Options Strategies in a Neutral Market

Transcription

1 Class: Options Strategies in a Neutral Market

2 This document discusses exchange-traded options issued by The Options Clearing Corporation. No statement in this document is to be construed as a recommendation to purchase or sell a security, or to provide investment advice. Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies of this document may be obtained from your broker, from any exchange on which options are traded or by contacting The Options Clearing Corporation, One North Wacker Dr., Suite 500 Chicago, IL ( ) i

3 Class: Options Strategies in a Neutral Market "Options Strategies in a Neutral Market" (Options 305) is the third of The difficulty rating for this the market direction theme courses available from 888options.com. class is: ADVANCED This course has been created to educate investors on various option strategies best suited for a non-directional or neutral market. A unique component of this course is that every strategy presented is a spread. These different spreads are designed to use time decay to its advantage. At the completion of the chapters and prior to the final quiz the student should know and understand all the strategies presented. Chapter 1 - Introduction In the introduction, a description of time decay is given along with the uses of writing options to take advantage of time passage. The risk reward and profit potential of these spreads is discussed in the introduction as well. Chapter 2 - Time Spread This chapter covers the use of time spreads in a neutral market. The erosion of front month time premium is explained and interactive examples are provided for using a time spread. Chapter 3- Covered Call In this chapter the adaptability of the covered call is explored in depth as a tool that can be used in a neutral market. This chapter illustrates in specifics the time decay function of the covered call and how a covered call can be customized to a neutral market environment. Chapter 4 - Collar Chapter 5 - Straddles & Strangles For this chapter straddles and strangles are introduced in the context of a neutral market environment. While these strategies are directly affected positively by time decay, this chapter explains that the associated risk is higher as well. This chapter gives examples of various strangles and straddles in a neutral market. Chapter 6 - Butterfly The final strategy discussed in Options 305 is the butterfly. In this chapter the butterfly is explained along with instructive descriptions of figuring maximum profit, fixed maximum losses and the ideal outcome. This chapter also describes the various components of a butterfly and the ability to close out each component separately. Chapter 7 - Conclusion and Quiz Review of key topics and final quiz. This chapter introduces the student to the protective collar as a strategy for a neutral market. This chapter explains how a collar can take on the role of a covered call along with a protective put. The ability to put this type of trade on as a credit is explained in detail

4 Introduction There are market conditions that call for what are known as directional strategies. In a bull market you can buy stock or choose from a variety of bullish options strategies. In a bear market you can sell stock short or choose a decidedly bearish options strategy. But what can you do if you think the market as a whole, or a particular stock, will go nowhere over a period of time, and buying or selling shares won t result in much profit? You might consider one of a range of neutral options strategies. Choose your objective Calls and puts are flexible financial products, and can be put together into a variety of strategies that reflect many financial objectives. In a neutral market you might: Speculate that a stock will remain stuck in neutral and profit from this lack of momentum. Decide that generating income from an existing, sluggish stock position suits your needs and expectations. Have unrealized profits from a previous stock purchase and decide to position your shares for an up or down move with one simple strategy. Whatever path you take, you ll want to make sure the options strategy has the potential to meet your expectations and objectives before jumping into the marketplace. Time Spread When you think an underlying stock is not going to change in price by very much, you might consider buying an at-the-money time spread. This strategy involves: Underlying assumptions For simplicity s sake, calculations of profit or loss do not include the impact of commissions, transaction fees, or taxes. You should discuss these with your brokerage firm before making a transaction. You should also discuss the tax consequences of these strategies with a tax adviser. Similarly, the discussions that follow assume the use of regular calls and puts that is, contracts whose terms have not been adjusted due to an underlying stock split or any corporate action such as a special dividend, spin-off, merger, or acquisition. The examples also assume that all contracts in the course represent 100 unadjusted shares with a strike and premium multiplier of 100. Buying an at-the-money option with a given expiration month. Writing an option on the same stock at the same strike price expiring in a closer-term month. In a time spread, you use either two calls or two puts, and the short option you sell is considered covered by the long one you purchase. Make the most of time decay The object is to let time decay erode the near-term option s value more than the far-term option s. You ll see your limited, maximum profit if the stock closes exactly at the strike price at the near-term expiration. The loss on both the upside and downside is limited

