IFG Options 301: Advanced Option Trading Concepts

Welcome to IFG’s Options 301 Course!
This course is designed to help you understand and apply

advanced option trading concepts. Although this course deals
specifically with futures options, the same concepts hold true in
stock options as well.
Just use the Next Page and Previous Page buttons to move
back and forth through this course. If you have any questions,
or would like further discussion please drop us an e-mail at
courses@ifgnet.com. Or you can contact us by voice line at
800-687-4334.
This information is confidential. No reproduction in any form is permitted without written consent.
There is risk of loss in futures and options trading and trading is not suitable for everyone. No
representation is made that any account is likely to achieve profits or losses similar to those shown,
or in any amount. You should carefully review your financial condition before deciding to trade.
Page 1
Objectives of This Course
In American style football, you can have a respectable team if you have a solid
offense and defense. However, with poor special teams (field goals, punt
returns, etc.) even the best team would lose a great many games. We’ve
covered the basics in Options 101 and 201. Options 301 is about special
teams. We hope this course will help enhance your trading by enabling you to
spot profit opportunities that exist outside of traditional price biases (kind of like
kicking field goals instead of scoring touchdowns). Accordingly, you should
finish this course with a few new weapons in your trading arsenal. (You can’t
kick extra points without a place kicker!) Finally we hope that you can begin to
see how you can put all these tools together into one cohesive trading
philosophy!
There were two things that made this course more difficult to write than Options
101 or 201. The first was simply limiting the scope of the course. (For example
there are probably a dozen situations that create opportunities to trade implied
volatility, we’ve covered only three!) We’ve endeavored to include only the
most relevant topics. The second reason this course was more difficult was
because we wanted to avoid technical discourse (tough to do in an advanced
course). Hopefully, you’ll find this course presents advanced topics in a
manner that doesn’t feel advanced. Here’s what’s in store...
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Table of Contents
Page #’s
Volatility Trading……….……….……....………………………….5 -52
Volatility Trends………….…..…...…………………………..9 -25
What is a Skew?…………………………………………….26 -31
Calendar Spreads…………………………………………...32 -43
Contract Skews……………………………………………...44 -50
Volatility Summary…………………………………………..51 -52
Value Hunting with Variants……………………………………..53 -56
Follow-up Strategies……………………………………………...57-68
Offensive Follow-ups………………………………………..58 -66
Defensive Follow-ups……………………………………….66 -67
Follow-up Summary…………………………………………68
Putting it All Together…………………………………………….69
IFG’s Strategy Grid……………………………………………….70 -71
IFG’s Strategy Summary………………………………………...72 -92
Glossary and Index……………………………………………….93 -95
Hypothetical Risk Disclosure…………………………………….96
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Prerequisites
This is an advanced course. In order to understand the material presented in
this course, you should have sound, working knowledge of all option
mechanics. You should understand not only option buying and selling but also
how option spreads are created and the advantages that spreads can create.
(They can be used to shift risk, increase probabilities and maximize returns.)
You should thoroughly understand both time decay and volatility. Finally you
should possess a basic knowledge of the “greeks” and understand how they
can be used to quantify underlying risk exposure. This course does not
frequently regress to previously covered concepts, so if you are not confident in
your knowledge of these subjects, we suggest you download our free Options
101 and 201 courses and study through them several times before tackling this
course.
If you are ready to proceed, then let’s get started. We’ll kick off with a discussion
of volatility trading...
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Volatility Trading
In Options 101 and 201, we discussed positions that are price oriented. In other
words, situations where the success or failure of the trade is primarily
determined by the price movement of the underlying asset. If the price moved
according to our expectations, we made money, if not, we lost money.
However, remember there are three main ingredients in a option’s premium
(price of the underlying, volatility and time). Using options, it is possible to
structure a trade which is designed to profit because of changes in volatility.
(Although we have discussed the impact of implied volatility on positions, the
positions were not designed with the sole purpose of capitalizing on changes in
implied volatility.) This is an area that we believe offers tremendous potential so
let’s examine how we can construct positions designed to profit if implied
volatility changes.
Why trade Volatility?

You may be curious why we want to trade implied volatility. Why not just focus
on price movement? The answer is simple. We believe that volatility is
frequently more reliable, and easier to forecast than price! You may want to
read that last sentence again, it’s important! The idea that trends in volatility
Page 5
Volatility Trading continued...
may be more reliable than price trends makes some amount of intuitive sense.
(Field goals are easier than touchdowns, right?) To see how this is intuitive,
consider the grain markets.
There is no way to know, with any certainty, whether or not a drought will occur
next summer and drive grain prices higher. However, it would certainly be
reasonable to anticipate that grain traders will be concerned about this
possibility. Because of this concern, they will be inclined to raise option prices.
This increase in option prices is quantified and expressed as a seasonal
increase in grain option implied volatility. The fact of the matter is that drought
occurrences have historically been very rare. Implied volatility increases
however, have historically been very common. The high reliability of implied
volatility trends has made implied volatility trading one of our favorite concepts.
In the investment world, the ability to forecast an event is only useful if you can
use that knowledge to generate a profit. You should already recognize that an
option’s premium can fluctuate greatly from changes in implied volatility. The
potential for large changes in an option’s premium is what creates trading
opportunities. For example, an at-the-money option with 100 days until
expiration has an implied volatility of 15% and a theoretical value is $500. If you
change the implied volatility to 25%, the theoretical value jumps to $800!
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Clearly in the example above, if you bought 10 of these options when volatility
was at 15% and sold when volatility had expanded to 25%, you would have
quite a profitable trade. (Or, if you bought high volatility and sold low it would
be a painful loss!)
Note: this illustration is overly simplistic. It does not take into account any change in time or price of the
underlying. The point is to conceptually convey that trading volatility offers the opportunity for profit.
At this point two things should be clear: first, it can be argued that volatility is
easier to forecast than price, and second, accurately forecasting volatility can
offer strong profit opportunities (which also means it carries it’s share of risk)!
Here are the situations that we believe create the greatest opportunities to
profit on changes in volatility:
1. Volatility Trends
2. Calendar Volatility Skews
3. Contract Volatility Skews
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The upcoming sections of this course are designed to help you spot trading
opportunities in each of these three areas, and to know which strategies to use
to trade volatility successfully. We’ll look at some examples that demonstrate
how we recognize trading opportunities, and we’ll employ a few new strategies
such as backspreads, long strangles, long straddles and calendar spreads.
We’ll also learn how to trade volatility with a few positions outlined in the 201
course (namely ratio spreads, short strangles and short straddles).
Let’s get started with the phenomenon that we believe offers the best profit
opportunities for the public trader…volatility trends.
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Volatility Trends
Implied volatility is basically a barometer of the nervousness in the option pits.
If the market anticipates wild price swings, traders increase option premiums
to compensate for this perceived risk. If the cause for nervousness persists,
then volatility continues to increase as more and more traders become attuned
to this perceived risk. This creates strong trends. In our opinion, there are two
different types of volatility trends that can offer profitable trading opportunities.
Seasonal trends and “major-event” trends.
Seasonal trends are common in markets where weather can significantly
influence supply and demand factors such as the grain markets, orange juice
or heating oil. “Major-event” trends are caused by a period of sustained
nervousness related to an independent, non-seasonal event. An example of a
“major-event” trend occurred in 1998 when many markets experienced
sustained increases in volatility because of economic nervousness due to the
Asian financial meltdown and the potential impeachment of President Bill
Clinton.
Major-Event Trends
Let’s begin our discussion of volatility trends by looking at a “major-event” trend
created by this turbulent timeframe in 1998.
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Major Event Trends continued...
If you look at the eurodollar price chart below you will notice the
extremely tight band of consolidation towards the end of the chart.
This type of coiling, tightly bound price action is frequently a good sign that
volatility is extremely low. We’ll take a quick look at the volatility chart to
see if this tendency was true at the time.
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As would be expected, volatility had declined to 5 year lows, both for
implied and statistical*. The combined fact of extremely tight price action
and extremely low volatility was a catalyst for action. We began to
evaluate different ways we could buy volatility with the idea that a volatility
breakout was imminent.
The blue line is

implied volatility.
The red line is

statistical volatility.
*In the best case scenario, implied volatility would

be lower than statistical, however we feel that the
relationship between implied and statistical should
be a secondary consideration in trend trading.
Delta Neutral
As we begin to evaluate this eurodollar trade, it is imperative to remember that
in trading volatility, the main goal is a change in volatility, NOT NECESSARILY
a change in price. This means it would be advantageous if we could reduce our
exposure to price risk. This is accomplished by making a position ‘delta neutral’.
Ideally, delta neutrality prevents the possibility of correctly forecasting volatility
but losing money because an adverse price move negates the volatility profits.
Before we rush off to learn how to make our position delta neutral, we should
first determine if we plan to make ‘adjustments’ to maintain delta neutrality.
In delta neutral trading, adjustments may be necessary if you wish to continually
avoid price risk. This is because delta neutral only implies that price is neutral
in the short term. Indeed as the market has a sustained price move, a position
quickly loses its delta neutrality and inherits price risk. (Why does this happen?
Refer back to ‘Gamma’ in the 201 course.) In effort to manage this risk, some
traders make ‘adjustments’ to restore delta neutrality. This is frequently
accomplished by buying or selling the number of futures contracts required to
rebalance the delta. (Remember, buying a futures contract has a delta of +1.00
so if price movement has caused a position to have a delta of negative 3.00,
you could “adjust” by simply purchasing three futures contracts.) There are two
basic types of traders who employ delta neutral strategies, those who make
delta adjustments, and those who don’t.
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The first type of trader intends to make frequent delta adjustments in an attempt
to maintain neutrality. Traders in this category tend to be market makers and
other industry professionals who have very low clearing cost and may trade in
massive volume. They are normally looking for a very minor change in volatility
(1 or 2%). They tend to buy options that are slightly undervalued and sell
options that are slightly overvalued (relative to the theoretical price determined
by Black Scholes or some other pricing model). The goal is to maintain almost
constant neutrality via delta adjustments and reap the profits created by
purchasing theoretically undervalued premium and selling theoretically
overvalued premium.
The second type of trader who utilizes delta neutral strategies makes infrequent
or no adjustments to the position. This trader begins with a neutral posture.
Then, if the price moves favorably, the trader allows the position to assume
price risk. Conversely, if an adverse price move is sustained, the trader simply
liquidates or makes minor adjustments. Logically, prior to establishing the
position, this trader must endeavor to account for the potential impact of price
risk. Another important distinction is that this trader tends to be looking for
major changes in volatility. (They may be expecting volatility to double whereas
the institutional trader may only be looking for a 1 or 2% change.)
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We believe the second (no adjustments) approach is the only viable alternative
for most public traders. Why? Transaction cost, small volume and the lack of
an on the floor presence make it difficult to pursue an adjustment based
approach in our opinion. So, in the eurodollars, we wanted to start with a delta
neutral position and maintain a no-adjustments philosophy.
In the case of the

At this point you may ask, why even bother
eurodollar, we had no price
to start delta neutral? The answer is that it
bias whatsoever. We
is entirely possible that we realize the
simply believed the tight
anticipated volatility change before we
price/ volatility contraction
would ever need to readjust our delta! This
would not be sustained
is particularly true in cases where a volatility
indefinitely. Since we didn’t
decline is anticipated.
plan on making any delta
adjustments, it was very
important we consider the potential outcome of a sustained price move.
Ideally, we wanted a position that would profit equally regardless of whether
the futures moved substantially higher or lower (since we didn’t have a bias).
Either a long strangle or a long straddle seemed to best suit this criteria.
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Long Straddle Long Strangle
$1000 $1000
Decay Decay
$500 $500
Decay
$0 $0
-$500 -$500
A B
-$1000 -$1000
A
9250 9450 9650
9250 9450 9650
Long Straddles & Strangles

To create a long straddle you buy puts and calls at exactly the same strike price
(i.e. 9450). To create a long strangle, you buy puts and calls at different strike
prices (i.e buy puts with a 9350 strike and calls with a 9550 strike). The two
positions have a similar profile. Both have limited risk and make money if the
market makes a substantial move in either direction. Additionally both have a
strong positive vega (they should profit if volatility increases), and an ugly
negative theta (the passage of time hurts the positions badly). Straddles
generally have higher cost (risk). However they don’t require the underlying to
move as far before profits accrue. (They make money quicker than strangles.)
Page 15
In the eurodollar situation, we utilized strangles simply because of the leverage

created by a lower premium outlay. (In other words, for the same total dollars
invested, we could buy more contracts of strangles than straddles.) Because we
expected a large move, we felt the leverage created by additional contracts was
more important than having a higher probability of success (using the straddles).
Finally, we wanted to give the market ample time to move so we bought options
with about nine months until expiration. Buying the deferred options also
seemed advantageous because deferred options typically have a greater
sensitivity to changes in volatility (they have a bigger vega).*
Now that we knew the type of strategy we wanted to use and the expiration
month, how did we make our position delta neutral? Simple, we were buying
the 9350 puts which had a delta of approximately -.18. If we bought 7 of the
9350 puts our delta on the puts would be -1.26. On the call side, we wanted to
buy the 9550 calls which had a delta of approximately +.14. How many calls
would we need to buy in order to be delta neutral (given our total put delta was -
1.26)? The answer is that we should buy 9 calls. (Net put delta / individual call
delta = x number of calls. So -1.26 /.14 = 9 call purchases.)
*We anticipated an additional benefit in using the deferred contract. The eurodollar futures have historically been
more volatile in the deferred contracts. This proved true again and was indeed an advantage.
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You can make any position delta neutral, simply by adding up the net delta of
one side and buying (or selling) an opposing number of deltas*. If you bought
12 calls that each had a delta of .34, how many puts should you buy to be delta
neutral, given that each put has an individual delta of -.23? The answer is 18
puts. (12 calls x .34 delta = 4.08 net delta / -.23 delta per each put = 17.7 puts
needed, round to 18.)
So what happened to the eurodollars? Within a few weeks the Russian

economy was under severe stress. The Dow began to decline as the release
of the historic Starr Report caused Wall Street to become legitimately
concerned about the possible impeachment of President Clinton. The
Eurodollar futures responded by rallying abruptly in concert with the other US
interest rate futures. The traders believed the Fed would cut interest rates in
an attempt to stabilize the Dow and other world economies. As we broke out of
the sideways price range, implied volatility doubled in just the course of a few
weeks. This explosion in volatility and price caused the premium of our
strangles to increase five fold, making a nice play.
*Note: Larger traders may even want to pursue establishing a “gamma

neutral” position for added neutrality. Call our office for more details.
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The chart below gives a visual depiction of how the futures unfolded. The
breakout was quick and powerful. Again we really didn’t have a clue which
way the market would break, we just felt that it was unlikely the low
volatility could be sustained. The volatility chart is on the next page.
Page 18
Wow! Volatility
spikes higher!
So lets review the trade. We noticed a period of extremely quite price

action on the chart. This aroused our suspicions that implied volatility
may be low. We consulted the volatility charts and found our expectations
were true. We decided to take a position simply because we believed
Page 19
that the contracted volatility could not continue indefinitely. We believe in a “no
adjustments” policy towards delta neutral trading and consequently elected to
use a position which should benefit if a) implied volatility increased or b) price
moved substantially in either direction. Trading volatility can be just that
simple. When looking for a “major-event” trend, we typically begin by
examining the price charts for periods of either extreme quietness or price
volatility. Then we check the volatility charts to confirm any extreme highs or
lows in implied volatility. Finally we build a trade with a high vega sensitivity
that also reflects any price bias we may hold.
Seasonal Volatility Trends

