21

PROVEN STRATEGIES
FOR TRADING FUTURES OPTIONS
 Option Strategies

HOW TO USE THIS BOOKLET

An illustration is used wi th each strategy to demonstrate the effect of ti me decay on

the total option premium involved in the position.

The basic diagram in bl ack shows the profit/loss scale on the left verti cal axis. The
horizontal zero line in th e middle is the break-even point, not including commissions.
Therefore, a nything above that line indicates pr ofits, anything below it, losse s. Th e
price of the underlying instrument would be represented by a scale along the bottom,
with lower prices to th e left and higher prices to the right. "A," "B" a nd "C" in the
diagrams indicate the strike price(s) involved.

Arrows on the diagrams under the heading of "Pattern e volution" in dicate what
impact the decay of option prices with time ha s on the total position. The blue lin e
reflects the situation with four months left until expiration, the red line t he status with
one month left and the green line the situation at expiration, which is also reflected in
the box at the top of each strategy.

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 Option Strategies

1. LONG FUTURES

Class: Directional
Synthetics:
Long call A, short put A

When to use: When you are bullish on the market and uncertain about volatility. You
will not be affected b y volatility changing. However, if you have an opinion on
volatility and that opinion turns out to be correct, one of the other strategies may have
greater profit potential and/or less risk.
Profit characteristics: Profit increases as
market rises. Profit is ba sed strictly on the
difference b etween the exit price a nd the
entry price.
Loss characteristics: Loss increa ses as
market falls. Loss is based strictly on the
difference b etween the exit price a nd the
entry price.
Decay characteristics: None

2. SHORT FUTURES

Class: Directional
Synthetics:
Long put A, short call A

When to use: When you are bear ish on the market and uncertain a bout volatilit y.
You will not be affected by volatility changing. However, if you have a n opinion o n
volatility and that opinion turns out to be correct, one of the other strategies may have
greater profit potential and/or less risk.
Profit characteristics: Profit incr eases
as market f alls. Profit is based strictly on
the difference between the entry price
and the exit price.
Loss characteristics: Loss increa ses as
market rises. Loss is ba sed strictly on the
difference b etween the entry price and
the exit price.
Decay characteristics: None

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 Option Strategies

3. SYNTHETIC LONG FUTURES

(SPLIT STRIKE)

Class: Directional
Long call B, short put A

When to use: When you are bulli sh on the market and uncertain a bout volatilit y.
Normally this position is initiated a s a follow-up t o another st rategy. Its risk/reward is
the same as a LONG FUTURES except that there is a flat area of little or n o
gain/loss.
Profit characteristics: Profit incre ases as market rise s p ast the long call. Profit at
expiration is exercise price of B plus or minus price re ceived or paid to initiat e
position.
Loss characteristics: Loss increases as
market falls past the short put. Loss at
expiration is open-ended and is ba sed on
the exercise price of A plus or minus price
received or paid to initiate position.
Decay characteristics: Depending on the
underlying futures, time decay works for you
(if futures are lower) or against you (if
futures are higher).

4. SYNTHETIC SHORT FUTURES

(SPLIT STRIKE)
Class: Directional
Long put A, short call B

When to use: When you are bear ish on the market and uncertain a bout volatilit y.
Normally this position is initiated a s a follow-up t o another st rategy. Its risk/reward is
the same a s a SHORT FUTURES except tha t there is a flat area o f little or no
gain/loss.
Profit characteristics: Profit increases as market falls pa st the long put. Profit a t
expiration is exercise price of A plus or minus price re ceived or paid to initiat e
position.
Loss characteristics: Loss increases as
market rises past the short call. Loss at
expiration is exercise price of B plus or
minus price received or paid to initiate
position.
Decay characteristics: Depending on the
underlying futures, time decay works for you
(if futures are higher) or against you (if
futures are lower).

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 Option Strategies

5. LONG CALL

Class: Directional.
Synthetics:
Long instrument, long put.