5 When choosing the expiration months for your time spread, remember that the rate of decay for any option increases as expiration nears. Whatever the strike price or expiration months you choose, you should hope that the underlying stock closes at or very near the strike price at or around the short, near-term option expiration. For example, you think XYZ stock, currently trading around $50, will not have much of a trading range over the next six months. You decide to purchase an at-the-money call time spread, or to buy and sell calls that both have a strike price of $50. You check current XYZ call prices and choose to: Buy a July XYZ 50 call currently trading for $5.00 Write a May XYZ 50 call trading for $3.50 Since the July call you re buying for $5.00 costs more than the May call you re selling for $3.50, you re in effect buying this May/July 50 call time spread for a net debit of $5.00 paid $3.50 received = $1.50, or a total cash amount of $150. The ideal result What do you want to happen? You want XYZ to have a narrow trading range around $50 between now and May, the near-term expiration date, and for the price of the short May call to erode more than the price of the long July one. Ideally, you want XYZ stock to be exactly at $50 per share at the close of trading for expiring May options and to not be assigned on the short 50 call. It s now Friday before the May, or near-term, expiration, the last trading day for expiring options. Take a look at the best-case, predicted scenario that XYZ stock closes exactly at $50 as trading ends: Trade-off There's a trade-off when selecting the near-term month to sell against the longer-term month: cash received vs. rate of time decay. Say it's late March. You choose to buy a July 50 option and want to write an option with a $50 strike price that expires sooner. But which month do you sell? April or May may be available. The longer-term May option is worth more, and so reduces your net debit for the spread more than by selling the April option. On the other hand, the shorter-term April option will erode faster than the May, and time decay is what you want. Whatever your decision, this is a trade-off that you have to be comfortable with. Your near-term, expiring May 50 call will be exactly at-the-money. You expect it to expire with no value, with its total premium eroded away, and to most likely not be assigned. The longer-term July 50 call you own should have value, so you have two choices. You can either sell it, realizing your theoretical maximum profit, and close out the spread altogether. Or, you can keep it as a bullish position, depending on your opinion about XYZ stock at that point. Let s say the July 50 call you own is trading for $3.50 at May expiration and you sell it for that amount. Your profit would be $3.50 received - $1.50 debit originally paid for the time spread = $2.00, or $ total

6 What if XYZ stock is not exactly at $50 at May expiration, but it s close? You can still make a profit. Let s look at two scenarios, one with XYZ above and one with it below the $50 strike price. XYZ stock closes at $48 per share. If you were to sell your long July 50 call for, say, $2.50, and were not assigned on your out-of-the-money short May 50 call, your net profit would be: $2.50 received $1.50 debit originally paid for the spread = $1.00, or $ total. XYZ stock closes at $52 per share. Your expiring short May 50 call will be in-the-money and you expect assignment. To avoid this you can close out the spread, or buy the May 50 call and sell the long July 50 call, before the close of trading. If you buy the May 50 call for its intrinsic value of $2.00, and sell the long July 50 call for, say, $4.75, you d receive a net amount of $4.75 $2.00, or $2.75. Your net profit would be: $2.75 received for the spread s sale $1.50 debit originally paid = $1.25, or $ total. What if XYZ either soars above or drops well below the $50 strike price by the near-term May expiration? You'll likely see a loss, but in both cases a limited one. XYZ closes at $25. The short May 50 call will expire out-of-the-money and worthless, but the long July 50 call may have no market value either. In this case you'll have an unrealized loss of the whole debit initially paid for the spread. However, you could always hold onto the July 50 call hoping that it will gain value if XYZ starts to rise sometime after the May expiration. Some or all of your unrealized loss could then be recovered. XYZ closes at $75. Both calls would be deep in-the-money, with the expiring May 50 call trading at or near its intrinsic value of $25, and the long July 50 call worth slightly more than that, say $ Closing out the spread at these prices before the close of trading would result in a realized loss: $25.50 received $25.00 paid = $0.50 credit. Since you paid $1.50 for the spread, your loss would be $1.50 initial debit $0.50 credit from spread's sale = $1.00 net, or $ total. Selling your time spread If the underlying stock moves in the narrow trading range you predicted, you're free to sell your time spread at any time before expiration when you can make a profit. On the other hand, if the stock moves away from the strike price and the spread begins to lose money, you can sell it to cut further loss. A look into the future Why can't you accurately forecast a time spread's maximum profit when you establish it? Who's to say today exactly where a longer-term option will be trading at a nearterm expiration? One thing you do know in advance is that to realize this maximum profit the price of the underlying stock must be as high (for a long call spread) or low (for a long put spread) as possible for the expiring option to have no value. This point is exactly at the strike price. A key factor in the longer-term option's value is its implied volatility when the near-term option expires. Ultimately, any assumption about this in advance is a prediction

