market neutral options strategy guide

8/3/2019 Market Neutral Options Strategy Guide

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Copyright 2007 MarketNeutralOptions

Strategy Guide-------------------------------------------------------------------------------------------------------A guide to successful options trading

Version 2


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PRINT THIS BOOK NOW!Please take a moment to print this ebook right now!

There is a higher chance that you will read this book

and actually learn something if you have it printed out

in physical form. I have dozens of ebooks in my

computer and those that Ive read through thoroughlyare those that Ive printed out.

You can carry the physical form of this book with you

and read it wherever you go.

Its much easier to flip through a book for reference

than to search through your document folder, find thefile and wait for it to load. You really dont want to have

this book take up your screen space while you are

trading or watching the market isnt it?


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M A R K E T N E U T R A L O P T I O N S A D V I S O R Y S E R V I C E L E G A L N O T I C E

DISCLAIMER AND WAIVER OF CLAIMS

Please read through the following notice very carefully.

Upon using any MarketNeutralOptions services or products, you are deemed to have agreed to this legalnotice.

Options involve risk and are not suitable for all investors. All investors who deal with options should read andunderstand the publication "Characteristics and Risks of Standardized Options." A copy of this publication canbe obtained by clicking on this link:http://www.optionsclearing.com/publications/risks/riskchap1.jsp

All examples cited in this e-book are hypothetical. You should not assume that the stocks and options pricing orprofits from trades used as examples in this e-book will be in accordance with actual pricing or results in themarket place. Commission costs will impact the outcome of all stock and option transactions and must be

considered prior to entering into any transactions.

The examples used in this e-book are not to be construed as a recommendation to purchase or sell anysecurity or group of securities.

MarketNeutralOptions is the copyright owner of all text and graphics contained in this publication. Copying,publishing or redistributing any material in any way without the written consent of MarketNeutralOptions isstrictly prohibited.

The owners, publishers, and agents of MarketNeutralOptions are not liable for any losses or damages,monetary or other that may result from the application of information contained within this publication. Withinthis publication, we publish materials that meet specific criteria representing characteristics associated withdescribed trading strategies. Individual traders must use their own due diligence in analyzing featured options

to determine if they represent a suitable opportunity.

MarketNeutralOptions and any of their agents, affiliates, representatives, employees, principals, businessassociates or affiliates, partners or independent contractors are not responsible for any losses or profits thatmay result from the application of information contained within this publication.

Past performance is not indicative of future results. Option trading involves substantial risk.You can losemoney trading options. The past results posted on this site are meant to give you a reasonable idea of whatyou could have made or lost trading by following the MarketNeutralOptions strategy but are in no way an exactreflection of what you would have made or lost. Therefore, you should not rely on our past trade results as aperfect replication of what your returns or losses would have been by following our service. There are inherentrisks involved in the stock market and these risks should be considered prior to any decision. Therepresentatives of MarketNeutralOptions may or may not hold a position in any stocks listed at the time ofpublication and reserve the right to buy or sell any security, option, future or derivative product withoutnotification.

Nothing published by MarketNeutralOptions should be considered personalized investment advice. Althoughthe MarketNeutralOptions team may answer your general customer service questions, they are not licensedunder securities laws to address your particular investment situation. No communication by theMarketNeutralOptions team to you should be deemed as personalized investment advice.
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IntroductionThank you for choosing MarketNeutralOptions Advisory Service.

Here at MarketNeutralOptions we strive to offer the best value and

best customer service to our subscribers. Our advisory service isone of the most reasonably-priced services in the industry bypegging our subscription fee to our advisory performance.

You pay for what you get, not what you were promised, and we profittogetherwith you.

This Strategy Guide will shed more light on the strategies that weuse for our advisory service. Even if you are totally new to options

trading, I hope this book will help you understand market-neutralstrategies such as iron condors and double diagonals that we use in

our advisory service regularly.

I hope you will find this book useful in this never-ending journey tolearn to be a better trader.

Gary AngFounder of MarketNeutralOptions


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Table of Contents

Introduction to the Basics of Options Trading ........................... 1

What are options? .................................................................... 2

Moneyness of an Option .......................................................... 3

Leverage .................................................................................. 7

Basic Options Trading Strategies ........................................... 10

Basic Building Blocks ............................................................. 10

A Spread ................................................................................ 10

Vertical Spreads ..................................................................... 11

Calendar Spread .................................................................... 15

Iron Condor ............................................................................ 16

Break-Even Points ............................................................................................... 18

Capital Requirement ............................................................................................ 19

Expected Returns ................................................................................................ 20

Risk/Reward Ratio (R3) ....................................................................................... 22

Exit Strategy ......................................................................................................... 27

Double Diagonal ..................................................................... 29

Roll ....................................................................................................................... 30

Capital Requirements .......................................................................................... 32

Characteristics of a Double Diagonal .................................................................. 32

Conclusion ........................................................................................................... 33

Appendix: An Introduction to the Greeks in Options Trading .. 34

The Delta ............................................................................................................. 34

Gamma ................................................................................................................ 36

Theta .................................................................................................................... 37

Vega ..................................................................................................................... 37


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M A R K E T N E U T R A L O P T I O N S A D V I S O R Y S E R V I C E

S T R A T E G Y G U I D E

1

www.MarketNeutralOptions.com


Introduction to the Basics

of Options Trading

Never risk your hard-earned money on something you hardlyunderstand. Not only have you risked losing your money, you maynot even know why you lose.

t is extremely important that you have a firm understanding of the basics

of options before you even start trading with your hard-earned money.

Options have been labeled as highly risky and speculative by critics. Butwhat these critics fail to understand is option itself is neither risky nor

speculative. In fact, when used properly, option can be less risky than buying

actual stocks. Option not only serves as a strategic investment vehicle, it can

also be used to reduce risk with its hedging property. Option is only risky when

you dont know what you are doing with it!

Option trading is a skill that may take a long time to master. In fact, I

personally think that education in option trading is never over. It is therefore

critical that you fully understand how options work to take full advantage of

option trading. Options are complex investment instruments that present

traders unlimited style or strategies of trading. Whether you are a bull, a bear

or market neutral, you can be sure to find a few strategies to suit your market

view. Whether you are delta neutral, trading gamma or vega, you will be able

to take advantage of what options offer.

Before you learn complicated strategies such as the Iron Condor and Double

Diagonal, it is imperative that you understand the basic building blocks of

these strategies. At the end of this e-book, you should be able to understand

how an Iron Condor and Double Diagonal work and how you can expect to

make money from trading them.

I


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2

What are options?

Basics of Calls and Puts. Readers who are already familiar withthe basics of Calls and Puts may skip to the next section.

earning to trade options can be one of the most challenging and

rewarding endeavors in your investment education. Unlike stock, options

are multi dimensional investment vehicles. The terminology used in

options trading can be intimidating for most beginners and it is not surprising

that many beginners give up on learning options because they simply find it

too difficult.

In the simplest terms, options are derivatives that derive their values from the

value of an underlying. The underlying of a stock option is the stock itself;

likewise, the underlying of an index option is the index. For example, an IBMoption derives its value from the share price of IBM. Depending on the

characteristics of the option, the value of the option may increase or decrease

when the share price of IBM rises.

Options are contracts to buy or sell an underlying at a specific price before or

on a specific date. There are two types of options: calls and puts. Calls are

contacts to buy an underlying at specific price before or on a specific date

while puts are contracts to sell an underlying at a specific price before or on a

specific date.

