Volatility is loosely defined as the “range” a particular stock or index may trade within.  For example, a highly volatile stock may move +/- $4 on a given day, but a stock that is not as volatile may only move +/- $1 at any given time.  The more volatile a stock, the more it will move around.  Think back to 2008, when the market was going through those daily wild swings, where it would be down 700 points one day and up 100 points the next day.  Compare that to today, where the market trades within a much narrower range and the large wild swings of 2008 have subsided.

Each individual security (stock or index, etc) has its own volatility, but the VIX provides an implied volatility reading on the S&P 500 index.  The term “implied” means that the market is implying that the index may move this given amount.  In reality, this move or may not occur, but that is what is being implied right now!!  So how do you convet volatility to a number that you can understand.  Here is the secret:

• Take the volatility reading and multiply it by the square root of (number of trading days left, divided by 252)

For example:  Let’s say that the VIX is at 35% and there are 15 trading days left.  You would take 35% and multiply it by √(15/252), so you would have 35% * 0.239 = 8.54%.  So the market is implying that the S&P 500 index is expected to move 8.54% within the next 15 days.  So that gives a range of +/-4.27%.

So why use the VIX?  Generally speaking, it gives me an indication of what the market is thinking right now in regards to the S&P500 and helps me plan the type of trades I should place.  For one, when volatility is high, I won’t trade straight calls/puts because you end up paying a lot of premium for the options.

Here is a graph of the VIX over the past 20 years!

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VIX 1990 - 2008 [Source: File from the Wikimedia Commons

To take advantage of a neutral market situation, a trader would simultaneously place a trade for a long call spread and a short call spread.  The two call spreads must be worth the same, meaning that the difference between strikes must be same for both spreads.  By entering a long call spread, a trader is placing a bullish bet, but by placing a short call spread, a trader is entering a bearish position.  By trading both sides of the market, a trader is expecting the market to trade within a range that will allow him to take advantage of time decay or theta.

1 Long Call Spread + 1 Short Call Spread = Long Butterfly Spread

In order for the strategy to function as intended, the long call spread and short call spread must share the short strike price.  For example, let’s say you form a neutral bias on RIMM (currently at ~$71) and believe that the stock will trade within a range ($70 and $80) during the current expiration cycle and end up around $75 by expiration Friday.  In order to enter a butterfly trade, you will now simultaneously enter a long and short call spread.

Taking a look at the option chain, you decide to go long the 70/75 call spread (buy  70 call/sell 75 call) for a debit of $2.25 and short the 75/80 call spread (sell 75 call/buy 80 call) for a credit of $1.24.  The cost of the butterfly spread is a net debit of $1.01.  **Please take note that both of the call spreads share the same short strike (75 call) and are worth the same amount ($5).  This is absolutely critical if you want to construct a butterfly spread.  The risk profile of this sample trade is shown below:

From the risk profile, you will notice that by adding a long and short call spread that share the same short strike (strike that you sell), you are able to create a butterfly spread.  The spread makes money as long as RIMM trades within a specified range.  This range can be determined by calculating the two breakeven points:

Upper Breakeven Point = Strike Price of Higher Long Call – Debit Paid [80 – 1.01] = $78.99

Lower Breakeven Point= Strike Price of Lower Long Call + Debit Paid [70 + 1.01] = $71.01

As long as RIMM ends up between $71.01 and $78.99 by expiration, this trade will make money.  But, how much money?  The maximum that any of the two spreads can be worth at any time is $5 (difference between strikes), thus if you pay $1.01 for the butterfly, then the maximum you can make will be $3.99 ($5 – $1.01).  On the other hand, if RIMM ends up outside of the two breakeven points, then the maximum amount lost on this trade would be the debit.

Max. Profit = Call Spread Value – Debit Paid [$5 - $1.01 = $3.99]

Max. Risk = Debit Paid

Many if not most of the advanced option trading strategies are composed of vertical spreads, thus it’s critical that you understand their makeup and function.

