Chapter 5 Rules-Based Trading – The Options Trading Primer

CHAPTER 5

Rules-Based Trading

Option Trading Levels (Permissions)

Every brokerage has what are called trading levels. The levels can vary from one brokerage to another. For example, some use three levels, while others use four and even five. In this discussion, we examine four levels.

Option levels are used to protect trader accounts, but they protect the brokerage too. If a trader experiences a massive loss that exceeds his or her account value, the brokerage is stuck with the bill, because the brokerage is ultimately responsible for settling the transaction. This is why every brokerage has an active risk department, where risk managers monitor every client account and the risk of their trades. And brokerages have buffering rules, which limit the amount of money their clients are allowed to put at risk.

One buffer is the value assigned to shares of stock held within a trader’s account. It’s typical for a brokerage to permit traders to access 50 percent of the value of stocks and exchange-traded funds (ETFs) held within their account for buying or selling equities. For example, $5,000 worth of account equity (or margin) may be used to finance a trade when $10,000 worth of “big board” stock is deposited within his or her brokerage account.

As the option trading levels increase, the traders are permitted to use option strategies that carry higher risk. Hence, when a trader is granted level 2 trading permissions, the option strategies that are included in both levels 1 and 2 are permitted. Similarly, level 3 adds more strategies, such as vertical spreads that include short puts or short calls that carry more risk than those strategies permitted in levels 1 and 2.

Some people decide they can manage their retirement accounts better than the responsible fund managers. They are convinced that they can achieve a better return on their investments by picking their own stocks and ETFs and perhaps by trading options within a brokerage account. This is why millions of traders actively manage rollover IRA accounts held within brokerages. However, U.S. Security and Exchange Commission (SEC) rules disallow unlimited risk option trades to occur within a qualified retirement account. An example would be an option trade that includes an uncovered short call. However, dozens of option strategies are permitted, including covered calls, vertical put and call spreads, and long calls and puts. This includes the popular iron condor strategy, which is prominently described in this book. The synthetic long stock combination strategy described in a hands-on activity in Chapter 6 can also be traded in a rollover IRA account.

Option Level 1

This is the lowest option trading level. It includes defined-risk strategies such as covered calls and cash-secured put option trades. In both cases, if the trades achieve their largest possible loss, the trader must have sufficient equity in his or her margin account to cover the entire cost of the trade. These option trades do not add risk to the brokerage. Covered calls, for example, are short options that are covered (or protected) by the stock a trader owns. Cash-secured puts are covered by the cash the trader holds within his or her margin account.

Option Level 2

This level permits option traders who have some options trading knowledge and/or experience to add the purchase of call and put options. Long calls and puts do not require the use of account margin, although they can certainly lose money. Long calls and puts lose when the trader’s bias is wrong. And if the underlying price doesn’t change, time decay, especially as the long option contracts approach expiration, can erode premium values to zero. Hence, long puts and long calls require the underlying security to either rally (calls) or drop (puts) to succeed.

Option Level 3

This level adds a whole new universe of trades, including spreads. Recall the vertical spread strategies briefly introduced in Chapter 2. The Buying and Selling Put and Call Spreads paragraph introduced these and mentioned their popularity.

More examples of both put and call spreads are included in Chapter 6. As you will see, these spreads are risk-defined option strategies, which makes them extremely popular. But they can be overtraded when too many contracts are used. Also know that the risk-defined trades that are permitted by level 3 traders prevent traders from exceeding the total value of their account holdings. However, because level 3 trades include either short calls or short puts, it’s possible to exceed allowable account margin levels from an unwanted move in the price of the underlying security. The added risk can exceed the brokerage’s margin allowance. Because only 50 percent of the stock values held in the trader’s margin account is available, it’s quite possible to trigger a margin call or even an SEC Regulation T call.

Note that trading platforms can beta weight the current use of account margin against the S&P 500 index. A good trading platform can even beta weight simulated trades. This permits a knowledgeable trader to examine his or her margin allowance before making a defective trade.

This is also how brokerages monitor each trader’s margin allowance. Brokerages use the S&P 500 index value and the current volatility rate to measure margin risk. For example, one popular brokerage does not permit clients to exceed 100 percent of their account values at 12 percent above or below the S&P 500 index value or to exceed 200 percent of the account value at 20 percent above or below the S&P 500 index value.

