Annuities and Other Retirement Products: Designing the Payout Phase (Directions in Development)_7 pot

13  Butterflies and condors: combining call spreads and put spreads 145 T able 13.5 Marks and Spencer long April 320–330–340–350 put condor M&S 310.00 320.00 322.25 330.00 340.00 347.75 350.00 360.00 Spread debit –2.25 Value of long 350–340 put spread at expiry 10.00 10.00 10.00 10 .00 10.00 2.25 0.00 0.00 Value of short 330–320 put spread at expiration –10.00 –10.00 –7.75 0.00 0.00 0.00 0.00 0.00 Profit/loss –2.25 –2.25 0.00 7.75 7.75 0.00 –2.25 –2.25 *Long at-the-money put condor For stationary markets Put condors, like call condors, can be placed at many different strikes, depending on your near-term outlook for the underlying. If your out- look calls for a stationary market, but you wish to leave room for error on the downside, you can substitute the long at- the-money put condor for the at-the-money put butterfly. You might, for example, buy the above April 360–350–340–330 put condor for a debit of 3.5 The downside profit potential of this spread is 330 2 4 6 8 10 0 –2 –4 310 320 340 350 360 Figure 13.5 Expiration profit/loss relating to Table 13.5 Put condors, can be placed at many different strikes, depending on your near-term outlook for the underlying 146 Part 2  Options spreads the same as the upside profit potential of the long April 340–350–360–370 call condor. The profit/loss at expiration is summarised as follows: Debit from long April 360 put: –16.25 Debit from long April 330 put: –3.75 Credit from short April 350 put: 10.25 Credit from short April 340 put: 6.25 ––––– Total debit: –3.50 Maximum profit: difference between highest two strikes minus spread debit: (360 – 350) – 3.5 = 6.5 Range of maximum profit: 350 – 340 Upper break-even level: highest strike minus spread debit: 360 – 3.5 = 356.5 Lower break-even level: lowest strike plus spread debit: 330 + 3.5 = 333.5 Profit range: 356.5 – 333.5 = 23 Maximum loss: cost of spread: 3.5 The risk/return ratio is again favourable at 3.5/6.5 = 0.54 for 1, or 1/1.85. By now you should be an expert at tabulating and graphing the expiration profit/loss levels of condors and butterflies. * Short at-the-money put condor For volatile markets Like the butterfly, the condor can be sold in order to profit from a vola- tile or trending market. Although this is more of a market-maker’s trade, you might consider trading it during volatile mar- kets. For example, you could sell the above April 360–350–340–330 put condor at 3.5. If Marks and Spencer closes above 360 or below 330 at expira- tion, you earn the credit from the spread. In this case you are taking a slightly bullish position. The profit/loss figures are exactly the opposite of the above long put condor. Like the butterfly, the condor can be sold in order to profit from a volatile or trending market 13  Butterflies and condors: combining call spreads and put spreads 147 * Short at-the-money call condor for volatile markets If instead your outlook is for volatile conditions and you are slightly bear- ish, you might sell the April 340–350–360–370 call condor at 2.75. (Don’t be surprised if you earn your profit on the upside.) If at expiration Marks and Spencer closes below 340 or above 370, then you earn the credit from the spread. Again, this is a market-maker’s trade, but you might learn about it to increase your market awareness. Your profit/loss summary is as follows. Credit from short April 340 call: 17.00 Credit from short April 370 call: 3.75 Debit from long April 350 call: –11.25 Debit from long April 360 call: –6.75 ––––– Total credit: 2.75 Maximum profit: spread credit: 2.75 Range of maximum profit: below 340 and above 370 Lower break-even level: lowest strike plus spread credit: 340 + 2.75 = 342.75 Upper break-even level: highest strike minus spread credit: 370 – 2.75 = 367.25 Maximum loss: difference between lowest two strikes minus spread credit: (350 – 340 – 2.75 = 7.25 Price range of shares for potential loss: 367.25 – 342.75 = 24.5 points The risk/return ratio is 7.25/2.75 = 2.64 to 1. *Butterflies and condors with non-adjacent strikes Butterflies are flexible spreads which can profit from a variety of trading ranges. You can extend the profit range of a butterfly by extending the distance of the strikes. If XYZ is at 100, and you expect it to rally into a range of between 105 and 115, then you can buy the 100–110–120 call but- terfly. This spread costs more than the adjacent strike, 105–110–115 call butterfly, but it has a greater profit range. Butterflies are flexible spreads which can profit from a variety of trading ranges 148 Part 2  Options spreads Using the set of Marks and Spencer April options, you could pay 11.25 