Now lets look at an example of how it is possible to capitalize on seasonal
increases in implied volatility. Several markets exhibit strong seasonal volatility
trends. Usually these seasonal volatility trends occur because the balance of
supply and demand is threatened by weather factors. Droughts during the
summer cause strong volatility trends in the grains and winter storms can play
havoc in the energies. Other markets also exhibit seasonal volatility trends as
well. Regardless of the market you trade, it is always advisable to examine a
volatility chart for a seasonal volatility trend. We’ll look at a volatility chart on
the soybeans.
Feel Free to Call IFG for Average Volatility Charts 800-687-4334 Page 20
Seasonal Volatility Trends continued...
Seasonal Volatility Increases During the Summer Months
The chart above is a 6-year average implied volatility chart for the soybeans.
The seasonal volatility increase is very clear. Historically, implied volatility
has begun to increase in the early Spring, and the average increase is
approximately 14%. If we wanted to try to take advantage of this tendency
how would we begin? We know we want to be in the the market a little prior
to when volatility begins to accelerate. So, we will probably want to place our
position in the late winter/ early spring.
Page 21
If we use a “no adjustments” delta neutral position, we should consider our

exposure to sustained price movements. Interestingly enough for the soybeans
(and the other grains), the seasonal volatility increase often coincides with a
price increase. (This can be observed by examining price charts…When
looking for seasonal volatility moves, always check price charts to see if there
has been a historical correlation between price and seasonal volatility changes.)
Because of the potential for a price rally, we want a position that retains the
ability to benefit in a runaway bull market in addition to volatility increases.
Call Backspreads Call Backspread

A call backspread should fit this $10000
scenario perfectly. To create a call $6666
A
backspread, you sell one at/in the $3333
money call (point A) and buy two or $0
more calls at a higher strike (point B),
-$3333
ideally to a delta neutral ratio. In this
example, we’ve sold 11 of the 550 calls -$6666 B
(delta = -.75 each) and bought 22 of the 500 550 600 650 700
600 calls (delta = +.375 each) for a 6
cent, or $300, credit per spread. The
blue line in the graph depicts the position at expiration. However we want to
focus our attention the red line which depicts the trade with 60 days until
Page 22
expiration. Why? When we are trading volatility trends, we don’t plan on

holding the position until expiration. At expiration an option no longer carries any
implied volatility, it’s value is comprised entirely of intrinsic value. So we should
plan on liquidating the position prior to expiration if we plan to reap profits from
an increase in implied volatility. Getting back to our graph, the depiction on this
page shows our 550/600 call backspread with 60 days until expiration (all three
lines have 60 days until expiration). The only difference between each line, is
that we changed the implied volatility level.
Volatility & the Backspread
The red dashed line shows the position $10000
with no change in volatility. The green
$6666
line evaluates the position with a 14%
increase in implied volatility and the blue $3333
line shows a 14% decrease in implied $0
volatility. Clearly, if we are correct in -$3333
our volatility forecast, we will have a -$6666
very strong position, with zero loss
500 550 600 650 700
potential due to price movement. On
the other hand, if we are incorrect and implied volatility drops significantly, our
loss could be more severe (however, your maximum loss is still limited.)
Page 23
The two volatility situations we have examined thus far were designed to
participate in volatility increases. Both of these positions involved limited risk
positions and exposure to time decay. Why? As you may remember from
Options 201, buying options creates a positive vega. When you anticipate a
volatility increase you want a positive vega, which means you will be a net
buyer of options. If you are looking for a volatility decrease you should have a
negative vega, which means you must be a net seller of options. As the vega
goes further away from zero (either positive or negative) the sensitivity to
volatility increases.
If you refer back to the volatility chart on Page 21 you will notice that over the
given timeframe, implied volatility frequently peaked out around 30% and
declined sharply thereafter. What type of position could we use to capitalize on
this apparent seasonal decline in implied volatility? Generally, ratio spreads,
short strangles and short straddles are effective strategies to capitalize on a
decline in implied volatility. (refer to the 201 course if you need a refresher on
these positions.) If you are utilizing a “no adjustments” approach and you have
a price bias, you will want to lean towards ratio spreads. If you don’t have a
price bias and expect a fairly quiet market, you should consider short strangles
and straddles.
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Volatility Trends Summary
Seasonal Volatility Trends: Trading opportunities can be spotted by looking

for seasonal patterns on the implied volatility charts. Price charts should be
reviewed to discern any potential price & volatility correlation.
Event Driven Volatility Trends: Trading opportunities can be spotted by
looking for extreme quietness or volatility on the price charts. This should be
confirmed by similar action on the implied volatility chart.
Once you have a spotted a trading opportunity, then you can start to evaluate
potential strategies based on the following:
Strategies for a Volatility Rally For a Volatility Decline
1. Call Backspreads (bullish price bias) 1. Call Ratio Spread (bullish)

2. Put Backspreads (bearish price bias) 2. Put Ratio Spread (bearish)
3. Long Straddles 3. Short Straddles
4. Long Strangles 4. Short Strangles
5. Calendar Spreads (we’ll discuss later)
Page 25
What is a Skew?
We’ve seen how volatility trends can give big, dramatic trading opportunities.
Volatility can also provide more subtle trading opportunities. Many of these
subtle opportunities arise in the form of ‘volatility skews’. Since the concept of a
skew may be unfamiliar, we’ll begin our discussion there.
The weather impacts our lives on a daily basis. However, most people are
especially attuned to the weather while on vacation. Nothing is quite as
discouraging as having your vacation ruined by inclement weather. Dreams of
sun bathing with oil soaked, salty skin, and the scent of sea air in your hair, can
quickly be dashed by a major thunderstorm. The astute vacationer, watches the
weather forecast closely, and heads to the museum when the forecast is for rain
and to the beach when the forecast is for sun and fun. Watching the weather
can help you have more fun on vacation. As a weather forecast attempts to
predict sunshine, a ‘volatility skew’ is the option market’s forecast of potential
volatility in the underlying instrument. In short, if an option market is exhibiting a
skew, it has factored in a perception of added risk.
Our goal when trading skews is to design positions which will be profitable if the
observed skew dissipates, or corrects to a more normal posture. At this point it
is quite reasonable to ask... Why should a volatility skew correct to a more
Page 26
Volatility Skews continued...
normal posture? The answer is twofold. First when an option expires, it’s value
is entirely composed of its intrinsic value. It is impossible for there to be any
time value left in the option! Volatility changes only impact time value, so we
can logically conclude that volatility in the expiring month will eventually be
reduced to zero. Secondly it is not uncommon for a volatility skew to be
associated with short term nervousness created by a pending report or other
market news. As soon as the event passes, the volatility skew frequently
dissipates. The disappearing skew is what give the opportunity for profit!
There are two primary types of volatility skews- contract skews and calendar
skews. Either of which can occur independently or simultaneously. Let’s start
by examining contract skews.
Strike Imp. Vol. Contract Skews
800 57% In Options 201, we talked about disparity between
775 50% strike prices. In reality, this disparity is just a contract
750 44% skew. A contract skew is when there is gradated
725 39% disparity in the volatilities of the individual strikes of a
700 36%
675 32% particular expiration month. As an example, let’s say
650 29% the November soybeans futures were trading at 6.70
625 27% and you observed the strike prices and implied
volatilities in the chart at left.
Page 27
Notice how the implied volatility increases with each successively higher strike
price. This gradated distribution makes contract skews easy to spot. From this
particular skew we can also determine that there is an increased perception of
bullish nervousness. How can we draw this conclusion? We know that as
volatility increases, options become more expensive to purchase. The higher
strike prices are obviously more expensive (in relative terms only). This is
evidence that either: a) there is increasing demand for the higher strike options
or b) the option sellers are nervous about selling these options and are
accordingly asking a higher selling price. Either of these two alternatives
clearly point to the perception that, although it’s quiet now, a bullish storm could
appear on the horizon. It’s like a forecast for sun this morning and
thunderstorms later this afternoon.
When you make a statement that a “bullish storm may be on the horizon”, it is
tempting to begin to look for trading clues. (i.e. the option traders must know
something if they are factoring the possibility of a bullish move.) On the
contrary, skews may occur because of perceived risk and not necessarily price
biases. For example, beginning after the crash of 1987, the S&P market has
demonstrated an almost continual “bearish” contract skew throughout the
biggest bull run in all of history! This bearish skew was not a forecast of doom,
it simply reflected the mentality that the risk of another crash was too great to
overlook.
Page 28
Calendar Skews
As stated, there are two principal types of skews, contract skews and calendar
skews. Whereas a contract skew deals in one contract month only, a calendar
skew is when a particular contract expiration month carries a substantially
higher (or lower) average implied volatility than another month. (The forecast
calls for rain today and sunshine tomorrow,as opposed to a contract skew which
is more like a forecast for rain in the morning and sun in the afternoon of the
same day.) We’ll look at the Jan. soybean options versus the Nov. options in
this example of a calendar skew. (To arrive at an average volatility, we have
used the simple technique of averaging the volatilities of each individual strike.)
Nov. Options Jan. Options

First, notice that there is definitely
Strike Imp. Vol. Strike Imp. Vol. a large contract skew in both
800 57% 800 44% months. (Remember we said
775 50% 775 42% that calendar and contract skews
750 44% 750 37%
can occur simultaneously.) The
725 39% 725 34%
700 36% 700 32% calendar skew is obvious as well.
675 32% 675 27% The January options are clearly
650 29% 650 23% cheaper with an average implied
625 27% 625 22% volatility of 32% verses 39% in the
Avg. Volatility = 39.3% Avg. Volatility = 32.6% Nov. options.
Page 29
Now that we can recognize and have discussed both, let’s summarize the
differences between a contract skew and a calendar skew. A contract skew is
when there is a volatility difference between the individual strike volatilities of
one particular contract month. A calendar skew is when there is a volatility
difference between the average volatilities of two different contract months. In
other words, a contract skew is a directional perception of risk whereas, a
calendar skew is simply the perception that one timeframe will be more volatile
than another. A contract skew is similar to a weather forecast that calls for rain
in the morning and sunshine in the afternoon (the forecast calls for changing
weather during the same time period) A calendar skew is similar to a weather
forecast for mostly rain today and mostly sunshine tomorrow. (The forecast is
different between two different time periods.)
It is worth noting that many markets will carry a natural skew (either calendar,
contract or both) to some extent. As mentioned, a contract skew often persist
in the S&P’s. If you don’t have analysis software that allows you to observe the
natural skew of a market, you should ask your broker for this information.
Otherwise, an apparent trading opportunity could be a routinely occurring skew
that accurately accounts for a statically justified price bias. (In other words,
there is a low probability of profit.)
Page 30
Let’s apply our new knowledge of skews, by looking at a trading opportunity

created by a calendar skew. Remember, you can spot calendar skews by
observing the average volatilities of options with different expiration months.
You are looking for situations where the volatility in a nearby contract is
substantially higher than the volatility of a deferred contract. We will attempt to
capitalize on this disparity by selling options in the nearby month (where
volatility is high) and purchasing options in deferred months (where volatility is
low). Remember our objective is to take advantage of the times when the skew
disappears or corrects to a more normal posture. We’ll start with a traditional
calendar spread.
Page 31
Calendar Spreads
A calendar spread is a position that should be profitable if a large calendar
skew disappears (abstaining a significant price move). To create a calendar
spread, you purchase an option with a deferred expiration (where volatility is
low), and sell an option with the same strike that expires in a closer month
(where volatility is high). For example, if it is March now, then buying a July
20.00 Crude oil call and selling a June 20.00 crude oil call would be a calendar
spread. You should consider utilizing a calendar spread if you notice that a
near term option contract has a significantly higher average volatility than a
deferred contract (there is a substantial calendar skew).
Initially, we will limit our discussion of calendar spreads to commodities which

