priced along the upper boundary, there would be a downward-sloping term
structure .
A positive-sloping term structure usually exists during bullish markets and/or if VIX
is quite low-priced. A negative-sloping term structure usually exists during the throes of
an ongoing bear market especially if VIX is high-priced. For example, during the last few
months of 2008 and off and on until March 2009, there was a severe negatice slope to the
term structure of the VIX futures. So a bullish stock market \\rill cause the term structure
to slope upward; the more bullish the market is, the steeper the term structure will slope
upward. But when the market hegins to decline, that upward slope will lessen. Further-
more, if the stock market continues to decline, the term structure will move from a
FIGURE 41-2.
Implied volatilities of OEX options over several years.
50
45
40
g 35
-~ 30
g 25
"O
,Q:!
ci 20
E
15
10
5
0
0 10 20 30 40
Time to Expiration (months)
Chapter
41: Volatility
Derivatives 873
positive slope, to a flattened state, and eventuall~, to an inverted (negative slope) if an

ongoing bear market gets underway.
In these regards, the term structure can sometimes be a good indicator of whether
the market is m·erbought or oversokl, for if the term structure slopes "too steeply" in one
direction or tht' other, odds are that it will flattt'n out somewhat, and the stock market will
reverse direction-at least temporarily-in order for that to occur.
Novice traders often ask why these futures trade at such different prices than VIX,
even the short-term ones. Besides the natural term structure of option pricing, as shown
in Figure 41-2, there is another important factor-the way that VIX is computed as com-
pared to what the VIX futures measure. Recall that, in the VIX calculation, one uses the
two near-term strips of SPX options, whereas the futures only track the SPX options that
expire 30 days hence.
As an example, examine what happened in August 2011, when VIX exploded to
48 as the stock market collapsecl, but VIX futures didn't come close to that level. \i\fhen
VIX closed 8t 48 on August 8, 2011, the near-term (front-month) August VIX futures
settled at 36.5,5-a huge discount of 11.4,5.The September futures (second month) dis-
count was a rather stupendous 17.80 on that day, for the September VIXfutures settled
at 30.20.
When traders see prices like this, they might react with comments such as "Are these
futures traders crazy? Why are they keeping the futures so far below VIX? Don't they
know that stocks are collapsing?" The futures prices don't have anything much to do with
traders ' opinions. Rather, the reason this pricing occurs is that VIX and the futures do not
have the same components. VIX and VIX futures prices are based on the implied volatili-
ties of SPX options. On that date, VIX was a weighted calculation of the August and Sep-
tember SPX options. The VIX futures however, are based on just one strip of SPX
options-those that expire 30 days after the VIX futures expiration. Hence, on that elate
of August 8, August VIX futures were based on the SPX September options. Similarly,
September VIX futures were based on SPX October options.
Let's look at the details, to see why these large discounts occurred. Table 41-1 shows
the implied volatilities of certain SPX options at the close of trading on August 8, 2011.
VIX is effectively a weighted combination of the implied volatilities in the columns labeled
"August" and "September."
August futures, however, are a combination of only the options in the column labeled
"September." September futures are a combination of only the options in the column
labeled "October." So it is quite easy to see why VIX is so much higher priced than the
August futures, and why August futures are higher in price than September futures. It all
has to do with the implied volatilities being paid for SPX options-and those are far more
expensive in the "August" column.
Eventually such a discount will disappear-at expiration, certain!:', if not sooner.
andTrading
Volatility
TA BLE 41-1.
SPX Implied Vols 8/08/2 0 11.
SPX: 1119.46
, - 79.92
Strike August September October
1000 61.6% 43.4% 37.9%
1025 60.0 42.2 36.9
1050 57.8 40.9 35.7
10 75 55.2 39.4 34.6
1100 52 .0 37.8 33 .2
1125 49.0 36.2 32.0
1150 45.7 34 .5 30.7
1200 39.7 31.2 28.3
Futures Xxx Aug futures: 36 .55 Sept futures : 30 .20
VIX 48.00 XXX
It might be instructive to see how the term structure changed at a few extreme times
in the past. \\'hen VIX futures first began trading, in 2004, VIX was quite low since a
full-fledged bull market was in force. In fact, VIX stayed low until ea rly 2007. But, on
February 27, 2007, the Chinese raised margin rates, causing markets to fall all around the
world. China's stock market fell by 8%, the Dow fell by 400 points, and SPX dropped ,50
points-all in one day. This was quite a shock coming after such a long period of low vol-
atilitv . The behavior of the futures was unusual. Table 41-2 shows the term structure
before and after th e market implosion th at day.
TABLE 41-2.
V IX derivatives' behavior, February 2 00 7.
Feb.15,2007 Feb.27,2007 Pctchang
e
VIX 10.22 18.31 +79%
M arch futures 11.55 14.80 + 28%
April futures 12.60 14.50 +15%
M ay futures 13.40 14.40 + 7%
June futures 13.80 14.40 + 4%
July futures 14.15 14.55 + 3%
A ugust futures 14.55 15.10 + 4%
N ov futures 15.10 15.15 +0.3%
Chapter
41: Volatility
Derivatives 875
There is quite' a bit of telltale information in Table 41-2. First, notice how much VIX
increased compared to the various futures contracts. Essentially , the term structure went
from an upward-sloping one 011 February 1.5 to a somewhat downward-sloping one on
February 27. And while none of the futures really kept pace with VIX, the near-term
March contract was clearly better than any of the others. This is the first example of many
that will show that when one wants to simulate VIX-either for speculation or for protec-
tion of a stock portfolio-he must stay in the ne ar-te rm contract.
One reason that the futures didn 't really increase all that much on February 27,
2007, was that they seemed to be implying that the market was overreacting, and the bull
trend would resume-and it did recover very quickly thereafter. Tims, when all of the
futures trade at a discount to VIX (as they were on February 27), then the market is over-
sold, and a buy signal for the market ensues when VIX drops back down. Alternatively
stated, a spike peak in VIX-especially when all of the futures are trading at a discount
to VIX-is a buy sign al for th e broad stock market.
The fact that the futures didn't keep pace with VIX was a cause for much conster-
nation amongst the relatively few traders who were trading the product at that time. After
all, some forward-thinking individuals, who were not completely wrapped up in the ongo-
ing, low-volatility bull market as the calendar turned toward 2007, figured that volatility
had to increase sometime in the next year. So they bought August or November VIX
futures. Imagine their disappointment when the first VIX explosion took place in Febru-
ary 2007, and their futures barely rose at all. There were many erroneous explanations
given by the media and misinformed analysts for what happened. Some were pure folly.
Others were close, but not really on the mark, such as citing the fact that SPX options are
European exercise .
The correct reason is that long-term August and November volatility did not really
rise much on that February clay. Only the implied volatility of SPX March and April
options did to any real extent. As we saw from the typical term structure graph (Figure
41-2), near-term option implied volatility is far more explosive than is longer-term option
implied volatility. In this case, March and April options were the most explosive, with the
heavier weighting in March options pushing VIX sharply higher. April options, on which
March VIXfutures were based, rose in line with that month's volatility only. Later months
didn't budge much at all. Thus, if one is going to try to simulate an explosive move in VIX,
he can't be in a long-term VIX futures or options. Rather, he must stay short-term and
keep rolling his position forward each month or two .
Sometimes the longer-term months will react more violently, especially if "smart
money" perceives that there is longer-term risk to the market. It seems that in February
2007, the most perceptive traders didn't feel that there was anything more than a
short-term risk to the market-that the Chinese rate increase was just a mw-timc event.
And they were right, as the market quickly resumed its upward trend in March, :2007.
andTrading
Volatility
TABLE 41-3.
VIX derivatives' behavior, July 2007 to August 2007.
July
16,2007 Aug.
16,2007 Pctchange
VIX 15.59 30.83 +98%
August futures 16.70 30.60 +83%
Sept futures 16.79 2725 +62%
Oct futures 16.97 23.50 +38%
Nov futures 16.98 22.38 +32%
Dec futures 1704 22 .45 +32%
Feb '08 futures 1720 22.50 +31%
May '08 futures 1729 22.45 +30%
But in July and August 2007, a completely different picture arose. The stock market
was making new highs in mid-July 2007, when a new term appeared: subprime debt (well,
new to most). The stock market quickly suffered a sharp drop of nearly 200 SPX points in
a month. That was certainly something new in light of the fact that the market had gen-
erally been advancing without volatility or major corrections since the 2002-2003 lows.
That correction ended in mid-August. Over the course of that month, a completely dif-
ferent volatility term structure had emerged. Table 41-3 shows what happened over that
tim e.
There are rnst differences between the futures' reaction in Table 41-3 as compared
to Table 41-2. First, notice that VIX made a much larger move-nearly doubling over the
course of the month. The near-term VIX futures contract, August, matched that gain for
tht> most part, rising 83% . Hence the futures and options traders were not predicting a
quick rt>turn to lower volatility as they had been in Table 41-2. If you had owned the
August contract as insurance, you would have been quite pleased with that performance.
One is not going to get much closer than that-an 83% move in the derivative as com-
pared to a 98<7()move in the underlying. But if instead you had hedged with a contract
e:\piring later in the year-November, say-you'd have been sorely disappointed, for the
longer-ter m contracts only rose 30% or so.
So, t>ven though the financial markets were undergoing a major eruption (this was
the beginning of one of the \\·orst bear markets in history), the longer-term contracts only
rose modestly in terms of implied volatility. Once again, the point is made that if one
wants to simulate the performance of VIX, then he must utilize a short-term contract and
keep rolling it over.
Also, notice that the term structure on July 16 had been sloping upward mildly, but
a 1no11thlater it was sloping downward sharply. The hull market shape had changed to a
Chapter
41: Volatility
Derivatives 877
TABLE 41-4.
VIX derivatives' behavior, September 2008 to October 2008.
Sept.3, 2008 Oct.10,2008 Pctchange
VIX 21.43 69.96 +226%
Sept + Oct futures 21.64 62.00 +186%
Oct futures 23.10 56.71 +146%
Nov futures 23.42 38.30 + 64%
Dec futures 23.20 33.78 + 46%
Jan '09 futures 23.66 32.41 + 37%
Feb '09 futures 23.82 31.35 + 32%
Mar '09 futures 23.64 29.29 + 24%
bear market shape in that time frame. This was hut one morP sign that the bull market
had ended and a bear market had begun.
The third and final example of the VIX futures performance is presented in Table
41-4. In this instance the data encompasses the bankruptc:· of Lehman Brothers, as the
market went from a nervous bear market to a complete financial crisis. \Ve will use this
data in other examples later as well.
If one ever needed protection from volatility, this was the time, when one of the
greatest financial disasters in history unfolded. VIX jumped by 226o/c (and actually went
much higher, later). On September :3, 2008, the September futures were the near-term
contract. If you had owned that contract and thPu rolled to October when the Septembers
expired, you would have gained 18Ro/cwith your futures positions. While once again, that's
not as much as VIX, it would certainly have stood one in good stead as a hedge against
falling stock prices. Even if yon had owned the October contract throughout-a 146%
gain-you would have at least garnered some healthy amount of protection.
But if you had been in longer-term contracts-say, those Pxpiring in 2009-your
gains would have been paltry i11comparison to the rise i11VIX and in comparison to the
decimation that was taking place in the stock market. The March 2009 contract only rose
24% over the time period covered in Table 41-4. Clearly, the npar-term contracts are the
only ones that approximate what VIX is doing, ewn when VIX explodes in a financial
crisis.
Notice the sharp, downward slope of the term structure on October 10, 2008. All of
the futures were trading at huge discounts to VIX. As notPcl earlier, a sharp spike 1wak in
VIX when all of the futures are trading at disco11nts is a buy signal for tlw stock market-
but in this case, VIX didn't peak 11ntil quite some ti11H'later. So nwrcl: noting that the
878 PartVI:MeasuringandTradingVolatility
FIGURE 41-3.
Term structure of VIX futures.
Term Structure of VIX Futures

56
54 08/11/08
52 ..........
08/26/08
09/12/08
50
48
46
•
---
--\:-
09/15/08
09/16/08
09/17/08
44
---
-
09/30/08
42
" ~ 10/02/08
10/07/08
40
38
36
34
32
30
28
26
-n J~
24
22
20
VIX Sept Oct Nov Dec Feb 09
futures are all trading at discounts is not a reason to buy stocks, although it is a warn ing
sign that a bu:,;signal lies on the short-term horizon. As we will see later, there are (option)
strategies that can be employed in such situations-especially the VIX/SPX hedged
strategy.
Figure 41-:3 displa>·s much the same information as Table 41-4, but in graphical
form. Each line rn1 the graph depicts the term structure at a different date. On each line,
tlw nodes show tlw prices of the ,·arious futures and VIX. The lmvest line on the graph
shm,·s the term structure on August 1L 2008. On that date, VIX was just above 20, and
the futures were trading with small premiums, extending out to the February 2009 con-
tract \\'liich \\'as trading at about 2:1.So the term structure sloped slightly upward on that
date .
Chapter
41: Volatility
Derivatives 879
Even though there was an ongoing hear market at the time, it was a rather
slow-moving affair, and there wasn't any sense of urgc>ncyamong the VIX derivatives. By
late August 2008, the term structure hadn't changed much at all. However, as September
began, there were fpars an<l rumors that perhaps Lehman Brothers would not survive.
But even on September 12, 2008, the term structure was still quite flat; VIX was just
below 26, and the various futures were trading at 24 or 25.
However, by September 1.5,it was made clear by the U.S. government that there
would not be a bailout for Lehman, and the stock market began to collapse. VIX rose
sharply on September 1.5through the 17th, so that by September 17,the term structure had
taken on a distinctly negative slope. VIX was now trading just above 36, but the near-term
contract-which, on that clay,was the October contract since the Septembers had expired
that morning-was trading just above 26! This was a 10-point discount on the near-term
futures. The other futures were trading at slightly lower prices, all the way out to the
February 2009 contract, at a price of 25. In other words, even though the stock market
was plunging and VIX was exploding to the upside, the VIX futures were rather sanguine,
trading only slightly higher than they had been in the <lays and weeks before. This was
both unusual and, as it turned out, incorrect-incorrect in the sense that volatility went
much higher. So whoever was selling future volatility at such low prices was extremely
misinformed.
The last date on the graph in Figure 41-:3 is October 7, 2008. By that time VIX
was all the way up to 54, but the October futures were still much lower-at 42. The
other futures were much lower: November at 34, December at 30, and February 2009
at 29. Thus the term structure now had a very steep downward slope. This is what hap-
pens in extreme bear markets. VIX continues to rise, but the futures do not keep pace.
Only the near-term future has any hope at all of keeping up with VIX. Of course, by
expiration day, there is a convergence between the near-term futures price and VIX,
and that fact will lead to some interesting strategies in these types of situations, as we
shall see.
Eventually, in that bearish cycle of October 2008, VIX rose to 88, intraday, and
peaked there. That peak was coincident with a strong stock market rally near the end of
October 2008.
There had been other pPaks in volatility <luring the ongoing bear market that started
in 2007. Those previous peaks weren't as extreme as the one in October 2008, but they
all bore similar characteristics: all the VIX futures were trading at a discount, and the
term structure was sloped negatively downward. Each time that VIX peaked, a strong
stock market rally occurred. These took place most noticeably in August 2007, November
2007, January 2008, March 2008, and July 2008. Each time the stock market rallied.
These rallies were not the encl of the bear market, hut they n:crr quite tracleahle, inter-
mediate-term rallies of at least 100 points on th e SPX Inde x.
andTrading
Volatility
However, not every major bottom in the stock market is signaled in this manner. For
example, at the eventual bottom of that bear market in March 2009, there was no spike
peak in VIX. VIX had only risen slightly as the stock market descended into its depths.
The only clue that one had, from volatility , that the bottom had been reached was the fact
that the term structure of the futures went from a negative slope to a positive slope as the
market finally rallied. But even that didn't happen immediately. The term structure still
had a negative slope until about April 13, 2009-more than a month after the actual lows
had been made in the stock market.
There are many other times, of course, when these conditions exist-not just during
bear markets. In fact, most severe drops in the stock market are accompanied by a swiftly
rising VIX, and when VIX makes a spike peak that is a buy signal for the stock market.
If the VIX futures are also all trading at discounts when this spike peak occurs in VIX, it
is an even more conclusi ve buy signal for stocks.
VARIANCE FUTURES
For completeness, we will discuss the only other listed volatility futures that the CBOE/
CFE introduced in 2004: the Variance Futures. Variance is a measure of realized volatil-
ity. So these contracts measure how volatile the market has been. Technically, they settle
at the 90-day historical volatility of SPX, once per quarter. Variance is standard deviation
(or rnlatility, in the traditional sense) squared. In Chapter 28, in the section titled "Char-
acteristics of the Model," the formula for variance was given. These contracts use that
formula to determ ine the settlement value .
There are contracts expiring in March, June, September, and December. These
contracts settle on the third Friday of the month, just as '"regular" options do. Since they
are quite volatile, a one-point move is worth only $50. As an example of their range, when
volatility rose from 20 to nearly 90 in the fall of 2008, the front-month variance future
rose from 400 to 8100 (squaring the ends of the volatility range). That move of 7700 points
was worth $38,500 ($50 tim es 7,700).
The margin required for a variance futures contract is variable-depending on the
initial price. If all of the futures contracts listed are trading at prices of 400 or less, then
margin is $5,.500 per contract. The scale slides higher, all the way to: If all the contracts are
trading between 10,000 and 11,025, then the margin for one contract is $230,000. The
entire table oh·ariance futures margin is available on the CFE website (http://cfe.cboe.cm n).
Before continuing with the explanation of these contracts, it should be pointed out
that, unlike volatility futures, these variance contracts have been a great disappointment.
E,·en at their best, the open interest was only a few hundred contracts. More recently,
there is barel:· any open interest at all. This is somewhat surprising because they are pat-
tt'rned after similar contracts that successfollv traded in the over-the-counter markets.
Chapter
41: Volatility
Derivatives 881
Perhaps it is because they are quoted in variance terms, rather than volatility terms. For
example, if the market-maker is making a volatility market of "20 bid, 21 offered," in vari-
ance terms that would be "400 hid, 441 offered." So the market is 41 "ticks" wide. That
doe s not encourage liquidity.
The CBOE has some interesting calculations available with respect to these futures,
due to the way that the settlement value is actually calculated. Once a contract has 90 days
or less until expiration, the calculation of actual volatility begins. This is called the compu-
tation period. So the futures price "implies" a volatility for the remainder of the period.
Example: The June variance futures are exactly halfway into their "computation
period"-the 90 calendar days leading up to expiration. Suppose that the variance calcu-
lation (see Chapter 28) for the 45 days thus far is 200 (a volatility of 14.1%).
Furthermore, suppose that the June variance futures contract is trading at a price
of 300. Then we can infer what the marketplace is estimating for variance over the
remainder of the futures' life.
If actual variance is 200, and the future is trading at 300, then the remaining actual
variance would have to be 400 over the remaining 45 days. That is, if actual variance is
200 for the first 45 days, then is 400 for the remaining 45 days, the variance over the total
90 days would be 300.
So, the futures price is implying that the market will be quite a bit more volatile over
the remainder of its life-averaging 400 (or a volatility of 20%). A trader might then be able
to make an assumption or prediction about the futures price with this information in hand.
The CBOE publishes the implied variance (400 in the above example) and the realized
variance (200 in the above example) daily under the symbols IUG (implied) and RUG (real-
ized). These indices-IUG and RUG-can sometimes be useful to traders, for informa-
tional purposes, even if they are not necessarily trading the variance futures themselves.
These calculations only apply to the front-month futures contract-the one that is
in the computation period. The longer-term variance futures aren't really tied to any spe-
cific data, except that one knows that someday they will be in the computation period and
will thus have to converge on realized volatility. As a result, the contracts have tradition-
ally traded at a rather high variance estimate. From their inception in May 2004 through
the summer of 2007 (before the bear market started), it was typical for SPX actual vari-
ance to be approximately 100 (a volatility of 10%). These variance contracts would nor-
mally only trade at that low of a variance at the encl of their life. In effect, they could be
shorted at almost any time , and the trader would make money.
The CFE has indicated that they may, in the future, revamp this contract so that it
has broader appeal. If they clo, it might be interesting to trade. But for now, the liquidity
is too small for anything other than a small speculation.
andTrading
Volatility
OTHER LISTED VOLATILITY PRODUCTS
In this section, we will cover other volatility products, but not options-yet. Volatility
option s will be covered in the next section.
There are a number of volatility-based indices and data that are available pub-
licly, but they do not necessarily have products that one can trade. For example, the
S&P 500 Index (SPX) was created in 1957, although it was extrapolated backward
for several decades for comparison to other indices. However, there was no way to trade
the index directly until S&P futures were listed in 1982. VIX was created in 1993,
but there was no way to trade it until 2004. Likewise, there are other volatility
measures-most published by the CBOE-that might be useful for traders to observe,
but there is no way to trade them directly at this time. In the future, though, there might
well be.
The concept is expanding rapidly, and there are now volatility-related products on
certain indices, ETFs, and even stocks. As mentioned earlier, in the future it may be
commonplace to have calls, puts, and volatility futures and options listed on every stock
that has listed options. Put options won wide acceptance shortly after their introduction
in 1976. Volatility options are not as obviously useful to the general public as put options
are, so their acceptance may be harder to win, but it will eventually get done.
OTHER VOLATILITY INDICES
There are other volatility indices. So this same calculation that VIX uses can be applied
to any entity that has a continuous series of listed option markets, with "good" bids and
offers at all times. For example, the NASDAQ-lO0's (NDX) volatility is tracked with a
VIX-like calculation, and it is available via the symbol VXN. A competing calculation for
NASDAQ, using a slightly different formula, can be found with the symbol QQV. Like-
wise the Russell 2000 Index (RUT) VIX volatility calculation is RVX, and the Dow-Jones
30 Industrials (DJX) VIX volatility calculation is VXD.
Certain statistics and data related to VIX include the VIX bid (symbol: VWB) and
VIX ask (symbol: VWA).
Recall that VIX is a 30-day volatility estimate. The CBOE publishes a longer-term,
:1-month volatility estimate, also using a VIX-like calculation, under the symbol VXV.
There are also some interesting strategy indices. One is the VPD-the Premium
Strategy Index-that tracks the performance of merely selling the one-month VIX futures
contract each month and rolling it over. There is a similar strategy: VPN-selling the
one-month VIX future, capped by the purchase of a call option. There is also a volatility
arbitrage index, VTY.
Chapter
41: Volatility
Derivatives 883
Most of the indices listed above are entities that one would glance at only occasion-
ally, for they cannot be traded.
VOLATILITY INDICES ON STOCKS, FUTURES, AND ETFs
Of far more interest is the increasing trend of taking the VIX calculation and applying it
to options on other entities. For example, GLD is the Gold ETF. Its options are very liq-
uid and heavily traded. Thus, one could use them in a VIX calculation and come up with
a "GLD VIX." In fact, the CBOE has started doing this on a number of entities, and it is
a certainty that many more will follow in the future. At this time, most of these are only
index calculations; there are not listed futures or options on them and thus they cannot
be traded. However , they will likely be tradeable in the near future .
In this regard, the original VIX should really be known as the ''SPX VIX," although
that moniker may never take hold. Since the list of these products is short at this time, it
is listed in Table 41-5.
TABLE41-5.
Available VIX calculations.
Name Symbol VIX
Calculation
Symbol
ETFVolatility Indices:
Gold ETF GLD GVZ
Oil ETF USO ovx
EuroCurrency ETF FXE EVZ
EmergingMarkets ETF EEM VXEEM
Silver ETF SLY VXSLV
China ETF FXI VXFXI
Gold Miners ETF GDX VXGDX
EnergySector ETF XLE VXXLE
EquityVolatility Indices:
Apple Computer AAPL VXAPL
Amazon.com AMZN VXAZN
Goldman Sachs GS VXGS
Google GOOG VXGOG
IBM IBM VXIBM
andTrading
Volatility
TABLE 41-6.
CME Volatility Calculations Based on Futures Options.
Product BaseSymbol VIX
Index
Symbol VIX
futures symbol
Gold futures GC GVX GV
Crude oil futures CL OIV CV
Soybeans futures s SIV Not traded
Corn futures C CIV Not traded
Of this entire list, the only one that has tradeable products at this time is GLD, where
there are listed futures traded on the CFE (base symbol: CV) and options traded on the
CBOE (under the symbol CVZ). To date, they have not been too popular, but it is highly
likely that this list and many more underlyings will one day have listed volatility futures
and options.
To complete this topic, the CME Croup, where futures on gold and crude oil trade-
among many other things-has attempted to enter the fray as well. They have created a
VIX-like index using the gold futures options and another using the crude oil futures
options. Note that these options are different from GLD and USO options, although their
implied volatilities are not much different-to no one's surprise. There hasn't been a lot
of interest in these, either. CME has also created a VIX-like volatility calculation for soy-
beans and corn, but no products are listed on these at this time. While the intention to
list these products is good, the actual products have not been a success. The symbols for
these various CME products are in Table 41-6.
VOLATILITY ETFsAND ETNs
Once the popularity of volatility futures became evident, other entities tried to copy the
product. The CROE and CFE have certain licensing agreements in place, so that the
exact same products could not be duplicated. That is, it is not possible to create another
futures exchange and then start trading volatility futures in the same way. However, a
number of ETFs (Exchange Traded Funds) and ETNs (Exchange Traded Notes), which
utilize the VIX futures have been created.
The first, and the most popular and liquid of these, is the Barclays Bank creation,
VXX. It is formally known as the iPath S&P .500 VIX Short-term Futures Exchange
Traded Note. It was launched on January 31, 2009, and has been a way for entities that
cannot trade futures and options to trade volatility. The components of this ETN are the
hrn front-month VIX futures that trade on the CFE. Barclays rolls them daily, to keep
them in the proper ratio according to the VIX formula.
Chapter
41: Volatility
Derivatives 885
Then_, is a companion ETN. the iPath S&P ,500 VIX Mid-term Futures ETN, traded
under the s:nnbol \'XZ. It utilizes the VIX futures in months 4 through 7, to create a
longer-terlll \'Olatilit:· product. It has been far less popular than VXX, because-as we
have already shown-longer-term ,·olatility futures do not track the short-term move-
ments of VIX well. E,·en so, it has a fairly large arnount of liquidity. \'XX and \'XZ both
han' listed options, which expire on the "'regular" third Friday of the month.
\'XX is, by far, the most actin" and popular of the volatility ETFs and ETNs. How-
ever, others are gaining in popularity and-clue to the overall demand for volatilit:' hedg-
ing products-there will probahl:· continue to he more of these in the future. The
following list is a brief re,·iew of the major ones that exist at this time. It should be under-
stood that something which is not liquid now might become so in the future, through
marketing efforts of the firm that created it, or from uniqueness in finding a niche that
investors want filled.
There are some direct cop:·cat products to VXX and VXZ, created by other firms.
These other products utilize the VIX futures to create the encl product as well. Velocity-
shares has a short-term ETN and a medium-term ETN, trading under symbols \'IIX and
VIIZ, respectively. Proshares has volatility ETFs trading under the symbols VIXY and
VIXM, which are the short-term and mediurn-tenu products, respectively. I realize this
starts to look like alphabet soup after a while, but these products are all being marketed
to traders who want volatility protection. The liquidity of VXX is currently about 40 or .50
times that ofVIXY , and as much as 200 times that ofVIIX.
Some of the other creators of products have trie<l to get more creative. There is an
inverse VIX ETN, created by Velocityshares, trading under the symbol XIV (which is VIX
in reverse, get it?). This has begun to trade several million shares per clay. as traders have
come to understand how these products work. In the next section, ,,.re'll describe the foi-
bles of some of these contracts, and why the im:erse product has a definite profit potential
to it. There is an intermediate-term inverse ETN as well: symbol ZIV.
Velocityshares also has created ETNs with double the speed of VIX: TVIX is the
short-term product, and TVIZ is the intermediate-term one. TVIX has become quite
popular as well, as traders looking to speculate on volatility like the extra "action" that this
double-speed product produces.
There is even a product designed to reflect the steepness of the term structure
(XVIX). Moreover, the CBOE produces an index (hut no actual product that can be traded)
to reflect the ske1c in the price of SPX options; it is broadcast under the S:'mbol SKE\ V.
\Vith so many of these, one might be tempted to ignore them all. However, that
would not he the best approach, for some of them have definite attractions.
There will ct>rtainly he changes in the relative liquidity of these products in the
future, hut at tlw current time VXX, XIV (im·erst'), and TVIX (double-speed) are th(' most
heavily traded by far.
886 Part VI:Measuring
andTra
dingVolatility
A POTENTIAL PROBLEM WITH ETFsAND ETNs
One of the main problems with commodity-based ETFs is that they don't necessarily
track the underlying commodity very well. This is mainly due to the fact that the ETF is
forced to trade the futures contracts, and there are times when it isn't feasible for the
ETF managers to roll from one futures contract to the next without making a "losing"
trade that puts drag on the performance of the ETF vis-a-vis the spot index or commod-
ity itself.
There have been many articles written about the US Oil Fund ETF (USO) and/or
the US Natural Gas Fund ETF (UNG) as they compare to actual crude oil or natural gas
prices, respectively. These funds huy the actual commodity futures, rolling them forward
when they expire. The "problem" arises from the fact that-when the longer-term con-
tracts are more expensive than the near-term contracts-the ETF pays the differential.
Example: The front-month crude oil futures are expiring, and thus are near the spot/cash
price at expiration. Let's assume that price is 7.5.The USO ETF sells out their position in
the front-month futures, and buys the next month out-at a price of 76.50, say.
A month later, assume that the cash market is still unchanged at 75. The now-expiring
futures, which cost 76.,50, are now trading at 7,5. So the ETF has a loss of 1.50 on these
contracts, even though the spot/cash market is unchanged.
Over time, the cumulative effect of all these rolls forward into futures trading at higher
prices puts a drag on the performance of the fund, with respect to the cash market. Fur-
thermore, the ETF only has a limited amount of assets, and eventually, these losses could
theoretically cause the ETF to run out of cash.
This same problem can sometimes affect the volatility index ETNs, VXX, VXZ, and
all of the others (including XIV, which is the rnerse ETN, which is affected in the oppo-
site way). VXX utilizes the front two VIX futures contracts, while VXZ utilizes months 4
through 7. Each day, the weighting of the various contracts changes, to reflect the proper
ratio of the futures.
Example: Consider the VXX ETN. Suppose that the September VIX futures have just
expired, so the VXX consists of being long both the October and November VIX futures.
With 19 trading days (four weeks) to go, the ratio might be 95% October and 5% Novem-
ber. Then tomorrow, 90%/ 10%, and the day after 8,5%/1.5%,and so forth. Each day, at the
close, the managers of the ETN (Barclays Bank) sell some October futures and buy some
November futures.
\\'hen the term structme of the VIX futures is positive, the Novembers are more
expensin., than the Octobers (not to mention the fact that the market-makers know these
Chapter
41: Volatility
Derivatives 887
orders are corning into the pit, and thus there is a certain additional cost to Barclays to
execute trades in a market where your trades are known in advance).
However, sonzeti111csthe term structure slopes dmcnward and the ETN actually
makes mone:-,·on the roll because the second month is lower-priced than the front-month.
This typically happens in a bearish market.
Consider Figure 41-'"-Lwhich shows the simple charts of VIX and VXX from their
inception in Januar:-,·2009 through the middle of 2010. Even without statistical verifica-
tion, one can see that VXX performed far worse than VIX itself. Consider points A and
B-which represent the VIX peaks of March 2009 and May 2010, respectively. In terms
of VIX, point B was nearly as high as point A. But in terms of VXX, point B is far below
point A.
The term structure of the VIX futures was positive almost continuously during this
time period. As a result, the daily rolls that VXX had to perform cost money. The net
effect is the poor performance of VXX vis-a-vis VIX.
Points C, D, and E further strengthen the case. From point C to D, VXX per-
formed nearly in line with VIX. The term structure was very flat during this time period,
so the drag on VXX was minimal. From point D to B, the stock market fell, and VXX
actually gained ground-more about that later. But as the summer wore on, the premi-
ums on VIX futures grew huge, and the term structure steepened considerably-both of
which hurt VXX performance. So by point E, VXX was at new lows, even though VIX
was not.
Figure 41-4 is illustrative: when the term structure slopes upward, VXX managers-
even though they only have to roll a portion of their position each day-are making losing
trades every day. But when the term structure slopes downward, the Barclays traders are
making money every day on the roll.
In any case, the overall point is that VXX outperforms when the term structure
slopes downward (which only happens in bearish times or when VIX is at very high levels),
while VXX underperfonns when the term structure slopes upward (which is common
during bullish times). Moreover, at times when there is great demand for protection from
SPX put buyers, the term structure slopes upward even more steeply, thus putting an even
greater drag on VXX.
I'm not sure anyone really buys VXX and just holds it, but VXX can be a useful tool,
despite the fact that it underperforms VIX in bullish times. Note that VXX outperforms
in a bearish market, and so that's when you' clwant to be long VXX. Meanwhile, since VXX
underperforms during a bullish market period, that's when you'd want to be short VXX.
In fact, since there is an inverse ETN (XIV), rather than actually shorting VXX, one could
merely huy XIV at those times. The inverse XIV takes advantage of the upward-sloping
term structure. XIV was first introduced in December 2010, and one can compare its
chart with that of VIX and VXX to see the relative performance since then.
andTrading
Volatility
FIGURE 41-4.
VIX and VXX from January 2009 inception to mid 2010.
' ' '

VIX
0 I O I I I I I I I ' I I ' I
- - - - .. - -'. • I ,._ - • I-- - - ... - -I -
I
- -< - - -I-
I
- _,_
I
- ,.
I
- - ~
I
- - ,0 • - -I • - _,_ - -•• - - ..
: -:--'.- 74.000
I I I I I I ! I I
• - • - ➔
,
• - ◄
, I I I
- - -,- - - ,- - - .. - - .. - - ➔
I
I
I
- -
I
.... - -
I
_,_ -
I
- ,_ - - .. - -
I
.. -
I
I
•
,
t - - ➔
I
I
I
- - ... - - -,-
O
I
I
....
I
I
-i--;--;-70.000
------------------,---,---,---,---.---➔---,--
' ' I ' I '
- : - - ; - - ~ - 66.000
--- ---------- ·-----,-·;-·-:---~ :- -- ;_ ; __, --,---;--:--:--;---:---:---~--~--:--j- 62.000
-- -- _;__
A--:---:---i--:--;--~--->--:---~--:--:--~---:---:---H--H
- 58.ooo , • I ' I
, , , - - -:-· - ~ - - ; - { - 54.000
. . .. ~ : : :: 1 [Ti] Bl!! '.:iii~

····· H\~-i
-~--~:__:_
__
-It;:_L:'.:::~~~
::-:_:\ • : : - -- - - , - - • -- : - ~ , - • ,, 26 000
-----------------------~---:------H--~-+-~-
_ . :_ : !- : - 22 ooo
-- -- - , ~ :- ~ -~--\--:--~---:·-----~--; :·- ;--~--,-- ,E 18 ooo
-f--i ·: : ··:·-·f--!C~-l/
- -------------;--~--+--:---i : i : -!- 14.ooo
· -: -:- -'---~--;--;--,---:---,---,--f--'--,---'---:---:---,--'--i-
I I I I I I
10.000
9 I I I I !
F M A M J J A S O N D J F M A M J J A 10
vxx -'-A·:- . ----:--,--~---:·--------,--,--~------.-----:

, I
I
•
'
I
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I '
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,
I
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I
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------
< I
132.000
124.000
o
------..,---,---, --,--·r··y··1··1 ·, --·-·r··r··y--1 -

' ' + ' ' I
116.000
108.000
100.000
92.000
84.000
76.000
68.000
60.000
52.000
44.000
36.000
28.000
20.000
12.000
.1 •••
'
L ••
+
L ••
'
l •• .,_
'
4.000
9 I I I I
F M A M J J A S O N D J F M A M J J A 10
01w could makt> these decisions (to bt> long or short), based on the term strncturc>
of the \'IX foturt>s (be long VXX when futures are at a discount to VIX, and be long XIV
wlit'n fotmt"s art> at a prt>mium). So, contrary to tlw negativism about commodity ETFs
Chapter
41: Volatility
Derivatives 889
(of which this is one), there are ways that VXX can be gainfully used. But if yon just want
to speculate on volatility, the VIX futures appear to be superior to VXX.
LISTED V IX OPTI ON S
VIX futures were first listed in March 2004. Variance futures followed in May. But it took
nearly two years before VIX options were listed. Initially they were scheduled to begin
trading in April 2005, but that launch was aborted when it became clear that there wasn't
a viable way for market-makers to hedge their positions. After some further creative work,
VIX options began trading on February 24, 2006. These options have proven to be very
popular, although they do have some characteristics that are different from other listed
options one may be used to trading.
We noted earlier that some of the ETNs, such as VXX, have listed options. Those
options are of the "normal" variety-expiring on the third Friday of the month, and set-
tling into VXX shares if they are exercised or assigned.
But the VIX options are cash-based options, settling for cash on their expiration
day-ostensibly like OEX or SPX options do. The same a.m. VIX futures settlement price
that was discussed earlier is used for the VIX options settlement.
Ex ample: A trader owns the VIX July 25 put. He does not exit the contract in the open
market, but rather holds it until expiration. The settlement price (VRO) is determined to
be 20.84. The July 25 put is thus 4.16 points in the money (25 minus 20.84), and after
expiration the customer would receive $416 in his account, while the put contract would
be removed from the account.
But nearly all other aspects of VIX option trading are different from other listed
equity or index options , whether they be cash-based or not.
First, they are subject to the same expiration dates as VIXfutures-30 days prior to
the next listed SPX option expiration. That date is always a Wednesday, often the Wednes-
day before the third F1iday, but occasionally the Wednesday after the third Friday.
But the most important thing to understand about VIX options is that they are
priced off the VIX futures-not off of VIX itse(f Or perhaps you would prefer to think of
it this way: VIX options are priced off of the implied volatility of the various strips of SPX
options (which is what the VIX futures represent, of course). However you want to look at
it, the implied volatility-and hence the futures prices-can vary greatly from month to
month. If one is discussing IBM, October IBM and December IBM, say, are the same
thing-IBM's price. Same for an index, such as SPX. But not the same for the im7Jlied
volatility of the options on those underlying indices .
andTra
dingVolatility
Example: On February 24, 2006, on the first day of VIX option trading, VIX was trad-
ing at 11.46. The following were the prices of the VIX put options with a striking price
of 15:
VIX Index: 11.46

VIX March 15 put: 3.00
VIX April 15 put: 2.55
VIX May 15 put: 2.00
First of all, this looks rather strange, doesn't it? The longer-term puts sell for a lower
price than the near-term ones? But any option trader will always relate an option's price
to parity, first of all. For a normal American-style option, parity of an in-the-money put
is the striking price minus the underlying price.
If we (erroneously) assume VIX is the underlying, then we would calculate:
Parity= 15 - 11.46 = 3.54
These puts are trading well below parity, it seems. The May 1.5put-trading at a
price of 2.00-seems to be trading at nearly a point and a half discount to parity.
What is possibly going on here? The answer to that question lies in the fact that, for
pricing purposes prior to expiration, the underlying for these VIX options is not VIX itself
(at least not until the last instant of their life),but rather the VIX futures. Consider, then,
this further piece of information, Table 41-7:
Consider the following general information about a proverbial XYZ option:
XYZ: 13.86
XYZ May 15 put: 2.00
TABLE41-7.
VIX options and futures prices.
Option
Contract Option
Price Futures
Price
VIX March 15 put 3.00 March: 12.10
VIX April 15 put 2.55 April: 12.76
VIX May 15 put 2.00 May: 13.86
Chapter
41: Volatility
Derivatives 891
One would not think there is anything unusual about this. XYZ stock is slightly below the
striking price of 1.5,and it's 1.14 in the money (15 minus 13.86). The put option is trading
at 2.00-well above intrinsic value.
Substitute the data for the May 15 put from Table 41-7:
May VIX futures: 13.86
VIX May 15 put: 2.00
Now the option prices in Table 41-7 make sense-if you consider that the
underlying is the futures contract and not VIX itself. In fact, VIX may differ from the
futures prices by a substantial amount, as we have seen from earlier examples. Not until
the settlement process takes place does VIX have to converge with the near-term futures
price. Hence, for nearly all of a VIX option's life, the price of VIX itself is a piece of
irrelevant information! True, there may be strategies that we can employ by knowing that
the near-term futures and VIX will have to eventually converge, but for the purpose of
pricing the options, VIX is not needed. VIX options are priced off of the futures
contracts!
To reinforce this point, consider the VIX option prices on one of the days during the
financial crisis in 2008-October 10, 2008, the same day that we used for the futures
example in Table 41-4. On that day, this information was available:
VIX: 69.96
VIX Oct 25 call: 31.70
VIX Nov 25 call: 13.70
VIX Dec 25 call: 10.00
Now, if one was not aware of the pricing structure of VIX futures and options, he
would certainly think that the above list contained some misprints. How can a November
call sell for so much less than an October call with the same strike? The same question
applies to the December call as well. Moreover, with VIX near 70, and the striking price
of all the calls at 25, parity is seemingly 45. Why are all the calls so far below parity?
Surely there must be a mistake here.
But there isn't. Remember that the price of VIX is an irrelevant piece of information
as far as pricing the VIX options. Rather, we need to consider the prices of the October,
November, and December futures contracts. Table 41-8 incorporates the above option
prices with the futures prices from Table 41-4:
The fourth column shows the call options' parity (intrinsic value) with respect to the
futures contract. That is, it's the price of the futures contract minus the strike, 25. In this
892 PartVI:Measuring and TradingVolatili
ty
TABLE 41-8.
VIX Options and Futures Prices on October 10 , 2 00 8 .
Option
Contract Option
Price Futures
Price Parity
(Futures)
VIX Oct 25 call 31.60 October 56.71 31.71
VIX Nov 25 call 13.70 November: 38.30 13.30
VIX Dec 25 call 10.00 December 33.78 8.78
light, the options seem quite accurately priced. The October and November 2.5 calls are
near parity since>they are so deeply in the>money, and the December 2.5 call-while in
the money also-has a little time value premium because it has a longer life remaining.
Again , the price of VIX is irrelevant for pricing the options.
vVhat is most important to understan<l throughout this discussion is tha t the individ-
ual \'IX futures prices are different, and may not relate to each other in the same way at
all times. Traders who are familiar with other futures contracts know, for example, that
December wheat and July wheat are !lot the same thing. Yes, they are somewhat relat ed,
hut their prices can spread apart or colltract at various times. The same holds true for VIX
futures.
VIX OPTION CALENDAR SPREADS
Using these same concepts, let ·s see how what appears to be a rather benign strategy-
the call calendar spread-can actually have some unexpected results. The following
examples closel:; replicate what actually happelled in the fall of 2008, much to the cha-
grin of both customers and their brokerage firms.
Date: September 8, 2008

VIX: 22.64
VIX Oct 2.5 call: 1.7.S
VIX Nov 2.5 call: 2.1.S
!\lost brokerage option platforms at that ti1ne-and, sad to say, most still today-do
not calculate VIX option Creeks and implied \'Olatility correctly, because they are not
'"smart enough .. to use tl1e futures prices as the underlying. Rather they just use VIX,
which we know is wrong. That colltrilmted to the problem. Using VIX (incorrectly) as the
tmclerl:-,'ing,it appears that the irnplit>clvolatilities of these two options are out of line-
that tlw October 275call is traclillg with a much higher implied than the November 2.5 call.
Thus, traders thought that a call calendar spread might make sense.
Chapter
41: Volatility
Derivatives 893
VIX Call Calendar:

Buy Nov 25 call and Sell Oct 25 call for 0.40
Now if this wt>re I BM or an index, or anything lwsidt>s the equivalent of a futures

option, :mu know that a "'regular" calt>nclarspread risks the initial debit (0.40 in this case)
and can makt> a limited profit depending on where the underlying is at the time of
near-term (Octobt>r) expiration and what the implied volatility of the long-term (Novem-
ber) call is at that time. There isn't anv such thing as "November IBM" and "October
• C
IBM." IBM is just IBM.

