Category Archives: Neutral Income Strategies

Special Dividends and Option Contract Adjustments

There are times when option contracts are adjusted for corporate events like stock splits or special dividends.  In the case of a 2-1 stock split for example, the option contract strike price is adjusted in half and the number of contracts doubled.

There is no contract adjustment for ordinary dividends. Regular dividends that are paid on a quarterly basis are factored into the option’s price. When a stock goes ex-dividend the stock’s price is adjusted by the amount of the dividend. The call and put option’s price reflects the amount of the dividend.

Due to the ongoing fiscal cliff negotiations, many companies are opting to pay out special dividends this year before the anticipated increase in the dividend tax rate. Currently dividends get a special tax rate of 15%. That rate could go as high as 39.6% in 2013 depending on the outcome of the fiscal cliff negotiations. Campbell soup became the last major company to declare a special dividend. Over 100 companies with a market cap greater than $240 million have declared special dividends this year. The total value of all the dividends is almost $23 billion.

If you’re using a covered call or a collar strategy to collect dividends, remember that with these special dividends, the strike price will be adjusted downward to reflect the special dividend unlike the ordinary dividend.

Option Chain for Boise showing Strikes reduced by $0.72 foe dividend.

Option Chain for Boise showing Strikes reduced by $0.72 for dividend.

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Earnings Dual Calendar Spread

Earnings Dual Calendar

The dual calendar spread consists of a put calendar spread and a call calendar spread. It can be put on for a net credit or a net debit. A debit dual calendar spread can be an effective strategy around earnings time. We’ll call it an earnings dual calendar and here’s how it works. We want to be long the options that are in the reporting month because we are forecasting a rise in implied volatility in the option price until the report comes out, and then the implied volatility will fall rapidly. We’ll be short the contracts that will expire before the earnings release because we know that their implied volatility will drop with their expiration date. He’s an actual example from the time of this writing. This is not a trade recommendation. STI, Sun Trust Bank will report earnings on Monday October 22nd, 2012. We anticipate that the implied volatility of the November options will remain elevated until the earnings announcement. We forecast that the implied volatility of the October options that expire on October 20th, before the earnings announcement will collapse by the expiration date. We can put this trade on in the first week of October and plan to hold it until the October expiration on October 20th. Here are some of the key data points;

Size        Exp                Strike           Put/Call         Price      IV                   Theta              Delta

+1          Nov 17           28                 Put                   0.93       31.27%         -1.34              -39.72

+1           Nov 17           29                Call                  1.00        29.45%         -1.32               47.22

-1            Oct 20             28                Put                 -0.39      27.75%          +1.85               34.31

-1            Oct 20              29               Call                 -0.46      25.52%           +1.85              -41.91

So, the net debit is $108 which is also the maximum risk. For a ten contract position that would be $1080. The theta is $1.01 which means that for each contract you’ll earn the decay of $1.01 per day, for a ten contract position that amounts to just over $10 per day in option decay. The net delta is -0.10 which is essentially delta neutral. The plan is to close the position on the day of the first expiration before the earnings come out for a net debit greater than $1.08. If the underlying makes a substantial price movement the position will take on some delta and some form of a gamma scalping strategy can be applied to make the position delta neutral again.

Reverse Gamma Scalping

In a prior post I wrote about gamma scalping around a long straddle. Reverse gamma scalping is a defensive strategy that can be used for short straddles, strangles and other credit spread positions like the popular iron condor or short iron butterfly.

The way it works is really simple. Say for example that you initiate one of the short positions above, at the time you establish the position you’re delta neutral. You hope that the underlying security remains motionless during your holding period. However, that is rarely the case and price movement will work against you. Positions that have high positive theta will also have high negative gamma. What that means is that if you’re the seller of a credit position and want to profit from option decay, you’ll be at risk for large price movement.