have serial options. A serial option is an option which expires in a month in
which there is no underlying futures expiration. At expiration, serial options
settle versus the closest futures contract. For example, in the currencies, there
are January, February and March options. All of which trade and settle versus
the March futures. (The January and February options are considered serial
options since there is not a Jan. or Feb. futures contract.) Serial options exist
on several contracts including the S&P’s, currencies, bonds and notes, precious
metals, sugar, orange juice, and cattle. (Be sure to check liquidity, which can be
a problem in serial options).
Page 32
Calendar Spreads continued...
In this example, we’ll assume that you notice the April D-Mark options are high
priced relative to the June D-Mark options. You elect to place a calendar spread
to attempt to capitalize on this calendar skew. You call your broker and buy 5 of
the June 55 calls (we buy the low volatility options) and sell 5 of the April 55
calls (we sell the high volatility options) for a debit of .32 or $2000 (each point in
the DM options is worth $12.50. So 32 X $12.50 X 5 contracts = $2000) The
maximum loss on serial calendar spreads is always the initial debit plus fees or
$2000 in this case. (Provided you liquidate both positions at the expiration of
the sold option.)
DM Calendar Spread
The blue line on the graph
$4000
provides a profit and loss profile
$3000
of this position at the expiration of
the April calls. If a calendar $2000
spread is held until expiration, the $1000
front half of the skew is forced to $0
disappear. (The April options will -$2000
expire to intrinsic value, therefore -$4000
there can no longer be a volatility
49.00 52.00 55.00 58.00 61.00
factor in their premium.)
Futures price
Page 33
By examining the profit and loss profile on Page 33, it is readily apparent that
profitability is dependant upon the price hovering in a fairly sideways range. At
expiration of the nearby contract, profits occur if the futures have not moved
substantially enough to overcome the time value still present in the deferred
options. However, if the market makes a sustained move in either direction,
the deferred strike price will lose a majority of its time (extrinsic) value, and a
loss occurs.
The main reason calendar spreads are so effective in exploiting calendar
skews is because calendar spreads capitalize on the inherent decaying
character of options. It is readily observed
Time Premium (extrinsic value)
that time depreciation accelerates the closer

you get to expiration (especially for at the
money options). The graph to the left, shows
the decay of an at the money option. Notice
that the closer you get to expiration, the
faster the extrinsic (time) value approaches
0 1 2 3 4 5 6 zero. This is evidenced by the slope of the
Months until expiration curve becoming steeper.
Since the impact of time decay accelerates as expiration approaches, it makes
logical sense that a nearby option will lose time value faster than a deferred
Page 34
option. It is important to grasp that when implied volatility changes, the change
is solely reflected in the extrinsic (time value) of the option. (If volatility goes up,
the extrinsic value goes up and vice versa.) The less extrinsic value that is
present, the less volatility can impact the option. So, if an option is losing
extrinsic value due to time decay, then implied volatility changes can bear less
influence. By selling nearby premium and buying deferred, calendar spreads
take advantage of this trait.
If you expect a market to move fairly sideways and a large calendar skew is
present, a calendar spread can be a strong trade. It can be superior to short
strangles and straddles because it has limited risk and no margin calls. The
profit and risk profile is similar to a long butterfly (which we’ll discuss later), but
execution is much simpler than a butterfly.
Until now, we have limited our discussion to serial options because calendar
spreads have additional risk when there are no serial options present. Without
serial options, different option months trade and settle against distinct and
separate underlying contract months. For example, The March options trade
and settle relative to the March futures. The June options trade and settle
relative to the June futures. Since the March futures and June futures are two
separate and distinct contracts, there is no guarantee that they will move in
Page 35
tandem. The spread between the two distinct futures contracts creates
additional risk for the calendar trader*. Let’s take a closer look at how this risk
plays out.
*Note: Stock option traders have an advantage over commodity traders when it comes to calendar spreads. In
stock options, all option contract months are settled and traded to the same underlying instrument, the stock itself.
Calendar spreads are much easier to find and implement in stock options.
Non-Serial Calendar Spreads

In this example, we will suppose that it is currently April, and you notice extreme
disparity between the June Live Cattle options and the Aug Live Cattle options.
We’ll assume the June futures are currently at 64.00 and the Aug futures are
currently at 66.00. You decide to place a calendar spread to try to capitalize on
this disparity. Since the June options expire versus the June futures and the
Aug options expire versus the Aug futures, you have additional calendar spread
risk as there is no guarantee the June and Aug. futures will move in tandem.
The current June/ Aug spread would be -2.00 (June futures at 64.00 less Aug
futures at 66.00 = -2.00). Changes in this spread represent risk.
You actually have a more complicated proposition than it would at first appear.
Since the June futures are at 64.00 and the Aug is at 66.00, it would be difficult
to create a pure calendar spread using the same strike prices. If we used the 64
Page 36
strike, the June 64 call would be at the money, but the Aug. 64 call would be
2.00 in the money. We’ll create a more balanced position by selling 10 of the
June 64 calls and buying 10 of the Aug 66 calls, since both of these options are
at the money. We’ll pay 2.40 for the Aug. calls and sell the June calls for 1.80
for a total debit of 6.00 points or -$2400.
In the graph below, the blue line represents the profit and loss of the position at
expiration of the June options if the spread relationship between the June and
Aug futures stays constant at -2.00. Non-Serial Calendar Spread
(Notice this position has the same
profile as the graph on Page 33 $5000
using serial options on the D-mark.) $4000
Now let’s look what happens if the $3000
spread changes. The red line
$2000
shows the profit and loss of the
position at expiration of the June $1000
options if the June/Aug futures $0
spread has changed to -1.00 (We’ll -$1000
say the June futures have rallied by -$2000
1.50 points to a price of 65.50,
while the Aug futures have 56.50 60.25 64.00 67.75 71.50
June Futures price Page 37
only rallied .50 to 66.50). Notice how harmful the spread move from -2.00 to -
1.00 has been to the profitability of the trade. Since we sold a call in the June
contract and the June futures gained relative to the August, the short June call
lost more than we recuperate in the Aug. contract. Upside risk is only limited by
the change in the spread. (In this case, it has increased by an additional $4000.
The 1.00 spread change or $400 on 10 contracts.)
Of course where there is risk, there is opportunity for profit. The green line
shows the result if the futures spread moved to -3.00 (We’ll say the June futures
rallied 1.00 to 65.00 and the Aug rallied 2.00 to 68.00.) Because the Aug.
futures gained relative to the June futures, the position generates additional
profits (perhaps as much as $4000)! There are times when you may elect to
pursue a calendar spread (in non serial options) to attempt to capitalize on
disparities in futures spread relationships as well as a calendar skew.
What if you noticed that the March futures were trading at a historic low versus
the July contract, and there was a strong upcoming seasonal tendency for the
spread to narrow? You may wish to place a calendar spread in an attempt to
capitalize on this spread relationship (especially if the March options were
significantly overpriced relative to the July options). However it is important to
recognize that your intention on this type of calendar spread is largely to
Page 38
capitalize on an expected change in the spread relationship of the underlying

futures. In short, you are making a trade based on spread price relationships
rather than solely attempting to profit on the calendar skew. Because of the
additional spread and volatility risk, we would only recommend that very
experienced traders pursue non-serial calendar spreads. If you are a relative
newcomer to the options world, we would strongly suggest limiting your
calendar spreads to commodities which have serial options.
Trading Time: Diagonal Calendar Spreads-

Before we end our discussion of calendar spreads, a discussion of diagonal
spreads is in order. A diagonal calendar spread is simply any traditional option
spread which has components executed in different expiration months. For
example, to diagonalize a bull call spread, you would buy a lower strike call in
the deferred option (i.e. the June 80 call), and sell a higher strike call in the
nearby option (i.e. the May 86 call). Generally, diagonal spreads are initiated in
an attempt to capitalize when a calendar skew is present and the trader has a
price bias in the underlying.
Page 39
In this example we will return to the D-Mark scenario we outlined on Page 33.
This time, we’ll assume that we anticipate a mild rally, and would like to
capitalize on this rally as well as the calendar skew between the April and June
contracts.
In the graph, the blue line represents the profit and loss profile (at April
expiration) of our original calendar spread (sell 5 of the April 55 calls and buy 5
of the June 55 call for .32). The green line represents a diagonal bull
call spread (at April expiration)
DM Calendar Spread
created by selling 5 of the Apr 56
calls and buying 5 of the June 55
$4000
calls for .52
$3000
Notice how the green line has a
$2000
bullish skew relative to the blue
$1000
line. This is reflective of the fact
$0 that a bull call spread has a positive
-$1000 delta, and a traditional calendar
-$2000 spread has zero delta. The
diagonal bull call spread has a
49.00 52.00 55.00 58.00 61.00 higher breakeven and more
Futures price
potential downside risk.
Page 40
This additional downside risk occurs because you will receive less premium for
the short April call, as it is further out of the money. (We sold an April 55 call in
the original spread and an April 56 call in the diagonal bull call spread.) The
diagonal bull call spread still retains the limited risk/ limited profit profile of a
traditional bull call spread.
It is important to remember that any traditional option spread can be initiated as
a diagonal calendar spread, so the possibilities are virtually limitless. Also, like
traditional calendar spreads, diagonal spreads can be created with serial
options or with non-serial options (of course non-serial diagonal spreads
represent additional risk because the underlying contracts may not move in
tandem.)
Accounting
There is onefor Volatility-
crucial aspect of calendar spreads that remains. You should
recognize that calendar spreads are very sensitive to changes in overall
volatility. Increases in implied volatility are beneficial to calendar spreads, and
decreases are detrimental. (This occurs because changes in volatility have a
greater impact on deferred premium). This sensitivity to overall volatility levels
means that you could be correct about your forecast for the calendar skew and
still lose money if overall volatility declined substantially.
Page 41
Since increases in overall volatility are beneficial and decreases are

detrimental, you should be hesitant to apply a calendar spread if you notice that
overall volatility appears to be in a strong downtrend. Therein lies the apparent
dichotomy of calendar spreads. We’ve stated that it is detrimental to calendar
spreads when overall implied volatility decreases (usually a sign of a quiet
market) and yet it is clear that calendar spreads make the most money in a
quiet market! How can these two seemly contrary perspectives be reconciled?
DM Calendar & Volatility In reality, as volatility increases, (the
green line) it increases the range of
$4000 profitability. Notice how this line is
$3000 profitable over a much wider range of
$2000 prices. If volatility decreases (a quiet
$1000
market), it narrows your profit range
(the red line). The perspectives are
$0
reconciled because the range of
-$1000
profitability moves with the volatility.
-$2000
(It all comes out in the wash so to
say.) We believe the most
49.00 52.00 55.00 58.00 61.00 dangerous trap is too narrow of a
Futures price profit range and suggest simply
Page 42
avoiding using calendar spreads when a strong volatility downtrend exist.
In summary, calendar spreads offer unique trading possibilities. You should

consider utilizing a calendar spread whenever you notice a strong calendar
skew between two different contract expiration months. You can build positions
to capitalize on this disparity and any price expectations simply by
diagonalizing traditional option spreads. You should be cautious of overall
volatility declines which can narrow your profit range. Also, be sure to monitor
futures spread risk if you implement a non-serial calendar spread.
Advantages -Calendar Spreads- Disadvantages
1. Capitalize on calendar skew. 1. Liquidity concerns.

2. Time works in your favor. 2. Non-serial options have
3. Very flexible, often limited risk additional risk.
4. Take advantage of additional 3. Sensitive to volatility declines.
pricing disparities (diagonal
spreads).
Page 43
Trading Contract Skews
Let’s move on to examine contract skews. As discussed, a contract skew is
when the individual options with the same expiration date have a gradated
distribution of volatility levels. (The weather forecast calls for rain in the morning
and sunshine in the afternoon.)
There are two frequent types of contract skews; a positive skew, and a
negative skew. A positive skew is like the initial example from Page 27 (also
shown below). In a positive skew, the volatility increases the higher the strike
price. A negative skew is just the opposite. The volatility increases as the
strike price decreases. A positive
Positive Skew Negative Skew
volatility skew is indicative of a
Strike Imp. Vol. Strike Imp. Vol.
market that has increased
800 57% 800 28% nervousness about a potential price
775 50% 775 29%
750 44% 750 31% rally. Conversely, a negative skew
725 39% 725 33% is indicative of a market that is
700 36% 700 35% more concerned about price
675 32% 675 38% declines (like the S&P market since
650 29% 650 42% 1987).
625 27% 625 47%
Page 44
Contract Skews continued...
Of all the volatility scenarios we have discussed, we believe that contract

skews offer the fewest trading opportunities for the public trader. We have
found that the expected change in volatility rarely offers the large profit
opportunity we believe is required to justify a non-adjustment delta neutral
approach. Nonetheless, contract skews should be closely monitored as they
may provide opportunities to substantially “enhance” positions. What do we
mean by “enhance” a position? Rather than trade contract skews looking to
take a quick profit on a correction of the skew, we suggest the public trader
view contract skews as a way to enhance a position that is established
because of other rationale. For example, if you believe the copper should rally
and are looking to establish a bullish position, structuring a position to capitalize
on a contract skew may give you a nice theoretical edge and increase your
mathematical odds of a profitable trade. However, we would not suggest you
establish a position just because a contract skew exist in a given market.
As mentioned on Page 30, certain markets often exhibit a tendency towards a

contract skew. (Such as the negative skew in the S&P’s or the positive skew
routinely found in the grain markets.) It could be argued that trading
Page 45
in these markets can be advantageous because the skew is always gone at

expiration. However, we know these markets carry a skew because of the
perception of additional price risk in one direction or the other. If the market
does move in the direction of the skew, the result is often that the skew just
becomes even more pronounced and risk escalates. (For example, if the S&P
market begins to show sustained weakness, the public can rapidly hyper inflate
put premiums (expanding the existing skew) as nervous investors scramble for
protection.) We suggest caution if you are trading a market that has a routinely
appearing skew.
How to Use a Contract Skew

