THE OPTIONS COURSE- Advanced Delta Neutral Strategies

THE OPTIONS COURSE


Advanced Delta Neutral Strategies

Understanding the mechanics of a variety of delta neutral strategies is vital to becoming a profitable nondirectional trader. Instead of being overwhelmed by the complex nature of market dynamics, you can implement a delta neutral strategy that takes advantage of market conditions. Determining which strategy best fits the situation can easily be deduced through the use of risk profiles and relatively easy mathematical calculations. Delta neutral trading is all about empowering traders to maximize their returns and minimize their losses.

Although professional traders have used delta neutral strategies on the major exchanges for years, off-floor traders are rarely aware of these strategies. We have already explored the basic delta neutral trading techniques. It’s time to turn the spotlight on some advanced strategies: ratio spreads and ratio backspreads. Ratio spreads are interesting strategies that provide a wide profit zone; however, they also have unlimited risk. Ratio backspreads, in contrast, offer limited risk with unlimited reward potential.

RATIO CALL SPREAD

A ratio spread is a strategy in which an uneven number of contracts with the same underlying instrument are bought and sold. Unlike straddles and strangles, which use a 1-to-1 ratio of the same kind of options, ratio spreads offset an uneven number of different types of options. A ratio call spread is useful when a trader sees a slight rise in a market followed by a sell-off. If this trade is done at a credit, the chance for success increases.

Although a ratio spread simply involves the buying and selling of an uneven number of contracts, there are a variety of complex ways to implement this strategy. For example, you can buy one OTM call option and sell two call options that are even further out-of-the-money. You can also use a ratio other than 1-to-2. For instance, you might buy two ATM options and sell three OTM options.

Many traders are willing to take the risk involved in shorting OTM options because they believe that the probability of the market moving that much is slim. Meanwhile, they are taking in a lot of premium. However, a volatile market can easily move enough to lose money on the uncovered short option. For that reason, we do not recommend this strategy, but we present it here in order to lead up to one of our favorite strategies—the ratio backspread.

Ratio Call Mechanics

For example, during the month of February, let’s say you decide to create a ratio call spread by purchasing one July ATM 50 call at $4.50 and selling two July XYZ 55 calls at $2.50. This trade will not cost you any money to place because you’re spending $450 (4.50 × 100) to buy the 50 call and receiving $500 [(2 × 2.50) × 100] in credit for selling the 55 calls. Thus, you are receiving a credit of $50 to place the trade. This trade has limited profit and unlimited risk. One of the short July OTM 55 calls is covered by the long 50 call. 

If the market goes to 60, you would make 10 points on the long call, lose 5 on the first call, to lock in a net profit of 5 points. However, the second 55 call is uncovered and even though it was an OTM option when the trade was initiated, there is some margin and risk on it. If the market rises to 60, the second 55 call loses 5 points, reducing the net profit to 0 points: (10 – 5 – 5 = 0). The maximum profit of a ratio call spread is calculated using the following equation:

   Number of long contracts × (difference in strike prices × 100) + net credit (or – net debit)

In this trade, the maximum profit is limited to $550: (55 – 50) × 100 + $50 = $550. However, the risk is unlimited to the upside above the breakeven point. The upside breakeven is calculated by using the following equation:

Lower call strike price + (difference in strikes × number of short contracts) ÷ (number of short calls – number of long calls) + net credit (or – net debit)

In this case, the upside breakeven is 60.50: 50 + [(55 – 50) × 2] ÷ (2 – 1) + .50 = 60.50. There is no risk to the downside because the trade was entered as a credit. This trade is best entered during times of high volatility with expectation of decreasing volatility. 


FIGURE  Ratio Call Spread Risk Profile

Ratio Call Spread Case Study

Eastman Kodak (EK) has been trading in a range and you expect the stock to either stay in that range or make a modest move higher. The stock is trading for $29.50 per share during the month of June. In order to profit from the stock’s sideways trading, let’s create a ratio call spread by selling two October 35 calls for $1.75 each and buying one October 30 call for $3. You earn a credit of 50 cents or $50 when establishing this trade. Ideally, after establishing the trade, the stock will move only gradually higher. 

