A student shared with me a hedge that he was constructing for his client with a large equity portfolio.  The student chose the QID (ETF: ProShares UltraShort QQQ) as a hedge for his client, but rather than buy 50oo shares of QID he wanted to do a Skip Strike Slingshot Hedge.  The student also thought that rather than use the shares as part of the slingshot hedge, he would buy the at-the-money JAN(2011) 17 Strike (Long Call / Short Put) Combo.

ANALYSIS of Proposed Trade

Conceptually, what he wanted to do was fine.  In reality it would be very difficult to execute or transact the planned strategy.  The proposed strategy position would have generated a $5503 Credit, which seems attractive.  However, to execute a total of 350 contracts, shown in Rows 19&20 in the image below, it would have to be done as 3 trades with a lot of Delta exposure along the way. 

Most inefficient way to enter the orders: Short 50 JAN 17 Combos plus Long 50 JAN 16 Puts plus Short 100 JAN 18/25 Call Verticals.

Less inefficient way to enter the orders: Short 50 JAN 16/17 Put Verticals plus Long 50 JAN 17/18 Call Verticals plus (50) by 100 JAN 18/25 Call (LongMore) Back Spreads.

Least inefficient way to enter the orders: Short 50 JAN 16/17 Put Verticals plus Long 50 JAN 17/18/25 Unbalanced Butterflies plus Long 50 extra JAN 25 Calls.

There are many other ways but some legs require a lot of margin, for example doing 50 JAN 17/18 Call (ShortMore) Ratio Spreads plus 100 JAN 25 Calls plus Short 50 JAN 16/17 Put Verticals

It turns out that this can be done with only 250 contracts, shown in Row 31 in the image below, as it is not necessary to buy shares or the JAN 17 Combo as a substitute for the shares. 

ALTERNATIVE to Proposed Trade

Using the Risk Doctor’s New Risk Illustrator Software to remove 50 JAN 16/17 Boxes, we can see that there are at least three better ways to go about it:

Removing the 50 JAN 16/17 ‘3-Legged Box’ (in Rows 19 & 20) via the 50 Dissected-Out Boxes, demonstrated in Rows 28&29, yields the 50 Synthetically Long Jan 16 Calls) in column AG, Row 31 where the overall Synthetic Equivalent is the Better Position to Achieve the Objective.

Good way to enter the orders: Long 50 JAN 16 Calls plus Short 100 JAN 18/25 Call Verticals.

Better way to enter the orders:  Long 50 JAN 16/18 Call Verticals plus (50) by 100 JAN 18/25 Call (LongMore) Back Spreads.

Best way** to enter the orders: Long 50 JAN  16/18/25 Unbalanced Butterflies plus Long 50 Extra JAN 25 Calls

Any of these orders can be entered in any order, which one depends on your short term market opinion.

Legend:

Pink Solid Bolder Line is the Profit and Loss profile at Expiration 289 days away.

Pink Solid Thinner Curved Line is the Profit and Loss profile for the current day with 289 days to go until expiration.

*More details on this subject in Chapter 6 and 9 of “Options Trading: The Hidden Reality”.

**  This would be the best way if your trading platform can accomodate an unbalanced butterfly as a single order and if the order is fillable by the counterparties rather quickly for a fair price that is not much beyond the aggregate average between the bid and ask price.

My Favorite SOS – ITM* Put Back Spread for Credit Was Once One Guru’s Favorite Trade....

By Charles Cottle

It was a while back but a ‘still’ famous Options Seminar Guru (Ex-Real Estate Seminar Guru) used to tout ITM* put back spreads for credits.  One of his students sent me one of the expensive videos where the guru stated that this was his favorite strategy.  That was until the student told him what he learned.  The video later was deleted from the product line.

Attractive ITM* put back spread criteria:
1) A stock that can really move
2) Overall implied volatility levels are reasonably low
3) The spread can be executed for a credit.
4) The options to sell have greater implied volatility than the ones being bought.
MMM met all the criteria and was trading at $76.20

The NOV 85/80 Put (+2*80P by -1*85P) back spread for a credit of about .45 or so by paying 4.20 for each 80 put, twice and receiving 8.85 for the 85 put, once.  The following image uses Position Dissection to uncover the ‘Hidden Reality’.  The position, as it turns out, is no essentially a cheap call bull spread and an ITM* put.

So what’s the problem?

Ask yourself (look at the synthetic dissected position in red):

1) Would I buy an ITM* put for 4.20 and an OTM call vertical for .35 as a spread? 

Not many traders would because there are better ways to get short.  The vertical would not protect the upside loss until MMM got above 84 or so – a very impotent hedge.

2) Would I buy an OTM* 80/85 call vertical for .35 when the naked 80 call is only .40? 

Not many traders would because for .05 more, why have the hindrance of the short eating into the performance of the long?  You normally prefer a vertical when the sale option provides a reasonably discounted price for the play.

3) Would I sell an OTM* 85 call at .05?   Synthetically, that is what is being achieved on the vertical and the actual proceeds net of commissions.

Not many traders would because the 85 call is too cheap to be short and there is the added pain if you ever needed to buy it back.

4) OK, forget about the 85 call.  Would I buy an 80 Straddle when the put is 10 times greater and stronger than the call?

Not many traders would because it is severely unbalanced and in a normal up-move, the call will not make as much or more than the put would lose.

5) OK, forget about the 80 call, also.  That leaves just a long 80 put.  Would I simply buy the 80 put? 

You might but you would have to be bearish.  Wait a minute.  Who said anything about being bearish? 

BTW: The spread is synthetically a 4.55 debit (80 straddle price minus 85 call price) which is the most one could lose if the stock settled at 80.00 on expiration day.

*ITM stands for ‘in-the-money’ and OTM stands for ‘out-of-the-money’.

By Charles Cottle

What’s the difference between a Butterfly, involving 3 equidistant strikes, and a BrokenWing Butterfly (aka BWB, Unbalanced Butterflies or ratioed verticals), also involving 3 equidistant strikes?

Answer: A certain amount of credit spread verticals that help to pay for the butterflies.

If you started with a 3 strike butterfly (like the 1by3by2 in Pink below), targeting a likely expiration range (you can use Diamonetrics™ for this) and you wished for a convenient way to pay for it, then you would sell additional credit spreads involving the existing short and long strikes of the selected butterfly.  To sell a greater amount of credit spreads is more aggressive, because it adds exposure to the potential liability in the event the market goes out of the range on the more heavily weighted side.  The more heavily weighted side in the image below is to the upside.

 Image Courtesy of Chapter 6 of “Options Trading: The Hidden Reality”(Exhibit 6-31)

To be most effective, it helps to have an opinion of where the underlying price may go and not go.  The most vital consideration in selecting strikes for all options strategies is establishing action points.  Action points consist of:

1. A predetermined entry point based on one's opinion of suppor and resistance until expiration
2. Exit levels based on the underlying violating support and resistance.  This is where the trader says: "I'm Wrong", and either liquidates the trade or adjusts it to represent a brand new market opinion.
3. Level for taking profits, harvesting baby butterflies, or parlaying profits with other adjustments.

Both Butterflies and BrokenWing Butterflies, involving the same strikes, play for the exact same target, i.e. the middle short “body” strike.  The BWB is more aggressive and requires more attention but I am happy to report that many traders are becoming very good at managing, adjusting and rolling the risks involved.

 

 

 

 

 

 

 

 

 

 

 

 

What’s the difference between a Butterfly over 3 consecutive strikes and a Condor over 4 consecutive strikes (including the Butterflies’ 3 strikes)?