Cue up the hyperanalysis, there’s some VIX OTM call trading going on……

The CBOE Volatility Index (.VIX) is down .28 to 20.88, as the S&P 500 (.SPX) has traded in a relatively narrow 10 point range Tuesday. The S&P 500 is nearly unchanged midday. In the options market, VIX July 42.5 calls are the day’s most actively traded contract, with more almost 87K traded. A lot of that volume is due to ratio spread trading, where a strategist was apparently bought 4 July 42 calls for every 1 (short) July 32.5 call. More than 25K July 32.5 calls have also traded today. They paid $1 per 1×4, according to a contact on the floor. The position is tied to VIX futures at 32.6 (might be a roll of long calls).

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Erin asked:

Let’s also assume that the short option is 10 points farther OTM than the long option.

The last assumption is that we will exit a position as the adjustment of choice.

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Iron Condor

With an IC, you are short a call spread that can become worth $1,000 (worst case); and you sold it for far less.  Our responsibility as risk manager, is to prevent that (or any similar loss) from happening.

The danger occurs as GOOG approaches 440.  If holding or closing the trade is the only consideration, I recommend establishing a maximum acceptable loss, and if and when that point is reached, exit.  That may when the call spread reaches $4, or $5, or whichever price your comfort zone allows. [Remember that if you bought the IC and collected $3 originally, then paying $5 is not the disaster it would be if you collected only $1.]  Your decision is when to pull the trigger.

Ratio Spread

With a ratio spread, you face a far different situation.  This time you own the 440s and are short twice as many 450s.

There’s the good news:  You own a spread that is ITM and is heading towards the point where it will reach maximum value of $1,000 (if it remains there at expiration).  So that’s a better situation than you faced with the iron condor.

But, you are short two calls instead of only one, and the second is a naked short. Some brokers do not allow customers to carry naked short call positions.  But, if you are allowed to do so, it’s considered to be a risky trade and I no longer allow myself to own such positions, but that’s not the point of this discussion.

Once GOOG moves past 450, then the naked short option quickly eliminates any profit you had from the 440/450 call spread [Mentally breaking this trade into two parts: the call spread and the naked short].  In fact, if there is much time remaining before the options expire, the position quickly turns into a  loser, with the loss mounting as the stock rises.

When there’s very little time remaining, the position still has terrible negative gamma, but the limited time prevents the extra 450 call from exploding.  If time runs out (the market closes on expiration Friday), and if GOOG is under 460 (your break-even point if you paid zero cash to establish the position), things are not too bad.  Obviously, a lower price is better.

The major factor in deciding whether to hold or exit is going to be time.  With expiration rapidly approaching, you may still want to exit because you probably have a profit (although it’s only risk that should matter, but I know that most traders only want to know if they have a profit or loss, and risk be damned.  This is not good thinking, but it is the way the world turns).

Thus, it’s possible to have a good profit as the stock moves towards 450, and that profit possibility makes this trade look ‘better’ than the iron condor – which has virtually no chance of being profitable as GOOG moves towards 440 – a full 10 points lower!

The ratio has a higher profit range, but there is that ‘unlimited loss’ possibility that makes it more dangerous to own.  In response to your question Erin, I’d rather have the adjustment decision with this position than with the iron condor.

This is just another personal comfort zone decision.  The optimist  understands that the stock is currently at its sweet spot, but danger looms.  The pessimist sees the danger, and may fold in the name of safety.

These are interesting positions to own, but I have removed them from my arsenal of strategies – just because I do not want to face a margin call (whcih can happen as the stock rises) or a nightmarish stock market opening gap.

Broken-Wing Butterfly

With a BWB, you are short a 20-point spread, and the maximum loss is $1,000 less the premium collected to open the trade.

This is essentially the same as the ratio spread, but this time you are not naked short any options.  You own the 470 call and there is neither a potential margin call nor an unlimited loss in your future.

I’d treat this spread the same as the ratio spread because it is the ratio spread.

Erin,

I hope that helps.  The iron condor is really the odd man out.  The other spreads are similar to each other and the IC trades very differently.  IMHO, the ratio (better yet the BWB) is easier to adjust because time is THE consideration.  Iron condors are risky at all times (if the short strike is approached).

In our never ending quest to keep you as option-informed as possible, we will be adding some occasional content from WhatsTrading.com. Such as

iShares Brazil Fund (EWZ) December 35 put is among the most actively traded contracts in the first hour of Thursday’s session. 30K traded so far. Most of the volume is due to one spread, where a strategist bought 15K Dec 45 puts and sold 2X more Dec 35 puts. They paid $1 even for this bearish 1X2 put ratio spread. EWZ is up 17 cents to $53.17.

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Let’s look at some pictures.

Short Straddle

This is the profit and loss chart for selling a straddle, where the 175 call sells for $1.60 and the 175 put sells for $1.20. Total premium received is $2.80. If the stock ends the day at 175, that will be the return on the trade.

Since we receive $2.80 in premium, our break even points are $175 plus $2.80, or $177.80 and $175 – $2.80 or $172.20. Outside of that range, the trade loses money.

Return For A Short Straddle

Ratio Spread

What if instead of selling straddles we put on a ratio spread? That is, when the stock is at $175 we buy one in-the-money call with a $170 strike and sell three at-the-money calls with a strike of $175. The $170 call will cost $5 since it is deep in the money with no time left, and the $175 calls might sell for $1.60 as we saw above. In this case, we receive $4.80 and pay $5 so net we have to pay $0.20.

As you can see below, that is our exposure to the downside. If the stock rallies past $175, we are protected until the stock gets to $177.40. At that point, the 170 call that we are long is worth 7.4 and the three 175 calls we are short are each worth 2.4. So the three of them are worth -7.2 and we paid .2 for the position. So our break even point on the upside is $177.4 and on the downside $170.20.

Return for Ratio Spread

So the ratio spread has a wider range where it is profitable and very little downside risk. On the upside. it loses money faster than the short straddle.

If you wanted the mirror image of this return, $0.20 loss if the stock goes above $177 and the large losses if the stock falls below 170, Then you could buy the 180 for $5 put and sell four 175 puts for $1.20 each. This is more dangerous because we had to sell four puts to take in the same premium we got from three calls.

It all depends on where you think the danger lies.

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