Picturing profit, loss, decay characteristics 19 option strategies and when to use them By H. Phillip Becker and Willian H. Degler - T ] You can use one of these 19 basic op: [ markat | “eromt | ose | acay | (iis atgics to capitate on ane [ "aas" | potent | potent | ‘etoct ‘ions Staeais | The table at the left summarizes sour profit and loss potential slong with the ect time decay has on the position. Detailed illustrations on the net five pages break the strategies doscn inte three major classes: locked trade (gold), directional (green) and precision (blue). Terms such as "stran fle” and “condor” are generic terms that the professionals use. Diagrams tient tovach siraiegy illustrate the op. {ion position at expiration. These strategies apply to any op tions contract and will be described in more detail in fasure issues. You || may want to keep this section as a reference. Firms or individuals wish 1 bg reprints should contact Futures SHORT BUTTERFLY | Mixed .| Limited | Limited | Mixed | Magazine (319-277-6341) The diagram below provides @ quick fix on what happens in an op: Ay 2NN [Lone eurterrty | mixed | tinted | Limiea | mixed e[Sigis LONG CONDOR Mixed | Limited | Limited | Mixed | ons position. For example, if vou ex pect prices to go up, vou can buy a call 157" stort conor ied | timited | Limted | mixed | and have limited riskor sell a put and hhave unlimited risk. For options on ] debt instruments such as T-bond fu LONG STRADDLE Mixed | Open | Limited | Hurts | ures, pur “rates fall” (and prices go + up) by the plus signs and "rates rise SHORT STRADDLE | Mixed | Limited | Open | Helps | ‘and prices drop) by the minus signs. $a CALLI+) PUTED LONG STRANGLE Mixed | Open | Limited | Hurts oy | ae | om | Ure SHORT STRANGLE | Mxed | Limited | Open | Helps ee a ik CALL RATIOSPREAD | Mixed | Limes | Mixed | Mixed Madde one ea |E aes — H. Phillip “Skip” Becker is president of : | Becker Midams and Co, and Hedged cA RAT mixed | Minos | cites | aod | Porjotio Adviaorn, and Wilhan i Degler is president of Chronometries Inc, invtrelated Chicago companies which specialize in options. They have more than 20 sears of experience int stocks, furwes and related options. PUT RATIO Sea Mixed | Mixed | Limited | Mixed I [<|<[S/$5|<|>|<sire | Break even ine Teal ree of Spas) 4 mo, ett — 1 mo. let { — Atoxpiraton —— toss 5 Prot — Underlying instrument price ——Faling Rising ‘The illustration above is used with each strat demonstrate the effect of time d premium involved in the position. ‘The basic diagram in black shows the prolit loss scale on the lelt vertical axis, The horizontal zero line in the middle is the break-even point, not including commissions, Therefore, anything above that line indi ccates profits, anything below it, losses. The price of the underlying instrument would be represented by a scale along the bottom, with lower prices (o the left and higher prices to the right. The vertical dashed line above and "A," "B," °C" and "D” in the diagrams indi cate the strike price(s) involved Arrows on the diagrams under the heading of "Pat tern evolution” indicate \chat impact the decay of op tion prices with time hason the total position. The blue line reflects the situation with four months left until expiration, the orange line the status with one month lett and the red line the situation at expiration, which is also reflected in the box at the top of each strategy ‘on the total option ‘lass: Drectans Synthetics: ang mate ong eu. ‘whan you are very bush on the market. The ‘you are, the more out-olhe-money (gher] ‘Should be the gpton jou buy. No other positon gives you as much leveraged advantage in a ring! market (wih fed ‘Sowmsige ek). Profit characteristics: Pott increases as market rises. AL txpration, break-even point wil be option exercise price A = pce paid for option. For each point above break-even. prot Roveases by an additonal point Loss characteristics: Loss imited to mount pas for option ‘Maximum loss realized market ends below option oxorese A For each point above A loss decreases by acdkional port. Decay characteristics: Postion is a wasing assol. As time Dasaes, value of positon erodes toward expiaton valet ‘olatity increases, erosion slows: as vlalty decreases, ero Sion speeds up. Pattern evolution: BOXOR CONVERSION