7 Covered Calls The covered call, or writing a call on stock that you own, is one of the more widely used options strategies. Perhaps this is due to its adaptability. It has bullish and bearish, or protective, possibilities, and can be used to generate income as well, which might be your motive in a neutral market. If you have unrealized profits from a previous stock purchase, and now foresee the stockzs price not moving much over a period of time, you might consider writing a number of call contracts equivalent to the number of shares you own. Premium income Remember that you keep any premium received from a call s sale, no matter what happens. If your stock does have a narrow trading range, and at expiration closes below your written call s strike price, the call will expire out-of-the-money and with no value. The premium you received from its sale can be considered generated income (or increased return) from the underlying shares, and a supplement to any dividends that you might be paid. This is attractive during a neutral market when your unrealized profit from owning underlying shares doesn t increase. Trade-off There is a trade-off between selecting an appropriate expiration month and strike price. For a given expiration, writing a lower strike price will result in more premium received, but less upside profit participation if you re assigned. And for a given strike price, the longer the term of a call contract, the more premium you ll receive, but there s also a longer period of time during which the underlying stock can change in price. In balancing these factors you need to be disciplined, with a specific scenario in mind about a possible trading range for your shares, and a time frame for it. Then you can choose your strike price and expiration accordingly. For example, say you own 100 XYZ shares purchased at $45 per share that are now trading for $56. You expect the price to be at this level for a period of time and want to generate a little income. So you write an XYZ 60 call for $3.50, or a total of $350. Say the price of XYZ stock is below the strike price of $60 at the option s expiration. The call will expire with no value, so: You keep the $350 premium received. This premium is income in addition to the unrealized stock profit you have and any dividends XYZ might have paid you. The premium of $3.50 also reduces the cost basis for your stock, from $45 to $41.50 per share. If XYZ has dropped precipitously in price, the premium you received from the call s sale can at least partially offset any decrease you ve seen in your unrealized stock profit. What if XYZ increases dramatically over the lifetime of the written call and is above $60 at the option s expiration? You have a couple of choices. You could let the XYZ 60 call expire and expect assignment. If so, you ll be obligated to sell your 100 shares at the strike price of $60 per share, and will realize a profit of $15 per share over the original purchase price of $45. In addition, the $3.50 per share premium you received from the call s sale supplements this profit

8 A lost opportunity Although your neutral opinion on XYZ stock was incorrect, you ve participated to some extent in its bullish move. The downside is that you locked yourself into a $60 per share sale price if assigned, and will not see any additional profit from the stock s increase above that level. That s known as an opportunity loss. If you don t want to be assigned, you could purchase the XYZ call contract, or close out the position, before it expires. Though you might buy the call at a net loss over its initial sale price, you hold onto your shares and still have unrealized stock profits, supplemented by the $3.50 per share premium you received. Collar Have you ever owned shares with unrealized profits, seen the market stuck in neutral, and been worried that it might move unexpectedly but have no feeling about which way it might move? This is an ideal situation in which you might put a collar on your profits. If the stock price increases and you're assigned, you may realize a profit. What you have lost is the potential for greater gain based on future increases in the stock's price. Constructing a collar The collar is a strategy combining the features of both a covered call and a protective put. In fact, that s how you establish one. You own underlying shares, you write a call covered by those shares on the upside, and you purchase a protective put for a possible downside move. Both the call and the put have the same expiration month and are generally out-of-the-money compared to current stock price levels. A collar can be established at either a net debit or net credit, depending on the strike prices chosen and the options current trading prices. Suppose you own 100 XYZ shares that you purchased at $65, with the stock now trading around $73. You see the market as currently neutral, but you re worried that world events may precipitate a sudden move, up or down. In this case you might establish a 70/75 collar. In other words, you purchase an XYZ 70 put and at the same time write an XYZ 75 call. The XYZ 70 put you buy will protect your shares on the downside by guaranteeing a selling price at the strike of $70 per share if the price of XYZ drops below that level and you choose to exercise the put. The XYZ 75 call you write is covered by the 100 underlying shares you own, so you ll have limited upside profit potential over current stock price levels. You ll be obligated to sell your XYZ shares at the strike price of $75 if you re assigned on the written call. If you establish the collar at an initial net credit, that s yours to keep as well