When to use: When you are very bullish on th e market. The more bul lish you are,
the more ou t-of-the money (higher) should be the option you buy. No other position
gives you a s much leveraged advantage in a rising market (with limi ted downside
risk).
Profit characteristics: Profit in creases a s market rise s. At expiration, break-even
point will be option exercise pri ce A + price pai d for option . For each point above
break-even, profit increases by an additional point.
Loss characteristics: Loss limited to amount paid for option. Maximum loss realized
if market ends below option exercise A.
For each point above A, loss decrea ses
by additional point.
Decay characteristics: Position is a
wasting asset. As time passes, value of
position erodes toward expiration value.
If volatility i ncreases, e rosion slows; as
volatility decreases, erosion speeds up.

6. SHORT CALL
Class: Directional.
Synthetics:
Short instrument, short put.

When to use: If you firmly believe the market is not going up. Sell out- of-the-money
(higher strike) options if you are only somewhat convinced; sell at-the-money options
if you are very confident the market will stag nate or fall. If you dou bt market will
stagnate, sell in-the-money options for maximum profit.
Profit characteristics: Profit limited to premiu m received. At e xpiration, break-even
is exercise price A + premium recei ved. Maximum profit re alized if market settles a t
or below A.
Loss characteristics: Loss increases as market rises. At expiration, losses increase
by one poi nt for each point mark et is
above bre ak-even. Because risk is
open-ended, position must be watched
closely.
Decay characteristics: Position is a
growing asset. As time passes, value of
position increases as option lose s its
time value. Maxi mum r ate of inc reasing
profits occurs if option is at-the-money.

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 Option Strategies

7. LONG PUT
Class: Directional.
Synthetics:
Short instrument, long call.

When to use: When you are very b earish on market. The more bearish you are, t he
more out-of-the-money (lower) should be the opt ion you buy. No other p osition gives
you as much leveraged advantage in a falling market (with limited upside risk).
Profit characteristics: Profit increases as market falls. A t expiration, break-eve n
point will be option exercise price A - price paid for option. For each point below
break-even, profit increases by additional point.
Loss characteristics: Loss limited to amount paid for option. Maximum loss realized
if market ends above o ption exercise
A. For ea ch point b elow A, lo ss
decreases by additional point.
Decay characteristics: Position is a
wasting asset. As time passes, value
of position erodes toward expiration
value. If volatility incre ases, erosi on
slows; as volatility decr eases, erosi on
speeds up.

8. SHORT PUT
Class: Directional.
Synthetics:
Long instrument, short call.

When to use: If you firmly believe market is not going down. Sell out-of-the-mon ey
(lower strike) options if you are only somewhat convinced; sell at-the-money options
if you are very confid ent market will stagna te or rise. If you doubt market wi ll
stagnate, sell in-the-money options for maximum profit.
Profit characteristics: Profit limited to premiu m received from sale. At expiration ,
break-even point is exercise pr ice A - premium received. Maximu m profit realized if
market settles at or above A.
Loss characteristics: Loss in creases as m arket falls. At e xpiration, losses increase
by one poi nt for each point mark et is
below break-even. Be cause risk is
open-ended, position must be watched
closely.
Decay characteristics: Position is a
growing asset. As time passes, value of
position increases as option lose s its
time value. Maxi mum r ate of inc reasing
profits occurs if option is at-the-money.

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 Option Strategies

9. BULL SPREAD
Class: Directional.
Synthetics:
Long call A, short call B.
Long put A, short put B.
Long call A, short put B, short instrument.
Long put A. short call B, long instrument.

When to use: If you think the mark et will go up somewhat or at least is a bit more
likely to rise than fall. Good position if you want to be in the market but are unsure of
bullish expectations. You're in good company: This is the most popular bullish trade.
Profit characteristics: Profit limited, reaching maximum if market ends at or ab ove
B at expiration. If ca ll-vs.-call version (most co mmon) used, break-even is at A + net
cost of spread.
Loss characteristics: What is gained by limiting profit potential is mainly a limit t o
loss if you guessed wrong on market.
Maximum loss if market at expiration is
at or below A. With call- vs.-call version,
maximum loss is net cost of spread.
Decay characteristics: If market is
midway bet ween A an d B, no t ime
effect. At B, profits incr ease at fastest
rate with tim e. At A, losses increa se at
maximum rate with time.