If it rises above $33, but below $35, the short options will expire worthless and you can book a profit on the long EK October 30 call. The maximum gain occurs at exactly $35 a share at expiration. At that point, both EK October 35 calls expire worthless and the long call is worth $5. In that case, the trader keeps the $350 for selling the two short calls and earns another $200 in profits from the long call. The total maximum gain is therefore $550.

If EK falls sharply, the trader can do nothing but let the calls expire worthless. In this example, that’s exactly what happened: The trade generated a $50 return. The upside breakeven is equal to 40.50: [30 + (5 × 2)] +.50 = 40.50. Losses begin to develop as the stock moves above the breakeven and are unlimited due to the naked short call. A move to $50 a share, for instance, would result in a $950 loss. Therefore, the strategist is taking a significant risk in order to earn a maximum of $550.




FIGURE  EK Ratio Call Spread

RATIO PUT SPREADS

A ratio put spread involves buying a higher strike put option and selling a greater number of lower strike OTM put options and should be implemented in a bullish market. The maximum profit of a ratio put spread is calculated by multiplying the difference in strike prices by 100 and then adding the net credit received. The maximum risk is limited to the stock going to zero and equals the lower strike price minus the difference between the two strike prices plus the net credit times 100. 

The downside breakeven is calculated by dividing the difference in strike prices times the number of short contracts by the number of short contracts minus the number of long contracts and subtracting that number from the higher put strike price. Then, subtract the net credit received or add the net debit paid. A ratio put spread can be implemented when a slight fall in the market is anticipated followed by a sharp rise. This strategy works well in the stock market, as stocks generally tend to move up in price. However, it is important to place this trade on only high-quality stocks. 

If the company has reported lower than expected earnings or bad news is released, exit the position.  A ratio put spread also works well in many futures markets, especially during seasonal periods when prices tend to go up (such as heating oil in the winter months). The main risk in ratio spreads comes from the uncovered short call or put. These options have unlimited risk. Watch the market closely and exit or adjust the trade if the market moves to the strike price of the short options.

Ratio Put Spread Mechanics

Let’s create an example with XYZ trading at $50 a share in February that consists of going long one July XYZ 50 put at $4.50 and two short July XYZ 45 puts at $2.50 each. This trade creates a net credit of .50 or $50: [(2 × 2.50) – 4.50] × 100 = $50. The maximum profit of a ratio put spread is calculated by using the following formula:

             (Difference in strike prices × 100) + net credit (or – net debit)

In this trade, the maximum profit is limited to $550: (50 – 45) × 100 + $50 = $550. The maximum risk is limited because the stock can only fall to zero and is calculated using the following formula:

             Lower strike price – (difference in strikes – net credit) × 100

In this example, the maximum risk is $3,950: 45 – [(50 – 45) – .50] × 100 = $3,950. The downside breakeven is calculated by using the following formula:

Higher strike price – [(difference in strikes × number of short contracts) ÷ (number of short contracts – number of long contracts)] – net credit (or + net debit)

In this example the downside breakeven is 39.50: 50 – [(50 – 45) × 2] ÷ (2 – 1) – .50 = 39.50. 



FIGURE  Ratio Put Spread Risk Profile

Ratio Put Spread Case Study

General Electric (GE) has been performing well and the stock is expected to take a pause or perhaps trade lower. With shares near $23.40 in February 2003, let’s short sell two January GE 20 puts at $2 and go long 1 January 25 put at $4. The sale of the puts offsets the cost of the long put and the trade is executed at even (without a debit or credit). After establishing the trade, the strategist wants to see shares of General Electric edge lower. The maximum gain occurs at expiration if the stock is trading for $20 a share. 

