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qxd 1/8/01 1:40 AM Page 17

OPTIONS STATEGIES

OPTIONS STRATEGIES

odays professional options traders have a full arsenal

THE
VERTICAL
T of products and strategies at their disposal. They may
have become successful in different ways, traded var-
ious markets and used diverse strategies, but they would cer-
tainly all agree on one thing:

CREDIT Most of the money made in options trading is made by

SPREAD those selling options rather than by those who buy them.

We described in a previous article (YTE April-May) how some

Option trading is not for the faint traders tried to maximise their chances for success by putting
hearted but can provide high returns. the odds and time on their side selling out-of-the-money calls
or puts - aiming to benefit from time decay. Remember,
Jacques Mallen investigates.
options are a wasting asset - they lose their time value as they
get closer to expiry. It is important to note that selling naked
options is a potentially high-risk strategy and requires a high
degree of product knowledge.You should only consider doing
so after consulting your adviser. The potentially unlimited risk
associated with selling naked options is a risk that most traders
cannot afford to take. Those unfamiliar with the concept of
short selling need to be aware that in futures and options mar-
kets you can sell something you dont own in the first place.
One of the greatest benefits of options is the high level of
flexibility they offer.The unlimited risk characteristic of a sold
naked option can simply be overcome by combining it with
another option - a bought option.

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OPTIONS STATEGIES

If a trader wants to profit from time decay by selling an out-

COMMON TERMS GLOSSARY of-the-money call, the upside risk can be limited by buying,
at the same time, a further out-of-the-money call. The same
strategy can be replicated for puts. A trader selling an out-of-
the-money put could limit the downside risk by simultane-
Volatility
ously buying a further out-of-the-money put.
A measure of the degree of movements in the
This strategy is called a vertical credit spread. On the one
price of the underlying around their statistical hand we receive a premium from selling an option; on the
mean. other hand we pay a smaller premium to purchase the further
out-of-the-money option. The difference between the two
Time decay premiums is a credit. The credit received is the maximum
It is the erosion of the time value component of profit from the strategy. The maximum potential loss is the
difference between the two strikes less the net premium
the premium as the option approaches expiry.
received.
One can argue that, at face value, the downside risk exceeds
Delta profit potential. So what would be the point of entering into
The change in the value of an option for a unit such a strategy? As often mentioned in connection with
change in the price of the underlying. options, it all comes down to probabilities. If there is a high
probability of a small profit each time you trade, and you
Out-Of-The-Money Call trade month after month and every month, while at the same
time managing risks, you are giving yourself some very good
Strike Price > Market Price
chances to succeed in the long run. How far out-of-the-
money you can sell options, while still receiving a worthwhile
Out-Of-The-Money Put premium, is the trade-off that each trader would analyse, tak-
Strike Price < Market Price ing into consideration individual tolerance to risk, and profit
targets.
Underlying
The share, commodity, currency, stock index or
futures contract against which the options con-
HOW TO IDENTIFY SUITABLE TRADES
tract is valued.
Volatility is a very important factor when trading options.
Vertical credit spreads tend to be more profitable when the
Short selling underlying asset is more volatile - meaning the options are
The sale of a security that is not yet owned, in worth more. To identify vertical credit spreads with a high
the expectation that its price will fall so that it potential profit, the first step is to look for commodities,
can be bought back later at a profit. stocks, stock indices, or any other underlying market where
the current level of volatility is high in comparison with his-
torical levels (see example in Graph 1).The higher the volatil-
ity, the higher will be the net premium received.

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OPTIONS STATEGIES

HISTORICAL PRICE VOLATILITY

FTSE 100 Index for EurOpts
45
10 day % 10.77
P 40
C
T Sharp increase in volatility 35

V 30
O
L 25
A
T 20
I
L 15
I
T 10
Y
5

27 17 01 15 01 15 02 16 01 15 01 15 02 16 01 15 01 15 02 17 01 15 01 15
Jul Aug Sep Oct Nov Dec 2001 Feb Mar Apr May Jun

N = 10 days Annualization factor = 260

GRAPH 1

FTSE 100 Index

7000 7000
6000 6000
6800 6800
6700 6700
6600 FT100 Index 6600
6500 6500
6400 6400
6300 6300
6200 6200
6100 6100
6000 6000
5900 5900
5300 5300
5700 5700
5600 5600
5500 5500
Trade date: 22/03/2001
5400 5400
5300 Expiry date: 20/04/2001 5300
Strike of the Sold out-of-the money Put Option: 5025
5200 5200
"The view is that the market won't get to that level
5100 by expiry date." 5100
5000 5000
4900 4900
4800 Strike of the Bought out-of-the-money Put Option: 4925 4800
"Protective leg of the spread against a crash scenario."
4700 4700
4600 4600
Relative Strength Index (31.3387)
70 70