Option Level 4

This is frequently the highest option trading level, although a few brokerages offer five levels. The highest level requires the option traders to have several years of trading experience and/or to pass an options trading test. This level permits traders to enter strategies with undefined risk; in other words, strategies that could potentially lose a trader’s entire holdings in addition to causing the brokerage to suffer a financial loss.

Trades that can lose massive amounts of money include short calls, short puts, or both. If either a short call or put on an expensive stock or a financial index becomes deep in the money (ITM) and is either exercised or permitted to expire ITM without being closed or rolled, the trader could potentially lose millions of dollars. This is why the brokerage (and SEC) require option traders to understand the risk that corresponds to short option positions. In addition, the leveraged account margin must be carefully monitored in order to close a threatened trade before an excessive loss becomes a reality.

Although these short option strategies carry substantial risk, they can be extremely profitable for traders who know how to trade them. This includes choosing far out of the money (OTM) strikes that have extremely low probabilities of becoming ITM and that expire within a matter of days to perhaps a week or two. Many traders thrive on short calls and puts, but they must be carefully monitored. And, as traders who hold the highest option trading permissions know, short (uncovered) calls are more dangerous than short cash-covered puts because the calls can exist at strikes that are hundreds of dollars higher than the OTM puts, which increases risk.

The S&P Volatility Index: Symbol VIX

The S&P 500 index includes the top 500 company stocks in the nation. It has greater following than the other equity indexes such as the Dow Jones Industrial Average and the NASDAQ Composite index and is considered to be the best representation of the health of the US stock market. This is because the S&P 500 has a highly diverse constituency and valuation weighting methodology. Hence, the S&P 500 is used by brokerages to beta weight the holdings within brokerage accounts relative to the current volatility of the S&P index.

The Chicago Board Options Exchange (CBOE) manages the S&P 500 volatility index, which measures current trading volume and direction—the measure of the overall price fluctuations of the 500 constituent equities within the index. When the VIX is in the low teens, trades carry considerably less risk than when VIX value begins to exceed 20. In fact, when the VIX rises beyond the mid 20’s, many traders who frequently sell short puts and calls retreat to the sidelines until the VIX value drops back to more normal values in the mid-to-low teens.

Many option traders buy and sell VIX calls and puts depending on their bullish or bearish bias. When the VIX moves into the low teens, some option traders buy long-term calls. Their plan is to sell them when the VIX rises to the mid-twenties or thirties for a profit. When the VIX begins to drop from the low thirties or high twenties, traders may decide to buy long-term puts and wait for the VIX to retreat to the teens, at which time they buy to close their VIX put options for profit. In spite of the trader’s style, symbol selection, and favorite options strategies, experienced traders use the rules-based trading setups described in this book.

Standard Margin

Most brokerages offer margin accounts that permit traders to use their deposits in cash and the value of equities held in their accounts as collateral when buying or selling securities, including stocks, options, futures, and foreign exchange pairs. Before margin accounts became popular, traders had what were called “type 1” accounts, in which their cash and securities, such as shares of stock, were held. However, if a trader wanted to sell one stock and use the proceeds of the sale to buy a different stock, they had to wait for the stock sale to settle before they could buy the second stock. Because it typically took three days for the stock sale to settle, the trader had to wait till the cash was available before they could purchase the second stock. After three days, the price of the second stock could have rallied by several dollars per share, causing the trader to suffer a loss or simply give up. This often meant the trader had to wait on the sidelines for a different buying opportunity to materialize.

Today’s margin accounts coupled to rapid electronic communications networks permit traders to sell one stock and use the proceeds to buy a second stock within a matter of seconds. The underlying value of the margin account, which includes the credit from a recent stock sale, serves as collateral for the second trade. As already noted, standard margin accounts typically permit the account owner to collateralize 50 percent of the value of their big board stocks, where big board stocks are traded on a major exchange such as the New York Stock Exchange (NYSE) or the American Stock Exchange (AMEX). Recall from Chapter 3, over-the-counter, also called penny stocks and pink sheet stocks, are not eligible for use as account equity.

