Q&A
Explore Your Options
| Got a question about options? Tom Gentile
is the chief options strategist at Optionetics (www.optionetics.com), an
education and publishing firm dedicated to teaching investors how to minimize
their risk while maximizing profits using options. To submit a question,
post it on the STOCKS & COMMODITIES website Message-Boards.
Answers will be posted there, and selected questions will appear in future
issues of S&C. |
Tom Gentile of Optionetics
|
RATIO BACKSPREAD
Could you please explain what a ratio backspread is? -David BJ
A ratio backspread is a delta-neutral strategy that is directional in
nature, and allows the trader to enter the position with a zero debit or
credit (margin is required). The trade is designed to profit from a large
move in the underlying but lose little or nothing should the underlying
move in the opposite of the intended direction. Generally, the trade is
set up when the implied volatility of the underlying options is low, and
more options are purchased than sold. The idea is that the options you
sell should pay for all of the long options. The most common ratios are
one option sold for every two bought, or two sold for three bought (known
as 1x2 and 2x3 ratios, respectively). Of course, you can have any ratio
you want, but the math becomes complex, and your ability to generate a
sufficient profit to justify the ratio becomes questionable with higher
ratios.
The risk curve shown in Figure 1 shows a 1x2 ratio backspread on the
QQQs, created by shorting the 30 strike calls and buying the 33. The colored
lines represent various time intervals during the course of the trade,
beginning with today (red line) to expiration (black line).
Figure 1: risk curve. This is the risk curve for a sample 1x2
ratio backspread.
As you can see, there is not much risk in the trade until it is close to
expiration. This is why we refer to these types of trades at Optionetics
as "vacation trades." You can set 'em and forget 'em for a while
if the large move you expect doesn't take place right away.
Margin is required on this type of trade, since you do have at least
one short option that is closer to the money than the long. The margin
is determined by the distance between the strikes, minus the credit or
plus the debit incurred.
ATM LEAPS
If I buy an at-the-money-- (ATM) 15 strike call LEAP--
and sell a short-term ATM 15 strike call, what happens on expiration if
I get assigned? Would there be an upfront margin requirement on this option
play?-D. Diebold
Since this position is your plain-vanilla calendar spread in which both
strikes are the same, there is no additional margin required to sell the
short-term call. If you are assigned at expiration because the stock finishes
in-the-money-- (ITM), say at $16, then you will be short the stock
at 15 and lose $1 on that position. However, you are still long the LEAP
15 call, and can exercise the right to buy back the short at $15. Exercising
may not be the best method, however, since your LEAP was partly "paid
down" by the money you took in for the short position. It may therefore
have enough time value left to offset the $1 loss on the short stock.
A combination of being short the stock and long a call is known as a
synthetic put and can make money to the degree the stock trends down, minus
the net debit of the LEAP. Alternatively, since you are now short the stock,
you have a chance to earn more premium by buying back the stock and selling
another short-term option against the LEAP. Provided the stock continues
to trade within a close range of the strike prices, you can repeat this
a few times until you eventually own the LEAP outright. This will give
you a risk-free trade at that point. If you don't have enough money in
your trading account to cover the margin requirements on the short assignment,
then you will be forced either to deposit funds immediately or to liquidate
the LEAP, thereby losing your time value and creating a total loss equal
to the original debit of the trade.
COVERED CALLS
Under what circumstances would a stock be called if you have covered
calls on a NASDAQ stock?
Regardless of the exchange it's on, when the stock trades higher than
the strike sold at expiration, it will be called away from you. If it's
within 25 cents of the strike, it could go either way, since the transaction
costs may be greater than it is worth to the other side to call the stock
away.
Options that are closer to expiration generally stand the greatest risk
of assignment. If you've sold a covered call with a near-term option (say
it expires within 30 days), generally you will be assigned, or have your
stock called away, before those traders who have longer-term short calls
(say more than 30 days).
--Optionetics Platinum
--See Editorial Resource Index
-- See Traders' Glossary for definition
Return to September 2003 Contents
Originally published in the September 2003 issue of Technical
Analysis of STOCKS & COMMODITIES magazine.
All rights reserved. © Copyright 2003, Technical Analysis, Inc.