10. BEAR SPREAD

Class: Directional.
Synthetics:
Short call A, long call B.
Short put A, long put B.
Short call A, long put B, long instrument.
Short put A, long call B, short instrument.

When to use: If you think the market will fall somewhat or at l east is a bit more likely
to fall than r ise. The most popular position among bears b ecause it may be entere d
as a conservative trade when uncertain about bearish stance.
Profit characteristics: Profit limite d, reaching maximum at expiration if market is a t
or below A. If put-vs.-put version (most common ) used, break-even is at B - net cos t
of spread.
Loss characteristics: By accepting limit to profits, you gain a limit to risk. Losse s, at
expiration, increase as market rises to
B, where they stabilize. With put-vs.-put
version, maximu m loss is net cost of
spread.
Decay characteristics: If market is
midway bet ween A and B, no t ime
effect. At A, profits incr ease at fastest
rate with tim e. At B, losses in crease at
maximum rate with time.

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 Option Strategies

11. LONG BUTTERFLY

Class: Precision.
Synthetics:
Long call A, short 2 calls B, long call C.
Long put A, short 2 puts B, long put C.
Long put A, short put B, short call B, long call C.
Long call A, short call B, short put B, long put C.
(Note: B - A must equal C - B.)

When to use: One of the few positions which may be ent ered advantageously in a
long-term option serie s. Enter when, with one month or more to go, cost o f th e
spread is 10% or less of B - A (20% if a strike exists between A and B). This is a rule
of thumb; check theoretical values.
Profit characteristics: Maxi mum profit occur s if market is at B at expiration. Th at
profit would be B - A - cost of doing spread. This profit develops, almost totally, in last
month.
Loss characteristics: Maxi mum loss, in either direction, is cost of sp read. A very
conservative trade, break-evens are at A
plus co st of spread and at C less cost of
spread.
Decay characteristics: Decay negligible
until final month, during which distinctive
pattern of butterfly forms. Maximu m profit
growth is at B. If you are away fro m A-C
range entering last month, you may want
to liquidate position.

12. SHORT BUTTERFLY

Class: Precision.
Synthetics:
Short call A, long 2 calls B, snort call C.
Short put A, long 2 puts B, short put C.
Short put A, long put B, long call B, short call C.
Short call A, long call B, long put B, short put C.
(Note: B - A must equal C - B.)

When to use: When t he market is either be low A or above C and position is

overpriced with month or so left. Or when only a few weeks are left, market is near B,
and you expect an imminent move in either direction.
Profit characteristics: Ma ximum profit is cre dit for which spread is put on. Occurs
when mark et, at expiration, is belo w A or abo ve C, thus making all options in-t he-
money or all options out-of-the money.
Loss characteristics: Maxi mum los s
occurs if market is at B at expiration.
Amount of that loss is B - A - credit
received when setting u p position. Break-
evens are at A plus initial cred it and C
less initial credit.
Decay characteristics: Decay negligible
until final month, during which distinctive
pattern of butterfly forms. Maxi mum loss
acceleration is at B.

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 Option Strategies

13. LONG STRADDLE

Class: Precision.
Synthetics:
Long call A, long put A.
Long calls A, short instrument.
Long puts A, long instrument.
(All done to initial delta neutrality. A delta neutral spread is a ratio spread
established as a neutral position by using the deltas of the options involved.
The neutral ratio is determined by dividing the delta of
the purchased option by the delta of the written option.)