So how do you manage your position against adverse price movement? One way is through reverse gamma scalping. You start out in a delta neutral position. Say you have sold an iron condor, as the price of the underlying moves you’ll begin to take on some delta. If the underlying moves up, you’ll become short deltas, once your position hits -100 deltas, you can buy 100 shares of the underlying and become delta neutral once again. If the underlying declines in price you’ll become long deltas and can short some shares to offset.

Remember, reverse gamma scalping is a defensive move that can help to limit losses. It is not meant to  produce additional profits to a position like gamma scalping can do to a long straddle or strangle.

Dynamic Delta Hedging

Dynamic Delta Hedging

Dynamic delta hedging is a term used for adjusting the delta of an option position due to price changes in the underlying security. One of the beauties and challenges of options trading is that there are so many different combinations to consider for any market outlook. Say you’re an income oriented investor and you have just established a delta neutral iron condor. In order to receive the maximum profit, you want the underlying security to stay between the two strikes and the entire position to expire worthless. As the stock or ETF begins to move your position will start taking on delta. The gamma of your position is the rate of change of the delta. If you were delta neutral when the position was initiated, check your gamma, the gamma is how much the delta will move with a one point move in the underlying. By knowing the gamma you can be prepared to make adjustments to your position to remain delta neutral. Complex positions that have a high positive theta will also have short gamma, meaning that you have to be prepared to adjust according to price movement in the underlying. In the case of a delta neutral iron condor, if the underlying makes an upward price move you have the choice of adding some long calls, more short puts or some long shares of the underlying stock. If it makes a downward move, you can add long puts, short calls or short some of the stock. Instead of just adding you can also look to reduce some contracts, so in the case of an upward move you’d want to buy back some of the short calls, or in the case of a downward move you could buy back some of the short puts, or you could consider any combination of the above.

One thing that you need to consider is how often you want to adjust, do want to check your position daily or several times during the trading day? Another consideration is how you choose to define delta neutral. Of course the strict definition is that delta neutral means zero deltas, however when it comes to trading you should establish a guideline so that you’ll allow some flexibility. It’s impossible to stay at exactly zero, so a good rule of thumb might be to say that you’ll allow a range of plus or minus 50 deltas. Allow the position to range from -50 deltas to +50 deltas and don’t make any adjustments until those levels are exceeded.

The final consideration is how to make the adjustments and that is where the fun comes in. Because there are so many different possibilities to evaluate for each position, it is wisest to use an expected return calculator and see which adjustments have the best mathematical expectancy. Remember if you want to add delta and want to add to the position you can buy stock, buy calls or sell puts. If you want to subtract delta and want to add to the position you can buy puts, sell calls or short stock. You can also adjust delta by closing out part of the existing position. Evaluating all of the possibilities is what makes options trading so flexible and challenging.

 

Bear Call Spread

Bear Call Spread

The bear call spread is a vertical credit spread. With a vertical credit spread the investor will sell a lower priced strike call option and purchase a farther out of the money call option as insurance to limit risk. The credit received is the premium received for the short call minus the premium paid for the long call. The maximum risk is defined as the distance between the strikes selected minus the net premium received. The bear call spread is used when your forecast for the underlying is neutral to bearish. To obtain the maximum credit we want the underlying to stay below the short call so that both options expire worthless and we collect the credit. Let’s look at an actual example that currently has decent profit potential. On April 27th, 2012, Amazon, AMZN closed at $226.85. If we look at the weekly call options that expire on May 4th, the $230 call will sell for $2.80 and the $235 call can be bought for $1.44. The net credit we’ll receive is $1.36 or $136 per contract. If we set our maximum allowable loss at $5,000 we’d use 13 contracts. The actual maximum loss would be $4,732, the theoretical profit or expected return would be $1,453 and the maximum profit would be $1,768. If AMZN rises to the lower strike at $230 you could close out the position or do some dynamic delta adjusting to control loss. The position could be adjusted by adding some long calls, short puts or buying some AMZN stock or any combination of those.  The chart below shows the profit/loss points for this call spread.

