YTE Aug - Sep (master).

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

18 AUG-SEP 2001 YTE

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

Trade date: 22/03/2001 (high volatility, oversold
market, only four weeks to expiry from the selected
April contract)

Selling an out-of-the-money April put option at a strike
of 5025 points, premium received: 76.5 points

Buying a further out-of-the-money April put option at
a strike of 4925 points, premium paid: 57 points

Net premium received: 76.5 57 = 19.5 points (each
index point in the FT100 Index options is valued at
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:
jmallen@afsonline.com.au

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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