The specific price to buy or sell the underlying is called the strike price. Since

options are time-sensitive, the last day of an options validity is known as

expiration date. The expiration date of most options falls on the third Friday of

every month. Exceptions are index options such as the SPXthe symbol of the

S&P 500 indexexpire on the third Thursday of every month and quarterly

options that expire on the last trading day of the month. An American-style

option can be exercised before or on the expiration day itself while a

European-style option can only be exercised on the expiration day itself. Most

of the stock options listed in the American markets are American-style.

As mentioned earlier, options are multi dimensional investment vehicleswhose prices are determined by factors such as price of the underlying, days

to expiration, interest rate and implied volatility. For example, an IBM Feb 95

call option is a contract to buy 100 of IBM shares at the strike price of $95

before or on the third Friday of February. When you buy (go long) this call, you

have the right to buy 100 shares of IBM at the strike price of $95 anytime

L

Main Points A call (put) buyer has the

right to buy (sell) theunderlying at a fixed price.

A call (put) seller has theobligation to sell (buy) theunderlying at a fixed price.

The strike price is the fixedprice stated in the option.

Options have expiry dates. American-style options can

be exercised before or onexpiration.

European-style optionscan only be exercised onexpiration.

The price of an option isdetermined by many

factors such as the price ofthe underlying, days leftbefore expiration, interestrate and implied volatility.


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before or on the third Friday of February regardless of how much IBM is

worth. Even if IBM is trading at $120 in February, you can choose to exercise

your long call and buy 100 shares of IBM at $95. However, if IBM were to

trade at a price of $80, you will not want to exercise your long call to buy IBM

at $95 since you can get it at a market price of $80.

Similarly, an IBM Feb 95 put options is a contract to sell 100 shares of IBM at

the strike price of $95 anytime before or on the third Friday of February.

When you long this put, you have the right to sell 100 shares of IBM at the

strike price of $95 anytime before or on the third Friday of February regardless

how much is IBM trading at. If IBM is trading at $120 in February, you will not

exercise your Feb 95 put because you will not want to sell IBM at $95 when

you can sell at $120 in the open market. However, if IBM is trading at $90 in

February, you may choose to exercise your long Feb 95 put to sell 100 shares

of IBM at $95 when it is trading at $90 in the open market.

Moneyness of an Option

he value of an option may be difficult to model. There are a few option

pricing models around; the most celebrated would most probably be the

Black-Scholes model, which is a Nobel Prize winner. Fortunately, one

does not have to be a Nobel Prize winner to understand the basics of options!

The price of an option can be broadly divided into two main parts: its intrinsic

value and its time value, sometimes called the extrinsic value.

An IBM Feb 95 call option may cost $1.80 when IBM is trading at $96.

Remember that owning an IBM Feb 95 call gives you the right to buy IBM at

$95 no matter how much IBM is trading at. When IBM is trading at $96, your

long IBM Feb 95 call will be worth at least $1 since it gives its owner the right

to buy IBM at $95 when it is currently trading at $96. This $1 is the intrinsicvalue of the call option. But you may notice that the actual price of the call

option almost always exceeds its intrinsic value. In our example, the call

option cost $1.80 when it only has an intrinsic value of $1. The difference of

$0.80 is known as the time value. An options time value is directly related to

the number of days left to expiration. The more days the option has before

expiration, the more time value is has. On expiration day, all options will have

Intrinsicvalue

Timevalue

Price ofoption

T


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zero time value. When IBM is trading at $96, we say that the Feb 95 call option

is in-the-money (ITM). Similarly, an IBM Feb 100 put will have a positive

intrinsic value of $4 when IBM is trading at $96 because the put gives its

owner the right to sell IBM at $100 even if IBM is trading at $96. An ITM

option is an option with positive intrinsic value.

If IBM were to be trading at $95, the Feb 95 call will not have any intrinsic

value because nobody would care for a right to buy IBM at $95 when everyone

can buy it at $95 in the open market. Likewise, a Feb 95 put will also not have

any intrinsic value when IBM is trading at $95 since nobody will care for a right

to sell IBM at $95 when everyone can sell it at $95. The Feb 95 call and put

options are known as at-the-money (ATM) options. When an options intrinsic

value is zero, i.e. the stock price is equal to the strike price, it is ATM.

Now, lets say IBM is trading at $90, the Feb 95 call will have negative intrinsicvalue since nobody will be interested in the right to buy IBM at $95 when it is

trading at $90. This Feb 95 call option is called an out-of-the-money (OTM)

option. On the put side, a Feb 85 put will be OTM when IBM is trading at $90

since nobody will be interested to sell IBM at $85 when they can sell it at $90

in the open market. However, an ATM or OTM option will not be worthless

until on expiration day because it will still have time value. On expiration day,

all ATM and OTM options expire worthless.

Table 1: A typical option chain

Call Strike Price Put

ITM 87.5 OTM

ITM 90 OTM

ITM 92.5 OTM

ATM 95 ATM

OTM 97.5 ITM

OTM 100 ITM

OTM 102.5 ITM

This table shows the moneyness of Call and Put options when underlying is trading at $95

Main Points Price of an option is the

sum of its intrinsic valueand its time value.

In-the-money (ITM) optionsare options with positiveintrinsic value.

At-the-money (ATM)options are options withzero intrinsic value.

Out-of-the-money (OTM)options are options withnegative intrinsic value.

All options will have zerotime value on expirationday.

All ATM and OTM optionswill be worthless on

expiration day.


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A Call Example

Alvin bought a SPY Aug 131 call from Ben for $0.50 with 40 days toexpiration. SPY is, say, currently at $130. Alvin would have thought orhoped that SPY would rise to above $131 within the next 40 days since he

had the right to purchase the stock at $131 even if it happens to be tradingat $135 in the next 40 days. On the contrary, when Ben sold the Aug 131call to Alvin, he must have been bearish on the SPY and hope that SPYwould be trading below $131 since he had the obligation to sell SPY at $131to Alvin even in the event that SPY is trading at $135 within the next 40days. Ben obviously would not want to sell Alvin SPY at $131 when it istrading at $135!

As illustrated, buying a call is bullish and selling a call is bearish.

Now, when expiration comes and SPY is trading at, say, $129, the 131 callwould expire worthless since it is out of the money (OTM). What this meansto Alvin is that he would have lost his entire investment of $0.50 since his

investment is now worthless. For Ben, he would have profited the $0.50since the option he sold to Alvin is now worthless.

However, if SPY were to trade at $133 on expiration day, the 131 call wouldbe worth $2 since Alvin can exercise the right to buy SPY at $131 when it istrading at $133 currently. This 131 call is said to be in-the-money (ITM).Alvin can choose to exercise the right to buy SPY at $131 and thensubsequently sell it back to the open market at $133 to make a $1.50 profit($2$0.50). Alternatively, he can choose to sell the option to another traderbefore the market closes. Alvin has the potential to make unlimited profitbecause the higher SPY goes before expiration, the more profit he makeswith his long call.

Now, Ben on the other side of the market would be sweating cold sweat.The 131 call he sold Alvin for $0.50 is now worth $2. Ben can choose toclose out his short call position by buying back the call, now worth $2, fromAlvin, and thus suffer a $1.50 loss. However, if Alvin were to exercise hislong call before expiration, Ben would have to honor his obligation to sellSPY at $131 to Alvin. Ben would have to buy SPY at $133 from the openmarket and then sell it to Alvin to $131. He would have suffered $1.50 lossfrom either scenario. Unlike Alvin, who can only lose his entire investment of$0.50, Ben is exposed to unlimited risk. The higher SPY goes beforeexpiration, the more Ben loses.

As illustrated, long call presents limited risk while short calls presents unlimited risk.