9 For example, suppose you establish the collar at an initial net credit, at the following prices: Buy 1 XYZ 70 put for a market price of $5.00 Write 1 XYZ 75 call for a market price of $6.50 Your net for establishing this spread is actually a credit: $6.50 received for the call $5.00 paid for the put = $1.50 net credit, or $150 total. You keep this cash, whether you exercise your put or happen to be assigned on your short call. To your credit Since you initially bought 100 XYZ shares at $65 per share and it s currently trading at $73 you have an $8.00 per share unrealized profit to protect. This profit has protection below $70 per share provided by the put, and upside participation to $75 per share if you're assigned on the short call. For this scenario you didn t pay anything. Instead, you actually received the cash amount of $150. Here are various expiration scenarios for your strategy. They let you see the advantages of putting a collar on existing, underlying stock profits. If at expiration XYZ stock closes at any point between the $70 strike price of the long put and the $75 strike of the short call, both options would be out-of-the-money and expire with no value. For both the protection and upside potential you gained during the lifetime of the position you received and keep $150. Collaring a profit If XYZ closes below the $70 strike price of the put at expiration, the contract would be in-the-money so you could exercise it and sell your stock at $70 per share. The net stock profit would be $5.00 per share over the original $65 purchase price, or a total of $500. You also keep the credit of $150 originally received, for a total profit from the point of stock purchase of $650. If XYZ closes above the short call s strike of $75, your alternatives are much the same as with a covered call: If assigned, you ll sell your shares at $75 for a per share profit of $10, or $1,000 total. Add the $150 credit received from establishing the collar, and you have a total profit from the point of stock purchase of $1,150. If you choose to avoid assignment and close out the written call by buying it back, you might pay more for the contract than you sold it for. Although this would result in a real loss from the option transaction, it would be offset by both unrealized stock profits and the net credit you received for the collar. In addition, you keep the stock. Two important points about collars First, collars are not always set up at a net credit. You might have to pay a net debit. This depends on the current price level of the stock compared to the available strike prices when the position is established. Secondly, not all collars will be profitable. This depends on the amount of unrealized gain you are protecting, your choice of strike prices, and the cost of setting up the strategy to begin with

10 Straddles & Strangles During periods of market inactivity, or when you feel a particular stock isn t going to move much for a period of time, you can let option time decay work to your advantage. You do this by writing covered call options on stock you own, but also by writing both an uncovered call and a put on the same stock, creatintg at-the-money straddles and strangles. Getting the details right Writing an at-the-money straddle involves selling a call and a put with the same strike price currently at-the-money and expiration month. Your maximum profit is limited to the premium you receive from the straddle s initial sale and requires the underlying stock s being at a precise point at expiration the chosen strike price. Selling both a call and a put that are currently out-of-the-money, or with two different strike prices, can reduce the risk of a written straddle somewhat. This is called writing a strangle. Increased profit, increased risk! By writing two options each time you establish one of these strategies, you have double time decay, and take in the premium of two options, from both a call and a put. However, with double time decay and more potential profit from selling two options comes increased risk. You are essentially unprotected from a significant upside or downside move in the underlying stock. In addition, depending on the type of account you have and your brokerage firm's assessment of your financial situation, you may not be allowed to establish uncovered option positions. If your firm does allow it, the margin requirement may be quite large. XYZ is currently trading around $50 and you firmly expect it to remain at this level over a given period of time. You might choose to write both a $50 call and a $50 put, each expiring in the same month. You go to the marketplace and: Write a 50 call for $4.50 Write a 50 put for $3.75 When time works for you You ll receive a net credit amount of $ $3.75 = $8.25, or $825 total, which is yours to keep. As expiration approaches, and if XYZ does not change appreciably in price, time decay will work to your advantage and the straddle should decrease in value. Trade-off Remember, you re looking for time decay to generate profits from a written straddle. And generally speaking, the quicker the decay the better, considering the considerable risk you ve taken on. Selling longerterm options will bring in more premium, but closer-term options will generally decay at a faster rate. For this reason, you must carefully weigh the time frame you predict for the underlying stock to trade in a narrow trading range, and select potential profits that are acceptable to you