Investors who have long term stock holdings may also want to use a bear call spread to produce income and have potential for upside gain. One of the disadvantages of the popular covered call strategy is that in exchange for the income received from the covered calls, the investor is forced to forgo upside gain. If the underlying fund makes a large upside move, the investor does not participate. With a bear call spread income is produced by selling out of the money calls and purchasing further out of the money calls in the same quantity.  This way in the event that the stock makes a large upside move, the investor will participate and still receive some income. For example if our investor owns 100 shares of ABC at $25, she could sell one $30 call and buy one $35 call for a net credit.  Above $30 the shares would get called away, but she would still own the $35 call.  Therefore, if the stock were to rise above $35 she would still have unlimited profit potential from the remaining long call at the 35 strike.

The Iron Condor

The Iron Condor

The iron condor is a defined risk market neutral strategy. It is composed of a bull put spread and a bear call spread put on for a net credit. The risk is defined as the distance between one of the spreads minus the credit received. The investor hopes that the underlying market will stay between the two short strikes and the net credit will be collected as profit. This can be a good income strategy. It can have a high probability of success depending on the width of the condor or how far the short strikes are from the underlying. It can also have a poor risk reward ratio depending on the distance between the short and long strikes on the call and put spreads.  The closer the strike prices are together, the less risk there is, but you’ll also receive less credit for the overall position.

Let’s look at an actual example as of the time of this writing. The SPY closed at 137.57. If you had the  market opinion that the SPY would not rise by more than $4.43 or fall by more than $5.57 by expiration, you could consider selling an iron condor that would consist of 1 short SPY 132 put, 1 short 142 SPY call, 1 long SPY 145 call and 1 long SPY 129 put. The net credit using the current bid/ask prices and by going out 41 days in time would be $88 for each condor. The risk would be defined as the distance between a spread and the net credit or $212. Volatility is low now so the option prices are not real high. You can get more credit by widening the distance between the spreads, but then there is also more risk. For example is you decided to use a 4 point spread, it would be for a net credit of $104, but now the risk would be $296.

Using the standard deviation is a good way to determine where to place the spread, it can be calculated so that there is a low probability that the underlying will move far enough against you, but you’ll also have the long positions there for the absolute risk control.

The iron condor can be applied when you think that volatility is high and you believe it will fall. If the implied volatility is high in the current month and lower in the farther out months, a calendar spread might make more sense.

SPY Iron Condor

SPY Iron Condor

Delta Neutral Call Option Writing

Advanced Call Writing Strategies

Delta Neutral Call Writing

Much has been written about the popular covered call writing strategy, where an investor will purchase 100 shares of a stock or an ETF and sell one call option for some income and partial downside protection. The term covered call means that for every option you sell that option contract is covered by 100 shares of the underlying investment.

Advanced option traders will be familiar with the term delta neutral. For those readers who are not familiar, the term means that your position is delta neutral, it has no market directional bias, in other words the position is neutral to market movement.  So, if we buy 100 shares of XYZ stock, that position alone will have a delta of 100, now if we sell an at the money call with a delta of 50, because we are short the call it will have a negative delta, so the net position delta will be 50, 100 deltas for the 100 shares of XYZ stock and -50 deltas for the short XYZ call. This is how your typical covered call position works. If you were to sell an out of the money call with a delta of 25 your net position delta would be 75, in other words the total position would behave like 75 shares of the underlying instead of 100.

Now, if we want to create a market neutral position, we’ll sell enough calls so that the net position is delta neutral. So, if we buy 100 shares of XYZ again we could sell two 50 delta at the money calls, three 33 delta out of the money calls, or four 25 delta out of the money calls and so on. If the net position delta is at or near zero, your position will not have directional risk as long as it remains delta neutral. Then you can earn the theta or the decay from the short options. You don’t have to sell the options at just one strike price, either. For example you could sell one at the money 5o delta call and two out of the money 25 delta calls.

