Volatile Limited Risk Option Plays

Long Straddle / Long Strangle

• Long call and long put at same strike (straddle) or different strikes (strangle) at same expiration
• Unlimited profit potential to upside and downside
• Loss limited to the cost of the straddle or strangle
• Break-even points are the strike plus and minus the value of the straddle, or high strike plus and lower strike minus the value of the strangle
• The definitive position for volatile markets
• Time decay (theta) is your enemy
• The technique called "gamma scalping" can be used with straddles and strangles to offset time decay

Back Spreads

• Long more options than short options
• Unlimited profit potential with limited risk
• This position has net long options, and is long volatility (vega)
• Be aware that a backspread can be initiated for a debit (pay for it) or credit (receive money for it)
• Sluggish stock price movement and time are your enemies

Range Bound Option Plays

Trading Range Limited Risk

Long At-The-Money Butterfly/Condor

• A condor is like a "stretched out" butterfly with two different middle strikes rather than just one
• Can be a relatively inexpensive option strategy that has limited risk and limited profit potential
• The closer a butterfly is to expiration, the more it will react to changes in the stock price
• A strategy used by professional traders for years because of its protective characteristics
• For a long butterfly, you want the stock to stay near the middle strike
• Time decay (positive theta) is your friend

Long At-The-Money Time Spread

• Long back month call (put) and short front month call (put) with the same strike price
• Maximum loss is limited to the price of the time spread, but can be greater in certain index options
• This spread works best if the stock price stays right at the strike price
• Implied volatility can change at different rates in different expirations
• The position becomes more sensitive to changes in the stock price as expiration nears

Bearish Option Plays

Bearish Limited Risk Long Put Easy to execute and manage The delta of a put tells you your exposure to changes in the stock The delta of a put will change with stock price movement and the passage of time Don't forget about time decay (negative theta) Keep in mind that volatility of the underlying and fluctuations in implied volatility (supply and demand for premium) affect option prices Put Back Spread Long more lower strike puts and short higher strike put at same expiration Like a long put, it has unlimited downside profit potential with limited risk At expiration, the stock needs to be significantly below the long strike to make money This position has net long options, and is usually long volatility (vega) Be aware that a backspread can be initiated for a debit (pay for it) or credit (receive money for it) The potential liability is the difference between the strikes

Bullish Option Plays

Bullish Limited Risk

Long call

• Easy to execute and manage
• The delta of a call tells you your exposure to changes in the stock
• The delta of a call will change with stock price movement and the passage of time
• Don't forget about time decay (negative theta)
• Keep in mind that volatility of the underlying and fluctuations in implied volatility (supply and demand for premium) affect option prices

Call Back Spread

• Long more higher strike calls and short lower strike call at same expiration
• Like a long call, it has unlimited upside profit potential with limited risk
• At expiration, the stock needs to be significantly above the long strike to make money
• This position has net long options, and is usually long volatility (vega)
• Be aware that a backspread can be initiated for a debit (pay for it) or credit (receive money for it)
• The potential liability is the difference between the strikes

Exercise and Assignment

If you trade options, it's imperative that you understand the basics of exercise and assignment. You don't need to know all the theoretical details, but you must be prepared for it, especially if you're short options where you don't control the exercise feature.

Exercise is the term used when the owner of a call or put (i.e. someone who has a long position in a call or put) uses his right to buy (in the case of a call) or sell (in the case of a put) the stock. Assignment is the term used when someone who is short a call or put is forced to sell (in the case of the call) or buy (in the case of a put) the stock. Remember, for every option trade there is a buyer and a seller, so if you are short an option, there is someone out there who is long that option and who could exercise.

As you know from the basic definition of options, a call gives its owner the right, but not the obligation, to buy the stock at the strike price. But the seller of a call must sell the stock at the strike price whenever the call owner exercises. A put gives its owner the right, but not the obligation, to sell the stock at the strike price. But the seller of a put must buy the stock at the strike price whenever the put owner exercises.

Remember, on expiration, thinkorswim will automatically exercise any equity option that is $0.01 or more in-the-money.

American-style options can be exercised as soon as they are purchased and all the way up to the expiration date. European-style options can be exercised only on the last trading day before the expiration date. All equity options traded in the U.S. are American-style. But some index options are American-style (OEX), while others are European-style (SPX, NASDAQ). It's very important to know precisely when an option expires, and how it is settled.

Basically, settlement is what you get if you exercise an option. If an option is stock-settled, you will get a long position in the underlying stock if you exercise a call, or a short stock position if you exercise a put. U.S. equity options are stock-settled. If an option is cash-settled, you will get cash in the amount of the difference between the strike price of the option and the settlement value of the underlying index. The OEX and SPX index options are cash-settled.

The Greeks: What They Are and How to Use Them

The Greeks have given us feta cheese, philosophy, mathematics, and the Oedipal complex. They also tell us how much risk our option positions have.

There are ways of estimating the risks associated with options, such as the risk of the stock price moving up or down, implied volatility moving up or down, or how much money is made or lost as time passes. They are numbers generated by mathematical formulas. Collectively, they are known as the "greeks", because most use Greek letters as names. Each greek estimates the risk for one variable: delta measures the change in the option price due to a change in the stock price, gamma measures the change in the option delta due to a change in the stock price, theta measures the change in the option price due to time passing, vega measures the change in the option price due to volatility changing, and rho measures the change in the option price due to a change in interest rates.