11 Your objective is for XYZ to be precisely at $50 at expiration, and for both the call and put to expire exactly at-the-money, with no value and no assignment. If this occurs, the $825 you originally received is yours to keep, and is the maximum profit you could realize. If XYZ stock remains stable in price and your straddle performs as you expect that is, it decreases in value due to time decay you might begin to see a profit. At any point before expiration you can close out the straddle by buying it back in the marketplace. If you buy the straddle back for less than you initially sold it for, you ll realize a gain. Closing out your position For example, suppose some time has passed and you find: The 50 call trading for $3.00 The 50 put trading for $2.50 To close out the position you purchase both a call and put at these prices for a net debit of $ $2.50 = $5.50, or a total of $550. Since you initially sold the straddle and received $8.25, or $825 total, your profit would be: $825 credit $550 debit to close out the position = $275. Take your profits At anytime before the options expire you re free to buy the straddle back in the marketplace to close out the position at a partial profit. Again, considering the risk of this strategy, you might choose to take an acceptable profit whenever you can, and not necessarily wait for expiration. Say your prediction of price stability for XYZ stock proves incorrect, and the stock moves substantially up or down. Your straddle begins to show a loss, and you're not comfortable maintaining the position until expiration. What can you do? You can always buy the straddle back in the marketplace and cut your loss. For example, XYZ stock moves up in price to around $60 per share. You find: The 50 call trading for $10.50 The 50 put trading for $

12 Cutting your losses You decide to close out the position and cut further risk. You buy the call and put for these prices for a net debit of $ $0.25 = $10.75, or a total of $1,075. Since you initially sold the straddle and received $825, your loss would be this $1,075 debit to close out the position $825 initial credit received = $250. Buying back a straddle to either cut a loss or to avoid assignment on either the short call or short put can be done at any point before the option contracts expire or up to their last trading day. Theoretically unlimited loss The risk in writing a straddle is theoretically unlimited. On the upside there s no limit on how high the underlying stock can go, leaving you vulnerable to assignment on your short call. On the downside, substantial losses are possible if the underlying stock plummets in price. That s a vulnerability for any short put position if buying stock on assignment isn t your original objective. This risk is limited only by the underlying stock going to zero. What about writing a call and put with somewhat less risk than selling a straddle? You might consider selling a strangle. This strategy is similar to a straddle in that you re writing both an uncovered call and a put. However, you re selling a call and a put with different strike prices, usually out-of-themoney when you re establishing the strangle. Limiting your risk Why does this strategy pose less risk? Your maximum profit, as with a straddle, is limited to the premium you take in when you initially sell the strangle, but this maximum profit can be realized over a range of stock prices at expiration. That is, you need the underlying stock to close at any point between the two strike prices for both the call and put to expire outof-the-money and worthless. The trade-off for reduced risk is less premium at the front end, or when you first sell the strangle. This is because you are generally selling a call and put that are both out-of-the-money at the time. Trade-off Just like a written straddle, you re looking for time decay to generate profits from a written strangle, and the quicker the decay the better from the risk perspective. Selling longer-term options will bring in more premium, but closer-term options will generally decay at a faster rate. For this reason, you ll want to carefully balance your predicted time frame for the underlying stock to trade in a narrow trading range with potential profits that are acceptable to you. For example, XYZ is currently around $58 per share, and you expect a trading range of between $55 and $60 for a while. You decide to sell a strangle consisting of a $55 put and $60 call both currently out-of-themoney. In the marketplace you find: The 55 put is trading for $3.00 The 60 call is trading for $4.00 Your net credit for selling this strangle is $3.00 received for the call + $4.00 received for the put = $7.00 net, or a total of $