But these are not IBM options, an<l what happened was devastating to some. You
have already seen these prices in the preceding tables:
Date: October 10, 2008

VIX Oct 25 call: 31.60
VIX Nov 25 call: 13.70
This VIX call calendar spread is now trading at minus 17.90 points. Thus, to exit the
spread costs another $1,790! You would have to buy back the October 25 call for 17.90
more than you would get from selling out your long November 25 call. Since you already
paid $40 to enter the spread, your total loss is $1,830 plus commissions.
Traders who used this strategy lost a lot of money, and in many cases their brokerage
firms did, too, because those brokerage firms had not properly margined the position-
thinking it was a "normal" calendar spread. Now most experienced brokerage firms are
asking for naked margin for any short options in a VIX calendar spread or diagonal spread;
only vertical spreads receive the usual reduced margin requirement.
THE VOLATILITY OF VOLATILITY
Before getting into the more intricate aspects of VIX option pricing, it may be beneficial
to see how volatile the underlying index, VIX, and its futures, can be. Understanding the
volatility of volatility, as it were, can help in pricing the VIX options, for it is necessary to
have a volatility estimate to price options. Also, knowing how volatile VIX and its deriva-
tives can be aids one in understanding how effective they are as a hedge or spt>culation in
times of high volatility.
Figure 41-5 shows the historical volatility of VIX over a ten-year period. This time
frame encompasses both bull and bear markets. Moreover, the actual price of VIX has
varied greatly over that time. It rose to 60 or so in the bear market of 2002, and then
collapsed to 10 in 2006, only to explode to nt>arly90 in 2008 and then return to the teens
in 2011 before jumping to 50 once more.
andTrading
Volatility
FIGURE 41-5.
Historical volatility of VIX.
Historical Volatility of VIX
0
C\l C\l C") C") "St" "St" I.{) I.{) co co I'-- I'-- CX) CX) 0) 0)
.... 0.... ....
0 ....
.... ..__
~00
~
Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q
C\l C\l C\l
~ ~ ~ ~ C\l 00 C\l ~
C\l C\l
~ ~ ~ ~ C\l ~
C\l C\l C\l C\l
C\l 00 00 C\l 00
- 20-day HV -- 100-day HV
A great variance in the price of VIX is encompassed in the data. However, the one
thing that stands out is that-bull market or bear, high-priced VIX or low-priced-the
historical volatility of VIX remains amazingly constant, averaging about 90%.
The black, less rnlatile line on the chart is the 100-clay historical volatility and it has
generally ranged between 60% and 1.50%.The gray line is the 20-day historical-often
the time frame of choice used by traders for a volatility estimate-and it has ranged
between 40% and 270%.
The highest spikes on the chart occurred at times of significantly high VIX readings
(and hence, at major market bottoms): September 2001, July 2002, May 200,5, June 2006,
February 2007, November 2007, November 2008, May 2010, and August 2011. It is inter-
esting to note that VIX has been more volatilf, since listed VIX options began trading
(February 2006). It is unclear if that is a coincidence or not.
The 111€'dia11 100-<lay historical volatility over the data span included in Figure 41-,5
is 90Clc.There are no stocks that I can think of that have a 100-clav historical volatilitv as , ✓
high as 9017c0H--'rany time period of any significant length-much less a mc>dian100-day

anywhere near that high.
Chapter
41: Volatility
Derivatives 895
FIG URE 41-6.

VX continuous futures chart.
VX Continuous Futures Chart

90 ,-----------------------------------
80-+---------------------IIW--'....__----------____J
60-+------------------+---------------____J
50 +-------------------l--------__l,~--l--ltl4-....-----_J
40 +-~---.::,:--.-...::::--.-,----------A,;f!/¥-:'\,.,k-/----------+-----.--l
30 +--------__::=.,_,,,,.._....-,:!. ______________ __..,.__
_______JII-II
20 -+----------------------------_____.::il!W-____J
10
LO LO LO co co co r-- r-- r-- r-- (X) (X) (X) 0) 0) 0) 0 0 0
*~
T"" T"" T""
~ ~ C\l ~ ~ ~ ~ ~ co ~
0 Q 0 Q Q Q 0 T"" T"" T""
r::: co
T"" T"" T""
LO r::: co ~
~ 2l
0 r-- .,...
C\l ~
T"" (X)
co ~ .,...
T""
C'5 T""
T""
C\l 0) -- LO ~
T""
T""
T""
~
r-- -- C'5 co
T""
T""
~
T""
0
T""
C\l ~
LO o5
T""
~ co
But one cannot trade VIX. Rather one must trade the VIX derivatives. The VIX
futures are not as volatile as VIX itself, but they can be quite volatile during times of dis-
tress in the stock market. Figure 41-6 shows the long-term graph of the continuous VIX
futures. You may recall that a continuous futures contract chart is constructed by "con-
necting" the ongoing charts of the front-month futures contract, but eliminating the gaps
from one to the next. It purports to show the results a futures trader would have experi-
enced had he continuously held a position in the front-month futures, rolling it over each
time it neared expiration (or first notice day, in the case of a physical futures contract).
Note: This is somewhat similar to the Barclay's VXX, except the VXX is a weighted blend
of the two front-month futures, whereas the continuous chart is merely the front-month.
But both have a long-term downtrend because one is more or less constantly paying a
premium for the futures. That premium is then lost by expiration. The only time that the
continuous chart-or VXX-gains on VIX is when a bear market is in progress, and the
futures are thus trading at discounts to VIX.
Returning to the subject of actual volatility, consider a single futures contract.
Figure 41-7 shows the 20- and 100-day historical volatility of the November futures, dat-
ing back to their inception in 2006. The November contract is a pertinent one, because it
is often the one that one would be using for protection in September and October-the
typical "bad" months for the stock market. You can see that volatility explodes in this con-
tract as well-and this one can be traded. In 2007 and 2008, actual volatilitv of the
November mntract rose to over 100% (from below 40%) when the stock market declined.
andTrading
Volatility
FIGURE 41-7.
VIX futures historical volatility.
Nov VIX Futures - 20-day Historical Volatility
20-day HV - 100-day HV I
140 ············································································································································,
120 -4------------------------------:
100-4--------------,..,...._.---+----------~
80-+--------------+-.-----+------------
60-+--------------t-- ~-------·------,
40 -+-------------~----------.--....,--,.,r-,---- I:
hJii
0
,;:t- U") U") co co r,... r,... co co 0) 0) 0 0 ,...
0 0 0 0 0 0 0 0 0 0 0 ..... ,.... ,.... .....
---
0)
,.... ---
,.... --- ,... ---
0)
,.... ---
0) --- ---
0)
,.... ,... ,.... ---
,... ---
0)
,... ---
0)
,... ---
,... --- 0) --- ---
,... ,... ,... ---
0)
,....0) 0) 0) 0) 0) 0) 0)
---
co --- a5 --- ---
C\I co --- ---
C\Ico --- ---
co --- ---
C\I co --- ---
co --- ---
C\I co C\I C\I C\I
SKEWS IN VIX OPTIONS
\\'hen one ohseIYes the entire set of VIX options available for trading, he is looking as
far as se\·en or eight months out. These option prices are based on the underlying
futures contract expiring in that month. Each successive longer-term month is less vola-
tile than its predecessor. Table 41-9 shows a typical array of VIX futures volatility (using
the 20-da:· histoiical volatilit_v).This data is a snapshot from July 22, 2010, but it is gen-
erallv illustrati\·e of how the volatilities are related. There is greater volatility in the
front-month than the second, and greater volatility in the second month than in the
third, and so forth.
This concept can be reinforced by once again referring to Figure 41-2-the general
graph of the term structure of implied volatilities. Think of a vertical line between the
two c1m·es 011 the graph at each month as representing the range of possible volatility for
that 111ontl1.That vertical line wonlcl he longest in the front-month; then next longest in
tlw seco11d rnontli, and so forth. That is exactly what Table 41-9 represents: the range of
volatilities of each futures month.
Inciclentall:·- iu Jnl:· 2010, rnlatilit:· was decreasing from the peak it had reached in
\Lt:· and J11ne(the "Hash crash") and perhaps the futures were anticipating that decrease
Chapter
41: Volatility
Derivatives 897
TABLE 41-9.
2 0-day Historical Volatility (HV) of VIX futures on July 22, 2010.
Entity 20-Day
HV
VIX 100%
August futures 56%
September futures 45%
October futures 41%
November futures 39%
December futures 37%
January futures 36%
February futures 35%
continuing (as it did). Thus there might he more of a discrepancy between VIX's historical
volatility and the futures· historical volatility than there normally would be. In any case,
VIX is generally more volatile than the futures.
The data in Table 41-9 is illustrative for the purpose of pricing VIX options because
it shows that option VIX August options should trade with a higher implied volatility than
that of a later month. Also, September VIX options should trade with a higher implied
volatility than any later month, and so on. This means that there will always be a lwri::.on-
tal skeu; in VIX options. The near-term options will always be trading with a higher
implied volatility than later months.
Unlike an individual stock, though, this does not necessarily present a volatility trad-
ing opportunity. In the case of an individual stock, if near-term options are expensive with
respect to longer-term options, a calendar spread might be an appropriate strategy
(although, even there, there might be a justifiable reason why such a skew is correct-an
upcoming event in the form of an earnings announcement, for example). But with VIX
options, this is the norm, because spreading August options against October options, say,
involves two different underlyings, not just one-as would be the case for stock options-
and the nearer-term underlying is more volatile than the other one .
In addition to the horizontal skew that is present in VIX options, there is also aver-
tical skew. There are a couple of ways to justify why this skew exists. One is that the down-
side is limited in VIX, while it can he very explosive to the upside. Hence lower strikes
should sell with a lower implied volatility than higher strikes.
Another way to look at the same thing involves using SPX options. \Ve have clemon-
stratecl in an earlier chapter that index options have a negative skew in their pricing-a
skew that has existed sinct' the Crash of 'H7. Out-of-tlw-mm1cy puts 011SPX arc quite
andTrading
Volatility
expensive in terms of implied volatility, when compared with at-the-moneys, or when

compared with out-of-the-money calls. Thus, the lower strikes have higher implied vola-
tilities than the higher strikes. VIX is the inverse of SPX (when one goes up, the other goes
down), so it would stand to reason that VIX options should display mirrored characteris-
tics to SPX options. Thus, for VIX, higher strikes should have higher implied volatilities
than lower strikes.
Both arguments are valid ways of explaining the skews.
TRADING STRATEGIES: DIRECTIONAL SIGNALS
Now that we have the definitions in place and the reader is familiar with the mechanics
of listed volatilit:' futures and options, we can discuss some strategies. Initially, we will
look at using VIX and derivatives data to aid in market prediction .
Let's begin by looking at a long-term chart of VXO-the "original " VIX-in
Figure 41-8. We use this because, when the CBOE first introduced VIX in 1993, they
backdated the data to 1986, so as to theoretically include the Crash of '87. As you may
recall, that "original" VIX changc>dits symbol to VXO when tlw new VIX \Vas introduced
in 2003. So it is VXO that has the longest (theoretical) history.
FIGURE 41-8.
VXO history.
VXO - Entire History
80 150 crisis
Crash
70 of '87 Long-term
capital
60
Terrorist
Iraq attack *
50 1nva es Tech stock
Kuwait Dow limit
40
30
20
10 ': Bear market
panic bottoms
0
Chapter
41: Volatility
Derivatives 899
A number of general observations about volatility and its performance during cer-
tain market periods are evident in this chart. First and foremost is the fact that spike
peaks in volatility accompany market crises and are eventually indicators of market
bottoms.
The actual level of VXO at the time of the peak is not particularly important, either,
although it does measure the magnitude of the crisis that occurred to produce the spike
peak in the first place. For example, the spike peak in 1994 after the Fed surprisingly
raised interest rates was just as valid of a "buy" as many other signals, even though VXO
barely rose to 20 at that time .
Most of the signals occurred as the result of some specific event-war, financial cri-
sis, terrorist attack etc. However, some were merely the result of a falling market that
developed its own sense of panic, pushing VIX and VXO sharply higher. The two highest
peaks were the Crash of '87 and the financial crisis of 2008. Recall that all data prior to
1993 is theoretical (backtested) data, so it is only an estimate that VIX-had it existed-
would have exploded to 150 in 1987. On the other hand, we do know that VXO traded at
103 in 2008.
We have previously discussed how a spike peak in VIX or VXO is often coincident
with a solid trading low in the stock market. Such a spike peak is ideally set up by a swift
rise in volatility <luring a sharply declining stock market. Then, when VIX spikes up to its
highs and reverses quickly downward, that is usually an intermediate-term trading low
for the stock market.
What is actually happening in such cases is that traders are panicking to own SPX
puts as the market is dropping. As one might expect, those puts can get quite expensive
in the midst of a crashing stock market. It's akin to trying to buy fire insurance for your
house when it's already on fire-it's going to be very expensive.
In this sense, the spike peak in VIX is a contrary indicator. When the "last" trader
has paid top dollar for the "last" put, then all the players have thrown in the towel, and
then the stock market turns and rallies.
Figure 41-8 shows other important data as well. For example, VIX and VXO rarely
fall below 10, and so we could say there is a floor of sorts at that level. In a following sec-
tion, there will be a further discussion of the meaning of VIX trading at 10, but suffice it
to say that it has not spiked down to 10 and popped right back up. Rather, VIX takes a
good long time making rounding bottoms near the 10 level on its chart. Eventually this
leads to a much higher level of volatility.
In this sense, many analysts say that VIX is "mean-reverting." That means that it
won't trend up or down forever, like the market or a stock might. Rather, it remains in the
general range of 10 to 50, say, and after reaching either extreme, eventually finds its wa_v
back toward the center of that range.
andTrading
Volatility
In general, statistics show that VIX moves opposite to the market about 75% or 80%
of the time. That is 011a daily basis. On a longer-term basis, the movements are negatively
correlatecl at a slightly higher rate. Simpl_vstated. when the market goes down, VIX goes
up-and vice versa. This is clearly evident on the chart and is why owning volatility is
good protection for a portfolio of stocks .
THE TREND OF VOLATIILITY
The trend of rnlatility is important, too. VIX knds to trend lower over the course of a bull
market, and to trend higher during a bear market. \Vhile Figure 41-8 doesn't show the
stock market-only VXO- some larger trends are evident. For example, the bull market
of 200:3 to 2007 was accompanied h:' VIX trending lower and lower, until it eventually
reached 10. In retrospect, it was subsequently made known that the Fed was manipulat-
ing interest rates, trying to engineer a ·'perfect" environment for owning financial instru-
ments and real estate (and as a b:·-product, crushing volatility). However, that all fell apart
in the financial crisis of 2007-2008.
Another interesting trend was an incrrnse in volatilit:· over the 1995-2000 period,
pretty much all during the bull market of that time frame. It is unusual to see VIX rising
vvhile the market is rising, but that was a very volatile bull market. Recall that volatility is
the standard de,·iation of daily price changes. For \'Olatility to increase during a bull mar-
ket, there needs to bt' a lot of counter-tren<l. volatile, back-and-forth movement, but
within a general rising price trend.
The trend of \TX can be used as a confirming indicator on a shorter-term basis, as
well. For example. if the market is declining, but VIX is not rising, then one might con-
clude that the market decline is temporary in nature. However, if the market is declining
and VIX is rising. then that is a bearish combination that should be respected as identify-
ing an ongoing bearish market phase .
The c011,·erseholds true for rising markets. If the market is rising and VIX is falling,
then that's a bullish confirmation. However, if the market is rising and VIX is rising as
well, the uptrend may be suspect.
VIX Measures the Cost of Protection. This might be a good place to point out a
gPneral description of VIX: it is a measure of the cost of insurance. Of course, VIX is more
than that. hut this is a useful description-one that would help many novices understand
how a11clwhy \'IX sometimes rises and sometimes remains docile. So when the market is
plunging and traders are scrambling to bu:· SPX puts. the cost of protection is high and so
is VIX.
:\.s \\'as pointed out. not e,·er: lo\\' in the stock market is marked by a spike peak in
\T'\.. Tht>1Tarc certain tirncs ,,·hen the stock market declines. \'et VIX does not move
Chapter
41: Volatility
Derivatives 901
sharply higher. There can be \·arious reasons for this, hut they basically all center on the
same fact: either traders don't feel the need to buy protection in such cases, or protection
is being supplied readily .
Recall that we previously said that, at the bottom of the large 2007-2009 bear mar-
ket, when SPX traced out the last leg into the March 2009 lows, VIX was not rising rap-
idly. Knowledgeable traders felt that most people already had protection in place by that
late elate in the hear market, and thus there wasn't much demand for protection. VIX was
relatively high-slightly above SO-but it wasn't spiking.
In general, when one sees a declining market, but VIX is not rising, then one can
assume protection is cheap. Sometimes it's cheap because traders who previously had the
foresight to buy protection before the market started to decline are now selling out their
protection to take profits. This increases the supply of protection and holds the cost down,
even though the stock market is falling. It has the same effect as would be the case if no
one wanted to buy protection. A lack of demand or a preponderance of supply can both
hold the cost of protection down-and keep VIX relatively low and/or stable.
Just because protection is cheap doesn't mean that the people who are eschewing
protection are smart-in fact, just the opposite was true in August 2011, as VIX was quite
cheap when that market first began to decline. VIX was still in the low 20s even after SPX
had fallen by nearly 100 points. Shortly after, however, SPX plunged and VIX exploded-
doubling in a matter of days. By that time, demand for protection had skyrocketed.
This same concept of sharply rising implied volatility coincident with a trading low
in the underlying is equally true for individual stocks, futures, ETFs, and so forth. Most
of these don't have a VIX calculation at this time, but that isn't a problem. One merely
needs to look at a chart of the composite implied volatility of the options on the entity to
observe the spike peak in volatility .
Extreme Lows in VIX. If a spike peak in VIX is a buy signal for stocks, is an extreme
low a sell signal? It can be, but it's sometimes better to consider in a broad sense what low
volatility means. If traders aren't willing to pay much for options, then the consensus opin-
ion is that the underlying isn't going to he volatile-it isn't going to change much in price.
Looking at this from a contrarian viewpoint, if "everyone" thinks the underlying is going
to remain stable, then it's quite likely that the opposite will be true, and the underlying
will explode in price. That explosion can be on the upside or the downside. Hence, in the
general sense, extremely low volatility is a sign to buy volatility-perhaps in the form of
long straddles if volatility is not directly tradeahle 011 the entity in question.
At the very least, when VIX is low, one should consider buying VIX calls or SPX puts
as protection for a stock portfolio. If the market explodes 011 the upside, one's portfolio
would profit. Conversely, if the market plunges, the cheap protection is snre to serve a
useful purpose .
andTrading
Volatility
It should be pointed out, though, that volatility can remain low for long, long periods
of time. Conversely, volatility tends to spike up to extreme highs and then fall back rather
quickly. Stated in another way, VIX makes rounding bottoms and spike tops. Since the
stock market moves in the opposite way to VIX, that is akin to saying that SPX makes
rounding tops and spike bottoms-a fact that any experienced trader knows is true.
Having said that, there is evidence that extremely low VIX often precedes a sharp
market decline. The "modern" VIX has backdated data to 1993; the "old" VIX-now
called VXO-was backdated to 1986. In the entire history of these two volatility indices,
VIX has onl_vfallen below 10 a few times. \,\Then it has, a sharp market decline has usually
followed.
It turns out that VIX and VXO have only closed below 10 at nine different "periods"
throughout their histories (a "period" might contain multiple days with VIX or VXO below
10, but those days are all close together). In recent years, VXO has generally traded at lower
prices than VIX most of the time. So VXO tends to drop below 10 first. In fact, VIX doesn't
always follow along completely. For example, on February 1, 2007, VXO closed below 10,
hut VIX never actually closed below 10-making its low at 10.08-on February 2. After
that, SPX went sideways for a week before eventually dropping 10 points.
There were two other occasions where VXO closed below 10 but VIX didn't. So one
rnight say that these two indices are "too low" when VXO is below 10, and VIX is below
10.30, for example. Using that as the entry criteria, Table 41-10 shows the results of SPX
rnm·ement. The first column, "entry date," is the date on which this "too low" criterion was
first met. The second column shows how many trading days later SPX went into a sharp
decline. The size of that SPX decline is shown in the third column, both in terms of SPX
points as \vell as the percentage drop. Finally, the fourth and last column shows how big
a draw down one would have had-i.e ., how far, in points , SPX rose during the waiting
period as defined by the second column.
O\ ·erall, this is a pretty good system for finding a spot where a sharp (about 1 per-
cent) SPX decline in a day or two is about to take place. That is a sizeable decline in such
a low rnlatility market. That decline always took place within about a week, and some-
times as soon as the next day. Moreover, the draw downs while one waited were quite
small.
The worst signal was the first one, in 1993 (perhaps traders didn't really understand
what a VXO below 10 exactly meant in those days-VIX was new, having just been
introduced earlier that year). The draw down in 1993 was large in comparison to the even-
tu al drop in SPX.
So the rt>quirement for VXO to be below 10 and for VIX to be below 10.30 appears
to he a good entr:,· criterion. But if one is treating this like a trading system, an exit point
wo11lclhe neC('Ssar:,·as well. In most of the occurrences shown in Table 41-10, the hulk of
Chapter
41: Volatility
Derivatives 903
TABLE 41-10.
11
Market Declines after a Low" VIX.
Daysuntil SizeofSPX
Drop: Draw
down while
Entry
Date SPX
Drop Points(%) waiting
(Points)
2/14/07 8 -50.3 (3.3%) 4.3
2/2/07 5 -10.3 (0.7%) 1.7
1/24/07 -16 .2 (1.1%) 0.0
12/14/06 5 -12.8* (1.0%) 1.6
11/20/06 4 -19.0 (1.3%) 5.5
12/22/05 2 -12.1 (0.9%) 0.5
7/20/05 1 -8 .2 (0.7%) 0.0
1/28/94 5 -10.9 (1.9%) 3.3
12/22/93 5 -4.1 * (0.9%) 4.7
* Total of 2-day decline.
the decline came in the one or two days noted in the third column. Hence one would be
encouraged to take profits on the first big SPX drop, or at least to use a tight trailing stop
for any shorts that may have been established. The main exception to that was the signal
in January 1994, which was a predecessor to a more serious decline. The Fed raised rates
on February 1, 1994, and knocked the market for a loop. Many small-cap indices and
individual stocks dropped sharply that year. In fact, most small cap investors count 1994
as a bear market year, even though SPX and OEX were mostly sideways. Hence, 1994 is
sometimes known as the stealth bear market.
In summary, it is extremely rare to see VIX at or below 10, but it is noteworthy when
it happens.
USING VIX FUTURES INFORMATION
The VIX futures can help one decide on strategies and sometimes on market direction. It is
their relationship to VIX and to each other (the term structure) that can provide these insights.
EXTREMEPREMIUMS OR DISCOUNTS ON VIX FUTURES
The relationship of the front-month VIX futures contract to VIX is important for traders
and observers of volatility. When VIX derivatives first started trading in 2004, VIX was
904 PartVI:MeasuringandTrading Volatility
low-priced, as volatility was dormant during an ongoing bull market. In fact, VIX traded
mostly between 10 and 16-with one brief exception in the summer of 2006-until early
2007. All during that time, VIX futures traded with fairly large premiums, but that wasn't
so much that traders felt volatility was going to increase hut rather because they knew it
coulchi't go nmch lower, so there was an outside chance that it might increase. In any
case. that period of time is not considered as useful data for determining if the VIX
future s premium has any predictive or strategic value .
Howe,·er, when \'IX is higher-priced, and the front-month futures trade at a large
premium, that is usuall:,; a sign that "smart 1rnmey" is expecting a sharp increase in
volatility-which, by inference, means a sharp decline in the stock market. Although, as
will he shown, this phenomenon was far more effective in the bear market than in the
ensuing hull market. One of the first times that this came to light was in late 2007.
Example: In 2007, the stock market had tumbled for the first time in years, with SPX
d ropping lSO points in July, only to recover to new all-time highs by mid-October, 2007.
Then another decline started, taking SPX down 170 points by Thanksgiving 2007. At that
point, a large rally ensued, leading into the Christmas holiday. SPX rallied 110 points
between the two holidays, and the Dow-Jones 30 Industrials gained about 1000 points.
Table 41-11 shows the prices of VIX, the January VIX futures, and SPX, along with
the future s premium on the days leading up to the end of the year, 2007 .
First, note the rall:· in SPX from 144.Sto 1497, dating from December 17 to Decem-
be r 26. Then note the accompanying decrease in VIX over that same time frame, frorn
24.52 to 18.66. That is typical behavior : VIX decreases as the market rallies .
Howe,·er, 1101c look at the price of the January VIX futures. They dropped a little
m·er that time frame, but not nearly as far as VIX. The difference between the January
VIX futures price and VIX is shown as the "Futures Premium." In all the cases in this
table, the January futures were trading at a premium. vVhen the premi u m is less than
1.00, that isn't too unusual, but when it grows to 4.63, as it did at the close of trading on
December 2 L or remaim abm·e 3.00 as it did from December 20th through December
26th , that is not eworth y.
In effect, \'IX futures were "saying" that VIX was going to remain high-that VIX
mts going to ha,·e to rise to catch up to the futures price. \Vhen VIX rises, the market falls.
In fact that was a major sell signal, as SPX dropped 230 points in less than a month!
£\·eu to this cb:·, it is rare to see the front-month VIX futures premium above 4.00.
Frorn om earlier description of how \'IX is calculated and what comprises the VIX
futures. we know what is hehind this large discrepancy. In the above e\.ample, in late
December, \'IX was comprised of two strips of SPX options-those expiring in January
Chapter
41: Volatility
Derivatives 905
TABLE 41-11.
January VIX Futures vs. VIX, December, 2007.
Date JanFutures VIX Futures
Premium SPX
12/17/07 25.45 24.52 0.93 1445.9
12/18/07 24.57 22.64 1.93 1454.9
12/19/07 24.42 21.68 2.74 1453.0
12/20/07 24.17 20.58 3.59 1460.1
12/21/07 23.10 18.47 4.63 1484.4
12/24/07 22.17 18.60 3.57 1496.4
12/26/07 22.01 18.66 3.35 1497.6
12/27/07 22.72 20.26 2.46 1476.2
12/28/07 22.80 20.74 2.06 1478.4
12/31/07 23.11 22.50 0.61 1468.3
2008, and those expiring in Fehruary 2008. The weighting between those two strips
changes daily, but in late December they were about equally weighted, more or less. The
January VIX fut11n:'sprice, however, is based on only one strip of options-the February
2008 SPX options. Hence, what was really happening was that traders were selling down
the price of January options, thus lowering VIX, but were not selling February options
with the same aplomb. It could have been the converse, of course: traders were buying
February protection in SPX, but not January protection. In either case, the SPX option
activity derived from the fact that there were large expectations from professional and
retail investors alike that the end of the year was going to be positive and it would con-
tinue on into 2008. Tims, the large VIX futures premium was something of a contrary
indicator.
As it turned out, the reality of the situation was that traders began to sell as soon as
the new year began, and that selling was exacerbated by the discovery of a rogue trader
at Societe Generale that caused that hank to liquidate a massive long position right in the
midst of an already serious market decline in mid-January 2008.
There are other instances of the premium on the front-month futures being a useful
sell signal when the premium gets extremely high. For example, in May of 2008, a similar
set of large premiums appeared on the VIX futures, shortly before SPX collapsed 240
points in two months.
The effectiveness of this technique was greatly reduced during the large bull market
rally that took place after March 2009. As that rally progressed into the late sumrner of
2009, traders began to heavily buy SPX options at relatively expensive prices, forcing up
andTrading
Volatility
the price of the VIX futures. This included not only the near-term VIX futures but the
next few months as well. No serious market decline ever developed, leading volatility
analysts to seek answers as to what had changed. One theory is that VIX derivatives were
a relatively new product in 2007 and early 2008 and were therefore mostly the purview
of "smart money"-professional traders. But by the middle of 2009, the benefits of protec-
tion had become well-known in the wake of the bear market that had taken place, and so
the public and unsophisticated mutual fund a.ml hedge managers were now buying protec-
tion as the bull market continued in 2009. They expected some sort of market correction
in th e fall of 2009 that never materialized.
But rather than trying to affix labels such as "srnarf' (or "dumb") to groups of trad-
ers, this phenomenon can be explained in another way. Recall once again, Figure 41-2,
which shows how the term structure looks in general. In a hull market, volatility is low
and the term structure follows the lower curve in Figure 41-2. That is, it is normal for the
futures to have premium over VIX. In a hear market, \·olatility is high, and the term struc-
ture follows the ll/J7Jer curve on the graph. That is, the term structure slopes downward,
and the futures tend to trade at discounts to VIX.
So, <luring the bull market that began in 2009, it was natural for the futures to gain
premium and keep it. Hence, large premiums were not sell signals, but were just reflec-
tions of the ongoing bull market. But in tht> bear market of 2007-2009, premiums were
rare, and so when they appeared, they were sell signals. It would seem that in the next
bear market (and in otliers that will assured!:-,·follow) large premiums on the front-month
futures can be interpreted as sell signals. But during an ongoing bull market, large pre-
miums on the front-month futures are not a signal of anything in particular.
Extreme discounts on the VIX futures have often been a buy signal for the broad
stock market. That is, traders panic to buy short-term SPX protection, forcing up the price
of VIX. But the implied volatility of the next month SPX options, which are reflected as
the price of the near-term \1IXfi1t11res are not as nmch in demand. Hence the futures lag
below the price of VIX. \Vhen that discount expands to large levels and then begins to
contract sharply, that is usually a sign that the stock market is ready to rally. This, too, is
a bit of a contrarian indicator. \\'hen "e\·eryone" has panicked into buying the near-term
SPX puts , the market then rallies .
During the financial crisis of October 2008, the discount reached an astounding
2.5 points 011 the front-month futures. During the "flash crash" of May 2010, the discount
reach ed 10 points, and during the August 2011 hear mid, the discount reached 16 points.
In each case, the market rallied thereafter.
Figure 41-9 is a scatter diagram of the daily blended front-month futures premium
m·erlaid with a line chart of SPX. Notice the deep discounts at market lows, and-in the
first two years-large premiums just before major market declines.
Chapter
41: Volatility
Derivatives 907
FIGURE 41-9.
SPX vs. blended front month VIX futures premium.
SPX vs. Blended Front Month VIX Futures Premium: 01/02/07 - 08/26/11
Prem
10.00+-------------'-------4E-------------------l
-10.00 -+-----------"'♦I...:♦-~---------=-----------~
....
..
♦
,.
-20.00 -+-----------~------------------l
::
-30.00
I'-- I'-- I'-- I'-- co co 00 co 0) 0) 0) 0) 0 0 0 0 ..-
..- ..-
..- ..-
..-
..- ..- ..- ..-
~..- ~..- ~ ~
0 0 0 0 0 0
~ ~ g g ~ ~
?,
~ ~ ,:::: 0..- ~ ~ ~
~
?, ?,
~ ,:::: 0 ..- -.:t" ~ ..- I'--
..-
..- ~
..-
• Prem - SPX
However, one must make some adjustments before determining what the near-term
discount or premium is. One cannot merely subtract VIX from the shortest-term VIX
futures contract, because that gives a biased statistic near the expiration of the VIX
futures contract.
You will note that this chart has the word blended in its title. It is necessary to use
the prices of the tico front-month futures to create a "blended" futures price and pre-
mium, weighting the two front-month futures. The advantage of doing this is that there
isn't a big jump in the blenclecl futures price on the clay that the actual near-term contract
expires. This blended futures price computation was described earlier. The weights
decrease hy 5% per clay in months with 20 trading days between expirations, or by 4% per
clay in months with 25 trading clays between expirations. If there are trading holidays
involved, then one wou kl adjust the blending factor for those (24 trading, or 19 trading
days, etc.; this can he significant in January when there are usually three holi<laysbPtween
VIX expiration dates).
andTrading
Volatility
Example: On the first day after July VIX expiration-the following prices exist:
August VIX futures: 28.00

September VIX futures: 30.75
Weighting factors: 95%/5%
Weighted (blended) futures price= 0.95 X 28.00 + 0.05 X 30.75 = 28.14
Assume that VIX is at 24.38, and so the blended futures premium is
28.14 - 24.38 = 3.76.
USING AND TRADING THE TERM STRUCTURE
As was noted earlier, in a bull market the term structure slopes upward. The various
futures are all at a premium to VIX, and each futures contract trades at a higher price
than its predecessor. In futures market lingo, this upward-sloping term structure is also
referred to as forwardation, which is the same as contango.
During bear markets, the term structure slopes downward. The VIX futures are at
discounts to VIX, and each successive futures contract trades at a price lower than its
predecessor. In futures markets, this is knows as backwardation.
Since most equity option traders and volatility traders are not necessarily experi-
enced futures traders, in this text we refer to the term structure as upward-sloping (or
having a positive slope) and downward-sloping (or having a negative slope), as opposed to
using the futures terms. It is just much easier to visualize what is taking shape
without having to constantly refer to the definition of forwardation, backwardation, or
contango.
Sometimes the term structure is not completely sloping upward or downward. That is
a condition that usually takes place in a transition from bullish to bearish markets, and
vice versa.
One way that the term structure can be useful is to compare its shape with market
action. This is especially useful when one is uncertain as to what type of market is in exis-
tence. For example, if the term structure is downward-sloping-reflective of a bear
market-and it maintains that shape during a market rally, then one can infer that the
rally will be a short-lived, hear market rally, and not a change of direction from bear mar-
ket to bull market.
The term structure can be traded via futures (calendar) spreads. This is a highly
len-'raged wa~,to trade, and as such can he a very interesting way to either speculate on
Chapter
41: Volatility
Derivatives 909
market direction or to sometimes take advantagt' of a large premium or discount in the

front-month futures as e:-,,:piration11pars.Note that in this section, we are not referring to
a blended front-month premium. Rather, the front-month futures contract is the price of
the shortest-term VIX futures contract.
The CBOE Futures Exchange (CFE) imposes minimum margin requirements. They
are quite low for a calendar spread involving two futures contracts in the first three listed
months. \\"hen the VIX futures were first listed, that spread margin was $100. It has since
been raised to $625, but it is still quite low. Recall that the VIX futures movements are
worth $1,000 per point. So, a spread can make or lose large percentages.
Example: Assume that the following prices exist:
VIX: 36
Sept VIX futures: 32
Oct VIX futures: 30
Since September is the front-month, the 4-point differential between September

VIX futures (32) and VIX (36) will have to disappear by September expiration. Hence, one
might consider buying the September VIX futures and simultaneously selling the
October VIX futures, for a two-point differential:
Buy Sept and Sell Oct VIX futures: 2.00 points (Sept over Oct)
Suppose that later, September is drawn toward VIX, and the following prices e:-,,:ist:
VIX: 38
Sept VIX futures: 35
Oct VIX futures: 32
So the spread has widened to 3.00 points (35-32).
If the spread trader exits the position, he will have a profit of $1,000-a large return
for a short period of time, since the margin required is only $62,5. The details of the trade
are shown below:
Initial
Trade Exiting
Trade Prof
it/Loss
Buy Sept@ 32 Sell Sept at 35 +$3,000
Sell Oct@ 30 Buy Oct@ 32 -$2,000
Total Trade: Bought @ 2.00 Sold@ 3.00 +$,1000
and Tra
ding Volatility
MA RKET SPECULATION WITH TERM STRUCTURE SPREADS
The futures spread can be used for market speculation. Some traders prefer the spread to
an outright ETF or long index call position, because the spread has large leverage. Dur-
ing a bullish market move the term structure will tend to steepen. That is, the second
month futures contract will rise in relationship to the front-mon th futures. So if one has
a buy signal via his trusted indicators on the stock market in general, it may be worth his
while to establi sh th e futures sprea d .
Converselv , if the market makes a bearish move , the term structure will likely flatten
or even invert. In that case , one would want to own the nearest-term VIX futures and sell
th e seco nd or third month .
To Summari ze:
VIX Futur es Spr eads As Market Speculation:
If bullish, buy the second month VIX futures and sell the front-month VIX futures.
If bearish, lmv the front-month VIX futures and sell the second month VIX futures.
There is no guarantee that the VIX futures spread will indeed move as hoped for.
In theory it wilL and it does more than 7.So/cof the time , but there arc occasions where
the stock market makes a mm·e but the futures spread does not follow. Also, it should be
noted that professional traders who use the futures calendar for this purpose also some-
times take an offaetting position in SPY or SPX options, as a hedge against risk. For
example, suppose :·m1 are bullish on the market and thm huy the second month and sell
the front-month. You might also buy some SPY puts in case the stock market falls instead,
and the spread thus moves against you. If using this approach, it is wise to he careful not
to m'E'r-hedge, for lrn:·ing too many SPY puts could significantly harm the spread's profit
pot enti al if th e stock mar ket doe s indee d rise.
The steepness of the term structure itself might also be a clue as to general market
direction. For example, if the term structure slopes downward, that is the result of a bear-
ish stock market move . But if it slopes downward too steeply , then the market can be
considered m·ersolcl. In that case, one would expect a stock market rally, which would
cause the term structure to flatten somewhat. Thus a VIX futures spreader could sell the
front-month and buy the second month, expecting th('m to converge somewhat during a
stock ma rket rally.
Figure 41-10 shows an example of this. In August 2007 , when the financial mar-
kets had first begun to hear of the problems that might arise from "subprime debt" ancl
oth er mortgage issue s, the stock market had declined sharply. That threw the term
struct u re into a clo\\'11\\'ar cl-sloping (inn--rted) state-'. It remained like that throughout a
market-s t abilizing rally in September 2007.
Chapter
41: Volatility
Derivatives 911
FIGURE 41-10.
Term structure of VIX futures.
Term Structure of VIX Futures
26
25
9/17/07; 1476
9/24/07; 1518
------ 10/5/07; 1557
19
18
X
> 2 2 2 2
15.. t3 >
0
.0
<I)
<I)
(/)
0 z LL
By September 17, 2007, the term structure was quite steep ("oversold") as shown by
the highest line in Figure 41-10. SPX was at 1476 at that time.
A trader who thought that the term structure might flatten-either because he
thought it was too steep at this time, or because he was bullish on the stock market rnight
have executed this spread:
andTrading
Volatility
Buy Nov futures: 22.83

Sell Oct futures: 24.33
Spread differential: -1.50
The margin at the time was only $100 to establish this spread. Currently, it would cost
$625.
Shortly thereafter, Ben Bernanke significantly eased monetary policy, and the stock
market had a huge rally. By September 24 (middle line in Figure 41-10), SPX had rallied
to 1518, and the term structure had flattened almost completely. The prices at that time
were :
Nov futures : 19.91
Oct future s: 19.70
Spread differential : +0.21
The spreader ha s made 1.71 at this point. There are two ways to see this:
1. The spread that was bought for -1..50 and can now be sold for +0.21, or a gain of 1.71
Or
2. One can verify it by computing the gains or losses on the individual futures
contracts:
November : Bought at 22 .83, sold at 19.91-a loss of 2.92 points

October : Sold at 24 .33, bought at 19.70-a gain of 4.63
So a gain of 4.63, minus a loss of 2.92, is once again an overall gain of 1.71
This is a profit of $1,710, since a one point move is worth $1,000 on an investment of $625
in one week. Clearly this is high leverage and is why some traders prefer to trade the
future s spread rath er than the actual SPX or stock market equivalent.
Finally, note that if one stayed on until October .5,the lower line in Figure 41-10, the
spread widened further as the term structure actually began to attain a positive slope.
TRADING THE TERM STRUCTURE WHEN LARGE