Some believe that being allowed to trade only 50 percent of the value of their securities is to protect the brokerage. But it also protects the trader. The 50 percent reserve prevents the account holder from losing their entire account holdings. If they lose every trade, they still have half their account holdings. So the reserve protects both the trader and the brokerage. The 50 percent held in reserve prevents traders from losing the entire value of their margin accounts. And the brokerage is rarely required to finance bad trades made by their clients.

Portfolio Margin

The SEC permits brokerages to offer what is called portfolio margin to experienced traders who meet account deposit minimums in the $100,000 to $125,000 range. Option traders who hold the highest trading levels, as in level 4 described early in this chapter, and who meet the minimum deposit requirements, may upgrade to a portfolio margin account. Brokerages grant portfolio margin accounts to incentivize traders to deposit and maintain a minimum amount of money in their accounts. Having portfolio margin permits traders to use 85 percent of the value of the stock and ETF equities held within their margin accounts instead of the usual 50 percent. However, if the account value falls below the minimum deposit requirement, it reverts to standard margin.

Margin Calls

If an option trader risks more money than is permitted by his or her brokerage by:

  • Using excessive account margin
  • Overtrading during a rise in the value of the VIX
  • Having a short option that moves either too close to or ITM

the trader’s brokerage will issue a margin call. This requires the trader to close either part or all of losing trades, to sell off shares of stock held in the margin accounts for cash in order to bring the account margin back within compliance, or as a last resort, add more funds or securities to the margin account to cover the overage.

Regulation T Calls

There are also Regulation T calls that are issued by the SEC, notifying an option trader that he or she has 10 days to settle a trade by delivering the required funds or shares of stock to one or more traders on the opposite side of a trade. Failure to settle punishes both the trader and the trader’s brokerage, which receives a written reprimand from the SEC.

Setting Up and Scanning Multiple Price Charts

Regardless of the trading venue, that is, stocks, options, futures, or foreign exchange, it’s useful to study multiple interval price charts to see how both historical and current prices have varied over different periods of time. Figure 5.1 illustrates a setup that displays four different time periods.

Notice the “personality” of the S&P 500 financial index. It has trended upward for the better part of 3 years (upper left-hand quadrant). It experienced a drop in value in late 2018 and recovered in early 2019. This can be seen on both the 3-year and 1-year price charts at the top of the quartile. The bottom left-hand 20-day, 1-hour candle chart shows a bottom at $2,722.27 and a recovery from Friday of the previous week and Wednesday of the current week when these charts were examined. The tick chart in the lower right-hand quadrant, which displays a candle for every 50 trades, began to trend downward at approximately 2:30 p.m. The S&P 500 index lost approximately $4.00 per share in the final 15 minutes of the trading day.

Notice how long VIX put and call options could be traded when reaching their low and high points. Because the VIX trades within a narrow range, this makes price actions reasonably predictable. Notice how the VIX remains in the midteens for long periods of time with what could be rewarding rallies and drops, as can be seen in the charts in Figure 5.2. However, the SPX financial index is not nearly as predictable, although a series of far OTM short-term puts, calls, and perhaps some short strangles could have been sold by level 4 traders for a substantial amount of weekly premium incomes. (More about this in Chapter 6.)

Price Trends

Every experienced trader looks for a sustained upward or downward price move. Trends were mentioned earlier in the preface of this book and again in Chapter 2. Price trends are described as a medium- to long-term series of price moves that are either predominantly upward or downward. Most traders consider a series of higher highs and higher lows to be trending upward. Traders who short stocks or buy put options look for downward-trending stock prices formed by a series of lower lows and lower highs.

Strong companies that are characterized by a series of increasing quarterly profits are good candidates to trade. The exception is when the profit takers, especially financial institutions that hold several million shares of stock, begin taking profits by dumping large quantities of shares on the market. These institutions struggle with market liquidity, because it can take several days or even weeks to exit a large position. The increase in selling creates an oversupply, drives the stock price down, and punishes those traders who also hold positions in the stock. This results in a bearish trader sentiment; individual retail traders may rush to sell, while others take advantage of the downward trend by shorting the stock, buying puts, or selling calls. When the stock hits bottom, the bulls return to buy the stock, which is now oversold and undervalued.