A Put Example

Alvin bought a SPY Aug 129 put from Ben for $0.50 with 40 days toexpiration. SPY is, say, currently at $130. Alvin would have thought orhoped that SPY would fall to below $129 within the next 40 days since hehad the right to sell the stock at $129 even if it happens to be trading at$125 in the next 40 days. On the contrary, when Ben sold the Aug 129 putto Alvin, he must have been bullish on the SPY and hope that SPY would be


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trading above $129 since he had the obligation to buy SPY at $129 to Alvineven in the event that SPY is trading at $125 within the next 40 days.Surely, Ben would dread the idea of having to buy SPY at $129 when it istrading at only $125.

As illustrated, buying a put is bearish and selling a put is bullish.

Now, when expiration comes and SPY is trading at, say, $131, the 129 putwould expire worthless since it is out of the money (OTM). The right to sellSPY at $129 is worthless because nobody would want to sell SPY at $129when they can sell it at $131 in the open market. What this means to Alvin isthat he would have lost his entire investment of $0.50 since his investmentis now worthless. For Ben, he would have profited the $0.50 since theoption he sold to Alvin is now worthless.

However, if SPY were to trade at $127 on expiration day, the 129 put wouldbe worth $2 since Alvin can exercise the right to sell the SPY at $129 whenit is trading at $127 currently. This 129 put is said to be in-the-money (ITM).

Alvin can choose to exercise the right to sell SPY at $129 and thensubsequently buy it back from the open market at $127 to cover his shortstock position and make a $1.50 profit. Alternatively, he can choose to sellthe 129 put option to another trader before the market closes. Alvin has thepotential to make unlimited profit because the lower SPY goes beforeexpiration, the more profit he makes with his long put.

Now, Ben on the other side of the market would be watching the marketnervously. The 129 put he sold Alvin for $0.50 is now worth $2. Ben canchoose to close out his short put position by buying back the put, now worth$2, from Alvin, and thus suffer a $1.50 loss. However, if Alvin were toexercise his long put before expiration, Ben would have to honor hisobligation to buy SPY at $129 from Alvin even though SPY is currentlytrading at $127. Ben would have to buy SPY at $129 from the Alvin andthen sell it to the open market at $127 if he does not want to have any longstock position. He would have suffered $1.50 loss from either scenario.Unlike Alvin, who can only lose his entire investment of $0.50, Ben isexposed to unlimited risk. The lower SPY goes before expiration, the moreBen loses.

As illustrated, long put presents limited risk while short put presentsunlimited risk.

Main Points An option controls 100

shares of the underlying. Buying a call is bullish

while selling a call isbearish.

Buying a put is bearish

while selling a put isbullish.

Long options presentlimited risk while shortoptions present unlimitedrisk.


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7

Leverage

Using options as leverage to control stocks.

imilar to warrants, options offer leverage. With a small amount of upfront

capital, an option buyer can control 100 shares of a more expensive stock.

For example, Google (GOOG) is trading at $684.16 on 6 December 2007 (16

days to December expiration) and Table 2 shows the option chain for December

expiration.

Lets say you are bullish on GOOG. To buy 100 shares of GOOG, you will need

about $68,416 [$684.16 X 100]. In the next 10 days, Google shares soar $100 to

$784.16. You would have made $10,000 [$100 X 100] in profit. In percentage

terms, you would have made about 14.62% returns on your investment. Not bad

at all.

Now, lets say you are an option trader and you are also bullish on GOOG. You look

at the option chain (Table 2) and you decide to buy the Dec 680 Call for $25.20

apiece. You upfront investment will be $2,520. Remember that with GOOG

currently trading at $684.16, your Dec 680 call has an intrinsic value of only $4.16.

You are paying $21.04 for time value. In the next 10 days, GOOG shares soar $100

to $784.16. Based on a simple computer simulation, your Dec 680 call should be

worth about $100. You would have profited $7,480 [($100 $25.20) X 100]. In

percentage terms, you would have profited an amazing 296.83% returns on your

investment!

S


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Table 2: Google option chain when Google is trading at $684.16.

Source: Screenshot taken from thinkorswim trading platform.

In both cases GOOG advances $100 in 10 days but the option trader seems to have

a better deal. This is the power of leverage. Many people learn about options in

this manner. Before you get all excited and start counting the number of days itwill take for you to become a millionaire, let me get you back on earth by saying

that youll probably have to be a psychic or fortune-teller, a very accurate one at

that, in order to trade options successfully this way.

Why? This is because you have to know that leverage, as amazing as it is, is a

double-edged sword and it works both ways. Lets go back to our Google example

and instead of advancing $100 in the next 10 days, GOOG declines $10.

The stock trader would have suffered a loss of $1,000 [$10 X 100]. In percentage

terms, the stock trader would have made a loss of 1.46%. However, based on a

simple computer simulation, the options traders Dec 680 call option would beworth only $11.62. The options trader would have made a loss of $1,358 [($25.2

$11.62) X 100]. In percentage terms, the options trader would have made a loss of

about 53.89%.

Things will only get worse for the options trader who punted on the wrong side of

the market. With GOOG trading at $674.16 after the $10 fall, his Dec 680 call

option is now OTM with zero intrinsic value. Lets say GOOG remains at $674.16


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for the remaining days until December expiration, the Dec 680 call option will

expire worthless and the option trader would have suffered a 100% loss on his

investment. On the other hand, the stock trader can hold on to his GOOG shares

and can wait forever for a rebound.

Now, let me present you a third scenario. Lets say after the option trader bought

his Dec 680 call option, GOOG remains at $684.16 until December expiration with

no gains or losses. Remember that the Dec 680 call option has an intrinsic value of

only $4.16. Come December expiration, this call will only be worth its intrinsic

value of $4.16.

The stock trader would not make any profit or loss because the stock did not gain

or lose its value. In fact, the stock trader stands to receive any dividend paid by

Google for as long as he holds on to his GOOG shares.

The option trader will again be in an undesirable position. Even though GOOG didnot gain or lose a single cent, the option trader sees his Dec 680 call option shrinks

its value from $25.20 to $4.16 in a short 16 days.

Now, even if GOOG were to advance $10 by December expiration, how will the

option trader fare? Bear in mind that the option trader was bullish and he was

right. By expiration, if GOOG is trading at $694.16, his Dec 680 call option will be

worth only $14.16 [the initial intrinsic value of $4.16 plus the additional $10 as

GOOG goes up by $10]. In fact, the option trader will only breakeven if GOOG were

to advance by $21.04 to $705.20 [initial GOOG value of $684.16 plus time value of

$21.04]. If GOOG were to trade at anything less than $705.20 on expiration, theoption trader makes a loss.

Many would agree with me that making money by buying calls and puts is not

easy. Underlying goes against you, you lose. Underlying goes sideway, you lose

again. Even if underlying goes in the direction that you speculated, you may still

lose if the move isnt spectacular enough.

Even though buying straight calls and puts is a difficult way to make money, many

option traders are still doing it. This is because buying straight calls and puts is the

easiest way to trade options. It does not help that many options trading courses

out in the market are teaching new option traders this simple strategy. Theirclaims of making 300% profit on a single trade will lead many newbies to think that

trading options is the fastest way to get rich. This is partly why most new options

traders lose money despite spending a fortune on courses and seminars.

Of course there are a handful of traders who manage to make a fortune by simply

buying calls and puts but they are really the minority and it involves a different set

of skills altogether.


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Basic Options Trading StrategiesBasic yet versatile strategies go a long way. Whether you are a bull,

bear or neutral, you can be sure to find something you can use.