DISCOUNTS OR PREMIUMS EXIST
Another time when oue might want to use the futures spread as a speculative trade is
when there is a large discount or premium on the VIX futures. However, one must be
Chapter
41: Volatility
Derivatives 913
certain that the "pull" of VIX will be greatest on the contract he is setting up in the
spread. Consider these prices, taken from Table 41-:3, on October 10, 2008:
Example: The following prices existed at the close of trading on October 10, 2008:
VIX: 69.96
Oct VIX futures: 56.71
Nov VIX futures: 38.30
Dec VIX futures: 33.78
The October futures were set to expire on October 22, meaning there were only seven
trading days remaining until October expiration. Therefore, the 13.25 discount on the
October futures was going to have to shrink to zero by that date. So one consideration
would be to buy October and sell November-not because one is bearish on the market,
but rather because the "pull" of VIX on the October futures will be heavily asserting itself
over the next seven trading days.
The problem with that spread, though, is that the November futures are also at a
tremendous discount to VIX: :31.66 points! As the October futures near expiration, there
will be a ''pull" on the November futures, upward toward VIX. In fact, paying 18.41 for
the spread between the two front-months is just so large that one would have to be leery
about establishing it.
But the November-December spread might be more viable. Since the December
contract is the third month out, it will not experience as much of a "pull" from VIX in the
near term. Hence the better spread to establish, looking for VIX to "pull" the near-term
contracts higher is to:
Buy November and sell December for a differential of 4.52 (Nov over Dec)
That spread began to widen immediately, and by October expiration had widened to 8.62
points, a profit of $4,100. It never really marked clown at all. The spread continued to
widen-reaching 14.00 points at one time-before the December contract itself began to
feel the "pull"of VIX.
Note: As an alternative, the spread of buying October and selling December is

also viable. That spread was about 2:3 points, using the above prices. It, too,
qualifies for the lower margin requirement since both contracts are in the first
three available months. That spread was much more volatile though. First it
dropped to 17 points or so, before later widening to 28. It is highly unlikely
that anyone would enjoy a $6,000 markdown on a spread with a $62,5 initial
914 Part VI:Measurin
g andTradingVolatility
margin requirement, so the November-December spread was the better

spread by far.
Similar situations exist when there is a large premium on the VIX near-term futures.
Consider the following example of contracts trading at a large premium to VIX.
Example: The following prices existed at the close of trading on October 11, 2010:
VIX: 18.96
Dec VIX futures: 27.05
In this example, October futures-which are due to expire soon and have only six
trading days remaining-have a premium of 2.34 that is going to have to disappear by the
expiration elate of the October futures. Thus, VIX will assert a "downward" pull on those
October futures.
The November futures are also trading with a fairly large premium (6.14), consider-
ing that they will become the front-month contract in six trading days, and therefore VIX
will begin to exert a downward "pull" on them as well.
The December contract is unlikely to feel any "pull" downward from VIX in the
near term.
In this case , there are two spreads to consider once again:
Buy November, sell October at 3.80 (Nov over Oct)

Or
Buy December , sell October at 5.75 (Dec over Oct)
Or
Buy December , sell November at 1.95 (Dec over Nov)
The November-October spread never really widened, and then it collapsed on the
last trading day of October, so it was not a successful spread. Likewise, the
December-October spread didn 't really widen either.
Only the November-December spread widened. It reached 2.,50 hy the time Octo-
ber arrin'd (in six trading clays), and widened to 2.90 or so in the week after that.
So in both of these examples, the pull of VIX was about equal on both of the front two
months. That was the case because the front-month was so close to expiration. If there
had hee11a longer time (say three weeks or more) remaini11g until the front-month expired,
Chapter
41: Volatility
Derivatives 915
then the ··pull" of VIX might havt' ht>t>llisolatt'd to just the front-month futures contract.
As it was, the pull 011tht> second month (Nowmher), with about five weeks oflife remain-
ing, was greater than that on tht> third month (Dt>cember) in both examples.
So in these situations wht>re the front-month is close to expiration, the better spread
is to trade the second and third months.
In any case, this is another \fable use of the futures calendar spread. Note that cal-
endar spreads can also be traded on variance futures, but the margin is huge ($2.5,000 for
a calendar spread) because the same principles do not apply. With variance futures, the
near-term contract is pegged to realized volatility, while the next contract can fluctuate
wildly until it reaches the "computation period."
Some final comments should be kept in mind. First, there is tremendously high
leverage in trading the calendar spread with futures. If one were to attempt to trade the
term structure with either calendar spreads in VIX options or ETNs or ETN options, the
leverage would no longer apply-at least not to any great extent.
Speculating on Volatility Itself. We have already shown that one cannot actually
trade VIX, but must instead trade one of the derivatives. However many traders try to
predict volatility and take speculative positions in the VIX derivatives .
Some of the time, volatility can be predicted. For example, when VIX falls to 10, we
know that it isn't going any lower. We just don't know when it's going higher. Conversely, when
VIX is quite high-priced-near .50, say-we are fairly confident that it will decline in price
relatively soon. But those statements are too vague to actually use in a trading system.
Some traders actually attempt to chart VIX with technical indicators-just as one
might do with a stock. This author is not a fan of such attempts. Using Bollinger Bands,
MACD, or even put-call ratios on VIX and its options does not produce steady or signifi-
cant results. To further demonstrate this, consider the put-call ratio. There is always a
much higher volume in the VIX calls than in the puts-because the vehicle is mainly used
as a hedging tool by professional traders. As we know, put-call ratios (and other sentiment
or contrarian indicators) lose their effectiwness wht>n hedging activity is heavy, for that
activity bears 110 relationship to what actual investors are thinking about the market in
question.
What we do know is that when volatility explodes, it does so with extreme ferocity.
VIX and VIX futures' 20-day historical volatility jumps by multiples of 4, .5,or more when
extreme stock market disruptions occur. Thus, buying calls on volatility can he a profitable
strategy. In fact, there is a strategy that is named the "perpetual VIX call buy," in which
one is constantly long out-of-the-money VIX calls.
Such a stratt>gy would not work with stock options. For example, 10-yt>ar studies
were conducted in which IBM calls were bought, one full strike out of the mo11q each
month on expiration day, and rolling tht>m over at the next t>xpiratio11.Dl'spitt> the large
andTrading
Volatility
bull market in 2003-2007, the call buying only showed a small profit by early 2008. Since
then it has lost a considerable amount of money, despite IBM's recovery, since calls have
remained fairly expensive. Put buyers didn't fare much better. The large stock market
decline in late 2008 briefly made the put buyers profitable, but with the losses in the next
bull market , the y are large net losers as well .
Consider Figure 41-1 L ·which is the result of buying VIX calls one, two, or three
strikes out of the money, holding to the last trading day, and rolling to the next month. For
the purposes of this study, a strike is 2 ..5 points if VIX is below 30, and is .5points if VIX
is above :30. So if the August VIX futures were trading at 18, and you want to buy August
calls three strikes out of the money, you would buy the 25 strike. Or if, in another month,
Septemher VIX futures were at .3.5,then you would buy Sept .SOcalls if you wanted to buy
three strikes out of the money. By buying this far out of the money, the monthly cost is
not too great.
FIGURE 41-11.
Out-of-money VIX call.
Buy one out-of-money VIX call
$50.00 1 Strike OOM

2 Strikes OOM
3 Strikes OOM
$40.00 -+---------------------------
en
s5$20.00 -t------------+----·----'--c:+--;.-~=---t-
(fJ
(fJ
~ $10.00 -+--------------1------------- ---'.----
c
'iii
a
~ $0.00 -+-..:r,-rrm.-,-,.-r-r-m-rr-,...,...,.......,....,"'T"T"m+....-,...,...,.~~~~~~~~~--~
0
0
-$20 .00 -+----------
-$30 .00
Chapter
41: Volatility
Derivatives 917
Concentrate on the black line, which is the result of buying VIX calls monthly, three
strikes out of the money. You can see that this has been a profitable strategy over the
,5-plus years since VIX options first started trading. Not only wert' profits ge1wrated in the
large market decline in the fall of 2008, but also in 2010 when VIX again leaped higher
in the May-June broad markt>t declint>, and then again in the late summer of 2011.
Of course, there were losses from inception through the fall of 2008, as the market
was moving higher, and volatility was subdued (you can see some upward blips on the gray
line, reflecting the first temporary VIX rise in the summer of 2007). At the worst, this
strateg:· had a loss of about $1,:300 by August of 2008 (black line). But then the profit
kicked in and, through August of 2011, buying one contract each month has resulted in a
total profit to date of about $2,000 (black line , before commissions).
Perhaps in the fullness of time-ten or twelve years, say-this strategy of buying
VIX calls three strikes out of the money will not hold its gains. But as long as there are
bear markets, it seems to be reasonable to expect that the strategy will profit.
One reason that this is feasible is that the volatility of VIX itself explodes during
sharp market declines. Meanwhile in stock bull markets, VIX declines, but it doesn't
behave like a stock would in a bear market. Rather, it flattens out in the low teens (rarely
trading below 10), and its volatility declines. These are the main differences between how
VIX behaves and how a stock-or even an index, such as SPX-behaves. The strategy of
perpetual call buying wouldn't work with a double- or triple-speed ETF, either, since
those reset daily.
One might try to refine the teclmique by only buying calls when VIX is "cheap," but
then one gets into the problem of deciding what's cheap. In 2010, VIX got down to 16 or
so before exploding to 48. In 2008, VIX was around 20 before the Lehman-driven market
calamity which saw VIX rise to 89. In 201 l, VIX got down to 1.5before rising to 48. So,
based on that data, you'd want to be "in" the strategy if VIX was below 20.
But earlier, in 2006 and 2007, VIX just kept falling, down to the 10-12 area and just
stayed there for months on end. Even in late 2007 and the first three quarters of 2008,
when the bear market had already begun, VIX was below 20 many times, with several
spikes above 30-none of which produced much of a profit for the call buyer (perhaps
there was an intra-month profit, but not by expiration day, which was the basis for our
study).
So, what is "cheap"? Before you answer, perhaps you need one more data point. On
the last trading day before VIX expiration in September 2008, VIX was at 36. If you hacl
decided VIX was too expensive to buy calls on at that time, you would have missed tlw
move to 69, at October VIX expiration, and then 80 by November .
If you are using this strategy for speculation, or for protecting a stock portfolio (to
be addressed later), it is hest to continually huy the VIX calls three strikes out of the
money, without fail. Then one does not have the leeway to make a mistake.
andTrading
Volatility
PROTECTING A STOCK PORTFOLIO

WITH VOLATILITY DERIVATIVES
Many portfolio managers-even if they are merely managing their own portfolio-are
concerned about protecting the gains of a bull market, or protecting against losses if a
bear market should emerge. However, most portfolio managers are reluctant to give away
the upside. That is, they don't want to move to a large cash position or to sell short against
their position.
This is where derivatin's strategies can be quite useful. One is able to buy "insur-
ance" in case the market declines. The cost of such insurance can be adjusted to fit the
needs of the individual portfolio manager. Moreover, with new products, such as volatility
futures and options, e\·en better hedges are available to the forward-thinking portfolio
manager.
There are many ways that a portfolio can be protected without actually selling out
the stocks. One can take a '"macro'' approach and use broad-based index options to hedge
broad market risk (such as the S&P 500, the NASDAQ 100, or VIX). This approach is
usuall>· the most efficient in terms of cost, but might not meet one's needs in other areas.
For example, if the incli\·idual portfolio does not really track the S&P 500 very well, then
a hedge using S&P 500 options may not work properly .
The "micro" approach is more work. It generally involves hedging individual stocks
with options 011 that stock. This approach gi\·es the best hedge, of course, since the hedg-
ing vehicles pertain exactly to the individual stocks. However, it can be quite costly, hoth
in tenns of '"insurance dollars" and in terms of time spent managing the positions.
MACRO APPROACHES
Those managers utilizing the macro approach feel that their portfolio resembles a major
index m·erage closely enough, so that futures or options on that index can be used to
hedge the portfolio. Unless one is running au index fund, he is likely to have some track-
ing error between his actual portfolio and that of the index derivatives used as a hedge.
Howe\·er, in most cases, the portfolio manager does not mind a small tracking error, as
long as he knows that the prott>ction is in place, guarding against a swift or severe market
decline . Macro strategies include:
1. Buying broad-based index puts. This is probably the most popular form of protection
11Singhroacl-hasecl index options (that doesn't necessarily mean ifs the best form of
protection, though). Om· generally buys puts whose protective features don't engage
irn1nediatek. That is, tht> cost of insurance is lower if one onlv. needs the insurance in
Chapter
41: Volatility
Derivatives 919
seriously declining markets. The differenee between the eurrent portfolio price and
the le\·el at whieh the puts' insurance beeomes effective ean be thought of as a
"deductible," in insurance terms. Specifically, one buys puts whose striking prices are
somewhat below the current market price by ,5%, 10%, or possibly even 1.5%(i.e., they
are 011t-uf-tht'-11wncyputs). The manager figures that he will risk that much of a loss
in the market. But then, if the market falls any more than that, he wants essentially
full protection for his portfolio.
\Vhile the cost of this form of insurance varies greatly with market prices and
market conditions, on average, SPX puts that are 10% out of the money cost between
2% and 3% on an annual basis as insurance.
2. Broad-based index put spreads. To mitigate the cost of insurance, some portfolio
managers will buy out-of-the-money puts, but then will also sell puts that are even
farther out of the money in order to bring in some dollars to reduce the cost of the
insurance. The risk in using this strategy is that one puts a "cap" on his protection.
For example, if he buys puts that are 10% out of the money and spreads them by
simultaneously selling puts that are 1.5% out of the money, then he will effectively
only have insurance if the market falls between 10% and 1.5%.If it falls farther than
that, his insurance benefits are limited. For this reason, this author does not recom-
mend the put spread approach to protection.
3. Selling broad-based index calls. This is not a particularly popular strategy among
those needing or wanting "disaster" insurance, but it is popular among managers who
feel that the sale of a wasting asset (a call option) will provide superior returns if
applied continuously over long market cycles. The drawback is that the sale of the
calls cuts off the upside potential of the portfolio above the striking price of the calls
that were sold. Mitigating that, though, is the fact that this form of insurance actually
costs nothing in dollar terms (its costs are in lost opportunity to the upside). The
CBOE has created several index-based covered call writing benchmark indices that
theoretically track this approach, the primary one of which can be quoted with the
symbol BXM.
4. Collars. This strategy combines numbers 1 and 3 above: It is the purchase of an
out-of-the-money put a11dthe sale of an out-of-the-money call. The sale of the call
reduces the cost of the put-thereby reducing the cost of insurance overall. One appli-
cation of this strategy is the "zero-cost" collar, in which the price of the call is greater
than or equal to the price of the put (not always feasible in every situation). For that
benefit, however, once again the portfolio manager runs the risk of cutting off upside
profit potential by the fact that he has sold call options. So he reduces the cash cost of
the insurance in exchange for opportunity costs in potential lost profits on the upside.
andTrading
Volatility
.S. Futures. One could conceivably sell broad-based index futures against his stock port-
folio. These might be S&P 500 futures, NASDAQ-100 futures, or a few others. This
approach is generally not very popular because even though the sale of futures pro-
tects the downside, it also removes any potential profits in a rising market. Even if
only a small percentage of the portfolio is hedged with short futures, most managers
find the prospect of giving away the upside to be too much of a burden. Moreover,
this was the strategy that was widely blamed for the Crash of '87, and thus has a nega-
tive aura associated with it.
6. Volatility Derivatives. This is a different tack. Volatility generally rises when the
market falls. So, as a portfolio hedge, one would buy volatility futures or, preferably,
call options on volatility. Figure 41-8 showed how VIX rises (dramatically) when the
stock market falls sharply. Thus being "long" volatility is a valid form of protection-
perhaps the best one.
a. Volatility futures. Shortly before the volatility futures were listed in 2004, an
analysis performed by Merrill Lynch showed that a 10% volatility hedge was
sufficient to protect a broad-based stock portfolio. In other words, if 90% of the
assets were invested in stocks that behaved similar to SPX and 10% were
invested in "VIX," the resulting portfolio outperformed SPX in both bull and
bear markets. In actual practice , this theory proved to be unworkable due
mainly to the high premium cost of buying VIX futures . In later years, other
studies have shown that a 20% hedge is more appropriate, but the principle is
valuable , if only to show that one need only hedge a small percentage of his port-
folio's notional net asset value with volatility futures.
Using volatility futures to hedge does not have the same disadvantage as
using SPX futures does, although there are still some disadvantages. Mainly, if
the stock market rises, volatility futures are likely to lose money until they get to
a very low level (in the 10 to 15 area, say). Thus, they could present a large drag
on portfolio performance during a bull market. Not as big a drag as being short
S&P futures, but still potentially large.
b. Call Options on VIX. A portfolio hedge can be constructed by buying
out-of-the-money call options on VIX . Since VIX increases sharply when the
stock market falls, these calls would profit and therefore act as a hedge against
losses in an equity portfolio.
This is a similar strategy to buying put options on SPX as "insurance"-
the purchase of an option with limited risk and large, open-ended profit poten-
tial if needed as a hedge. However , VIX calls are much more efficient as an
equity portfolio hedge than SPX put options are.
Chapter
41: Volatility
Derivatives 921
VIX CALLS ARE A BETTERPORTFOLIO HEDGE THAN SPX PUTS
The simple reason that VIX calls are a better he<lge for a broacl-base<l equity portfolio is
that they provide dy11(lJ11icprotection, whereas SPX puts do not. To demonstrate this,
consider the following:
Example: In June, with SPX at 1.530, a portfolio manager decides that he wants to buy
SPX puts as a hedge. He chooses the December 1400 puts-approximately 8% out of the
money. After the protection is purchased, suppose that the stock market has a strong sum-
mer rally. By early September, SPX has reached 1700. The puts that were bought for pro-
tection are now :300 points out of the money at perhaps the time they are most
needed-entering the fall of the year (traditionally a rough time for stocks). The problem
is that the put strike was fixed and, when the market rose, the protection became less and
less valuable. At this point, one would have to either buy more protection at a more rea-
sonable distance out of the money (8%-10%) or forsake the protection altogether.
It is for the reason shown in this example, that many portfolio managers eschew
buying puts as protection, for they lose their protective ability when the market rallies.
The same thing does not occur with VIX options. Consider the same portfolio man-
ager in the following example, but now he decides to buy VIX call options as protection.
Example: In June, with SPX at 1.530, and with VIX trading near 1.5,a portfolio manager
decides to buy VIX calls as a hedge. He chooses the December 20 calls. That is, they will
provide protection if VIX climbs above 20 by expiration. This is only likely to happen in a
sharp market decline, hut VIX normally spikes into the mid-30s and higher during a sharp
market decline-even when it starts from such a low level.
As in the previous example, SPX rallies throughout the summer, reaching 1700 by
early September. At that time, VIX is likely to be trading lower, perhaps near 12. But even
though VIX has declined, it doesn't really matter much. For if the market drops sharply
from 1700, VIX will shoot up into the 30s and the VIX long calls will provide protection
even though the stock market is much higher than it originally was.
This example shows how VIX calls are dynamic protection. They don't lose their protec-
tive ability when the broad market rallies. This is especially true when VIX is relatively
low to begin with.
IMPLEMENTING MACRO PROTECTION SY BUYING SPX PUTS
The equity portfolio manager is most concerned with the cost of his protection. It will
vary according to market conditions, of course. If volatility is high-particularly <luring
an already-declining market-SPX puts and VIX calls will he more expensive.
andTrading
Volatility
In order to estimate the cost of this protection , some simulations were run, using
actual prices. The net cost of the protection was then estimated.
As an example, Figure 41-12 shows the net cost of buying three-month SPX puts
10% out of the money. Furthermore, it was assumed that the protection was held all the
way to expiration-collecting the intrinsic value if the put expired in the money, or expir-
ing worthless otherwise. Then, a new 3-month put, 10% out of the money was bought.
This was done each quarter-using actual SPX put prices. Puts were bought on expiration
days in March, June, September, and December.
The data in Figure 41-12 began in Janua1y 1997, so it encompasses a full 13-year
period . This graph shows only the cost of protection, expressed as a cumulative percent-
age of the price of SPX (left scale). In other words, at the end point, in the summer of
2010, note that the graph is at about -0.18, or minus 18 percent. In other words, the
cumulative cost of the protection over the 13+ years was 18% of the SPX value (or, 18%
of the portfolio value, if you prefer ). On average, that's a less than 2% annual cost for the
prot ection.
Even at its lowest point , in the late summer of 2008, the graph is at about minus 32
percent. In other words, the cumulative cost of the protection over the 11+ years to that
date was 32% of the portfolio value. On average, that's a little less than 3% annual cost for
the protection.
FIGURE 41-12.
10% Out-of-money spx hedge using 3-month options.
10% Out-of-Money SPX Hedge Using 3-Month Options

Q%7JllTITTTTTTTTTTTTTTTTTTTTTTTTTTIITTTTTTITTTTTTTTTTTTTTTTTTTITTTITTITTTTTTTTTTTTTTTTTTTITTTTTTIITTTTTTITTTTTTTTTTTTTTTTTTTITTTITTITTTTTTTTT
~ ~ ~ ~ t>< (\ <::)O:,
~ ~
-30% -t-- -------------------------__Jl--~-----1
35% _.________________________________ ___J

Chapter
41: Volatility
Derivati~es 923
Note that the protection worked at two specific times-during the bear market of
2001-2002 and again in the fourth quarter of 2008. The graph rises during those periods,
indicating that the puts were making money in those quarters. However, prior to as well
as after that period, the protection lost money in nearly everlj quarter. Note the down-
ward stair-step pattern of the graph outside of the bear market time frames. That indicates
losses on the puts purchased for protection.
It should also be noted that during some of these quarters, the puts were profitable,
but then lost their value by the end of the quarter. This was true, for example, in the 3rd
quarter of 2007-when the term "'subprime debt" first reared its ugly head. There was a
sharp market decline <luring July and August during which time the protective puts were
trading at profits, but then a strong Fed-induced rally in September caused the protection
to expire worthless.
\Vhen the stair steps are tall, that is a time when put protection was very expensive.
That is, the implied volatility of the options was high. This has been true, in general, since
rnid-2008. Notice how small the stair steps were in 2006, when VIX was hovering at low
levels, near 10.
Overall, the loss on the puts m·er the 13 years of hedging was about 18% of the
portfolio, or a rather acceptable 1.4% per year (not compounded).
Other studies were conducted with SPX options, using a different deductible and/or
buying longer-term options, but they did not offer an improvement on the statistics shown
above.
With an SPX hedge, one would buy enough puts to fully hedge the adjusted value of
his portfolio at the striking price .
Example: Suppose one has a portfolio that behaves exactly like SPX. Moreover, the net
asset value of his portfolio is $3 million. He decides to hedge by buying SPX June 1500
puts. Then he would buy this quantity :
Portfolio Value/ (100 x Strike)= 3,000,000/ (100 x 1500) = 20 puts
(This assumes that the options are worth $100 per point of movement; that's where
the 100 comes from in the formula.)
If one's portfolio does not exactly mirror SPX, then he must adjust the portfolio to con-
form to SPX before he buys the protection. This process is similar to what was described
in Chapter 30 under "Simulating an Index ."
Without going into an extreme amount of detail, here are some salient points that
one should consider when determining an "equivalent futures position." First, each stock
in one's portfolio should be volatility-adjusted in dollar terms. That is, the dollar value of
andTrading
Volatility
each hokling should be adjusted by its comparative volatility (some might say Beta). If one
has stocks in his portfolio with negative Beta (for example, gold stocks), they should prob-
ably be excluded from the macro calculations.
Example: One has a small portfolio of three diverse stocks. He would like to hedge it with
SPX put options. The price of each stock is shown in Table 41-12. Its volatility is shown as
well. Furtlwrmore, the "adjusted volatility" is shown, which is merely the stock's volatility
<livi<le<lby SPX volatility. One could substitute Beta for adjusted volatility, but Beta is such
a long-term measure that it can giw' inaccurate hedging calculations. Finally, the dollar
amount of each stock is 111ultiplie<l by the adjusted volatility. The sum of the adjusted vola-
tilities is thus the gross dollar amount of SPX to hedge.
The total dollar ,·alue of this portfolio, adjusted for SPX volatility is the sum of the
three numbers in the right-hand column of Table 41-12, or $.5.50,000. Note that this is
quite different from the actual net asset value of the three stocks, which is $.'300,000. In
otlwr words, these stocks are all more volatile than SPX, so one needs to buy $550,000
worth of SPX protection in order to hedge the $:300,000 value of this small portfolio. The
number of puts to buy is:
# of SPX puts= (Volatility- adjusted value)/(100 X SPX Striking Price)
So if one were going to buy SPX puts with a striking price of 1100 to hedge this
portfolio, he would hny (.550,000)/( 100 X 1100) = .5 puts. Note: The 100 in the denomi-
nator of the formula is the trading unit of the puts; they are worth $100 per point of move-
ment. For example, if one had a portfolio of technology stocks, he might want to use QQQ
as the hedging index. The san1c steps as in the above example would apply, except that
one would use the rnlatility of QQQ,not SPX, when calculating the volatility-adjusted
dollar value of each stock.
TABLE 41-12.
Portfolio value, volatility-adiusted (SPX vty = 16%).
Stock Stock
Price Stock
Volatility Adjusted
Volatility Adjusted
Dollars
1000 IBM 160 24% 1.50 240,000
500 GS 120 40% 2.50 150,000
200 AAPL 400 32% 2.00 160,000
Sum: $550,000
Chapter
41: Volatility
Derivatives 925
IMPLEMENTING MACRO PROTECTION BY BUYING VIX CALLS
If the equity portfolio manager desires to use VIX calls as protection, he must decide two
things. The first is similar to the decision that must he made when buying SPX puts: How
far out of the money should the protection be'? This is the "deductible" portion of the
insurance. \Vith a portfolio that is similar in natme to SPX, one can easily determine his
risk ("deductible'')-5%, 10%, etc. However, with VIX calls, ifs not quite so easy. VIX
doesn 't necessarily rise 10% if SPX falls 10%. In fact, it usually rises much more than that.
So, the VIX calls can be bought somewhat farther out-of~the-money-thereby saving
some cost of the initial insurance premium.
The second question is ''How much protection to buy'?" With SPX puts and a port-
folio that relates well to SPX, that question can easily be answered merely by converting
the portfolio's net asset value into an SPX "equivalent," as in the previous example. How-
ever, with VIX calls, there is no such direct measure. Therefore, we rely upon the original
Merrill Lynch study for this answer-preferring to buy enough VIX calls to hedge 10%
to 20% of the portfolio's value .
Example: Suppose SPX is trading at 1530 and VIX is at 15. The hedger decides to buy
the VIX Dec 20 calls. Suppose he has a portfolio worth $10 million, volatility adjusted for
SPX. Then, citing the Merrill study, he decides to buy protection on 10% of portfolio
value , equal to $1 million. Since his protection will engage if VIX is above 20, we use that
striking price to determine the quantity of VIX calls to buy:
Quantity= 10% X NAV/(100 X Strike price)

= 10% X $10,000,000/(100 X 20)
= $1,000, 000/2000
= 500 calls
This is not a large quantity as far as VIX calls go, since it is one of the more liquid
contracts.
Assuming that one-month calls are being purchased (for they will track most closely
with VIX if that index rises sharply), then the cost of these calls can be expected to be less
than 1.00 per contract ($100). Hence 500 of them would cost less than $50,000-or
slightly less than one half of one percent of the portfolio's actual net asset value. If one
had decided instead to hedge 20% of adjusted value, he would buy 1,000 calls.
Note this formula is not exactly correct, because it would imply that one should buy fewer
calls if a higher strike were used. Rather, as will be shown shortly, we prefer to buy calls
andTrading
Volatility
at a relatively fixed distance from the current VIX futures price. Also, one may prefer to
use a number up to 20% where 10% is located in the above formula, because the more
recent studies-based on expansion of the original Merrill study-indicate that the
prop er hed ge may be closer to 20% of the portfolio 's asset value .
How much protection will these calls provide? Recall that it was stated that VIX
uses only the two nearest-term series of options on SPX. Thus, longer-term SPX options
may be trading at substantially different implied volatilities and may not necessarily track
well with VIX itself.
In the case of VIX, even the nearest-term futures and options do not necessarily
have to track VIX exactly. Continuing with the above example, suppose that the VIX calls
were bought for 1.00 apiece. Furthermore, suppose that the stock market dropped sharply
and VIX shot up to 27. It is unlikely that the VIX calls would immediately reflect the full
value of being 7 points in the money (due to the term structure of options)-but they
might easily be trading at .5. Thus, the profit would be $400 per contract, or $222,000 -
2 .2% of the NAV of the portfolio.
If a severe market shock were registered, VIX would trade even higher and the calls
would provide more protection. In addition, the level of protection can be increased by
buying VIX calls with a lower strike, but that increases the cost of the insurance to
begin with .
Figure 41-13 shows the actual results, since VIX options began trading in 2006,
of buying one-month VIX calls three strikes out of the money and rolling them over.
(Note: Three strikes means at least 7..5 points out of the money when VIX is below
30 and 1.5 points out of the money when VIX is above 30.) Also, note that the
out-cftlic-nwney status is based on the price of the corresponding VIXfutures contract,
and not VIX itself.
The y-axis shows a percentage gain or loss, assuming that one bought enough VIX
calls to hedge 10% of the notional net asset value of a portfolio (SPX, in this case).
You can certainly see the effectiveness of owning VIX calls when a true crisis arises.
VIX calls registered large profits in October 2008, and smaller profits in May 2010 and
Augu st 2011.
Just to quantif)' things a hit, the historical volatility of VIX is routinely above .50%
and sometimes reaches 100%, whereas the volatility of SPX averages 1.5%in the long nm
and has been much lower than that during long bull markets. Hence, one can statistically
justify buying farther out-of-the-money VIX calls, as compared to the distance out-of-the-
money for SPX put s, du e to th e much highe r actual volatility of VIX .
\Ve have already stated that VIX is a 30-day measure of volatility. Therefore, there
is no reas on to buy longer-term VIX option s.
Taking all of this into account, a better answer to how many VIX calls to buy could
he expressed this way, based on the average VIX mm·e in past market declines:
Chapter
41: Volatility
Derivati-res 927
FIGURE 41-13.
Call hedge rolling.
VIX Call Hedge Rolling Every Month

3 Strikes Out-of-the-Money
6%
Q)
.g>2% -+---------------f---------------1--'\---------
Q)
::c
?fl.
0
~ 0% --+-r-~--~--~-----......._---------~----
c:
"iii
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~ -2% -+-----~---------------------~---L
o...
C:
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~ -4% -+---------- ----1------- -----------
8!.
- 8%
(0 (0 (0 (0 I'-- I'-- I'-- I'-- CX) CX) CX) CX) en en en en 0 0 0 0 T"" T""
~ ~ ~ ~ co ~ ~
Q Q 0 0 Q Q Q 0 Q Q T"" T"" T"" T"" T""
T"" 0 0 C\l CX) CX) CX) (0 IO co LO LO ~ --- LO (0
?.s co o'i ~
T"" T""
~
T""
~ ~
T"" T"" T""
~
T"" T"" T"" T""
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o'i ~
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co o'i --- ?.s co o'i ---

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C') (0 C') N N N ?.s --- (0

T"" T"" T"" T"" T""
l. Convert your portfolio into a "volatility-adjusted" value , basis SPX.

2. Buy VIX calls three strikes out-of-the-money as designated above.
3. Calls to buy per $100,000 of volatility-adjusted value = percentage X 0.3.5 where per-
centage is the percentage of your adjusted value that you want to hedge (between 10
ancl 20, according to the Merrill studies). So if percentage= 20, you would buy 7 VIX
calls per $100,000 of volatility-adjusted value. In my opinion, percentage should be
20, or perhaps even higher, if one is not near a VIX expiration date .
andTrading
Volatility
OTHER MACRO STRATEGIES
At the beginning of this section on portfolio protection , several other strategies were
outlined-all variations of the simple purchase of options for protection. I am not in favor
of the spread strategies, but the collar is something that many traders find useful.
THE SPX COLLAR
In addition to buying SPX puts as protection, one could reduce the expense of those puts
by simultaneously selling out-of-the-money calls on SPX. If the calls are sold for a price
equal to or greater than that of the puts, the resulting position is called a ''no-cost"
collar .
There is an opportunity cost, of course-in the loss of upside profit potential beyond
the striking price of tl1e written call. fa· en so, certain investors find the collar to be a
desirabl e strat egy.
The no-cos t collar is usually best approached with long-term options, and best used
when dividend yields are low, and volatility is high. One might not find all of those com-
ponents at once, hut here is an example from 2007, near the end of the last hull market,
wh en all of those cond itions existed :
Jun e 200 7:
SPX: 1.517
D ec ('09) SPX 145 0 put : 107.6
D ec ('09) SPX 1700 call: 118.8
In June of 2007, dividends were low, and while volatility wasn't all that high, it was
off its lows. Using the options that expired 2.5 years hence, one was able to set up a
no-cost collar that limited losses below 14,50 (less than 5% below current market prices)
and allmved for appreciation all the way up to 1700, well above the all-time highs for SPX.
This was therefore a ,·ery attracti,·e collar, especially in light of what eventually happened
in 2007 and 200 8.
ADJUSTING THE COLLAR
\ \'hat does one do with the collar once it's in place? One could just leave it alone-
planning on accepting the consequences, whate\ ·er they may he. That may not be the best
approach.
:\Ian: · im·estors will adjust the collar if the underlying declines in price. Continuing
\Yith the ex,unple ahon ', s11ppost' that aftpr a whilt', SPX drops to 1300. The put in the
Chapter
41: Volatility
Derivatives 929
collar is then deepl)· in the mone:· and will be selling for quite a hit more than the
(then) cleepl)1 out-of-the-111011t')'
call. Hence the existing collar could be removed for a nice
credit.
\\'hat should one then do with the money? There are several choices: (1) Establish a
new collar with lower strikes. If another ·'no-cost" collar is established, the upside strike
will be lower than before, so a strong rally b:· SPX might be limited by that short call. Most
traders are reluctant to do this unless they're fairly certain that the stock market is headed
lower (in which case, it would have been best to leave the original collar in place). (2) Use
the credits to bu:· some out-of-the-money puts. These puts will act as protection against
further erosion in the stock price, while at the same time the upside is no longer limited.
(3) Do nothing, leaving the stock "naked" long in the portfolio. This would normally be
done only if one is fairly certain that a market bottom has been made.
On the other hand, if the underlying rallies after the collar has been established, the
investor does not have an attractive array of choices. The call will have increased in price
and the put will have decreased, so that it would require a debit to remove the collar. Of
course , the stock portfolio will have increased as well, so overall the investor is ahead, just
by not as much as he might have been had he not established the collar in the first place.
Usually, a trader would only remove the collar during a rally if he is fairly certain that the
worst was over, and the underlying was heading higher.
THE VIX COLLAR
One can establish a collar with VIX options but in this case, one would sell VIX puts
against the VIX calls that are owned as protection.
Example: With VIX at a price of 2.3.,50,one might establish the following VIX protective
collar:
Buy VIX Nov 30 calls at a price of 0.90

Sell VIX Nov 20 puts at a price of 1.00
The VIX collar has a few different characteristics from an SPX collar. First, one does
not really limit his portfolio's profits as mueh as with an SPX collar. Yes, if the market ral-
lies, VIX will fall, and may well fall below the striking price of the written put. However,
VIX can't really go below 10, so there is a limit to the "drag" that the written VIX put can
have on the upside profit potential of one's portfolio. A written SPX call, however, is a
continuing limitation on upside profits in a rising market.
In the above example, the collar is a no-cost collar. But in order to do this, the writ-
ten VIX put is quite close to the price of VIX. That means that only a modest stock market
930 PartVI:MeasuringandTrading Volatili
ty
rally would likely force the price of VIX below 20, and might cause losses against the ris-
ing stock portfolio .
In a more practical sense, one would probably sell VIX puts farther out-of-the-money.
However, in that case it is unlikely that a no-cost collar could be established, but the sale
of th e put would still reduc e th e cost of the VIX call prote ction somewhat.
AN O THER STRATEGY FOR VOLATILITY PROTECTION
Institutional traders are constantly on the lookout for protective strategies that don't cost
anything on an ongoing basis. That's why the no-cost collar is so attractive. If one has that
protection in place, hut doesn't need it or use it, then it doesn't really cost him anything.
The "cost" is an opportunity cost that there will be a cap on profits if the underlying rises
far enough in price (i.e., rises above the striking price of the written SPX call or falls
below th e striki ng pric e of th e writt en VIX put ).
In that vein, a VIX call backspread strategy has been designed to take the loss
out of using VIX options for protection or speculation. This strategy purports to be
better because it allows you to exit before much, if any, loss occurs. As all thinking traders
know, howe\·er, there is no free lunch. If there's really no 1isk,then something else has to give.
Th e strat egy is bas ed on a 2xl call backspread , such as thi s example :
Example: Of a 2-by-l VIX call back spre ad.
Date: mid-May at expiratio n of the May VIX derivatives contract s

VIX: 17
July VIX fut ure: 20.25
Buy 2 VIX July 32.5 calls @ 0.80
and Sell l VIX July 25 call@ 1.60
Outl ay: $0
On the May \ 'IX deri\·atin's· expiration date, a VIX call backspreacl is established in
July options: selling one out-of-the-money call and buying two further out-of-the-monev
calls, where the price of the one being sold is approximately twice that of the one being
bought. Note that the options expire two months hence , not one. If one has to pay a small
debit for the spread-say, up to LSor 20 cents-that would work nearly as well.
The main idea behind using this position is that-at least for a while-a 2xl call
hackspread acts jmt like a long call, until the position gets too close to expiration, in which
case the losses nea r the higher stri ke can bec ome large.
Figure 41-14 shows the profit graph of such a spread. There are three lines in Figure
-!-1-14. Th e straight hlack lines shmv what would happen if the position were held all the
Chapter 41: Volatility
Derivativ_es 931
FIGU RE 41-14.
V IX 2xl call backspread.
VIX 2x1 Call Backspread

1345.5
1076.4
807.3 /
538.2 /
269.1 _J./
/v
0.0
-269.1 '~L /
-538.2
~ /
1/
-807.3
V
6.0 12.0 18.0 24.0 30.0 36.0 42.0 48.0 6.0
way to July expiration: there is no gain or loss (except commissions) below 25. Between 25
and 32.5, losses begin to grow, reaching their maximum of 7.,5 points ($750) at 32.,5 at
expiration. Above 32.,5, losses diminish until the upside break-even point is hit at 40.
Above there , unlimited gains are possible .
There is nothing particularly attractive about the dark gray line itself. The curved
dark gray line shows how the position would perform ten days prior to expiration. Again,
relatively large losses of $300 or so are possible near 32. That isn't very attractive, either.
The true attractiveness of this position is the gray line. It shows how the position
would behave on the last trading day of the June VIX derivatives (or about one month
before the July derivatives expire). With this much time left until expiration, the gray line
barely dips into negative territory at all. The worst point is a small loss of about $60 near
25, with a month to go. Yet, it has plenty of upside profit potential (as do all three lines)
because two calls are owned in this spread, and only one has been sold.
If you just look at the gray line alone, it looks very much like the profit graph of own-
ing a long call at some point prior to expiration. The gray line turns sharply upward at a
price of about 31 or 32, so July VIX futures would have to rise to there or above in order
for this position to start generating profits with a month to go.
This backspread could thus theoretically be used for strategies where one would
normally buy VIX calls-mainly, as either protection for a stock portfolio, or as outright
speculation on a large increase in volatility.
andTrading
Volatility
So, is this 2xl backspread really better than buying a short-term call? It might
not be. The crux of the strateg)· is simple: one establishes the 2xl backspread and then
rolls to the next expiration before losses start to set in. Simplistically, this means that the
position is established two months before expiration and then rolled one month before
expiration.
On the surface, the backspread strategy seems veiy attractive. Perhaps if one is merely
looking to speculate 011 volatility, it might be approp1iate, but there are two major flaws in this
strategy . One flaw has to do with the term structure of VIX futures. As we know, the options
trade off thef11turcs and not VIX. Fmthennore, in a severe bear market, when VIX explodes
to the upside, the term structurc> turns negative (i.e., all the h1tures trade at a discount to
VIX). When that happens, the backspread strategy-since it is the second month and not
the front-month-may not produce the desired gains.
The simplest way to illustrate this is to once again look at the worst bear market since
VIX derivatives have been listed-that of October 2010. At one point, the following prices
existed, roughly:
VIX: 70 on 10/10/2010
Oct VIX future: 56
Nov VIX future: 38
The long October VIX call was 18 points farther in the money than a November 2xl
call backspread! As October e~piration approached, VIX stayed near 70, and so the October
futures sucked right up to 70. Meanwhile, November futures rose only into the mid-40s.
This is the hazard of owning protection in the second month and not the near-term month.
A counterargument would be to buy nwrc of the November 2xl backspreads as
opposed to outright long October calls. That's fine, hut there is also a big difference in the
margin required.
The margin for a hackspreml is the difference in the strikes, plus any debit incurred
in establishing the spread. Obviously, the only requirement for an outright long call is
merely to pa)· for the call. Even if the 2x 1 backsprea<l is using strikes .Spoints apart (not
alwa)'S possible, if one wants to pay only a small debit for the spread), this is how the com-
parison would look vs. an outright long call at 0.60:
Requirement Comparison
2xl Call Backspread for $0 debit: $500
Outright Long Call for 0.60: $60
So it might be easy to say "do more backspreads," but it's more costly to do so, in
tcrllls of im·estrnent rE:'q11irc>rnents.
This could he significant say, if one were trading long
Chapter
41: Volatility
Derivatives 933
stocks fully margined, or selling naked imlt'x or Pquity puts with the foll equity in the
account. In that case, one would likf'lv hm'e to clost' down some of the account's "main''
strateg y in ord er to fund the back spr eads .
Term structure is important. But perhaps the major Haw is where the profit potential
arises. From Figure 41-14 one can see that, using the hackspread, the profit potential
kicks in at just below the level of the higher strike in the backspread (31 or 32 in the exam-
ple). That is likely to be much farther out of the money than the "three strikes" we are
recommending for our long call purch ases.
In the example for Figure 41-14, VIX was at 17, and the July futures were 20.2.5. The
June futures would have been trading near 18.,50 or so. If one were merely buying long
VIX calls for protection, he would have bought the June 2.5 call. The outright June 2.5 call
would start making profits well before the back spre ad does.
In summary, the 2xl call backspread strategy has a certain appeal because losses are
minimal if the position is rolled well before expiration. However, in the direst crisis, the
strategy will not perform nearly as well as a front-month call purchase does. For those
looking for disaster protection, that makes all the difference in the world. If one pays the
small amount for the outright long call, he thus has protection that "kicks in" at a lower
volatility level and more closely adheres to movements in VIX on the upside.
PORTFOLIO PROTECTION SUMMARY
VIX call options offer a superior, more dynamic hedge than SPX put options do. This is
due to two main facts: (1) whatever strike is purchased for VIX will prove useful in a true
crisis, for VIX will blast higher easily, and (2) the rnlatility of VIX is so much greater than
that of SPX that it only takes a small number of calls to hedge a whole portfolio, compared
to the number of SPX puts that would have to he purchased for protection.
Perhaps the VIX hedge is more of a crisis hedge, but that is generally what protection
is all about. Normally, one would not he using protection to capture a small market
decline-the cost of doing that would eventually pro ve to be too great.
HEDGED STRATEGIES USING VOLATILITY DERIVATIVES
Up to this point, we have mainly concentrated on using VIX and its d<:>rivativesas direct
purchases for speculation or protection. However, there are also hedged strategies that
are useful. One such strategy is the calendar spread, which we hm;e discussed to a certain
extent.
It was shown that the calendar spr<:>adbetween two futures months can be a proxy
for trading the stock market, or it can be used when one expects a change in th<:>term
andTrading
Volatility
structure of the VIX futures. This is a highly leveraged strategy since the margin for a
futures spread involving the first three months is only $625.
We also previously saw that a calendar spread using VIX options does not behave at
all like a calendar spread in a stock. That's because there are two underlying entities for
the two VIX options in a calendar (or diagonal) spread-not just one as there would be
for a simple stock, like IBM or Apple.
VIX CALENDAR COMBINATION
In either of the above VIX derivatives strategies, there is a great deal of risk-theoretically
unlimited. But many traders would like to be able to trade the calendar spread with fixed,
limited risk. This can be clone, although one no longer has the heavy leverage of the
futures spread if he does so. Instead of using futures to trade the calendar, one can create
a similar position by using in-the-money options.
It has been pointed out elsewhere in this book that any intermarket spread can be
established with in-the-money options, often for a superior position. For the option pos-
ition can make money in two ways: ( 1) if the internrnrket spread actually converges or
diverges as one had planned for it to do, or (2) if both underlyings are extremely volatile;
in this latter case, one option ¥.rillmake large profits while the other option has limited
risk. Thus in the second case, it is possible to profit even if the intermarket spread itself
does not "behave."
Example: A trader wants to be short October VIX and long November VIX. He could
merely buy November VIX futures and sell October VIX futures. But if the spread moves
against him sharply, as that very spread did in the fall of 2008, he could suffer huge losses.
Rather, a position consisting of a long November VIX call and a long October VIX put-
both in-the-money-could be a good substitute for the futures calendar spread.
The following prices existed on September 8th:

VIX: 22.64
Suppose that one had established the futures calendar, buying November and selling
October. As we saw earlier, in Table 41-7, things quickly went awry.