13 Seeking maximum profit For maximum profit, just like a straddle, you want both options to expire with no value. At expiration, if XYZ closes at any point between $55 and $60, both the call and put will expire out-of-the-money and worthless. As long as you re not assigned on one of the short options, the $700 premium you first received, and which is yours to keep, is the maximum profit. Realizing profits and losses with written strangles works the same way as with written straddles. If you can buy the strangle back, or close it out, for less than you initially sold it for, you ll have a net profit for the position. If it costs more to buy it back than you first sold it for, then you ll realize a net loss. Comparing possible outcomes For example, if XYZ's trading range remains stable, and at any time before expiration you can buy the strangle for a net debit of $400, your total profit would be the $700 credit initially taken in $400 debit to buy the strangle = $300. On the other hand, say XYZ plummets in price to about $47 and you find your 55 put trading for $8.50, and the call for $0.50. Your net debit to close out the strangle would be $8.50 to buy the put + $0.50 to buy the call = a net debit of $9.00. Since you sold the strangle in the first place for a net credit of $7.00, your loss in this case would be $9.00 debit $7.00 credit = $2.00, or $200 total. Theoretically unlimited loss The risk in writing a strangle, like a straddle, is also theoretically unlimited. You're vulnerable on the upside because of your uncovered short call. You're vulnerable on the downside because of your uncovered short put. However, this risk is tempered somewhat because you don't need the underlying stock to close precisely at the strike price to make maximum profit. It can close anywhere between the two strike prices, and you can select these to suit your tolerance for risk

14 Butterfly One way to write options, benefit from time decay, and at the same time limit your potential loss from an up or down move in the underlying stock is by using a strategy with the unlikely name of butterfly spread. If you re unwilling to accept the unlimited risk from writing straddles or strangles, you might consider this strategy as a way to potentially profit from a neutral market. Limiting your losses If you re convinced a particular stock will have a narrow trading range, or will be at a specific strike price at a given option expiration, or both, a butterfly has a profit profile similar to that of a written straddle. That is, you ll see maximum profit if the underlying stock is at that strike price at expiration. However, one benefit of the butterfly strategy that s not available with either a written straddle or strangle is that if the stock moves appreciably in one direction or the other, your losses are limited. Butterflies can be put together with either all calls or all puts, with each of four options having the same expiration month. When you buy a butterfly, you ll always pay a net debit, and this debit is your maximum loss. When you use a butterfly strategy, first establish a price at which you think the underlying stock will be trading around at expiration. Select that as the strike price for the two options you ll sell for each butterfly that is the middle strike price. At the same time you ll buy an option with a lower strike price, and one with a higher strike. The increments between strikes should be the same. Creating a butterfly spread For example, you think stock XYZ will be trading around $70 for a while, and will be at this price at expiration. You decide to buy a call butterfly centered on a $70 strike, and with strike price increments of $5. You go to the marketplace and: Buy 1 XYZ 65 $8.00 Write 2 XYZ 70 $5.25 each Buying butterfly spreads Buy 1 lower strike, sell 2 middle strikes, buy 1 higher strike Can be all calls or all puts Same expiration month Same strike price increments (e.g., the standard $2 1/2, $5, or $10) Loss limited to debit paid Dissect a butterfly Take a butterfly spread apart and what do you have? Two vertical spreads! In our example you ll essentially end up with both a: Bull 65/70 call spread (long a 65 call and short a 70 call) Bear 70/75 call spread (short a 70 call and long a 75 call) The point of maximum profit for the 65/70 bull spread would be for the underlying stock to close at or above $70 at expiration. For the bear 70/75 spread, the point of maximum profit would be for the stock to close at or below $70. This $70 stock price is, of course, the strike price of the two written calls. Buy 1 XYZ 75 $3.25 You re now long the 65/70/75 call butterfly. You paid $8.00 for the XYZ 65 call + $3.25 for the XYZ 75 call, or $ However, you wrote 2 XYZ 70 calls for $5.25 each and received $ The net for the spread is $11.25 paid $10.50 received = a net debit of $0.75, or $75 total