In spite of the sell-off, the company continued to thrive. So the price of its stock was affected by market sentiment and had nothing to do with company operations. The price trends shown in Figure 5.3 are typical. In fact, you can look at the SPX price trends in Figure 5.1 to see this sawtooth pattern, which is an accurate representation of a series of upward and downward price trends.

Traders look for, trade, and profit when they find equities having sustained directional price trends. The price charts provide the keys to finding these price trends. Once the price trend is found, the corresponding option chains are used to select an appropriate option strategy—a call, a put, a vertical spread that combines a short and long put or call, and so on. And knowing where to place the trade based on the potential risk and reward is where the rules come into play. This book was written to help its readers understand and apply these time-tested rules.

Rules-Based Trading

The following is a series of option trading rules that seasoned option traders use to increase the probability of achieving successful trading outcomes. As you will see, the rules evaluate what the market is doing now as well as what is expected. But, as every trader knows all too well, the market can be fickle. So those of us who have spent several years trading the market are rarely surprised by unexpected moves. And these events can be either favorable or hurtful.

Trading rules are based on both historical and current values. The rules evaluate most of the following factors:

 

Long-term and current price trends (rallying, dropping, moving sideways)

Support and resistance levels (historical bottoms or tops where frequent price reversals occur)

Oversold/overbought calculations (Check momentum oscillator values; see Chapter 3.)

Daily average price movement (Examine the ATR(14) value.)

The potential for a price breakout (Examine the TTM_Squeeze on the relevant price chart.)

The current volatility level (IV%) (Compare with historical volatility [HV%] levels.)

The time till expiration (Sell inside 5 to 7 weeks; buy at or outside 90 days.)

 

Examine These Values on the Underlying Option Chain to Select One or More Strike Prices

 

Implied Volatility (IV%)

±Price Movement

Delta

Bid, Ask, and Mark

Bid-to-Ask Spread

Open interest

Theta

Vega

 

Selling Puts (Bullish) or Selling Calls (Bearish)

 

Short calls are permitted only by traders having the highest options trading permissions.

Implied volatility (IV%) (Consider IV% at or above 40 percent for acceptable premium. High IV% values increase the premium credits received by the option sellers.)

±Price Movement (The difference between the ATM strike and the selected strike of your short option should be greater than the ±price movement value.)

Time till expiration should not exceed 5 to 7 weeks. (Shorter is better to reduce risk.)

Delta at or below 0.25 (Provides a 75 percent probability of remaining OTM.)

Open Interest (2-strike trades: 10 × the number of contracts; 3+ strikes strategies: a minimum of 300 at each strike with several thousand in Open Interest at all strikes)

Theta (Theta’s daily premium reduction should be sufficient to earn each short option several dollars per day.)

Vega (Mid- to high Vega values are preferred based on current high trading volume. A reduction in the value of Vega also reduces premiums, which is desirable when options are sold for credit.)

Bid–Ask spread should be relatively narrow (Narrow spreads reduce premium slippage at entry and indicate strong trading volume.)

Mark value: (Premium should be at or above 50 cents to make the risk worthwhile, although some traders accepts premium values of 30 cents.)

 

Buying Puts (Bearish) or Buying Calls (Bullish)

 

Implied Volatility (IV%) (Consider IV% at or below 20 percent in order to pay a relatively inexpensive premium debit; an increase in IV% toward historical trading volume increases premium values. Low IV% values reduce the premium debit paid by option buyers when trading long calls and long puts.)

±Price Movement (The difference between the ATM strike and the selected strike of your long option(s) should be less than the ±price movement value except when used in a defined-risk spread and placed farther OTM as a protective long option. Vertical spreads, such as those used in an iron condor, are examples of these spreads. See the iron condor risk profile later and the iron condor trade example in Chapter 6.)

Time till expiration should be 90 or more days; LEAPS options that expire in a year or more are frequently used when a sustained price rally is expected.

Delta at or near 0.50 (the ATM strike price)

Open Interest (2-strike trades: 10 × the number of contracts; 3+ strike strategies: a minimum of 300 at each strike with several thousand in Open Interest at all strikes)

Theta (The daily premium reduction per share should only be a few cents per share when buying long-term options.)

Vega (Mid- to low Vega values are preferred based on currently low trading volume. An increase in the value of both Vega and volatility is highly desirable because it increases the premium value of long options.)