To trade neutral markets, there are three types of basic option strategies one can employ.  Once you are able to understand the three basics strategies, you will be able to trade more advanced option strategies for neutral markets, like diagonals or double diagonals.  The first neutral strategy is a butterfly spread, which is a mix of two vertical spreads that expire in the same month.  The two vertical spreads share one common strike.  The second strategy is a calendar spread, which is a mix of two options (same strike price) that expire in different months.  The last of the three basic neutral strategies is the Condor, which is basically a modified version of the butterfly strategy.  The idea behind all of the strategies described above is to take advantage of the option greek – theta.

As we discussed earlier, theta provides a measure of time decay or the change in an options value with each passing day.  With a long butterfly or a long calendar spread, you position will be theta positive, meaning that with each passing day, your trade will make money.  By placing this type of trade in a neutral or sideways market, the intent is to take advantage of theta as the market stagnates.  This is not to say that you cannot place a butterfly or calendar spread with a directional bias.

In summary, the three basic strategies for neutral markets are as follows:

• Butterfly Spread
• Calendar Spread
• Condor Spread     

In subsequent posts, we will cover each of these strategies in detail.

Happy Trading!!

By buying a “higher strike” put option, you gain the “right” to sell shares of an underlying at a given price and by selling a “lower strike” put option; you undertake an “obligation” to accept (buy) those same shares at a lower price.  This is very similar to shorting stock, where you sell shares at a higher price and then buy them back a lower price, booking the difference as a profit.  Therefore, the most you can make on a bear (long) put spread is the difference between the two strikes.   Maximum Value of Spread = Difference between Strike Prices

By combining a long put option with a short put option, you will be able to create a bear put spread, also referred to as a long (buying) put spread.  This type of spread is placed for a debit, thus the term “long” put spread.  Take a look at the risk profile below for further clarification:

Now that you understand how a bear put spread functions, let’s look at an example.  Let’s say that you are bearish on Research in Motion (RIMM) and after looking at RIMMs option chain, you decide that buying a straight put is too expensive (65 strike would cost $1.97), thus you decide to buy a put spread instead.  Your expectation is that RIMM will drop to $60 within the next 5 weeks, so you decide to buy a 65 put and sell a 60 put simultaneously, creating a bear (long) put spread.

The 65 put will cost a debit of $1.97, while the 60 put will bring in a credit of $0.94.  Combining the two put options together would create a bear put spread, which would cost a net debit of $1.03.  Since the spread can be worth only $5 (difference between strikes), the most you could make on this trade would be $5 – $1.03 = $3.97, at expiration.

Basically, you would be risking a debit of $1.03 (max loss) to make $3.97 (max profit).  Max. Risk (Loss) = Debit Paid

Max. Profit = Difference between Strike Prices – Debit Paid

Before placing this type of trade, you must analyze the likelihood of RIMM dropping all the way from $72 to $60.  Otherwise, you could always analyze the 70/65 put spread, which would cost you a net debit of $1.89.  Trading options is all about balancing your risk with the expected reward and your analysis of the underlying stock.

The 65/60 bear put spread would breakeven once the debit paid ($1.03) to enter the trade is recovered.  In this case, your breakeven would be $65 – $1.03 = $63.97.  At expiration, RIMM would have to drop to $63.97 before the 65/60 put spread would start to make money.

Breakeven = Long Put Strike – Debit Paid to enter spread

Now that we know how a bear put spread functions, let’s look at the several advantages of this strategy:

• Lower cost than buying a straight puts because you are also selling an option
• Spread can be morphed into other advanced strategies

The risk profile of a bull put spread is the same as that of a bull call spread because the idea behind the trade is the same – it’s a bullish trade.  However, the fundamental difference is that a bull put spread is a credit spread, meaning that you will receive a credit for placing the trade, while a bull call spread is a debit spread, where you must pay a debit to enter the trade.  Therefore, a bull put spread is also called a short put spread.

So what does it mean to trade a bull put spread?  To answer this question, let’s breakdown the individual components of the trade and analyze them individually.  By selling a put option, you are taking on the obligation to accept shares of an underlying at a given strike price.  If you are unclear about selling put options, refer to the basics once again.  With a short put option position, as the underlying drops in price, the put option gains in value, leading to a loss.  This loss is unlimited because the underlying can keep dropping!!  To protect against this loss, a lower strike put option is purchased – creating a bull put spread!!