At that point, both GE January 20 puts expire worthless and the long put is worth $5 a contract, or $1 more than the entry price. If so, the strategist earns $1 in profits with the long call and keeps the $4 in premium for selling the short puts. The maximum gain is therefore $500. If GE rises sharply, the strategist can do nothing but let the puts expire worthless. In that case, the loss is equal to the commissions paid for the trade. On the other hand, if the stock falls sharply, the losses can be substantial. 

The downside breakeven is equal to: higher strike price – [(difference in strike prices × number of short contracts) ÷ (number of short contracts – number of long contracts)] – net credit (or + net debit), or $15: [25 – (5 × 2)] ÷ (2 – 1) – 0 = $15]. Losses begin to develop as the stock moves below the breakeven and are limited to the stock falling to zero. In this case, if the stock falls to zero, one short put will cover the long put and result in a $5 profit. The other put will probably be assigned for a $20 loss. The total loss would therefore be $1,500. Therefore, the strategist is risking $1,500 to earn $500 from this trade.



FIGURE  GE Ratio Put Spread 

EXIT STRATEGIES FOR RATIO SPREADS

Whether trading call or put ratio spreads, it is important to remember that these strategies involve substantial risk for limited reward. The strategist wants to be careful because these types of spreads involve more short than long options and therefore involve naked options. In a call ratio spread, the risk is unlimited to the upside. If the underlying stock moves beyond the short strike price before expiration, the strategist might want to consider closing the position by buying back the short calls and selling the long call. 

If the stock drops, do nothing, let the options expire, and keep the net credit received for establishing the trade. In the case of the put ratio spread, the opposite holds true. In that case, a sharp move lower in the stock can result in substantial losses. If the stock falls below the short strike price before expiration, the strategist might consider closing the position by purchasing back the short puts and selling the long put. If the stock moves higher, do nothing, let the options expire, and keep the credit.

CALL RATIO BACKSPREADS

Ratio backspreads are one of my favorite strategies for volatile markets. They are very powerful strategies that will enable you to limit your risk and receive unlimited potential profits. These strategies do not have to be monitored very closely as long as you buy and sell options with at least 90 days (the longer the better) until expiration. I like to call them “vacation trades” because I can place a ratio backspread, go on vacation, and not even worry about it. For some traders, ratio backspread opportunities are hard to find. Perhaps they are looking in the wrong places. 

It is difficult to find ratio backspread opportunities in highly volatile markets with expensive stocks or futures. For example, you will rarely find them in the S&P 500 futures market. This index is simply too volatile and the options are too expensive. Focus on medium-priced stocks (between $25 and $75) or futures. These trades can be quite profitable, so be persistent. They’re out there—just keep looking. Additionally, when looking for the right market for a call ratio backspread, scan for markets exhibiting a reverse volatility skew. 

In these markets, the lower strike options (the ones you want to sell) have higher implied volatility and can be overpriced.  The higher strike options (the ones you want to buy) enjoy lower implied volatility and are often underpriced. By finding markets with a reverse volatility skew, you can capture the implied volatility differential between the short and long options. A ratio backspread strategy involves buying one leg and selling another in a disproportionate ratio that does not create a net debit. The following seven rules must be diligently observed to create an optimal ratio backspread trade:

1. Choose markets where volatility is expected to increase in the direction of your trade.

2. Avoid markets with consistent low volatility. If you really want to place a ratio backspread in a market that does not move, pay close attention to rule 4.

3. Do not use ratios greater than .67—use ratios that are multiples of 1:2 or 2:3.

4. If you choose to trade a slow market, a .75 ratio or higher is acceptable only by buying the lower strike and selling the higher. However, there is more risk.

5. To create a call ratio backspread, sell the lower strike call and buy a greater number of higher strike calls.

6. To create a put ratio backspread, sell the higher strike put and buy a greater number of low strike puts.

7. Try to avoid debit trades. But if you do place a ratio backspread with a debit, you must be able to lose that amount.

Call Ratio Backspread Mechanics

As previously stated, a call ratio backspread involves selling the lower strike call and buying a greater number of higher strike calls. For example, let’s pick a fictitious market (it doesn’t matter which market as long as it is volatile) with strikes starting at 40, 45, 50, 55, and 60. The ATM calls are at 50, which means that the current price of the underlying market equals $50 also. Now, according to rule 5, the first part of a call ratio backspread is to sell the lower strike call. Which is the lowest strike call here? The 40 is the lowest strike call. Now, the other part of the rule tells me to buy a greater number of higher strike calls. 