At MarketNeutralOptions, we believe that the best way to make money

consistently by trading options is to let time decay work in our favor. If you havent

understand the working principles behind market-neutral strategies or how

positive theta works, please read our Introduction to Market-Neutral Options

Strategies.

Basic Building Blocks

A SpreadLong calls and puts offer leverage and limited risk. The most you can lose is

your initial investment paid to buy the call or the put. However, if the market

moves in your favor, you stand to be rewarded handsomely.

Unlike short calls and puts, long calls and puts do not present unlimited risk to

the buyer. However, that is not to say that long calls or puts are risk-free. The

most obvious risk is time decay.

Options are decaying assets: their value reduces as time goes by. If the

underlying does not move, your long call or long put position may start to beworth less and less in value as time goes by. In fact, your long option positions

run the risk of becoming worthless by expiration. You would have lost your

entire investment should your long positions become worthless by expiration.

Furthermore, long option positions are also subject to changes in volatility.

The value of an option (call or put) is directly proportional to the change in

volatility. The higher the volatility, the higher the value of long options and

vice versa. This is because, in a volatile market, where there are large

movements in either direction, there is a higher chance that your long options

will end up ITM. Thus the higher prices reflect the higher probability that yourlong options may expire ITM.

In fact, more often than not, a long call position may lose money even if the

underlying is moving up. This is because the value of the option is decreasing

due to time decay and a reduction in volatility. The move up is not enough to

make up for the loss in time decay and volatility.

Main Points Most professional traders

use a spread to offset therisk associated with a longor short position.


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Therefore, most professional traders use spread (a combination of long and

short options) instead of simply long calls or puts. A spread involves the buying

and selling of an option to offset some risk associated with the long or short

position per se.

Vertical Spreads

Verticals are the most basic spread. It involves the buying and selling of a call

or put with different strike price but in the same expiration month. Vertical

spreads can be done for a debit (you pay) or a credit (you get paid). The

reason why it is called vertical is because option prices are listed according to

expiry month. Each month forms a column with strike prices one above

another. When you buy and sell a call or a put in the same expiration month,

you are looking at the prices in a vertical fashion. Thats why the name vertical

spread.

Debit Spreads

Debit call or put spread allows trader a long exposure. A debit call spread is

also known as a bull call spread while a debit put spread is known as a bear

put spread. Generally, when a spread is a net debit, you are said to be long

the spread. Conversely, when a spread is a net credit, you are said to be short

the spread.

Bull Call Spread

A bull call spread is long a lower strike call and short a higher strike call in the

same expiration month. For example, you can go long SPY 130 Aug call andshort a SPY 132 Aug call when SPY is trading at $129. Since the 130 call is near

to the money, it will cost more than the 132 call that you sold. Therefore, the

spread ends up a debit spread.

When you put up a bull call spread, you are bullish and believe that SPY would

trade higher than $130 before expiration.

If SPY trades at $133 on expiration, your long 130 call would be worth $3 and

your short 132 call would be worth $1. To avoid assignment and have the

underlying delivered to you on Monday, you can close the trade by selling

your long 130 call and buying back your short $132 call. You would have made

$2 minus whatever debit you paid to initiate the trade. Even if SPY were to

trade at $140 (yes, you were right to be bullish), you will still make only $2

minus the debit you paid. Your profit is limited to $2 minus the debit you paid

even though you are right in your prediction.

Main Points A debit spread involves

buying a more expensivecall (put) and selling acheaper call (put).Therefore, you have to payto initiate a debit spread.

The maximum risk of aspread is limited. So is theprofit.

A bull call spread is bullishbecause you are usingcalls to be bullish.

A bear put spread isbearish because you areusing puts to be bearish.


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If you only bought the 130 call, you would have unlimited profit potential. If

SPY were to be trading at $140, your 130 call will be worth $10 and youll

profit that $10. Selling the 132 call to create the spread ensures that your

profit is capped at $2 no matter how high SPY is trading. Why would anyone

want to initiate a trade like that you may ask? The reason is simple: reduce

risk. If you only go long your 130 call and SPY fails to rally and trades at $128,

you would have lost your entire investment (the amount you paid for the 130

call). By selling the 132 call at the same time as you bought your 130 call, you

reduce your risk since your short 132 call would bring in some credit, i.e. youactually pay less for your long 130 call because of the 132 call you sold.

Since you paid less for the 130 call, you stand to lose less than if you were to

go long 130 call only. The tradeoff is, of course, you limit your otherwise

unlimited profit potential.

Bear Put Spread

A bear put spread is long a higher strike put and short a lower strike put in the

same expiration month. For example, you can go long a SPY 129 Aug put and

short a SPY 128 Aug put when SPY is trading at $130. Since your long 129 put isnearer to the money, it will be worth more than you short 128 put and

therefore, your spread is a net debit.

When you long a put spread, you are bearish and believe that SPY will trade

below $129 by expiration.

If SPY were to trade at $127 on expiration day, your long 129 put will be worth

$2 and your short 128 put will be worth $1. You can close the trade by buying

back your short 128 put for $1 and selling your long 129 put for $2 and pocket

the difference. Your profit would be $2 minus the debit you paid to initiate the

trade.

If SPY trades above $129 on expiration day, both your short and long puts will

expire worthless and youll lose your entire investment.

A bear put spread (long/debit put spread) works the same way as a bull call

spread (long/debit call spread) just opposite.

Maximum profit of a debit spread= difference between the strikes the initial debit paid.

Maximum loss of a debit spread = the initial debit paid.


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Credit Spreads

A credit spread allows a trader to have a short exposure. A credit call vertical

spread is also known as a bear call spread while a credit put vertical spread

is also known as a bull put spread. When your sprea d ends up a net credit,

you are said to be short the spread.

Bear Call Spread

A bear call spread is also known as a credit call vertical. It involves selling a

lower strike call and buying a higher strike call. For example, SPY is trading at

$130. To put up a credit call vertical is to sell 1 Aug 131 call and buy 1 Aug 132

call. Since your short 131 call is nearer to the money, it will be worth more

than your long 132 call and therefore, you end up receiving a credit.

When you put up a credit call spread, you are bearish and believe that SPY will

expire below $131 on expiration day.

If SPY were to trade below $131 on expiration day, both your long and short

calls will expire worthless and you get to keep the credit you received for

initiating the trade.

However, if SPY were to be trading at $133 on expiration day, you short 131

call will be worth $2 and your long 132 call will be worth $1. To close the trade

you will have to buy back your short 131 call at $2 and sell your long 132 call

for $1. You will lose the $1 difference minus any credit that you received

earlier. Say you received $0.30 credit for initiating this trade, your loss would

be $1 $0.30 = $0.70.

Bull Put Spread

A bull put spread is also known as a credit put vertical. It is short a higherstrike put and long a lower strike put. For example, SPY is trading at $130 and

you are bullish on SPY. You set up a credit put spread by selling a 129 put and

buying a 128 put.

If SPY is trading above $129 on expiration day, both your short and long puts

will expire worthless and you get to keep the credit you received for initiating

the trade.

Maximum profit of a credit spread = the initial credit collected.

Maximum loss of a debit spread= the difference between the strikes the initial credit collected.

Main Points A credit spread involves

selling a more expensivecall (put) and buying acheaper call (put).Therefore, you get paidwhen you initiate a creditspread.

A bear call spread isbearish because you areusing calls to be bearish.

A bull put spread is bullish

because you are usingputs to be bullish.


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However, if SPY were to be trading at $127 on expiration day, your short 129

put will be worth $2 and your long 128 put will be worth $1. To close the trade

youll have to buy back your short 129 put at $2 and sell you long 128 put for

$1. Your loss will be limited to the difference between the strikes ($1) minusthe credit you received.

