OPTIONS LESSON: How to choose Option Spread Trades?


Choosing the right options spread is important to earn profits.


A trader can initiate a neutral long strangle if he/she anticipate implied volatility will rise (without being bullish or bearish).


Likewise, traders can establish a neutral short strangle if they expect implied volatility will drop (without being bullish or bearish). Or, they may prefer to establish a near-to-the-money iron condor.


It is important that each trader choose the strategy that matches his/ her volatility outlook. Also they must ensure that the strategy is suitable for his/her risk tolerance and account size.


STRATEGY SUMMARIES


Each strategy is summarised below:


• Long strangle

–      Out-of-the-money (OTM) long call

-       OTM long put

-       Greek values = positive gamma, negative theta and positive Vega

• Short strangle

–      Out-of-the-money (OTM) short call

–      OTM short put

– Greek values =negative gamma, positive theta and negative Vega

• Strangle swap

–      Short strangle

–      Near -to-the-money long strangle in a deferred month

– Greek values =positive gamma, negative theta and positive Vega

• Iron condor

–      Near -to-the-money credit call spread

–      Near -to-the-money credit put spread

– Greek values =negative gamma, positive theta and negative Vega

What is the meaning of the GREEKS values?


• Positive gamma = position benefits from market movement (it gets delta long on rallies and delta short on declines)


• Negative gamma = position gets delta short on rallies and gets delta long on declines


• Positive theta = money earned per day from positive time decay


• Negative theta = money lost per day from negative time decay


• Positive Vega = money earned if implied volatility rises 1%


• Negative Vega = money lost if implied volatility drops 1%

OPTION LESSON: Options Spread on NIFTY


Assume you open the following NIFTY position in June 2012:


• Long 100 Jul 4800 put


• Short 200 Jul 4700 puts


And


• Long 1 Aug 4500 put


You could describe this position as a Jul 4800 / 4700 put ratio spread along with a long Aug 4500 Put.


Or you could describe it as a Jul 4800 / 4700 debit (bear) put spread along with a Jul / Aug 4500 diagonal calendar put spread.


You can understand the dynamics better if Greeks are calculated –  In other words, the position is defined by its delta, gamma, theta and vega figures.


Here are its Greeks and required margin as of the close of business 18 June 2012

The position has a vega of 140%.

These Greek variables are important, since they describe how the position will respond to market movement (delta and gamma), to the passage of time (theta), and to changes in implied volatility (vega). They also help us to know how to adjust positions.