Let’s buy an option to buy this market at $60 because we think the market is going to reach $65. Am I going to pay less for this call than for the 40, or more? I’m going to pay less because now I’m speculating that the market mood is bullish. Speculating on market direction is one of the main reasons why many people lose money when they trade options. However, I’m going to go ahead and speculate that the market is going to go to 65, even though it’s only at 50 right now. Furthermore, I’m going to pay less for a 60 option than a 55 strike. As the strike price goes up, the premiums of the ITM options also go up, as they are more and more valuable. 

If our market is currently trading at 50 but it’s starting to rise, the price of the 60-strike option will also rise. Now let’s introduce the delta into this situation. The delta is the probability an option has of closing in-the-money at expiration. If a 50-strike option is at-the-money, which way can the market go? The market can move in either direction, which means there is a 50 percent probability of it closing in-the-money. Obviously, a price that’s already in-the-money has a higher probability of closing in-the-money than something that’s out-of-the-money. 

Therefore, the delta for an ITM option is higher than the delta for the ATM option or an OTM option. The higher the probability an option has of closing in-the-money, the higher its premium. This relationship enables a trader to create trades that are virtually free of charge. Ratio backspreads take full advantage of this relationship. It’s a relatively simple concept. As the underlying instrument’s price changes, the option deltas change accordingly. For example, our 40-strike option has a higher delta than one with a 60-strike, and therefore a higher premium as well. 

Let’s set up a call ratio backspread using XYZ, which is currently trading at 50. To satisfy the rules, let’s sell a 40 call and buy more of the 60 calls in a ratio of 2-to-3 or less.  This trade would receive a credit on the short 40 call and a debit on the long 60 calls. However, we have limited the risk of the short 40 call by offsetting it with one of the long 60 calls and can still profit from the other long 60 call. As previously stated, determining risk is the most important part of setting up any trade. The risk of this trade can be calculated using the following option premiums:

             Call                 Price
              60                   $ 60
              55                   $ 70
              50                   $ 80
              45                   $ 90
              40                   $100

If we sell one 40-strike call option and buy two of the 60-strike call options, we have a debit of $20: 100 – (2 × 60) = –$20. But if the prices rise, we’ll make more money on the 60-strike calls than on the 40-strike call. If the market falls, the out-of-pocket cost of placing the trade is the maximum risk. The most we can lose is $20 on the downside. The trick to creating an optimal trade is to avoid risk by using a ratio that makes the trade delta neutral. In this way, it is possible to place a trade for free at no net debit. 

That’s right! You can create ratio backspreads that don’t cost a penny (except for commissions) and still make healthy profits. You can do this by offsetting the credit side with the debit side so that they cancel each other out and you don’t have to spend any money out-of-pocket. In this example, you can create a 2 × 3 ratio backspread at a $10 credit: [(2 × 100) – (3 × 60)] = +$20. This is the best kind of trade to place (especially if you’re 100 percent wrong about market direction), because you won’t lose any money. 

In this case, as long as the market breaks down below the 40 strike, both options expire worthless.  However, there is some risk between the 40 and 60 strike prices because the trade could lose more than it profits. To figure out the most effective ratio, you have to accurately calculate the net credit of a trade. This can be accomplished by calculating the full credit realized from the short options and dividing it by the debit of one long option. You can then use up as much of the credit as you can to make the most profitable ratio.

         Credit = Number of short contracts × short option premium × 100

         Debit = Number of long contracts × long option premium × 100

Once you have figured out the best ratio of the trade, you still have to calculate your risk.