Bid–Ask spread should be relatively narrow. (Narrow spreads reduce premium slippage at entry and indicate strong trading volume.)

Mark value: (Premium should be affordable; find options on securities that have strong directional price trends at or above 50 cents to make the risk worthwhile.)

 

Trading Spreads

Vertical spreads combine an equal number of short and long calls or puts. Spreads are used within a large number of option strategies. You were introduced to the bull put spread and the bull call spread in Chapter 2. Recall how the bull put spread included an OTM short put above a long put, while the bull call spread included a long call at a strike close to the money and an OTM short call above.

The iron condor was also introduced. This popular premium collection option strategy combines a bull put spread, already described, with a bear call spread (a short call with a long call a few strikes above). There are also calendar and diagonal vertical spreads.

A calendar spread includes a long call or put that expires one expiration later than the short call or put. A diagonal spread includes a long call or long put that expires several expirations later than the short call or put. The long-term options typically expire 90 or more days later than the short-term options. Both calendar and diagonal spreads are used by many option traders.

There is also a bullish horizontal credit spread that combines a short ATM put that expires in 2 weeks and an ATM long call that expires in 1 week. The longer-term short put collects more premium than the shorter-term long call. If the trader’s bullish bias is correct, this option strategy can be closed within a few days for a fast profit, even if the price moves sideways. If the trader’s bullish bias is correct, both the call and the put return profit as the call moves ITM and the put moves OTM. But if wrong, the call loses value as it moves farther OTM and the put moves ITM. If the vulnerable put is not closed, it becomes vulnerable to being exercised.

It’s always the short options, either puts or calls, included in every type of vertical spread that are the “Achilles heel.” Therefore, option traders who trade spreads want to place their short options at strikes that are unlikely to become ITM throughout the life of the option contract. They never want a short option to expire ITM! Knowing this helps option traders configure their option trades to reduce the probability of having their short calls or puts exercised.

This is done by first developing a trading bias using a watch list of optionable securities, examining the underlying price charts and some of the available chart studies, using implied volatility and price movement values, and checking the option Greeks and Open Interest values. After time and with practice, these steps become second nature. And you learn how the foregoing option trading rules give short put and call options a 75 percent probability of remaining OTM through expiration.

Following the rules discussed within this book will help you achieve many more profitable trades than losing ones. But if you become a frequent option trader, you will occasionally suffer a loss. If you always ensure the money you put at risk is affordable, your account will continue to grow in value. Traders who never lose never trade. Every seasoned trader understands that there will always be losses. But if you use risk-defined strategies such as vertical spreads and long call or put butterfly spreads, all of which can be traded by option traders with level 3 trading authorization, you should earn a weekly income. And consider using bracketed trades by adding protective stops and profit targets that were introduced in Chapter 2 and illustrated in Chapter 4. If unsure of how to set up a bracketed trade, check with a member of your trading platform’s technical support staff.

Examining Risk Profiles

Every practicing option trader is quite familiar with risk profiles. In fact, if you show a risk profile (also called risk graphs) to an experienced option trader, the trader can likely identify and name the underlying strategy and tell you how a change in the price of the underlying security affects the option premium value.

Risk profiles include a vertical Y axis up the left-hand side of the graph and an X-axis across the bottom. The X and Y axes converge at 0,0 at the bottom left-hand corner of the graph. When an option trade is plotted, the Y axis shows the option value, while the X-axis shows the price of the underlying stock, ETF, or index. Figure 5.4 includes an example of a bull put spread on a typical risk profile.

Examine the risk profile to determine the information provided. The Y axis plots the value of the option premium at different stock prices that are displayed from low to high across the X-axis. In this risk profile, if the price of the stock remains between $36 and $43, the trade will succeed. The highest profit is achieved at approximately $42.50. If the price drops below $35, the options will begin to lose value.

Notice the gray shaded area. This region represents one standard deviation, or 68.27 percent, above and below the current stock price of $38.52. Many traders use one standard deviation as the price range within which the price of the underlying security is likely to remain through the option’s expiration date. However, many option traders add a bit more safety margin by using 25.00 percent rather than 31.33 percent, which is the reciprocal of the 68.27 percent standard deviation value. Also notice how the hypothetical price value of the underlying stock is represented by the smooth line that is plotted parallel to the premium value of option.

