Protecting Portfolios with Options Strategies

Options strategies are often used to reduce or eliminate the risk of holding one particular investment position by taking another position. In general, a long option position is a speculation that something will happen (bear, bull, lateral) whereas a short option is a speculation that something will NOT happen (not bear, not bull, not lateral).

Options strategies

When looking for an option strategy, there are three main things to consider:

1. The forecast of the direction of the underlying
2. The forecast of the volatility of the underlying
3. The amount of acceptable risk

A bullish underlying forecast requires an option strategy that profits when the market rises (long delta). Instead, a neutral underlying forecast implies the underlying to remain in a tight range so that the option profits when the underlying remains range-bound. A realized volatility forecast provides information about the expected underlying’s volatility (expressed through a Gamma position), whereas an implied volatility forecast is a statement about the value of the options traded (expressed through a Vega position). Finally, an increasing forecast requires a long position (gamma or vega).

Spreads

An option spread is constructed with a long option and short option that may differ only in the strike price (a vertical spread) or in the expiration date (a calendar spread) or in both (a diagonal spread). 

• For a vertical spread, both legs should be out‐of‐the‐money when the trade is executed or one leg is at‐the‐money and the other leg is out‐of‐the‐money since they similarly behave. In general, buying call spread needs the market to rally for the spread to be profitable; instead, selling an OTM call spread needs the underlying to go down, sideways, and even up a little, but below the strike price. It is the long OTM put spread requiring the underlying stock to fall in order to make money. Shorting an OTM put spread, needs the underlying to rally, to move sideways, and even to fall a little bit.

• Calendar spreads can be bullish, bearish, or neutral, depending on the strike price we select and its relationship to the at‐the‐money level. Generally, the further the strike price is from at‐the‐money, the more volatility needed for the trade to be profitable, so the more volatility you would be expecting if you chose to initiate that trade. A long call/put calendar is inexpensive to initiate but requires a significant movement in the underlying stock in order to be profitable; instead, neutral calendars are more expensive. Catalysts (earnings releases, dividends, new product releases, the release of clinical trial data and many other types of market-moving events) might impact the later expiration but not the first expiration of their calendar spread. After the first expiration, the remaining option can be sold or it can be extended in a super-calendar by selling another option, identical to the remaining option but with a shorter time to expiration. Thus, a super-calendar can help to profit from a winning trade or to rehab a calendar spread that didn’t work out because the front-month option was in‐the‐money at expiration.

More Complex Options strategies

• A butterfly uses three strike prices with the middle strike (body) being shared by the two vertical spreads (wings). It is constructed with two vertical spreads so that either the long leg of the first vertical spread and the long leg of the second vertical spread are the same option or the short leg of the first vertical spread and the short leg of the second vertical spread are the same option. A long OTM call butterfly is a bullish trade and it occurs when buying the outside strikes (wings), and selling twice as many of the inside options (body); the amount paid is the maximum risk. A long OTM put is a bearish strategy. A short OTM call butterfly is obtained by selling the wings, the outer strikes, and buying twice as many of the body, the middle strike; it collects a premium, its maximum profit. 
• A condor is a spread of two vertical spreads. In a long condor, one ITM vertical spread is bought and another OTM vertical spread is sold; the spread we buy is an in‐the‐money vertical spread meaning both legs are in‐the‐money, while the spread we sell is an out-of-the-money vertical spread in that both legs are out‐of‐the‐money. A long condor, either call or put, is a limited risk, nondirectional trade when low volatility is expected. With respect to a butterfly, a condor splits the body using two different strike prices. The maximum profit is realized with the underlying stock between the two vertical spreads at expiration; thus, the underlying should not move and should not be volatile. In the opposite case, the right trade is a short condor. By tweaking the bid/ask spread by selecting the out‐of‐the‐money options to have narrower bid/ask spreads than the in‐the‐money options an iron condor is obtained. An iron condor is executed by simultaneously selling an out‐of‐the‐money put spread and an out‐of‐the‐money call spread. Both spreads generally have the same width and they are roughly equidistant from the current stock price. An iron condor is a limited risk, nondirectional trade suitable for low volatility; the goal is to have both vertical spreads expire worthlessly.
• A back spread is a volatility spread and a directional spread; it is constructed by selling one option and buying two options of the same type and expiration with a strike price that is farther from at‐the‐money. It requires substantial volatility in the desired direction and consistent movement, upward for a call back spread and downward for a put-back spread; strike prices are generally selected so that the trade is done for zero or very little net premium. However, a smaller movement produces losses.
• A long straddle is constructed with a long call and a long put; it is a defined risk strategy with unlimited profit potential employed whenever some movement in the underlying is expected. The underlying stock can move in either direction but substantial volatility is required for a long straddle to be profitable; for instance, a big catalyst imminent such as an earnings release, court verdict, or Food and Drug Administration decision. A long strangle is the same but cheaper strategy based on OTM options; moreover, it requires a substantial underlying movement by expiration, usually rare.
• Among options strategies, a collar is the combination of long underlying, a covered call, and a long put that is initiated against an existing stock position; it is a defined risk strategy with limited profit. In the case skew (or tail risk ) is not extensive (i.e. assets rise faster than they drop), the collar can be structured to protect only such a drop, not all its way to zero, that is the long put is replaced with a long vertical put spread. Some instances include U.S. government bonds, crude oil, gold, and VIX. Indeed, such markets spike on geopolitical turmoil or supply shocks and then fall to their normal level. At expiration, there are three possible outcomes:
  1. the underlying is greater than the strike of the covered call (maximum profit)
  2. the underlying is lower than the strike of the protective put (maximum loss)
  3. the underlying is lower than the call strike but greater than the put strike price (variable result) 

References

Sinclair, E. (2016). Options Trading Strategies

Sebastian, M. (2016). Trading options for hedge

Cohen, G. (2011). The Bible of Option Strategies

Harmon, G. (2012). Trading Options