Class Locked rade | “Tse spreads ara eteradto a8 "ockes vader because nee | Yau a exyeaton fe tlaly independent ofthe pre atthe | Xuderng intent you can buy ther for lege ran that ‘aise Sse hem bor mde, You wil mare pat gorng | ommsion cos) 1 i i When touse: Occasionally a market wii getoutoline enough {ojusity an inal entry info one of tase positon. However, {hey ae most commony sea to lock al or part ola portiots by buying or seling fo ceate ihe missing "legs ofthe postion. ‘These are atematves to closing oul postions at possibly un favorable prices {Long box: Longa bul spread, long a bear spread — thats Tong cai hor calB,iong ai, shor putA value = BA ‘Short Box: Long cal 8, short call A, long put A. short put B. | Vaue A= 8. ° i LLong.instrument conversion: Long insitument, ong put A. ocak Value = 0.-Pree” = inaument > put A "eal 3: Short insvument. long cal A, ‘rice’'= A= cal instrument put Class: Oractons! hates: sron nstunett Son sa non to use: you imi betive the markets not 2208 ve SPU ey Tita shee) opting # you Se ory SShenatconiced’ sel acthemaney aptons yoy ae very SSBC ke ott wi stagnate or airy ceubt mart Castagtae Sa eine ony opsone or mmo Pre Prof chaectrstie: Prot ined 0 gremu recewed. At tpiaion esiceen's wercsepreg A perm acevee. sina pot wate t marke setts a Doon A Love choraciertice: Los ncresses as mark ies AL Paton Goss inttae by oe pot or each pont ares Bore ea even Because rake open-ended, poston must fetched casey Decay characteristics: Postion isa growing asset. As tine Passes caus 9 positon wreases 02 option sess ine {aloe Maseru ete ofneesnng polis cuts Toptonis a emony Decay with time Sea June 1984 Futures 477 Cass: Orectona i Synthetics: : ‘Sort inert. iong eat ‘When to use: when youare very bearish on market, The more bearish you are, the more out-ote-money lower) shoul be | the opton you buy No other positon gives you as much lever |) aged'advantage im a fang market (win imited upside 73k) *) profit characteristics: rot increases as market lls. At ex ration, breakeven point will be option exerese pice A price paid for opten. For each point below break-even, prt Increases by adaivonal pol. Loss characteristics: Loss limited to amount pad for option. Maumum oss realized market ands above option exorcise A For each point below A, loss decreases by aadiional pont Decay characteristics: Posiion is a wasting asset. 2s time passes. value of positon erases toward expvation vaive i ‘oul increases, erosion slows; a8 volahity cecrease®, eo ‘ion speeds up. 2 pater j, Mate Decay with time ee chars Clase: Drectena! Brgcal& enor cate Long got shor pa ong Sal A Show ut, hort nstumen ang aut A: short at ong natant When to use: I'yu think tha market wi go up somewhat ora Teas is2 ‘Bt ove tkaly to so then fall Gage postion ya Meant en the marae tare unsure ot buih expectation. Yeutrein good company: Tiss the os! popuir Bish ado |. Prottcharacteristes: Pott ited reacirg maximum mar fotends ator above al expat, icatvecallraion most k ‘common) used, break-even is at A + net cost of spread. It Loss characteristics: Wnatis gained by limiting profit paten jigs mainly a imtio oss nyau guesseo wrong on marked Maximum loss market at exptaioh ator boow A Wich cal \p-call version, maximum loss net cost of spread Decay characteristice: market's midway between A and 8 ne fme eters vB pots neeate aasten eto. At losses increase at maximum rate wih time Decay with te ya Long inatumert Snot eat Aeon ute ou ty eae mart nt gong dow. eh gute the-mbnay Tower ska) optane i you are ot Eomewhat convinced sel'aine-mangy options youre vor) angen market wil stagnate o ie. you doubt market wl Stagnato, sel inthe-morey options tr maximum prot Proitcharacteristies Protimtedto premum recevediom | SN eae area. | Diemum received Maximum prot realized f market setties at ‘or above A. soap metres ar mraers meta it Aes | Braton, losses increase by one port for each point market is below break-even, Because risk is open-ended, positon must bbe watctied closely. : f i I I Decay characteristics: Postion is growing asset As ime asset. valuo of positon ineeases 28 option loses Is tine fale Maximum rate of creasing prtts occurs option i thesnorey Pattern evolution: Decay wih ime (lass: Orectona! Synthetics: ‘sport cot a og cats crotch onstage 8 put longest