Risk = [(Number of short contracts × difference in strikes) × 100] + net debit paid (or – net credit)

Let’s use these equations to determine an optimal call ratio backspread using XYZ trading at $50 during the month of February. Let’s create a call ratio backspread by going short 1 XYZ January 50 call for $8.50 and going long 2 January 60 calls for $4.25 each. In this case, we are using long-term equity anticipation securities, or LEAPS. Our short calls give us a credit of $850: (8.50 × 100) = $850. The two long calls also cost $850: (2 × 4.25) × 100 = $850. Therefore, this trade can be placed at even. While the call ratio backspread using one short 50 call and two long 60 calls can be set up at even, let’s consider what happens when we increase it to a 2-to-3 ratio. 

By going short two XYZ January 50 calls at $8.50 and going long three XYZ January 60 calls at $4.25, we’ll receive $1,700 from the sale of the short calls and pay only $1,275 to buy the long calls for a net credit of $425: (2 × 8.50) – (3 × 4.25) = $425. Actually, we could also buy four XYZ January 60 calls against the credit received for selling the three XYZ January 50 calls ($1,700 ÷ 425 = 4), but the ratio of 2 to 3 is recommended in the guidelines as a more optimal ratio for a ratio backspread. 

Therefore, let’s create a ratio backspread with a 2-to-3 ratio, which satisfies rule 3 and garners a net credit of $425. The next step is to take a look at this trade’s risk profile. This risk graph shows the trade’s unlimited potential reward if XYZ moves higher. It also reveals that the maximum risk of $1,575 is realized only if the underlying instrument is at the strike price of the long option (60) at expiration. The maximum risk is computed using the following formula:

         [(Number of short calls × difference in strikes) × 100] – net credit

In this case, the maximum risk equals $1,575: [(2 × 10) × 100] – 425 = $1,575. Now let’s calculate the upside breakeven of this example using the following equation:

Higher strike call + [(difference in strikes × number of short calls) ÷ (number of long calls – number of short calls)] – net credit

In this case, the upside breakeven is $75.75: 60 + {[(60 – 50) × 2] ÷ (3 – 2)} – 4.25 = $75.75. The downside breakeven is simply computed by adding the lower strike price of the short options to the net credit divided by the number of short options. If a call ratio backspread is entered with a net debit, there is no downside breakeven. In this trade, the downside breakeven is $52.12: 50 + (4.25 ÷ 2) = 52.12. That means this trade makes money as long as the price of the underlying closes above the upside breakeven. Call ratio backspreads are best implemented during periods of low volatility in a highly volatile market that shows signs of increasing activity to the upside.


FIGURE  Call Ratio Backspread Risk Profile

Call Ratio Backspread Case Study

Let’s say you’re bullish on eBay (EBAY) and want to set up a strategy that has limited risk, but high profit potential. During the month of February 2003, the stock is trading for $75.25 a share. A call ratio backspread can be created by going short 2 EBAY January 80 calls at $11 and going long three EBAY January 90 calls at $6.50. The trade yields a net credit of $250. Now, let’s do the math. The maximum risk will occur at expiration if the stock moves to $90 a share. At that point, the short calls are worth $10 each and the long calls expire worthless. 

So, we lose $2,000 per contract minus the net credit $250, for a maximum risk of $1,750. Since you want to avoid this possibility at all costs, if the stock does not move above that level within a reasonable period of time, close the trade and move on. If the stock fails to rise or falls sharply, there’s little we can do other than keep the credit and let the options expire worthless. Ideally, however, the stock will move higher. The upside breakeven at expiration is equal to $107.50: 90.00 + [(10 × 2) ÷ (3 – 2) – 2.50 = $107.50. However, we do not intend to hold this position until expiration. 

Instead, we want to exit the position at least 30 days before expiration or after a reasonable profit has accrued. In this case, eBay did indeed move higher. Six months later, the stock was trading near $110 a share. Although you would have probably booked profits long before that time, at $110 a share in August 2003, the long calls would have sold for $25.30 (a profit of $5,640) and the short calls could have been bought to close at $33.40 (a loss of $4,480). Thus, the net profit would have been $1,160 plus the original credit of $250, or $1,410.

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