Advanced Concepts & Strategies

Introduction

At this point you should be comfortable with buying and selling individual options and the mechanics of married puts, covered writes and synthetic puts. This section will introduce you to a few of the strategies used by professional option traders. These strategies typically involve buying and selling multiple options in order to create different risk/reward profiles. This section will also introduce two statistical tools: delta and position delta. These tools will be valuable in helping you evaluate complex option positions.

Delta

A statistical relationship that is used to understand an option's price relative to the value of the underlying stock is called delta. The delta of an option indicates the rate of change of an option's price if the underlying stock's price moves by 1 point. For example, a call option with a delta of .50 would move $0.50 for every $1 move in the stock. On a call option the delta is positive, on a put option the delta is negative.

It is important to note that delta is not a fixed value. In practice, as an option moves further in-the-money its delta increases, tending toward one. In other words, a deep in-the-money option will move in almost lockstep with the underlying stock. Similarly, the further out-of-the-money an option becomes, the closer its delta moves toward zero.

Note that stock has a delta of 1.00. Also, please note that an option is generally for 100 shares. This means that if an option has a delta of .50 and the stock moves $1, the value of the option should have moved $50, which is the delta of .50 multiplied by 100 shares. For this reason, you will sometimes see Delta noted without the decimal point.

Position Delta

Position delta is a way to use delta to quickly determine your equivalent stock position. The sum of the position deltas of ALL the stock and options you have in a single security indicates the equivalent stock position.

Position delta = option delta X number of contracts X 100

The delta of a long stock or call position is a positive number, whereas the delta of a short stock or put position is a negative number.

For example, if you owned 200 shares of XYZ and 1 XYZ JUN 40 PUT that had a delta of .50, then your position delta would be 150, that is, 50 for the put plus 200 for the long stock. This combined position is the equivalent of being long 150 shares of stock.

Introduction to Spreads

By now, you should already be familiar with strategies involving stock and option positions such as married puts and covered writes.

The remainder of this section will introduce you to a group of strategies known as spreads. Spreads typically involve simultaneously buying and/or selling two options in the same stock but with different strike prices, expiration dates, or both. Spreads allow you to use profits from one option to offset losses from the other. In some cases this reduces your overall risk. In other cases, it changes the characteristic of your risk. With normal stock or buying a call or some of the spreads available, you take directional risk. You buy a stock or a call and your risk is that the stock will drop. In some strategies, notably straddles, success is less dependent on the direction a stock moves than it is on a stock's movement in general. The writer of a short straddle profits if the underlying stock does not move out of the straddle range, while the purchaser of the long straddle hopes for significant movement outside the strike prices of the straddle.

Spread transactions are considered to be net-debit, net-credit or even-money depending on whether you spend or receive money for the spread.

Bull Spread

A bull spread achieves its maximum profit when the stock rises. Although bull spreads can be created with either calls or puts, we will use calls in this example.

To create a call bull spread you buy calls with a lower strike price and sell an equal number of calls with a higher strike price. All the options in the spread must have the same expiration date. For example, if XYZ were trading at $32, you could create a bull spread by purchasing 1 XYZ JUN 30 CALL for $3 and at the same time selling 1 XYZ JUN 35 CALL for $1.

This trade would be a net-debit of $2. In other words, it would cost you $2 to create the spread ($3 to buy the JUN 30 CALL less $1 received from the sale of the JUN 35 CALL).

Bull Spread Example

Because the profit and loss from the two calls are used to offset one another, the most you can ever lose with a bull spread is the cost of the spread itself, in this example $2. In addition, the most you can ever gain from a bull spread is the difference between the two strike prices less the cost of the spread, in this case $3 (35 - 30 - 2).

Note that a bull spread reaches its maximum loss when the stock is below the lower strike price, and its maximum profit when the stock is above the higher strike price.

Here are the returns based on the stock price at expiration:

Bear Spread

A bear spread is a spread that reaches its maximum profit when the stock declines. As with a bull spread, a bear spread can be created with either calls or puts. Again, there must be an equal number of options on either side of the spread and all the options must have the same expiration date. A put bear spread is created by buying a put with a higher strike price and selling a put with a lower strike price.

With XYZ trading at $33 you could create a put bear spread by selling 1 XYZ JUN 30 PUT for $1 and buying 1 XYZ JUN 35 PUT for $3, giving you a net-debit of $2.

Bear Spread Example

A put bear spread's maximum profit is reached when the underlying stock trades below the lower strike price, $30 in this example. Conversely, the spread's maximum loss is reached when the stock trades above the higher strike price, in this case $35. Again, the maximum loss with a put bear spread is the cost of the spread itself, while the maximum profit is the difference between the strike prices less the cost of the spread.

Here are the returns based on the stock price at expiration:

Long Straddle

A straddle is another type of strategy using multiple options. During periods of lower volatility, you may want to buy a long straddle when you want to profit from expected high volatility in the underlying stock, but do not know which direction the stock is going to move.

To create a long straddle, buy an equal number of puts and calls on the same underlying stock with the same strike price and expiration date.

Creating a long straddle involves buying options as opposed to selling; therefore, the maximum risk is the cost of buying both the option positions.

Long Straddle Example

With XYZ trading at $42, you could create a straddle by purchasing 1 XYZ JUN 40 CALL for $3 and 1 XYZ JUN 40 PUT for $1. The result is a net-debit of $4.

The straddle would become profitable when the stock moved away from the strike price and one of the options became far enough in-the-money to cover the cost of the straddle. In this case it would be below $36 or above $44. In addition, the maximum loss would be reached when the stock traded at the options' strike price.

Here are the returns for various stock prices at expiration:

Long Combo

A long combo is when you buy both a call and a put option on the same underlying security. A vertical combo is when the calls and puts have different strikes. A horizontal combo is different expirations, and a mixed combo is different strikes and expirations. A long straddle is when the strike and expiration are the same.

Other Combinations of Spreads

Above we have described only four types of strategies: call bull spreads, put bear spreads, long straddles and long combos. Many other different strategies exist, including put bull spreads, call bear spreads, short straddles and short combos as well as other types of spreads such as butterflies, time spreads and boxes.

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