Option strategies for more potential profit, using undefined-risk trades that draw roots from their defined-risk cousins.
How do you turn a nice, sweet little option strategy—one that has a maximum loss that can be calculated and identified—and turn it into pure poison? Easy. Take a deep breath and take off the protection. It’s collecting positive time decay and NOT sleeping at night. What’s that mondo-delicious fish that they eat in Japan, that if it’s not prepared perfectly can kill you? Yeah, kind of like that. What do I mean?
These are the types of positions that many firms had in 2008—the firms that blew up. Take your eye off ’em, and you might as well be speeding through a red light at a busy intersection. Scared yet? Good. Go ahead and walk away. There’s no shame. But if you’re curious, read on.
Do you like short put verticals?—The higher risk trade is the short naked put.
Like the long butterfly?—Take off the protection and you have a short straddle.
Short iron condor?—Next of kin is a short strangle.
Long unbalanced butterfly?—How about a put ratio spread.
The idea with each of these is that you’re still collecting positive time decay by selling options, and you’re still speculating that the stock or index won’t make a big move either up or down. But remember, you can’t separate risk and reward. If you want less risk, you have to hedge those short options and eat into that positive time decay. And if you are willing to accept more risk? Then you exchange the hedging long option for constant attention and more risk for higher potential profits. That, in a nutshell, is the appeal. Remember that any of these complex option strategies can incur multiple commission charges and contract fees.
If you believe that a stock won’t drop very much and have a bullish bias on it, you could consider the defined risk short put vertical, or the undefined risk short naked put (Figure 1). The short put vertical is selling an out- of-the-money put and buying a further out-of-the-money put. The short naked put is just selling the out-of-the-money put. The long put limits the risk of the short put vertical to the difference between the strike minus the premium received, and also reduces the total credit for the trade, which is its max profit. The breakeven point is the short strike price minus the premium.
FIGURE 1: SHORT NAKED PUT
A short vertical put (credit spread) without the long hedge is a short naked put, and might be used when you believe the stock will trade higher or sideways until expiration. For illustrative purposes only.
Compare that to a short naked put, which has a much higher max loss that is the strike price minus the premium received. But because the premium received on the short put is higher, its max profit is higher, and the breakeven point is lower because it’s the short put strike minus the larger premium. It’s that larger premium that is tempting if you’re willing to accept much larger risk and margin requirements. And if you don’t think that max risk on a short put is possible, the past couple of years contains a veritable who’s who of once-mighty companies with double-digit stock prices that are now either worthless or just plain bankrupt.
Think you can hit ’em right between the eyes? Or at least the short strike price? If you believe that a stock is going to stay in a very narrow range, the defined risk trade is a long butterfly spread, which is long a lower strike option, long a higher strike option, and short two options at a strike in the middle. Its max profit occurs if the stock is right at the middle strike price at expiration and has a max loss limited to the debit paid. The breakeven points are the lower strike plus the debit and the higher strike minus the debit.
The much riskier version of this trade is a short straddle (Figure 2 below), which is a short-naked call and short-naked put at the same strike price. Like the long butterfly, it loses money if the stock rises or drops beyond the breakeven points, which are the strike price plus and minus the credit received. But unlike the long butterfly, the maxi- mum loss on a short straddle is not definable because a stock can theoretically go higher and higher without end, or to zero. The credit for a short straddle can be very high, and that large credit comprises the max profit, which can be much greater than the max profit on the long butterfly if the stock does land at the strike price of the short options at expiration.
FIGURE 2: SHORT STRADDLE
A butterfly without protective “wings” is a short straddle, and might be used when you think the stock will trade in a certain range up to the expiration of the options. For illustrative purposes only.
When would you consider a short straddle? One scenario is when a stock has some major news announcement, like earnings, coming up. Because of the uncertainty of whether the stock might go up or down on the news, and whether that move might be big or small, the implied volatility in the stock’s options increases. When that happens, the premium received for selling the straddle can be very high. Of course, the high volatility can also mean that the stock could make a huge move either up or down, and cause major losses in a short straddle. But if the news comes out and the stock doesn’t move as much as the market expected or feared, then the short straddle may drop in a lot of value and profit.
Similar to a long butterfly, an iron condor is a trade that profits if the stock stays in a somewhat wider price range than what would work for a long butterfly. It’s a long out-of-the-money put, a closer, short put, at the stock price, a short call at the stock price, and a long out-of-the-money call. Its max loss is limited to the difference between the strike prices of the long and short options, and the profit is limited to the credit received. The breakeven points are the short put strike minus the credit and the short call strike plus the credit.
The scary version is to sell the short put and the short call without the long options to limit the risk. This is a short strangle (Figure 3), and because it takes in a larger credit than an iron condor, the max potential profit is larger, and the breakeven points are wider at the short put strike minus the credit and the short call strike plus the credit. But the risk of a short strangle is much higher than for an iron condor. Like a short straddle, if the stock makes a big move up or down, the short strangle loses money. The max risk is undefinable if the stock goes infinitely high, or to zero.
FIGURE 3: SHORT STRANGLE
An iron condor without protective “wings” is a short strangle, and might be used when you think the stock will trade in a wider range up to the expiration of the options. For illustrative purposes only.
Of course, the further out of the money the short options are, the more the stock can move before either the iron condor or the short strangle lose money. That also reduces the credit for both trades. Just as long as the stock doesn’t move above the short call strike or below the short put strike, you’re OK. And when it gets close, you’re white-knuckled or you ain’t alive. That’s why you may want to employ short strangles in broad- based index products, where inherent diversification helps to keep event risk down and makes big moves somewhat less likely. But tell that to anyone who was short strangles in 2008.
When you combine short out-of-the-money options with a long out-of-the-money vertical, don’t think that you’re hedged—but the trade has interesting characteristics. A ratio spread (Figure 4) is made up of some quantity of long out-of-the-money options and a larger quantity of short further-out-of-the-money options, sometimes at different strike prices. These types of positions are typically established for a net credit, where the premium received from the short options exceeds that paid for the long options. The breakeven point is the short strike price minus the net credit for puts, and plus the net credit for calls. The max potential loss of a ratio spread can be very high.
FIGURE 4: CALL RATIO SPREAD
An unbalanced butterfly without the lower long call hedge is a call ratio spread, and might be used when you believe a stock will trade sideways, with a possible upside breakout before expiration. For illustrative purposes only.
In this way, the ratio spread can profit over a wide range of stock prices. But if the stock has a large move past your short options, the long options provide only a partial hedge. If implied volatility increases along with the price change, the long vertical component will have its value reduced, and the short options will see their value rise. Ouch.
With all these warnings, then, why would a trader ever use these strategies? They can collect more positive time decay faster, and so you can take these trades off sooner and potentially capture an equal profit as holding trades with limited risk longer. That’s why you have to monitor these trades at all times. Not only do you have to be ready to close the trade in the event that the stock moves against it, but you also have to be ready to close the trade to take profits. How much profit you want is up to each trader, but I don’t think it’s worth being greedy with these strategies. Holding out for that extra couple of pennies of time decay can leave you open to the wild swings the market can have as expiration approaches. These strategies aren’t for novice traders. In the same way that you can build up a resistance to a toxin, you need to build the discipline to exit these trades if the losses reach a certain point, and build the respect for the losses they can dish out to the unwary. Bon appétit!
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