15 Ideally you want XYZ stock to trade around $70 between purchase and expiration, and for the two short 70 calls to decay in value. To see maximum profit, just like a written $70 straddle, you need XYZ stock to close exactly at the short strike price of $70 at expiration. Finding maximum profit If this occurs: The long XYZ 65 call would expire in-the-money and have an intrinsic value of $5.00 The short XYZ 70 calls would expire exactly at-the-money and be worthless The long XYZ 75 call would expire exactly at-the-money and be worthless If you sold the long 65 call for its intrinsic value of $5.00, and the other options expired with no value (and no assignment on the short calls), your maximum profit would be $5.00 received for 65 call $0.75 debit initially paid = $4.25 net, or $425 total. The theoretical maximum profit for a call or put butterfly depends on the purchase and sale prices of the options when you first buy the spread. In formula, this can be calculated in advance as the strike price increment (in this example $5.00) less the debit paid for the spread. In comparison, let s look at a couple of maximum loss scenarios. Below lowest strike price XYZ is $63 at expiration. Each call will expire out-of-the-money and worthless, which would be the case if XYZ closed at any price below the $65 lowest strike price. You d see your maximum loss of the $75 debit paid for the spread in the first place. Above highest strike price XYZ is $77 at expiration, and each call expires in-the-money. If you let the exercise and assignment process generate the maximum loss it would work this way: Exercise the long 65 call and buy 100 shares at $65, but be assigned on one of the short 70 calls and sell those shares at $70 = a profit of $500. Exercise the long 75 call and buy 100 shares at $75, but be assigned on the other short 70 call and sell the shares at $70 = a loss of $500. The net of all this would be to break even on the stock transactions. However, you d still lose the $75 debit paid for the spread in the first place, and you'd incur several commission charges. The limited maximum loss at expiration, either on the upside or downside, will occur if the underlying stock closes at expiration below the lowest strike price or above the highest strike

16 If you can ever sell, or close out, the butterfly before expiration for more than you paid for it, then you ll see a profit. For example, if several weeks before expiration XYZ stock is trading for around $72, you might close out, or sell, the whole spread for the following prices: Sell the XYZ Buy the 2 XYZ 70 $3.80 each Sell the XYZ 75 $1.50 Realizing a profit or loss You buy 2 XYZ 70 calls for $3.80 each and pay $7.60. However, you receive $7.50 for the XYZ 65 call + $1.50 for the XYZ 75 call, or $9.00. The credit for selling the spread is then $9.00 received $7.60 paid = $1.40 net. Since you initially paid a $0.75 debit for the spread, your profit would be the difference of $0.65 between the net credit and the debit, or $65 total. But if XYZ moves significantly up or down from the strike price you might have to sell the butterfly for less than you paid for it. In this case you d realize a loss for the strategy. Conclusion When you re convinced the market or a particular stock is on hold and will continue to be stalled for a period of time, you can take advantage of time decay to generate income in the meantime. Unlike investors who need underlying stock movement to overcome this option phenomenon, investors who write options can take advantage of it. Weighing the limitations In a neutral market, whether you re writing covered calls to generate income or collaring an existing stock position, you must always weigh the income provided or protection offered against any limitations to your potential upside profits. If you re more risk tolerant, writing straddles or strangles can produce the profits you expect for the increased risk you take. If you adopt these strategies, however, you must be firm in your conviction that market conditions will remain stable enough for these strategies to become and remain profitable