When to use: If market is near A an d you expect it to start moving but are not sure
which way. Especially g ood position if market has been quiet, then star ts to zigzag
sharply, signalling potential eruption.
Profit characteristics: Profit open-ended in either direction. At expiration, break-
even is at A, plus or minus cost of spread. However, p osition is seldom held to
expiration because of increasing decay levels with time.
Loss characteristics: Loss limited to cost of spread ( assuming most common
version, the call-pu t spread).
Maximum loss incurred if market is
at A at expiration.
Decay characteristics: Decay
accelerates as optio ns approach
expiration. For this reason, positio n
is adju sted to neutrality by frequent
profit-taking. It is norma lly taken off
well before expiration.

14. SHORT STRADDLE

Class: Precision.
Synthetics:
Short call A, short put A.
Short calls A, long instrument.
Short puts A, short instrument.
(All done to initial delta neutrality.)

When to use: If market is near A an d you expect market is stagnating. B ecause you
are short options, you reap profits as they decay - as long as market remains near A.
Profit characteristics: Profit maximized if market, at expiration, is at A. In call-pu t
scenario (most common ), maximum profit is cre dit from establishing po sition; break-
even is A plus or minus that amount.
Loss characteristics: Loss potential
open-ended in eit her d irection. Po sition,
therefore, must be closely monitore d and
readjusted to neutrality if market be gins to
drift away from A.
Decay characteristics: Because you are
only short o ptions, you pick up time-value
decay at an increasing rate as expiration
nears, maximized if market is near A.

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 Option Strategies

15. LONG STRANGLE

Class: Precision.
Synthetics:
Long put A, long call B.
Long call A, long put B.
Long put A, long put B, long instrument.
Long call A, long call B, short instrument.
(All done to initial delta neutrality.)

When to use: If market is within or near A-B ra nge and has been stagnant. If mark et
explodes either way, you make money; if market continue s to stagnate, you lose less
than with a long straddle.
Profit characteristics: Profit open -ended in either directio n. With put A vs. call B
version (most common), break-evens are at A minus cost of spread and B plus cost
of spread. However, spread is usually not held to expiration.
Loss characteristics: Loss limited . In most c ommon version, loss is equal to n et
cost of position. Maximum loss incur red
if, at expiration, market is between A
and B.
Decay characteristics: Decay
accelerates as options appr oach
expiration but not as rapidly as with long
straddle. To avoid largest part of decay,
the position is normally taken off prior to
expiration.

16. SHORT STRANGLE

Class: Precision.
Synthetics:
Short put A, short call B.
Short call A, short put B.
Short put A, short put B, short instrument.
Short call A, short call B, long instrument.
(All done to initial delta neutrality.)

When to use: If marke t is within o r near A-B r ange and, t hough activ e, is quietin g
down. If market goes into stagnatio n, you make mone y; if it continues to be active,
you have a bit less risk than with a short straddle.
Profit characteristics: Maxi mum profit equals option re ceipts if pu t-call versio n
employed. Maximum profit realized if market, at expiration, is between A and B.
Loss characteristics: At expiration, losse s o ccur only if market is above B plus
option receipts (for put- call) or belo w A less tha t amount. Potential lo ss open-ended.
Although less risky than short straddle, position is not riskle ss. It got its name during
the April 1978 IBM price swings, w hen
a number of good trader s holding this
position were wiped out.
Decay characteristics: Because y ou
are only short options, you pick up
time-value decay at an increasing ra te
as expiration nears, maxi mized if
market is within A-B range.

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17. RATIO CALL SPREAD

Class: Precision.
Synthetics:
Long call A, short calls B.
Long put A, short calls B, long instrument.
(All done to initial delta neutrality.)

When to use: Usually entered when market is near A and user expects a slight rise
in market but sees a p otential for sell-off. One of the most common spreads, seldom
done more than 1:3 (two excess shorts) because of upside risk.
Profit characteristics: Maximum profit, in amount of B - A - net cost of position (fo r
call-vs.-call version), realized if market is at B at expiration.
Loss characteristics: Loss limited on downside (to net cost of po sition in ca ll-vs.-
call) but o pen-ended if market rises.
Rate of loss, if market rises beyond B, is
proportional to number of excess shorts
in position.
Decay characteristics: If market is at
B, profits fr om option decay accele rate
the most ra pidly with p assage of time .
At A, you have greatest rate of loss
accrual by decay of long option.