Similar to debit spreads, credit spreads offer limited risk as well as limited

profit potential.

For debit spreads, the selling of a higher strike call or lower strike put serves as

a way to reduce risk by reducing the cost of buying the long call or put. It can

be regarded as a discount for buying the call or the put. To have the discount

youll have to limit you profit potential.

Similarly, for credit spreads, the buying of a higher strike call or lower strike

put is also to reduce risk. The long options serves as a hedge against you short

options. Without the long option hedge, you will be simply short a call or a put

(a naked call or a naked put). A naked call or put position is highly risky and

requires exorbitant margin. As we discussed earlier, the seller of an option is

exposed to unlimited risk should the market goes against your favor. By buying

a higher strike call or lower strike put, you effectively limit you risk to the

difference between the two strikes.

It is important to know that a debit spread is theta (the Greek for time decay)

negative and vega (the Greek for implied volatility) positive, meaning it loses

money as time goes by and make money as implied volatility increases. A debit

spread only makes money when the underlying moves in your favor or the

implied volatility increases.

Conversely, a credit spread is theta positive and vega negative: it makes

money as time goes by and when implied volatility drops. A credit spread

makes money as long as the underlying does not breach the short strike. On

expiration, whether you get to keep 100% of the credit you received depends

solely on the price of the underlying.

If you are unfamiliar with the Greeks, please read the Appendix on

Introduction to the Greeks in Options Trading on page 34.

It is vital that you have a solid understanding of vertical spreads because they

are the building blocks of market neutral strategies such as Iron Condor and

Double Diagonal.

Main Points A short call (put) without

any long hedge is called anaked call (put).

A naked call (put) presentsunlimited risk and thusrequires high margin tomaintain the position.


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Calendar Spread

A calendar spread (sometime known as time spread) involves the selling a

near month option and buying a far month option with the same strike. Similar

to verticals, a long calendar is a net debit while a short calendar is a net credit.Specifically, a long call calendar spread could be long SPY Nov 130 call and

short Oct 130 call. Since the Nov 130 call has more time value, itll be worth

more and thus, you end up a net debit since you have to pay more than you

receive. Likewise, a long put calendar could be set up by going long a SPY Nov

130 put and short an Oct 130 put. A long calendar requires no margin as the

maximum you can lose is the debit you paid to initiate the trade.

A long calendar, whether call or put, has its maximum value when the price of

the underlying is at the strike price of the options. Conversely, it has its

minimum value when the price of the underlying is far away from the strike

price of the options.

A calendar spread is theta positive and vega positive: it makes money as time

passes and when implied volatility rises.

A calendar spread works under the principle that options lose its value fastest

in the last 30 days of their lifespan. For example, you believe that SPY is going

to be trading at $130 for the next 30 days. You can set up a calendar spread by

buying the Nov 130 call at $3 and selling the Oct 130 call for $2. Your net cost

for this trade would be $3 $2 = $1 debit. This is the most you can lose with

this trade. Now, if SPY is indeed trading at or near $130 on October expiration,your short Oct 130 call will have no more time value left while your long Nov

130 call will have roughly about a months time value left. You can then buy

back your Oct 130 call and sell your Nov 130 call for about $2, which is the

same price of your short Oct 130 call when you initiated the trade. You will

collect $2 for this roll and would have made a $1 profit on this trade. In this

example, you paid $1 for this trade and make a profit of $1. This trade makes a

percentage profit of 100%!

Although a calendar spread has defined risk, the most you can lose is the debit

you paid, it is not possible to know exactly how much you can make from theroll until you really do it. However, you can roughly estimate the value of the

roll by looking at the value of the options in the current month.

Main Points A net debit position does

not require any marginbecause the most you canlose is the debit you paidwhen you initiated thetrade.

On the other hand, a netcredit position requires amargin to maintain theposition because youcollected a credit.


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Iron Condor

An iron condor is made up of a credit call spread and a credit put spread. It is a

defined-risk strategy and is theta positive.

Remember that a credit call (put) spread makes money as long as the

underlying does not breach the short call (put).

For a credit call spread, as long as the price of the underlying stays below the

short strike, both the long and short calls will expire worthless and thereby

allowing the trader to keep the credit he received when he initiated the trade.

As such, the risk profile of a credit call spread looks like this:

For a credit put spread, as long as the price of the underlying stays above the

short strike, both the long and short puts will expire worthless and thereby

allowing the trader to keep the credit he received when he initiated the trade.

As such, the risk profile of a credit put spread looks like this:

Profit

Loss

PriceShortstrike

Long

strike

Profit

Loss

PriceShortstrike

Longstrike


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Combining the two vertical spreads would result in an iron condor.

The maximum potential profit or loss is determined when you enter the trade.

You can easily calculate the break-even points the moment you put up the

trade.

For example, lets say SPY is currently trading at $130 and it is about 30 days

to the next expiration date. You believe that SPY is going to stay within the

range of $127 and $133 for the next 30 days. You enter a 125/127/133/135

SPY Iron Condor for $1.00 credit. Specifically, you short an OTM credit call and

put spread, that is:

Profit

Loss

Price127125 135133

$100

-$100

126 134

Sell 133 SPY call

Buy 135 SPY callSell 127 SPY put

Bu 125 SPY ut

Credit call spread

Credit put spread

Profit

Loss

Price

Short putstrike

Long putstrike

Long callstrike

Short callstrike

Main Points An iron condor is made up

of a credit call spread anda credit put spread.

The maximum potentialprofit and loss can bedetermined when the tradeis entered.


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As shown in the risk profile, if SPY were to trade between the profit range of

$126 and $134, this Iron Condor is profitable. However, if SPY were to trade

beyond $134 or below $126 on expiration day, this condor will be a loser.

Break-Even Points

Lets take a look at how the break-even points of $126 and $134 are

calculated. For the put side, remember that we are short the 127 put and long

the 125 put. As long as SPY does not breach our short 127 put, the two puts

will expire worthless on expiration day. However, if SPY were to trade below

$127 but above $125, our short 127 put with have some intrinsic value. The

exact value will depends on the price of SPY on expiration day. The same is

true for our 133/135 call spread on the other end.

Now, since we collected $1.00 credit when we put up this trade, well still

profit if our short options (127 put and 133 call) are worth less than $1.00 on

expiration day. For example, if SPY were to trade at $126.50 on expiration day,

our short 127 put will be worth $0.50. The right to sell SPY at $127 when SPY is

trading at $126.50 is worth $0.50 on expiration day. We can simply buy back

our short 127 put for $0.50 and let the rest expire worthless. We would have

made ($1.00 $0.50 = $0.50) $0.50 profit from this trade.

The same is true for the call side. If SPY were to trade at $133.60 on

expiration, our short 133 call will be worth about $0.60. The right to buy SPY

at $133 when it is trading at $133.60 will be worth about $0.60 on expiration

day. Now, we can simply buy back our short 133 call at $0.60 and make aprofit of $0.40 for this trade.

Since we have collected $1.00 credit when we initiated the trade, well make a

profit as long as our short options (127 put and 133 call) is worth less than

$1.00 on expiration day.

However, if SPY were to be trading at $126 on expiration day, our 127 put will

be worth about $1.00. Well break-even if we cover our short 127 put for

$1.00. Similarly, well also break-even if SPY were to trade at $134 on

expiration day since well have to buy back our short 133 call for $1.00. This ishow we calculate our break-even points for an Iron Condor.


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In short,

These break-even points also tell us the profit range. As long as the underlying

stays within these two points, the Iron Condor is a winner!