17 Options Strategies in a Neutral Market Quiz (Answers on next page) 1. When you expect the stock market to be neutral for a period of time, you might take the opportunity to either: A. Speculate and profit if your market opinion is correct B. Generate income from an existing, sluggish stock position C. Protect unrealized stock profits while providing downside stock price protection D. All of the above 2. If you wish to buy a call time spread you should do which of the following? A. Buy near-term call and sell far-term call with the same strike price B. Buy far-term call and sell near-term call with the same strike price C. Buy both a near-term and far-term call with the same strike price 3. In terms of potential profit or loss, a call time spread provides: A. Unlimited profit and limited loss B. Limited profit and unlimited loss C. Limited profit and limited loss 4. Generally speaking, under what circumstances can maximum profit for a call time spread be realized at near-term expiration? A. The underlying stock closes exactly at the strike price. B. Both calls have the same market value C. Both of the above 5. Establishing a collar on an existing stock position generally involves: A. Buying an out-of the money put and selling an outof-the-money call B. Selling an out-of the money put and selling an outof-the-money callon the stock C. Leveraging your position in a particular stock 6. Buying a put that is currently out-of the money and selling a call that is also currently out-of the money will always result in a collar established at a net credit. True or false? True False 7. A difference between a short straddle and a short strangle is: A. Ashort straddle involves selling at the same strike price while a short strangle involves selling at different strike prices B. The potential loss from a short straddle is unlimited while that from a short strangle is not C. The potential profit from a short straddle is limited while that from a short strangle is not 8. To realize the theoretical maximum profit from a short straddle and a short strangle requires the underlying stock to close at a specific price point at expiration. True or false? True False 9. Which of the following would probably not be your motivation for purchasing a butterfly spread? A. You want the butterfly s unlimited potential profit and limited potential loss. B. You expect the underlying stock to have a narrow trading range before expiration. C. You expect the underlying stock to close at the middle strike price at expiration. 10. When you purchase a butterfly spread you can expect your potential loss to be limited to: A. The strike price increment less the debit initially paid for the spread. B. The net debit initially paid for the spread. C. The difference between the lowest and highest strike price less the debit initially paid

18 Options Strategies in a Neutral Market Quiz Answers 1. D. The flexibility of options provides you multiple ways to position yourself during neutral, sluggish markets. You can speculate and possibly profit with time spreads, butterflies, and short straddles and strangles. Selling covered calls on existing stock positions is a convenient way to generate income. Establishing a collar on an existing stock position can provide downside protection for unrealized gains as well as offer limited profit opportunity on the upside. 2. B. This is a long time spread. You expect the value of the near-term call to erode faster than that of the far-term, and for the spread between the two prices to widen for a profit opportunity. 3. C. Long call time spreads offer both limited loss and limited profit potential. The maximum loss is limited to the initial net debit paid for the spread. The limited, maximum profit cannot be calculated in advance because it s determined by the value of the long far-term call when the near-term call expires. 4. A. Maximum profit for a call time spread can be realized if the underlying stock closes exactly at the strike price of both calls at near-term expiration. You definitely don t want both options to have the same value at near-term expiration. Instead, you want the near-term call to expire with no value, to not be assigned, and for the remaining long-term option to have as much value as possible. 5. A. Buying an out-of the money put offers downside price protection for the underlying shares you own. The written out-of the money call is covered by these shares on the upside, and you ll see limited upside price participation. The result is a collar on any unrealized stock gains when the position is established

19 6. False Establishing a collar, or buying a out-of the money put and selling an outof the money call, on shares you already own, is sometimes done for a net credit, but at other times for a net debit. This depends on the current price level of the underlying stock compared to the available strike prices. 7. A. Writing a straddle involves selling both a call and a put with the same strike price and expiration month. Writing a strangle involves selling a higher strike call and lower strike put with the same expiration month. Despite this difference, the potential profit from either strategy is limited to the premium received from its initial sale. The potential loss with both risky strategies, however, is unlimited. 8. False. Realizing the theoretical maximum profit from a short straddle requires the underlying stock to close at a specific price the written strike price at expiration. Since the written strangle involves an out-of-the-money call and an out-of-the-money put, maximum profit can be realized at expiration if the underlying stock closes at any point between the two strike prices, and both options expire out-of-the-money and worthless. 9. A. When you purchase a butterfly spread, the potential profit and potential loss are both limited. 10. B. Your theoretical, potential loss from purchasing a butterfly spread is limited to the premium paid for the spread in the first place. This is true no matter how high or how low the underlying stock price is at expiration. However, you will likely be assigned on the short calls if the stock has risen above the short position, or middle strike position