When Are Risk Profiles Used?

Risk profiles are available and easily accessed on every full-featured trading platform. Once the trade is constructed and displayed on an order bar, the risk profile is usually displayed in a separate window using a shortcut or by clicking “analyze” on a drop-down menu. Before confirming and then sending the trade to the market, a large percentage of traders spend the extra time required to display and view the corresponding risk profile.

This is a precise representation of how the option values are affected across a range of prices in the underlying stock. And although the trader carefully selected the option chain’s expiration date and strike prices on the basis of the mathematical probabilities provided by the Greek values, Open Interest, and other essential values contained within the option chain, looking at the risk profile confirms the trader’s bullish or bearish bias and plots how the option will respond to price changes in the underlying.

Risk Profile Examples

The following are seven common risk profiles. Brief descriptions of each option strategy and how it works are also provided.

Long Call Risk Profile

This risk profile illustrated in Figure 5.5 represents a long call strategy that expires in 96 days. It sells five call options on S&P 500 financial index’s volatility index, ticker symbol VIX, for a debit (cost) of approximately $1600. The VIX has periods of high volatility that often moves its price above $30. Notice how the risk graph in Figure 5.5 shows the option value of close to $7,000 when the VIX rallies to a value near $30. When looking at practically any one-year VIX price chart, brief rallies in volatility occur several times per year. And even at a VIX value of $25, the five long calls will net a profit close to $5,000, as shown in the long call risk profile.

Short Put Risk Profile

The risk profile illustrated in Figure 5.6 reflects the sale of five OTM put options on Boeing Aircraft stock. The trade expires in 22 days and collects $1,340 in premium when filled. When traded, Boeing stock had suffered a decline in its stock price of nearly 25 percent as a result of the recent failure of two of its popular 737 Max airliners. These events resulted in strong selling, which drove Boeing’s stock from $446 to $336 within a matter of 2 days. The price of the stock finally stopped dropping and began to move sideways as stock sales declined and traders began to buy Boeing stock again. In addition, aircraft back orders for a new series of jumbo jets encouraged buyers to begin buying Boeing again in anticipation of a strong recovery. Therefore, five short put options were sold in anticipation of an increase in Boeing’s stock price from fresh buying.

Short Strangle Risk Profile

The strangle is a premium collection strategy. The short calls in this short strangle option strategy can be sold only by traders having the highest options trading permissions. This short strangle example sells five call and five put options on Ligand Pharmaceutical, symbol LGND. At the time of this trade, the option chain displayed an IV% value of 50.30 percent with a price movement value of $14.19. This option trade collected $1,400 in combined premium when filled. Both strikes were placed well OTM. The call option’s strike has a Delta value of .13 and provides a credit in premium of 97 cents. The put option’s strike has a Delta value of .14 and a premium of $1.60. The 50.30 percent IV% produced excellent premium values—ideal for short options. This trade expires in 35 days and has an 86 percent probability of expiring safely OTM based on the highest Delta value of .14. Notice how the risk graph shows how the premium is retained by the trader if the Ligand’s stock price remains between $85 and $160.

Long Straddle Risk Profile

A long straddle buys one or more ATM long calls and long puts, making it a fairly expensive debit spread. There is also a short straddle that sells an equal number of ATM short calls and puts for a credit in premium. In this example, the IV% value on the popular SPDR S&P 500 ETF, ticker symbol SPY, was trading at the $281.54 strike. When traded, the IV% was only 15.28 percent, making buying this trade ideal because of the relatively low premium values.

Two call and put contracts were traded for a total premium debit of $2,964. This is the maximum amount of money that can be lost, making this a risk-defined strategy. As can be seen on the risk profile, the entry cost is at the bottom of the plot, which resembles a wide “V” shape. The SPY must rally above $296 or drop below $267.48 for this straddle to recover the initial premium that was paid. However, when a trader detects what may become a sustained directional move, the losing leg can be sold to partially offset the initial debit paid when this trade was originally filled. The winning leg becomes either a long call or a long put. If the SPY continues its directional price move, the trader can realize a substantial profit, especially with a few months remaining till expiration (Figure 5.8).