VIX: 69.96
Chapter
41: Volatility
Derivati~es 935

The spread was established for 24 cents (November over October) and now is mark-
ing at 18.4 l (October over November), so the total loss on the futures trade would be
18.65 (0.24 + 18.41) points, or $18,650. But what would have happened had an option
combo originally been purchased instead?

Buy VIX Nov 20 call: 5.00
Buy VIX Oct 27.5 put: 4.30
Combo cost: 9.30 points
The maximum risk on this spread is the initial investment of $9,30. For that to hap-
pen November VIX futures would have to fall below 20, while October VIX futures rose
above 27.5-an almost impossible scenario for such low values of VIX.
Instead, as we know, VIX exploded but October outpaced November by a good deal.
Even so, this combo makes money under the second scenario described above-a volatile
move by both underlyings. These were the prices on October 10, 2008:

Long VIX Nov 20 call: 17.70
Long VIX Oct 27.5 put: 0.00
So the spread is showing a profit of 8.40 points ($840 per combo). That's a return of
90% on the initial investment of $930 (not including commissions)-perhaps not as great
as the leverage available in a futures spread, but a much superior result.
THE VIX/SPY HEDGED POSITION
Earlier, when it was first shown that VIX futures can sometimes trade at large discounts
to VIX (and large premiums, as well), it was mentioned that one strategy to take advan-
tage of that was the VIX/SPX hedge. This section will describe the strategy in detail-
discussing its basic concepts, determining how many options to trade on each side of the
hedge, and finally how to handle follow-up strategies.
The hedged portion of the trade derives from the fact that, in general, VIX goes up
when the stock market goes down (and vice versa). Hence a purchase of similar options
(puts or calls) in both instruments is a hedged trade. For example, in theory if one owns
andTrading
Volatility
calls on \'IX and also owns calls on SPX (or more likely, on S&P SPDRS [SPYJ), they
hedge each other. Similarly, if one owns puts on both, it is a hedged position.
Furthermore, as was shown in the previous section, hedges in which options are
used have two chances to make money: (1) if the hedge converges, or (2) if prices of the
und erlyings move a great distance. For example, suppose the hedge is established by buy-
ing calls on both SPY and VIX. On one side, the call can only lose a fixed amount, while
on the other side, the call can profit handsomely.
THE BASIC CONCEPT
The relationship between VIX and the front-month VIX futures is the key as to when this
strategy is applicable. When that differential is too great-either too much of a premium
or too much of a discount-the trade is viable.
In calm times, the strategy can be established when that differential reaches 2.0
points or more-either a 2-point discount or a 2-point premium. In more extreme times-
especially in sharply declining bearish markets-extremely large discounts can exist (as
we've seen in several previous examples in this chapter). Those are even more attractive
times to establish the hedge. So, as a general rule, we want to establish the strategy when
there is a large difference between VIX and its front-month futures contract. Eventually
that differential must disappear-certainly by expiration, if not before.
Let's look at a quick conceptual example:
Example of discount: Suppose the following prices exist:
VIX: :31
VIX front-month futures: 25 (6-point discount)
SPX: 1200
(These roughly correspond to prices on 9/15/08.)
Scenario 1: If the VIX futures are "correct," then VIX will fall to meet their price,
and SPX should correspondingly rise as VIX falls.
Scenario 2: But what if the opposite occurred'? What if VIX is "correct"'? Then the
futures will rise to meet it. In that case. \'IX might he unchanged, so SPX might be
unchanged as well.
So what strateg_\·would work for these scenarios'? Buying calls 011 both. since VIX options
are priced off tlwfitt11rcs as their undt>rlying, not off VIX itself. We would want to stay in
the "front-month" calls because that is where the greatest moves are.
In Sct>nario 1 ahm·e, the VIX futures remain unchanged, and SPX rises. So \'IX calls
Chapter
41: Volatility
Derivatives 937
might lose a little bit of time value premium, hut SPY calls would profit nicely on the
upward movement of SPX.
In Scenario 2, SPX remains relatively unchanged, while VIX futures rise in price.
Tims SPY calls would lose a little time value premium, while VIX calls would gain in value
since the futures rise in price.
Now let's consider an example of the opposite situation, after VIX futures have risen
to a pren1iu111 to VIX. If a hedged trader wanted to use this VIX/SPX strategy in this case,
he would buy puts on both VIX and SPX.
Example of premium:
VIX : 18
VIX front-month futures: 22 (a 4-point premium)
SPX: 1400
Scenario 1: The futures are "correct," so VIX rises and SPX falls. SPY puts would
profit.
Scenario 2: VIX is "correct," so the futures decline to meet VIX, while SPX and
VIX remain relatively unchanged. VIX puts would profit, since VIX futures decline.
HOW MANY OPTIONS TO BUY?
There is a generic formula for determining a proper hedge when dealing with two differ-
ent underlying instruments.
where
V; = volatility
P; = underlying price
U; = unit of trading
D; = delta of options
Typically U is 100 shares per contract if stock or index options are involved, but if
1
you are hedging futures options against stock, ETF, or index options, it could be some-
thing different.
Volatility is typically the 20-day historical volatility, although in extreme times, one
may want to take a broader view of volatility.
In general, the delta of the options is important only if you are, in fact, using options
in the trade. If you are hedging futures against ETFs, for example, then there is no delta
component .
andTrading
Volatility
Regarding the VIX/SPX hedge, as a rule of thumb, historically, this formula generally
tells one to buy about twice as many VIX options as SPY options. However, each market situ-
ation can produce some outlying volatilities for VIX futures or for SPX itself, so the formula
should he applied each time the hedge is established. Do not merely rely on the 2-to-l ratio.
The two pre\·ious examples will be continued here, in order to show how one
would set these ratios. If one is trading VIX options vs. SPY options, the variable U is equal
for both (100). Furthermore make the assumption that options with similar deltas will be
bought. Tims. onl:· price and rnlatilit:· determine the ratio (HV is Historical Volatility):
Example of discount (continued):
Price 20-day
HV
SPY: 120 28
VIX Oct futs: 25 49
Ratio: = (120 x 28) / (26 x 49) = 2.63
That is ro11ghl:·,5-to-2. meaning one would buy ,5 VIX calls and 2 SPY calls (or 10
VIX vs. 4 SPY, and so forth).
Example of premium (continued): This is the continuation of the second example from
above. Stock market volatility was much lower in this case:
Price 20-day
HV
SPY: 140 15
VIXJune futs: 22 48
Ratio:= (140 x 15)/ (22 x 48) = 1.99
So 2 VIX puts would be bought against every 1 SPY put in this case.
Remember that these ratios need to be adjusted if one buys options with widely different
deltas.
EXITING/ ADJUSTING THE HEDGE
Once the position is in place, one would want to remove it if VIX and the front-month
futures returned to a ''normal" state in which they trade at more or less the same price.
That wonld be conwrgence. Howe\·er, there is another way to make money in this spread,
and that's if tht' urnlcrl:·ings move swiftly and sharply in one direction or another. Con-
sider this example:
Chapt
er 41: Volatility Derivatives 939
Example:
VIX: 45
Oct VIX futures: 34 (11-point discount)
Determine the ratio:
Price 20-day
HV
SPY: 112 50
VIX Oct futs: 34 82
Ratio:= (112x 50) / (34 x 82) = 2.01
That is a 2-to-l ratio: buy 2 VIX calls for each SPY call purchased.
To actually implement the trade, buy slightly in-the-money calls on each of VIX and
SPY (so that they have similar deltas):
Buy 10 VIX Oct 32.5 calls @ 3.70

Buy 5 SPY Oct 111 calls @ 5.90
Total debit, excluding commissions: $6,650
Furthermore, assume that a week later, the stock market has taken a big tumble, and
the following prices existed:
VIX: 64
VIX Oct futures: 52
VIX Oct 32.5 call: 20.50
SPY: 90.75
SPY Oct 111 call: 0.00 (worthless)
The spread had not converged (the discount on the October futures has grown from
11 to 12 points), but it was very profitab le because of the large move that had occurred
(VIX rose, SPYfell).
Profit/Loss on trade:
10 VIX calls (bought at 3.70, now worth 20.50): +$16,800
5 SPYcalls (bought at 5.90, now worthless): -$2,950
Total gain on position: +$13,850
So this he<lge<lposition produced a large profit because the underlying instruments

andTrading
Volatility
moved in such a volatile manner-not because there was a convergence between VIX and
futures, as had been expected. In general, convergence will result in relatively small prof-
its, while the second way to profit-volatile moves-will result in much larger profits. The
second scenario is, of course, rarer than the first.
In either scenario, when profits build up, one should take partial profits. If the
futures remain at a significant differential from VIX, the entire position could be
"re-centered" to remove any extreme delta from one side of the position or the other.
WHAT CAN GO WRONG?
No strategy is infallible. In this hedged strategy, the entire debit is at risk if VIX and SPY
"diverge" and yet they don't make a volatile move. That is unlikely over a sustained time
period, but it can happen in the short term.
For example, if VIX futures are at a large discount, the strategy dictates buying calls
on both VIX and SPY. If the stock market then rallies, implied volatility will usually
decline. Hence VIX falls, and the VIX futures fall as well, causing a loss in the long VIX
calls . Moreover, declining volatility is a drag on the price of the SPY calls that are owned.
Hence, it is possible that both sides of the hedge could lose in that case. It would be
unlikel y for that situation to persist, but in theory anything can happen.
The effect of declining VIX is less detrimental when puts are owned on both, for the
VIX puts would be making some money in that case, even as the declining VIX is some-
thing of a problem for the long SPY puts .
Another potential source for error is in the adjustment process . If a large delta
builds up on one side of the position or the other, one needs to either re-center the posi-
tion or take partial profits, or at least use a trailing stop on the profitable side of the trade.
To fail to do so exposes the built-up profits if there should be a sharp reversal in the
market.
GENERAL OBSERVATIONS
If one steps back and thinks about it, this strategy should work whether one owns calls on
both or puts on both, as long as the market is volatile. Hence the strategy might be
employable at almost any time. In fact, owning this hedge is very similar to owning a
straddle on "the market." That would include either buying straddles on SPY (or SPX) or
on \'IX itself. The "edge" in the hedged trade comes from the fact that there is a signifi-
cant discount or premium on the VIX futures, and that differential has to disappear by
the time the futures expire.
There is a second condition to success in this general strategy , as well: it will only
Chapter
41: Volatility
Derivatives 941
TABLE 41-13.
Implied volatilities of VIX options. On July 15, assume that VIX is at 21.
Months:
Strikes August September October November
At-money-1 76% 76% 65% 60%
At-money 86% 84% 71% 63%
At-money+1 97% 89% 75% 67%
At-money+2 104% 94% 80% 70%
At-money+3 113% 98% 83% 72%
Futures 20.60 21.92 22.59 22.80
20-day HY 53% 43% 38% 34%
work as long as the general relationship between SPY and VIX remains in effect. That is,
it works as long as volatility and the stock market move in opposite directions at roughly
the same speed. Without this component, the hedge doesn't work.
Since there is no absolute relationship between VIX and SPY, we cannot always tell
how the hedge will behave. That's something one doesn't have to worry about in the case
of buying straddles on either VIX or SPY. In actual practice, there will surely be times
when a SPY or VIX straddle buy might outperform the hedged position, but-especially
if one waits until there is an "edge" in the VIX futures-the vast majority of times, the
hedged position will outperform.
SUMMARY
In summary, this hedged strategy is an excellent way to trade volatility. That is, the posi-
tion sets up when the VIX futures are trading at a significant distance from VIX. By using
options , the profits are open-ended and can be made with either a convergence of VIX
and VIX futures or with a volatile market move in either direction.
RATIO SPREADS WITH VIX OPTIONS
In the discussion surrounding Table 41-8, it was shown why VIX options trade with both
a horizontal and a vertical skew. Table 41-1.3shows what might be a typical array of VIX
option implied volatilities:
Notice the distinct horizontal skew (near-term options are more expensive than
longer-term options). This is based on the similar skew in the futures (last line of Tahle
942 PartVI:Measurin
g andTrad
ing Volatility
41-13, where HV stands for "historical volatility"). Also, note that the VIX options arc
quite a bit more expensive than the recent historical volatility of the individual futures
contracts. That is because VIX futures always have the potential to explode, and so the
options are priced with a forward-looking volatility rather than a historical one.
Also, there is a vertical skew. The first column shows five striking prices, all with
respec t to "at the money," which can be a different striking price for different futures
contracts. The designation of strikes above (+l, +2, +3) and below (-1) the "at the money"
strike are 2.50 points apart. The options with lower strikes have lower implied volatilities
than do the options with higher strikes. This linear skew bears certain similarities to the
skew in SPX options (but in the opposite direction) and is conducive to ratio spreads and
backspreads, using options in the same expiration month. The VIX option vertical skew is
a forward or positive skew, while the SPX option vertical skew is a reverse or negative
skew.
However, calendar spreads and diagonal spreads-usi ng options in different
months-are not necessari ly at an advantage, even though there is a hor izontal skew in
the options. The apparent horizontal skew should be there, since the underlying futures
have actual volatilities that are highest for the near-term futures, and then decline for
each successive longer-term month.
Ratio call spreads have a theoretical advantage in that one is buying an option with
a lower implied volatility than the one being sold.
Example:
VIX: 22.73
July VIX futures: 21.95

Volatil
ity
July 22.5 call 2.30 97%
July 25 call 1.75 108%
July 275 call 1.35 116%
July 30 call 1.05 122%
Sample Call Ratio Spread:

Buy 1 July 25 call @ 1.75
Sell 2 July 30 calls @ 1.05
Net Credit: 0.35
Upside Break-even: 35.35
Chapter
41: Volatility
Derivatives 943
The spreader must collateralize the one naked call, according to the usual margin
requirement for naked index calls (this is not considered to be a broad-based index).
The profit graph of this ratio spread is shown in Figure 41-1.5.The theoretical advan-
tage of the call ratio spread in this example comes from the fact that options with an
implied volatility of 108% are being bought, while options with an implied volatility of
122% are being sold.
The spread will make money as long as VIX is not above 3.5.3.5at expiration. Below
2.5, the profit is merely the 3,5-cent credit for which the spread was established. But
betv.reen 2.5 and 3.5, larger profits are attainable, with the maximum profit of .5.3.5being
reached if VIX were at exactly 30 at expiration. Prior to expiration, of course, the spread
could have losses if the July futures rally too much and/or the implied volatility of the
options expands. The gray lines in Figure 41-1.5 show results prior to expiration.
These characte1istics are very similar to those of an SPX or SPY put ratio spread.
Traders who favor the SPX put ratio spread strategy will also likely consider the VIX call
ratio spread strategy as a viable one. Both are subject to swift losses if the market sud-
denly plunges. When that happens, implied volatility explodes and so does the volatility
of volatility.
FIGURE 41-15.
VIX call ratio spread.
VIX Call Ratio Spread

548.1
365.4
/ ~
182.7
/ ~
/ '\
/ '\.
0.0
-182.7 +-~
""~~
-365.4
-548 .1
-730.9
-913.6
8.6 12.9 17.2 21.5 25.8 30.1 34.4 38.7 43.0
andTra
ding Volatility
It seems to be a fair question to ask which is "safer." As an unhedged strategy, that

is a difficult question to answer because both are subject to the aforementioned dangerous
volatility increases. However, if one is managing a portfolio of SPY or SPX put ratio
spreads, he can buy some out-of-the-money VIX calls as a hedge against a market collapse.
But the VIX call ratio spreader is unlikely to do the same, because that would turn his
ratio spread into a butterfly spread, and the butterfly probably wouldn't have the desired
characteristics of profitability.
VIX PUT RATIO SPREADS
Certain institutional traders seem to like VIX put spreads, even though there is a theo-
retical disaduemtage to the strategy. The disadvantage arises because one is buying
options that are more expensive than the ones he is selling, in terms of implied
volatility.
Example: Suppose a trader thinks VIX will decline, but he is not certain about it. He might
buy VIX puts, but that would be a losing strategy if volatility does not drop within the time
frame of the options he is buying. He might consider using a bear spread or even a put ratio
spread to offset some of the risk of owning VIX puts, while he waits for the market to decline.
VIX: 22.73
July VIX futures: 21.95

Volatility
July 20 put 1.30 85%
July 18 put 0.50 74%
July 16 put 0.10 64%
Sample Put Ratio Spread:
Buy 1 July 20 put @ 1.30

Sell 2 July 18 puts @ 0.50
Net Debit: 0.30
Downside Break-even: 16.30
One would have to put up margin for the one naked put in this position .
Out-of-the-money put prices drop sharply in VIX options, because of the decrease in
illlpliecl volatility at lower strikes. If one had merely bought the July 20 put for 1.30, he
Chapter
41: Volatility
Deriva~ive
s 945
would make money if July futures fell at any time, and specifically if they were below
18.70 at expiration.
Figure 41-16 shows the profit graph for this put ratio spread. With the put ratio
spread, he only risks 30 cents if VIX doesn't fall, but won't make much money if July VIX
futures drop right away, because the short options will weigh against the position (the
curved lines of Figure 41-16). Eventually, at expiration, he makes money if VIX is between
16.30 and 19.70,but can lose considerable amounts if VIX falls well below 16.,50.
So this strategy really only makes sense if one is expecting a modest decrease in the
price of VIX-something that is not that easy to predict.
VIX PUT BACKSPREADS
However, there is a put strategy that does take advantage of the skew in the options, and
that is the put backspread. This strategy would typically be used if one thought VIX were
FIGURE 41-16.
VIX put ratio spread.
VIX Put Ratio Spread

162.6
122.0 I\
81.3
I/ \
40.7 I \\
0.0 I \
- 40.7 I \
- 81.3
I
-122.0
- 162.6
15.1 17.3 19.5 21.6 23.8 25.9 28.1
946 PartVI:Measuringand TradingVolatility
going to make a sizeable move, with a downward move being more likely than an upward
move. So usually it is established with VIX at or above 30.
Example: After a market drop, VIX has risen substantially and is trading near 38. A
trader feels that a market rally is likely, and that VIX will thus fall in price. However, there
is always the chance that the market collapses again and VIX explodes even further to the
upside.
VIX: 37.81

Volatili
ty
Nov 45 put 10.70 99%
Nov 375 put 4.80 85%
Sample Put Backspread:

Buy 2 Nov 37.5 puts @ 4.80
Sell l Nov 45 put@ 10.70
Net Credit: 1.10
Downside Break-even: 31.10
There are no naked puts in this position. Rather the margin is equal to the maximum
risk, which is the difference in the striking prices (7..50)minus the initial credit (1.10), or
$640 margin for the 2xl spread.
The profit graph for this backspread is shown in Figure 41-17. In this strategy,
one has established the backspread for a credit (which is what a strategist normally wants to
do in a backspread). Moreover, the options being bought are trading with a substantially
lower implied volatility than those being sold, so the spread has a theoretical edge.
If VIX explodes to the upside, and all the puts expire worthless, the spreader will
keep the 1.10 initial credit as his profit. Conversely, if VIX drops sharply (in a rising mar-
ket, say), then he will have profits at expiration as long as VIX is below 31.10. In fact, since
the strategy has one net long put, rather substantial profits can be made if VIX falls well
below the break-even.
The worst result would occur if VIX were exactly at the long strike, 37.5, at expira-
tion, where the maximum loss of $640 would be realized. Clearly, this spread is most
attractive if VIX moves away from its initial price by a great deal.
One does not have to wait until expiration, however, to realize profits. If VIX makes
a move right away, there will Le profits if the move is large enough. The spreader can
Chapter
41: Volatility
Derivati~es 947
FIGURE 41-17.
VIX put backspread.
VIX Put Backspread

719.5
539.7 ~~-
I
359.8
179.9 ~
0.0
~ I
/ -
' I\. ,/ I
v-
I
-179.9
-359 .8 ~
-539.7
~~ /
V
-719.5
22.6 27.1 31.6 36.2 40.7 45.2 49.7 54.2 58.8
make adjustments to lock in some of those profits, or take partial profits, or even close out
the whole spread if he desires. However, if VIX does not move, then one would probably
want to exit this spread by November 1st or so, for the losses at that time would be along
the darker gray line in Figure 41-17. Waiting much longer would expose the position to
the maximum losses as shown on the solid black line on the profit graph.
SUMMARY
Ratio spreads and backspreacls in VIX options can be useful and theoretically attractive.
The call backspread, described earlier, is useful as a protection strategy or for upside
speculation with small risk. The put backspread is theoretically advantageous for down-
side speculation in VIX. Call ratio spreads are attractive from the viewpoint of the for-
ward skew. Only the put ratio spread seems to lack much of a useful purpose, but even it
is popular with some traders .
VOLATILITY DERIVATIVES SUMMARY
The introduction of listed derivatives on the volatility asset class is one of the most
significant developments in the history of listed options and futures. In the fntur<:, rnor<:
948 PartVI:Measuring Volatility
andTrading
individual stocks, indices, and futures contracts will have listed volatility derivatives also.
Volatility has always been the most difficult variable to hedge and control, but now it can
be done directly via these new products. While their primary use should be the hedging
of volatility risk in equity portfolios, they make excellent speculative and strategic vehi-
cles as well.
Taxes
In this chapter, the basic tax treatment of listed options will be outlined and several tax
strategies will be presented. The reader should he aware of the fact that tax laws change,
and therefore should consult tax counsel before actually implementing any tax-oriented
strategy. The interpretation of certain tax strategies by the Internal Revenue Service is
subject to reclarification or change, as well.
An option is a capital asset and any gains or losses are capital gains or losses. Differ-
ing tax consequences apply, depending on whether the option trade is a complete trans-
action by itself, or whether it becomes part of a stock transaction via exercise or assignment.
Listed option transactions that are closed out in the options market or are allowed to
expire worthless are capital transactions. The holding period for option transactions to
qualify as long-term is always the same as for stocks (currently, ifs one year). Gains from
option purchases could possibly be long-term gains if the holding period of the option
exceeds the long-term capital gains holding period .
Gains from the sale of options are short-term capital gains. In addition, the tax treat-
ment of futures options and index options and other listed nonequity options may differ
from that of equity options . We will review these points individually.
HISTORY
In the short life of listed option trading, there have been several major changes in the tax
rules. When options were first listed in 197,3, the tax laws treated the gains and losses
from writing options as ordinary income. That is, the thinking was that only professionals
or those people in the business actually wrote over-the-counter options, and thus their
gains and losses represented their ordinary income, or means of making a living. This
949
andTrading
Volatility
rule presented some interesting strategies involving spreads, because the long side of the
spread could be treated as long-term gain (if held for more than 6 months, which was the
required holding period for a long-term gain at that time), and the short side of the spread
could be ordinary loss. Of course, the stock would have had to move in the desired direc-
tion in order to obtain this result.
In 1976, the tax laws changed. The major changes affecting option traders were
that the long-term holding period was extended to one year and also that gains or losses
from writing options were considered to be capital gains. The extension of the long-term
period essentially removed all possibilities of listed option holders ever obtaining a
long-term gain, because the listed option market's longest-term options had only 9 months
of life.
All through this period there were a wide array of tax strategies that were
available, legally, to allow investors to defer capital gains from one year to the next, thereby
avoiding payment of taxes. Essentially, one would enter into a spread involving deep
in-the-money options that would expire in the next calendar year. Perhaps the spread
would be established during October, using January options. Then one would wait for the
underlying stock to move. Once a move had taken place, the spread would have a profit
on one side and a loss on the other. The loss would be realized by rolling the losing option
into another deep in-the-money option. The realized loss could thus be claimed on that
year's taxes. The remaining spread-now an unrealized profit-would be left in place
until expiration, in the next calendar year. At that time, the spread would be removed
and the gain would be realized. Thus, the gain was moved from one year to the next.
Then, later in that year, the gain would again be rolled to the next calendar year, and
so on.
These practices were effectively stopped by the new tax ruling issued in 1984. Two
sweeping changes were made. First, the new rules stated that, in any spread position
involving offsetting options-as the two deep in-the-money options in the previous
example-the losses can be taken only to the extent that they exceed the unrealized gain
on the other side of the spread. (The tax literature insists on calling these positions "strad-
dles" after the old commodity term, but for options purposes they are really spreads or
covered writes.) As a by-product of this rule, the holding period of stock can be terminated
or eliminated by writing options that are too deeply in-the-money. Second, the new rules
required that all positions in nonequity options and all futures be marked to market at the
end of the tax year, and that taxes be paid on realized and unrealized gains alike. The tax
rate for nonequity options was lowered from that of equity options. Then, in 1986, the
long-term and short-term capital gains rates were made equal to the lowest ordinary rate.
All of these points will be covered in detail.
Chapter
42: Taxes 951
BASIC TAX TREATMENT
Listed options that are exercised or assigned fall into a different category for tax pur-
poses. The original premium of the option transaction is combined into the stock transac-
tion. There is no tax liability on this stock position until the stock position itself is
closed out. There are four different combinations of exercising or assigning puts or calls.
Table 42-1 summarizes the method of applying the option premium to the stock cost or
sale price .
Examples of how to treat these various transactions are given in the following sec-
tions. In addition to examples explaining the basic tax treatment, some supplementary
strategies are included as well.
CALLBUYER
If a call holder subsequently sells the call or allows it to expire worthless, he has a capital
gain or loss. For equity options, the holding period of the option determines whether the
gain or loss is long-term or short-term. As mentioned previously , a long-term gain would
be possible if held for more than one year. For tax purposes, an option that expires worth-
less is considered to have been sold at zero dollars on the expiration date.
Example: An investor purchases an XYZ October 50 call for 5 points on July 1. He sells
the call for 9 points on September 1. That is, he realizes a capital gain via a closing trans-
action. His taxable gain would be computed as shown in Table 42-1, assuming that a $2,5
commission was paid on both the purchase and the sale .
TABLE 42-1.
Applying the option premium to the stock cost or sale price.
Action TaxTreatment
Call buyer exercises Add call premium to stock cost
Put buyer exercises Subtract put premium from stock sale price
Call writer assigned Add call premium to stock sale price
Put writer assigned Subtract put premium from stock cost
Net proceeds of sale ($900 - $25) $875
Net cost ($500 + $25) -525
Short-term gain: $350
andTrading
Volatility
Alternatively, if the stock had fallen in price by October expiration and the October .50
call had expired worthless, the call buyer would have lost $.52,5-his entire net cost. If he
had held the call until it expired worthless, he would have a short-term capital loss of
$.52.5to report among his taxable transactions.
PUT BUYER
The holder of a put has much the same tax consequences as the holder of a call, provided
that he is not also long the underlying stock. This initial discussion of tax consequences to
the put holder will assume that he does not simultaneously own the underlying stock.
If the put holder sells his put in the option market or allows it to expire worthless, the gain
or loss is treated as capital gain, long-term for equity puts held more than one year. His-
toricall y, the purchase of a put was viewed as perhaps the only way an investor could
attain a long-term gain in a declining market.
Example: An investor buys an XYZ April 40 put for 2 points with the stock at 43. Later,
the stock drops in price and the put is sold for ,5 points. The commissions were $2.5 on
each option trade , so the tax consequences would be:
Net sale proceeds ($500-$25) $475

Net cost ($200 + $25) -225
Short-term capital gain: $250
Alternatively, if he had sold the put at a loss, perhaps in a rising market, he would have a
short-term capital loss. Furthermore, if he allowed the put to expire totally worthless, his
short-term loss would be equal to the entire net cost of $22.5.
CALL WRITER
Written calls that are bought back in the listed option market or are allowed to expire
worthless are short-term capital gains. A written call cannot produce a long-term gain,
regardless of the holding period. This treatment of a written call holds true even if the
investor simultaneously owned the underlying stock (that is, he had a covered write). As
long as the call is bought back or allowed to expire worthless, the gain or loss on the call
is treated separately from the underlying stock for tax purposes.
Example: A trader sells naked an XYZ July 30 call for 3 points and buys it back three months
later at a price of l. The commissions were $2.5 for each trade, so the tax gain would be:
Chapter
42: Taxes 953
Net sale proceeds ($300 - $25) $275

Net cost ($100 + $25) -125
If the investor had not bought the call back, but had been fortunate enough to be able to
allow it to expire worthless, his gain for tax purposes would have been the entire $27.S,
representing his net sale proceeds. The purchase cost is considered to be zero for an
option that expires worthless.
PUT WRITER
The tax treatment of written puts is quite similar to that of written calls. If the put is
bought back in the open market or is allowed to expire worthless, the transaction is a
short-term capital item.
Example: An investor writes an XYZ July 40 put for 4 points, and later buys it back for
2 points after a rally by the underlying stock. The commissions were $2,5 on each option
trade, so the tax situation would be:
Net put sale price ($400 - $25) $375

Net put cost ($100 + $25) -125
If the put were allowed to expire worthless, the investor would have a net gain of $37.5,
and this gain would be short-term.
THE 60/40 RULE
As mentioned earlier, nonequity option positions and future positions must be marked to
market at the end of the tax year and taxes paid on both the unrealized and realized gains
and losses. This same rule applies to futures positions. The tax rate on these gains and
losses is lower than the equity options rate. Regardless of the actual holding period of tlie
positions, one treats 60% of his tax liability as long-term and 40% as :short-term. This
ruling means that even gains made from extremely short-term activity such as day-trading
can qualify partially as long-term gains.
Since 1986, long-term and short-term capital gains rates have been equal. If
long-term rates should drop, then the rule would again be more meaningful.
andTrading
Volatility
Example: A trader in nonequity options has made three trades during the tax year. It is
now the encl of the tax year and he must compute his taxes. First, he bought S&P ,500 calls
for $1,500 and sold them 6 weeks later for $3,,500. Second, he bought an OEX January
160 call for 3.25 seven months ago and still holds it. It currently is trading at 11.50. Finally,
he sold ,5 SPX February 250 puts for 1.50 three days ago. They are currently trading at 2.
The net gain from these transactions should be computed without regard to holding
period .
Nonequity Original Current Gain/

Contract Price Price Cost Proceeds Loss
S&Pcalls $1,500 $3,500 +$2,000 realized
OEXJanuary160 3.25 11.50 $ 325 $ 1,150 + 825 unrealized
SPXFebruary 250 1.50 2.00 $1,000 $ 750 250 unrealized
Total capital gains + $2,575
The total taxable amount is $2,575, regardless of holding period and regardless of whether
the item is realized or unrealized. Of this total taxable amount, 60% ($1,545) is subject to
long-term treatment and 40% ($1,030) is subject to short-term treatment.
In practice, one computes these figures on a separate form (Section 1256) and
merely enters the two final figures-$1,545 an<l $1,030-on the tax schedule for capital
gains and losses. Note that if one loses money in nonequity options, he actually has a tax
disadvantage in comparison to equity options, because he must take some of his loss as a
long-term loss, while the equity option trader can take all of his loss as short-term.
EXERCISEAND ASSIGNMENT
Except for a specified situation that we will discuss later, exercise and assignment do not
have any tax effect for nonequity options because everything is marked to market at the
end of the year. Howc>ver,since equity options are subject to holding period consider-
ation s, the following discussion pertains to them .
CALLEXERCISE
An equit:' call holder who has an in-the-money call might decide to exercise the call
rather than sell it in the options market. If he does this, there are no tax consequences
on the option trade itself. Rather, the cost of the stock is increased by the net cost of
the original call option. Moreover, the holding period begins on the day the stock is
Chapter
42: Taxes 955
purchased (the day after the call was exercised). The option's holding period has no bear-
ing on the stock position that resulted from the exercise .
Example: An XYZ October .SOcall was bought for .Spoints on July l. The stock had risen
by October expiration, and the call holder decided to exercise the call on October 20th.
The option commission was $2.Sand the stock commission was $8.S.The cost basis for the
stock would be computed as follows:
Buy l 00 XYZ at 50 via exercise

$5,085
($5,000 plus $85 commission)
Original call cost ($500 plus $25) 525
Total tax basis of stock $5,610
Holding period of stock begins on October 21.
When this stock is eventually sold, it will be a gain or a loss, depending on the stock's sale
price as compared to the tax basis of $.5,610 for the stock. Furthermore, it will be a
short-term transaction unless the stock is held until October 21st of the following year.
CALL ASSIGNMENT
If a written call is not closed out, but is instead assigned, the call's net sale proceeds are
added to the sale proceeds of the underlying stock. The call's holding period is lost, and
the stock position is considered to have been sold on the date of the assignment.
Example: A naked writer sells an XYZ July 30 call for .3points, and is later assigned rather
than buying back the option when it was in-the-money near expiration. The stock com-
mission is $7.S.His net sale proceeds for the stock would be computed as follows:
Net call sale proceeds ($300 - $25) $ 275

Net stock proceeds fromassignment
of 100 shares at 30 ($3,000 - $75) 2,925
Net stocksale proceeds $3,200
In the case in which the investor writes a naked, or uncovered, call, he sells stock
short upon assignment. He may, of course, cover the short sale by purchasing stock in the
open market for delivery. Such a short sale of stock is governed by the applicable tax rules
956 Part VI:Measuringand Trading Volatility
pertaining to short sales-that any gains or losses from the short sale of stock are
short-term gains or losses.
Tax Treatment for the Covered Writer. If, on the other hand, the investor was
assigned on a covered call-that is, he was operating the covered writing strategy-and
he elects to deliver the stock that he owns against the assignment notice, he has a com-
plete stock transaction. The net cost of the stock was determined by its purchase price at
an earlier date and the net sale proceeds are, of course , determined by the assignment in
accordance with the preceding example.
Dett'rmi11ing tlw proceeds from the stock purchase and sale is easy, but determining
the tax status of the transaction is not. In order to prevent stockholders from using deeply
in-the-money calls to protect their stock while letting it become a long-term item, some
complicated tax rules have been passed. They can be summarized as follows:
1. If the equity option was out-of-the-money when first written, it has no effect on the
holding period of the stock.
2. If the equity option was too deeply in-the-money when first written and the stock icas
not yet held !011g-tcr111,
then the holding period of the stock is eliminated.
:1. If the t'quit_voption was in-the-money, but not too deeply, then the holding period of
the stock is suspended while the call is in place .
These rules are complicated and merit further explanation. The first rule merely says
that one can write out-of-the-money calls without any prohlem. If the stock later rises and
is called away, the sale proceeds for the stock include the option premium, and the trans-
action is long-term or short-term depending on the holding period of the stock.
Example: Assume that on September 1st of a particular year, an investor buys 100 XYZ
at .'3,5.He holds the stock for a while, and then on July l.Sth of the following year-after
the stock has risen to 43-he sells an October 4.Scall for 3 points.
Net call sale proceeds ($300 - $25) $ 275

Net stock proceeds from
assignment ($4,500 - $75) $4,425
Net stock sale proceeds $4,700 $4,700
Net stock cost ($3,500 + $75) $3,575
Net long-term gain +$1,125
Chapter
42: Taxes 957
Tims, this covered writer has a net gain of $1,125 and it is a long-term gain because the
stock was held for more than one year (from September 1st of the year in which he bought
it, to October expiration of the next year , when the stock was called away).
Note that in a similar situation in which the stock had been held for less than one
year before being called away, the gain would be short-term.
Let us now look at the other two rules. They are related in that their differentiation
relies on the definition of "too deeply in-the-money." They come into play only if the stock
was not already held long-term when the call was written. If the written call is too deeply
in-the-money, it can eliminate the holding period of short-term stock. Otherwise, it can
suspend it. If the call is in-the-money, hut not too deeply in-the-money, it is referred to as
a qualified covered call. There are several rules regarding the determination of whether
an in-the-money call is qualified or not. Before actually getting to that definition, which
is complicated, let us look at two examples to show the effect of the call being qualified
or not qualified.
Example: Qualified Covered Write: On March 1st, an investor buys 100 XYZ at 35. He
holds the stock for 3½ months, and, on July 15th, the stock has risen to 43. This time he
sells an in-the-money call, the October 40 call for 6. By October expiration, the stock has
declined and the call expires worthless.
He would now have the following situation: a $,575 short-term gain from the sale of
the call, plus he is long 100 XYZ with a holding period of only 3½ months. Thus, the sale
of the October call suspended his holding period, but did not eliminate it.
He could now hold the stock for another 8½ months and then sell it as a long-term
item.
If the stock in this example had stayed above 40 and been called away, the net result
would have been that the option proceeds would have been added to the stock sale price
as in previous examples, and the entire net gain would have been short-term due to the
fact that the writing of the qualified covered call had suspended the holding period of the
stock at 3½ months.
That example was one of writing a call which was not too deeply in-the-money. If,
however, one writes a call on stock that is not yet held long-term anJ the call is too deeply
in-the-money, then the holding period of the stock is eliminated. That is, if the call is sub-
sequently bought back or expires worthless, the stock must then be held for another year
in order to qualify as a long-term investment. This rule can work to an investor's advan-
tage. If one buys stock and it goes down and he is in jeopardy of having a long-term loss,
but he really does not want to sell the stock, he can sell a call that is too deeply in-the-money
(if one exists), and eliminate the holding period on the stock.
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Qualified Covered Call. The preceding examples and discussion summarize the
covered writing rules. Let us now look at what is a qualified covered call. The following
rules are the literal interpretation. Most investors work from tables that are built from
these rules. Such a table may be found in Appendix E. (Be aware that these rules may
change, and consult a tax advisor for the latest figures.) A covered call is qualified if:
1. the option has more than 30 days of life remaining when it is written, and
2. the strike of the written call is not lower than the following benchmarks:
a. First determine the applicable stock price (ASP). That is normally the closing
price of the stock on the previous day. However, if the stock opens more than
110% higher than its previous close, then the applicable stock price is that higher
opening.
h. If the ASP is less than $2.5, then the benchmark strike is 8.5% of ASP. So any call
,vritten with a strike lower than 8.5% of ASP would not be qualified. (For exam-
ple, if the stock was at 12 and one wrote a call with a striking price of 10, it would
not be qualified-it is too deeply in-the-money .)
c. If the ASP is between 2.5.01 and 50, then the benchmark is the next lowest strike.
Thus, if the stock were at 39 and striking prices were spaced at .S-point intervals
and one wrote a call with a strike of 35, it would be qualified.
d. If the ASP is greater than .SOand not higher than 1.50,and the call has more than
90 <laysof life remaining, the benchmark is two strikes below the ASP. There is
a further condition here that the benchmark cannot be more than 10 points lower
than the ASP. Thus, if a stock is trading at 90, one could write a call with a strike
of 80 as long as the call had more than 90 days remaining until expiration, and
still be qualified.
e. If the ASP is greater than 1.50 and the call has more than 90 days of life remain-
ing, the benchmark is two strikes below the ASP. Thus, if there are 10-point
striking price intervals, then one could write a call that was 20 points in-the-money
and still be qualified. Of course, if there are .S-point intervals, then one could not
write a call deeper than 10 points in-the-money and still be qualified.
Note that in cases where a stock has striking prices that are one point apart, the
writer can barely write any in-the-money call, lest it not be qualified. These rules are
complicated. That is why the~: are summarized in Appendix E. In addition, they are
always subject to change, so if an investor is conside1ing writing an in-the-money covered
call against stock that is still short-term in nature, he should check with his ta,x advisor
arnl/or broker to determine whether the in-the-money call is qualified or not.
Tlwre is one further rule in connection with qualified calls. Recall that we stated
Chapter
42: Taxes 959
that the above rules apply only if the stock is not yet held long-term when the call is
written. If the stock is already long-term when the call is written, then it is considered
long-term when called away, regardless of the position of the striking price when the call
was written. However, if one sells an in-the-money call on stock already held long-term,
and then subsequently buys that call back at a loss, the loss 011 the call must be taken as a
long-term loss because the stock was long-term.
O,·erall, a rising market is the best, taxwise, for the covered call writer. If he writes
out-of-the-money calls and the stock rises, he could have a short-term loss on the calls plus
a long-term gain on the stock
Exam p le: On January 2nd of a particular year, an investor bought 100 shares of XYZ at
32, paying $75 in commissions, and simultaneously wrote a July 3,5 call for 2 points. The
July 35 expired worthless, and the investor then wrote an October 35 call for 3 points. In
October, with XYZ at 39, the investor bought back the October 3,5 call for 6 points (it was
in-the-money) and sold a January 40 call for 4 points. In January, on the expiration day,
the stock was called away at 40. The investor would have a long-term capital gain on his
stock, because he had held it for more than one year. He would also have two short-term
capital transactions from the July 35 and October 3,5 calls. Tables 42-2 and 42-3 show his
net tax treatment from operating this covered writing strategy. The option commission on
each trade was $25.
Things have inJeed worked out quite well, both profit-wise and tax-wise, for this
covered call writer. Not only has he made a net profit of $850 from his transactions on the
stock and options over the period of one year, but he has received very favorable tax treat-
ment. He can take a short-term loss of $175 from the combined July and October option
transactions , and is able to take the $1,025 gain as a long-term gain.
TABLE 42 -2.
Summary of trad es.
January 2 Bought 100 XYZ at 32
July Sold 1 July 35 call at 2