for the 350 call, sell two 370 calls at 3.75, and pay 1 for the 390 call, for a net debit of 4.75. Your profit range is then 354.75 to 385.25, or 30.5 points, or 8.7 per cent of the share’s value. Condors can also increase their profit ranges by increasing the distance of the strikes. This is especially feasible while that stock indexes and, as a result, options premiums, are at high levels. Consider the set of FTSE options below. June FTSE-100 options June Future at 6250 4 106 days until expiry ATM implied at 26 per cent Strike 6225.0 6325.0 6425.0 6525.0 6625.0 6725.0 6825.0 6925.0 Calls 359.5 303.0 253.5 205.0 165.0 131.0 102.5 80.0 If you discern that the path of least resistance is up, or if you’re simply bullish, you may wish to take a long call position in the UK market. But if the thought of spending £2,000 to £3,000 for one options contract gives you pause, then you may instead consider financing your call purchase with a spread. For £470, the 6325–6525–6725–6925 call condor can be purchased with- out taking out a second mortgage. The maximum profit is 200 – 47 = 153 ticks. The break-even levels, at 6372 and 6878, provide a profit range of 506 points. The risk/return for this spread is favourable, at 47 / 153 = 0.31. The trade-off with this spread is that if the FTSE rallies quickly, then the spread will show only a modest profit. Like all butterflies and condors, this spread needs time decay to work for it. Non-adjacent strike butterflies and condors are preferred alternatives in the OEX or SPX and SPY (SPDRS) as well. They are sensible ways of reduc- ing premium exposure while minimising risk. Some exchanges have reduced the tick size of these contracts in order to accommodate the indi- vidual investor, and to improve liquidity and price discovery. 4 If and when the FTSE reaches this level again. The point is to use butterflies and condors when options premiums are expensive. 13  Butterflies and condors: combining call spreads and put spreads 149 Volatility, days until expiration, and butterflies and condors Likewise when volatilities are high, you can often find inexpensive adja- cent strike butterflies and condors, such as in the above FTSE example. This is because the underlying is trading in a wide range, and the prob- ability of it settling near a particular strike at expiration is small. The same factors apply to these spreads when there are many days until expiration. At times like these, it is preferable to trade butterflies and condors with non-adjacent strikes. The advantages In this chapter we have covered butterflies and condors in depth. The rea- sons for this are twofold: when purchased, these spreads have low risk/ return ratios; also, they can easily be opened and closed in one transac- tion. They are therefore justifiable trading strategies under many market conditions. It is worth learning how to use them. 14 The covered write, the calendar spread and the diagonal spread The diagonal spread for trending markets There are two additional spreads that profit from stationary markets. The covered write involves selling a call against a long underlying position, and the calendar or time spread involves selling a near-term at-the- money option, usually a call, and buying a further-term at-the-money option, again usually a call. Both spreads profit from time decay. The covered write or the buy-write If an investor owns or is long an underlying con- tract, he may sell or write a call on it to earn additional income. This strategy is known as the covered write and it is often used by long-term holders of stocks that are temporarily underper- forming. It is often traded in bear markets. When the underlying is bought and the call is sold in the same transac- tion, this spread is also known as the buy-write. For example, if you own XYZ at a price of 100, or hopefully less, you may sell one 105 call at 3. The maximum profit is the premium earned from the sale of the call plus the amount that the underlying appreciates to the strike price of the call. Here, this would be 5 + 3 = 8. The downside break- even level is the price of the underlying at the time of the call sale less the call income. Here, this would be 100 – 3 = 97. There are two risks: When the underlying is bought and the call is sold in the same transaction, this spread is also known as the buy-write 152 Part 2  Options spreads O The first is that the underlying may decline below the downside break- even level, and that you will take a loss on the total position. O The second is that the underlying may advance above the call strike price, the underlying will be called away, and you will relinquish the upside profit from the underlying. This spread is best used