Iron Condor Risk Profile

The ever-popular iron condor option strategy was discussed in Chapter 2 and again in some detail in Chapter 4. The iron condor strategy was shown on an option chain in Figure 4.2. Here, you can examine a typical iron condor risk profile. It is similar to the short strangle risk profile illustrated in Figure 5.7, except that the long put and call options limit losses. Hence, the construction of an iron condor makes it a defined-risk strategy.

Recall how the iron condor combines a bull put vertical spread and a bear call vertical spread. Both typically expire at the same time, although it’s possible to use more than one expiration as in a calendar or diagonal spread. And the puts could expire earlier than the calls. Because options are quite flexible, many adjustments can be made, although the deviations suggested here are rarely considered. Hence, most iron condors use one expiration date.

The fact that the iron condor is a defined-risk strategy is illustrated by the horizontal lines, drawn below the zero line, and created by the long calls and long puts. However, most option traders would close the threatened spread and keep the profitable one. Notice how the iron condor returns a credit when filled. This is because the short options are closer to the money than the long options. And, as alluded to earlier in this book, the long options are referred to as “buying insurance” as they cover the risk created by the short puts and short calls.

The iron condor risk profile shown in Figure 5.9 trades Five Bellows, Inc., symbol FIVE, all of which expire in 14 days. The IV% is at a high 58.32 percent with a price movement value of ±$11.083. When traded, a credit of $775 is collected. The Delta value of the short puts is at 0.16, and the Delta value of the short calls is at 0.21. The risk graph illustrates how this iron condor remains profitable, that is, the $773 credit is kept, as long as the price of the Five Bellows, Inc. stock remains between the short strikes of $105 and $130. The probability of this happening is better than 79 percent based on the .21 Delta value of the short $130 call’s strike. Most traders would consider this a reasonably safe trade.

Long Call Butterfly Risk Profile

The long call butterfly strategy is used by many option traders. It is a limited risk strategy, as you can see by the risk profile in Figure 5.10. This butterfly trades AAPL stock options that expire in 14 days. It is a balanced long call butterfly with five long calls at $187.50, 10 short calls at the $190 OTM strike (the butterfly’s body), and another five long calls at the $192.50 strike. The strike widths are identical and the number of long call options in each wing is identical (balanced). Some butterfly strategies vary the strike widths between the wings and the body. These are called broken wing butterflies. When viewed on a risk profile, one of the wings droops below the other, hence the expression broken wing.

This trade requires a $170 debit at entry, while having a potential maximum profit of $1,080. However, most traders are willing to close this trade when their butterfly trades achieve a profit of between 15 and 20 percent. You should also know that closing this trade at the peak of the tent-shaped plot, or “witches hat” as it is sometimes called, is rarely achieved. Hence, aiming for 20 percent in profit is common. Doing this week in and week out can add up to a substantial amount of annual income.

Examine the risk profile to see how this bullish butterfly trade has an excellent chance of becoming profitable with a small price rally in the underlying AAPL stock. Also notice the long horizontal lines at the $170 on the Y axis. This is the maximum amount this butterfly can lose. Hence, this is another example of a defined-risk option strategy. Finally, prudent option traders close this trade whenever the central short calls are threatened to expire ITM. This would require the trader to pay for100 shares of AAPL stock for each of the 10 option contracts—a cost of $95,000 plus commissions. Of course, the stock can be sold, but most option traders are not interested in stock ownership unless they can make a substantial profit.

Broken Wing, Unbalanced Long Call Butterfly Risk Profile

The broken wing butterfly was briefly mentioned in the previous discussion. The broken wing unbalanced long call butterfly is an interesting option strategy that can profit regardless of the directional move in the underlying stock price.

Using AAPL again, this butterfly strategy expires in 7 days. The IV% was 21.37 percent, and the price movement value was a meager ±$4.608 based on the short expiration of only 7 days. The trader selects all OTM call option strikes. AAPL stock is currently trading at $186.12. The trader buys +3 calls at the 190 strike, 10 calls at the 192.50 strike, and +7 calls at the 197.50 strike. By reducing the number of long calls in the bottom wing and increasing the number of long calls in the upper wing, the trader is able to construct a credit spread rather than paying the usual debit in premium. Some traders refer to broken wing butterflies as skip strike butterflies, since the strike widths vary. It is unbalanced because fewer options are bought below the body than above. This configuration results in a total credit of $50 when filled. But as shown on the risk profile in Figure 5.11, the trader can lose $2,700 if AAPL’s price rockets past the short strikes in the body to $196.68. This loss occurs only if the price of the AAPL stock exceeds $194.60. However, the short options at the $197.50 strike have a Delta value of .04. The underlying math suggests a failure to keep the initial $50 credit is a meager 4 percent, which is quite unlikely.