Once a position is established, the delta will change by the rate of the gamma, and adjustments will have to be made to remain delta neutral. You can adjust the shares of stock you own, sell more calls, or buy some calls back to make the delta neutral adjustment.

As with any strategy there are risks, the underlying can drop rapidly before you can adjust and you can experience a loss. Since you have uncovered short calls, if the underlying explodes upward rapidly you can also experience a substantial loss. Stocks that have high volatility or may be potential takeover targets should be avoided. Mega cap stocks can be good candidates or broad based index ETFs can be good candidates for a delta neutral strategy. Indexes can rise and fall rapidly, but they have never dropped all the way to zero like individual equities can or explode upwards the stocks getting taken over can.

Looking at some current prices as of this writing, the SPY is at $131.82 and the Feb 135 calls are 21 days from expiration. The Feb 135 calls sell for $0.61 and have a delta of 24. You could sell 4 of those calls against a 100 share position of SPY and take in $2.44 in premium, the theta is -0.03 so you’d be getting $12 per day in decay. You could make delta neutral adjustments as time goes by on a regular basis, but you wouldn’t have to worry about loss unless the SPY rises to above 135 by expiration. This is not a recommendation for the above SPY trade, I like using some real numbers for illustrative purposes, this is a strategy for sophisticated investors who understand the risks and are familiar with options and making delta neutral adjustments.

Option Greeks ~ Delta and Gamma

To determine the theoretical price of an option, an option pricing model is used. Buyers and sellers on the marketplace determine the actual price constantly throughout the trading day. The most commonly used pricing model is the Black Scholes Model. From the Black Scholes Model we can derive some calculations used to determine how an option price will react to market variables, known as the Greeks because letters from the Greek alphabet are used to designate them. The Delta is the rate of change of option price with a corresponding one point move in the underlying instrument. A one hundred share position in the underlying instrument will always have a delta of 100. I like to express the delta in terms of the number of shares of the underlying that you hold. If you are long 100 shares of XYZ then you are a positive 100 delta position. If you are short 100 shares of XYZ then you have a negative -100 delta position. When you combine complex option and stock positions you’ll have to keep track of the deltas which are additive. At the money options will have a delta of about 50. So, if you own 100 XYZ and decide to sell an at the money call with a delta of 50, your net position delta will now be 50, 100-50 = 50. Which means that as long as the delta of the short call remains at 50 your combined position will behave like 50 shares of the underlying, not 100 shares, so the risk of ownership in the underlying is reduced by a 50 share equivalent. As call options move in the money, the delta will increase, as they move out of the money, the delta will decrease. The delta is also roughly equivalent to the probability of the option being in or out of the money at expiration. An at the money option will have a delta of about 50, which means that it will move half of what the underlying moves, but also has a 50/50 chance of being in the money at expiration. A long call with have a positive delta and a long put will have a negative delta. Conversely the short call will have negative delta and the short put will be a positive delta position. If you hold a 100 share position and are concerned about risk you could sell an at the money call and use the proceeds to buy an at the money put. If the short call has a -50 delta and the long put also has a -50 delta you now have a delta neutral position, 100-50-50=0. As long as the position stays delta neutral you do not have market risk. The deltas, however are not fixed but are variable so they change when the price of the underlying stock changes and adjustments have to be made if the investor wishes to maintain a delta neutral position. The rate at which the delta changes is known as the Gamma, the gamma is the rate of change of the delta with a corresponding one point underlying move.

Option income investors who use short straddles, short strangles, iron condors, iron butterflies, etc. will have delta neutral positions with short gamma, meaning that they don’t want the underlying to move, if the underlying moves the delta will change and the position will take on a directional bias.  So they have to adjust to maintain a delta neutral position.