If you are evaluating different strategies, and notice a considerable contract
skew, what should you do? Really it is quite simple. You simply want to buy
options that have low volatility and sell options with high volatility. Ratio spreads
and backspreads are the strategies that should be the most effective in
capitalizing on a contract skew. Here are some good general guidelines.
If there is a positive skew present, then options with a higher strike price have
higher volatilities than lower strike price options (i.e. the 120 puts and calls have
higher volatilities than the 100 puts and calls). If you are slightly bullish and a
Page 46
positive skew exist, consider using a call ratio spread (buy one 100 call and sell
two 120 calls). If you are strongly to slightly bearish and a positive skew exist,
consider using a put backspread (buy two of the 100 puts and sell one of the
120 puts).
If there is a negative, skew then options with lower strike prices have higher
volatilities than options with higher strike prices (the 80 puts and calls have
higher volatility than the 100 puts and calls). If you are strongly to slightly bullish
and a negative skew exist, consider using a call backspread (buy two of the 100
calls and sell one of the 80 calls). If you are slightly bearish and a negative
skew exist, consider using a put ratio spread (buy one 100 put and sell two of
the 80 puts). Notice that regardless of whether the skew is positive or negative,
in each instance we are buying the strike prices with low volatility and selling the
strikes with high volatility. Let’s walk through a quick contract skew example.
Through technical analysis you have developed a strongly bearish price bias on
the Jun. Crude. As you begin to evaluate strategies, you notice that there is a
large positive skew in the Jun. options (the higher strike options are carrying a
larger volatility than the lower strike options). A put backspread seems
appropriate since you are strongly bearish and would like to capitalize on the
positive skew.
Page 47
Let’s take a quick look at the theoretical edge we obtain by trying to naturally
capitalize on the positive volatility skew. The chart below shows a put
backspread created by selling 5 of the 16.00 puts (which have an
implied volatility of 42%) and Put Backspread
buying 10 of the 15.00 puts (which
$7500
have an implied volatility of 30%).
We’ve applied this spread for a $5000
credit of .50 or $500. The blue line $2500
on the graph evaluates the position $0
at expiration. Notice that the -$2500
potentially unlimited downside profit -$5000
correlates with our strongly bearish
price bias. As a reference point, 13.00 14.00 15.00 16.00 17.00
we’ve plotted the red line which shows the position 60 days prior to expiration
with no change in the implied volatility skew. Finally we’ve plotted the green line
which is the same position, 60 days prior to expiration, only we’ve eliminated the
volatility skew by increasing the volatility of the 15.00 put to 42% (the same as
the 16.00 put.) The distance between the red line and the green line is the edge
that is acquired by capitalizing on the skew.
Page 48
Before we depart from the topic of contract skews, we should mention vertical
spreads. We discussed vertical spreads in the 201 course. You may want to
refer back to the 201 course, but for a quick refresher: To create a bull call
vertical spread, you buy a lower strike call and sell a higher strike call (i.e. buy
the 100 call, sell the 120 call.) If you are bearish you can create a bear put
vertical spread by purchasing a higher strike put (the 100) and selling a lower
strike put (the 80).
Vertical spreads also can be used to capitalize on a contract skew. If you have
a positive skew (the higher strike options have higher implied volatilities than
the lower strikes), then it would be advantageous to sell the out of the money
call and buy the at the money call. In essence, you are buying the cheap
option and selling the expensive option. As it pertains to skew trading, vertical
spreads are not as aggressive as ratio spread and backspreads. Therefore, if
you have a very pronounced skew, you may want to lean towards utilizing
ratios and backspreads. If you have a mild skew, you may lean towards
traditional vertical spreads.
Page 49
Let’s quickly review trading contract skews. First of all, we believe contract
skews should normally be used to simply enhance a position. So you should
begin evaluating skew opportunities after you already have a price bias. A
positive skew is when the higher strike options carry larger volatilities. A
negative skew is when the lower strike options carry larger volatilities. The
following chart correlates skews with price biases:
Price Bias
Very Bullish Mildly Bullish Mildly Bearish Very Bearish
Mild Positive Skew Bullish Vertical
S
k Strong Positive Skew Call Ratio Put Backspread Put Backspread
e Mild Negative Skew Bear Vertical
w Strong Negative Skew Call Backspread Call Backspread Put Ratio
Page 50
Volatility Trading Summary
There are three situations that we believe offer the greatest opportunities to
trade volatility. They are:
1. Volatility trends- There are seasonal and event driven trends. You can spot
seasonal opportunities by examining long term volatility charts for seasonal
moves. We have found that unusual quietness or volatility in the price charts is
often a good flag to alert you of potential event driven opportunities. Consider
using Strangles, Straddles and Ratio spreads.
2. Calendar skews- Look for a major disparity between the nearby and
deferred contracts. (i.e. May options have higher volatility than June options.)
Utilize calendar spreads to capitalize. Be cautious of non-serial options and
strong overall volatility downtrends.
3. Contract skews- Exist when there is strong disparity between options with
the same expiration month. (i.e. The June 120 strike calls have substantially
higher implied volatility than the June 100 strike calls). Ratio spreads,
backspreads and vertical spreads are best suited to capitalize.
Page 51
Volatility Summary continued...
The pure volatility trader would desire to eliminate exposure to price movement.
This suggests a delta neutral approach is in order. We believe fees and liquidity
mandate that the public trader embrace a non-adjustment approach. This
means the potential impact of long term price movement must be considered.
Simply stated, if you believe implied volatility will move higher, you want a
positive vega (a net buyer of premium). If you believe implied volatility will be
lower you want a negative vega (a net seller of premium).
It should be noted that all three types of volatility opportunities can exist
independently or in concert with one another. Indeed, you could find a situation
wherein a strong seasonal volatility trend exists and there is a pronounced
calendar and contract skew, all occurring simultaneously in the same
commodity!
Finally, even if you are considering a trade solely because of a price bias, you
should still be aware of opportunities to trade both price and volatility in the
same position. Always strive to have the odds as much in your favor as
possible!
Page 52
Value Hunting with Variants
Sometimes the key to profitability isn’t in the
major deals, it is continuously making Margin: No
Bull Call Debit Spread
sound smaller decisions on a daily basis.
We hope that you finish these courses
B
equipped to make the big trading decisions,
Decay
but also we hope you understand the little
decisions that should still be evaluated.
P Decay
One of the little decisions is determining & A
which variant of a strategy to utilize. If you’ll L
recall from the Options 201 course, there
are several different ways (or variants) you Market Price
This is the traditional approach
can use to place the same strategy. Synthetics
Variants give you the exact same profit and *Buy call A, Sell call B.
Buy put A, Sell put B. This is a variant.
risk profile, only different instruments are Buy call A, Sell put B, Sell underlying.
used to construct the strategy. Before we Buy put A, Sell call B, Buy underlying.
examine value hunting with variants we
should cover the concept of “bid/ask”
A “bid” is the price (or premium) someone is willing to pay for a spread. An
“ask” the price at which someone is willing to sell a spread. When you tell your
broker to get a “bid/ask” on a spread, you are essentially saying, tell me
Page 53
Value Hunting continued...
the price someone is willing to pay for this spread and the price at which
someone is willing to sell the spread. Requesting a “bid/ask” is generally a
good idea, because it can help you determine the price levels that would
realistically be required to obtain a fill. When you are initiating debit spreads,
you will be paying out money for the position, and your order will be a bid.
Conversely, if you are initiating a credit spread, you will be receiving money for
the position and your order will be an ask.
Now with that groundwork covered, let’s move on to examine how you can use
variants to hunt for value. In this example, we’ll consider a vertical spread.
Let’s say you believe the June D-Mark will rally over the next few months.
Given the potential profits, volatility scenario and your risk tolerance, you elect
to use a bullish vertical spread to capitalize on the anticipated price move. A
bull call spread is the most common bullish vertical spread. You call your
broker and ask for the bid/ask on buying the June 56 call and selling the 60
call. You broker tells you this spread is currently bid at 1.20, ask at 1.30. If you
were anxious for the fill, you could put in a bid to buy the spread at 1.30 (there
would be a good chance you would receive a fill since you are bidding at the
asking price).
Just before you place the order, you remember from the Options 201 course
that a bullish vertical spread can also be created by selling a higher strike put
Page 54
and buying lower strike put. So just to be sure your getting the best value, you
ask your broker, what is the bid/ask on selling the June 60 put and buying the
June 56 put. Your broker tells you the spread is bid at 2.75 and the asking
price is 2.85. If you were to place this bullish put credit spread, you would likely
receive a fill if you offered to sell the spread at 2.75 (you are asking at the
current bid price). Now things get interesting.
The green line below is the profit and loss profile of the bull call spread created
by purchasing 10 of the 56 calls and the selling 10 of the 60 calls for a debit of
1.30. The blue line is the sale of Bull Call Spread vs. Bull Put Spread
10 of the 60 puts and the
purchase of 10 of the 56 puts for $33330 Strike of 60
a credit of 2.75. First, notice the B
$24990
positions have exactly the same
profile (hence variants) Next, $16660
notice that the bullish put spread $8330
(the blue line) has greater profit $0
potential and less risk! The -$8330 A
difference is is represented by the -$16660
gray shaded area, and is not to Strike of 56
scale. The total dollar difference

54.00 56.00 58.00 60.00 62.00
is actually $625.00.
Futures price Page 55
When you look at the total risk and profit potential on the trade, $625 may seem
like a small figure. However this savings could make a big dent in your
transaction cost. And why pay more when a better value is present!
In all fairness, you should recognize that these situations do not happen often.
Floor brokers normally erase any edge that can be obtained by simply using a
different variant. However, liquidity issues can make one option strike have a
tighter bid/ ask and it’s usually worth taking a quick look. Sometimes the edge
is there for the taking.
Note: One of the favorite tricks of floor traders is to find a situation where
someone is willing to buy an overvalued spread. The floor trader will sell the
spread to the unknowing trader, and then immediately execute an offsetting
variant of the position to totally eliminate risk. The floor trader then simply
holds the position until expiration and has a locked in profit. Unfortunately, this
approach is not generally available to non-floor traders due to higher
transaction cost and less immediate pricing information.
Page 56
Follow-up Strategies
After you have done everything to select the strategy best suited to your
objectives, you may be given an opportunity to improve your position mid-trade.
This is the world of Follow-up strategies...
A number of years ago there was an obscure and silly cartoon show that
featured a brother and sister duo called the “Wonder Twins.” As with all
superhero cartoon characters, the Wonder Twins had special powers that
enabled them to fight the bad guys and conquer evil. The brother could
physically turn himself into any object made from water or ice (for example, a
bridge made of ice). The sister could transform into any animal (a gorilla for
example). They both had tremendous flexibility but they were still limited. (She
could be any animal, but she couldn’t turn into any other object.) As bizarre as
this whole premise sounds, the Wonder Twins were quite effective at fighting
crime. Whenever they were faced with danger, they would calmly evaluate the
situation and visualize what animal and ice/ water object would best suit their
needs. Then they would transform themselves and escape the claws of doom
at the last moment.
When you are trading options, you should realize that, similar to the Wonder
Twins, you can transform your option position into an other option strategy.
Page 57
Follow-ups continued...
(However, you are still limited and can’t transform into a different market or
onto a different planet.) And like the Wonder Twins, you should get in the habit
of always evaluating the trading environment to visualize if another strategy
would be more advantageous than your current position. When you transform
your position, it is called a “follow-up” strategy. Follow-ups take advantage of
the flexibility that options provide. With options, you can fine tune your initial
exposure, and you can use a follow-up to reduce, or even eliminate your
exposure half way through a trade.
There are two basic types of follow-up strategies, defensive follow-ups and
offensive follow-ups. Simply stated, a defensive follow-up is when you are
losing money at the time you alter your position. An offensive follow-up is when
you are making money at the time you alter your position. Let’s start by
examining some offensive follow-ups.
Offensive follow-ups
In our opinion, the goal of any follow-up strategy should be to improve the
position. You can improve a position in three ways. You can lower the total
dollars at risk, you can increase profit potential, or you can increase your odds
of success. An ideal adjustment never overly influences any of the other
factors. If you make a follow-up that reduces risk, it shouldn’t substantially
reduce your odds of success or your profit potential. (Obviously there will be
an influence on the other factors, however it should be acceptable.) Page 58
We’ve already discussed one of our favorite follow-up strategies, the free trade
(covered in the 201 course). In a free trade follow-up, you convert an outright
option purchase to a vertical spread. For example, if you purchase the 120
call for $500 (including fees), then you wait for a favorable price move and/or
increase in implied volatility in hopes of selling the 140 call for $500 (including
fees). Notice you are selling a higher strike call for the same premium paid for
the lower strike call. Once completed a free trade has zero risk, or cost. A free
trade can enhance a simple call purchase because it reduces the total dollars
at risk (by $500 in this case) and it dramatically increases the probability of
success. The tradeoff is that you sacrifice unlimited potential profits. (However,
your initial capital investment is freed to be reinvested.)
Typically, a follow-up will just involve converting an option position into a
different strategy (such as the free trade follow-up where you convert a long
call to vertical spread). In essence, you are simply looking to see if you can
convert to a strategy that protects open profits, or that better suits your risk,
profit and probability objectives. Since follow-ups normally involve converting
to a different strategy, we believe the key to making successful follow-up
decisions is knowing what alternatives are available. (The brother Wonder
Twin knows every type of ice object imaginable!) A chart of option strategies
such as IFG’s strategy summary is invaluable for this purpose. Let’s take a
quick example.
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Long 10 of the 750 Calls
Let’s say the the Nov. Soybean $30,000
futures are trading at 700. In $20,000
anticipation of a volatility increase $10,000
and/ or weather scare you buy 10
$0
of the Nov. 750 calls for .20 each
(or $10,000 total). The blue line -$10,000
shows the profit and loss on these -$20,000
calls at expiration. 650 700 750 800 850
Thirty days later the futures have rallied to 800 as drought concerns have
indeed surfaced. Your calls are showing a substantial profit (the red line). You
would like to continue to hold the position because a full blown drought could
send “beans to the teens” and equate to several thousand dollars of profits.
However, the first major rain shower could easily send beans back to the 600
level and wipe out all your profits and your initial investment! In short, there is a
tremendous amount of price uncertainty and strong potential for an explosive
move in either direction.
If you could have any position at this point, what would it be? Ideally you want
the best of both worlds. You would like the ability to participate in a continued
rally without exposure of your initial capital. Better yet, you would like to profit if
prices go higher or plummet lower.
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Long Straddle Fortunately you remember that a long
straddle makes money if the market
makes a substantial move in either
Decay direction. Is it possible that you can
convert your long calls into a long
P
& straddle? You quickly consult IFG’s
L Strategy Summary and pull up the Long
A
Straddle depiction (at right.)
Market Price
Synthetics
As you begin to analyze the variants
*Long call A, Long put A.
Long calls A, Short underlying. Hummm... under the “Synthetics” section you notice
Long puts A, Long underlying.
(All initiated to delta neutrality.) that you could create a long straddle by
simply selling futures contracts on top of
Long Calls vs. Straddle your inventory of long calls. The bottom
$30,000 graph depicts a long straddle (the red
$20,000 line) that could be created by simply
$10,000
combining your long calls with the sale 5
futures contracts at 800. The straddle
$0
can’t lose! You have unlimited profit
-$10,000 potential in either direction and are
-$20,000 ensured of at least a reasonable profit.
650 700 750 800 850
Page 61
It is crucial to recognize that there is a tradeoff involved. If the futures move