by investors who have purchased the underlying at significantly lower levels, who think that there is little or no upside potential, and who can tolerate short-term declines in the underlying. Consider Coca-Cola at 52.67; August options with 60 days until expiration: Strike 40.00 42.50 45.00 47.50 50.00 52.50 55.00 57.50 60.00 August calls 4.04 2.52 1.45 0.79 0.34 August puts 0.34 0.47 0.82 1.30 2.05 2.90 For example, Coca-Cola is currently trading at 52.67, and the August 60 calls, with 60 days until expiration, are priced at 0.34. You may sell one call on each 100 Coca-Cola shares that you own. Alternatively, you may pay 52.67 for 100 shares, while selling the call, as a spread. At expiration, the maximum profit for your spread occurs at the strike price of the call. There, you gain the price appreciation of the stock plus the full income from the call. The maximum profit is calculated as the strike price minus the purchase price of the stock plus the income from the call, or (60 – 52.67) + 0.34 = 7.67. Above the call strike price, the profit from the stock is offset by the loss on the call, on a point for point basis. The maxium profit is earned, no more, no less. The stock will be called away from you at expiration. The lower break-even level for your position is the price at which the call income equals the decline in the stock price. This is calculated as the price of the stock minus the income from the call, or 52.67 – 0.34 = 52.33. Below this level the spread loses point for point with the stock. The expiration profit/loss for this covered write is summarised as follows. Maximum profit: strike price minus stock price, plus income from call: (60 – 52.67) + 0.34 = 7.67 The maximum profit occurs at or above the strike price of the call 14  The covered write, the calendar spread and the diagonal spread 153 Break-even level: stock price minus income from call: 52.67 – 0.34 = 52.33 Maximum loss: full amount of stock price decline below break-even level: 52.33 The expiration profit/loss is summarised in Table 14.1. Table 14.1 Coca-Cola covered write: with Coca-Cola at 52.67, sell August 60 call at 0.34 Coca-Cola (below) 45.00 50.00 52.33 52.67 55.00 60.00 65.00 Credit from 60 call 0.34 Value of call at expiration 0.00 0.00 0.00 0.00 0.00 0.00 0.00 –5.00 Stock profit/loss at expiration (–full amt) –7.67 –2.67 –0.34 0.00 2.33 7.33 12.33 Total profit/loss (–full amt) –7.33 –2.33 0.00 0.34 2.67 7.67 7.67 The expiration profit/loss is shown in Figure 14.1. 2 4 6 8 10 0 –2 –4 –6 –8 –10 –12 42.5 45 47.5 50 52.5 55 57.5 60 62.5 65 Figure 14.1 Expiration profit/loss for Coca-Cola 154 Part 2  Options spreads Two comments First, if this chart looks like a naked short put, then you’re absolutely right. The buy write is no more than a synthetic short put. (Refer to Chapter 21 on synthetics.) So why bother with the complications? Make it simple: if you want to buy stock and write the call, and if there are no dividends involved, and if you’re a short-term investor, then just sell the in the money put and save yourself commissions. You’ll have the same risk profile. (Obviously, I’m not a fan of selling naked puts.) Second, and more importantly, there is currently a lot of common advice which tells you to initiate buy-writes for tempting yields. Well-meaning advisers usually tell you that you could pay 52.67 for Coca-Cola and sell the August 55 call at 1.45. Your annualised return would be 1.45/52.67 × 360/60 = 16.5% But this yield projects that the stock stays where it is for a year while you write more calls. True, if Coca-Cola rallies then you’ve made a bit, but then you’re making the classic mistake of trading on hope. Instead, if Coca-Cola declines past 52.67 – 1.45 = 51.22 then you’re a loser. This is why I don’t recommend the buy-write as an initiating trade. On the other hand, if you’ve inherited the stock from your father, who bought it for $20 or thereabouts, and we’re at the start of a bear market, or maybe we’re in a bull market, and Coca-Cola is looking toppy, and you can’t afford to sell it because you’ll pay capital gains tax, then, in either of these cases you might consider writing a call. But only do it once or twice. And a story Several years ago, I gave a lecture at a major London bank. During the interval, a trader confided to me that they had recently done very well with a buy-write on shares. He also stated that they were disappointed because the shares had rallied past the cut-off level, or the short call level, and that they had missed out on a good deal of profit. Knowing what they had done, I suggested that there were better ways of capturing the upside. These are outlined in the examples at the end of Chapters 1 and 2, and they are called substitution trades. [...]