If Apple’s stock price does move into the tent, the trader would close the trade for a few hundred dollars without hesitation. However, if all strikes remain OTM, the trader would let the trade expire worthless and keep the $50 credit received when this trade was filled.

Rolling Up, Down, and Out

Recall from Chapter 2 how options were described as being flexible financial instruments. This flexibility is derived from the ability to:

  • Move an option to a later expiration date (roll out)
  • Move an option’s strike price to a higher strike price (roll up)
  • Move an option’s strike price to a lower strike price (roll down)
  • Move an option’s strike price and expiration to a higher strike price at a later expiration (roll up and roll out)

The following paragraphs describe these transformations and include examples of option order bars.

Rolling Up

Rolling up typically involves selecting a working short call option that may be threatened by an upward price move in the underlying security—usually a stock or ETF. The trader may decide to buy the current call option using the premium originally received plus some more money in order to buy to close the existing short call and simultaneously sell to open another short call at a safer strike that is farther OTM. This transaction is referred to as “rolling up.”

The order bar below shows how a short $13 call is closed with a buy-to-close order and a farther OTM $16 short call is sold to replace the original call. The net cost is $1.10 per share.

Rolling Down

Rolling down typically involves selecting a working, cash-secured short put that may be threatened by a downward price move in the underlying security. The trader may decide to buy the current put option using the premium originally received and use additional money in order to buy to close the existing short put and simultaneously sell to open another short put below at a strike that is farther OTM. This transaction is referred to as rolling down.

The order bar below shows how a short $170 put is closed with a buy-to-close order and a farther OTM $160 put is sold to replace the original put.

Rolling Out

Rolling out involves either buying or selling a working option contract and simultaneously buying or selling a similar option that expires at a later date. This is frequently combined when either rolling up or rolling down and is the most common roll used by option traders because it usually returns a credit in premium.

The following order bar shows a $13 call being closed with a buy-to-close order being replaced with another $13 call that expires 21 days later. This is rolling the $13 option contract out to a later expiration date. Also notice this is a credit spread because it sells more time (Extrinsic) value resulting from a lower Theta value due to an increase in time.

Rolling Up and Out; Rolling Down and Out

Rolling up and out and rolling down and out are both used to salvage a working trade that may be threatened by an unwanted price move. Both include choosing a different strike and expiration date than the original call or put option. Rolling up chooses a strike price above and is often used with short calls. Rolling down chooses a strike price below and is often used with short puts. Rolling out chooses a later expiration date for the new trade that replaces the existing trade.

The following order bar shows a $170 put being closed with a buy-to-close order and being replaced with a $160 sell-to-open put order that expires five months later. This trade produces a small 2-cent per share credit owing to the increase in time value. The example illustrates how options are simultaneously rolled down and rolled out.

Legging a Vertical Spread into a Long Call Butterfly

In addition to rolling trades, they can also be converted. For example, a short call can be converted into a vertical spread by adding a long call either above or below. The short call could be morphed into a diagonal bull call by buying a call below that expires at a later time, called either a diagonal or calendar spread. A vertical call spread can be transformed into a butterfly spread by adding short and long calls above or below. These adjustments are done for a few reasons. One would be to convert a losing trade into a profitable one. Another might be to reduce a potential loss by converting a vulnerable trade to a risk-defined trade.

To illustrate, consider a bull call vertical spread that includes a long ATM call and a short call two strikes above. All options expire in 3 weeks. After 1 week, the trader decides to convert this common vertical call spread into a long call butterfly. The trader does this by selling one more short call at the same strike as the first short call. Another long call is added two strikes above the two short calls. All options expire at the same time. This results in a traditional balanced long call butterfly—a very popular risk-defined options strategy.