To determine the theoretical price of an option, an option pricing model is used. Buyers and sellers on the marketplace determine the actual price constantly throughout the trading day. The most commonly used pricing model is the Black Scholes Model. From the Black Scholes Model we can derive some calculations used to determine how an option price will react to market variables, known as the Greeks because letters from the Greek alphabet are used to designate them. The Delta is the rate of change of option price with a corresponding one point move in the underlying instrument. A one hundred share position in the underlying instrument will always have a delta of 100. I like to express the delta in terms of the number of shares of the underlying that you hold. If you are long 100 shares of XYZ then you are a positive 100 delta position. If you are short 100 shares of XYZ then you have a negative -100 delta position. When you combine complex option and stock positions you’ll have to keep track of the deltas which are additive. At the money options will have a delta of about 50. So, if you own 100 XYZ and decide to sell an at the money call with a delta of 50, your net position delta will now be 50, 100-50 = 50. Which means that as long as the delta of the short call remains at 50 your combined position will behave like 50 shares of the underlying, not 100 shares, so the risk of ownership in the underlying is reduced by a 50 share equivalent. As call options move in the money, the delta will increase, as they move out of the money, the delta will decrease. The delta is also roughly equivalent to the probability of the option being in or out of the money at expiration. An at the money option will have a delta of about 50, which means that it will move half of what the underlying moves, but also has a 50/50 chance of being in the money at expiration. A long call with have a positive delta and a long put will have a negative delta. Conversely the short call will have negative delta and the short put will be a positive delta position. If you hold a 100 share position and are concerned about risk you could sell an at the money call and use the proceeds to buy an at the money put. If the short call has a -50 delta and the long put also has a -50 delta you now have a delta neutral position, 100-50-50=0. As long as the position stays delta neutral you do not have market risk. The deltas, however are not fixed but are variable so they change when the price of the underlying stock changes and adjustments have to be made if the investor wishes to maintain a delta neutral position. The rate at which the delta changes is known as the Gamma, the gamma is the rate of change of the delta with a corresponding one point underlying move.

Option income investors who use short straddles, short strangles, iron condors, iron butterflies, etc. will have delta neutral positions with short gamma, meaning that they don’t want the underlying to move, if the underlying moves the delta will change and the position will take on a directional bias.  So they have to adjust to maintain a delta neutral position.

Index Call Option Spreads for Income

Index Call Spreads

This strategy can be used to enhance returns on a stock portfolio. The first step is to look at the portfolio and determine which index it correlates most closely to. A mostly technology stock portfolio may correlate most closely to the NASDAQ, or the QQQQ ETF. A portfolio of foreign stock might have the closest correlation the EAFE or the EFA ETF. For our example we’ll assume that the investor has a $260,000 portfolio that is highly correlated to the S&P 500. The ETF for the S&P 500 is the SPY. The next step is to determine how many option contracts represent the value of the portfolio. As of the writing of this book the SPY is trading at about $130 so 20 contracts ((20 X100) X $130) = $260,000. The next step is the sell a credit spread on the SPY. If we sell the 133 X 134 spread we receive a credit of 0.25 cents or $500. The maximum risk on the spread is the amount of the spread minus the credit or 0.75 cents or $1,500. If the SPY stays below 133 we keep all of the credit. If the S&P declines, the portfolio will decline and we’ll still keep the credit for additional income or an offset to the decline. If the SPY rises above 134 at expiration we’ll have our maximum loss on the spread, but it will be offset by the gain in the portfolio. Say the SPY is at 135 at option expiration. We’ll have a loss of $1,500 in the call spread, but if the portfolio is 95% correlated to the S&P 500, we’ll have a gain of 3.85% on the SPY. Assuming the portfolio has a 95% correlation to the S&P 500 that translates to a gain of over $9,500 in the portfolio. Using this strategy consistently the investor will have profits on the spread when the market is flat, declines or rises slightly. When the market makes a large gain, the investor will have a loss on the spread that is offset by the gain in the portfolio. Strike prices for the spread can be selected using out of the money options that have a low probability of loss. Remember when a loss does occur it is offset. Over time there should be more winning months than losing months based on lognormal distribution of market returns and the strategy will have a positive expected return.