By hos neue ‘When to use: It you think the make wi fal somewhat 0° at want's bint mote key to fal an nae. The most popular n among bears because {may be entered a8 con Senative rage when uncertan about Bearish stance. Profit characteristics: Pott ited, reacting maximum at exprationi markets ator below A. iputtvs-pul version (most Eotrmon) uses, breakeven i a8 ~ net cost of spread Loss characteristics: By accopting mito profs. you gain a limitorse Losses, at expeaton. ncteave ae market ses 05, were hey stabuize. With puts put verson, maximum oss 6 ‘el cost of spread Decay characteristics: marke is midway between A and 8, ppimectecs AA pelts nveae attasiestratewibtire rease at maximum rate wih ime. Pattern evolution: Decay wath timeLONG 8 BUTTERFLY Se” eee eae ek eevee nono fits @ — a mustequalc - 8) When to use: One ofthe few positions which may be enteres Advantageously n'a long-rm option series. Enor wien, wih ‘one mor or mare to go cost ol ho spread is 10% or ess Of B on (20% a eke excts between A and B).Thisis a rule ot ‘thumb, check theoretical values. Profit characteristies: Maximur profi occursit marketis at 8 al expiration. That prott would be BA ~ cast ol doing Spread. Ths prolt develops, ames otal, in ast month Loss characteristics: Maximum toss, 9 eter ecton,g ‘ostol spread. Avery conservaive rade, orakcovens te at A ‘lus Cost of spread and a € less cost cf spresd Decay characteristics: Oscay negigile untl final month, ‘danng whieh dstneive pattern of utterly forms. Maximurs pratt growths al. lyouare away tom AC rangeertenngiast {ronth, you may want iguidate postion. bate Pathe Cl LONG 5 ¢ |CONDOR cou: Poon A Do he “long A. ehort 8. short C. ong O. ‘Aiputs— long A shart B: snot Cong Corpeae A Than Sa 8 sho ot Es Kongo stot pt, sor etc og fa8 Ac - Bardo - Cat ‘When to use: Enter In far-out months. if desired. ts worth lvoe times the average of AB-C and B-C-D ulteres be. Cause thas tree tres the profit area. Check postion against {hooretical valves prior to entering. Profit characteristics: Maximum prott realized f market is between B and Cat expiraton. For al-cal or al-put versions, that prott equals & A ~ cost of options at setup Break: fevers areal Aplus that cost and D less that cost ‘Loss characterlstics: Maximum oss occu'sif markets below ‘Avr above Ot exraton For al-cal or aleput versions, that {oss is cost setup of positon Decay characteristics: Decay negigble unt final, month, ‘daring whieh the vsuper buttery CONDOR develops Is ‘charabterisic shape, Maximum profits occur in B-C range Patter evolution: . SHORT BUTTERFLY Cass: Preciion ‘Shor cat Along 2 calls 8. short eat ‘Shot put hb pute shot pt ‘he pit Arg ur 8m Sal 8 chow cal ‘Short ea ong cal. a But, ‘shot but (oote:@ — A mustecual eB) When to use: When the market is ether below A or above C lana postion overpriced wi month or sole Or when only 3 few weoks ar fell, markets near B, and you expect an ime rent move i ether rection. Protit characteristics: Maximum proit is credit for which ‘Spreads puto Occurs when marke, at expicaton, below A ‘or above thus making al options inthe-money 0% al optons outa the-money. Lose characteristics: Maximum loss occursif markets atB at fexprraion Amauntol that ossis 8 ~ A ~ cred eetved when ‘eltegeppoaton BreacevensateatAptooalowat ane loss intial coat Decay characteristics: Decay negicible uni tinal month, ‘osng wnioh Gstinctve patert of Buty forms, Maxum tose acceleration 5 at 8, Pattern evolution: Decay with tne SHORT CONDOR |}, _, eras corconsoennstanst || Fe ae, crinning poeta orca een eat ens omounwnnte tate as, Peet aera ipaciraite ent eaue tate ia soe aaa grea cent te Beate es en Pec eree arenes SuSE Meant Pattern evolution: June 1984 Futures 49LONG STRADDLE ‘cass: Presson synthetics BAER song out ong ets & lng nce a (atedsete nal cos nouty ‘When to use: Il market is ear A and you expect ito stat ‘moving but are not sure whieh way. Espetialy good postion i ‘arket has Been quiel, bin Sars to 2209 sharply, 810M Botental upton Profit characteristics: Profit open-endedin ether divecion. At @xaiaion, break-even is at A. plus or minus cost of spread However positon is sekdom ned fo expiration because olin creasing decay ivels with time, Lots characteristics: Loss lmitad to costo sare (assum- ing mast common version, te