July call expired worthless (XYZ at 32)
Sold 1 October 35 call at 3
October Bought back October 35 call for 6 points (XYZ at 39)

Sold 1 January 40 call for 4 points
(of the following year)
January 100 XYZ called away at 40

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TABLE 42-3.
Tax treatment of trades.
Short-term capital items:
July 35 call: Net proceeds ($200 - $25) $175
Net cost (expired worthless) 0
Short-term capital gain $175
October 35 call: Net proceeds ($300 - $25) $275

Net cost ($600 + $25) - 625
Short-term capital loss . ($350)
Long-term capital item:

l 00 shares XYZ: Purchased January 2 of one year and sold at January
expiration of the following year. Therefore, held for
more than one year, qualifying for long-term treatment.
Net sale proceeds of stock (assigned call):
January 40 call sale proceeds
($400 - $25) $375
Sold l 00 XYZ at 40 strike
($4,000 - $75) + 3,925
Net cost of stock (January 2 trade): $4,300
Bought 100 at 32 ($3,200 + $75) - 3,275
Long-term capital gain $1,025
This example demonstrates an important tax consequence for the covered call
writer: His optimum scenario tax-wise is a rising market, for he may be able to achieve a
long-term gain on the underlying stock if he holds it for at least one year, while simulta-
neously subtracting short-term losses from written calls that were closed out at higher
prices. Unfortunately, in a declining market, the opposite result could occur: short-term
option gains coupled with the possibility of a long-term loss on the underlying stock. There
are ways to arnid long-term stock losses, such as buying a put (discussed later in the chap-
ter) or going short against the box before the stock becomes long-term. However, these
maneuYers would interrupt the covered writing strategy, which may not be a wise tactic.
In summary, then, the covered call writer who finds himself with an in-the-money
call written and expiration elate drawing near may have several alternatives open to him.
If the stock is not yet held long-term, he might elect to buy back the written call and to
write another call whose expiration elate is beyond the date required for a long-term hold-
ing period on the stock. This is apparently what the hypothetical investor in the preceding
Chapter
42: Taxes 961
example did with his October 3.5 call. Since that call was in-the-money , he could have
elected to let the call he assigned and to take his profit on the position at that time. How-
ever, this would have produced a short-term gain, since the stock had not yet been held
for one year, so he elected instead to terminate the October 35 call through a closing
purchase transaction and to simultaneously write a call whose expiration date exceeded
the one year period required to make the stock a long-term item. He thus wrote the Jan-
uary 40 call, expiring in the next year. Note that this investor not only decided to hold the
stock for a long-term gain , but also decided to try for more potential profits: He rolled the
call up to a higher striking price. This lets the holding period continue. An in-the-money
write would have suspended it.
DELIVERING .1✓NEW" STOCK TO AVOID A LARGE LONG-TERM GAIN
Some covered call writers may not want to deliver the stock that they are using to cover the
written call, if that call is assigned. For example, if a covered writer were writing against
stock that had an extremely low cost basis, he might not be willing to take the tax conse-
quences of selling that particular stock holding. Thus, the writer of a call that is assigned
may sometimes wish to buy stock in the open market to deliver against his assignment,
rather than deliver the stock he already owns. Recall that it is completely in accordance
with the Options Clearing Corporation rules for a call writer to buy stock in the open
market to deliver against an assignment. For tax purposes, the confirmation that the inves-
tor receives from his broker for the sale of the stock via assignment should clearly specify
which particular shares of stock are being sold. This is usually accomplished by having the
confirmation read "Versus Purchase" and listing the purchase date of the stock being sold.
This is done to clearly identify that the ''new" stock, and not the older long-term stock, is
being delivered against the assignment. The investor must give these instructions to his
broker, so that the brokerage firm puts the proper notation on the confirmation itself. If
the investor realizes that his stock might be in danger of being called away and he wants
to avail himself of this procedure, he should discuss it with his broker beforehand, so that
the proper procedures can be enacted when the stock is actually called away.
Example: An investor owns 100 shares ofXYZ and his cost basis, after multiple stock splits
and stock dividends over the years, is $2 per share. With XYZ at 50, this investor decides
to sell an XYZ July 50 call for .5 points to bring in some income to his portfolio. Subse-
quently, the call is assigned, but the investor does not want to deliver his XYZ, which he
owns at a cost basis of $2 per share, because he would have to pay capital gains 011 a large
profit. He may go into the open market and buy another 100 shares of XYZ at its current
market price for delivery against the assignment notice . Suppose he does this 011 July 20th,
the day he receives the assignment notice on his XYZ July 50 call. The confirmation that
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he receives from his broker for the sale of 100 XYZ at 50-that is, the confirmation for the
call assignment-should be marked "Versus Purchase July 20th." The year of the sale date
should be noted on the confirmation as well. This long-term holder of XYZ stock must, of
course, pay for the additional XYZ bought in the open market for delivery against the
assignment notice. Thus, it is imperative that such an investor have a reserve of funds that
he can fall back on if he thinks that he must ever implement this sort of strategy to avoid
the tax consequences of selling his low-cost-basis stock.
PUT EXERCISE
If the put holder does not choose to liquidate the option in the listed market, but instead
exercises the put-thereby selling stock at the striking price-the net cost of the put is
subtracted from the net sale proceeds of the underlying stock.
Example: Assume an XYZ April 45 put was bought for 2 points. XYZ had declined in
price below 45 by April expiration, and the put holder decides to exercise his in-the-money
put rather than sell it in the option market. The commission on the stock sale is $85, so
the net sale proceeds for the underlying stock would be:
Sale of 100 XYZat 45 strike ($4,500 - $85) $4,415

Net cost of put ($200 + $25) - 225
Net sale proceeds on stock for tax purposes: $4,190
If the stock sale represents a new position-that is, the investor has shorted the underly-
ing stock-it will eventually be a short-term gain or loss, according to present tax rules
governing short sales. If the put holder already owns the underlying stock and is using the
put exercise as a means of selling that stock, his gain or loss on the stock transaction is
computed, for tax purposes, by subtracting his original net stock cost from the sale pro-
ceeds as determined above .
PUT ASSIGNMENT
If a written put is assigned, stock is bought at the striking price. The net cost of this pur-
chased stock is reduced by the amount of the original put premium received.
Example: If one initially sold an XYZ July 40 put for 4 points, and it was assigned, the net
cost of the stock would be determined as follows, assuming a $75 commission charge on
the stock purchas e:
Chapter
42: Taxes 963
Cost of l 00 XYZassigned at 40 ($4,000 + $75) $4,075

Net proceeds of putsale ($400 - $25) - 375
Net cost basis of stock $3,700
The holding period for stock purchased via a put assignment begins on the day of the put
assignment. The period during which the investor was short the put has no bearing on the
holding period of the stock. Obviously, the put transaction itself does not become a capital
item; it becomes part of the stock transaction.
SPECIAL TAX PROBLEMS
THE WASH SALE RULE
The call buyer should be aware of the wash sale rule. In general, the wash sale rule denies
a tax deduction for a security sold at a loss if a substantially identical security, or an option
to acquire that security, is purchased within 30 days before or 30 days after the original
sale. This means that one cannot sell XYZ to take a tax loss and also purchase XYZ within
the 61-day period that extends 30 days before and 30 days after the sale. Of course, an
investor can legally make such a trade, he just cannot take the tax loss on the sale of the
stock. A call option is certainly an option to acquire the security. It would thus invoke the
wash sale rule for an investor to sell XYZ stock to take a loss and also purchase any XYZ
call within 30 days before or after the stock sale.
Various series of call options are not generally considered to be substantially identi-
cal securities, however. If one sells an XYZ January 50 call to take a loss, he may then buy
any other XYZ call option without jeopardizing his tax loss from the sale of the January
50. It is not clear whether he could repurchase another January .SOcall-that is, an identi-
cal call-without jeopardizing the taxable loss on the original sale of the January .SO.
It would also be acceptable for an investor to sell a call to take a loss and then imme-
diately buy the underlying security. This would not invoke the wash sale rule.
Avoiding a Wash Sale. It is generally held that the sale of a put is not the acquisition
of an option to buy stock, even though that is the effect of assignment of the written put.
This fact may be useful in certain cases. If an investor holds a stock at a loss, he may want
to sell that stock in order to take the loss on his taxes for the current year. The wash sale
rule prevents him from repurchasing the same stock, or a call option on that stock, within
30 days after the sale. Thus, the investor will be "out of" the stock for a month; that is, he
will not be able to participate in any rally in the stock in the next 30 days. If the underlying
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stock has listed put options, the investor may be able to partially offset this negative effect.
By selling an in-the-money put at the same time that the stock is sold, the investor will be
able to take his stock loss on the current year's taxes and also will be able to participate in
price movements on the underlying stock.
If the stock should rally, the put will decrease in price. However, if the stock rallies
above the striking price of the put, the investor will not make as much from the put sale
as he would have from the ownership of the stock. Still, he does realize some profits if the
stock rallies.
Conversely, if the stock falls in price, the investor will lose on the put sale. This cer-
tainly represents a risk-although no more of a risk than owning the stock did. An addi-
tional disadvantage is that the investor who has sold a put will not receive the dividends,
if any are paid by the underlying stock.
Once 30 days hm·e passed, the investor can cover the put and repurchase the under-
lying stock. The investor who utilizes this tactic should be careful to select a put sale in
which early assignment is minimal. Therefore, he should sell a long-term, in-the-money
put when utilizing this strategy. (He needs the in-the-money put in order to participate
heavily in the stock's movements.) Note that if stock should be put to the investor before
:30 days had passed, he would thus be forced to buy stock, and the wash sale rule would
he invoked, preventing him from taking the tax loss on the stock at that time. He would
have to postpone taking the loss until he makes a sale that does not invoke the wash
sale ru le.
Finally, this strategy must be employed in a margin account, because the put sale
will he uncovered. Ob\·iously, the money from the sale of the stock itself can be used to
collateralize the sale of the put. If the stock should drop in value, it is always possible that
additional collatera l will be required for the uncovered put.
THE SHORT-SALE RULE-PUT HOLDER'S PROBLEM
A put purchase made by an investor who also owns the underlying stock may have an
effect on the holding period of the stock. If a stock holder buys a put, he would normally
do so to eliminate some of the downside risk in case the stock falls in price. However, if a
put option is purchased to protect stock that is not yet held long enough to qualify for
long-term capital gains treatment. the entire holding period of the stock is wiped out.
Furthermore, the holding period for the stock will not begin again until the put is dis-
posed of. For example, if an investor has held XYZ for 11 months-not quite long enough
to qualif\ as a long-term holding-and then buys a put on XYZ, he will wipe out the
entire accrued holding period on the stock. Furthermore, when he finally disposes of the
put. the holding period for the stock must begin all over again. The previous 11-month
Chapter
42: Taxes 965
holding period is lost, as is the holding period during which the stock and put were held
together. This tax consequence of a put purchase is derived from the general rules
governing short sales, which state that the acquisition of an option to sell property at a
fixed price (that is, a put) is treated as a short sale. This ruling has serious tax conse-
quences for an investor who has bought a put to protect stock that is still in a short-term
tax status.
#Married" Put and Stock. There are two cases in which the put purchase does not
affect the holding period of the underlying stock. First, if the stock has already been held
long enough to qualify for long-term capital treatment, the purchase of a put has no bear-
ing on the holding period of the underlying stock. Second, if the put and the stock that it
is intended to protect are bought at the same time, and the investor indicates that he
intends to exercise that particular put to sell those particular shares of stock, the put and
the stock are considered to be "married" and the normal tax rulings for a stock holding
would apply. The investor must actually go through with the exercise of the put in order
for the "married" status to remain valid. If he instead should allow the put to expire
worthless, he could not take the tax loss on the put itself but would be forced to add the
put's cost to the net cost of the underlying stock. Finally , if the investor neither exercises
the put nor allows it to expire worthless but sells both the put and the stock in their
respective markets, it would appear that the short sale rules would come back into effect.
This definition of "married" put and stock, with its resultant ramifications, is quite
detailed. What exactly are the consequences'? The "married" rule was originally intended
to allow an investor to buy stock, protect it, and still have a chance of realizing a long-term
gain. This is possible with options with more than one year of life remaining. The reader
must be aware of the fact that, if he initially "marries" stock and a listed 3-month put, for
example, there is no way that he can replace that put at its expiration with another put and
still retain the "married" status. Once the original "married" put is disposed of-through
sale, exercise, or expiration-no other put may be considered to be "married" to the stock.
Protecting a Long-Term Gain or Avoiding a Long-Term Loss. The investor

may be able, at times, to use the short-sale aspect of put purchases to his advantage. The
most obvious use is that he can protect a long-term gain with a put purchase. He might
want to do this if he had decided to take the long-term gain, but would prefer to delay
realizing it until the following tax year. A purchase of a put with a maturity date in the
following year would accomplish that purpose .
Another usage of the put purchase, for tax purposes, might be to avoid a long-term
loss on a stock position. If an investor owns a stock that has declined in price and also is
about to become a long-term holding, he can buy a put on that stock to eliminate the
966 . PartVI:Measuring
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holding period. This avoids having to take a long-term loss. Once the put is removed,
either by its sale or by its expiring worthless, the stock holding period would begin all over
again and it would be a short-term position. In addition, if the investor should decide to
exercise the put that he purchased, the result would be a short-term loss. The sale basis
of the stock upon exercise of the put would be equal to the striking price of the put less
the amount of premium paid for the put, less all commission costs. Furthermore, note that
this strategy does not lock in the loss on the underlying stock. If the stock rallies, the
investor would be able to participate in that rally, although he would probably lose all of
the premium that he paid for the put. Note that both of these long-term strategies can be
accomplished via the sale of a deeply in-the-money cal-1as well.
SUMMARY:
This concludes the section of the tax chapter dealing with listed option trades and their
direct consequences on option strategies. In addition to the basic tax treatment for option
traders of liquidation, expiring worthless, or assignment or exercise, several other useful
tax situations have heen described. The call buyer should be aware of the wash sale rule.
Th e put buyer must be aware of the short sale rules involving both put and stock owner-
ship. The call writer should realize the beneficial effects of selling an in-the-money call
to protect the underlying stock, while waiting for a realization of profit in the following
tax year. The put writer may be able to avoid a wash sale by utilizing an in-the-money put
write, while still retaining profit potential from a rally by the underlying stock.
TAX PLANNING STRATEGIESFOR EQUITY OPTIONS
DEFERRING A SHORT-TERM CALL GAIN
The call holder may be interested in either deferring a gain until the following year or
possibly converting a short-term gain on the call into a long-term gain on the stock. It is
much easier to do the former than the latter. A holder of a profitable call that is due to
expire in the following year can take any of three possible actions that might let him
retain his profit while deferring the gain until the following tax year. One way in which to
do this would he to buy a put option. Obviously, he would want to buy an in-the-money
put for this purpose. By so doing, he would be spending as little as possible in the way of
time value premium for the put option and he would also be locking in his gain on the
call. The gains and losses from the put and call combination would nearly equal each
otlwr from that time forward as the stock moves up or clown, unless the stock rallies
Chapter
42: Taxes 967
strongly, thereby exceeding the striking price of the put. This would be a happy event,
however, since e, ·en larger gains would accrue . The combination could be liquidated in
th e followi ng tax year, thu s achievin g a gain .
Example: On September 1st, an investor bought an XYZ January 40 call for 3 points. The
call is due to expire in the following year. XYZ has risen in price by December 1st, and
the call is selling for 6 points. The call holder might want to take his 3-point gain on the
call, but would also like to defer that gain until the following year. He might be able to do
this by buying an XYZ January .SOput for ,5 points, for example. He would then hold this
combination until after the first of the new year. At that time, he could liquidate the entire
combination for at least 10 points, since the striking price of the put is 10 points greater
than that of the call. In fact, if the stock should have climbed to or above .SOby the first
of the year, or should have fallen to or below 40 by the first of the year, he would be able
to liquidate the combination for more than 10 points. The increase in time value premium
at either strike would also be a benefit. In any case, he would have a gain-his original
cost was 8 points (3 for the call and .5for the put). Thus, he has effectively deferred taking
the gain on the original call holding until the next tax year. The risk that the call holder
incurs in this type of transaction is the increased commission charges of buying and sell-
ing the put as well as the possible loss of any time value premium in the put itself. The
investor must decide for himself whether these risks, although they may be relatively
small, outweigh the potential benefit from deferring his tax gain into the next year.
Another way in which the call holder might be able to defer his tax gain into the next
year would be to sell another XYZ call against the one that he currently holds. That is, he
would create a spread. To assure that he retains as much of his current gain as possible,
he should sell an in-the-money call. In fact, he should sell an in-the-money call with a
lower striking price than the call held long, if possible, to ensure that his gain remains
intact even if the underlying stock should collapse substantially. Once the spread has been
established, it could be held until the following tax year before being liquidated. The obvi-
ous risk in this means of deferring gain is that one could receive an assignment notice on
the short call. This is not a remote possibility, necessarily, since an in-the-money call
should be used as protection for the current gain. Such an assignment would result in
large commission costs on the resultant purchase and sale of the underlying stock, and
could substantially reduce one's gain. Thus, the risk in this strategy is greater than that in
the previous one (buying a put), but it may be the only alternative available if puts are not
traded on the underlying stock in question .
Example: An investor bought an XYZ February ,50call for 3 points in August. In Decem-
ber, the stock is at 6,5 and the call is at 1.5.The holder would like to "lock in" his 12-poiut
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call profit, but would prefer deferring the actual gain into the following tax year. He could
sell an XYZ February 4.5 call for approximately 20 points to do this . If no assignment
notice is received, he will be able to liquidate the spread at a cost of 5 points with the stock
anywhere above .50 at February expiration. Thus, in the end he would still have a 12-point
gain-having received 20 points for the sale of the February 4.5 and having paid out
:3points for the February .SOplus ,5 points to liquidate the spread to take his gain. If the
stock should fall below ,50 before February expiration, his gain would be even larger, since
he would not have to pay out th e enti re 5 point s to liquidat e the spread .
The third way in which a call holder could lock in his gain and still defer the gain
into the following tax year would be to sell the stock short while continuing to hold the
call. This would obviously lock in the gain , since the short sale and the call purchase will
offset each other in profit potential as the underlying stock moves up or down. In fact, if
the stock should plunge downward, large profits could accrue . However, there is risk in
using this strategy as well. The commission costs of the short sale will reduce the call
holder's profit. Furthermore , if the underlying stock should go ex-dividend during the
time that the stock is held short, the strategist will be liable for the dividend as well. In
addi tion, mor e mar gin will be required for the short stock.
The three tactics discussed above showed how to defer a profitable call gain into the
following tax year. The gain would still be short-term when realized. The only way in
which a call holder could hope to convert his gain into a long-term gain would be to exer-
cise the call and then hold the stock for more than one year. Recall that the holding period
for stock acquired through exercise begins on the day of exercise-the option's holding
period is lost. If the investor chooses this alternative, he of course is spending some of his
gains for the commissions on the stock purchase as well as subjecting himself to an entire
year's worth of market risk. There are ways to protect a stock holding while letting the
holding period accrue-for example , writing out-of-the-money calls-but the investor
who chooses this alternative should carefully weigh the risks involved against the possible
benefits of eventually achieving a long-term gain. The investor should also note that he
will have to advance considera bly mor e mon ey to hold the stock.
DEFERRING A PUT HOLDER'S SHORT-TERM GAIN
\\'ithout going into as much detail, there are similar ways in which a put holder who has
a short-term gain on a put due to expire in the following tax year can attempt to defer the
realization of that gain into the following tax year. One simple way in which he could pro-
tect his gain would he to huy a call option to protect his profitable put. He would want to
lm_v an in-the-mone: · call for this purpose. This resulting combination is similar in nature
to the one descr ibed for the call buyer in th e prev ious secti on.
Chapter
42: Taxes 969
A second way that he could attempt to protect his gain and still defer its realization
into the following tax year would be to sell another XYZ put option against the one that
he holds long. This would create a vertical spread. This put holder should attempt to sell
an in-the-money put, if possible. Of course, he would not want to sell a put that was so
deeply in-the-money that there is risk of early assignment. The results of such a spread
are analogous to the call spread described in detail in the last section.
Finally, the put holder could buy the underlying stock if he had enough available
cash or collateral to finance the stock purchase. This would lock in the profit, as the stock
and the put would offset each other in terms of gains or losses while the stock moved up
or down. In fact, if the stock should experience a large rally, rising above the striking price
of the put, even larger profits would become possible .
In each of the tactics described, the position would be removed in the following tax
year , thereby realizing the gain that was deferred.
DIFFICULTY OF DEFERRING GAINS FROM WRITING
As a final point in this section on deferring gains from option transactions, it might be
appropriate to describe the risks associated with the strategy of attempting to defer gains
from uncovered option writing into the following tax year. Recall that in the previous sec-
tions, it was shown that a call or put holder who has an unrealized profit in an option that
is clue to expire in the following tax year could attempt to "lock in" the gain and defer it.
The dollar risks to a holder attempting such a tax deferral were mainly commission costs
and/or small amounts of time value premium paid for options. However, the option writer
who has an unrealized profit may have a more difficult time finding a way to both "lock
in" the gain and also defer its realization into the following tax year. It would seem, at first
glance, that the call writer could merely take actions opposite to those that the call buyer
takes: buying the underlying stock, buying another call option, or selling a put. Unfortu-
nately, none of these actions "locks in" the call writer's profit. In fact, he could lose sub-
stantial investment dollars in his attempt to defer the gain into the following year.
Example: An investor has written an uncovered XYZ January .SOcall for 5 points and the
call has dropped in value to l point in early December. He might want to take the 4-point
gain, but would prefer to defer realization of the gain until the following tax year. Since
the call write is at a profit, the stock must have dropped and is probably selling around 45
in early December. Buying the underlying stock would not accomplish his purpose,
because if the stock continued to decline through year-end, he could lose a substantial
amount on the stock purchase and could make only l more point on the call write. Simi-
larly, a call purchase would not work well. A call with a lower striking price-for example,
the XYZ January 45 or the January 40-coulcl lose substantial value if the underlying
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stock continued to drop in price. An out-of-the-money call-the XYZ January 60-is also
unacceptable, because if the underlying stock rallied to the high ,S0's, the writer would
lose money both on his January 50 call write and on his January 60 call purchase at expira-
tion. Writing a put option would not "lock in" the profit either. If the underlying stock
continued to decline, the losses on the put write would certainly exceed the remaining
profit potential of 1 point in the January 50 call. Alternatively, if the stock rose, the losses
on the January .50 call could offset the limited profit potential provided by a put write.
Thus, there is no relatively safe way for an uncovered call writer to attempt to "lock in" an
unrealized gain for the purpose of deferring it to the following tax year. The put writer
seeking to defer his gains faces similar problems.
UNEQUAL TAX TREATMENT ON SPREADS
There are two types of spreads in which the long side may receive different tax treatment
than the short side. One is the normal equity option spread that is held for more than one
year. The other is any spread between futures, futures options, or cash-based options and
equity options.
With equity options, if one has a spread in place for more than one year and if the
mm·ement of the underlying stock is favorable, one could conceivably have a long-term
gain on the long side and a short-term loss on the short side of the spread.
Example: An investor establishes an XYZ bullish call spread in options that have 15
months of life remaining: In October of one year, he buys the January 70 LEAPS call
expiring just over a year in the future. At the same time, he sells the January 80 LEAPS
call, again expiring just m·er a year hence. Suppose he pays 13 for the January 70 call and
receives 7 for the January 80 call. In December of the following year, he decides to
remove the spread, after he has held it for more than one year-specifically, for 14 months
in this case. XYZ has advanced by that time, and the spread is worth 9. With XYZ at 90,
the January 70 call is trading at 20 and the January 80 call is trading at 11. The capital
gain and loss results for tax purposes are summarized in the following table (commissions
are omitted from this example):
Option Cost Proceeds Gain/Loss

XYZJanuary 70 LEAPScall $1,300 $2,000 $700 long-termgain
XYZJanuary 80 LEAPScall $1,100 $ 700 $400 short-termloss
::--Jo
taxes would be owed on this spread since one-half of the long-term gain is less
than the short-term loss. The investor with this spread could be in a favorable position
Chapter
42: Taxes 971
since, even though he actually made money in the spread-buying it at a 6-point debit
and selling it at a 9-point credit-he can show a loss 011 his taxes due to the disparate
treatment of the two sides of the spread.
The above spread requires that the stock move in a favorable direction in order for
the tax advantage to materialize. If the stock were to move in the opposite direction, then
one should liquidate the spread before the long side of the spread had reached a holding
period of one year. This would prevent taking a long-term loss.
Another type of spread may be even more attractive in this respect. That is a spread
in which nonequity options are spread against equity options. In this case, the trader
would hope to make a profit on the nonequity or futures side, because part of that gain is
automatically long-term gain. He would simultaneously want to take a loss on the equity
option side, because that would be entirely short-term loss.
There is no riskless way to do this, however. For example, one might buy a package
of puts on stocks and hedge them by selling an index put on an index that performs more
or less in line with the chosen stocks. If the index rises in price, then one would have
short-term losses on his stock options, and part of the gain on his index puts would
be treated as long-term. However, if the index were to fall in price, the opposite would be
true, and long-term losses would be generated-not something that is normally desirable.
Moreover, the spread itself has risk, especially the tracking risk between the basket of
stocks and the index itself.
This brings out an important point: One should be cautious about establishing
spreads merely for tax purposes. He might wind up losing money, not to mention that
there could be unfavorable tax consequences. As always, a tax advisor should be consulted
before any tax-oriented strategy is attempted.
SUMMA Y
Options can be used for many tax purposes. Short-term gains can be deferred into the
next tax year, or can be partially protected with out-of-the-money options until they
mature into long-term gains. Long-term losses can be avoided with the purchase of a put
or sale of a deeply in-the-money call. Wash sales can be avoided without giving up the
entire ownership potential of the stock. There are risks as well as rewards in any of the
strategies. Commission costs and the dissipation of time value premium in purchased
options will both work against the strategist.
A tax advisor should be consulted before actually implementing any tax strategy,
whether that strategy employs options or not. Tax rules change from time to time. It is even
possible that a certain strategy is not covered by a written rule, and only a tax advisor is <p1al-
ified to give consultation on how such a strategy might be interpreted by the IRS.
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Finally, the options strategist should be careful not to confuse tax strategies with his
profit-oriented strategies. It is generally a good idea to separate profit strategies from tax
strategies. That is, if one finds himself in a position that conveniently lends itself to tax
applications, fine. However, one should not attempt to stay in a position too long or to close
it out at an illogical time just to take advantage of a tax break. The tax consequences of
options should never be considered to be more important than sound strategy
management.
The Best Strategy?
There is no one best strategy. Although this statement may appear to be unfair and disap-
pointing to some, it is nevertheless the truth. Its validity lies in the fact that there are
many types of investors, and no one strategy can be best for all of them. Knowledge and
suitability are the keys to determining which strategy may be the best one for an individ-
ual. The previous chapters have been devoted to imparting much of the knowledge
required to understand an individual strategy. This chapter attempts to point out how the
investor might incorporate his own risk/reward attitude and financial condition to select
the most feasible strategies for his own use. The final section of this chapter describes
which strategies have the better probabilities of success.
GENERAL CONCEPT: MARKET ATTITUDE

AND EQUIVALENT POSITIONS
A wide variety of strategies has been described. Certain ones are geared to capitalizing
on one's (hopefully correct) outlook for a particular stock, or for the market in general.
These tend to be the more aggressive strategies, such as outright put or call buying and
low-debit (high-potential) bull and bear spreads. Other strategies are much more conser-
vative , having as their emphasis the possibility of making a reasonable but limited return,
coupled with decreased risk exposure. These include covered call writing and in-the-money
(large-debit) bull or bear spreads. Even in these strategies, however, one has a general
attitude about the market. He is bullish or bearish, but not overly so. If he is proven
slightly wrong, he can still make money. However , if he is gravely wrong, relatively large
percentage losses might occur. The third broad category of strategies is the one that is not
oriented toward picking stock market direction, but is rather an approach hased on the
value of the option-what is generally called volatility trading. If the net change in tht>
973
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market is small over a period of time, these strategies should perform well: ratio writing,
ratio spreading (especially "delta neutral spreads"), straddle and strangle writing, neutral
calendar spreading, and butterfly spreads. On the other hand, if options are cheap and
the market is expected to be volatile, then these would be best: straddle and strangle
buys, backspreads, and reverse hedges and spreads.
Certain other strategies overlap into more than one of the three broad categories.
For example, the bullish or bearish calendar spread is initially a neutral position. It only
assumes a bullish or bearish bias after the near-term option expires. In fact, any of the
diagonal or calendar strategies whose ultimate aim is to generate profits on the sale of
shorter-term options are similar in nature. If these near-term profits are generated, they
can offset, partially or completely, the cost of long options. Thus, one might potentially
own options at a reduced cost and could profit from a definitive move in his favor at the
right time. It was shown in Chapters 14, 2:3,and 24 that diagonalizing a spread can often
be very attractive.
This brief grouping into three broad categories does not cover all the strategies that
have been discussed. For example, some strategies are generally to be avoided by most
investors: high-risk naked option writing (selling options for fractional prices) and covered
or ratio put writing. In essence, the investor will normally do best with a position that has
limited risk and the potential oflarge profits. Even if the profit potential is a low-probability
event, one or two successful cases may be able to overcome a series of limited losses. Com-
plex strategies that fit this description are the diagonal put and call combinations described
in Chapters 2.3 and 24. The simplest strategy fitting this description in the T-bill/option
purchase program described in Chapter 26.
Finally, many strategies may be implemented in more than one way. The method of
implementation may not alter the profit potential, but the percentage risk levels can be
substantially different. Equivalent strategies fit into this category.
Example: Buying stock and then protecting the stock purchase with a put purchase is an
equivalent strategy in profit potential to buying a call. That is, both have limited dollar
risk and large potential dollar profit if the stock rallies. However, they are substantially
different in their structure. The purchase of stock and a put requires substantially more
initial investment dollars than does the purchase of a call, but the limited dollar risk of
the strategy would normally be a relatively small percentage of the initial investment. The
call purchase, on the other hand, involves a much smaller capital outlay; in addition, while
it also has limited dollar risk, the loss may easily represent the entire initial investment.
The stockholder will receive cash dividends while the call holder will not. Moreover, the
stock will not expire as the call will. This provides the stock/put holder with an additional
alternati,·e of choosing to extend his position for a longer period of time by buying another
put or possibly hy just continuing to hold the stock after the original put expires.
Chapter
43: TheBestStrategy? 975
Many equivalent positions have similar characteristics. The straddle purchase and
the reverse hedge (short stock and buy calls) have similar profit and loss potential when
measured in dollars. Their percentage risks are substantially different, however. In fact,
as was shown in Chapter 20, another strategy is equivalent to both of these-buying stock
and buying several puts. That is, buying a straddle is equivalent to buying 100 shares of
stock and simultaneously buying two puts. The "buy stock and puts" strategy has a larger
initial dollar investment, but the percentage risk is smaller and the stockholder will receive
any dividends paid by the common stock.
In summary, the investor must know two things well: the strategy that he is contem-
plating using, and his own attitude toward risk and reward. His own attitude represents
suitability, a topic that is discussed more fully in the following section. Every strategy has
risk. It would not be proper for an investor to pursue the best strategy in the universe
(such a strategy does not exist, of course) if the risks of that strategy violated the investor's
own level of financial objectives or accepted investment methodology. On the other hand,
it is also not sufficient for the investor to merely feel that a strategy is suitable for his
investment objectives. Suppose an investor felt that the T-bill/option strategy was suitable
for him because of the profit and risk levels. Even if he understands the philosophies of
option purchasing, it would not be proper for him to utilize the strategy unless he also
understands the mechanics of buying Treasury bills and, more important, the concept of
annualized risk.
WHAT IS BEST FOR ME MIGHT NOT BE BEST FOR YOU
It is impossible to classify any one strategy as the best one. The conservative investor
would certainly not want to be an outright buyer of options. For him, covered call writing
might be the best strategy. Not only would it accomplish his financial aims-moderate
profit potential with reduced risk-but it would be much more appealing to him psycho-
logically. The conservative investor normally understands and accepts the risks of stock
ownership. It is only a small step from that understanding to the covered call writing
strategy. The aggressive investor would most likely not consider covered call writing to be
the best strategy, because he would consider the profit potential too small. He is willing
to take larger risks for the opportunity to make larger profits. Outright option purchases
might suit him best, and he would accept, by his aggressive stature, that he could lose
nearly all his money in a relatively short time period. (Of course, one would hope that he
uses only 15 to 20% of his assets for speculative option buying.)
Many investors fit somewhere in between the conservative description and the
aggressive description. They might want to have the opportunity to make large profits, but
certainly are not willing to risk a large percentage of their available fonds in a short period
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of time. Spreads might therefore appeal to this type of investor, especially the low-debit
bullish or bearish calendar spreads. He might also consider occasional ventures into other
types of strategies-bullish or bearish spreads, straddle buys or writes, and so on-but
would generally not be into a wide range of these types of positions. The T-bill/option
strategy might work well for this investor also.
The wealthy aggressive investor may be attracted by strategies that offer the oppor-
tunity to make money from credit positions, such as straddle or combination writing.
Although ratio writing is not a credit strategy, it might also appeal to this type of investor
because of the large amounts of time value premium that are gathered in. These are gen-
erally strategies for the wealthier investor because he needs the "staying power" to be able
to ride out adverse cycles. If he can do this, he should be able to operate the strategy for
a sufficient period of time in order to profit from the constant selling of time value
premiums .
In essence, the answer to the question of "which strategy is best" again revolves
around that familiar word, "suitability." The .financial needs and investment objectives of
the individual investor are more important than the merits of the strategy itself. It sounds
nice to say that he would like to participate in strategies with limited risk and potentially
large profits. Unfortunately, if the actual mechanics of the strategy involve risk that is not
suitable for the investor, he should not use the strategy, no matter how attractive it sounds.
Example: The T-bill/option strategy seems attractive: limited risk because only 10% of
one's assets are subjected to risk annually; the remaining 90% of one's assets earn interest;
and if the option profits materialize, they could be large. What if the worst scenario
unfolds? Suppose that poor option selections are continuously made and there are three
or four years of losses, coupled with a declining rate of interest earned from the Treasury
bills (not to mention the commission charges for trading the securities). The portfolio
might have lost 1.5 or 20% of its assets over those years. A good test of suitability is for
the investor to ask himself, in advance: "How will I react if the worst case occurs?" If
there will be sleepless nights, pointing of fingers, threats, and so forth, the strategy is
unsuitable. If, on the other hand, the investor believes that he would be disappointed
(because no one likes to lose money), but that he can withstand the risk, the strategy may
indeed be suitable .
MATHEMATICAL RANKING
The discussion above demonstrates that it is not possible to ultimately define the best
strategy when one considers the background, both financial and psychological, of the
individual investor. However, the reader may be interested in knowing which strategies
Chapter
43: TheBestStrategy? 977
have the best mathematical chances of success, regardless of the investor's personal feel-
ings. Not unexpectedly, strategies that take in large amounts of time value premium, have
high mathematical expectations. These include ratio writing, ratio spreading, straddle
writing, and naked call writing (but only if the "rolling for credits" follow-up strategy is
adhered to). The ratio strategies would have to be operated according to a delta-neutral
ratio in order to be mathematically optimum. Unfortunately, these strategies arc not for
everyone. All involve naked options, and also require that the investor have a suhstantial
amount of money (or collateral) available to make the strategies work properly. Moreover,
naked option writing in any form is not suitable for some investors, regardless of their
protests to the contrary.
Another group of strategies that rank high on an expected profit basis are those that
have limited risk tcith the potential of occasionally attaining large profits. The T-bill/
option strategy is a prime example of this type of strategy. The strategies in which one
attempts to reduce the cost of longer-term options through the sale of near-term options
fit in this broad category also, although one should limit his dollar commitment to LS to
20% of his portfolio. Calendar spreads such as the combinations described in Chapter 23
(calendar combination, calendar straddle, and diagonal butterfly spread) or bullish call
calendar spreads or bearish put calendar spreads are all examples of such strategies. These
strategies may have a rather frequent probability of losing a small amount of money, cou-
pled with a low probability of earning large profits. Still, a few large profits may be able to
more than overcome the frequent, but small, losses. Ranking behind these strategies are
the ones that offer limited profits with a reasonable probability of attaining that profit.
Covered call writing, large debit bull or bear spreads (purchased option well in-the-money
and possible written option as well), neutral calendar spreads, and butterfuly spreads fit
into this category .
Unfortunately, all these strategies involve relatively large commission costs. Even
though these are not strategies that normally require a large investment, the investor who
wants to reduce the percentage effect of commissions must take larger positions and will
therefore be advancing a sizable amount of money.
Speculative buying and spreading strategies rank the lowest on a mathematical
basis. The T-bill/option strategy is not a speculative buying strategy. In-the-money pur-
chases, including the in-the-money combination, generally outrank out-of-the-money
purchases. This is because one has the possibility of making a large percentage profit but
has decreased the chance oflosing all his investment, since he starts out in-the-money. In
general, however, the constant purchase of time value premiums, which must waste away
by the time the options expire, will have a burdensome negative effect. The chances of
large profits and large losses are relatively equal on a mathematical basis, and thus become
subsidiary to the time premium effect in the long run. This mathematical outlook, of
course, precludes those investors who are able to predict stock movements with an
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above-average degree of accuracy. Although the true mathematical approach holds that
it is not possible to accurately predict the market, there are undoubtedly some who can
and many who try.
SUMMAR¥
Mathematical expectations for a strategy do not make it suitable even if the expected
returns are good, for the improbable may occur. Profit potentials also do not determine
suitability; risk levels do. In the final analysis, one must determine the suitability of a
strategy by determining if he will be able to withstand the inherent risks if the worst sce-
nario should occur. For this reason, no one strategy can be designated as the best one,
because there are numerous attitudes regarding the degree of risk that is acceptable.
Postscript
Option strategies cannot be unilaterally classified as aggressive or conservative. There are

certainly many aggressive applications, the simplest being the outright purchase of calls
or puts. However, options can also have conservative applications, most notably in reduc-
ing some of the risks of common stock ownership. In addition, there are less polarized
applications, particularly spreading techniques, that allow the investor to take a
middle-of-the -road approach .
Consequently, the investor hirnself-not options-becomes the dominant force in
determining u;hether an option strategy is too risky. It is imperative that the investor
understand what he is trying to accomplish in his portfolio before actually implementing
an option strategy. Not only should he be cognizant of the factors that go into determining
the initial selection of the position, but he must also have in mind a plan of follow-up
action. If he has thought out, in advance, what action he will take if the underlying entity
rises or falls, he will be in a position to make a more rational decision when and if it does
indeed make a move. The investor must also determine if the risk of the strategy is accept-
able according to his financial means and objectives. If the risk is too high, the strategy is
not suitable .
Every serious investor owes it to himself to acquire an understanding of listed
option strategies. Since various options strategies are available for a multitude of pur-
poses, almost every money manager or dedicated investor u;ill be able to use options in
his strategies at one time or another. This is especially true now that the options have
been listed on the volatility assets class. For a stock-oriented investor to ignore the poten-
tial advantages of using options would be as serious a mistake as it would be for a large
grain company to ignore the hedging properties available in the futures market, or as it
would be for an income-oriented investor to concentrate only in utilities and Treasury bills
979
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while ignoring less well known, but equally compatible, alternatives such as municipal
bonds.
Moreover, in today's markets, with options being available on futures, equities, and
indices, the strategist in any one field should familiarize himself with the others, because
any of them will provide profit opportunities at one time or another.
V ,, "' , ,,... " ~, 6 '<;, ~="'..,,\l'~· ~•=)r~:: '; &t',,;>~,,,.~ ?>0-- .u>v h~;r,:'.<",;,.,_tff "'""7,t 7. '"' ..... ;_,'fie
~ \is
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I" ,.,, ,~~~~.,,~:;,,,-,..te..;~· • .,;"~'(,.,;.:~"'-~' > =<;u,¢;,,M,;.,;.f,,#¼,M.<,"'(.;&J
Appendices
Strategy Summary
Except for arbitrage strategies and tax strategies, the strategies we have described deal
with risk of market movement. It is therefore often convenient to summarize option strat-
egies by their risk and reward characteristics and by their market outlook-bullish, bear-
ish, or neutral. Table A-1 lists all the risk strategies that were discussed and gives a general
classification of their risks and rewards. If a strategist has a definite attitude about the
market's outlook or about his own willingness to accept risks, he can scan Table A-1 and
select the strategies that most closely resemble his thinking. The number in parentheses
after the strategy name indicates the chapter in which the strategy was discussed.
Table A-1 gives a broad classification of the various risk and reward potentials of the
strategies. For example, a bullish call calendar spread does not actually have unlimited
profit potential unless its near-term call expires worthless. In fact, all calendar spread or
diagonal spread positions have limited pro.fit potential at best until the near-term, options
expire .
Also, the definition of limited risk can vary widely. Some strategies do have a risk
that is truly limited to a relatively small percentage of the initial investment-the protected
stock purchase , for example. In other cases, the risk is limited but is also equal to the
entire initial invest11ient. That is, one could lose 100% of his investment in a short time
period. Option purchases and bull, bear, or calendar spreads are examples.
Thus, although Table A-1 gives a broad perspective on the outlook for various strate-
gies, one must be aware of the differences in reward, risk, and market outlook when actu-
ally implementing one of the strategie s.
983
984 Appendix
A
TABLE A-1.
General strategy summary.
Strategy
(Chapter) Risk Reward
Bullishstrategies
Call purchase (3) Limited Unlimited
Synthetic long stock (short put/ long call) (21) Unlimited □ Unlimited
Bull spread-puts or calls (7 and 22) Limited Limited
Protected stock purchase (long stock/long put) (17) Limited Unlimited
Bullish call calendar spread (9) Limited Unlimited
Covered call writing (2) Unlimited □ Limited
Uncovered put write (19) Unlimited 0 Limited
Bearish strategies
Put purchase (16) Limited Unlimited*
Protected short sale (synthetic put) (4 and 16) Limited Unlimited*
Synthetic short sale (long put/short call) (21) Unlimited Unlimited*
Bear spread-put or call (and 22) Limited Limited
Covered put write (19) Unlimited Limited
Bearish put calendar spread (22) Limited Unlimited*
Naked call write (5) Unlimited Limited
Neutral strategies
Straddle purchase (18) Limited Unlimited
Reverse hedge (simulated straddle buy) (4) Limited Unlimited
Fixed income + option purchase (25) Limited Unlimited
Diagonal spread (14, 23, and 24) Limited Unlimited
Neutral calendar spread-puts or calls (9 and 22) Limited Limited
Butterfly and Iron Condor spread (10 and 23) Limited Limited
Calendar straddle or combination (23) Limited Unlimited
Reverse spread (13) Limited Unlimited
Ratio write-put or call (6 and 19) Unlimited Limited
Straddle or combination write (20) Unlimited Limited
Ratio spread-put or call (11 and 24) Unlimited Limited
Ratio calendar spread-put or call (12 and 24) Unlimited Unlimited
'Wherever the risk or reward is limited only by the fact that a stock cannot fall below zero in price , the entry is
marked. Obviously, although the potential may technically be limited, it could still be quite large if the underlying
stock did fall a large distance.
Equivalent Positions
Some strategies can be constructed with either puts or calls to attain the same profit
potential. These are called equivalent strategies and are given in Table B-1. They do not
necessarily have the same potential returns, because the investment required may be
quite differen t. However, equivalent positions have profit graphs with exactly the same
shape .
Other equivalences can be determined by combining any two strategies in the
left-hand column and setting that combinati on equivalent to the two corresponding strat-
egies in the right-hand column .
985
986 Appendix
B
TABLEB-1.
Equivalent strategies.
ThisStrategy isequivalent
to ThisStrategy
Call purchase Long stock/long put
Put purchase Short stock/long call (synthetic put)
Long stock Long call/short put (synthetic stock)
Short stock Long put/short call (synthetic short sale)
Naked call write Short stock/short put
Naked put write Covered call write (long stock/short call)
Bullish call spread Bullish put spread
(long call at lower strike/ (long put at lower strike/
short call at higher strike) short put at higher strike)
Bearish call spread Bearish put spread
(long call at higher strike/ (long put at higher strike/
short call at lower strike) short put at lower strike)
Ratio call write Straddle write (short put/short call)
(long stock/short calls)
.. . and is also equivalent to .. . Ratio put write (short stock/short puts)
Straddle buy (long call/long put) Reverse hedge (short stock/long calls)
or buy stock/buy puts
Butterfly call spread Butterfly put spread
(long l call at each outside strike/ (long one put at each outer strike/
short 2 calls at middle strike) short two calls at middle strike)
All four of these "butterfly" strategies are equivalent
Butterfly combination Protected straddle write
(bullish call spread at two (short straddle at middle strike/
lower strikes/bearish put spread long call at highest strike/
at two higher strikes) long put at lowest strike
Formulae
Chapter references are given in parentheses. The following notation is used throughout
this appendix.
x = current stock price

s = striking price
c = call price
p = put price
r = interest rate
t = time (in years)
B = break-even point
U = upside break-even point
D = downside break-even point
P = maximum profit potential
R = maximum risk potential
Subscripts indicate multiple items. For example s 1, s 2 , s3 would designate three striking
prices in a formula. The formulae are arranged alphabetically by title or by strategy.
987
988 Appendix
C
Annualized Risk (Ch. 26)
Annualized risk = L INVi 3:~

l
where INVi = percent of total assets invested in options

with holding periods, Hi
Hi = length of holding period in days
Bear Spread
S1 < S2
-Calls (Ch. 8)
p = C1 -c2
R = s2-s1 -P
B =s1 +P
-Puts (Ch. 22)
P=c/-c ;;
R-=s2-s1-P
B =s1 +P
Black Model (Ch. 34):