higher than 800, your profits on the straddle will be smaller than the outright
calls. In effect you have sacrificed 1/2 of your upside profit potential (beyond
800) in exchange for unlimited downside profit potential. (By selling five futures,
you’ve neutralized half of your long calls which cuts your profit potential in half.)
However, given the market uncertainty and the fact that the statistical odds are
against a full blown drought, you may feel more comfortable with the straddle
and nice profits in either direction. Let’s examine one more offensive follow-up
strategy.
We’ll use this scenario to introduce a new strategy. Let’s say you anticipated a
sideways market in the bonds and wanted to place a short straddle to capitalize
on the high implied volatility. With 90 days until expiration, you sell the at the
money 120 put and 120 call for 2^52 each or $5625 in total premium. Sure
enough, you are correct and the market stays at a dead standstill. Now with
about two weeks until expiration, you graph out and analyze your position.
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Follow-ups continued... Short Straddle
$6000
The blue line shows the position at
expiration. The red line shows the $5000
current profit (with 14 days until $4000
expiration). With the market currently at $3000
120, you could take profits now and $2000
pocket about $3500. However, if the $1000
futures stay at 120 you could make an
extra $1100 on the position. In fact, as 116 118 120 122 124
long as the futures stay between approximately 117^25 and 122^10 (shown by
the gray area), you will make more money at expiration than if you took
profits now. So there is definitely incentive to Gamma vs. Days till Expiration
try to hold the position until expiration.
.06 At-the-money
However, you have a big concern. You .05
Out-of-the-money
remember from Options 201 that the

.04
Gamma
Gamma explodes exponentially during the
last two weeks for at-the-money options. .03
(See chart at right.) This gamma risk .02
means that if the futures breakout and .01
begin to move rapidly in one direction, your
profits may disappear QUICKLY. .00
0 10 20 30 40 50 60 70 80
Days until Option Expiration
So let’s recap the situation. You have a winning trade and could take $3500 in
profits today. If the market stays quiet, you could increase your profits by as
much as $1100. However, you have high gamma risk, and if the futures break
hard in either direction, your profits could slip away.
Long Butterfly Margin: No What type of follow-up strategy would be

ideal? You would like the ability to hold
B the position into expiration, but protect
Decay Decay your unrealized profits from disappearing
if the market makes a hard break in either
P Decay
direction. As you check through IFG’s
& A C
L Strategy Summary, you come across a
long butterfly.
Market Price
Synthetics A long butterfly looks similar to a short

*Long call A, Short 2 calls B, Long call C.
*Long put A, Short 2 puts B, Long put C.
straddle, only you have limited risk if the
Long put A, Short put and call at B, Long call C. market moves hard in either direction.
Long call A, Short put and call at B, Long put C.
Since we already have sold the 120 call
and the 120 put, all that would be necessary to convert the position to a
butterfly is to buy the 118 put and buy the 122 call. Let’s see how this would
look.
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The blue line is the Straddle held to Straddle vs. Butterfly
expiration. The red line is straddle at $6000
current prices, and the green line is the $5000
long butterfly at expiration. While you $4000
sacrifice some profit potential with the
$3000
butterfly, it may be a worthwhile
$2000
consideration. It protects a majority of
the profits and provides unlimited $1000
staying power. If the market stays quiet 116 118 120 122 124
you could capture additional profits.
What if you have sold a strangle instead of a straddle, can you still convert it to
a limited risk trade? Absolutely, this position is actually called a Long Condor.
It looks like this: Buy 100 put, Sell 110 put, Sell 120 call, Buy 130 call. Any
time you are short a strangle or straddle and you decide to convert it to a
butterfly or condor, you will just buy the outside strikes. This is called “buying
the wings”.
Many large traders will initiate a butterfly or condor all at once as a new trade
(they place the entire position simultaneously). You can easily see the
reasons why. You get all the benefits of selling premium in a limited risk
format! However, butterflies and condors are extremely commission intensive
(they require four transactions). Because of this fact, we prefer to use them
Page 65
primarily as a follow-up technique. (We can readily evaluate the tradeoff.)

However, there are times when considering initiating a butterfly or condor as an
outright position is justified (even despite the high transaction cost). If you are
considering selling short strangles or straddles you might quickly consider the
possibility of using a long butterfly or condor*. You also might want to take a
look at the inverse of long butterflies and long condors. These are aptly called
short butterflies and short condors. In short butterflies and condors, you
purchase the middle strikes and sell the wings. You can consult IFG’s Strategy
Summary for a depiction of these positions.
*Note: Butterflies and condors are fairly neutral with respect to volatility. If you are considering a
strangle or straddle with the sole intent of capturing a volatility decline, do not use a butterfly or
condor. But you can always “buy the wings” as a follow-up after volatility has declined substantially.
Defensive Follow-ups
Up until this point, we have just discussed offensive follow-ups. Now let’s turn
our attention to defensive follow-ups. Remember a defensive follow-up is when
you are losing money at the time you alter the position. The Wonder Twins
would only transform when they were in trouble. Unfortunately, and unlike the
Wonder Twins, defensive follow-up strategies are generally less effective than
offensive follow-up strategies. Why can’t a defensive follow-up allow you to slip
the hands of doom? Because, while every follow-up action
Page 66
involves a tradeoff, the tradeoff created by a defensive follow-up is often

paralyzing to an already wounded position. For example, you might slightly
reduce the total dollars at risk, but the tradeoff is that you substantially
decrease your profit potential. Or you might increase your probabilities of
success but as a tradeoff you substantially increase your total dollars at risk.
Because of these poor tradeoffs, generally we are opposed to defensive follow-
ups.
We believe that if you are wrong, you should simply allow your (prewritten)
trading plan to trigger an exit. We would rather take a predetermined,
acceptable loss than try to rework the position in the midst of the emotional
strain of a losing position. However, there is one type of defensive follow-up
that we do advocate. We advise a defensive follow-up if there is compelling
justification towards reducing risk faster than originally planned (such as the
development of a statistically verifiable chart pattern that projects an adverse
price move). In this situation we have found that liquidating the trade altogether
proves to be the best follow-up, but you should always evaluate each
alternative independently.
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Summary of Follow-up Strategies
Let’s summarize our discussion of follow-up strategies:
1. Like the Wonder Twins, you should calmly evaluate each trade and
visualize if any strategy would more advantageous than your current position.
(We believe it is especially advantageous to evaluate follow-ups upon
penetration of key areas of support and resistance.)
2. If you decide that a follow-up is worth pursuing, use IFG’s Strategy Guide
to see what “variant” combination of options and futures would be necessary
to transform the position into the strategy you desire.
3. Finally, you should be very cautious to ensure that the follow-up will
actually improve the position. How will the follow-up change your total dollars
at risk, your profit potential, and your probability of success? (This is
especially true with defensive follow-ups which tend to destabilize the original
position.)
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Putting It All Together
In building option spreads, you are only limited by your imagination. There are
literally hundreds of possible spread combinations. You can use one of the
traditional strategies outlined in IFG’s Strategy Summary, or you can create
your own strategies using any combination of the options and the underlying.
What are the three primary factors that influence options? Price of the
underlying, time and volatility. You must account for each of these factors
EVERY TIME you are trading options! You must put all of the factors together
for each trade! If you have a strong volatility bias and no price bias, then
trade volatility with a delta neutral posture. If you have a price bias and no
volatility bias then take a vega neutral position with a strong delta bias.
You can use IFG’s Strategy Grid and Strategy Summary to help you “put it all
together” and make decisions about which strategy to use. (See “Which
Strategy Should I Use?” in the Options 201 course for more info.) Both the
Strategy Grid and the Strategy Summary have been revised for the 301 course
and are now comprehensive of all strategies covered from Options 101
through 301. Although including the old material creates some replication, all
of the strategies are combined into one compact resource. For easy review,
the Strategy Grid and Summary were included as a separate document
(Strategy2.doc) with your 301 download.
Page 69
Page 70
IFG- BULLISH TO NEUTRAL STRATEGY GRID
Very Bullish Moderately Bullish Sideways / Neutral
U&U U&L L&L L&U U&U U&L L&L L&U L&L L&U
Volatility
Rising Buy Fut. Buy Calls Bull Vertical Buy Calls Bull Vertical Calendar Spreads**
Sharply Synth. Call Bkspd Free trade* Call Bkspd Free trade*
Volatility
Buy Fut. Buy Calls Bull Vertical Bull Vertical Calendar Spreads**
Rising
Moderately Synth. Call Bkspd Free trade* Free trade*
Volatility Buy Fut. Bull Vertical Bull Vertical Long Butterfly & Condor Short Strangles
uncertain Synth. Calendar Spreads**
or mixed
Volatility Buy Fut. Bull Vertical Sell Puts Bull Vertical Sell Puts Short Strangles
Falling Synth. Short Straddles
Moderately Sell Puts or Calls
Volatility Buy Fut. Bull Vertical Sell Puts Bull Vertical Sell Puts Short Strangles
Falling Synth. Call Ratio Short Straddles
Sharply Sell Puts or Calls
Skew Beneficiaries for Bullish to Neutral Bias:

Mild Positive Skew benefits Bullish Vertical **Calendar Skew = Benefits Calendar Spreads
Strong Positive Skew benefits Call Ratio
Strong Negative Skew benefits Call Backspreads
Legend:
U&U = Unlimited Profits & Risk Green = Helped by time decay
U&L = Unlimited Profits, Limited Risk Red = Hurt by time decay
L&L = Limited Profits & Risk *Free trades are hurt by time decay until completed
L&U = Limited Profits, Unlimited Risk
Page 71
IFG- BEARISH TO EXPLOSIVE STRATEGY GRID
Uncertain But Explosive Moderately Bearish Very Bearish
U&L L&L U&U U&L L&L L&U U&U U&L L&L L&U
Volatility
Rising Long Straddle Buy Puts Bear Vertical Sell Fut. Buy Puts Bear Vertical
Sharply Long Strangle Put Bkspd Free Trade* Synth. Put Bkspd Free trade*
Volatility
Long Straddle Bear Vertical Sell Fut. Buy Puts Bear Vertical
Rising
Moderately Long Strangle Free Trade* Synth. Put Bkspd Free trade*
Volatility Short Butterfly Bear Vertical Sell Fut. Bear Vertical

uncertain
Short Condor Synth.
or mixed
Volatility Bear Vertical Sell Calls Sell Fut. Bear Vertical Sell Calls
Falling Synth.
Moderately
Volatility Bear Vertical Sell Calls Sell Fut. Bear Vertical Sell Calls
Falling Put Ratio Synth.
Sharply
Skew Beneficiaries for Bearish to Explosive Bias:

Strong Positive Skew benefits Put Backspreads
Mild Negative Skew benefits Bear Vertical
Strong Negative Skew benefits Put Ratio
Legend:
U&U = Unlimited Profits & Risk Green = Helped by time decay
U&L = Unlimited Profits, Limited Risk Red = Hurt by time decay
L&L = Limited Profits & Risk *Free trades are hurt by time decay until completed
L&U = Limited Profits, Unlimited Risk
We will end this course with a detailed summary of
each strategy we have discussed in the Options
101, 201 and 301 courses. These summaries
should prove a useful reference as you begin to
examine trading opportunities. For further
convenience, we have compiled the IFG Strategy
Grid and this summary into a Microsoft Word
document entitled “Strategy2.doc” which you
should have received in your download.
Page 72
How to Read the Strategy Summary
The name of the strategy is on the left hand side. A list of the different profit, loss, time
and volatility profiles is included, as well as ideas on when it is appropriate to consider the
strategy. The margin label above the graph tells whether margin is required with the
position. The profit and loss is depicted on the vertical axis and the price of the underlying
is on the horizontal axis. The green line shows the profit & loss of the position
approximately 3-4 months prior to expiration. The red line is approximately 1 month prior
to expiration and the blue line is at expiration. The variants box list the different
combinations that can be used to create the strategy. The “*” under variants indicates the
most common combination.
Profit Profile: Unlimited potential. Profit increases as the Long Call Margin: No
Long Call
E
price of the underlying increases. At expiration, the breakeven
= strike price + initial premium + commissions and fees.
L
Loss Profile: Loss is limited to the initial purchase price plus
commissions and fees. Maximum loss occurs if the underlying
P
is at or below strike price (point A) at expiration.
P
Decay
M
Time Profile: Time hurts position. The value of the position
erodes into expiration. Theta is negative (can be quite large). & A
A
L
Volatility Profile: Volatility increases help the position.
Volatility decreases speeds premium erosion. Vega is always a
X
positive number.
E
Appropriate Use: A long call should be used when you have
a very bullish outlook, volatility is expected to increase and you
desire a limited risk posture.
Market Price
Variants-
*Buy call A.
Buy underlying, Buy put A.
Page 73
Profit Profile: Unlimited potential. Profit increases as the Long Futures Margin: Yes
price of the underlying increases. The breakeven = purchase
price + commissions and fees.
Loss Profile: Maximum potential loss occurs if the price of
the underlying drops to zero. Losses increase as the price of
the underlying declines. A
P
Time Profile: Time has no impact on futures contracts. &
L
Volatility Profile: Implied volatility has no impact on futures
contracts. Market Price
Appropriate Use: A long futures should be used when you Synthetics
are extremely bullish and don’t mind unlimited risk. The liquidity Long call A, Short put A.
of futures contracts can be a definite advantage.
Short Futures Margin: Yes

Profit Profile: Unlimited potential. Profit increases as the
price of the underlying decreases. The breakeven = sales price
- commissions and fees.
Loss Profile: Potential loss is unlimited. Losses increase as
the price of the underlying rallies. A
P
&
Time Profile: Time has no impact on futures contracts. L
Market Price
Volatility Profile: Implied volatility has no impact on futures
contracts. Synthetics
Appropriate Use: A short futures should be used when you Long put A, Short call A.
are extremely bearish and don’t mind unlimited risk. The liquidity
of futures contracts can be a definite advantage.
Page 74
Synthetic Long Margin: Yes
price of the underlying increases. If market is near strike B, the Decay
passage of time works against profits.
Loss Profile: Potential loss is unlimited. Losses increase as A
the market continues to decline past strike A. B
P
Time Profile: Mixed. Time hurts position if underlying &
rallies, time helps position if underlying declines. L Decay
Volatility Profile: Net position is neutral with respect to
volatility. Volatility risk is normally confined to disparity between Market Price
puts and calls. Variants-
Appropriate Use: When you expect either a topside *Sell put A, Buy call B.
breakout or trading range, and desire more flexibility than a Sell call A, Buy call B
futures contract affords. There may be increased effectiveness & Buy underlying.
when a negative contract skew exists.
Synthetic Short Margin: Yes

price of the underlying decreases. If market is near strike A, the Decay
passage of time works against profits.
Loss Profile: Potential loss is unlimited. Losses increase as B
the market continues to rally past strike B. A
P
Time Profile: Mixed. Time hurts position if underlying &
declines, time helps position if underlying rallies. L Decay
Volatility Profile: Net position is neutral with respect to
volatility. Volatility risk is normally confined to disparity between Market Price
puts and calls. Variants-
Appropriate Use: When you expect either a downside *Buy put A, Sell call B.
breakout or trading range, and you desire more flexibility than a Buy put A, Sell put B
futures affords. There may be increased effectiveness when a & Sell underlying.
positive contract skew exists.
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Profit Profile: Unlimited potential. Profit increases as the Long Call Margin: No
Long Call price of the underlying increases. At expiration, the breakeven
= strike price + initial premium + commissions and fees.
Loss Profile: Loss is limited to the initial purchase price plus Decay
is at or below strike price (point A) at expiration.
Time Profile: Time hurts the position. The value of the P
position erodes into expiration. Theta is negative (can be large). & A
L
Volatility Profile: Volatility increases help the position.
Volatility decreases speeds premium erosion. Vega is always a
Market Price
positive number.
Variants-
Appropriate Use: A long call should be used when you have *Buy call A.
a very bullish outlook, volatility is expected to increase and you
Buy underlying, Buy put A.
desire a limited risk posture.
Profit Profile: Limited to the premium received less Short Call Margin: Yes
commissions and fees. Maximum profits occur at any price at
Short Call
or below point A (the strike price). Profit increases as the price

of the underlying decreases. At expiration, the breakeven = A
strike price + initial premium - commissions and fees.
Loss Profile: Potential loss is unlimited. Loss increases as
price rises. As a rule of thumb, we typically liquidate if the
P Decay
premium doubles or if the underlying moves through the strike.
Watch the exposure created by large negative gamma. &
Time Profile: Time helps the position. Theta is always L
positive. Market Price
Volatility Profile: Volatility increases hurt the position. Do
not use when volatility is expanding, or before a seasonal
Variants-
volatility increase. Vega is always a negative number. *Sell call A.
Sell underlying, Sell put A.
Appropriate Use: When you believe a strong market rally (covered write)
is extremely unlikely and volatility is medium to high. Closer-to-
the-money strikes represent a more bearish stance. Page 76
Long Put Margin: No
Long Put Profit Profile: Unlimited potential. Profit increases as the
price of the underlying decreases. At expiration, the breakeven
= strike price - initial premium - commissions and fees.
Decay
Loss Profile: Loss is limited to the initial purchase price plus
is at or above strike price (point A) at expiration. P
Time Profile: Time hurts the position. The value of the & A
position erodes into expiration. Theta is negative. L
Volatility Profile: Increasing volatility help the position.
Market Price
Declining volatility hurts (vega is positive).
Variants-
Appropriate Use: A long put should be used when you have
a very bearish outlook, and volatility is expected to increase and *Buy put A
you desire a limited risk posture. Sell underlying, Buy call A
Profit Profile: Limited to the premium received less

commissions and fees. Maximum profits occur at any price at Short Put Margin: Yes
or below point A (the strike price). Profit increases as the price
Short Put
of the underlying decreases. At expiration, the breakeven =

strike price + initial premium - commissions and fees. A
Loss Profile: Potential loss is unlimited. Loss increases as
price rises. As a rule of thumb, we typically liquidate if the
premium doubles or if the underlying moves through the strike. P
Consider negative gamma risk carefully. & Decay
Time Profile: The passage of time helps the position. Theta L
is positive.
Market Price
Volatility Profile: Volatility increases hurt the position. Do
not use when volatility is expanding, or before a seasonal Variants-
volatility increase. Vega is negative. *Sell put A
Buy underlying, Sell call A.
Appropriate Use: When you believe a strong market rally
(covered write)
is extremely unlikely and volatility is medium to high. Closer-to-
the-money strikes represent a more bearish stance. Page 77
Profit Profile: Profits are limited. Maximum profits Bull Vertical Spread Margin: No
occur if the market is at point B or higher at expiration.
Prior to expiration, profits will move towards the
maximum level as the market moves continually B
higher. Initial delta is usually less than .50.
Decay
Loss Profile: Loss is limited. Maximum loss
occurs if the market is at or below point A at expiration.
Prior to expiration, losses will move towards the P Decay
maximum level as the market moves continually lower. & A
Time Profile: Time decay will slightly hurt the L
position. As the market approaches point B, profits
accelerate with the passage of time. As the market Market Price
approaches point A, losses accelerate with time.
Theta is usually slightly negative. Variants-
Volatility Profile: The position has a relatively *Buy call A, Sell call B.
neutral volatility stance. Exposure to volatility is limited Buy put A, Sell put B.
to contract skews (disparity between strike prices or Buy call A, Sell put B, Sell underlying.
disparity between puts and calls). Vega is usually Buy put A, Sell call B, Buy underlying.
slightly negative.
Appropriate Use: If you are slightly bullish, but do not expect a sharply higher market. The most
common form of this position is a long call at point A, and short call at point B. Bull spreads are frequently
implemented as a follow-up technique. For instance, if you bought calls outright and a major move occurred
and you felt the up-trend would likely continue but that the explosiveness of the move was over, you could
sell a call at a higher strike to convert your long call into a bull spread. One of our favorite techniques is to
buy a call, wait for the market to rally, and then sell a call at a higher strike for the same premium paid for the
initial call. If the higher strike call pays for the lower strike call, there is no cost and no risk in the position,
and the initial capital is freed for new positions. We call this follow-up a “free trade”. This approach is
especially effective in a market that is experiencing a rally in volatility. Also notice that legging into the put on
the last variant is a nice way to limit your downside exposure on a covered write. After a market rally, you
simply use your proceeds from the sale of a call to buy the put and limit your downside exposure. All variants
are especially effective when there is a positive contract skew.
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Profit Profile: Profits are limited. Maximum profits Bear Vertical Spread Margin: No
occur if the market is at or below point A at expiration.
Prior to expiration, profits will move towards the
maximum level as the market moves continually A
downward. Initial delta is usually less than .50 Decay
occurs if the market is at or above point B at
expiration. Prior to expiration, losses will move P Decay
towards the maximum level as the market moves & B
continually higher. L
Time Profile: Time decay will slightly hurt the
position. As the market approaches point A, profits
Market Price
accelerate with the passage of time. As the market
approaches point B, losses accelerate with time.
Theta is usually slightly negative. Variants-
Volatility Profile: Position has a relatively neutral *Sell put A, Buy put B.
volatility stance. Exposure to volatility is limited to a Sell call A, Buy call B.
contract skew (disparity between strike prices or Sell call A, Buy put B, Buy underlying.
disparity between puts and calls). Vega is usually Sell put A, Buy call B, Sell underlying.
slightly negative.
Appropriate Use: If you are slightly bearish, but do not expect a total free fall. The traditional approach
is the first variant. This variant is also sometimes used as a low cost way to build a large inventory of out-of-
the-money positions to leverage profits if a sustained downtrend does occur. Often the reduced cost of a
vertical spread will make it a superior strategy for profit maximization, especially compared to an outright
futures positions. For instance, you can easily apply a bear put spread in the S&P 500 contract for $1,500-
$2,000 premium outlay. Meanwhile, the margin requirement for shorting one S&P futures contract may
exceed $12,000. Buying five bear put spreads could require a smaller cash outlay than selling one futures
contract, and you still have limited risk and may actually have a bigger negative delta. (The position will make
money faster than an outright short futures contract.) With any variant, good value can be attained when
there is a negative contract volatility skew. (For example, the out of the money puts are high priced relative
to the at/in the money strikes.)
Page 79
Profit Profile: Potential profits are unlimited. The Long Straddle Margin: No
breakeven at expiration is the strike price plus and
minus the net premium paid (including fees). Prior to
expiration, profits continue to expand as the market
makes a substantial and sustained move in either
direction. Decay
Loss Profile: Potential loss is limited to purchase

price plus fees. Losses expand toward maximum as P
the market continues to hover around point A. Position &
has a very large positive gamma which must be L
closely monitored. A
Time Profile: The position is hurt dramatically by Market Price
the passage of time. Price must move faster than time
for profits to be realized. Theta is extremely negative.
Synthetics
Volatility Profile: Volatility increases improve the *Long call A, Long put A.
position substantially. Volatility trends should be Long calls A, Short underlying.
monitored throughout the duration of the position. Long puts A, Long underlying.
Vega is extremely positive. (All initiated to delta neutrality.)
Appropriate Use: If you expect the market to have a large breakout but you are uncertain as to the
direction of the breakout and/ or you anticipate a large increase in implied volatility. It’s an ideal way to
capitalize on bullish volatility trends. We like to utilize long straddles when there has been a prolonged period
of extreme quietness in the futures and the implied volatility has dropped to multiyear lows. Long straddles in
the deferred months will typically have a slightly larger vega and may be more appropriate for volatility plays.
If you are expecting an extremely large breakout, consider utilizing long strangles instead. If you have strong
technical boundaries you may wish to consider liquidating the opposing strike price in an effort to maximize
returns. Another breakout follow-up possibility is to roll into a free trade on the winning side. (This can be an
effective way to lock in some increases in implied volatility.)
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Profit Profile: Profits are limited. Maximum profits Short Straddle Margin: Yes
occur if the market is at point A at expiration. The
breakeven at expiration is the strike price plus and A
minus the net premium received. Prior to expiration,
profits move towards the maximum as the market
continues to hover around the strike price.
Loss Profile: Potential loss is unlimited. Losses
accelerate as the market moves increasingly away P Decay
from point A. Position has a very large negative &
gamma which must be closely monitored. L
Time Profile: Position is helped dramatically by the
passage of time. Time must move faster than price for Market Price
profits to be realized. Theta is extremely positive.
Variants-
Volatility Profile: Volatility increases wreck the *Sell call A, Sell put A.
position. Though not as susceptible to volatility Sell calls A, Buy underlying.
increases as strangles, volatility trends should still be Sell puts A, Sell underlying.
monitored throughout the duration of the position. (All initiated to delta neutrality.)
Vega is extremely negative.
Appropriate Use: If you expect the market to move into a tight sideways consolidation, and/ or you
anticipate a decrease in implied volatility. Ideal way to capitalize on bearish volatility trends. If you only
expect a moderately sideways market, consider utilizing strangles instead. Due to extreme gamma
exposure, we recommend liquidating this trade when there are 30 days or less until expiration (particularly if
the market is near the strike price used to establish the trade). If you have strong technical boundaries
surrounding the sideways consolidation, consider liquidating the losing side if a breakout occurs. Then you
can attempt to let the winning side expire worthless to recoup any losses. If technical boundaries are not
present, we strongly recommend using a monetary stop. We typically try not to risk more than fifty percent of
the total premium received on a short straddle. Another breakout follow-up possibility is to liquidate the losing
side, and purchase options in the direction of the breakout to create a synthetic futures.
Page 81
Profit Profile: Potential profits are unlimited. The Long Strangle Margin: No
breakeven at expiration is the strike A minus the net
premium paid (including fees) and strike B plus net
premium and fees. Prior to expiration, profits continue Decay Decay
to expand as the market makes a substantial and
sustained move in either direction.
Loss Profile: Potential loss is limited to purchase
price plus fees. Losses expand toward maximum as P
the market continues to hover between points A & B. & A B
Position has a very large positive gamma which should L
be closely monitored.
Time Profile: Position is hurt dramatically by the Market Price
passage of time. Price must move faster than time for
profits to be realized. Theta is extremely negative. Synthetics
Volatility Profile: Volatility increases improve the *Long put A, Long call B.
position substantially. Volatility trends should be Long call A, Long put B.
monitored throughout the duration of the position. Long call A, Long call B, Short underlying.
Because out of the money options are typically used, Long put A, Long put B, Long underlying.
long strangles may have an even bigger vega than (All initiated to delta neutrality.)
long straddles. Vega is extremely positive.
Appropriate Use: If you expect the market to have an extremely large breakout but you are uncertain as
to the direction of the breakout and/ or you anticipate a large increase in implied volatility. Ideal way to
capitalize on bullish volatility trends. We usually prefer long strangles to straddles when we expect the move
to be so large that we want to capitalize on the additional leverage created by owning more positions.
(Rather than owning one long straddle, we’ll take the long shot and buy three of the lower probability
strangles for the same total premium outlay.) We like to utilize long strangles when there has been a
prolonged period of extreme quietness in the futures and the implied volatility has dropped to multiyear lows.
Long strangles in the deferred months will typically have a slightly larger vega and may be more appropriate
for volatility plays. If you have strong technical boundaries you may wish to consider liquidating the opposing
strike price in an effort to maximize returns.
Page 82
Profit Profile: Profits are limited. Maximum profits Short Strangle Margin: Yes
occur if the market is between strikes A and B at
expiration. The position has two breakevens at
expiration: Strike A less 1/2 premium received and
fees and Strike B plus 1/2 premium received less fees. A B
Prior to expiration, profits move towards the maximum
as the market holds steady between strikes A & B.
Loss Profile: Potential loss is unlimited. Losses P