cal-pu spread). Maxum loss ineuroa i markt is at A at expiration. Decay characteristics: Decay accelerates as options ap. reach expiration. For this reason, postion agusiad a neu fray by frequen: profttakng. Kt “orally laken off wel betote expan Pattern ‘evolution: Decay with time q 4 LONG STRANGLE | ease EES ong cana, tg eat fang pur eng put Along put 8 org stunt {ng Bat long el. shat navomant [Ri'don te ea cose reuraiy) ‘when to use: If market is within ot near A range and has Been stagrant. If market explodes either way, you Take money: market coches to stagnate, You lose less tha ong saddle Profit characteristics: Proft open-ended in either dkecton ‘with put Ave cal 8 version (mest common), break-evens area ‘A minus Cosi ol sproad and & pus cost ol speed, However, Spread is Usual aot held fo expration Loss characteristics: Los tinted. n mast common version lose is equaltonetcosif positon. Maximum toss meured i ai ‘exaiation, markt is between A and 8. Decay characteristics: Decay accelerates as options ap- proach ex alas rapidly 2s win long saga. To void largest part of decay, the postion is normaly taken ot ror expiration, Patern evolution: Decay with time SHORT [——; STRADDLE cians: Precisen got et ganA her pa Gor pute shot narument wsidone tia gota sey) When to use: f market is near A ang you expect market is Siagnaing, Because you are short optors, ou esp pros as they decay — as long as market remains ear A Profit characteristics: Prot maximized i marke. al expire: tion, is at An calrput scenario (most commen), maximum bros cred romesiabishng poston breakeven GAPLSOr Loss characteristics: Loss potential open-ended in either Girecion. Postion. therefore, must be dose; montored ard ‘eecusted to neuialy t market begins to rit away Hom 5 Decay characteristics: Because you ae only short option, youpleruplime-value decay at an increasing rate as expiration heats, mauumisedi! manketisrear A " Pattern evolution: [7 omni SHORT STRANGLE cans: ress Syinees gota BR Tah ss Solan) hen touse: marti ying rea range an hough Ser dat eae Wihnter tee ae arate imate monty tonnes be see, jouRavesohss ok Bann Got ease Pratt charaterltce: Maximum ott equals opton eceps ‘pascal wreon employed aartom pl esited fant sepiasere bomeera ana tone characte: A expan, sss oer oly mar ‘i love puscpigneceige (opurcalartelu Aare thn moun: Renta os chewed Attseg oe hy nasa, pron snot teat, 3 fame ing he Ap 58 pice ewogs wera Ser of scee a osdng tna onion we pos Ot Oeeay characteristic: Because you weeny shor optons, Paupbcuptmeraus dara stan Nedtng tease aioe AE sedan comin eS rabce Decay wa teCALL RATIO SPREAD syne 4 gat A shor cats 8 {ord put A sort Cale B, ong nant (aiden 6 al cata nave ‘When (use: Usually entered when markstis near Aang user expects a sight rise market but se2s a potental or seat, ‘Ga ofthe mast common spreads, seldom dane more than 13 {wo excess shorts) because of upsie risk Profit characteristics: Maximum prot, n amount of B — A fet cost ot postion {lr calls eal velign), real 22d market IpatB at expiration Loss characteristics: Loss imited on downside to ratcost of positon in eallvs-call but oper-ended f markel isos. ato of fees, market nies beyond Bs proportional to numberof ‘excess shoris i positan Decay characteristios: If markets at B, protts tom option ‘decay accelerate the mast racy with passage of te. ALA, {ou Rave greatest rate of iss acetual by decay cl long option Pattern Decay with time evolution 8 a‘ Decay wih ume CALL RATIO A BACKSPREAD laze: Precision STEUER tong cats 8 2 SS pu eg i Bon arama ‘When to use: Normally entered when market is near Band ‘hows signe of increasing actly, with greater probably 1a ‘Upside (for example. last major thove was dow allowed by ‘stagnation. Profit characterietice: Prt limited on downside (tonet ced {ken in when postion was eat up i eal-vs-cal ven) But ‘open-ended in faving market Lose characteristics: Maximum loss a amount of ~ A — inal ordi is roalzedil markets. a8 al expiration. Ths oss is luvatent ong straddle, the rade-olor seer: nal on the downsice Decay characteristics: if markets at 8, loss trom decay wi fccalarate the most rapidly. Therelore, you may want ta ext arly it rarkotis near Bas ou enter last month. ALA. youve the greatest rato of prott aceual by decay of short phon. cay wath time Decay with time (12 spas) PUT RATIO SPREAD A Syathaucs: ong pu 8, shor pute 8 Long alg, stort is & shot navumen. . (i cone mit aes netrany) ‘When to use: Usually entered when market is near Band you expect market to fal sagnty but seo a potential or sharp se ‘Gao ofthe most common spreads, seldom done more than 13 {two excess shorts) because of downsie risk Profit characteristics: Maximum prot. amountol 8 — A — hetcastot postion toe puters pu version) tealzed i markets BIA at expiration Loss characteristics: Loss limited on upside (to net cost of Boston in put~s.