Theoretical futures call price= e-rt X BSM [r = 0%]
where BSM[r = OJis the Black-Scholes Model
using r = 0% as the short-term interest rate
Put price= Call price - e-rt X (f- s)
where f = futures price
X current stock price B break-even point

striking price u upside break-even point
C call price D downside break-even point
p put price p maximum profit potential
r interest rate R maximum risk potential
t time (in years)
f futures price
Subscripts indicate multiple items. For example s 1, s 2 , s 3 would designate three striking prices in a formula.
Th e formulae are arranged alphabetically by title or by strategy.
Appendix
C 989
Black-Scholes Model (Ch. 28)
Theoretical call price = xN (d 1) - se -rt N (di)
_ ln(x/s)+(r+,Yiv 2
)t
w h ere d 1 - IL
Vvt
and d2 = d1 -v/t
In = natural logarithm
N () = cumulative normal density function
v = annual volatility
Delta= N(d1)
Bull Spread
S1 < S2
-Calls (Ch. 7)
P=s2-s1-R
B =s2-P=s,-c2+c1
-Puts (Ch. 22)
P=p2-p1
R=s2-s1-P
B = s2-P
Butterfly Spread
A butterfly sprea<l combines a bull spread using strikes s, ands:!. with a bear spread
using strikes s 2 and s 3 •
S3 - S2 = S2 - S1
-if using all calls (Ch. 10)

R =c + c1 3 - 2c 2
-if using all puts (Ch. 23)
R = Pi + P2- 2p2
-if using put bull spread and call bear spread (Ch. 23)
p = C2 + P2- C3 - Pi
990 Appendix
C
-if using call bull spread and put bear spread (Ch. 23)
R = P2+ C2 -pl - C3 - S3 + S2
Then
P = S3 - s2 - R or R = S3 -s2 - P
D=s1+R
U = S3-R
Combination Buy (Ch. 18)
81 < Sz
Out-of-the-money: R = c2 + p 1
In-the-money: R = c 1 +p 2 - s2 +s 1
D = s1 -P
u = .','7 + p
Combination Sale (Ch. 20)
Out-of-the-money: P = c2 + p 1
In-the-money: P = c1 + p2 - s2 +s 1
D =s1 -P
U = S2 + p
Condor (Iron Condor) (Ch. 23)
S1 < s 2 < s3 < S_,
S4 - S3 = S2 - S1
If using both puts and calls (Iron Condor) (Ch. 23):

p = C3 - C4 + (p 2 - p 1)
R=s4-s3-P
Up side B = s3 + P
Downside B = s2 - P

striking price u upside break-even point
C call price D downside break-even point
time (in years)
f futures price
Subscripts indicate multiple items. For example s1, s2, s 3 would designate three striking prices in a formula.
The formulae are arranged alphabetically by title or by strategy.
Appendix
C 991
Conversion and Reversal Profit (Ch. 27)
Conversion: P = s + c - x - p + dividends - carrying cost

Reversal: P = x + p - c - s - dividends + carrying cost
where
.
carrvmg cost
{srt
(simple interest)
· s [ l - ( 1 + r) '] (compound interest, present worth)
Covered Call Write (Ch. 2)

P=s+c-x
B =x-c
Covered Straddle Write (Ch. 20)
P=s+c+p-x
B = s - ½P = ½(x + s - p - c)
Cumulative Normal Density Function (Ch. 28)
Approximation by fifth-order polynomial

a= 1- z (l.330274y 5 - l.821256y 4 + l.781478y 3
- .3565638y 2
+ .3193815y)
1
where
y = 1 + .2316419 J CYJ
z = .3989423e -er½
Then
a if CY> 0
N (CY)= { 1 - a if CY< 0
Delta-see Black-Scholes Model
Delta Neutral Ratio:

-stock versus option (Ch. 6)
Neutra l ratio = D etal } .

o opt10n
-spread (Chs. 11 and 24)

992 Append
ix C
Delta of long option

Neutral ratio=---------
Delta of short option
Equivalent Futures Position (Ch. 34]
EFP = Delta X Number of options
Equivalent Stock Position (Ch. 28]
ESP= Unit of trading X Delta X number of options
where unit of trading is the number of shares of the underlying stock tha t can be
bought or sold with the option (normally 100).
Futures Contract Fair Value (Ch. 29)
-Stock index futures
Index value X (1 +rt)+ Present worth (dividends)
Also see Present worth.
Future Stock Price (Ch. 28)
-lognormal distribution, assuming a movement of a fixed number of standard
deviations
where
q = future stock price
Vr = volatility for the time period
a= number of standard deviations of movement
(normally- 3.0 :Sa :S 3.0)
Gamma (Ch. 40)
Then
X current stock price u upside break-even point

striking price D downside break-even point
C call price p maximum profit potential
p put price R maximum risk potential
r interest rate
t time (in years)
B break -even point
Subscripts indicate multiple items . For example s1, s2, s3 would designate three striking prices in a formula.
The formulae are arranged alphabetically by title or by strategy .
Appendix
C 993
Iron Condor-see Condor

Probability of Stock Movement (Ch. 28)
-lognormal distribution
In (qlx)}
P(below q) =N { Vi
P (above q) =1- P (below q)

where
q = stock price in question
N () = cumulative normal density function
In = natural logarithm
Vr = volatility for the time period
Present Worth of a Future Amount (Ch. 28)

_ Future amount
P resen t wo rth - ( )
1+r 1
Put Pricing Model-Arbitrage Model (Ch. 28)
Theoretical put price = Theoretical call price + s - x + dividends

- carrying cost
where
srt(simple interest)
car ·n cost ={
ryi g s [l - (1 + r)- ](compound interest, present worth)
1
Ratio Call Write (Ch. 6)

General case: long m round lots of stock, short n calls
P = m (s - x) + nc
U=s+-P-
n-m
p
D=s--
m
2:1 ratio (straddle sale)
P=s-x+2c
U=s+p
D =s-p =x-2c
994 Appendix
C
Ratio Spread
-Calls (Ch. 11): buy n 1 calls at lower strike, s 1, and sell n 2 calls at higher
strike, s2
81 < 82
n1 < n2
R = n1c1 - n2c2
P = (s2-s1)n1-R
U = S2 + . p
n2 -n1
Break-even cost of long calls for follow-up action (Ch. 11)

n2(s2 -s1) -R
Break-even cost = ~~~~
n2-n1
-Puts (Ch. 24): buy n 2 puts at higher strike, s 2 , and sell n 1 puts at lower
strike, s 1
R = n2p2 -n1p1
P = n2(s2 -si)-R
D=s 1___ P__
Reversal-S ee Conversion and Reversal Profit

Reverse Hedge (Ch. 4)-sirnulated straddle purchase
General case: short m round lots of stock and long n calls
R = m(s-x) +nc
U=s+-R-
n-m
D=s-_B__
m

s striking price u upside break-even point
C = call price D downside break-even point
time (in years)
Subscripts indicate multiple items. For example si, s 2 , s 3 would designate three striking prices in a formula.
The formulae are arranged alphabetically by title or by strategy.
C
Appendix 995
2:1 ratio (straddle buy):
R = s + 2c- .r
U=s+R
D=s-R=x-2c
Using puts (long 100 stock, long 2 puts) (Ch. 18)
R =x+2p-s
U =s+R =x+2p
D=s-R
Straddle Buy (Ch. 18)
R=p+c
U=s+R
D=-R
Straddle Sale (Ch. 20)

P=p+c
U=s+p
D=s-p
Synthetic Put Purchase-short stock and long call (Ch. 4)
R=s+c-x
B =s-c
Variable Ratio Write (Ch. 6)

-long 100 shares of stock, short one call at strike s 1, short one call at
strike s2
P=c1+c2+s1-x
D = s1 - P = x -ci -c2
U = S2 + p
996 Appendix
C
Volatility-Standard Deviation (Ch. 28)
V2=i~l
f (x1-i)--
2
n-1
Where
xi = daily stock closing price

x = mean (average) of the x/s
n = number of observations
- if v is the annual volatility, then the volatility for a time period, t, is

Vr = vft
Graphs
Chapter references are in parentheses.
A. Intrin sic Value-Call (Ch. 1) B. Intrinsic Value-Put (Ch. 15)
C. Call Option Pricing Curve D. Put Option Pricing Curve

(Ch. 1) (Ch. 15)
997
998 Appendix
D
E. Time Value Premium Decay F. Lognormal Distribution

(Ch. 1) (Ch. 28)
;
~--~.,,~-=--••"~-,.-·~
G. Call Purchase (Ch. 1) H. Put Purchase (Ch. 16)
(long stock/long put-Ch. 17) (short stock/long call-Ch. 4)
----------,
I
-
~
I. Covered Call Write (Ch. 2) J.Naked Call Write (Ch. 5)

Naked Put Write (Ch. 19) (short stock/short put-Ch . 19)
AppendixD 999
K. Bull Spread (Chs. 7 and 22) L. Bear Spread (Chs. 8 and 22)
(covered call write + long put
f
out-of-the-money-Ch. 17)
I
i / '\ --- I•
_I ~ -~-7--~-J
M. Calendar Spread (Chs. 9 and 22) N. Butterfly Spread (Chs. 10 and 23)
0 . Naked Straddle Write (Ch. 20) P. Straddle Purchase (Ch. 18)

Ratio Call Write (long 100 stock, Reverse hedge (short 100
short 2 calls-Ch. 6) stock, long 2 calls-Ch. 4)
Ratio Put Write (short 100 stock, Put Hedge (long 100 stock,
short 2 puts-Ch. 19) long 2 puts-Ch. 18)
-~~-------P<i.t,W,'M>;!:'\
IA I ,
L =---
1000 D
Appendix
Q. Combination Sale (Ch. 20) R. Combination Purchase (Ch. 18)

Variable Ratio Write (long 100 (short 100 stock, long 2 calls
stock, short 2 calls with with different strikes-Ch. 4)
different strikes-Ch. 6)
S. Ratio Call Spread (Ch. 11) T. Ratio Put Spread (Ch. 24)
U. Reverse Calendar Spread (Ch. 13) V. Iron Condor (Condor) (Ch. 23)
t·
I
ii~
W. Dual Calendar Spread (Ch. 23)
Qualified Covered Calls
For tax purposes, there is no effect on the holding period of the stock when one writes an
out-of-the-money call. However, when one writes an in-the-money call, he eliminates the
holding period on his common stock unless the stock is already held long-term. The only
exception to this is that if the covered call is deemed to be qualified, then the holding
period is merely suspended rather than eliminated . Table E-1 shows the lowest striking
price that may be written if the stock is in the price range shown.
1001
1002 Appendix
E
TABLEE-1.
Qualified covered call strikes for stocks priced $2S or less, and Striking
Prices are at intervals of $2.S0.
Stock
Price* In-the-money
Qualified
Strike
Below 2.50 None
2.51 to 2.94 2.50
2.95 to 5.00 None
5.01 to 5.88 5.00
5.89 to 7.50 None
7.51 to 8.82 7.50
8.83 to 10.00 None
10.01 to 11.76 10
11.77to 12.50 None
12.51 to 14.70 12.50
14.71 to 15.00 None
15.01 to 17.50 15
17.51 to 20.00 17.50
20.01 to 22.50 20
22.51 to 25.00 22.50
TABLEE-2.
Qualified covered call strikes for stocks priced $2S or less, and Striking
Prices are at intervals of $1.00.
Stock
Price* In-the-money
Qualified
Strike
1.00 to 1.17 1.00
1.18 to 2.00 None
2.01 to 2.35 2.00
2.36 to 3.00 None
3.01 to 3.52 3.00
3.53 to 4.00 None
4 .01 to 4.70 4.00
4.71 to 5.00 None
5.01 to 5.88 5.00
5.89 to 6.00 None
6 .01 to 7.00 6 .00
7.01 to 25.00 Closest in-the-money strike only
Appendix
E 1003
TABLEE-3.
Qualified covered call strikes for stocks priced higher than $25.
31-90daystoexpiration
in-the-money More
than90daystoexpiration
Lowest
Stock
Price* Qualified
Strike in-the-money
Qualified
Strike
25.01 to 50 One strike below previous day's One strike below previous day's
close close
50.01 to 150 One strike below previous day's Two strikes below previous day's
close close as long as strike price
is greater than 50 (But not
more than $10 in-the-money)
More than 150 One strike below previous day's Two strikes below previous day's
close close
These rules are applicable, whether the striking price intervals are 1.00, ,S.00, or
10.00, or anything else. In all the above tables, "stock price" is the previous day's closing
price, unless the stock opens more than ll0% higher the next day and the option is writ-
ten on that gap day, in which case the opening price is the "stock price" for the purposes
of the above tables .
Portfolio Margin
On April 2, 2007, the final phase of the Portfolio Margin requirements for listed stock
and index options went into effect. Any account approved for naked option trading is
eligible to be granted these reduced margin requirements. Assuming that one's broker
has a real-time margining system, the minimum account size to be eligible for these
requirements is $100,000; otherwise, ifs $1.50,000, although any brokerage firm can
impose higher minimums. Your broker can elect not to grant you these requirements
(much as the broker doesn 't have to grant one exchange minimum margin requirements).
Under Portfolio Margin, requirements no longer are computed based on arbitrary
parameters, nor not even necessarily on the maximum risk of the strategy. Rather, the risk
of an option or stock position will be determined by evaluating the position at 10 equally
spaced intervals within a predetermined price range. The requirement will be the risk of
the most adverse move. The essential data used in these calculations is supplied daily by
the CBOE for each underl ying entity .
The movements are fixed, and not really volatility-based. This is where Portfolio
Margin can differ substantially from futures' SPAN Margin, which is more or less
volatility-based. Hence, selling a naked S&P 500 futures put will still have a lower require-
ment than selling the same SPX put listed on the CBOE (same expiration month and
striking price), for the likelihood of SPX dropping 8% immediately is minuscule, which
SPAN accounts for but Portfolio Margin does not.
The ranges are defined as:
+/-1.5%for stocks, stock options, stock futures, and narrow-based index options.
+/-10% for broad-based indices that are not high capitalization .
+6%/-8% for high capitalization broad-based indice s.
There is a minimum requirement of $37.50 per contrac t.
1006 Appendix
F
Thus a naked SPX put would be valued as if the underlying index had fallen 8%; a naked
SPX call would use a movement of +6% in the index. In either case, this is a lower require-
ment than the normal customer naked margin requirement. Most positions involving
naked options, especially ones such as reverse calendar spreads or reverse diagonal
spreads, will have greatly reduced margin requirements under the new system.
Any truly hedged position (long stock, long put for example) will benefit greatly from
this new computation, since the fact that risk is limited will be taken into account.
Even a covered call write will have greatly reduced requirements since one is only
forced to margin a decline of 1.5%in the stock price rather than putting up 50% of the
stock price.
Example: Suppose IBM is trading at 106 and one is considering a covered write on mar-
gin of the July llO call, trading at 1.50.
Old margin requirement: 50% of stock price (53) less option price (1.5) = .51..50
points
($5,150 per 100 shares), commissions not included.
New margin requirement: 15% of stock price (1.5.90)less option price (1..50)= 14.40
points ($1,440 per 100 shares).
This is a large difference, and may just make covered writing on margin a viable strategy
once again (the requirements for vertical spreads don't drop nearly as much, in general).
While actual Portfolio Margin requirements are dependent on the specific stock
price and its relationship to the striking price, we can make some general observations
about \Vhich strategies will benefit the most from this change in requirements:
Most reduced: protective put, collar, short calendar (or other strategies involving
buying near-term options and selling longer-term ones).
Potentially large reduction: long strangle, long straddle, especially if long-term
options are used (the stock price movement assumptions are so big that the straddles
and strangles appear to have little or no risk-an erroneous assumption that benefits
long options unfairly).
Reasonably sized reduction: covered call, short long-term strangle, short index
straddle, index condor, index naked option, short index strangle.
Smallest reductions: vertical spreads, long calendars, synthetic long stock.
An~,other strategies not mentioned (such as naked equity puts) likely will fall between
"smallest reduction" and "reasonably sized reduction"; in other words, there will be some
reduction , but not an extremely large one.
Tht>lower minimum requirement (for customer margin, it is 10% of the underlying
for naked options) will bt>beneficial as well. For example, if you sell a naked equity put
Appendix
F 1007
whose strike is more than 15% out of the money-or if you sell any naked equity put and
then the underlying makes a move to the upside of more than 1.5%-your requirement
could be very small.
An OCC portfolio margin calculator can be found at https://cpm.theocc
.com/tims_ online.htm.
The CBOE has se,·eral memos and examples regarding Portfolio Margin require-
ments and calculations on its website. Visit http://cboe.com/margin if you are interested.
SUMMARY
Portfolio Margin gives one more leverage. Leverage is not necessarily a good thing or a
bad thing. Leverage is within the trader's control-one can allocate more than the mini-
mum margin to any position and thereby reduce the leverage .
Glossary
American Exercise: a feature of an option that indicates it may be exercised at any time .
Therefore , it is subject to early assignment.
Arbitrage: the process in which professional traders simultaneously buy and sell the same
or equivalent securities for a riskless profit. See also Risk Arbitrage.
Assign: to designate an option writer for fulfillment of his obligation to sell stock (call
option writer) or buy stock (put option writer). The writer receives an assignment notice
from the Options Clearing Corporation. See also Early Exercise .
Assignment Notice: see Assign.
Automatic Exercise: a protection procedure whereby the Options Clearing Corporation

attempts to protect the holder of an expiring in-the-money option by automatically
exercising the option on behalf of the holder.
Average Down: to buy more of a security at a lower price, thereby reducing the holder's
average cost. (Average Up: to buy more at a higher price.)
Backspread: see Reverse Strategy .
Backwardation: see Term Structure.
Bear Spread: an option strategy that makes its maximum profit when the underlying
stock declines and has its maximum risk if the stock rises in price. The strategy can be
implemented with either puts or calls. In either case, an option with a higher striking
price is purchased and one with a lower striking price is sold, both options generally
having the same expiration date. See also Bull Spread.
1009
1010 Glossary
Bearish: an adjective describing an opinion or outlook that expects a decline in pr ice,

either by the general market or by an underlying stock, or both. See also Bullish.
Beta: a measure of how a stock's movement correlates to the movement of the entire stock
market. The beta is not the same as volatility. See also Standard Deviation, Volatility.
Black Model: a model used to predict futures option prices; it is a modified version of
the Black-Scholes model. See Model.
Board Broker: the exchange member in charge of keeping the book of public orders on
exchanges utilizing the "market-maker" system, as opposed to the "specialist system,"
of executing orders. See also Market-Maker, Specialist.
Box Spread: a type of option arbitrage in which both a bull spread and a bear spread are
established for a riskless profit. One spread is established using put options and the
other is established using calls. The spreads may both be debit spreads (call bull spread vs.
put bear spread), or both credit spreads (call bear spread vs. put bull spread).
Break-Even Point: the stock price (or prices) at which a particular strategy neither makes
nor loses money. It generally pertains to the result at the expiration date of the options
involved in the strategy. A "dynamic" break-even point is one that changes as time
passes.
Broad-Based: generally referring to an index, it indicates that the index is composed of

a sufficient number of stocks or of stocks in a variety of industry groups. Broad-based
indices are subject to more favorable treatment for naked option writers. See also
Narrow- Based.
Bu ll Spread: an option strategy that achieves its maximum potential if the underlying
security rises far enough, and has its maximum risk if the security falls far enough. An
option with a lower striking price is bought and one with a higher striking price is sold,
both generally having the same expiration date. Either puts or calls may be used for the
strategy . See also Bear Spread.
Bullish: describing an opinion or outlook in which one expects a rise in price, either by
the general market or by an individual security. See also Bearish.
Butterfly Spread: an option strategy that has both limited risk and limited profit poten -
tial, constructed by combining a bull spread and a bear spread. Three striking prices
are involved, with the lower two being utilized in the bull spread and the higher two
in the bear spread. The strategy can be establ ished with either puts or calls; there are
four different ways of combining options to construct the same basic position.
Glossary 1011
Calendar Spread: an option strategy in which a short-term option is sold and a

longer-term option is bought, both having the same striking price. Either puts or calls
may be used. A dual calendar spread (calendar combination) is a strategy that consists
of a call calendar spread and a put calendar spread at the same time. The striking prices
of the calls would be higher than the striking prices of the puts. A calendar straddle
consists of selling a near-term straddle and buying a longer-term straddle, both with
the same striking price .
Calendar Straddle or Combination: see Calendar Spread.
Call: an option that gives the holder the right to buy the underlying security at a specified
price for a certain, fixed period of time. See also Put.
Call Price: the price at which a bond or preferred stock may be called in by the issuing
corporation; see Redemption Price.
Capitalization-Weighted Index: a stock index that is computed by adding the capital-
izations (float times price) of each individual stock in the index, and then dividing by
the divisor. The stocks with the largest market values have the heaviest weighting in
the index . See also Divisor, Float, Price-Weighted Index.
Carrying Cost: the interest expense on a debit balance created by establishing a
position.
Cash-Based: Referring to an option or future that is settled in cash when exercised or
assigned. No physical entity, either stock or commodity, is received or delivered.
CBOE: the Chicago Board Options Exchange; the first national exchange to trade listed
stock options.
Circuit Breaker: a limit applied to the trading of index futures contracts designed to
keep the stock market from crashing.
Class: a term used to refer to all put and call contracts on the same underlying security.
Closing Transaction: a trade that reduces an investor's position. Closing buy transac-
tions reduce short positions and closing sell transactions reduce long positions. See also
Opening Transaction.
Collar: a strategy for protecting a stock holding, by buying an out-of-the-money put and
selling an out-of-the-money call. A "no-cost" collar is one in which the price of the call
is greater than or equal to the price of the put. When combined with the underlying,
the strategy has both limited profit potential and limited loss potential.
1012 Glossary
Collateral: the loan value of marginable securities; generally used to finance the writing
of uncovered options.
Combination: (1) any position involving both put and call options that is not a straddle.
See also Straddle. (2) the name given to the trade at expiration whereby an arbitrageur
rolls his options from one month to the next. For example, if he sells his synthetic long
stock position in June and reestablishes it by buying a synthetic long stock position in
September, the entire four-sided trade is called a combination by floor traders. See also
Straddle , Strangle .
Commodities: see Futures Contract.
Condor: a spread with limited risk and limited reward, using four different striking prices
but the same expiration date. The position can be constructed with all calls (Call Con-
dor), all puts (Put Condor), or more commonly, puts and calls-all of which are
out-of-the-money (Iron Condor). The maximum profit is realized between the two
inner strikes, and the maximum risk is realized outside of the higher and lower strikes.
Contango: see Term Structure.
Contingent Order: an order whose execution or price is dependent on the alignment or

price of the underlying security and/or its options. Most commonly it is an order to buy
stock and sell a covered call option that is given as one order to the trading desk of a
brokerage firm. Also called a "net order." This is a "not held" order. See also Market Not
Held Order.
Conversion Arbitrage: a riskless transaction in which the arbitrageur buys the underly-
ing security, buys a put, and sells a call. The options have the same terms. See also
Reversa l Arbitrage .
Conversion Ratio: see Convertible Security.
Converted Put: see Synthetic Put.
Convertible Security: a security that is convertible into another security. Generally, a

com,ertible bond or comfitible preferred stock is convertible into the underlying stock
of the same corporation. The rate at which the shares of the bond or preferred stock
are convertible into the common is called the conversion ratio.
Cover: to buy back as a closing transaction an option that was initially written, or stock
that was initially sold short.
Covered: a ,:vritten option is considered to be covered if the writer also has an opposing
1narkt't position 011 a share-for-share basis in the underlying security. That is, a short
Glossary 1013
call is covered if the underlying stock is owned, and a short pnt is covered (for margin
purposes) if the underlying stock is also short in the account. In addition, a short call
is covered if the account is also long another call on the same security, with a striking
price equal to or less than the striking price of the short call. A short put is covered if
there is also a long put in the account with a striking price equal to or greater than the
striking price of the short put.
Covered Call Write: a strateg~1 in which one writes call options while simultaneously
owning an equal number of shares of the underlying stock.
Covered Put Write: a strategy in which one sells put options and simultaneously is short
an equa l number of shares of the underlying security.
Covered Straddle Write: the term used to describe the strategy in which an investor
owns the underlying security and also writes a straddle on that security. This is not
really a covered position.
Credit: money received in an account. A credit transaction is one in which the net sale
proceeds are larger than the net buy proceeds (cost), thereby bringing money into the
account. See also Debit.
Cycle: the expiration elates applicable to various classes of options. There are three cycles:
January/ April/} uly/October, February/May/August/November, and March/June/Sep-
tember/December.
Debit: an expense, or money paid out from an account. A debit transaction is one in
which the net cost is greater than the net sale proceeds . See also Credit.
Deliver: to take securities from an individual or firm and transfer them to another indi-
vidual or firm. A call writer who is assigned must deliver stock to the call holder who
exercised. A put holder who exercises must deliver stock to the put writer who is
assigned.
Delivery: the process of satisfying an equity call assignment or an equity put exercise. In
either case, stock is delivered. For futures, the process of transferring the physical com-
modity from the seller of the futures contract to the buyer. Equivalent delivery refers
to a situation in which delivery may be made in any of various, similar entities that are
equivalent to each other (for example, Treasury bonds with differing coupon rates).
Delta: (1) the amount by which an option's price will change for a corresponding 1-point
change in price by the underlying entity. Call options have positive deltas, while put
options have negative deltas. Technically , the delta is an instantaneous measure of the
option 's price change, so that the delta will he altered for even fractional changes hy
1014 Glossary
the underlying entity. Consequently , the terms "up delta" and "down delta" may be
applicable. They describe the option's change after a full 1-point change in price by the
underlying security, either up or down. The "up delta" may be larger than the "down
delta" for a call option, while the reverse is true for put options. (2) the percent prob-
ability of a call being in-the-money at expiration. See also Hedge Ratio.
Delta Neutral Spread: a ratio spread that is established as a neutral position by utilizing
the deltas of the options involved. The neutral ratio is determined by dividing the delta
of the purchased option by the delta of the written option. See also Delta, Ratio Spread.
Depository Trust Corporation (DTC): a corporation that will hold securities for mem-
ber institutions. Generally used by option writers, the DTC facilitates and guarantees
delivery of underlying securities when assignment is made against securities held in
DTC .
Diagonal Spread: any spread in which the purchased options have a longer maturity than
<lothe written options, as well as having different striking prices. Typical types of diagonal
spreads are diagonal bull spreads, diagonal bear spreads, and diagonal butterfly spreads.
Discount: an option is trading at a discount if it is trading for less than its intrinsic value.
A future is trading at a discount if it is trading at a price less than the cash price of its
underl ying index or commodity. See also Intrinsic Value, Parity .
Discount Arbitrage: a riskless arbitrage in which a discount option is purchased and an

opposite position is taken in the underlying security. The arbitrageur may either buy a
call at a discount and simultaneously sell the underlying security (basic call arbitrage),
or buy a put at a discount and simultaneously buy the underlying security (basic put
arbitrage). See also Discount.
Discretion: See Limit Order , Market Not Held Order .
Dividend Arbitrage: in the riskless sense, an arbitrage in which a put is purchased and
so is the underlying stock. The put is purchased when it has time value premium less
than the impending dividend payment by the underlying stock. The transaction is
closed after the stock goes ex-dividend. Also used to denote a form of risk arbitrage in
which a similar procedure is followed, except that the amount of the impending divi-
dend is unknown and therefore risk is involved in the transaction. See also Ex-Dividend,
Time Value Premium.
Divisor: a mathematical quantity used to compute an index. It is initially an arbitrary

number that reduces the index value to a small, workable number. Thereafter the di\·i-
sor is adjusted for stock splits (price-weighted index) or additional issues of stock
(capitalization-weighted ind ex).
Glossary 1015
Downside Protection: generally use<l in connection with covered call writing, this is the
cushion against loss, in case of a price decline by the underlying security , that is
afforded by the written call option. Alternatively , it may be expressed in terms of the
distance the stock could fall before the total position becomes a loss (an amount equal
to the option premium), or it can be expressed as percentage of the current stock price.
See also Covered Call Write .
Dynamic: for option strategies, describing analyses made during the course of changing
security prices and during the passage of time. This is as opposed to an analysis made
at expiration of the options used in the strategy. A dynamic break-even point is one that
changes as time passes. A dynamic follow-up action is one that will change as either the
security price changes or the option price changes or time passes. See also Break-Even
Point , Follow-Up Action .
Early Exercise (assignment): the exercise or assignment of an option contract before its
expiration date .
Equity Option: an option that has common stock as its underlying security. See also
Non-Equity Option .
Equity Requirement: a requirement that a minimum amount of equity must be present
in a margin account. Normally, this requirement is $2,000, but some brokerage firms
may impose higher equity requirements for uncovered option writing.
Equivalent Positions: positions that have similar profit potential, when measured in dol-
lars, but are constructed with differing securities. Equivalent positions have the same
profit graph. A covered call write is equivalent to an uncovered put write, for example.
See also Profit Graph .
Escrow Receipt: a receipt issued by a bank in order to verify that a customer (who has
written a call) in fact owns the stock and therefore the call is considered covered.
European Exercise: a feature of an option that stipulates that the option may be exer-
cised only at its expiration. Therefore, there can be no early assignment with this type
of option .
Exchange-Traded Fund (ETF) or Note (ETN): an entity whose shares are publicly
traded on a listed exchange. The entity tracks an index, commodity, or basket of assets
(which could be futures), akin to an index fund. Options are listed on some ETFs. See
also Index Fund.
Ex-Dividend: the process whereby a stock's price is reduced when a dividend is paid. The
ex-dividend date (ex-date) is the date on which the price reduction takes place. Investors
1016 Glossary
who own stock on the ex-date will receive the dividend, and those who are short stock
must pay out the dividend.
Exercise: to inrnke the right granted under the terms of a listed options contract. The
holder is the one who exercises. Call holders exercise to buy the underlying security,
while put holders exercise to sell the underlying security.
Exercise Limit: the limit on the number of contracts a holder can exercise in a fixed
period of time. Set by the appropriate option exchange, it is designed to prevent an
investor or group of investors from "cornering" the market in a stock.
Exercise Price: the price at which the option holder may buy or sell the underlying
security, as defined in the terms of his option contract. It is the price at which the call
holder may exercise to buy the underlying security or the put holder may exercise to
sell the underlying security. For listed options, the exercise price is the same as the
striking price. See also Exercise.
Expected Return: a rather complex mathematical analysis involving statistical distribu-

tion of stock prices, it is the return an investor might expect to make on an investment
if he were to make exactly the same investment many times throughout history.
Expiration Date: the day on which an option contract becomes void. The expiration date
for listed stock options is the Saturday after the third Friday of the expiration month.
All holders of options must indicate their desire to exercise, if they wish to do so, by
this date . See also Expiration Time.
Expiration Time: the time of day by which all exercise notices must be received on the
expiration date. Technically, the expiration time is currently ,5:00 p.rn. on the expiration
elate, hut public holders of option contracts must indicate their desire to exercise no
later than ,5::30p.m. on the business <laypreceding the expiration date. The times are
Eastern Time . See also Expiration Date.
Facilitation: the process of providing a market for a security. Normally, this refers to bids
and offers made for large blocks of securities, such as those traded by institutions.
Listed options may he used to offset part of the risk assumed by the trader who is
facilitating the large block order. See also Hedge Ratio.
Fair Value: normally, a term used to describe the worth of an option or futures contract
as determined by a mathematical model. Also sometimes used to indicate intrinsic
value. See also Intrin sic Value, Model.
First Notice Day: the first clay upon which the buyer of a futures contract can be called
upon to take delivery. See also Notice Period.
Glossary 1017
Float: the number of shares outstanding of a particular common stock.

Floor Broker: a tradt-T 011 the exchange floor who executes the orders of public customers
or other investors who do· not have physical access to the trading area.
Follow-Up Action: any trading in an option position after the position is established.
Generally , to limit losses or to take profits.
FOREX Option: an option whose underlying entity is a physical foreign currency-yen,

pound , Euro, etc. See also Physical Option.
Fundamental Analysis: a method of analyzing the prospects of a security by observing

accepted accounting measures such as earnings, sales, assets, and so on. See also Tech-
nical Analysis.
Futures Contract: a standardized contract calling for the delivery of a specified quantity
of a commodity at a specified date in the future.
Gamma: a measure of risk of an option that measures the amount by which the delta
changes for a I-point change in the stock price; alternatively, when referring to an
entire option position, the amount of change of the delta of the entire position when
the stock changes in price by one point.
Gamma of the Gamma: a mathematical measure of risk that measures by how much
the gamma will change for a I-point move in the stock price . See Gamma.
Good Until Canceled (GTC): a designation applied to some types of orders, meaning
that the order remains in effect until it is either filled or canceled. See also Limit,
Stop- Limit Order , Stop Order.
Hedge Ratio: the mathematical quantity that is equal to the delta of an option. It is use-
ful in facilitation in that a theoretically riskless hedge can be established by taking
offsetting positions in the underlying stock ancl its call options. See also Delta,
Facilitation.
Historical Volatility: See Volatility.
Holder: the owner of a security.