60 60

50 50

40 40

30 30
The Relative Strength Index signalled an oversold market

Sep Oct Nov Dec 2001 Feb Mar Apl May Jun Jul Aug

GRAPH 2

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OPTIONS STATEGIES

The second step is to select the strike of the sold out-of-the- sibility to exit the trade before expiry. The level at which to
money option (see example in Graph 2). Look at the deltas trigger a stop loss is a matter of an individuals own toler-
of an option series as a guide for probabilities. For instance, ance to risk. As a guideline, you could decide to exit the
a delta of 25 implies that the option has only 25 per cent strategy when the loss equals the amount of the net premi-
chance to finish in-the-money, that is, selling that option um received. It is also a good idea to have your stop loss
implies that you have 75 per cent chance to profit from the level ready before entering the strategy, so you can emo-
trade. As a general guideline for our strategy, avoid selling tionally detach yourself from the trade.
options with deltas above 30 (here we have used the con- Capital management is crucial when trading options. The
vention of writing the delta without the decimal point). last thing you want to happen is to see one loss wiping out
Once you are comfortable with your selection of the sold most of your trading capital, and to find yourself in a situ-
option you can select the bought option, to put in place the ation where you cannot trade again, not only because of
protective leg of the spread. It is a trade-off between how lack of capital but also because your confidence as a trader
much premium you want and how much you can afford to has plummeted.
lose on one trade if the trade goes against you.
Another important factor is the time to expiry, as we want
to benefit from time decay. Time decay becomes steeper at
an ever-increasing rate the closer we get to expiry. As a rule TRADE EXAMPLE
of thumb we will be looking at selling vertical credit To illustrate the whole concept behind the strategy let us go
spreads less than six or seven weeks to expiry. through the following example. Graph 1 plots the volatility
Last, look for an overbought market when selling vertical for the FT100 Index. It shows a strong push in volatility lev-
call spreads, and for an oversold market when selling verti- els, starting around mid-March 2001. That created an
cal put spreads (see bottom of Graph 2). In addition, try to option selling opportunity.
select those markets with strong support or resistance lev-
els, so you can carefully pick your strikes based on those Graph 2 shows the FT100 Index price action during the
observations. same period. The example trade is as follows:
This is not an exact science, but if you take into consider-
ation these important factors it will help to stack the odds
Trade date: 22/03/2001 (high volatility, oversold
on your side. market, only four weeks to expiry from the selected
April contract)

Selling an out-of-the-money April put option at a strike

HOW TO MANAGE THE TRADE of 5025 points, premium received: 76.5 points
You are now in a trade. Whats next? In a perfect scenario,
the market will go sideways or move in the opposite direc-
Buying a further out-of-the-money April put option at
tion - down for call spreads, up for put spreads - in which a strike of 4925 points, premium paid: 57 points
case you will just have to wait for time decay to work in
your favour until expiry, to cash in on the full amount of the
Net premium received: 76.5 57 = 19.5 points (each
premium. index point in the FT100 Index options is valued at
If the market moves against you, there is always the pos- 10)

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OPTIONS STATEGIES

Expiry date: 20/04/2001

The level at which

Trade outcome: On expiry the FT100 Index finished
to trigger a stop above 5025, meaning that both out-of-the-money April

loss is a matter of put options expired worthless (from a buyers point of

view). The seller of the vertical credit spread makes a

an individuals own profit equal to the full amount of the net premium (19.5
points x 10 = 195 per spread, or approx $A 535 at the

tolerance to risk. time of writing). All figures are exclusive of transaction

costs.

The example shows that trading in vertical credit spreads can

be quite a viable strategy, although it needs to be approached
with some skill and caution.
Do not fall into the trap of repeating exactly the same strat-
egy time after time in the same market. You should bear in
mind that there is no magic strategy out there that is going
to make you money under all market conditions. You first
need to do your homework in order to formulate a view on
a particular market. Only when you have found a suitable
market to trade - one that meets all your criteria - can you
put the appropriate trading strategy in place. If you decide to
trade in only a few selected markets you should be wary of
changing market conditions and adjust your strategy accord-
ingly.
There is little in the way of literature available on this type
of strategy, so the best advice is to speak with someone who
knows, and learn from his or her experience.

Jacques Mallen is a technical analyst and an options strateg ist

with Australian Futures and Securities Pty Ltd, an Associate
Participant of the Sydney Futures Exchange. Questions regard-
ing options trading and strateg ies can be addr essed to:
[email protected]

Disclaimer: This article was produced for educational pur poses

only, and does not constitute nor imply any trading recommen-
dation. Trading in options may involve the risk of loss as well
as the potential for profit.

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