-put version) bul open-ended if marke ali, Rate oles. fmarkal als below A, isproporbonal a number of fxcess shorts m positon, Decay characteristics: If market is at A profts rom option decay accelerate tne mast rapidly wih passage ole. At, you have greatest rate of ise ace’ual by cecay ol ong option. Pattern evalution: Decay with time q 8 Decay with time 2 spa) PUT RATIO BACKSPREAD 8 ciate: Pression sro pt9, Segoe A short ca 8 long pus ang navument Tal aond ssi eta nearaiy) When to use: Nomaby etored whan mare nat A ong shows sgne of mereasg actly ster probably 10 Sera for exami, ast major move was up folowed by Stagnation Profit characteristics: Pott ited on upside (to net cet {akon in when positon was set up in puts put Version) but Spercended in collapsing marke loss characteristics: Maximum loss, in amount of B — A — inal ret ealeed il market is at Aa expiration This os is tess than forthe quaint long straddle, the trade-off tor Saziing roll polenta! on upsie. Decay characteristics: Ii marke is at A oss trom decay will focalerate te most rapidly. Therefore, you may wart f9 out tary marke is near Aas you ente ast month ACB. yoUNaVe the greatest rate of prolt aberal by decay of short Gpton Pattern evalution: Decay wih ume 8 ecay with time June 1984 Furures 51Goals are enhanced returns and reduced risk How traders use options: Pros fitting them into portfolios Options give you the right to be wrong and still be around. Or they might simply be called “investment Those descriptions from profes: sionals explain the appeal of a finan. cial instrument that a growing num: ber of institutions are including in their portfolios. New types of options introduced recently have allowed By Ginger Szala, assistant editor ‘money managers to become more so: phisticated in using options to hedge or increase rates of investment The main institutional use for op- tions still is writing calls (giving @ buyer the right to buy 100 shares of stock ata specific price within a given period of time) on stocks they hold. Yet, some institutions are testing the newer options products on stock in- During the bull market, everyone asked, "Why hedge?" Now they're calling Bruce Lipnick Wher he isn’t sure, H_Phillip Becker uses a “volatility spread” 10 catch any move. dexes, currencies, Treasury bonds and gold. The main reason these products aren't being accepted more rapidly than they are is their youth The problem with options is that tothe uninformed, they have the stig. eculation,” says Max Ans- e president of Bear Stearns & Co. in New York and author of several books on options. “I's diff cult getting chairmen to approve these trading strategies. They think, What? You want us to gamble the money of widows and orphans? Bruce Lipnick is a veteran at edu. cating corporate heads on the use of stock index and commodity options. He’ seen many blank faces on corpo: rate officers so is used to walking ‘through strategies step-by-step. Unfamiliar territory ‘They're not familiar with the ter~ minology,” he explains, “And they never have had the experience of trad- ing options.” Lipnick is president of Wharton As- set Managemen: Corp. of New York, a firm that manages close to $60 mil lion for corporations, pension funds, market makers and individuals. As a pioneer who was using options in the 1960s, Lipnick figures he has an edge by understanding both options and futures and knowing how touse them to-eliminate downside risk However, he found that during the bull market, the attitude from every- fone was, "Why hedge?” Today, with the stock market downturn and a choppy pattern, his expertise in both options and futures is an asset. "Now they're calling back,” he says. When building a portfolio, Lipnick