... at a strike further out-of -the- money part 3 Thinking about options Introduction Part 3 describes the finesse of options There’s a lot involved here and it takes you way past 1×1s This part guides you through advanced topics such as how the Greeks interact Bear in mind that the Greeks have non-linear variables, and so you need to read about them and work with them In other words, reading this part will... previously learned about the Greeks It places them all into perspective and describes their interaction Comparing options 1: the Greeks and time Let’s look again at December Corn options Tables 15.1 and 15.2 show two sets of options with different days until expiration, and with the corresponding deltas, gammas, thetas and vegas The price of the underlying is held constant You may compare the effect of time... remaining at -the- money This spread is best opened when the near-term option has between 60 to 30 days till expiration The time distance between the two options can vary A greater distance increases the cost of the spread, and reduces the hedge value of the further-term option, while a shorter distance reduces the difference in rates of decay, which in turn lowers the profit potential Optimally, there... all is that the implied volatility may increase more for the short, near-term option than for the long, further-term option, causing the spread to lose its value This is usually due to an unforeseen event The underlying may then move away from the strikes before profit is made from time decay Another possible risk is that the historical volatility of the underlying may decrease, bringing the implied... of interest rates can affect the delta spread between the two options contracts Short-term interest rate and other interest rate contracts have their own risks A central bank may unexpectedly announce a change in interest rates, or the change may be greater or less than expected Economic indicators may change the market’s assessment of the interest rate outlook This will cause the spreads between the. .. Gamma Theta up up up down These relationships hold true for all options, but they become more exaggerated as the underlying has less value, and less implied volatility, with less time until expiration, and with strike prices that are more widely separated Conversely, they become less exaggerated if, as the strike prices narrow, the underlying increases in value, and time and the implied increases Imagine... interaction of the Greeks The Greeks, the time until expiration and the implied volatility interact with each other in ways that work together and in ways that trade off They work differently for each options position By knowing how they interact you can test your position for market scenarios You can anticipate what may happen under the best, or return, scenario, or under the worst, or risk, scenario... 17.0 The values of the calendar spreads are given in parentheses (CS) Note that the calendar spread with the most value is the February–November 220 call calendar spread There the characteristic of at -the- money, accelerated time decay is most in evidence By comparing the February–November 220 call calendar spread to the February–November 180 and 260 call calendar spreads it can be seen that as the underlying... rises to 260 at the point when February has nine days until expiration, then the spread will be worth approximately 17, or the present value of the February–November 220 call calendar To get an accurate profit/loss assessment at expiration requires simulation by computer, which can determine the value of the calendar at various points in time and at various price levels of the underlying The above set... story and a bit of advice With the covered write, it is important not to think in terms of the short call as ‘downside protection’ Remember ’portfolio insurance’? A form of this 14  The covered write, the calendar spread and the diagonal spread now discredited strategy was a variation of the covered write During the 1980s portfolio insurance was sold to investors as a means of ‘downside protection’, in . in Table 14.2. Table 14.2 Expiration profit/loss for Coca-Cola Coca-Cola (below) 45.00 47. 50 50.00 52. 67 53.44 60.00 62.50 65.00 Total options debit –0 .77 –0 .77 –0 .77 –0 .77 –0 .77 –0 .77 –0 .77 . plus the full income from the call. The maximum profit is calculated as the strike price minus the purchase price of the stock plus the income from the call, or (60 – 52. 67) + 0.34 = 7. 67. Above. is the price of the underlying at the time of the call sale less the call income. Here, this would be 100 – 3 = 97. There are two risks: When the underlying is bought and the call is sold in