Delta

The first and most commonly used greek is "delta". For the record, and contrary to what is frequently written and said about it, delta is NOT the probability that the option will expire ITM. Simply, delta is a number that measures how much the theoretical value of an option will change if the underlying stock moves up or down $1.00. Positive delta means that the option position will rise in value if the stock price rises, and drop in value if the stock price falls. Negative delta means that the option position will theoretically rise in value if the stock price falls, and theoretically drop in value if the stock price rises.

The delta of a call can range from 0.00 to 1.00; the delta of a put can range from 0.00 to –1.00. Long calls have positive delta; short calls have negative delta. Long puts have negative delta; short puts have positive delta. Long stock has positive delta; short stock has negative delta. The closer an option's delta is to 1.00 or –1.00, the more the price of the option responds like actual long or short stock when the stock price moves.

So, if the XYZ Aug 50 call has a value of $2.00 and a delta of +.45 with the price of XYZ at $48, if XYZ rises to $49, the value of the XYZ Aug 50 call will theoretically rise to $2.45. If XYZ falls to $47, the value of the XYZ Aug 50 call will theoretically drop to $1.55.

If the XYZ Aug 50 put has a value of $3.75 and a delta of -.55 with the price of XYZ at $48, if XYZ rises to $49, the value of the XYZ Aug 50 put will drop to $3.20. If XYZ falls to $47, the value of the XYZ Aug 50 put will rise to $4.30.

Now, these numbers assume that nothing else changes, such as a rise or fall in volatility or interest rates, or time passing. Changes in any one of these can change delta, even if the price of the stock doesn't change.

Straddles & Strangles

Long Straddle
Long 1 XYZ Sep 50 call @ $2.00, Long 1 XYZ Sep 50 put @ $1.75
Total Cost	Option Premium Paid, $375
Maximum Loss	Option Premium Paid, $375
Maximum Profit	Unlimited Potential
Short Straddle
Short 1 XYZ Sep 50 call @ $2.00, Short 1 XYZ Sep 50 put @ $1.75
Total Credit Received	Net option premium received, $375
Maximum Loss	Unlimited Potential
Maximum Profit	Net option premium received, $375
Long Strangle
Long 1 XYZ Sep 40 put @ $1.00, Long 1 XYZ Sep 60 call @ $.75
Total Cost	Option Premium Paid, $175
Maximum Loss	Option Premium Paid, $175
Maximum Profit	Unlimited Potential
Short Strangle
Short1 XYZ Sep 40 put @ $1.00, Short 1 XYZ Sep 60 call @ $.75
Total Credit Received	Net option premium received, $175
Maximum Loss	Unlimited Potential
Maximum Profit	Net option premium received, $175

Explanation and Application

The names "straddle" and "strangle" may give you clues about these option positions. Like your favorite politician trying to win both Democratic and Republican votes, these positions are on both sides of the issue. Long straddles and strangles make money if the stock price moves up or down significantly. Who cares which way the stock goes, so long as it GOES!

Straddles and strangles are essentially speculations on whether the price of the stock will move a lot or not or implied volatility is going to go up or down. If you think the stock is going to move big in one direction or another and/or if you think implied volatility is going to rise, you would buy a straddle or strangle. If you think the stock is going to sit still or not move very much and/or if you think implied volatility is going to fall, you would sell short a straddle or strangle.

A long straddle is long 1 call and long 1 put at the same strike price and expiration and on the same stock. A long strangle is long 1 call at a higher strike and long 1 put at a lower strike in the same expiration and on the same stock. Such a position makes money if the stock price moves up or down well past the strike prices of the strangle. Long straddles and strangles have limited risk but unlimited profit potential.

Calls, Puts & Covered Writes

Essentials

Long Call
Long 1 XYZ Sep 50 call @ $2.00
Total Cost	Option premium paid, $200
Maximum Loss	Option premium paid, $200
Maximum Profit	Unlimited
Short Call
Short 1 XYZ Sep 50 call @ $2.00
Total Credit Received	Option premium received, $200
Maximum Loss	Unlimited
Maximum Profit	Option premium received, $200
Long Put
Long 1 XYZ Sep 40 put @ $1.00
Total Cost	Option premium paid, $100
Maximum Loss	Option premium paid, $100
Maximum Profit	Unlimited
Short Put
Short 1 XYZ Sep 40 put @ $1.00
Total Credit Received	Option premium received, $100
Maximum Loss	Unlimited
Maximum Profit	Option Premium Received, $100

Explanation and Application

Before you can trade the more complicated option positions, it would be wise to understand their building blocks: calls and puts. Critics of option trading always point out how risky, speculative, and unnecessary options are. But what they either don't understand or point out is that options are designed to be a tool for transferring risk from one trader to another. It is imperative to understand that when buying calls or puts, the potential loss is limited to the amount paid for the calls or puts. When selling calls or puts, the potential loss is unlimited (short puts really have risk limited to their strike price, but are considered unlimited for all intents and purposes). Therefore, when you buy an option, you are limiting your risk by transferring it to whomever sold the option. When you sell an option short, you are accepting the risk from whoever bought the option. Options can offer a great deal of leverage, meaning that you can have the risk/reward exposure of a large position in stock for a relatively small amount of money.

It's important to understand that there are trade-offs in options. There are good points and bad points about every option strategy. You must isolate your speculation, i.e. precisely what do you think is going to happen to a stock and when is it going to happen? You must balance potential risk versus potential reward. Always keep in mind that in option trading, you never get anything for free.