accelerate as the market moves increasingly below & Decay Decay
point A, and above point B. Position has a very large L
negative gamma which must be closely monitored.
Time Profile: The position is helped dramatically Market Price

by the passage of time. Time decay is one of the Variants-
essential ingredients of profitability. Theta is extremely
positive. *Sell put A, Sell call B.
Volatility Profile: Typically even more sensitive to Sell call A, Sell put B.
volatility increases than short straddles. In fact, of the Sell call A, Sell call B, Buy underlying.
standard option spread strategies, strangles are the Sell put A, Sell put B, Sell underlying.
most sensitive to volatility changes. Volatility must be (All initiated to delta neutrality.)
closely monitored as Vega is extremely negative.
Appropriate Use: If you expect the market to move into a moderately sideways consolidation, and/ or
you anticipate a decline in implied volatility. The ideal way to capitalize on bearish volatility trends. If you
expect a very tight sideways consolidation consider utilizing straddles instead. Due to extreme gamma
exposure, we recommend liquidating this trade when there are 30 days or less if the market is close to either
strike price A or B. If you have strong technical boundaries surrounding the sideways consolidation, consider
liquidating the losing side if a breakout occurs. Then you can attempt to let the winning side expire worthless
to recoup any losses. If technical boundaries are not present, we strongly recommend using a monetary
stop. We typically try not to risk more than fifty percent of the total premium received on a short strangle.
Often a move through either strike price will trigger us to initiate a follow-up even if a monetary stop has not
been hit.
Page 83
Profit Profile: Profits are limited. Maximum profits Margin: Yes
occur if the market is at strike B at expiration. If Call Ratio Spread
position is initiated at a credit, a relatively small profit B
occurs if the market is at strike A or below at
expiration. Breakeven at expiration is strike price B
plus the difference between B & A and plus or minus Decay
net debit or credit.
Loss Profile: Potential loss is unlimited. Losses Decay
increase as the market moves continually above the P A
breakeven. Prior to expiration, volatility increases can &
cause premature losses especially as the market L
rallies.
Time Profile: Although the net position is fairly Market Price

neutral with respect to time, the passage of time
usually helps the position in an up-trending market.
This is especially true if the position is initiated at close Variants-
to delta neutral. Theta is usually neutral to negative. Buy call A, Sell calls B.
Volatility Profile: Position is hurt by volatility Buy put A, Sell calls B, Buy underlying.
(Frequently initiated to delta neutrality.)
increases. The position is normally initiated during
times of major volatility swings. Therefore, the
volatility exposure is typically quite high. Vega is
negative.
Appropriate Use: If you are moderately bullish, volatility is at very high levels and is expected to fall
dramatically. It can be increasingly effective when a positive contract skew exist. The spread can be used to
trade volatility trends. We like the options we sell to have at least twice the volatility of the options we buy.
Because of the potential volatility exposure and the necessity of capturing time decay in an up market, we
strongly advocate having a predetermined monetary or technical liquidation point. (We ideally like to see
technical resistance above the market before initiating this strategy.). If the market moves quickly through
strike B and volatility has continued to increase, we will typically liquidate at a loss. There are times when
you can simply liquidate one of the short calls at strike B, and convert the position into a bull call spread. The
same result can be achieved by purchasing an additional call at strike A. However, if you pursue one of
these follow-ups, you need to feel very confident the trend will definitely continue higher.
Page 84
Profit Profile: Profits are limited. Maximum profits Margin: Yes
occur if the market is at strike A at expiration. If Put Ratio Spread
position is initiated at a credit, a relatively small profit A
occurs if the market is at or above strike B at
expiration. Breakeven at expiration is strike price A
less the difference between A & B and plus or minus Decay
net debit or credit.
Loss Profile: The potential loss is unlimited. Decay
Losses increase as the market moves continually P B
below the breakeven. Prior to expiration, volatility &
increases can cause premature losses especially as L
the market declines.
Time Profile: Although the net position is fairly Market Price

neutral with respect to time, the passage of time
usually helps the position in a down-trending market.
This is especially true if the position is initiated at close Variants-
to delta neutral. Theta is usually neutral to negative. Sell puts A, Buy put B.
Volatility Profile: Position is hurt by volatility Sell puts A, Buy call B, Short underlying.
(Frequently initiated to delta neutrality.)
increases. When the position is normally initiated is
during times of major volatility swings. Therefore, the
volatility exposure is typically quite high. Vega is
negative.
Appropriate Use: If you are moderately bearish, volatility is at very high levels and is expected to fall
dramatically. Can be increasingly effective when a positive contract skew exist. Can be used to trade volatility
trends. We like the options we sell to have at least twice the volatility of the options we buy. Because of the
potential volatility exposure and the necessity of capturing time decay in an down market, we strongly
advocate having a predetermined monetary or technical liquidation point. (We ideally like to see technical
support below the market before initiating this strategy.). If the market moves quickly through strike A and
volatility has continued to increase, we will typically liquidate at a loss. There are times when you can simply
liquidate one of the short puts at strike A, and convert the position into a bear put spread. The same result
can be achieved by purchasing an additional put at strike B. However, if you pursue one of these follow-ups,
you need to feel very confident the trend will definitely continue lower.
Page 85
Profit Profile: Potential profits are unlimited.
Margin: No
Profits increase as the market moves continually Call Ratio Backspread
higher. If the position is initiated at a credit, a relatively
small profit occurs if the market is at strike A or below
at expiration. Breakeven at expiration is strike price B
plus the difference between B & A plus or minus net A
debit or credit. If initiated for a credit, additional Decay
breakeven at strike A plus net credit.
Loss Profile: Potential loss is limited to the difference P

Decay
between A & B plus net debit (or minus net credit). &
Maximum losses occur at point B at expiration. Prior to L
expiration, volatility declines can cause premature losses B
in a quiet market.
Market Price
Time Profile: The net position is slightly negative
with respect to time. The passage of time usually hurts Synthetics
the position in a quiet market. Theta is usually slightly
negative to neutral. Short call A, Long calls B.
Short put A, Long calls B, Short underlying.
Volatility Profile: Position benefits strongly from (All typically initiated to delta neutrality.)
volatility increases. The position is normally initiated
during times of quietness when a upside breakout is
expected. Vega is positive.
Appropriate Use: If you are extremely bullish, but would prefer limited risk and/ or when you expect a
volatility increase and have a bullish price bias. Often used when the futures are near B, the market has
been moving sideways, and an upside breakout seems imminent. Usually a better value can be obtained if
applied when a negative contract skew is present. If the market moves rapidly higher after the position is
intact, you may wish to roll the short strike A to a short strike above point B. This results in a position
comprised of a bull vertical spread and a long call. Call ratio backspreads can also be easily converted into a
short butterfly buy selling a higher strike option and leaving the strike A intact. Both of these follow-ups can
be effective in helping to capture a portion of a volatility increase. Be careful if the market is at point B during
the final 30 days, as losses may accelerate.
Page 86
Profit Profile: Potential profits are unlimited.
Margin: No
Profits increase as the market moves continually Put Ratio Backspread
lower. If the position is initiated at a credit, a relatively
small profit occurs if the market is at strike B or higher
at expiration. Breakeven at expiration is strike price A
less the difference between A & B plus or minus net B
debit or credit. If initiated for a credit, additional Decay
breakeven at strike B less net credit.
Loss Profile: Potential loss is limited to the difference P Decay