Horizontal Spread: an option strategy in which the options have the same striking price,
but different expiration dates.
Implied Volatility: a prediction of the volatility of the underlying stock, it is determined
by using prices currently existing in the option market at the time, rather than using
historical data on the price changes of the underlying stock. See also Volatility
1018 Glossary
Incremental Return Concept: a strategy of covered call writing in which the investor
is striving to earn an additional return from option writing against a stock position that
he is targeted to sell, possibly at substantially higher prices.
Index: a compilation of the prices of several common entities into a single number. See
also Capitalization-Weighted Index, Price-Weighted Index .
Index Arbitrage: a form of arbitraging index futures against stock. If futures are trading
at prices significantly higher than fair value, the arbitrager sells futures and buys the
exact stocks that make up the index being arbitraged; if futures are at a discount to fair
value , the arbitrage entails buying futures and selling stocks.
Index Fund: a mutual fund whose components exactly match the stocks that make up a
widely disseminated index, such as the S&P 500, Dow-Jones, Russell 2000, or
NASDAQ-100. See also Exchange-Traded Fund.
Index Option: an option whose underlying entity is an index. Most index options are
cash-based.
Ins titution: an organization, probably very large, engaged in investing in securities. Nor-
mally a bank , insurance company, or mutual fund.
Intermarket Spread: a futures spread in which futures contracts in one market are
spread against futures contracts trading in another market. Examples: Currency
spreads (yen vs. deutsche mark) or TED spread (T-Bills vs. Eurodollars).
In-the -Money: a term describing any option that has intrinsic value. A call option is
in-the-money if the underlying security is higher than the striking price of the call. A
put option is in-the-money if the security is below the striking price. See also Intrinsic
Value, Out-of-the-Money .
Intramarket Spread: a futures spread in which futures contracts are spread against
other futures contracts in the same market; example, buy May soybeans, sell March
soybeans.
Intrinsic Value: the value of an option if it were to expire immediately with the underly-
ing stock at its current price; the amount by which an option is in-the-money. For call
options, this is the difference between the stock price and the striking price, if that
difference is a positive number, or zero otherwise. For put options it is the difference
between the striking price and the stock price, if that difference is positive, and zero
otherwise. See also In-the-Money , Parity , Time Value Premium.
Last Trading Day: the third Friday of the expiration month. Options cease trading at
3:00 p.m. Eastern Time on the last trading day.
Glossary 1019
LEAPS: Long-term Equity Antil'ipation Securities. These are long-term listed options,
current ly having maturities as long as two and one-half years.
Leg: a risk-oriented method of establishing a two-sided position. Rather than entering

into a simultaneous transaction to establish the position (a spread, for example), the
trad er first executes one side of the position, hoping to execute the other side at a later
time and a better price. The risk materializes from the fact that a better price may
never be available, and a worse price must eventually be accepted.
Letter of Guarantee: a letter from a bank to a brokerage firm stating that a customer
(who has written a call option) does indeed own the underlying stock and the bank will
guarantee delivery if the call is assigned. Thus, the call can be considered covered. Not
all brokerage firms accept letters of guarantee.
Leverage: in investments, the attainment of greater percentage profit and risk potential.
A call holder has leverage with respect to a stockholder-the former will have greater
percentage profits and losses than the latter, for the same movement in the underlying
stock.
Limit: see Trading Limit.
Limit Order: an order to buy or sell securities at a specified price (the limit). A limit order
may also be placed "with discretion"-a fixed, usually small, amount such as ¼ or ¼ of
a point. In this case, the floor broker executing the order may use his discretion to buy
or sell at 1/~or ¼ of a point beyond the limit if he feels it is necessary to fill the order.
Listed Option: a put or call option that is traded on a national option exchange. Listed
options have fixed striking prices and expiration dates. See also Over-the-Counter
Option.
Local: a trader on a futures exchange who buys and sells for his own account and may fill
public orders.
Lognormal Distribution: a statistical distribution that is often applied to the movement
of the stock prices. It is a convenient and logical distribution because it implies that
stock prices can theoretically rise forever but cannot fall below zero-a fact which is,
of course, true.
Margin: to buy a security by borrowing funds from a brokerage house. The margin
requirement-the maximum percentage of the investment that can be loaned by the
broker firm-is set by the Federal Reserve Board .
Market Basket: a portfolio of common stocks whose performance is intended to simulate

the performance of a specific index. See Index .
1020 Glossary
Market-Maker: an exchange member whose function is to aid in the making of a market,

bv, rnakincr
t-,
bids and offers for his account in the absence of public buy or sell orders.
Several market-makers are normally assigned to a particular security. The market-maker
system encompasses the market-makers and the board brokers. See also Board Broker,
Specialist.
Market Not Held Order: also a market order, but the investor is allowing the floor bro-
ker who is executing the order to use his own discretion as to the exact timing of the
execution. If the floor broker expects a decline in price and he is holding a "market not
held" buy order, he may wait to buy, figuring that a better price will soon be available.
There is no guarantee that a "market not held" order will be filled.
Market Order: an order to buv or sell securities at the current market. The order will be
filled as long as there is a market for the security.
Married Put and Stock: a put and stock are considered to be married if they are bought
on the same day, and the position is designated at that time as a hedge.
Model: a mathematical formula designed to price an option as a function of certain

variables-generally stock price, striking price, volatility, time to expiration, dividends
to he paid, and the current risk-free interest rate. The Black-Scholes model is one of
the more widely used models.
Monte Carlo Simulation: a model designed to simulate a real-world event that cannot
he approximated merely with a mathematical formula. The Monte Carlo simulation
approximates such an event (the movement of the stock market, for example) and then
it is simulated a great number of times. The net result of all the simulations is then
interpreted as the result, generally expressed as a probability of occurrence. For exam-
ple, a Monte Carlo simulation can be used to determine how stocks might behave
under certain stock price distributions that are different from the lognormal
distribution.
Naked Option: see Uncovered Option.
Narrow-Based: Generally referring to an index, it indicates that the index is composed

of only a few stocks, generally in a specific industry group. Narrow-based indices are
not subject to favorable treatment for naked option writers. See also Broad-Based.
"Net" Order: see Contingent Order.
Neutral: describing an opinion that is neither bearish nor bullish. Neutral option strategies
are generally designed to perform best if there is little or no net change in the price of
the underlying stock. See also Bearish, Bullish .
Glossary 1021
Non-Equity Option: an option whose m1derlying entity is not common stock; typically
refers to options on physical commodities, hut may also he extended to include index
options.
"Not Held": see Market Not Held Order.
Notice Period: the time during which the buyer of a futures contract can be called upon
to accept delivery. ~vpically, the :3to 6 weeks preceding the expiration of the contract.
Open Interest: the net total of outstanding open contracts in a particular option series.
An opening transaction increases the open interest, while any closing transaction
reduces the open interest.
Opening Transaction: a trade that adds to the net position of an investor. An opening
buy transaction adds more long securities to the account. An opening sell transaction
adds more short securities. See also Closing Transaction.
Option Pricing Curve: a graphical representation of the projected price of an option at

a fixed point in time. It reflects the amount of time value premium in the option for
various stock prices, as well. The curve is generated by using a mathematical model.
The delta (or hedge ratio) is the slope of a tangent line to the curve at a fixed stock price.
See also Delta, Hedge Ratio, Model.
Options Clearing Corporation (OCC): the issuer of all listed option contracts that are
trading on the national option exchanges.
Original Issue Discount (OID): the initial price of a zero-coupon bond. The owner
owes taxes on the theoretical interest, or phantom income, generated by the annual
appreciation of the bond toward maturity. In reality, no interest is paid by the
zero-coupon bond, but the government is taxing the appreciation of the bond as if it
were interest.
Out-of-the-Money: describing an option that has no intrinsic value. A call option is

out-of-the-money if the stock is below the striking price of the call, while a put option
is out-of-the-money if the stock is higher than the striking price of the put. See also
In-the-Money, Intrinsic Value.
Over-the-Counter Option (OTC): an option traded over-the-counter, as opposed to a

listed stock option. The OTC option has a direct link between buyer and seller, has no
secondary market, and has no standardization of striking prices and expiration dates.
See also Listed Option, Secondary Market.
Overvalued: describing a security trading at a higher price than it logically should. Nor-
mally associated with the results of option price predictions by mathematical rnoclels.
1022 Glossary
If an option is trading in the market for a higher price than the model indicates, the
option is said to be overvalued. See also Fair Value,.Undervalued.
Pairs Trading: a hedging technique in which one buys a particular stock and sells short
another stock. The two stocks are theoretically linked in their price history, and the
hedge is established when the historical relationship is out of line, in hopes that it will
return to its former correlation.
Parity: describing an in-the-money option trading for its intrinsic value: that is, an option
trading at parity with the underlying stock. Also used as a point of reference-an
option is sometimes said to be trading at a half-point over parity or at a quarter-point
under parity, for example. An option trading under parity is a discount option. See also
Discount, Intrinsic Value.
PERCS: Preferred Equity Redemption Cumulative Stock. Issued by a corporation, this
preferred stock pays a higher dividend than the common and has a price at which it can
be called in for redemption by the issuing corporation. As such, it is really a covered
call write, with the call premium being given to the holder in the form of increased
dividends. See Call Price, Covered Call Write, Redemption Price.
Physical Option: an option whose underlying security is a physical commodity that is not
stock or futures. The physical commodity itself, typically a currency or Treasury debt
issue, underlies that option contract. See also Equity Option, Index Option.
Portfolio Insurance: a method of selling index futures or buying index put options to
protect a portfolio of stocks.
Portfolio Margin: a reduced margin requirement that may be available, at the broker's
discretion, to experienced, fairly large option accounts.
Portfolio Protection: a strategy for protecting a portfolio of stocks using listed deriva-
tives. The most popular (although not necessarily the best) strategy is the purchase of
broad-based index puts. A more modern approach is to purchase VIX calls as protec-
tion. See also Collar and Portfolio Insurance.
Position: as a noun, specific securities in an account or strategy. A covered call writing
position might be long 1,000 XYZ and short 10 XYZ January 30 calls. As a verb, to
facilitate; to buy or sell-generally a block of securities-thereby establishing a posi-
tion. See also Facilitation, Strategy.
Position Limit: the maximum number of put or call contracts on the same side of the
market that can be held in any one account or group of related accounts. Short puts and
Glossary 1023
long calls are on the same side of the market. Short calls and long puts are on the same
side of the market.
Premium: for options, the total price of an option contract. The sum of the intrinsic value
and the time value premium. For futures, the difference between the futures price and
the cash price of the underlying index or commodity.
Present Worth: a mathematical computation that determines how much money would
have to be invested today, at a specified rate, in order to produce a designated amount
at some time in the future. For example, at 10% for one year, the present worth of $110
is $100.
Price-Weighted Index: a stock index that is computed by adding the prices of each stock
in the index, and then dividing by the divisor. See also Capitalization-Weighted Index,
Divisor.
Profit Graph: a graphical representation of the potential outcomes of a strategy. Dollars
of profit or loss are graphed on the vertical axis, and various stock prices are graphed
on the horizontal axis. Results may be depicted at any point in time, although the graph
usually depicts the results at expiration of the options involved in the strategy.
Profit Range: the range within which a particular position makes a profit. Generally used
in reference to strategies that have two break-even points-an upside break-even and
a downside break-even. The price range between the two break-even points would be
the profit range . See also Break-Even Point.
Profit Table: a table of results of a particular strategy at some point in time. This is usu-
ally a tabular compilation of the data drawn on a profit graph. See also Profit Graph.
Program Trading: the act of buying or selling a particular portfolio of stocks and hedg-
ing with an offsetting position in index futures. The portfolio of stocks may be small or
large, but it is not the makeup of any stock index. See also Index Arbitrage.
Protected Strategy: a position that has limited risk A protected short sale (short stock,
long call) has limited risk, as does a protected straddle write (short straddle, long
out-of-the-money combination). See also Combination , Straddle.
Public Book (of orders): the orders to buy or sell, entered by the public, that are away
from the current market. The board broker or specialist keeps the public book
Market-makers on the CBOE can see the highest bid and lowest offer at any time. The
specialist's book is closed (only he knows at what price and in what quantity the nearest
public orders are). See also Board Broker, Market-Maker, Specialist.
1024 Glossary
Put: an option granting the holder the right to sell the underlying security at a certain
price for a specified period of time. See also Call.
Put-Call Ratio: the ratio of put trading volume divided by call trading volume; some-
times calculated with open interest or total dollars instead of trading volume. Can be
calcul ated daily, weekly, monthly, etc. Moving averages are often used to smooth out
short-term, daily figures.
Quarterly Option: a listed option that expires at the end of a calendar quarter (March, June,
September, or December). Currently, only a few large indices have listed quarterly options.
Ratio Calendar Combination: a strategy consisting of a simultaneous position of a ratio

calendar spread using calls and a similar position using puts, where the striking price
of the calls is greater than the striking price of the puts.
Ratio Calendar Spread: selling more near-term options than longer-term ones pur-
chased, all with the same strike, either puts or calls.
Ratio Spread: constructed with either puts or calls, the strategy consists of buying acer-
tain amount of options and then selling a larger quantity of out-of-the-money options.
Ratio Strategy: a strategy in which one has an unequal number of long securities and
short securities. Normally, it implies a preponderance of short options over either long
options or long stock.
Ratio Write: buying stock and selling a preponderance of calls against the stock that is
owned. (Occasionally constructed as shorting stock and selling puts.)
Redemption Price: the price at which a structured product may be redeemed for cash.
This is distinctly different from a "call price," which is the price at which an issue may
be called away by the issuer. Sec also Call Price, PERCS, Structured Product.
Resistance: a term in technical analysis indicating a price area higher than the current
stock price where an abundance of supply exists for the stock, and therefore the stock
may have trouble rising through the price. See also Support.
Return (on investment): the percentage profit that one makes, or might make, on his
investment.
Return if Exercised: the return that a covered call writer would make if the underlying
stock were called away.
Return if Unchanged: the return that an investor would make on a particular position
if tlw 11nderl~·ingstock were unchanged in price at the expiration of the options in the
position.
Glossary 1025
Reversal Arbitrage: a riskless arbitrage that involves selling the stock short, writing a
put, and buying a call. The options have the same terms. See also Conversion
Arbitrage .
Reverse Hedge: a strategy in which one sells the underlying stock short and buys calls
on more shares than he has sold short. This is also called a synthetic straddle and is an
outmoded strategy for stocks that have listed puts trading. See also Ratio Write,
Straddle .
Reverse Strategy: a general name that is given to strategies that are the opposite of
better-known strategies. For example, a ratio spread consists of buying calls at a lower
strike and selling more calls at a higher strike. A reverse ratio spread, also known as a
backspread, consists of selling the calls at the lower strike and buying more calls at the
higher strike. The results are obviously directly opposite to each other. See also Reverse
Hedge Ratio Write , Reverse Hedge .
Rho: the measure of how much an option changes in price for an incremental move (gen-
erally l %) in short-term interest rates; more significant for longer-term or in-the-money
options.
Risk Arbitrage: a form of arbitrage that has some risk associated with it. Commonly
refers to potential takeover situations in which the arbitrageur buys the stock of the
company about to be taken over and sells the stock of the company that is effecting the
takeover . See also Dividend Arbitrage.
Roll: a follow-up action in which the strategist closes options currently in the position and
opens other options with different terms, on the same underlying stock. See also Roll
Down , Roll Forward, Roll Up.
Roll Down: close out options at one strike and simultaneously open other options at a
lower strike.
Roll Forward: close out options at a near-term expiration date and open options at a
longer-term expiration date.
Roll Up: close out options at a lower strike and open options at a higher strike.
Rotation: a trading procedure on the open exchanges whereby bids and offers, but not
necessarily trades, are made sequentially for each series of options on an underlying
stock or index.
Secondary Market: any market in which securities can be readily bought and sold after
their initial issuance. The national listed option exchanges provided, for the first time,
a secondary market in stock options .
1026 Glossary
Serial Option: a futures option for which there is no corresponding futures contract
expiring in the same month. The underlying futures contract is the next futures con-
tract out in time. Example: There is no March gold futures contract, but there is an
April gold futures contract, so March gold options, which are serial options, are options
on April gold futures.
Series: all option contracts on the same underlying stock having the same striking price,
expiration date, and unit of trading.
Skew: See Volatility Skew.
Specialist: an exchange member whose function it is both to make markets-buy and sell
for his own account in the absence of public orders-and to keep the book of public
orders. Most stock exchanges and some option exchanges utilize the specialist system
of trading.
Spread Order: an order to simultaneously transact two or more option trades. Typically,
one option would be bought while another would simultaneously be sold. Spread orders
may be limit orders, not held orders, or orders with discretion. They cannot be stop
orders , however . The spread order may be either a debit or a credit.
Spread Strategy: any option position having both long options and short options of the
same type on the same underlying security.
Standard Deviation: a measure of the volatility of a stock. It is a statistical quantity

measuring the magnitude of the daily price changes of that stock. See also Volatility.
Stop Order: an order, placed away from the current market, that becomes a market order
if the security trades at the price specified on the stop order. Buy stop orders are placed
above the market , while sell stop orders are placed below .
Stop-Limit Order: similar to a stop order, the stop-limit order becomes a limit order,
rather than a market order, when the security trades at the price specified on the stop.
See also Stop Order .
Straddle: the purchase or sale of an equal number of puts and calls having the same
terms .
Strangle: a combination involving a put and a call at different strikes with the same expi-
ration date.
Strategy: with respect to option investments, a preconceived, logical plan of position

selection and follow-up action.
Striking Price: see Exercise Pri ce.

Glossary 1027
Striking Price Interval: the distance between striking prices on a particular underlying
security. For stocks, the interval is normally 2 ..5 points for lower-priced stocks and ,5
points for higher-priced stocks. For indices, the interval is either 5 or 10 points. For
futures , the interval is often as low as one or two points.
Structured Product: a combination of securities and possibly options into a single secu-
rity that behaves like stock and trades on a listed stock exchange. Structured products
are created by many of the largest financial institutions (banks and brokerage firms).
Many of the more popular ones are known by their acronyms, created by the institu-
tions that issued them: MITTS, TARGETS, BRIDGES, LINKS, DINKS, ELKS, and
PERCS. See also PERCS.
Subindex: see Narrow-Based.
Suitable: describing a strategy or trading philosophy in which the investor is operating in

accordance with his financial means and investment objectives .
Support: a term in technical analysis indicating a price area lower than the current price
of the stock, where demand is thought to exist. Thus, a stock would stop declining when
it reached a support area . See also Resistance .
Synthetic Put : a strategy constructed by shorting the underlying instrument and buying
a call. The resulting position has the same profit and loss characteristics as a long put
option.
Synthetic Stock: an option strategy that is equivalent to the underlying stock. A long call
and a short put is synthetic long stock. A long put and a short call is synthetic short stock.
Technical Analysis: the method of predicting future stock price movements based on
observation of historical stock price movements.
Term Structure: a term used to describe the relationship of option implied volatilities,
or of the prices of volatility futures, over a number of months. In a bullish market the
term structure generally consists of a rising sequence of prices (contango); while in a
bearish market , the term structure is usually a declining sequence of prices
(backwardation).
Terms: the collective name denoting the expiration date, striking price, and underlying
stock of an option contract.
Theoretical Value: the price of an option, or a spread, as computed by a mathematical
model.
Theta: the measure of how much an option's price decays for each day of time that passes.
1028 Glossary
Time Spread: see Calendar Spread.
Time Value Premium: the amount by which an option's total premium exceeds its
intrinsic value .
Total Return Concept: a covered call writing strategy in which one views the potential
profit of the strategy as the sum of capital gains, dividends, and option premium
income , rather than viewing each one of the three separately.
Tracking Error: the amount of difference between the performance of a specific port-
folio of stocks and a broad-based index with which they are being compared. See Mar-
ket Basket.
Trader: a speculative investor or professional who makes frequent purchases and sales.
Trading Limit: the exchange-imposed maximum daily price change that a futures con-
tract or futures option contract can undergo.
Treasury Bill/Option Strategy: a method of investment in which one places approxi-

mately 90% of his funds in risk-free, interest-bearing assets such as Treasury bills, and
buys options with the remainder of his assets.
Type: the designation to distinguish between a put or call option.
Uncovered Option: a written option is considered to be uncovered if the investor does

not have a corresponding position in the underlying security. See also Covered.
Underlying Security: the security that one has the right to buy or sell via the terms of
a listed option contract.
Undervalued: describing a security that is trading at a lower price than it logically should.
Usually determined hy the use of a mathematical model. See also Fair Value,
Overvalued.
Variable Ratio Write: an option strategy in which the investor owns 100 shares of the
underlying security and writes two call options against it, each option having a different
striking price.
Variance: a statistical terlll, which is essentially "standard deviation squared," or "volatil-

it~,squared." Listed Variance Futures exist on the CBOE, although they have not been
a successful product.
Vega: the measure of how much an option's price changes for an incremental change-
usually one percentage point-in volatility .
Glossary 1029
Vertical Spread: any option spread strategy in which the options have different striking
prices but the same expiration dates .
Volatility: a measure of the amount by which an underlying security is expected to fluctu-

ate in a given period of time. Generally measured by the annual standard deviation of
the daily price changes in the security, volatility is not equal to the beta of the stock.
Also called historical volatility, statistical volatility, or actual volatility. See also Implied
Volatility.
Volatility Index (VIX): an index designed to track the volatility (usually, implied volatil-
ity) of the options on a widely traded index, stock, or futures contract. VIX is the
CBOE's Volatility Index. It is a formulaic method of calculating an estimate of 30-day
implied volatility. The VIX formula was updated in 2003 to be based on two strips of
prices of S&P .500 (SPX) options in the two nearest months. The "old" VIX, which is a
simpler formula involving 4 series of OEX options, was replaced in 2003 and can be
quoted under the symbol VXO.
Volatility Skew: the term used to describe a phenomenon in which individual options on
a single underlying instrument have different implied volatilities. In general, not only
are the individual options' implied volatilities different, but they form a pattern. If the
lower striking prices have the lowest implied volatilities, and then implied volatility
progresses higher as one rnoves up through the striking prices, that is called a forward
or positive skew. A reverse or negative skew works in the opposite way: The higher
strikes have the lowest implied volatilities.
Warrant: a long-term, nonstandardized security that is much like an option. Warrants on

stocks allow one to buy (usually one share of) the common at a certain price until a
certain date. Index warrants are generally warrants on the price of foreign indices.
Warrants have also been listed on other things such as cross-currency spreads and the
future price of a barrel of oil.
Weekly Op tion: a listed option that expires one week after it is listed. There are a limited
number of these available-usually 011 the most liquid stocks and indices. They are
generally listed on a Thursday to expire on the following Friday, eight calendar days
later. There is no guarantee that a stock which has weekly options listed one week will
have them the next, although the most active indices and stocks generally have them
each and every week.
Write: to sell an option. The investor who sells is called the writer.
Index
AAPL (Apple), 5, 22,488,492,865,883 interest rates, 416, 421-22, 423, 424-25, 427-28,
adjusted volatility (Beta), 520, 521, 524, 525, 555, 556 429-30,431,446,540,818
aggressive strategies, 973, 975, 976, 979 LEAPS , 368, 372-73, 391, 392-93
See also call buying; bear spreads; bull spreads; put margin, 421, 422-23
buying mathematics, 600-603, 993
American Stock Exchange, 22,490,568,569,574 mergers, 436-41, 446
American vs. European exercise, 7, 494-96, 508, pairs trading, 444-45
544-45,600,606 partial tender ("two-tier") offers, 442-44
AMZN (Amazon), 865, 883 profitability of, 444, 533-35
anticipating assignment, 17-21, 413 ratio writes, 434
applicable stock price (ASP), 958 reversals, 240, 419, 420, 422, 423, 424-27, 428, 429,
arbitrage, 412-46 430,434,446,601-2,991
bearspreads,430,431,432,433 risk arbitrage, 20-21, 416, 435-44
boxspreads,324-25,422-23,430-34,446,602-3 rolling strategy, 426, 427
bull spreads, 430,431,432,433, 602 special dividends, 416-17, 424, 436
butterfly spreads, 434 spreads, 539
carrying costs, 414, 416, 419-20, 420-22, 423, 424, stock market and, 434-35, 541-46
427,428,431,433,43~445,470,499,515,533, straddles. 434
540,602,603,606,722 summary, 428,446,991,993
commissions, 428, 444, 446, 533, 534-35 tender offers, 441-44, 446, 537
conversions, 239-40, 308, 418-19, 419-20, 421,422, time value premium, 415, 416, 417, 428, 429, 436,
423-24,427-28,430,434,446,530,533-34, 437-38,441,444,445,601,602
601-2, 721, 991 trade execution, 535-36
defined,8, 19,412 volatility, 433, 721-22, 793, 882
discounting, 413-15, 446, 600-601 See also option strategies
dividends , 414, 415-18, 419, 420, 421,422,423, 424, AT&T, 14, 44, 488
427,428,429,433,436,445,446,541,605,722 automatic exercise, 18
early assignments, 425, 427, 433 "averaging down," 102, 105-6
equivalence arbitrage, 412,414,415,416,430, 431,
434-35,446
fixed costs, 422, 428 backspreading the puts, 633, 644-46, 648, 649,
index arbitrage, 501, 502, 519, 528-37, 545, 601-2 651,652,653
index option products, 508 backspreads,219,974
institutional strategies, 536-37, 540 See also reverse spreads, reverse ratio call spreads
1031
1032 Index
Barclays, 598, 884-85, 887, 893 boxspreads ,324 -25 ,422-23,430-34,446,602-3

bearish strategies, 15, 984 "broad-based" indices, 492, 496, 507
bear spreads "Brownian motion," 761
arbitrage, 430, 431, 432, 433 bullish strategies, 15, 984
bull spreads vs., 167, 173, 174, 176-77 bull spreads
butterfly spreads, 192, 193, 194, 195, 196 aggressiveness, degrees of, 162-63
call options, 173- 77 arbitrage, 430, 431, 432, 433, 602
commissions, 174, 17,5,177 bear spreads vs., 167, 173, 174, 176-77
defined , 173-75 butterfly spreads, 192-93, 194, 195, 196
diagonal bear spreads, 226-27, 984 calendar spreads, 178, 179, 183-84, 185, 186, 209,
dividends, 177 21~212,320,322,984
follow-up, 177 call buying, 99, 100, 101, 102-3 , 267
futures and futures options, 644 call options, 157-72, 821, 973, 976, 977, 984,
margin, 175 986,989,999
put option buying, 248-49, 251-52 commissions, 160, 161, 162, 163, 164, 165, 166-67,
putspreads,316-19,320,321-22,988,999 168, 169, 171, 172
ratio call spreads, 220-21 covered call writing, 167-72, 263
ratio spreads using puts, 352, 358 defined, 160-62
reverse spreads, 217, 220-21 diagonal bull spreads, 164, 223-26, 984
risk measurement, 820, 821 dividends, 171
selecting position, 176-77 follow-up, 158, 166-67
spreads combining calls and puts, 323-24, 325,331, futures and futures options, 611
332-34,341,343,984 LEAPS, 394-97
straddle selling, 297 "legging" into/out, 159, 167
summary , 177, 821, 973, 976, 977, 984, 986, 988, 999 liquidating the spread, 166-67
time value premium, 176, 177 margin, 157, 158, 161-62, 167, 223
volatility, 733-34, 737, 794-95 put buying and call purchases, 267
volatility derivatives, 944 putspreads,316,319-20,984,999
See also butterfly spreads; call option strategies; ranking bull spreads, 163-66
combining calendar and ratio spreads ratio call spreads, 199, 204-5
best strategy , xxi, 824, 973-80 reverse spreads, 217
commissions, 977 risk measurement, 820, 821
dividends, 974, 975 rolling down, 168, 171, 172
equivalent positions, 974-75, 985, 986 spreads combining calls and puts, 167, 323-24, 325,
follow-up, 977 330,332-33,341
market attitude, 973-74, 983 stock ownership and put buying, 263
mathematical ranking, 976- 78 structured products, 570, 586-91, 592-93, 594, 596
suitability key, 3, 973, 975, 976, 978, 979 summary, 172
summary , 978 time value premium, 164, 166
time value premium, 976, 977 volatility. 163, 164, :2:2.5,723-,31, 7:31-:3:2,733,
See also option strategies 736-37, 797
Beta (adjusted volatility), 520,521,524,525,555,556 See also butterfly spreads; call option strategies;
Black, Fisher, 450 combining calendar and ratio spreads
Black Model, 606-8, 610, 635, 988 butterfly spreads, 187-96
Black-Scholes Model arbitrage, 434
futures and futures options, 635, 637 bear spreads, 192,193,194,195,196
index options, 520, 589-90, 599 bull spreads, 192-93, 194, 195, 196
mathematics, 447-53, 454, 464, 467, 468, 469, 470, commissions, 187, 188, 190, 191, 193, 194
478,480,603,604,605,610,989 defined, 187-90,209
volatility, 714, 715, 716, 753, 791, 802, 855, 860, diagonal butterfly spreads, 227-28, 340-43, 344-45,
863,864 346,347,984,986
blended premiums (futures) , 870-71, 906, 907, 908, 909 dividends, 193
block positioning (facilitation), 206, 445, 474-77 follow-up, 192, 193-95
board broker system, 21 "legging" into/out, 193-94
Index 1033
margin, 188, 192-93 day trading, 91-92

neutral position , 187, 191, 192, 196, 323 defensive strategies, 101-7
ratio call writing vs., 188 defined,32,85
selecting position , 190- 93 delta, 89-91, 92, 93,448, 802-4, 821
spreads combining calls and puts , 323-25 , dividends, llO, ll5, 116
986,999 doing-nothing strategy , 98-99, 100, 101, 267
summary , 196, 974, 977, 984 , 986, 989-90, 999 "fair value," 96
volatility , 191 follow-up, 97-107 , ll2-13, ll6-18, 121, 267
See also bear spreads , call options ; bull spreads , call intermediate calls, 88, 91, 92, 106
options ; call option strategies LEAPS, 85, 93
"buy and hold" strategi es 92 leverage, 85-86, 91, 112
"buying the market," 498, 557 liquidate strategy , 98, 99, 100, 267
"locking in" profits, 98-101
long calls to short stock, altering ratio,
calendar spreads, 178-86 118-21, 122
bearish calendar spreads, 320, 321-22 long-term calls, 85, 88, 89, 91, 92-93, 93,
bullish calendar spreads , 178, 179, 183-84 , 185, 186, 106, Ill
209,210,212,320,322 , 984 macro protection, 919, 920, 921, 925-27
call buying, 106- 7 margin, 85, 99, 107, lll-12, ll5
commissions, 178, 179, 180, 181, 182, 183, 185 mathematics, 466-69
defined, 178-79 near-term calls, 87-88, 91, 106, 129
doing-nothing strategy , 182 option pricing curve, 88-91, 997
dual calendar spreads, 334-38, 340, 343, 346, 347, overpriced calls, 95-96
984, 1000 protected short sale (synthetic put), 108-ll, ll3,
expiration series , using all, 185-86 255,984
follow-up, 181-83, 184-85 putspreads,328-30,334
future options, 653, 654, 662-67 , 678 ratio of long calls to short stock, altering,
LEAPS, 394,399 118-21, 122
"legging " into/out , 181, 184, 185, 186 reverse hedge (synthetic straddle), ll3-21, 143, 173,
margin, 182 217,219,269-70,984,994-95,999
mathematics, 471-72, 473 risk and reward, 86-91
neutral calendar spreads , 179-81, 185, 186, 320, 321, rolling-down strategy, 101-6, 107, 252
:339, 974, 977, 984 rolling-up strategy, 98, 99,100,267
put option buying, 251-52, 254 selecting position, 91-97
putspreads,316,320-22,984,999 short-term trading, 91, 92
ratio calendar combination, 355-57, 984 spread strategy , 91, 98, 99, 101-7, 267
ratio put calendar spreads, 353-55, 984 summary , 121-22, 973,984,986, 994-95, 998,
reverse calendar spreads , 217-19, 787-88, 1000 999, 1000
summary , 186, 821, 974, 977, 984 , 999 synthetic strategies, 108-22, 995
time value premium, 181 taxes, 951-52, 966
volatility, 179, 181, 184, 185, 186, 217, 218, 219, time value premium, 89, 94, 96, ll3, 116, 373
734-36, 787-88 trading against the straddle strategy, 117
volatility derivatives, 892-93, 933-35 underpriced calls, 95, 96
See also call option strategies; combining calendar and volatility, 86, 87, 93-94 , 95, 96-97, ll2 , 113,
ratio spreads ll6, 121, 466
calendar straddles, 338-40, 343-44, 346, 347, 984 See also call option strategies; put buying and call
call assignments and taxes, 955-61 purchases
call buying, 85-122 call exercises and taxes, 954-55
bull spreads, 99, 100, 101, 102-3, 267 call option holders, 15
calendar spreads, 106-7 call options, 3, 4, 22
cash accounts, 107 call option strategies, 32
certainty of timing, 88 put option strategies vs., 230 , 234 , 236, 238 , 240,
commissions, 91, 96, 97, 98, 99, 102, 103, 105, 109, 241,244
1J.'3, 11.5, 117 summary , 228
1034 Index
call option (cont.) conserva tive stra tegies, 973, 975, 979
See also bear spreads, call options; bull sprea ds, call See also bear spreads; bull spreads; covered call
options; butterfly spreads; calendar spreads; call writing
buying; combining calendar and ratio spreads; conversions, 239 - 40, 308, 418-19, 419-20, 421,422,
covered call writing; diagonalizing a spread; 423-24,427-28,430,434,446,530,533 - 34,
long-term option strategies; naked call writing; 601-2, 721, 991
option strategies; ratio call spreads; ratio call covered call writing, 33-84
writing; reverse spreads; spreads combining calls aggressive strategies, 37, 39, 53, 54, 61, 69- 72, 83, 84
and puts; synthetic stock positions created by annualized returns, 40-41, 51-52, 72
puts and calls bull spreads, 167-72, 263
call writers and taxes, 952-53, 966 called away, allowing stock, 77-78
cash-based options, 485, 492, 493-97, 508-9, 510, 512, cash accounts, 42-44, 55, 72
530,539,600,603-5 caution, ,56-57
"cash-based put writing," 280-81 "combined" write, 58-59
cash dividend rate of stock, 4, 14-15, 24 commissions, 40, 42, 43-44, 45, 48, 50-51, 55-56, 58,
Certificates of Deposit, 425 .59. 61, 67, 72, 74. 75, 79. S4. 261
chaos theory, 751-52 conservative covered writes, 40-41, 53,465
Chicago Board of Trade, 616 convertible securities, 78-80, 84
Chicago Board Options Exchange (CBOE) defined,32,33, 744
arbitrage, 412 diversification, 57-60
call options, 112 dividends, 35, 40, 42, 43, 44, 45, 46, 55, 56, 72, 73, 79,
CBOE Futures Exchange (CFE), 862, 867, 81, 83, 84
880,884,909 downside protec t ion, 33, 35, 38, 39, 40, 41, 42, 43-44,
defined,5,21-22 44,47,51,52-53,54,57,59,62,66,67,69,83,
index options, 493 84,384-85,465-66
out options , 359 execution of, 49-51
Portfolio Margin, 1005, 1007 exercise and assignment, 37, 56, 61, 73, 74, 80, 82, 84
volatility, 864, 880, 881, 882, 883, 884, 885, 898, 919 follow-up, 60-72, 76, 84
See also Volatility Index (VIX), CBOE "free" covered call writes, 385-87
Chicago Mercantile Exchange, 499, 500, 623, futures and futures options, 629
626,631 importance of, 33-36
"circuit breakers," 501-2, 542-43 incremen tal return concept (rolling for credits), 78,
classes of options, 6 81-83,84, 132-33,977
closing transactions, 6 interest rates, 48
CME Group, 884 LEAPS, 47, 78, 81, 381-87 , 400
collars (hedge wrappers), 261, 263-66, 593, 794, 919, "legging" into/out, 49-50
928-33 leverage, 47, 71, 386, 387
combining calendar and ratio spreads, 209-16 "locking in a loss," 63-66, 68, 261-62
collateral requirement, 210-11 margin,37,39,40,44-47,48,49,55,58, 72, 76, 1006
commissions, 210, 211, 212 mathematics, 465-66
delta-neutral calendar spreads, 214-15, 216, 821 naked call writing, 56-57, 71, 279-8 1, 744
follow-up, 210, 213-14, 215-16 net (contingent) orders, 50-51, 72, 84
margin, 21.5 net investment, 42, 43, 45
naked options, 210-11, 214, 215, 279 partial-extraction strategy , 73-78, 83
ratio calendar spreads, 209-14, 215, 984 partial roll-down strategy, 66-67
selecting position, 212-13 philosophy of, 36-39, 51
summary , 984 physical location of the stock, 37
time value premium, 212, 215 projected returns, 51-52
volatility, 212 protective strategies, 35, 37, 53, 57, 61-68, 83, 84
See also butterfly spreads; calendar spreads; call put selling, 279-82
option strategies; ratio spreads qualified covered calls, 958-61, 1001-3
commissions. 17 return if exercised, 41-42, 43, 45, 46, 49, 55, 59, 84
See also specific option strategies return if unchanged (static return), 42, 43, 46,
condorspreads,326-28,984,990 49,59,84
Index 1035
return on investment, 41-49 Depository Trust Corporation (OTC) , 37

rolling-down strategy, 61-68, 75, 76, 84, 261-62 derivativesmodels.com , 599
rolling-up/forward strategy, 69-72, 74, 75, 77, 78, 84 diagonalizing a spread, 157, 223-28
selecting position, 51-54, 84 diagonal backspreads, 227-28, 398-99, 984
size of the position, 48 diagonal bear spreads, 226-27, 984
special situations, 78-83, 84 diagonal bull spreads, 164, 223-26, 984
spreads , 66 diagonal butterfly spreads , 227-28, 340-43, 344-45,
stock ownership, 54-57 346,347,984,986
stock ownership and put buying, 260-66, 999 dividends and, 228
straddle selling, 288-91, 991 "free," 226-27
strategy, importance of, 53-54 LEAPS, 394, 395-99, 984
structured products, 567 margin, 223
summary , 83-84, 821, 973, 977, 984, 991, 998 summary, 974, 984
taxes, 73, 956-62, 1001-3 time value premium, 228
time value premium, 72, 73, 74, 76, 77, 82, 83 volatility, 225
total return concept, 39-41, 53-54 See also call option strategies
uncover ed position, avoiding, 76-77 discounting, arbitrage, 413-15, 446, 600-601
volatility, 36, 40, 41, 44, 51, 52, 53, 54, 55, 56, 58, 66, distribution of stock prices, 739-66
75,83,464,466, 765 "big" picture study, 745-48, 747, 750
warrants, 78, 80-81, 84,170,200 bull spreads, 765
See also call option strategies; ratio call writing buyer's rule, 744
covered puts selling, 286, 984 chaos theory, 751-52
credit spreads, 158, 175, 177, 787 cumulative density function (CDF), 448, 761, 989, 991
"crush" of trading, 23 endpoint calculation, 758-60
CSC (Cisco), 264 expected profit, 765
cumulative density function (CDF), 448, 761, 989, 991 fat tails distribution, 745, 746, 747, 753, 762-63, 764,
"customer margin," 505, 626, 630 765-66, 799
historical volatility, 740, 741, 742, 751, 754-58
inflection points, 748
day trading, 91-92 leverage, 744, 745
debit spreads, 158 lognormal distribution, 739-40, 741, 742, 743, 744, 745,
definitions, 3-30 746,752,753,758,761,762,763,764,765,766
delta margin, 745, 748
call buying, 89-91, 92, 93, 448, 802-4, 821 misconceptions, 739-43
defined,802,803,819-20 Monte Carlo calculator, 761, 762-64, 765-66
futures and futures options, 634-35, 821 normal distribution, 743, 744, 745-50, 751, 752
LEAPS, 365, 377-80, 397, 400 option traders, 750-51
mathematics, 855 pricing of options, 753
put option buying, 245-46, 802, 821 probability of stock movement, 753-64, 993
ratio spreads using puts, 353, 991-92 summary, 751-52, 765-66
straddle selling, 304-5, 821 vega (tau), 755
time and delta, 804, 805, 806 volatility skewing, 753
volatility, 709, 710, 711 See also volatility strategies
See also equivalent stock position (ESP); hedge ratio; dividends, 4, 9, 10, 14-15 , 18, 19-21, 22, 24-25, 26
risk measurement See also specific option strategies
delta-neutral "dogs in the Dow," 572
calendar spreads, 214-15, 216, 821 doing-nothing strategy
ratio call writing, 135, 136, 141, 142, 143, 144, 147, calendar spreads, 182
t48, 149,150,151, 155-56,476,991-92 call buying, 98-99, 100, 101, 267
ratio spreads, 201, 202, 203-4, 206-7 , 221-22, 353, put option buying, 247, 248, 250, 251
476,823,824,991-92 straddle selling, 296
spreads, 710-12,974 "doubling up," 133
straddle ratio, 824, 825 Dow-Jones 30 Industrials (DJX), 493, 494,513,597, 748,
volatility, 822-33 882,904
1036 Index
Dow-Jones Industrial Average, 486, 502, 514,541,542, "free" covered call writes, 385-87
543,544,572,578,601,752 "fudge factor," 687, 689
"downtick," 28, 310, 545 futures and futures options, 112, 497-506, 611-53
dual calendar spreads, 334-38, 340, 343, 346, 347, automatic exercise, 621
984, 1000 backspreading the puts, 633, 644-46, 648, 649, 651,
652,653
bear spreads, 644
early (premature) exercise, 19-21 bid-offer spreads, 623-24
Eastman Kodak, 416 Black Model, 606-8, 610, 635, 988
EEM (Emerging Markets ETF), 86,5, 883 bull spreads, 611
Elliott, R. N., 751 carrying costs, 613, 633, 634, 635
EMM (Emerging Markets), 562 cash-based futures, 497-99, 503
end of day trading, 23 commissions, 612, 618, 624-25
equity-linked notes, 596 commodities, 498, 499, 500, 502, 505, 511, 612, 615,
equivalence arbitrage, 412, 414, 415, 416, 430, 431, 616, 617, 618
434-35,446 covered writes, 629
equivalent futures position (EFP), 635, 650, 651, 674, delivery, 617-18
676,923-24,992 delta, 634-35, 821
equivalent positions description, 619-21
best strategy, 974-75, 985, 986 dividends, 499, 515, 516-18, 604, 613, 633, 635, 637,
put buying and call purchases, 269-70 653
put option buying, 255, 259, 260 e-mini futures, 499, 514
equivalent stock position (ESP) equivalent futures position (EFP), 635, 650, 651, 674,
defined,804-7,812,822 676,923-24,992
mathematics, 478-80, 804-7, 992 "fair value," 499, 514-18, 523-24, 528, 533, 534,
ratio call spreads, 206-7, 804-7, 821 535-36,538,539,540,541,542,544,551,557,
ratio call writing, 150-51, 155 603-4,613,623,637,643,992
straddle selling, 298-99, 804-7, 821 follow-up, 647, 650-53
See also delta futures contracts, 612-18
European exercise, 7, 494-96, ,508, 544-45, 600, 606 gam1na,650,807-13,819-20,821,855-56,992
"ever" calculator. 761-62 hedging, 498-99, 612-14
Exchange Traded Funds (ETFs), 6, 22, 511, 562, 566, implied vulatility, 643-44, 649, 651-52, 652
597-99,632,865,883,884-89 index arbitrage, 501, 502, 519, 528-37
Exchange Traded Notes (ETNs), 884-89 interest rates, 499, 500, 504, 613, 618, 633, 635, 636,
exercise and assignment 637,653
defined, 7, 15-21 leverage,498,500,501,614
taxes, 949, 954-63, 966 limits, 501-2, 542-43
exercise limits, 27 margin, 500-501, 503, 505, 613, 614, 615, 616, 617,
exotic options, 567-68 625-30,638,641,648,868
expected returns, 163, 458-64, 478-79, 481, 758-59, market baskets, 513-18, 528, 529, 536, 537, 539,
764-65 540-41, 547
expiration, 4, 5-6, 9, 10, 22-23, 231 mathematics, 603, 606-8, 610, 635-37, 988
options on futures, 619-32
options vs., 612, 616, 617
facilitation (block positioning), 206,445, 474-77 physical currency options, 630-32, 637
"Fact and Fantasy in the Use of Options" (Black), 450 position limits, 625
"far apart" strikes, 165 pricing, 618, 642-50, 651, 653
far- or long-term options, 5 put-call ratios, 511
fat tails distribution, 745, 746, 747, 753, 762-63, 764, quotes, 502
76.5-66. 799 ratio spreading the calls, 633, 646-48, 648-49,
"fighting the market," 57, 828, 845 650-51, 653
"float," 486, 4137,488, 489 serial options, 622-25
formulae. 987-96 slippage, 498
"Fractal Walk Down \Vall Street, A" (Elliott), 751 speculating, 498, 614-15, 618, 977
Index 1037
Standard Portfolio ANalysis of Risk (SPAN), 625-30 glossary, 1009-29

striking price intervals, 621 "good until canceled" stop orders, 29, 152-54
summary , 512, 653, 992 GOOG (Google), 5, 44, 488, 865, 883
taxes, 949 Government National Mortgage Association
terminology 505, 615-16 (GNMA), 410
trading limits , 616-17, 637-42 graphs, 997-1000
trading strategies, 499-502, 616-17, 633-42 "Greeks," 719, 801-2, 855-60
Treasury Bills/option strategy, 500, 612, 614, 615, 616, See also delta; gamma; rho; risk measurement; sigma;
617,618,633,659,673 theta; vega (tau)
volatility, 501, 502, 612, 615, 617, 621, 626, 627, 628- GS (Goldman Sachs), 263,865,883
30, 632,637,642, 643-44, 645,649, 651-52,
652,653,781
volatility derivatives, 867-81, 884, 889-92, 895, 896, hedged strategies using volatility derivatives, 933-41
903-8,920 hedge ratio, 448, 474-77, 481
volatility skewing, 642, 643, 651-52, 653 See also delta
See also arbitrage; futures spreads; index option hedge wrappers (collars), 261, 263-66, 593, 794, 919,
products; option strategies; stock index hedging 928-33
strategies hedging stock with index products. See stock index
Futures Magazine, 620 hedging strategies
futures spreads, 445, 654-78 historical volatility
calendar spreads with, 653, 654, 662-67, 678 distribution of stock prices, 740, 741, 742, 751, 754-58
carrying costs, 655, 660 mathematics, 451-52, 452-53, 685-87, 691, 693, 694,
crack spreads, 660-62 695,697,698,703,863
cross-currency spreads, 659 volatility trading, 767, 769, 771-73, 775-76, 777, 782,
follow-up, 671-76, 678 786,790, 799,863-64
index (inter-index) spreading, 563-64 See also volatility strategies
interest rates, 655, 658, 660 holders, 6, 7, 15, 17-18, 19-20, 21
intermarket, 658-62, 667, 668, 678 Holding Company Depository Receipts (HOLDERS),
intramarket , 655-58, 662, 665, 666, 667, 668, 676, 598
678 honoring the assignment, 16-17
leverage, 658
long combinations, 667-71
margin, 657,659,662,671, 672-73 IBM (IBM), 6, 22, 77, 286, 359, 429, 488, 492, 545, 662,
pricing differentials, 654-55, 656, 657 664,683, 748-50, 751,786,865,883,889,893,
reverse charge markets (contango), 655 915-16,924,934, 1006
stock sector indices, spreading futures against, 676-78 implied dividends, 605-6
summary, 678 implied volatility
TED spreads, 659-60, 669-71 futures and futures options, 643-44, 649, 651-52
time value premium, 667, 668, 669, 670, 671, 672, 673, mathematics, 454-58, 461-62
674,676 volatility trading, 683, 684, 685, 688-90, 691-99,
volatility, 659, 664, 669, 671, 672, 676, 677, 678 700-702,863,864,872
See also futures and futures options See also volatilit y strategies
FXE (Euro Currency ETF), 865, 883 increm ental return concept (rolling for credits), 78,
FXI (China ETF), 562, 865, 883 81-83,84, 132-33,977
index arbitrage, 501, 502, 519, 528-37, 545,
601-2
gamma, 650, 807-13, 819-20, 821, 855-56, 992 index (inter-index) spreading, 445, 559-66, 608
gamma of the gamma, 819-20, 856-59 "fair value," 565
GDX (Gold Miners ETF), 865,883 futures spreads, 563-64
Generalized Autoregressive Conditional margin, 560
Heteroskedasticity (GARCH), 687-88, 758, 767, options in index spreads, 562-66
769, 77,3 ratio of indices, 560-62, 677
General Motors, 416 striking price differential, 565-66
GLD (Gold ETF), 676,865, 883, 884 summary, 566
1038 Index
index (cont.) iron condor spreads, 326-28, 984, 990, 1000

