- 1997: Volume 6, No. 1 Advanced Strategies for Managing Index Option Positions

Two traders are talking. Trader one says, "I've got these calls and am wondering what to do."

"Look," says Trader two, "You can hold 'em or fold 'em or double up. That's all you can do. Take your pick."

Are there alternatives other than these three? You bet there are!

This article will first define what "managing positions" means. Second, three strategies will be explained in a practical, trading context with both their positive and negative aspects discussed. Finally, other considerations that traders must consider will be presented.

Managing Positions

The term "managing" means changing the risk profile of a position. Every position has a profit potential, a risk potential and a break even point. Any action will change all three.

Consider our first trader, Sally. She bought two calls last week at five each and is pleased to see them trading now at seven. Sally's initial break even point was five. If she sells one at seven, however, she can hold her remaining call until it falls to three before having a losing trade.

Of course, it also works the other way. Bill, our second trader, is unhappily wondering what to do with a long position. A few days ago he purchased two puts at eight each, and they are now trading at six. The decision to sell one means that he cannot break-even on the entire trade until his remaining put rises to 10.

"Doubling up" is another "managing" strategy which typically means adding to an unprofitable position by an amount equal to the original trade. The benefit of doubling up is lowering the break even point. The negative aspect is that total risk has been increased.

The following strategies are only three of the many possibilities for option traders. The examples presented involve additional risks beyond those of purchasing options, and are suitable only for experienced traders who meet the highest risk requirements of many brokerage firms. Also, transaction costs, margin requirements and tax considerations are not discussed in these examples. These considerations can affect the desirability of entering into options transactions and should be fully examined before engaging in any strategy involving options.

To illustrate the following managing alternatives, consider the situation of Don who trades OEX options, which are American style cash-settled options on the S&P 100 Index. Don bought an OEX 760 call for 12-7/8 when the OEX was at 750 with 40 days until expiration. It is now 28 days to expiration, the OEX has risen to 762, and Don's call is now trading at 16. Of course, Don can sell his call at 16 and realize a profit of 3-1/8 (before transaction costs), but he is reviewing the OEX Call prices in Table 1 and looking for alternatives.

Alternative 1: Create a Call Spread

Exhibit 1 illustrates a managing technique in which a long call is converted into a long call spread by selling a call with a higher strike and same expiration. Don's call cost 12-7/8, broke even at expiration at an OEX level of 772-7/8 and had unlimited profit potential. By selling the OEX 770 Call at 11-1/8, Don reduces his net cost to 1-3/4 and his break even point at expiration to 761-3/4, but he also limits his profit potential to 8-1/4.

Figure 1

In order to establish an OEX call spread, Don must be qualified by his brokerage firm to assume the risk of selling American style index options which are subject to the risk of early assignment. The theoretical risk of call spreads with American style cash-settled options is greater than the net investment, because notice of an early assignment is not received until the next morning by which time the market may have moved significantly. If, however, Don is suitable for these risks and willing to assume them, he may determine that, given his forecast, the benefits of creating a call spread outweigh the risks.

Table 1

OEX Call Prices OEX 762, 28 Days to Expiration 17% Volatility
Strike 760 Call 770 Call 780 Call 790 Call	Bid - Ask 16 - 16-1/2 11-1/8 - 11-1/2 7-1/4 - 7-1/2 4-3/4 - 5

Alternative 2: Creating a Butterfly Spread

A long call butterfly spread consists of a long call of a lower strike, two short calls of a middle strike and a long call of a higher strike. The calls have the same expiration and the middle strike is half way between the lower and upper strikes. A four-option position involves significant transaction costs which make it prohibitive for options traders who do not trade a sufficient quantity of contracts to qualify for commission discounts. It is therefore imperative to examine in advance the costs of this strategy. A butterfly spread involving American style index options also entails the risk of early assignment on a short call as described above.

