Sunday, January 17, 2010

Short Ratio & BWBs Spreads

***Disclaimer***

Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options (the "ODD"). Copies of the ODD are available from your broker, by calling 1-888-OPTIONS, or from The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, Illinois 60606. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes. In order to simplify the computations, commissions, fees, and margin interest and taxes have not bee in included in the examples used in this presentation. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any transactions. Investors should consult their tax advisor about any potential tax consequences. No statement within this presentation should be construed as a recommendation to buy or sell a security or to provide investment advice.

I've spent the weekend learning these new strategies so I thought I would share what I have gathered so far and writing this post also helps crystallize the content in my head... it may be a bit confusing and I may have got it totally wrong so feel free to post comments, corrections :P

Short Ratio Put Spread

Market Outlook: Neutral to Bearish
Buy 1 Closer to the Money Put
Sell 2 Further Out of the Money Put

Broken Wing Butterfly (BWB) Put Spread Market Outlook: Neutral to Bearish
Buy 1 Closer to the Money Put
Sell 2 Further Out of the Money Put
Buy 1 Even Further Out
of the Money Put (tail)

The difference with the BWB setup is we buy the last Put (tail) to firstly reduce our margin exposure (buying power effect) and protect our downside risk (remove the unlimited risk to this trade). It is optional to buy this Put (tail).

OEX Details
Target Price: $490
(thanks dream)
Expiry Month: March
OEX Last Price: $524.11

Example Setups


OEX Short Ratio Put Spread
Buy 1 490 Put
Sell 2 470 Put
Net Credit $1.00

Margin Held (depends on broker)

OEX BWB Put Spread
Buy 1 490 Put
Sell 2 470 Put
Buy 1 410 Put

Net Credit $0.10
Margin Held (depends on broker)

What we are looking for is the OEX to make a move down towards our 490 strike. The beauty of this example trade is that the OEX needs to move down a only couple of strike increments for the trade to make money. If we were totally wrong and the OEX moves higher by expiration and we have not adjusted the trade, the options will expire worthless, we get to keep the credit (less commissions) and the margin held will be returned.

If we were totally right on our market outlook and the OEX gapped down to below 470 we would start to incur losses. However since the OEX is an index, the probability of this happening is quite low (it would need to make a $50+ move down immediately based on some catastrophic event)

To illustrate this in pictures, here is a snapshot of what happens to the example trade should the OEX move up or down with price of the underlying being the only factor:









The last row is the Short Ratio spread price
(The prices were taken from th
e available mid spread prices on TOS platform)

The index is around the 525 price point so start there.

If we were wrong and the index goes UP $1
0, the short ratio spread will be trading for a credit of 90 cents (not bad). If we were wrong and the index goes UP $20 the short ratio spread will be trading for a credit of 80 cents and so on.

Looking at the P/L sheet, there is no price point of immediate loss within a $30 range of the OEX.

If we were right and and the inde
x moves DOWN $10, the short ratio spread will be trading for a credit of $1.15. If it moves down $20, the short ratio spread will be trading for a credit of $1.30.
Not a bad return on a less than 4% move down!

What this shows is that the OEX does not need to reach our price target of $490, however it needs to move down to generate the profits on the trade. A home run will be OEX reaching below $490 but above $470 by expiration. Most likely we will have taken the profits by then.

For this interested in the trade risk graph, here is the BWB risk graph at expiration:





















For the BWB example:
Max Profit at Expiration will be at 470 Strike
Max Loss at Expiration will be at 410 Strike (the loss will be unlimited to the downside on the Short Ratio Spread because we did not buy the last Put (tail)

Obviously there are a lot of strict mechanics in the entry and exit criteria but if followed correctly, it seems that this is an impressive strategy for anybody wanting to trade options.

Thanks for reading!
randomjaywalking









2 comments:

dream said...

hey jay, great stuff, man. I will have to go through it a few times to understand better.

Anonymous said...

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