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.

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.

 

 

 

 

 

 

 

 

 

 

 

 

Some Advisory Services Love this Strategy, I Don’t:

Sell a Put to Finance the Purchase of a Bull Spread.    

By Charles Cottle

Last week I received the following RDSOS: 

SMH (the popular ETF that tracks Semi-Conductor Stocks) February Options:  A trader thought it would be cool to buy the FEB 27/28 Call Vertical Bull Debit Spread (going for .41 (.90-.49) and finance the purchase by Shorting the FEB 26 Put (going for .46, so he actually received a .05 Credit to pay for commissions).  OK, I got it.  What follows is what the trader and some advisory services don’t get:

Obviously, the trader is bullish and believes or hopes that the wager of .41 will turn into 1.00 for a .59 profit.  Hmm, how does he pay for the .41?  By short selling the 26 put for .46. 

OK, Time Out! 

Quick Lesson:  Understand the game.  How can you win, if you don't know the game?  I suggested to the trader to; “Imagine that you put on a ‘Short Wings’ FEB 26/27/28 Iron Butterfly with the same strikes (as your strikes) and also Sell 10 FEB 27 Puts”

Firstly, you would see that the +10 FEB 27 Puts from the Iron Trade liquidates the -10 FEB 27 Puts on the second trade, leaving the trader with the actual trade that he initially put on (27/28 Call Bull Spread and Short 26 Put).  OK, so?  Well how many traders do you know who would put on a ‘Short-Wings’ Iron at these prices (.83 Debit to make .17 when the Iron goes to 1.00, if SMH is below 26.00 or above 28.00 at expiration)?  Most traders ‘BUY the Wings’ on Irons in order to risk less and make more.

Check out the image below using the New Risk Illustrator:

Legend:

10 ‘Short Wings’ FEB 26/27/28 Iron Butterflies: Green Dashed Line and Highlights.

Short 10 FEB 27 Puts: Red Dashed Line and Highlights.

Long 10 FEB 27/28 Call Bull Spreads & Short 10 FEB 26 Puts: Pink Solid Line and Highlights.

The yellow parallelogram represents the basic difference between 10 FEB 27 Puts, naked short and the 30 options (3-way) initiated by the trader.

Bottom Line: The initial trade is highly inefficient, harder to manage and has 3 times the slippage (bid/ask spreads) and commissions. 

So now what?

The simplest short premium trade to manifest the trader’s slightly bullish opinion would be to sell naked* puts.  Which strike?  How many?

If SMH rallies to $28.00 or higher by expiration, this trade would profit $630 (.17 from the Iron and .46 from the 27 Puts Shorted, 10 each).  Using the put options prices in the third row of the image, it would be more efficient to simply short 14 or 15 FEB 26 Puts (.44 each) for a credit of $616 or $660. 

I wouldn’t sell puts naked*, I would consider shorting 25 or 26 FEB 25/26 Put Credit Spreads that are Limited Risk Short Premium Bullish for a $625 or $650 Credit (receiving .44 for the 26 Puts and paying .19 for the 25 Puts). 

*Caution: There is really no need to sell them naked as a greater quantity of Put Credit Spreads will achieve a similar objective with limited risk.

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

By Charles Cottle

Friday, December 18^th, I received an RDSOS (not from Sting):

SPY (the popular ETF that tracks the S&P 500) 'Quarterly', DEC31 options expire on the last day of 2009, December 31st.  A trader, unaware that there was a Dividend on December 18th was assigned on some short calls when the SPY was trading about 109.50.  He was assigned on most of his short 'Body' Calls of his Long ITM 104/105/106 Call Butterfly (+15by-30by+15) originally bought for less than .10 or $150 (15 x .10 x 1oo shares).  Only mistakenly do Stock and ETF Calls get Early Exercised, because it is a beneficial cost savings not to exercise, since more capital would be required for taking delivery of the stock.

However, when there is a Dividend* that has a greater value than any OTM put, the corresponding call becomes a candidate for early exercise.  I say candidate but there are good reasons not to explained in Chapter 3 of my book, "Options Trading: The Hidden Reality".

When I was phoned, it was after the anxious trader hastily bought back 5oo of the 25oo (5 short DEC 105 Calls remained) short shares acquired.  BIG MISTAKE! Actually, using 20/20 hind-sight, buying back all the shares would have profited handsomely, with only minor sweating along the way because the SPY rallied to over 111 by expiration.  Even so, why was it a mistake?

It goes back to the original purpose of the trade and the approach and risk/reward threshold for the trade.  This trader initiated a limited risk butterfly position, risking under $150.  The trade morphed via assignment (trader not aware of and unprepared to pay a dividend).  This added limited risk in the amount $1475 (.5902 on 25oo shares -- the dividend pay-out).  The subsequent trade of 5oo shares added almost $2500 and would have added another $10,000, if the trader had covered (bought back) the remaining 20oo shares created from the assignment.   OK, Time Out!  Let's work it all out.

Quick Lesson:  Understand the game.  How can you win, if you don't know the game?  The most important aspect of my work is showing people how to look at positions a little differently.  It's not rocket science but you are required to use imagination.  Since positions can be dissected in order to better inform a trader, I am going to ask you to try to understand something perhaps different than you have done before.  I suggested to the trader to imagine that he was long and short (at the same time) 25 DEC31 Calls.  That is +25 and -25.  No position right? Flat, right?  Then, I said, "use the -25 for the purpose of reestablishing your butterfly (+15by-30by+15), the -30 is comprised of the imaginary -25 plus the remaining, unassigned, real -5 DEC31 105 Calls".

"Now, take the imaginary +25 and pair it off against the -25oo shares".  What is that, then?  Answer: +25 synthetic DEC31105 Puts going for about .40 (shy of the .59 added cost due to paying the dividend).

Bottom Line: The position still has limited risk and will, subsequent to assignment, behave like the original butterfly 1x30x15 PLUS 25 long cheap-out-of-the money puts. 

So now what?

It seems that the trader could simply trade 25 DEC31 105 Covered Writes (Buy 2500 shares / Sell 25 DEC31 105 Calls) to reestablish the position to the way it was before the assignment. Certainly if the market dropped a bit and he got filled on the call with an extrinsic premium of .59 then he would have recouped the potential loss for paying the dividend.  However, there is one potentially costly pitfall - when a call is well into-the-money, it will often trade with a wide bid/ask spread that is a rip-off to trade.
 

The easiest trade to salvage what is available would be to simply Sell the 25 DEC31105 Puts (whether taking loss or not).  All positions would go away at expiration (above 106) through the exercise process.  Caution: There would be the chance for Pin-Risk at expiry if SPY is trading exactly at 104, 105 or 106 to deal with.  That is a conversation for another Blog post.

Epilogue: You might like to know that our SOS hero, by his own choice, sold 25 various higher strike puts, creating synthetic bull spreads with the understanding that the lower strike synthetic 105 puts protected his downside.

* Actually it is the amount of the Dividend less the cost of carrying the stock – under .04 per share for the remaining period until expiration in this case (Strike of 105 x 13 Days Left, Divided by 365 Days in the Year x 1%, an approximate Interest Rate)