Capital Requirement

Even though a short Iron Condor is done for a credit, we still need capital to

put up this trade. As mentioned earlier when we discussed vertical spreads,

our brokers will need us to maintain a margin for such a position albeit our riskis limited.

Similar to a vertical spread, the maximum we can lose is the difference of the

short and long strike. Since we received a credit for initiating the trade, our

maximum loss will be reduced by the amount we collected in the beginning.

Going back to our previous example, if SPY is trading at $124 on expirationday, both our short 127 and long 125 puts will be ITM. Our short 127 put will

be worth roughly about $3.00 while our long 125 put will be worth roughly

about $1.00. To close our put position to avoid assignment, well have to buy

back our short 127 put at $3.00 and sell our long 125 put for $1.00 incurring a

loss of $2.00. However, since we collected $1.00 for initiating this Iron Condor,

our loss is only $1.00.

Since our maximum possible loss is $1.00, our margin requirement will be

$100 per contract. Because an Iron Condor is made up of two vertical spreads,

some less-informed brokers will require margin for both your call and put

spreads. Option orientated brokers, however, know that you can only lose onone side and require margin for only one of the spreads. You seriously should

consider changing to a better broker if your current broker requires you to

margin both sides for an Iron Condor.

Margin required = Difference between the strikes Net credit received.

Lower Break-even point = short put strike net credit received

Upper Break-even point = short call strike + net credit received


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Expected Returns

Iron Condors when set up properly can generate consistent profit month after

month no matter where the market goes. As shown in the previous example,

our maximum profit for that Iron Condor is $100 per contract and our

maximum loss is also $100 per contract. In essence, we are risking $100 to

make $100; our risk/reward ratio is 1: 1. If the probability of SPY trading

between $126 and $134 is more than 50%, we can expect positive expected

returns. What this means is: if we were to put up this trade month after

month, we are guaranteedto profit in the long run. Yes, guaranteed! I dont

use the word guarantee freely, but in this example, the mathematics behind

the trade guarantees that it will make money in the long run.

More accurately, it has to do with high school statistics. In high schoolstatistics, we learnt that expected value (mean) is equal to the sum of the

payoffs multiplied by its own probability.

This can be summarized by this formula:

Now, lets say the probability of SPY trading between $126 and $134 is 51%when we initiated the trade (as illustrated in the diagram below).

Our risk/reward can be easily summarized by this table:

Profit

Loss

Price127125 135133

$100

-$100

126 134

51%

E = P( = )


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Payoff +$100 -$100

Probability 0.51 0.49

Our expected returns can then be calculated this way:

Expected returns = (0.51)($100) + (0.49)(-$100) = $2

What this means is that we expect to make a positive return of $2 per trade.

Whenever we have a positive expected return we say that odds are in our

favor.

By the Law of Large Numbers, if we keep playing this game with these odds

forever, we are guaranteedto make money.

Think about it this way. If you and a friend were to play a game of tossingcoins: if it turns up head you win $1, tail you lose $1 to him. How much do you

expect to win? Well, the answer will depend on how many times you are going

to play. If you are only going to play this game once, you may win or lose that

$1 with equal probability. That is 100% profit or loss on your risk! That is a 1:1

risk/reward ratio.

Now, lets say you are going to play 1,000 rounds of this game. How much do

you expect to win or lose? You dont have to be a math genius to guess the

answer isnt it? The answer is zero. You dont expect to win or lose because

you are expected to lose 50% of the time. Even if you play this game infinite

number of times, you and your friend will get nothing more than tired fingers!

The more rounds you play, the closer you will get to zero. The Law of Large

Numbers states that! This scenario can be easily simulated by a scientific

calculator.

Let us change the situation a little, lets say you start with $50 and your friend

starts with $10 to play this game until someone becomes bankrupt. Who do

you think will become a bankrupt first? The answer is doubtlessly your friend!

Even though the two of you have equal probability to win from each other,

simply because you started with significantly more money than him, he will

become bankrupt before you!

Let us dwell into this a little further. Now lets say the coin is rigged, I dont

know how you can rig a coin but let us just say that the coin is rigged, and it

will turn up head 51% of the time (now you have a 51% chance of winning $1

for each round). Nothing changes; you will still start with $50 and your friend


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with $10, your friend will still become a bankrupt before you. The only

difference is hell become a bankrupt FASTER!

This is precisely how casinos make money! It is common knowledge that all

the games in a casino are not fair gamesthe house always has a betterchance of winning! Even if the games are fair, you will still go bankrupt first if

you play infinite number of rounds because you start with a smaller capital vis-

-vis the casino! The unfair games simply make you bankrupt at a faster rate!

This is known as the Gamblers Ruin.

Of course, youve heard stories of people who won millions from casinos. Yes,

these stories are true and casinos always pay up promptly. Casinos dont lose

any money by paying the winners because they know for sure the winners will

come back and play some more and because the more they play the more

they lose, the casinos will make back their money.

Even if the winners dont return to play some more, the casinos will have

thousands of other punters to pay for the winnings. That is the reason casinos

are open 24 hours a day, 7 days a week. It is to ensure that the Law of Large

Numbers works.

That said, Iron Condors with positive returns are extremely difficult to find. But

they do exist.

Risk/Reward Ratio (R3)

At MarketNeutralOptions, we pay close attention to the very important

Risk/Reward Ratio, which we term it R3 for short.

You dont have to be a math genius to calculate this ratio. To put it simply, it is

merely the number you get when you divide your risk by your reward

potential. The purpose of this ratio is to let you have a good idea of the risk

you are undertaking for the reward that you can get.

It should not be too difficult to tell that the higher the R3, the higher the risk

you are undertaking and therefore, the lower the R3, the lower the risk you

are undertaking.

R3 = Total RiskTotal Potential Reward

Main Points Risk/Reward Ratio is

known as R3.


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Do note that the R3 is most useful for trades with defined risk and profit. It will

not be useful to use the R3 on a long call, which has unlimited profit potential,

or a short put, which has unlimited risk.

There are two types of iron condors that we trade here atMarketNeutralOptions. The High R3 and Low R3 iron condors. When an iron

condor has a R3 of less than or equal to 2, it is a Low R3 iron condor. When an

iron condor has a R3 of more than 2, it is considered a High R3 iron condor.

High R3 Iron Condor

For example, we can set up an iron condor with a profitable probability of 90%

(see illustration below), maximum profit potential of $10 and maximum loss of

$90. In this case, well be risking $90 to make $10. Therefore, the R3 for this

iron condor is90

10 = 9. This R3 of 9 tells us immediately that were risking $9 forevery $1 we make. As you can see from the P&L chart below, high R3 iron

condors will almost always come with high probability of success. However,

this is not a wise iron condor because we are risking too much to make too

little.

At MarketNeutralOptions, we dont normally trade iron condors with a R3 of

more than 5. Most of the time our high R3 iron condors have a R3 of between

3 and 4.5.

Profit

Loss

Price

$10

-$90 90%

Main Points MarketNeutralOptions

Advisory Service tradesmainly 2 types of ironcondor: high R3 ironcondors and low R3 ironcondors.

When R3 is less than orequal to 2, it is a low R3iron condor.

When R3 is more than 2, itis a high R3 iron condor.


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A typical iron condor with a R3 of 3 to 4.5 will have a P&L chart that looks like

the one shown below (Chart 1).

Chart 1: RUT iron condor P&L.


As you can see from chart 1, this is a 10-point wide iron condor trade on RUTfor $2.30 credit. The maximum risk for this iron condor is $1,000 per position.

Because we took in $230 in credit, our maximum risk for this iron condor is

reduced by $230 to $770. This iron condor has a R3 of770

230= 3.35.