considers whether the client is the ‘ash-heavy corporation that wants 10 maximize returns and increase yields is a hedging institution that gets destroyed” in a choppy market About 90% of the portfolio is made up of individual stocks hedged againstprtsen callson the Standard & Po (S&P) 500, S&P 10 (DEX) ot Major Market Index (MMB, LapaiekS strat ey depends un whetticr he dunks the bmarket 1s going up or dawn. The ather 0% of the portly will be a combination of fulures and op. tions on those futures, such as T bonds, gold or currencies Once an institution is convinced 19 use new options stategies, another problem becomes market liquidity This problem might solve itself with time for billion-dollar portfolio man- agers, says Steven Lauer. vice presi dent and options portfolio manage: at Banker's Trust Co. in New York. His firm manages approximacely $28 bil- lion in pension funds, employee bene- fit assets and savings plans “To date, we haven't used the nar- row-based indexes because liquidity isn't as good (as for broad indexes) Laver says. "But they would serve the same purpose as large indexes. There's always an incubation period for new instruments. Banker’ Trust generally designs a portfolio, depending on client risk pa- rameters, with 50 to 60 individual stocks. Next, it looks at all the options of the underiying individual stocks. If they think the options are liquid and overvalued, they will sell acall option fon the underlying stock. If the under- Is ing: option is no Higa ov the fuplion prenHUNL is More wet tonnes tied ap itn Germany, it sult write options aysainst those funds ss the firm purchases a OEX, MMP or wie to genera tl nucone New York Stack Exchange composite the Deutsche m index option (NYA), Options on Tre d futures Lanse says that currency oF com: were ineorporated inte tl soit for his ei Minne: ions “don't make sense” —apolis Employees Retirement Fund ts because they do not ins last sear in ai effort to curtail risk, vest in the underlying instruments About 10% of the $460 million ac swith pension funds, However, iFthese count was invested in options on rmuirkets become more liquid and are bond futures. Managers want to earn a natural part of a portfolio, they arate of return that exceeds standard ‘would be used, he says. indexes and decrease the volatility on the downside as well as capitalize in fat or rising markets, according to Currency options are big for finan- John Chenoweth. executive secretary cial institutions that hedge customer: Although institutions are catching tailored, over-the-counter options on to options trading, their delayed with International Monetary Market entry into the market is typical. They contracts, says Jim Leatherberry of always have been slow to use less tra- ContiCurrency in Chicago. ditional financial techniques, says He also believes corporations will Beverly Gordon, head of institutional get more involved in currency op- marketing at the Chicago Board Op- ons. One reason will be to hedge tions Exchange. contingent contracts. For instance, a However, it not entirely because ‘manufacturer planning to buy mate-adventurism is lacking. Laws forbid rials from a German company but some money managers from invest- without a finalized deal might buy ing in certain areas, and that has cur- Deutsche mark options to hedge its tailed options trading. Position limits future investment. Ifthe deal doesn’t also curb what institutions can hold 0 through, the loss is limited to the on one side (short calls and long puts cost of the option premium combined or long calls and short puts Ora corporation may write an op- combined). As options become more sion against a position already held. accepted, however, these restrictions For example, if a corporation has are being modified. a Currency interest Sch ‘ those of stkicky but usually Tea kip" Becks ‘ ‘aon id to'dramiatic moves! Opti =an be itsed to get into position in such turbulent titnes, = if 't know which way the market will go. conviction as to whict es nest al lilo tnt ne acetal ie aden ola aaa ES) inal Nar easel ‘atin 66°61 atfn gaye him ae ae Ho sing that he was long and short spproximately the able: je’Amount of money despite the difference In nuri-\, "insurance,”Lipnick was still holding the fondo Boe eae ae oy Sine ee