time value premium, 563, 564-65 "irrevocable exercise," 413
volatility, 561,562, 563, 564-65 iShares, 598
See also index option products IUG (implied variance), 881
index option products, 485-512
arbitrage, 508
capitalization-weighted indices, 486-90, 517, 518, 528, Japan's Nikkei Index, 579
531,534,537-38,603 JEM, 579, 580
cash-based options , 485, 492, 493-97, 508-9, 510,
512,530,539,600,603-5
commissions, 495 "kicker," 158
dividends, 490, 49,5 King, Martin Luther, 543
divisor of an index, 486-88, 487, 489, 490, 491,
516-17,518,529,530,531,537-38,548,550
early assignments, 508-9, 510 "legging" into/out of a position, 49-50, 159, 167, 181,
European vs. American exercise, 7, 494-96, 508, 184,185,186, 193-94,296,322,342
,544-45, 600,606 Lehman Brothers, 877-79
exercise and assignment, 493-94, 494-96, 508 leverage, Portfolio Margin, 1007
follow-up, 507 See also specific option strategies
indices, 486-92 limit orders, 28
interest rates, 494 listed options, 3-4, 21, 230, 862-63
leverage , 506 See also options
margin, 492, 496-97, 505, 507, 893 lognormal distribution, 451, 452, 460-61, 462, 469, 739-
mathematics, 600-610 40, 741,742,743,744,745,746,752,753,758,761,
naked options, 507 762,763,764,765,766,992,998
option buying strategy, 506- 7 long stock/long put. See stock ownership and put buying
premiums, 504-5 long-term capital gains and taxes, 949, 950, 951, 952,
price-weighted indices, 490-92, 517,518, 528, 953,954,956-57,959,960,961-62,964-66,968,
529-30,534,538 970-71
put-call ratios, 510-12 Long-term Equity Anticipation Securities (LEAPS), 5,
sectors, 492 22,359
selling index options, 507-8 long-term option strategies, 359-40 0
Standard Portfolio ANalysis of Risk (SPAN), arbitrage, 368, 372-73, 391, 392-93
,505, 100,5 bull spreads, 394- 97
stock market crashes, 508, 519, 542, 543-44 calendar spreads, 394, 399
stock percentage in, 488-89, 491-92 call buying, 85, 93
stock splits, 487, 490-92, 538 "cheap," 375-77, 397
summary, 512 collars, 263, 264
taxes, 949 commissions, 366, 367, 368, 369, 370, 371, 372, 379,
terminology , 505 382,386,388,389,391
time value premium, 504, 505 covered call writing, 47, 78, 81, 381-87, 400
Treasury Bills/option strategy, 536 defined,5,22,359-60
volatility, 492, 505, 781 delta,365,377-80,397,400
volatility skewing, 507, 796 diagonal spreads, 394, 395-99, 984
See also index (inter-index) spreading; futures and dividends, 360,361,362, 363-64, 365,366,367,368,
futures options; option strategies; stock index 369,370,371,372,382,383,384,388,389,
hedging strategies; structured products 392-93,395,400
individual retirement accounts (IRAs), 18 early assignment, 391-93
interest rates. See risk-free interest rates; specific option "fair value," 361
strategies follow-up, 359, 381, 393
in-the-money calls, 7-8, 12-13, 18 interest rates, 360, 361, 362, 363, 364, 365, 366, 368,
intrinsic value of in-lout-of-the-money calls, 7-9, 369,370,375,376,377,384,392,396,400
10-13. 997 leverage, 373, 380, 385, 386, 387
iPath S&P 500 VIX Futures ETNs, 884,885 margin,370,371,383,385,386,387,394,400
Index 1039
pricing, 360-64 gamma, 650, 807-13, 819-20, 821,

protecting stock holdings with LEAPS puts , 371- 72 855-56,992
selling LEAPS, 381-93 gamma of the gamma, 819-20, 856-59
short stock vs., 372-73, 390-91 "Greeks ," 719, 801-2, 855-60
short-term options vs., 364-65 hedge ratio, 448, 474-77, 481
speculative option buying with, 373-80, 977 historical volatility, 451-52, 452-53, 685-87 , 686,
spreads using LEAPS , 394-99, 400 691,693,694,695,697,698,703,863
stocks vs., 366-71 implementation, 480-81
straddle selling, 393 implied dividends, 605-6
structured products , 594-95 implied volatility, 454-58, 461-62
summary , 400,984 index products , 600-610
time value premium, 366,367,369,371,372, 373-75, interest rates , 447, 470, 605, 607
381,384,391-92,393,395-96,398 lognormal distribution, 451, 452, 460-61, 462, 469,
uncovered LEAPS. 387-93 992,998
volatility, 360, 361, 362, 363, 364, 365, 366, 375-76, margin, 479
377, 384,385,393,395,396,398,400,691-92, naked options, 473-74
789-90, 799 neutrality, 837-39
See also put option strategies neutral spreads, 475-77
percent deviation, 859-60
profitability , 466-67 , 468
margin requirements, 17 programming languages for, 480
Portfolio Margin, 1005-7 put options, 469- 71
Standard Portfolio ANalysis of Risk (SPAN), 505, ranking put purchases, 246 - 47
625-30, 1005 ratio strategies, 473-74
See also specific option strategies reward/risk ratio, 469
market attitude , best strategy , 15, 973-74 , 983 rho,818-19,821,856
market-makers, 21-22 risk, 467-69, 855-60
market not held orders, 28, 29 spreads,471-72,473,475-77
market orders, 28 standard deviation (sigma), 327,448,451,452, 740,
"married" put and stock, 965 742,996
Martingale strategy, 133 strategy decisions, 465-74
mathematics, 447-81, 600-610, 855-60 summary , 481
arbitrage, 600-603, 993 theta,816-18,820,821,856
Black Model, 606-8, 610, 635, 988 time value premium, 457, 458, 476, 477
Black-Scholes Model, 447-53, 454,464,467,468, volatility, 44 , 52, 95, 448, 451-58, 461-62, 481,482,
469,470,478,480,603,604,605,610,989 605,606,607,996
calendarspreads , 471-72,473 weighting factor for call prices, 450-51
call buying, 466-69 See also Black-Scholes Model; delta; option strategies;
cash-based index options, 603-5 vega (tau)
closing prices, 159, 191-92, 464 Mayhew, Stewart, 761
covered call writing, 465-66 McMillan Analysis Corp., 123, 761
cumulative density function (CDF) , 448, 761, 989, 991 "mental" stop price, 97
dividends, 450-51, 465,470,471,478,480, mergers , arbitrage , 436-41, 446
603-6, 610 Merrill Lynch, 572, 579, 597, 598, 920, 925, 926
equivalent stock position (ESP), 478- 80, 804-7, 992 "money in the bank," 572-73, 574-75, 580,583
Eu ropean exercise, 606 Monte Carlo calculator, 761, 762-64, 765-66
expected returns, 163, 458-64, 478-79, 481, 758-59, Morgan Stanley, 263, 599
764-65 MSFT (Microsoft), 91
facilitation (block positioning), 206,445 , 474-77
"fair value," 603-4
follow-up, 477-80, 608-10 naked call writing, 123-34
formulae, 987-96 annualized current return, 131
futures and futures options, 603, 606-8, 610, collateral, 126, 127, 128, 133
635-37,988 commissions, 129
1040 Index
naked call writing (cont .) OEX

covered call writing, 56-57 , 71, 279-81, 744 futures and futures options, 693-9,5
defined, 124-26 index options, 490, 493, 494, 508, 518, 532, 545-46,
dividends, l 24 547, .5.51, .5.54,,56.5
"doubling up," 133 taxes, 954
follow-up, 127, 131-34 volatility, 691-92, 759-60, 782, 793, 794, 795, 796,
incremental return concept (rolling for credits), 797,864,872,889,903
1.32-33, 977 opening transactions, 6
investment required, 126-27 open interest, 6
margin, 124, 126, 127, 128, 131 "option delta," 804
marked to market daily, 127, 199, 210 option purchases, sales, and volatility, 713-18
Martingale strategy 133 options, 3-30
monitoring constantly, 128-29, 131 described, 3-9
ratio calendar spreads, 210-11 , 214, 21.5 exercise and assignment, 7, 15-21
ratio call writing, 137, 139, 156 option markets, 21-22
risk and reward, 129-31 option trading, 23-27
selling naked options, 128-29 order entry, 27-29
short sales vs., 124-26, 127, 131 profits and profit graphs, 29-30
stock ownership and put buying, 266 symbology of options, 22-23
strangle writing, 30,3 See also option strategies; pricing options
summary , 134, 821, 974, 977, 984, 986, 998 Options Clearing Corporation (OCC), 7, 16, 17, 18, 22,
time value premium, 123, 124, 130, 134 37,112,133,236,240,632,961, 1007
volatility, 123, 129, 134, 752, 763 Options Symbol Initiative (OSI), 22, 359, 505
See also call option strategies ; ratio call writing option strategies , xv-xxii, 2
naked options equivalent positions, 985, 986
combining calendar and ratio spreads , 210-11, 214, formulae , 987-96
215,279 glossary, 1009-29
index option products, 507 graphs, 997-1000
mathematics, 473- 74 Portfolio Margin requirements, 1005-7
ratio call spreads, 199, 220, 221 summary, 983, 984
straddle selling, 290, 292 , 999 See also arbitrage; best strategy; call option strategies;
volatility, 781 futures and futures options; index option
naked put writing/selling, 279-85 , 286, 998 products; mathematics; options; put option
"narrow-based" indices, 492, 497 strategies; risk measurement; taxes; Treasury
NASDAQ, 310, 743 bills/option strategy; volatility strategies
Index (NDX), 493, 559 option trading, 23-27
-100 (NDX), 562,566,748,882 order entry, 27-29
QQQ, 566, 597, 598, 599, 924 Original Issue Discount (OID), 570
neutral calendar spreads, 179-81, 185, 186, 320, 339, out-of-the-money calls, 7, 8, 10, 12-13, 14
974, 977, 984 over-the-counter options, 4
neutral position
butterfly spreads , 187, 191, 192, 196, 323
mathematics, 475-77 , 837-39 pairs trading, arbitrage , 444-45
multifaceted, 833-37 parity, 9
ratio call writing , 135, 136, 141, 142, 143, 144, 147, partial-extraction strategy, 73-78, 83
148, 149, 150, 151, 155-.56 partial roll-down strategy, 66-67
risk measurement, 800-801, 984 partial tender ("two-tier") offers, 442-44
volatility 710-12 percent deviation, 859-60
New York Stock Exchange Index , 490, 493 per-share basis, 26
New York Stock Exchange (NYSE), 310, ,501, 502 , 543, "phantom interest ," 570- 71
,54.5, 547, 568, .569, 61,5 PHLX Semiconductor Index (SOX), 598, 599
no-cost collars , 928, 929-.30 Portfolio Margin, 1005- 7
notes, 570 See also margin requirements
"notice period, " 618 position limits, 27
Index 1041
premiums, 7-8 short sale vs .. 241-43

pricing options spread strategy, 247, 248-49, 250,251
defined,6, 7-9,9-15,24-26 summary, 821,984,998
distribution of stock prices, 753 time value premium, 244-45, 246, 252, 254
futures, 618, 642-50, 651, 653 Treasury Bills/option strategy, 247
futures spreads, 654-55, 656, 657 volatility, 246,470, 471
LEAPS, 360-64 See also put option strategies
option pricing curve, 88-91, 997 put option holders , 15
put options, 233-34 put option strategies, 230-40
See also Black-Scholes Model anticipating assignment, 237-38
profitability, 466-67, 468 call options vs., 230, 234, 236, 238, 240, 241, 244
profits and profit graphs, 29-30 commissions, 236, 237, 239
program trading, 519-28 conversions, 239-40, 418-19
protected short sale (synthetic put), 108-11, 113, 255, 984 defined,4,22,230,231-33,234
protection using volatility derivatives, 918-33 dividends, 233, 234-36, 237-38, 239, 240
put backspreads, volatility derivatives, 945-47 exercise and assignment, 236-39
put bear spreads, 167 interest rates, 233
put buying and call purchases, 267-77 margin, 236
bull spreads, 267 mathematics, 469-71
commissions, 268, 270, 273, 277 position limits, 238-39
defined,267-68 pricing put options, 233-34
dividends, 270 summary, 358, 997
equivalences, 269- 70 taxes, 952, 953, 962-63, 966
follow-up, 271-74, 276, 277 time value premium, 232-33, 234, 235, 236,
mathematics, 470-71 237-38,240
reverse hedge (synthetic straddle), 270, 999 volatility, 233,238, 470, 471, 721-22
straddles, 268- 71, 273, 984, 995, 999 See also long-term option strategies; option strategies;
strangles, 268, 274-77 put buying and call purchases; put option buying;
summary, 973,984,986,990,995,999, 1000 put selling; put spreads; ratio spreads using puts;
taxes, 952, 966 spreads combining calls and puts; stock
ti me value premium, 277 ownership and put buying (long stock/long put);
trading against the straddle strategy, 273 straddle selling; synthetic stock positions created
volatility, 269, 271, 272, 470 by puts and calls
See also put option strategies put selling, 278-87
put option buying, 241-55 "cash-based put writing," 280-81
bearspreads,248-49,251-52 commissions, 281, 282, 283, 284, 286
calendar spreads, 251-52, 254 covered call writing, 279-82
call spreads, 330-31 covered puts, 286, 984
combining put and call strategy, 247, 249-50, 251 dividends, 281, 286, 287
commissions, 247,249,252,253,254 follow-up, 281-82
delta, 245-46, 802, 821 leverage, 286
dividends, 243 margin, 280, 282, 286
doing-nothing strategy, 247, 248, 2,50, 251 naked put writing, 279-85, 286, 984, 998
equivalent positions, 255, 259, 260 ratio put writing, 286-87, 984, 999
follow-up, 247-51 rolling-down/forward strategy, 281-82
leverage, 241, 242-43, 256 stock buying below market price , 285-86
liquidate strategy, 247, 248, 249, 250 summary, 984, 998, 999
"locking in profits, " 247-51 time value premium, 280, 281, 286, 287
loss-limiting actions, 251-54 uncovered puts, 278-81
margin, 241,254 volatility, 285
ranking put purchases, 246-47 See also put option strategies
rolling-down strategy, 247, 248, 250, 251 putspreads,316-22
rolling-up stra tegy, 251-52, 252-54, 254 bearspreads,316-19,320,321-22,988,999
selecting position, 243-46 bull spreads, 316, 319-20, 984, 999
1042 Index
put spreads (cont.) dividends, 154

calendar spreads, 316, 320-22, 984 , 999 equivalent stock position (ESP), 150-51, 155, 804- 7
commissions, 317, 320, 321 follow-up, 136, 137, 141, 146-56
dividends, 321 "good until canceled" stop orders, 29, 152-54
"legging" into/out, 322 investment required, 138-40
margin, 319 "locking in profits," 155
summary, 919,984,999 margin, 136, 138, 140
time value premium, 318-19, 321 naked call writing, 137, 139, 156
See also put option strategies neutral position, 135, 136, 141, 142, 143, 144, 147, 148,
149,150,151, 155-56
ratio call spreads vs., 197, 198-99, 200-201, 202,
QQQ, 566, 597, 598, 599, 924 204,208
qualified covered calls, 958-61, 1001-3 ratio put writing vs., 286-87
quote montage, 5 rolling strategies, 146-49, 150, 155, 156
selecting position, 140-43
stop orders, 28-29, 152-54 , 155, 156
ratio calendar spreads, 209-14, 215, 984 straddle selling, 305
ratio call spreads, 197-208 summary, 156, 821, 974, 976, 977, 984, 986, 991, 993,
adjusting the delta, 206- 7 995, 999, 1000
altering the ratio, 202-3, 208 time value premium, 138, 147, 156
bearspreads,220-21 variable ratio write (synthetic short strangle), 143-46,
bull spreads, 199, 204-5 995, 1000
commissions, 197, 198,200,206,221 volatility, 141, 155, 156, 794-95
credits, 200, 201-2, 220 See also call option strategies; covered call writing;
defined, 197-99 naked call writing
delta-neutral ratio spreads, 201,202, 203-4, 206-7, ratio put writing, 286-87, 974, 984, 999
221-22,353,476,823,824,991-92 ratio spreads
dividends, 200 futures and futures options, 633, 646-48, 648-49,
equivalent stock position (ESP), 206-7, 804-7, 821 650-51, 65.3
follow-up, 204-8 VIX options, 941-47
margin, 199 ratio spreads using puts, 348-58
naked options , 199, 220, 221 bearspreads,352,358
philosophies , 200-204 commissions, 349, ,354, 355, 356-57
ratio call writing vs., 197, 198-99, 200-201, 202, defined,348-53
204,208 delta, 353, 991-92
reducing the ratio, 204-6 follow-up, 350-51, 354, 355, 356-57
reverse ratio call spreads (backspreads), 219-22, 227, margin, 350,352,355
737-38, 794, 795-96, 797,930-33 ratio calendar combination, 355-57, 984
risk measurement, 840, 841-45 ratio put calendar spreads, 353-55, 984
rolling down, 204 summary, 821, 974, 977, 984, 994 , 1000
summary, 208, 984, 994, 1000 time value premium, 350-51, 353
time value premium, 200, 201, 203, 208 volatility, 351,357, 736-38, 944-47
volatility, 797, 821, 942-44, 947 See also put option strategies
See also call option strategies; combining calendar and regional option exchanges, 22
ratio spreads reversals, 240, 419,420,422,423, 424-27, 428,429,430,
ratio call writing, 135-56 434,446,601-2,991
adjusting with the delta, 148, 149-52 reverse hedge (synthetic straddle), 113-21, 143, 173,217,
butterfly spreads vs., 188 219, 269-70, 984, 994-9,5, 999
closing out the write, 154-55 reverse spreads, 217-22
collateral required, 139-40 bearspreads ,2 17,220-21
commissions, 136, 138-39, 147, 149, 154, 155 bull spreads, 217
defined,135-38 commissions, 220, 221
delta-neutral trading, 135, 136, 141, 142, 143, 144, 147, defined,217
148,149,150,151, 155-56,476,991-92 follow-up, 222
Index 1043
margin, 217, 218-19 RUG (realized variance), 881

reverse calendar spreads, 217-19, 787-88, 1000 Russell 2000 Growth Fund, 598
reverse ratio call spreads (backspreads), 219-22, 227, Russell 2000 Index (RUT), 882
737-38, 794, 795-96, 797,930-33 Russell 2000 (IWM), 562
summary, 984, 1000 Russell 2000 Value Fund, 598
volatility, 217, 218, 219, 222 Russian debt problems, 741
See also call option strategies
reward/risk ratio, 469
rho,818-19,821,856 Scientific American, 751
risk arbitrage, 20-21, 416, 435-44 SEC. 496
"risk array," 626 secondary markets, 17, 18
risk-free interest rates, 9, 10, 14, 360, 448, 449, 450, 464, Semiconductor HOLDRS (SMH), 598-99
575,580,604,606,607,610,637,690,801,856 series of options, 6
risk measurement, 800-855 settlement cycle, 23
bearspreads,820,821 "shares per contract," 804
bull spreads, 820, 821 "shares per option," 151, 804
commissions, 823 short- or near-term options, 5
delta neutral, 822-33 short-sale rule, 964-66
evaluation, 839-46 short side, 158
"fair value," 823 short-term capital gains, 949, 950, 951, 952, 953, 954,
follow-up, 822, 845-46 955,956,957,958,959,960,961,962,965,
gamma,650,807-13,819-20,821,855-56,992 966-69, 970-71
gamma of the gamma, 819-20, 856-59 sigma (standard deviation), 327, 448, 451, 452, 740, 742,
initial position, 841-45 996
interest rates, 818-19, 821, 861 Simpson's Rule, 463
mathematics, 467-69, 855-60 60/40 rule, 953-54
multifaceted neutrality, 833-37 SKEW, 885
neutral position, 800-801, 984 "sliding scale," 608-10
ratio spread, 841-45 SLY (Silver ETF), 863, 865
rho,818-19,821,856 "smoothing" effect, 456-57
strategy considerations, 820-55 Societe Generale, 90,5
summary, 860-61, 992 speculating
theta,816-18,820,821,856 LEAPS, 373-80, 977
time value premium, 804 volatility derivatives, 910-12, 915-17, 977
trading long gamma, 847-55 "splitting a quote," 159
volatility skewing, 832-33 splitting the strikes, 311-14
See also delta; vega (tau); volatility strategies "spot/spot price," 617
risk/reward summary, 983, 984 spreads combining calls and puts, 323-47
RMBS (Rambus), 776, 777 bearspreads,323-24,325,331,332-34,341,343,984
rolling for credits (incremental return concept), 78, boxspreads,324-25,422-23,430-34,446,602-3
81-83,84, 132-33,977 bull spreads, 167,323-24,325,330,332-33,341
rolling strategies butterfly spreads, 323-25, 986, 999
arbitrage, 426, 427 calendar straddles, 338-40, 343-44, 346, 347, 984
bull spreads, 168, 171, 172 call buying and put spreads, 328-30, 334
call buying, 98, 99, 100, 101-6, 107, 252, 267 commissions, 325, 326, 333, 334, 335, 337, 338, 339,
covered call writing, 61-72, 74, 75, 76, 77, 78, 84, 340-41,342,343
261-62 condor/iron condor spreads, 326-28, 984, 990, 1000
put option buying, 247,248,250, 251-54 diagonal butterfly spreads, 340-43, 344-45, 346, 347,
put selling, 281-82 984,986
ratio call spreads, 204 dual calendar spreads, 334-38, 340, 343, 346, 347,
ratio call writing, 146-49, 150, 155, 156 984, 1000
structured products, 595-96 follow-up, 327-28, 332-34
rotation system, 23-24 "legging" into/out, 342
Rubenstein, Mark, 752 "locking-in" profits, 333
1044 Index
spreads (cont.) collateral requirements, 557

margin, 327, 329, 331, 333, 347 commissions, 519
put buying and call spreads, 330-31 dividends, 515, 516-18, 541
selecting position, 343-46 execution risk, 540
straddle writes, 299-300 expiration, rush to exit, 544-46
summary, 346-47, 974, 977, 984, 986, 990, 999, 1000 follow-up, 527, 537-40
time value premium, 338, 339, 341, 344 high-capitalization stocks, 547-51
volatility, 327, 328, 335, 336, 343, 344, 345 index arbitrage, 501, 502, 519, 528-37
See also put option strategies index calls, 527-28
spread strategies index options, 522-24
arbitrage, 539 index puts, 524-27
call buying, 91, 98, 99, 100, 101-7, 267 interest rates, 517, 540
covered call writing, 66 margin, 536, 551, 557
defined,24,27,29 market baskets, 513-18, 528, 529, 536, 537, ,539,
horizontal spreads, 157, 158, 178 540-41, 547
introduction to, 157-62 market risk, removing, 519- 20
margin, 107 min-index, creating, 547-51, 552, 553-54
mathematics, 471-72, 473, 475-77 monitoring the hedge, 552-54
put option buying, 247, 248-49, 250, 251 options vs. futures, 554-55
summary, 976 portfolio hedge, 520-22
taxes,950,970-71 portfolio insurance, 543-44
theoretical value of the, 472 present worth, 516-18
vertical spreads, 157, 160, 173, 223, 224, 731-33, 744 program trading, 519-28
volatility 731-33 ratio writes, 527
See also bear spreads, call options; bull spreads, call rolling to another month, 538-40
options; butterfly spreads; calendar spreads; shares to buy, 529-33
combining calendar and ratio spreads; simulating an index, 546-55, 923
diagonalizing a spread; put spreads; ratio call stock market impacted by, 435, 541-46
spreads; ratio spreads using puts; reverse spreads; summary, 5,57-58
spreads combining calls and puts time value premium, 528
standard deviation (sigma), 327, 448, 451, 452, tracking error, 519, 520, 522, 541, 55 1-52,
740, 742, 996 555-57, 918
standardization of option contracts, 4-5, 7 volatility, 520, 521, 522, 524, 525, 543, 547, 555, 556
Standard & Poor's 100 Index. See OEX See also arbitrage; futures and futures options; index
Standard & Poor's 400 Index, 490 option products
Standard & Poor's ,500 Futures, 498,499,500, 501, 503, Stock Index return Security (SIS), 574-79
504,510,612,616,620,621,622,623,625,626, stock markets
627,628 arbitrage impact on, 434-35, 541-46
Standard & Poor's 500 Index (SPX), 5 crashes, 508, 519, 542, 543-44, 702, 715, 717, 745,
distribution of stock prices, 748 748,752,792,864,867,897,906,920
volatility and "beating the market," 681 option markets, 21
See also index option products; volatility derivatives stock ownership, covered call writing, 54-57
Standard & Poor's Bond/Stock Guide, 78 stock ownership and put buying (long stock/long put),
Standard & Poor's Depository Receipt (SPDR, "Spiders") 243,256-66
(SPY), 351, 545, 562, 597, 598, 910, 935-36, 937, adjusting the collar, 266
938,939,940,941,943,944 bull spreads, 263
Standard & Poor's Midcap 400 Index (MID), 574, 575, collars (hedge wrappers), 261, 263-66, 794
.576,577,578,579 commissions, 261
Standard Portfolio ANalysis of Risk (SPAN), 505, covered call writing, 260-66, 999
625-30, 1005 dividends, 259,261,264
"stimulating" stock purchase, 171 interest rates, 264
stock index hedging strategies, 513-58 leverage, 256
adjusted capitalization, 521,523,524, 525,555,556 lower strikes, partial covered writes, 264-66
Beta (adjusted volatility), 520,521,524,525, ,555, 556 naked call writing, 266
Index 1045
no-cost collars. 263-66 adjustment factors , 580-85

protection from, 256-58, 259 bull spreads, 570, 586-91, 592-93, 594 , 596
selecting position, 258-60 call options on an index, 570
summary , 984, 998 , 999 cash surrender value , 571-72, 573, 581, 584, .585, 586
taxes, 260 collars, 593
volatility , 264 covered call writes, 567
See also put option strategies debt (senior debt), 569
stock prices. See distribution of stock prices dividends, 567, 572, 573, 577, 598
stock sector indices , spreading futures against , 676-78 Exchange Traded Funds (ETFs), 6, 22, 511, 562, 566,
stock splits, 4, 24-26, 151, 418, 452, 487, 490-91, 492, ,597-99, 632, 865, 883, 884-89
538, 554, ,597, 619, 653, 961 expiration dates, multiple, 591
stocks vs. LEAPS, 366-71 financial engineers, 568, 586
stop-limit orders, 29 imbedded calls, 572-73, 575,580
stop orders , 28-29, 152-54, 155, 156 interest rates, 573, 574
straddles LEAPS. 594-95
arbitrage , 434 lists of, 596
put buying and call purchases , 268-71, 273, 984, margin , 593
995,999 multiplier computation, 592-93
strangles, 300-306, 974, 976, 977, 986 naked calls, 593
\·olatilitv. 29:3. 29--L:304. 712. 722-2:"3,,k:3, ,9K option strategies involving, 591-96
straddle selling, 288-306 price behavior prior to maturity, 573-74
bear spreads, 297 "riskless" ownership, 568- 71
commissions, 289, 290, 296, 297, .300, 305 rolling strategy, 595-96
covered call writes, 288-91, 991 Stock Index return Security (SIS), 574-79
credits , using, 306 striking price , changing the, 594-96
delta, 304-5, 821 summary, 599
doing-nothing strategy, 296 synthetic long calls, 596
equivalent stock position (ESP), 298-99, taxes. 570-71
804-7, 821 time value premium, 590, 595
excess trading, avoiding, 305 volatility, 567, 572, 573, 575, 580, 589, 591, 595,
follow-up, 291, 292, 294-99, 301, 304, 305 598,599
LEAPS, 393 zero-coupon bonds, 569- 70
"legging" into/out, 296 See also futures and futures options; index option
leverage , 289 products
margin, 291, 292, 297, 298, 300, 303 "subprime debt," 876, 898, 910, 923
naked options, 290, 292, 999 suitability key, best strategy, 3, 973, 975, 976,
protection, starting out with, 299-300 978,979
ratio call writes, 305 symbology of options, 22-23
rolling-up/down strategy, 296 synthetic convertible bond, 404-5
selecting position, 293-94 synthetic put (protected short sale), 108-11, 113,
strangle writing, 300-306 255,984
summary, 821, 825-32, 975, 984, 990, 991, 995, synthetic short strangle (variable ratio write), 143-46,
999, 1000 995, 1000
uncovered straddle writes, 291-93, 304-6 synthetic stock positions created by puts and calls,
volatility, 293, 294, 304 :307 -1,5
See also put option strategies bearishly oriented, 313-14
strangles bullishly oriented, 311-13
put buying and call purchases, 268, 274-77 commissions, 311, 313
straddle selling, 300-306 dividends, 308, 309, 311
synthetic strangles, 121 leverage , 309, 310-ll
volatility, 723, 780 margin, .307, 308, 309, 310
striking price, 3, 4, 5, 6, 8, 9, 10, 11, 12, 13, 14, 22-23, splitting the strikes , 311-14
24-26,231 summary , 314-15, 984
structured products, 567-99 synthetic long stock, 307-9
1046 Index
synthetic stock (cont.) time value premium decay, 13-14, 89,998

synthetic short sale, 307, 309-11, 984 total return concept, 39-41, 53-54
time value premium, 308, 309, 311 tracking error, 519,520, .522, 541, ,551-52,
See also put option strategies 555-57, 918
synthetic strategies, 108-22, 995 trapezoidal hedge (variable ratio write), 143-46, 995,
1000
Trapezoidal Rule, 463
"taking a partial profit," 101 Treasury Bills/option strategy, 368, 370, 387, 389, 397,
"targets," 680-81 403-11
tau. See vega commissions, 409
taxes, 949-72 defined,403-.S
basics, 951-,54 futures and futures options, 500, 612, 614, 615, 616,
call assignments, 9,55-61 617,618,633,659,673
call buyers, 951-52, 966 index options, 536
call exercises, 954-55 interest rates, 404, 409, 411
call writers, 952-,53, 966 margin, 411
commissions, 951, 952, 953, 9,55, 959, 962, 966, 967, put options, 233, 239, 247, 306, 368, 370, 387, 389,
968,969,970,971 397
covered call writing, 73, 956-62, 1001-3 risk, 403,404, 406-7, 408-11, 411, 988
deferring gains, 966- 70 risk-free interest rates, 9, 10, 14, 360, 448, 449, 4.50,
dividends, 961, 964, 968 464,575,580,604,606,607,610,637,690,801,
exercise and assignment, 949, 954-63, 966 856
futures options, 949 summary, 411, 974, 975, 976, 977, 979-80, 988
history , 949-50 synthetic convertible bond, 404-5
holding period for transactions, 949, 950 See also option strategies
index option products, 949 TVIX/TVIZ, 885
long-term capital gains, 949, 950, 951, 952, 953, 954,
956-57,959,960,961-62,964-66,968,970-71
margin, 964, 968 uncovered call options. See naked call writing; ratio call
"new" stock for avoiding long-term gain, 961-62 writing
planning strategies for equity options, 966-71 uncovered LEAPS, 387-93
put options, 952, 953, 962-63, 966 uncovered position, covered call writing, 76- 77
qualified covered call writes, 958-61, 1001-3 uncovered put selling, 278-81
short-sale rule, 964-66 uncovered straddle writes, 291-93, 304-6
short-term capital gains, 949, 950, 951, 952, 953, 954, "unencumbered" shares, 73
955,956,957,958,959,960,961,962,965, UNG (US Natural Gas Fund ETF), 886
966-69,970-71 USO (US Oil Fund ETF), 676, 677, 865, 883,
60/40 rule, 953-54 884,886
special tax problems, 963-66
spreads,950,970-71
stock cost or sale price and option premium, 951-52 value of options, 4
stock ownership and put buying, 260 variable ratio write (synthetic short strangle), 143-46,
structured products, 570- 71 99.S, 1000
summary, 966, 971-72, 1001-3 Variance Futures, 880-81
time value premium, 966, 967, 969, 971 vega (tau)
wash sale rule, 963-64, 966 defined,813-16,820,821
See also option strategies distribution of stock prices, 755
"telescoping" action points, 155 mathematics, 856
tender offers, 441-44, 446, 537 volatility, 705-9, 710, 712-13, 719, 720, 724, 727, 734,
theta, 816-18, 820, 821, 8.56 73,5,7:37,7:38
"tight" quotes, 1.59 volatility trading, 780, 787, 788, 789
time spreads. See calendar spreads See also risk measurement
time value premium, 7-9, 11, 12, 13, 234 Velocityshares, 88.S
See also specific option strategies VIX/SPXhedge, 878, 935-41
Index 1047
VIX/VIIX/VIXY, 885 stock market crashes, 702, 715, 717, 745, 748, 752,
volatility and popular strategies, 705-38 792,864,867,897,906,920
arbitrage, 433, 721-22, 793, 882 stock ownership and put buying, 264
bear spreads, 733-34,737, 794_g5 straddles, 293, 294, 304, 712, 722-23, 783, 798
bull spreads, 163, 164, 225, 723-31, 731-32, 733, strangles, 723, 780
736-37, 797 structured products, 567, 572, 573, 575, 580, 589, 591,
butterfly spreads, 191 595,598,599
calendar spreads, 179,181,184,185,186,217,218, summary, 738
219, 734-36, 787-88 time value premium, 718-21, 722, 736, 738
call buying, 86, 87, 93-94, 95, 96-97, 112, 113, 116, vega (tau), 705-9, 710, 712-13, 719, 720, 724, 727,
121,466 734,735,737,738
combining calendar and ratio spreads, 212 vertical put spreads, 731-33
commissions, 729, 732 volatility derivatives, 862-948
covered call writing, 36, 40, 41, 44, 51, 52, 53, 54, 55, adjusting the collar, 928-29
56,58,66, 75,83,464,466, 765 bear spreads, 944
defined,9 , 10, 14,15 blended premiums (futures), 870-71, 906,907,
delta, 709, 710, 711 908,909
delta-neutral spreads, 710-12, 974 calendar spreads, 892-93, 933-35
diagonalizing a spread, 225 calls for macro protection, 919, 920, 921, 925-27
dividends, 706, 707, 708, 719, 721, 722 collars (hedge wrappers), 919, 928-33
excess value, 718-21 commissions, 868, 893, 917, 931, 935, 939
futures and futures options, 501,502, 612, 615, 617, discounts and futures, 870-71, 903-8
621,626,627,628-30,632,637,642,643-44, dividends, 829
645,649,651-52,653, 781 dynamic protection, 921
futures spreads, 659, 664, 669, 671, 672, 676, 677, 678 "fair value," 863, 864
index (inter-index) spreading, 561, 562, 563, 564-65 follow-up, 935
index option products, 492, 505, 781 futures,867-81,889-92,895,896,903-8,920
interest rates, 706, 707, 708, 717, 719, 721 hedged strategies using, 933-41
LEAPS, 360,361,362,363,364,365,366, 375-76, interest rates, 890, 899, 900
377,384,385,393,395,396,398,400,691-92, leverage,867,868,908-9,910,912,915,934,935
789-90, 799 listed VIX options, 889-98
margin, 719, 732 macro approach to protection, 918-33
mathematics, 44, 52, 95,448, 451-58, 461-62, 481, margin, 867, 868, 874, 880, 893, 909, 912, 913-14,
482,605,606,607,996 915,932,933,934,943,944,946
naked call writing, 123, 129, 134, 752, 763 micro approach to protection, 918
naked options, 781 no-cost collars, 928, 929-30
neutral position, 710-12 other listed volatility products, 882-89
option purchases, 713-18 premiums and futures, 870-71, 903-8
option sales, 718 protection cost and VIX, 900-901
put buying and call purchases, 269, 271, 272, 470 protection using, 918-33
put option buying, 246, 470, 471 put backspreads, 945-47
put option strategies, 233, 238, 470, 471, 721-22 puts for macro protection, 918-19, 921-24
put selling, 285 ratio spreads with VIX options, 941-47
ratio call spreads, 797, 821, 942-44, 947 reverse ratio call spreads (backspreads), 930-33
ratio call writing, 141, 155, 156, 794-95 skews in VIX options, 896-98
ratio spreads using puts, 351, 357, 736-38, 944-47 speculating, 910-12, 915-17, 977
reverse calendar spreads, 787-88 summary, 903,933,941, 947-48
reverse ratio call spreads (backspreads), 737-38, 794, term structure of futures, 871-80, 872, 874, 876, 877,
795-96, 797,930-33 878, 908-17
reverse spreads, 217,218,219, 222 time value premium, 892, 937
spreads combining calls and puts, 327, 328, 335, 336, trading strategies, 898-903
343,344,345 trend of volatility, 900-903
stock index hedging strategies, 520,521, 522,524,525, Variance Futures , 880-81
,543, 547,555,556 VIX/SPX hedge, 878, 935-41
1048 Index
Volatility Index (VIX), CBOE, 717, 741, 742, 862-63, ratio call spreads, 797
864-67,868,882,888,898,903-4 ratio call writing, 794-95
volatility skewing reading the volati lity chart, 773- 75
distribution of stock prices, 753 reverse calendar spreads, 787-88
futures and futures options, 642, 643, reverse ratio call spreads (backspreads), 794, 795-96,
6,51-52, 653 797, 9,30-33
index option products, 507, 796 selecting position, 778-80, 790-91
risk measurement, 832-33 selling volatility, 703, 780-81, 787-90
volatility trading, 768, 791-98 stock price history, 783-86, 799
volatility strategies, 680-82 summary, 703-4, 790-91, 798-99, 860, 973-74
See also distribution of stock prices; historical time value premium, 788
volatility; implied volatility; option strategies; risk trend of volatility, 773-75
measurement; taxes; volatility and popular vega (tau), 780, 787, 788, 789
strategies; volatility derivatives; volatility volatility backspreads, 781, 788-89
skewing; volatility trading volatility of volatility, 690-98, 872, 893-95
volatility trading, 97, 113, 683-704, 767-99 volatility prediction, 768-91, 799
bear spreads, 794-95 volatility skewing, 768, 791-98
bull spreads, 797 See also backspreads; butterfly spreads; delta-neutral,
calendar spreads, 787-88 spreads; historical volatility; neutral calendar
commissions, 768, 780, 781, 783, 787 spreads; ratio call writing; ratio spreads; reverse
composite reading, 770 hedge; reverse spreads; straddles; strangles;
definitions, 684-87 volatility strategies
dividends, 689, 690 volume "screens," 464
follow-up, 768-69, 797-98 VTY/VWA/VWB/VXD/VXN, 882
"fudge factor," 687, 689 VXO, 864, 866, 898-99, 902
fundamentals, checking, 778 See also Volatility Index (VIX), CBOE
futures and futures options, 781 VXX, 884, 885, 886, 887, 888, 889, 895
Generalized Autoregressive Conditional VXZ, 885, 886
Heteroskedasticity (GARCH), 687-88, 758, 767,
769,773
implied volatility, 683, 684, 685, 688-90, 691-99, warrants, 78, 80-81, 84, 170, 200
700-702,863,864,872 wash sale rule, 963-64, 966
index options, 781 "wasting" asset, 4
interest rates, 689 weekly options, 5-6
LEAPS, 789-90, 799 writers, 6-7, 14, 16
margin, 781, 783, 787, 790, 793
moving averages, 688
naked options, 781 XAU (Gold & Silver Index), 676
past movements study, 786-87, 790 Xerox, 14, 86,5
percentile approach, 769-71, 772 XLE (Energy ETF), 865, 883
probability calculators, 782-83, 790, 798 XOI (Oil & Gas Sector), 676, 677
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PRENTICE HALL PRESS

Preface ........................................................ . ... . .. xv

Selecting a Covered Writing Position. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

Follotc - UJJAction ... 204

Selling LEAPS ............................................. . .......... 381

Price Behavior Prior to Maturity . . . . .. .. .... . ............................ 573

Trading the Volatility Skew . .. .... ... ............................ . ....... 791

Postscript . . ................... .. .......................... ... 979

Glossary . ........................................................... 1009

Spreads, the reverse calendar spread is described in detail because-in a high-volatility

The successful implementation of various investment strategies necessitates a sound work-

Four specifications uniquely describe any option contract:

1. the type (put or call),

THE VALUE OF OPTIONS

1. the January/April/July/October cycle,

The Price of an Option. Options trade in one-penny increments in many cases.

THE OPTION ITSELF: OTHER DEFINITIONS

Opening and Closing Transactions. An opening transaction is the initial transac-

RELATIONSHIP OF THE OPTION PRICE AND STOCK PRICE

FACTORS INFLUENCING THE PRICE OF AN OPTION

1. price of the underlying stock,

THE FOUR MAJOR DETERMINANTS

~ THE TWO MINOR DETERMINANTS

EXERCISE AND ASSIGNMENT: THE MECHANICS

EXERCISING THE OPTION

HON O RING THE ASSIGNMENT

Margin Requirements. If the assigned writer purchases stock to fulfill a contract,

AFTER EXERCISING THE OPTION

1. a call that is in-the-money at expiration,

Automatic Exercise. Assignment is all but certain if the option is in-the-mone:· at

must be sold to realize the gain.

1. Buy the January 40 call at 9.80.

Time value Call Striking Stock

Early Exercise Due to Dividends on the Underlying Stock. Sometimes the

1. Buy th e XYZ Janua ry 40 call at 10.25.

THE OPTION MARKETS

IB M Jan (21) 2011 45 call

DETAILS OF OPTION TRADING

POSITION LIMIT AND EXERCISELIMIT

Of the various types of orders, each specifies:

1. whether the transaction is a buy or sell,

Good-Until-Canceled Order. A limit, stop, or stop-limit order may be designated

PROFITS AND PROFIT GRAPHS

Stock Price at Expiration

In 1Jrnctice. such an example is too simple to require a table or a graph-certainly

J..__ ______________ __J

THE IMPORTANCE OF COVERED CALL WRITING

COVERED CALL WRITING FOR DOWNSIDE PROTECTION

THE BENEFITS OF AN INCREASE IN STOCK PRICE

Maximum profit potential= Strike price - Stock price+ Call price

QUANTIFICATION OF THE COVERED WRITE

Stock Price at Expiration

COVERED WRITING PHILOSOPHY

PHYSICAL LOCATION OF THE STOCK

TYPES OF COVERED WRITES

THE TOTAL RETURN CONCEPT

THE CONSERVATIVECOVERED WRITE

COMPUTING RETURNON INVESTMENT

J.. __________ J