By selling two 770 Calls at 11-1/8 each and buying one 780 Call at 7-1/2, Don receives a net credit of 14-3/4 which is more than the initial 12-7/8 cost of his 760 Call (not including transaction costs). An expiration profit and loss diagram of Don's butterfly spread assuming neither of the short 770 Calls is assigned early is presented in Exhibit 2. The maximum theoretical profit occurs if the OEX settles exactly at 770 at expiration and the spread remains in place without an early assignment. Since it is not very likely that the OEX will settle exactly at 770 at expiration, a trader who uses this strategy must be forecasting the index will trade in a range "near" the middle strike of a butterfly spread.

Figure 2

Alternative 3: Creating a Condor Spread

Condor spreads are sometimes referred to as "elongated butterflies." A long call condor spread consists of a long call of a lower strike, one short call of a second strike, one short call of a third strike and, finally, a long call of a fourth strike. The calls have the same expiration, and the strikes are equal distance apart. Condor spreads, like butterfly spreads involve significant transaction costs which make it prohibitive for option traders who do not qualify for commission discounts. The cost of this position must be examined before establishing it. A condor spread involving American style index options also entails the risk of early assignment on a short call as described above.

By selling one 770 Call at 11-1/8, selling one 780 Call at 7-1/2 and buying one 790 Call at 5, Don receives a net credit of 13-5/8 which is more than the initial 12-7/8 cost of his 760 Call (not including transaction costs). An expiration profit and loss diagram of Don's condor spread is presented in Exhibit 3 assuming neither of the short calls is assigned early. The maximum theoretical profit of 10-3/4 occurs if the OEX settles between 770 and 780 at expiration, and the spread remains in place without an early assignment.

Figure 3

How to Choose?

So now that Don has three alternatives to taking his profit in this example, which should he do? Which is best?

The bad news is this: there is no "best" alternative! Each alternative offers different trade-offs, different combinations of positives and negatives. The call spread takes in the lowest credit and has the lowest profit potential. However, the call spread has the greatest chance of achieving its maximum profit potential, because that profit is achieved at any index level above 770 at expiration, assuming the short option is not assigned early. The butterfly, in contrast, has the highest theoretical profit potential of the three strategies, but that profit is achieved at only one index level at expiration. The profit potential of the condor spread is in between that of the call spread and the butterfly. This is logical, because the condor's profit potential is achieved over a range between 770 and 780, and there is a greater chance that the OEX will settle within a range than at one point.

We have given Don more alternatives, but we have not made his job any easier! He must still make a forecast, choose a strategy which, in his estimation, is best suited to that forecast. And he must live with the risk that his forecast will not be realized.

Other Considerations

Traders who use these strategies must treat them differently than outright purchases and sales of individual options. Butterfly and Condor spreads are not "trading vehicles." These positions take time to "work." Consequently, when a long option is converted into one of these positions, the trader must consciously decide to "hold" rather than "trade."

In addition, these strategies behave differently when market conditions change than individual option positions. They have different deltas (sensitivity to market movement), different thetas (sensitivity to time decay) and different vegas (sensitivity to changes in volatility). Consequently, even experienced traders would be well advised to study these strategies with an option pricing computer program prior to implementation.

One possible approach to using these strategies is to remember there is no requirement to do 100% of anything. When thinking of taking a profit on a long option position, why not consider taking off half of the position and create a spread with the other half? In this way, there will be a realized profit and additional profit potential at the same time.

Summary

This article has introduced the concept of managing positions as taking action to change the profit potential, risk and break even point of a position. The strategies presented offer viable alternatives for experienced traders who are qualified to assume the risk of early assignment of short American style index options. There is no "best" alternative. Every strategy has its own set of trade-offs.

James B. Bittman is an instructor at The Options Institute, the educational arm of The Chicago Board Options Exchange and the author of Options for the Stock Investor. His second book, Trading Index Options, will be published by McGraw-Irwin in November 1997, and will include the option pricing and graphing software Op-Eval3.