The lower strike put option limits the risk introduced by the sale of a higher strike put.  This is the basic explanation behind the workings of a bull put spread!!  Here is the risk profile for a sample bull put spread trade:

Let’s say that you are bullish on Apple (AAPL) and after looking at AAPL’s option chain below you decide to sell a put spread.  You may be tempted to sell a put option by itself, but remember the unlimited risk issue!!  With AAPL at $212, you are of the opinion that the stock will reach $220 within the next 4 weeks. 

To take advantage of this move, you sell the 220 strike because as the stock moves up in price, the value of the 220 put option will decrease.  Then to limit your downside risk, you purchase a lower strike put option.  In this case, let’s look at the 210 put strike.  By putting the two together, you have just created a bull put spread!!

By selling a 220 put strike option, you receive a credit of $10.05 and the 210 strike put strike would cost you a debit of $3.15.  That leaves you with a net credit of $6.90 [$10.05-$3.15].  You can keep this amount as long as AAPL reaches $220 by expiration.  The amount of credit received is the maximum amount of profit you can make on this type of trade!!  And since this spread can only be worth $10, the difference between the two strikes (220-210); the maximum risk on this trade is the difference between the spread amount and the max. profit [$10 - $6.90 = $3.10].

Max Profit = Credit Received

Max. Risk (Loss) = Difference between Strike Prices – Credit Received

Once the max. risk is determined, the breakeven point for a bull put spread is just the lower put strike plus the amount of risk.  In this case, the breakeven would be $210 + $3.10 or $213.90.  Apple would have to reach this point by expiration in order for you to breakeven on the trade.

Breakeven = Long Put Strike + Max. Risk

1. Buy put options to protect their stocks holding (refer to the guidebook #1 for more information on this topic)
2. Close the position
3. Adjust the position

An investors’ reaction in this type of situation primarily depends on his/her investment style.  If you are risk averse, you may end up closing the position, but if you are somewhat optimistic, you may adjust your position.  However, before you make any decision, be sure to analyze your positional risk.  When panic sets in, even savvy investors can lose sight of their goal and close positions that end up being profitable.  Of course, we always have the benefit of hindsight.  However, as investors we must try to make an informed decision based on our risk tolerance and view of the market.  Let’s take a look the 1^st reaction listed above and closely analyze the factors that one must consider.

When a drop of this magnitude occurs, implied volatility rises, meaning that the market expects large price swings.  To account for these swings, the market marks-up the price of options.  This means that the time value or “extrinsic value” in an option becomes inflated and buyers end up paying more for options.  Also, the fact that people are rushing to buy put options also inflates their price to a certain extent because there is increased demand.  One way to counter the possible increase in volatility is to buy put spreads instead of put options.  Also, put spreads are cheaper in general than standalone put options because you end up buying an option and simultaneously selling another option. 

By buying a put spread, you are buying volatility at a high level and also selling volatility near the same level.  The two options counter each other and protect you from paying too much for the implied volatility built into the option price.  However, the one drawback of a put spread is that it gives you limited protection.  For example, if you own AAPL at $200 and buy a 190/180 put spread, you will have downside protection that starts at $190 and ends at $180, which is only $10 worth of protection.  Whereas, a 190 put option would have given you unlimited downside protection starting at $190, but you would end up paying a lot more in option premium to buy the 190 put option. 

These are some of the things that  you must consider before taking any action related to buying put protection for your portfolio.  Be sure to signup for the exclusive guidebook as it will walk you through protecting your portfolio from the time you initiate your position.

The most basic “bear call spread” is placed when the underlying (i.e. stock) is above both the call strikes, making it an ITM spread.  A trader buys a “higher” call strike and pays a debit and concurrently sells a lower call strike and receives a larger credit.  Combining the two, the short call spread end up being placed for a “credit”.  Take a look at the option chain below, along with the AAPL exmaple to understand this concept.