between A & B plus net debit (or minus net credit). &
Losses move towards maximum as market continues to L
hover around point A. Prior to expiration, volatility A
declines can cause premature losses in a quiet market.
Market Price
Time Profile: The net position is slightly negative
with respect to time. The passage of time usually hurts Synthetics
the position in a quiet market. Theta is usually slightly
negative to neutral. Long puts A, Shout put B.
Long puts A, Short call B, Long underlying.
Volatility Profile: Position benefits strongly from (All typically initiated to delta neutrality.)
volatility increases. The position is normally initiated
during times of quietness when a downside breakout is
expected. Vega is positive.
Appropriate Use: If you are extremely bearish but would prefer limited risk and/ or when you expect a
volatility increase and have a bearish price bias. Often used when the futures are near A, the market has
been moving sideways, and an downside breakout seems imminent. Usually a better value can be obtained
if established when a positive contract skew is present. If the market declines rapidly after the position is
intact, you may wish to roll the short strike B to a short strike below point A. This results in a position
comprised of a bear vertical spread and a long put. Put ratio backspreads can also be easily converted into a
short butterfly buy selling a lower strike option and leaving the strike B intact. Both of these follow-ups can be
effective in helping to capture some of a volatility increase. Be careful if the market is at point A during the
final 30 days, as losses may accelerate.
Page 87
Profit Profile: Profits are limited. Maximum profits Long Butterfly Margin: No
occur if the market is at point B at expiration. Prior to
expiration, profits may move very slowly. However, B
profits often accelerate dramatically during the final
weeks of trading.
Decay Decay
occurs if the market is at/ below point A or or at/ above
point C at expiration. Prior to expiration, losses will P Decay
move towards the maximum level as the market & A C
makes a sustained move in either direction. L
Time Profile: Overall, position is neutral with
respect to time. As the market approaches point B,
profits increase, especially during the final 30 days. Market Price
Losses will also accelerate at points A & C during the
final weeks. Theta is usually slightly positive. Synthetics
Volatility Profile: The position has a neutral *Long call A, Short 2 calls B, Long call C.
volatility stance. Exposure to volatility is generally *Long put A, Short 2 puts B, Long put C.
limited to the disparity between strike prices. When Long put A, Short put and call at B, Long call C.
used as a follow-up strategy, can help secure a Long call A, Short put and call at B, Long put C.
profitable volatility move.
Appropriate Use: Often is legged into as a follow-up strategy. We like to “buy the wings” when we have
been holding a short straddle and later want to try to maximize profits by holding the position into expiration.
Also you can convert a call ratio spread into a butterfly by purchasing the the upper strike (point C) to reduce
the upside risk of the call ratio spread. This may prove especially attractive if you have been holding a call
ratio spread in a market that has rallied and is now slowing it’s upside acceleration. Long butterflies can
occasionally be placed simultaneously in the deferred contracts. If used in this fashion, you may wish to
consider the position when cost (including fees) is 10% or less than the distance between points A & B. (Use
20% or less if there is a tradable strike between points A & B.) It is important to remember that butterflies
may hold their value until the last few weeks and then rapidly move towards profitability. This occurs
because max profits are realized when point B represents the at-the-money strikes (which have accelerated
time decay during the last 30 days).
Page 88
Profit Profile: Profits are limited. Maximum profits Short Butterfly Margin: No
occur if the market is at or below point A or at or above
point C at expiration. Prior to expiration, profits will
move towards the maximum level as the market A C
makes a sustained move in either direction.
Decay
occurs if the market is at point B at expiration. Prior to
expiration, losses will move slowly towards the P Decay Decay
maximum level if the market consolidates around B. &
L B
Time Profile: Overall, position is neutral with respect
to time. If the market is near B, time decay hurts the
position. If it is below A or above C then time decay Market Price
helps the position. Decay may prove minimal until final
weeks of trading. Theta is usually slightly negative. Synthetics
*Short call A, Long 2 calls B, Short call C.
Volatility Profile: The position has a neutral
*Short put A, Long 2 puts B, Short put C.
volatility stance. Exposure to volatility is limited to Short put A, Long put and call at B, Short call C.
disparity between strike prices or disparity between Short call A, Long put and call at B, Short put C.
puts and calls.
Appropriate Use: We like to convert a Ratio Backspread to a Short Butterfly by selling the out of the
money option. This can be an effective way to capitalize on a volatility increase and potential price
stagnation after a directional move. There are occasional opportunities to place all legs of a short butterfly
simultaneously. This usually occurs when the futures are below point A or above point C (don’t forget to
account for the high transaction cost and potential slippage). It is crucial to remember that short butterflies
will likely hold their value unless there is a sustained move (and the options are forced to intrinsic value) or
until the last few weeks of trading. Therefore, you may wish to place the position in an extremely deferred
contract and liquidate if a sustained move doesn’t occur prior to the last two months of trading. Or, in a more
speculative fashion, you can buy the position with just a few weeks left if the market is a point B and you feel
a breakout move is absolutely imminent. However, remember that time may squash you if your wrong!
Page 89
Profit Profile: Profits are limited. Maximum profits Long Condor Margin: No
occur if the market is between points B and C at
expiration. Prior to expiration, profits may move very
slowly. However, profits often accelerate dramatically
B C
during the final weeks of trading.
Decay Decay
occurs if the market is at/ below point A or or at/ above
point D at expiration. Prior to expiration, losses will P Decay
move towards the maximum level as the market & A D
makes a sustained move in either direction. L
Time Profile: Overall, the position is neutral with
respect to time. As the market hovers between B and
C, profits increase, especially during the final 30 days. Market Price
Losses will also accelerate at points A & D during the
final weeks. Theta is usually slightly positive. Synthetics
Volatility Profile: The position has a neutral *Long call A, Short call B & C, Long call D.
volatility stance. Exposure to volatility is generally *Long put A, Short put B & C, Long put D.
limited to disparity between strike prices. When used Long put A, Short put B & call C, Long call D.
as a follow-up strategy, it can help secure a profitable Long call A, Short call B & put C, Long put D.
volatility move.
Appropriate Use: Often is legged into as a follow-up strategy. We like to “buy the wings” when we have
been holding a short strangle and later want to try to maximize profits by holding the position into expiration.
In essence this position simply combines a bullish vertical spread with a bearish vertical spread. Accordingly
another way to leg into the position would be to place the opposing vertical spread after a favorable market
move. For example, if you have a bullish vertical spread and the market rallies substantially, as a follow-up
you can buy a bearish vertical spread and the result will be a long condor (assuming higher strikes are used.)
Long condors can occasionally be placed simultaneously in the deferred contracts. However, as with
butterflies, the position is transaction fee intensive and must be cost justified. It is important to remember that
all condors may hold their value until the last few weeks and then rapidly move towards profits or losses
(although condors are not usually as sensitive as butterflies in this regard).
Page 90
Profit Profile: Profits are limited. Maximum profits Short Condor Margin: No
occur if the market is at or below point A or at or above
point D at expiration. Prior to expiration, profits will
move towards the maximum level as the market A D
makes a sustained move in either direction.
Decay
occurs if the market is at or between points B and C at
expiration. Prior to expiration, losses will move P Decay Decay
towards the maximum level if the market consolidates & B C
between B and C. L
Time Profile: Overall, the position is neutral with
respect to time. If the market is between B & C time
decay hurts the position. If it is below A or above D Market Price
then time decay helps the position. Decay may prove
minimal until final weeks of trading. Theta is slightly Synthetics
negative.
*Short call A, Long call B & C, Short call D.
Volatility Profile: The position has a neutral *Short put A, Long put B & C, Short put D.
volatility stance. Exposure to volatility is limited to Short put A, Long put B & call C, Short call D.
disparity between strike prices or disparity between Short call A, Long call B & put C, Short put D.
puts and calls.
Appropriate Use: In essence, this position simply combines a bullish vertical spread with a bearish
vertical spread. Accordingly if you already own a vertical spread, you can leg into the condor by placing the
opposing vertical spread after a favorable market move. For example, if you have a bullish vertical spread
and the market rallies substantially, you may be able to protect profits by purchasing a bearish vertical spread
(using lower strike prices). The result will be a short condor. There are occasional opportunities to place all
legs of a short condor simultaneously. This usually occurs when the futures are below point A or above point
D (don’t forget to account for the high transaction cost and potential slippage). Finally, it is important to
remember that short condors will likely hold their value unless there is a sustained move (and the options are
forced to intrinsic value) or until the last few weeks of trading. Therefore, you may wish to place the position
in an extremely deferred contract and liquidate if a sustained move doesn’t occur prior to the last two months
of trading.
Page 91
We hope that you have enjoyed this course. The next
three pages contain a glossary and index. (Also included
in your download is a Word document entitled
“Compglsry.doc” that is a composite glossary/index of
courses 101-301.) If you have any further questions please
drop us an e-mail or give us a call. We also love feedback,
both good and bad. So please tell us your thoughts.
We encourage you to download our Technical Analysis
course. It is free as well, and covers basic and advanced
Technical Analysis concepts!
IFG e-mail: courses@ifgnet.com

IFG voice line: 800-687-4334 or 303-840-5147
IFG fax: (303)-840-5144
Page 92
Glossary and Index
Adjustments To buy or sell deltas to restore a position to a delta neutral state. (Pgs. 12-14)
Ask The price at which a trader is willing to sell a spread or other instrument. (Pgs. 53-56)
Bid The price at which a trader is willing to buy a spread or other instrument. (Pgs. 53-56)
Butterfly (long) A neutral option spread created by selling two of the at the money puts/calls and
buying the wings. All butterflies have limited risk and limited profits. (Pgs. 35,64-66,88)
Butterfly (short) A option spread that is profitable if the underlying makes a sustained move in
either direction. The position is created by buying two of the at the money puts/calls and selling the
wings. (Pgs. 66,89)
Buying the Wings To purchase the outside strikes of a long butterfly or condor. (Pgs. 65,66)
Calendar Skew When a particular contract expiration month carries a substantially higher (or
lower) average implied volatility than another month. (Pgs. 27-35,39-41,43,51)
Calendar Spreads The simultaneous sale of a nearby option and purchase of a deferred option.
Traditionally the same strike price is used. The position is designed to capitalize on a calendar
skews. (Pgs. 32-43, 51)
Call Backspread A bullish option position created by selling an at/in the money call and buying
two calls at a higher strike. Call backspreads have unlimited upside potential and limited downside
risk. The position has a large vega and can be used to trade a volatility increase. (Pgs.
22,23,25,47,50,86)
Condor (long) A neutral option spread created by selling two near the money puts/calls (at
different strikes) and buying the wings. All condors have limited risk and limited profits. (Pgs.
65,66,90)
Page 93
Glossary and Index continued...
Condor (short) An option spread that is profitable if the underlying makes a sustained move in
either direction. The position is created by buying two near the money puts/call (at different strikes)
and selling the wings. (Pgs. 66,91)
Contract Skew When the individual options with the same expiration date have a gradated
distribution of volatility levels. (Pgs. 27-30, 44-52)
Contract Skew (Positive) A contract skew in which the implied volatility generally increases with
each successively higher strike price. Positive skews are evidence of bullish nervousness. (Pgs.
44, 46-47,49-50)
Contract Skew (Negative) A contract skew in which the implied volatility generally increases with
each successively lower strike price. Negative skews are evidence of bearish nervousness. (Pgs.
44,45,47,50)
Delta Neutral A state of minimized price exposure created by purchasing or selling the number of
deltas required to take a position to a composite delta of zero. (Pgs. 12-14,16-17,20,22,45,52,69)
Diagonal Spread A variant of any traditional option spread in which two different contract
expiration months are involved. Diagonal spreads are often use to capture both a price bias and a
calendar skew. (Pgs. 39-41,43)
Follow-up A change made to a previously established trade in an effort to improve the position.
Offensive follow-ups are initiated when the position is profitable. Defensive follow-ups are initiated
when the position is at a loss. (Pgs. 57-68)
Futures Spread The difference between two futures contracts on the same underlying
commodity (i.e. June futures vs. July futures). Futures spreads create additional risk to a non-serial
calendar spread. (Pgs. 36-38,43)
Major Event (volatility trend) A sustained rally or decline in implied volatility that is caused by an
independent, non-seasonal event. (Pgs. 9,20)
Page 94
Glossary and Index continued...
Put Backspread A bearish option position created by selling an at/in the money put and buying
two puts at a lower strike. Put backspreads have unlimited downside potential and limited upside
risk. The position has a large vega and can be used to trade a volatility increase. (Pgs. 25,47-
48,50,87)
Seasonal Volatility Trend A somewhat cyclical, sustained rally or decline in implied volatility.
Commonly attributed to weather factors or other seasonal events. (Pgs. 20-22,25,52)
Serial Options A Serial option expires in a month in which there is no underlying futures
expiration. At expiration, serial options settle verses the closest futures contract. (Pgs. 32,35,37-
39,41)
Skew A forecast of potential volatility in the underlying instrument. Skews are visible as implied
volatility disparity between different strike prices or contract expirations. (Pgs. 26-31)
Straddles (long) A option spread that is profitable if the underlying makes a sustained move in
either direction. The position is created by purchasing a put and call at the same strike price.
Can be used to trade a potential volatility increase. (Pgs. 8,14,15,25,51,61-62,80)
Strangles (long) A option spread that is profitable if the underlying makes a sustained move in
either direction. The position is created by purchasing near the money puts and calls at different
strike prices. Can be used to trade a potential volatility increase. (Pgs. 8,14,15,25,82)
Variants A spin-off of a traditional option strategy that has exactly the same profit and loss
profile, but is created with different instruments that the traditional approach. (Pgs. 53-56,61,68)
Vertical Spreads A bull call debit spread or a bear put debit spread or any variant thereof.
(Pgs. 49,51,53-55,59,78-79)
Wonder Twins A brother and sister duo highly adept at fighting crime. Superpowers include
the ability to transform into other objects. (Pgs. 57-59,66,68)
Page 95
Some of the material in this course uses hypothetical examples. Although these
examples are intended only for educational purposes and in no way represent actual or
proposed trades, the CFTC still requires that we disclose the following statement:
HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS,
SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING
MADE THAT ANY ACCOUNT WILL OR IS LIKELY TO ACHIEVE PROFITS OR
LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY
SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS
ANTH ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR
TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL
PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE
BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT
INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN
COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL
TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE
TO A PARTICULAR TRADING PROGRAM IN SPITE OF TRADING LOSSES ARE
MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING
RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE
MARKETS IN GENERAL OR THE THE IMPLEMENTATION OF ANY SPECIFIC
TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE
PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF
WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS.

IFG Options 301: Advanced Option Trading Concepts

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IFG Options 301: Advanced Option Trading Concepts

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Welcome to IFG’s Options 301 Course!

This course is designed to help you understand and apply

Why trade Volatility?

The blue line is

The red line is

*In the best case scenario, implied volatility would

In the case of the

Long Straddles & Strangles

In the eurodollar situation, we utilized strangles simply because of the leverage

So what happened to the eurodollars? Within a few weeks the Russian

*Note: Larger traders may even want to pursue establishing a “gamma

So lets review the trade. We noticed a period of extremely quite price

Seasonal Volatility Trends

Seasonal Volatility Increases During the Summer Months

If we use a “no adjustments” delta neutral position, we should consider our

Call Backspreads Call Backspread

expiration. Why? When we are trading volatility trends, we don’t plan on

Seasonal Volatility Trends: Trading opportunities can be spotted by looking

Strategies for a Volatility Rally For a Volatility Decline

1. Call Backspreads (bullish price bias) 1. Call Ratio Spread (bullish)

Nov. Options Jan. Options

Let’s apply our new knowledge of skews, by looking at a trading opportunity

Initially, we will limit our discussion of calendar spreads to commodities which

that time depreciation accelerates the closer

Non-Serial Calendar Spreads

capitalize on an expected change in the spread relationship of the underlying

Trading Time: Diagonal Calendar Spreads-

Since increases in overall volatility are beneficial and decreases are

avoiding using calendar spreads when a strong volatility downtrend exist.

In summary, calendar spreads offer unique trading possibilities. You should

Advantages -Calendar Spreads- Disadvantages

1. Capitalize on calendar skew. 1. Liquidity concerns.

Of all the volatility scenarios we have discussed, we believe that contract

As mentioned on Page 30, certain markets often exhibit a tendency towards a

in these markets can be advantageous because the skew is always gone at

How to Use a Contract Skew

scale. The total dollar difference

It is crucial to recognize that there is a tradeoff involved. If the futures move

remember from Options 201 that the

Long Butterfly Margin: No What type of follow-up strategy would be

Synthetics A long butterfly looks similar to a short

primarily as a follow-up technique. (We can readily evaluate the tradeoff.)

involves a tradeoff, the tradeoff created by a defensive follow-up is often

Skew Beneficiaries for Bullish to Neutral Bias:

Volatility Short Butterfly Bear Vertical Sell Fut. Bear Vertical

Skew Beneficiaries for Bearish to Explosive Bias:

Short Futures Margin: Yes

Synthetic Short Margin: Yes

or below point A (the strike price). Profit increases as the price

Profit Profile: Limited to the premium received less

of the underlying decreases. At expiration, the breakeven =

Loss Profile: Potential loss is limited to purchase

Loss Profile: Potential loss is unlimited. Losses P

Time Profile: The position is helped dramatically Market Price

Time Profile: Although the net position is fairly Market Price

Time Profile: Although the net position is fairly Market Price

Loss Profile: Potential loss is limited to the difference P

Loss Profile: Potential loss is limited to the difference P Decay

IFG e-mail: courses@ifgnet.com

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