18. RATIO PUT SPREAD

Class: Precision.
Synthetics:
Long put B, short puts A.
Long call B, short puts A, short instrument.
(All done to initial delta neutrality.)

When to use: Usually entered when market is near B and you expect market to fall
slightly but see a poten tial for shar p rise. One of the most common spreads, seldo m
done more than 1:3 (two excess shorts) because of downside risk.
Profit characteristics: Maximum profit in amount of B - A - net cost of position (for
put-vs.-put version), realized if market is at A at expiration.
Loss characteristics: Loss limited on upside (to net co st of position in put-vs.-p ut
version) but open-ended if market
falls. Rate of loss, if market falls bel ow
A, is proport ional to number of excess
shorts in position.
Decay characteristics: If market is at
A, profits from option decay accelerate
the most ra pidly with p assage of time.
At B, you have greatest rate of lo ss
accrual by decay of long option.

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19. CALL RATIO BACKSPREAD

Class: Precision.
Synthetics:
Short call A, long calls B.
Short put A, long calls B, short instrument.
(All done to initial delta neutrality).

When to use: Normally entered when market is near B and sho ws signs o f
increasing activity, with greater probability to up side (for ex ample, if last major move
was down, followed by stagnation).
Profit characteristics: Profit limited on downside (to n et credit ta ken in when
position was set up in call-vs.-call version) but open-ended in rallying market.
Loss characteristics: Maximum loss, in amount of B - A - initial credit, is realized if
market is at B at expira tion. This lo ss is less th an for equiv alent long straddle, the
trade-off for sacrificing profit potential on
the downside.
Decay characteristics: If market is at
B, loss from decay will accelera te the
most rapidly. Therefore, you ma y want
to exit early if market is near B as you
enter last month. At A, you ha ve the
greatest rat e of profit accrual by decay
of short option.

20. PUT RATIO BACKSPREAD

Class: Precision.
Synthetics:
Short put B, long puts A.
Short call B, long puts A, long instrument.
(All done to initial delta neutrality.)

When to use: Normally entered when market is near A and sho ws signs o f
increasing activity, with greater probability to downside (f or example, if last maj or
move was up, followed by stagnation).
Profit characteristics: Profit limite d on upsid e (to net cre dit taken in when position
was set up in put-vs.-put version) but open-ended in collapsing market.
Loss characteristics: Maxi mum lo ss, in amou nt of B - A - initial cred it, realized if
market is at A at expiration. This loss is less than for the equivalent long straddle, the
trade-off for sacrificing profit potential on
the upside.
Decay characteristics: If market is at
A, loss from decay will accelera te the
most rapidly. Therefore, you ma y want
to exit early if market is near A as you
enter last month. At B, you ha ve the
greatest rat e of profit accrual by decay
of short option.

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 Option Strategies

21. BOX OR CONVERSION

Class: Locked trade.

These spreads are referred to as "locked trade s" because their value at expiration is
totally independent of th e price of the underlying instrument. If you can buy them fo r
less than that value or sell them for more, you will make a profit (ignoring commission
costs).

When to use: Occasio nally, a market will get out of line enough to justify an initi al
entry into one of these positions. However, they are most commonly used to "lock" all
or part of a portfolio by buying or selling to create the missing "legs" of the position.
These are alternatives to closing out positions at possibly unfavourable prices.
Long box: Long a bull spread, long a bear spread — that is, long ca ll A, short call B,
long put B, short put A. Value = B - A.
Short box: Long call B, short call A, long put A, short put B. Value = A - B.
Long-instrument conversion: Long instrument, long put A, short call A . Value = 0.
"Price" = instrument + put - A - call.
Short-instrument conversion: Short instrument, long call A, short put A. Value = 0.
"Price" = A + call - instrument - put.

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