For high R3 iron condors, we usually aim for at least 68% probability of

success. At 68%, we are aiming for one standard deviation range. We normally

try to initiate such iron condors 30 to 40 days before expiration. It is a well-

known fact that options decay the fastest during their last 30 days. If we were

to initiate such an iron condor with less than 30 days to expiration, it is very

likely that well get a higher R3 if we want a probability of at least 68%.

From the P&L chart above, you can see that we are risking $770 to make $230

with a probability of success of 71.34%. This gives us a negative expected

value of $56.60 [($230 X 0.7134) ($770 X 0.2866)]. What this means is that

we are losing $56.60 for every position we put up. Before you start thinking

that its foolish to enter such a trade, you may wish to know that our high R3

iron condors such as this example provide the most consistent returns.

Main Points We usually initiate high R3

iron condors about 30 to40 days before expiration.

We always try to aim for aprobability of at least 68%for high R3 iron condors.

High R3 iron condors havehigh risk but also highprobability of success.


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Although the probability theory paints a gloomy picture of this iron condor,

the trick is in managing it! For high R3 iron condors, we have to be ever

vigilant to major moves in the underlying. Because we are risking a lot more

than we can profit, all it takes is to suffer a maximum loss to wipe out 3 or 4winning months! If we were to practice a fire-and-forget strategy with such

iron condors, we will be helplessly governed by the probability theory and be a

guaranteed loser in the long run.

The way to defy the mathematics is to introduce human intervention. By this I

mean adjustments. The key lies in this: never ever suffer the maximum risk!

Yes, thats it! Thats the great secret behind the consistent returns that weve

been enjoying year in and year out.

The devil is, as usual, in the details.

First of all, it should be clear that the biggest enemy of a high R3 iron condor is

majormovement. This is why well normally avoid doing high R3 iron condor

with stock options. In fact, at MarketNeutralOptions, we only use index

options or index-tracking ETF options for our iron condors. This is because an

index represents a basket of stocks and is less likely to gap. Individual stock

options have the tendency to gap up or down when the company announces

their earnings. Index options and index-tracking ETF options do gap sometimes

but it is rare and less spectacular when compared with stock options.

After we put up a high R3 iron condor, the next most important thing to do is

to set up your defense. Think of your short options as your base camps and

the current price as your enemy. As your enemy (current price) moves closer

to your base camps, you would want to do something to prevent the enemy

from overrunning your base camps! A high R3 iron condor is usually dead if

your short Call or Put gets ITM. The idea is notto allow the short options to

get ITM (not to allow the enemy to overrun your base camps) at all cost!

To protect your base camps, we need to set up a perimeter that will provide a

kind of advance warning. For those Tom Clancy fans, its like setting up a

sentry or having an AWACS (Airborne Warning and Control System)!

Lets use the previous example or the RUT iron condor (Chart 1). You can see

from the P&L chart that we are shorting 860 Call and the 700 Put when the

RUT is trading at about 778. We will normally go at least 3% of the current

price away from our short options. In this case, 3% of 778 is about 23.34,

therefore well set up our fences at 30 points away from our short strikes.

Main Points Never suffer the maximum

loss for high R3 ironcondors.

Always trade high R3 ironcondors using indexoptions or index-trackingEFT options.

Be ready to adjust whenthe underlying gets tooclose to your short options.


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What this means is that were going to set a mental stop at 830 *860 30] and

730 [700 + 30].

When the RUT trades above 830 or below 730, it means that the enemy is

getting too close for comfort. Well have to reassess the trade to decide thenext course of action. Whether well adjust or close up the wing that is in

danger all depends on the existing market conditions. Remember, our main

objective is to prevent the enemy from overrunning our base camps (our short

options become ITM).

The way for high R3 iron condor to work in the long run is to be pro-active in

managing the position. It is usually too late to adjust if the underlying trades

pass your short options because you are risking a lot more than what you can

make.

Low R3 Iron Condor

As mentioned earlier, by low R3 iron condor we are referring to an iron condor

with a R3 of 1 to 2.

Lets take a look at a typical low R3 iron condor (see Chart 2).

Chart 2: IWM iron condor P&L.



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As you can see from the chart, this is a 2-point wide iron condor and thus, our

maximum risk is $200 per position. But because we collected $0.93 credit

($93), our maximum risk will be reduced to $107. What this means is we are

risking $107 to make $93, which will give us a R3 of 1.15 [107

93

]. From the chart

we can also see that this iron condor has a 50.40% chance of being successful.

Low R3 iron condors are less risky because we are risking about the same as

what we can potentially make. However, this lower risk brings about a lower

probability of success. How nice if we can have low risk and high probability at

the same time! Well, there is always a tradeoff. Otherwise who would want to

take our trade at the opposite end? Market-makers are not stupid you know!

For this kind of low R3 iron condors, we expect and should aim for a

probability of about 50%. The higher the R3, the higher the probability of

success should be.

The difference between a low R3 and a high R3 iron condor lies mainly in the

way we manage them.

We normally initiate a low R3 iron condor about 20 to 35 days from expiration.

When implied volatility (IV) is high, we can set up such an iron condor with

only 20-odd days left to expiration.

For low R3 iron condors, we normally avoid adjustments since any adjustment

will most probably increase the risk. We can normally be more patient withlow R3 iron condors. There is no need to set up defense for this kind of iron

condors because we are not looking for signs to adjust. In fact, the way to deal

with this kind of iron condor is use its price.

Using the example from chart 2, when we initiated the trade, the iron condor

was trading at $0.93. Well close up this trade when it starts to trade 40% to

50% more than what it was. In this case, well close up the trade when this

iron condor is worth more than $1.30.

Again the key is not to suffer the maximum loss. However, it can be very

frustrating when the underlying falls back into the profitable range afteryou

close the trade becauseit hits your stop.

Exit Strategy

When set up properly, it is best to leave the iron condors alone and let the

positive theta do its magic.

Main Points A low R3 iron condor has

lower risk but also lowerprobability of success.

We should always aim forabout 50% probability ofsuccess.

Main Points Try not to adjust a low R3

iron condor. A low R3 iron condor can

be initiated about 20 to 35days before expiration.

Use price as a guide todecide when to close thetrade.


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It is possible to leave the condors to expire worthless if the underlying is far

from the short strikes. However, it would be wise to close up the trade once it

is trading at $0.20 or $0.30. Especially for high R3 iron condors, lock in your

profit whenever you can. No point risking a winning trade to try to gainanother $0.20 or $0.30!

Usually it will be wise to close out the entire position in the last 10 days before

expiration. You would have pocketed most of the profit if you can close it for

$0.20 or less.

In fact, when the market is trading low and your call spread is cheap, you can

close up the call spread first and then close up your put side when the market

bounces back up. Exiting this way will not incur higher margin. However, this

exiting style may reduce your profit substantially when not done properly.


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Double Diagonal

The set up of a double diagonal consists of shorting a call and put option in a

near month and long a call and put option in a far month with different strikes.

One can think of a diagonal spread as a combination of a vertical and calendar

spread.

A typical vertical

spread

A typical calendar

spread

A typical diagonal

spread

Call Call Call

Aug Aug Sep Aug Sep

135 135 135 135 135

134 Long 134 134 134 134 Long

133 133 133 133 133

132 Short 132 Short 132 Long 132 Short 132

131 131 131 131 131

For example, lets say SPY is trading at $130, a call diagonal spread could be

initiated by selling the Aug 132 call and buying the Sep 134 call. Do the

equivalent for the put side (sell Aug 128 put and buy Sep 126 put) and you

have a double diagonal!