For example, let’s say that you form a bearish opinion on AAPL (Apple Inc.), currently trading at $210, and decide to place a bear call spread.  To enter the trade, you buy a higher call  strike (200) and sell a lower call  strike (195).  For the long 200 call you pay a debit of $11.20, but receive a credit of $15.70 for the short 195 call.  This is the entire concept behind a bear call spread, where the option you sell more than covers for the one you buy because its further ITM than the one you buy.  Thus, the trade is placed for a credit.  In AAPL’s case, you would receive a credit of $4.50.

As APPL stock moves lower, both the call option will lose value and when it passes the short strike by expiration, both call options will contain no “real” value and you will get to keep the entire premium of $4.50.

The maximum profit on a Bear Call Spread is the “credit” received and in this case, the maximum you can make is $4.50 given that AAPL closes below the short strike of 195 by expiration.  Once you know the max. profit, the maximum risk is just the total value of the spread minus the credit received.

Max Profit = Credit Received

Max. Risk = Difference between strikes – Credit Received

The breakeven point on bear call spread (short call spread) is calculated by adding the premium received (credit) to the short call strike.  For AAPL, the breakeven point would be $195+$4.50 = $199.50.  So by expiration, AAPL must be trading below $199.50 for you to make money, but it must close below $195 if you want to keep the entire credit.

Breakeven = Short Call Strike + Credit Received

By buying a “lower strike” call option, you gain the “right” to purchase shares at a given price and by selling a “higher strike” call option; you undertake an “obligation” to deliver (sell) those same shares at a higher price.  For example, by simultaneously buying a 40 call strike and selling a 45 call strike, you have just gained the right to purchase shares at $40 and taken on the obligation to sell them at $45.  Therefore, the most you can make or the bull call spread can be worth is $5, the difference between the two strikes!!

Maximum Value of Spread = Difference between the Strike Prices

By combining a long call option with a short call option, we are able to create a bull call spread, also referred to as a long (buying) call spread.  Take a look at the risk profile below for further clarification:

Now that we understand how a bull call spread functions, let’s look at a current example.  Let’s say that you are bullish on Google (GOOG) and after looking at GOOG’s option chain below you decide that a straight call is too expensive.  For a 640 call you would be paying a debit of $17.10 or $1710.  With Google at $627, you decide that a 640/650 call spread would work best with over a month remaining until expiration.

The 640 call could be bought for $17.10, while the 650 call could be sold for $13.00.  Combining the two call options together would create a bull call spread, which would cost a total debit of $4.10 or $410.  Since the spread can be worth only $10 (difference between strikes), the most you could make on this trade would be $10 – $4.10 = $5.90, at expiration.

Basically, you would be risking a debit of $4.10 (max loss) to make $5.90 (max profit).  Max. Risk (Loss) = Debit Paid

Max. Profit = Difference between Strike Prices – Debit Paid

The bull call spread would breakeven once the debit paid ($4.10) to enter the trade is recovered.  In this case, your breakeven would be $640 + $4.10 or $644.10.  Google would have to reach this point in order for you to breakeven on the trade.

Breakeven = Long Call Strike + Debit Paid to enter spread

Now that we know how a bull call spread functions, let’s look at the several advantages of this strategy:

• Lower cost than buying a straight call because you are also selling an option
• Spread can be morphed into other advanced strategies

I personally trade vertical spreads more often than straight calls and puts because they offer numerous advantages like the ones listed above.  The next vertical spread we will cover is the bear call spread.

To clear up any misconceptions, let’s explore the top 5 option trading myths and discuss the realities:

To counter these two areas (cost of option and unlimited risk of short options), one could use vertical spreads.  A vertical spread is a combination of two options (same type) with different strikes expiring in the same month.  The 4 basic vertical spreads are as follows:

Each of the four spreads described above has limited risk exposure and reward potential.  Additionally, spreads can be traded for a lower cost than straight calls and puts.  In trading vertical spreads, we give up some profit potential to limit our risk exposure and this trade-off is critical in options trading because managing RISK is everything!!

Spreads also form the foundation for all other advanced option trading strategies and I personally use vertical spreads on a daily basis.  As a start, click here to read about how the the bull call spread functions.