A double diagonal can be initiated for a debit or a credit. A properly set up

double diagonal should involve either a small debit or credit of not more than$0.30 per trade.

In this example, the short 132 call serves as a hedge for the long 134 call. The

credit received from the short 132 call is being used to offset the price of

buying the long 134 call. Depending on the implied volatility at the moment,

this can be done for a small debit, for free or even a small credit.

There is a strong temptation to search for skews in implied volatility between

the near month and far month options to get a credit. In fact, some options

coaching programs out there specifically teach their students to look for suchskews! However, it must be emphasized that the rise in the implied volatility in

the front month also heightens the possibility of a large price movement in

one direction or the other. Always believe that the market makers are as well

informed as you if not better informed. The spike in IV for the front month

options is there for a reason. Especially for individual stock options, it could be

some imminent bad news or some takeover bid by rival companies that are

Main Points A double diagonal is a

combination of a verticaland calendar spread.

A double diagonal can beinitiated for a debit, creditor even money.

Volatility skew between

front month options andback month options shouldbe as flat as possible.


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not made public yet and thus the fear associated with it. It is generally a good

idea to avoid large implied volatility skews.

When we set up a double diagonal, we would want to have a flat implied

volatility skew between the front and back months. Of course that is notalways possible but we try to have it as flat as possible.

Roll

How does a double diagonal make money? The answer to that lies in the

ability to roll the double diagonal into an iron condor.

Lets say SPY is trading at $130 and we initiated a double diagonal by selling an

Aug 132 call and an Aug 128 put and buying a Sep 134 call and a Sep 126 put

for $0.10 credit.

We can get a credit for this trade because the options we sold are nearer to

the money (worth more) than the ones we bought even though the ones we

bought have more time value.

About 10 days before August expiration, lets say SPY is still trading at $130,

our short options (132 call and 128 put) will be worth very little since they are

not ITM and there is little time value left.

We can now buy back our short Aug 132 call and Aug 128 put for a small debit

(since they are worth very little now) and sell Sep 132 call and Sep 128 put.Since the September options have roughly about a months time value, theyll

be worth a lot more than their August counterparts.

By making this roll, we will receive more credit for the position. After the roll,

we are now short Sep 132 call and Sep 128 put and long Sep 134 call and Sep

126 put. We are now short an iron condor!

Why dont we simply put up an Iron Condor?

When we put up an iron condor, much of the credit from the sale of the shortoptions goes to purchasing the long options.

For a double diagonal, we are basically setting up our iron condor a full month

ahead. Think about it as we are setting up a September iron condor by buying

the September long options first. We then sell the August options to finance

our purchase of the long options for our September iron condor. This way, we

Main Points The roll turns a double

diagonal into an ironcondor.

Roll a double diagonalwhen the short optionshave very little time valueleft.


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can purchase our long options for our September Iron Condor at a very low

price, in some cases, maybe even free!

When we roll our double diagonal into a full iron condor, the amount of credit

we get will not be reduced by the need to purchase the long options. At thepoint of rolling, the credit we get for the September iron condor is usually

unattainable by simply shorting the same Iron Condor at that time. What this

means is that well get an iron condor for September for a very good price.

It is generally not advisable to put up an iron condor more than 40 days away.

Although we are, in effect, setting up a September iron condor even before

August expiration, we are not taking a paramount risk for this trade. This is

because we will not suffer our maximum loss at least until September

expiration. Our long options will always be worth some value before

September expiration. Even things goes horribly wrong, we can choose toclose the trade before we roll and we lose the small debit we paid to initiate

the trade. If we received a small credit for initiating the trade, we may even

come out totally unharmed after commissions.

However, do note that in extreme market conditions, there may be an

extreme spike in IV for the front month, and we may incur losses more than

the debit we paid to initiate the trade to close up the trade. This is rare but not

impossible. Although a double diagonal is long vega (makes money when IV

goes up), a more extreme spike in IV for the front month as compared to the

back month will be detrimental to the position. This is because the spike in IV

may cause the value of the front month (short) options to increase more than

the back month (long) options.

When to roll?

It is generally advisable to roll the short front month options in the last 10

days of their lifespan. This is when they are the cheapest if they are not ITM or

near the money. When you can buy back the short options for $0.15 or $0.10,

it is a good time to roll.

At the point of rolling, if the underlying is trading very near your short strikes,you may want to consider rolling up your call strikes or rolling down your put

strikes since it will still be quite some time for the next expiration to come.

Shorting an Iron Condor when the price of the underlying is so near the short

strikes is often not a good idea. Alternatively, you may choose to close up the

entire trade for a small gain, a small loss or even-money. This is the cool part

about double diagonal, even if you are dead wrong, you wont suffer a huge

loss. You may even have a small gain!

Main Points An iron condor that was a

result of a double diagonalroll is almost always abetter priced iron condor

that is impossible to attainby simply putting up thesame iron condor trade.


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Capital Requirements

Similar to an iron condor, a double diagonal requires margin. Unlike an iron

condor, whereby the maximum profit and loss is known at the moment of

initiating the trade, a double diagonals maximum profit potential can only beestimated at the moment of initiation. The maximum profit of a double

diagonal will be known only at the point of rolling.

As such, the margin requirement of a double diagonal will be the maximum

you can lose from this trade, that is, the difference between the strikes.

For our previous example, we initiated a double diagonal by selling the Aug

132 call and Aug 128 put and buying the Sep 134 call and Sep 126 put for

$0.10 credit, our margin requirement will be (134 132 0.10 = 1.90) $190.

Characteristics of a Double Diagonal

Like the iron condor, a double diagonal is market neutral and theta positive.

Both strategies make money when the market trades within a range and as

time passes.

A double diagonal is vega positive before the roll and vega negative after theroll. What this means is that a double diagonal increases in value before the

roll when implied volatility rises and loses value after the roll when implied

volatility rises.

A properly set up double diagonal should have a delta close to zero. You can

adjust the actual delta value by adjusting the distance between your short

strikes and the current price. For example, SPY is trading at $130 and you think

that SPY is going down. You want to have a directional bias in your double

diagonal. You can do so by moving your short call closer to $130 and your

short put further from $130 to generate more negative delta. If you have a

directional bias, a double diagonal is generally not a suitable strategy todeploy. A double diagonal and iron condor are best suited for market neutral

stance. Verticals will be more appropriate for directional plays.

Margin required = Difference between the strikes Net credit received.

Margin required = Difference between the strikes + Net debit paid.


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Conclusion

Many people tend to ask: which is better? Iron Condor or Double Diagonal?

Neither is better than the other, they are just different. When you use them

depends on market conditions. The best way to really learn them is to tradethem. Enter the trade, watch how it makes money and try to do it again and

again. Your learning journey will be much less tedious if you have someone

guiding you.

I sincerely hope that this e-book has in one way or another benefited you in

learning Iron Condor and Double Diagonal. Options trading is a never-ending

journey. I wont claim to know everything about options trading but I do know

this much to be able to share with you.MarketNeutralOptionsis glad to be

able to play a small part in your journey to financial freedom.
http://www.marketneutraloptions.com/http://www.marketneutraloptions.com/http://www.marketneutraloptions.com/http://www.marketneutraloptions.com/


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Appendix: An Introduction to the

Greeks in Options Tradingraders enter the market with two main preoccupations: risk and reward.

While it is usually easy to determine the reward in monetary sense, it is

generally more difficult to determine the risk involve in each trade.

Unlike stock, options are multi-dimensional investment vehicles. The value of

an option is determined by many different factors that are constantly

changing. For example, an options value is determined by

market neutral options strategy guide

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