Beginning this Month, every Thursday the Monthly Cash Machine will be adding educational articles on various option strategies and general option information. These articles will include general option educational materials as well as specific option strategies from time to time.
Playing the middle against both ends, with the insurance of knowing what your maximum risk will be.
The Theory behind the Practice
Sometimes it is better to play the middle against the ends, especially when you have a stock that you feel is really not going anywhere or is stuck in a trading range. The combination double spread works similar to the straight naked combination. However, you can tell by its namesake that this is going to be a lot safer transaction than selling naked calls or puts. Basically, we are establishing risk and rewards with the anticipation that our stock will trade in a range and have both our call and credit spread expire worthless and keep the premiums. The strategy for this trade came about when in 1987 and again in the great Tech Wreck, individual traders would love to sell naked combinations and have a stock trade between a given trading range with both the written call and put expiring worthless and the seller collecting both sides of the premium. However, if one feels that naked call and put combination writing is the way to go, let me remind you of what can happen if you are NAKED the call or the put side. Unlimited losses on the call side and devastating losses on the put side. I only need to mention several high tech issues that fell by the wayside and told many a trader's account values along with them. The combination double spread alleviates the fear of the catastrophic crash or untimely buy out or merger. The strategy is very simple instead of trading anything naked you put on two credit spreads, one on each side of the market using puts and calls. Examine this hypothetical situation for a moment.
Let's say you think company MANX is going to lay flat in a trading range or slightly move up or down very little in the next 30-45 days. Well here is a little strategy that you might want to try with several issues, especially if you have a strong feeling that their performance is going to take them no where fast. Let's say MANX is trading at 65 and has been in a trading range between 60 and 70 for the last 6 months. In fact, the whole market has seemed to be just going nowhere, but you want to profit from this stagnation.
Well here's your opportunity. What we are going to do is to sell a MANX call spread
by doing the following:
Sell 10 MANX MAR 70 Calls to Open @ 3 and
Buy 10 MANX MAR 75 Calls to Open @ 1.
This we can do for a net credit of 2 times 10 contracts or a total net credit of $2,000
In addition, we will simultaneously execute the following:
Sell 10 MANX MAR 60 Calls for 2.75 and
Buy 10 MANX MAR 55 Call for 1
This we should be able to do for a net credit of 1.75 times 10 credits or a net credit of $1,750.
This should give us for the two spreads or 4 transactions a Total net credit of $3,750.
Now our goal here is to have MANX, which was trading at 65 when we made our trade, to close at the end of the March expiration between 60 and 70. If this happens all the options expire worthless and we keep the premiums.
MARGIN ISSUE: Although MANX cannot close at both above 70 and below 60 at the same time. The margin requirement for this trade is the difference between the strike prices and the premium received. Unfortunately, unlike a naked combination, where you are only marked against the mark on one side, you must put up the margin requirement for both the call and the put side. (Just a house requirement, doesn't make much sense, as they can at best only go against you on one side.). Check around, there are brokers out there that will only charge you a margin requirement on one side, not both. Anyway, the house requirement would be $300 per contract times 10 on the call side and $325 per contract times 10 on the Put side for a total margin requirement of $6,250. However, the most you would ever be at risk is $5000, which is the difference between the two strike prices on either side. Remember MANX can't close BOTH above $70 and below $60 on expiration. MANX can only close at one price. So one of the sides has to expire worthless. So your net loss would be $5000 less then $3,750 premium you received on an out of pocket maximum loss of $1,250.
IMPORTANT: It is important to put both sides of the trade on at the same time. (However, there are always exceptions to the rule.) This can get a little sticky if you try to be too cute with your entry points. If at all possible enter all 4 trades with a total net credit. This way if all 4 transactions do not get executed you will not be left owning one side of the spread, while failing to execute the other side, which may now have gotten away from you. Secondly, it is preferable not to try and guess which way the market is going to go and try to leg on these positions one at a time or by buying the long positions and then selling the shorts. You may guess right, but if you don't, the whole rationale for the trade could be tarnished and you might end up not getting enough premium as you thought or enough to make it a viable play.
Anyway, if MANX closes between 60 and 70 you keep the premiums. If it closes above 70 or less then 60 your loss is $1275 (plus transaction fees, but no more, even if the stock goes to zero or up to infinity.)
The perfect strategy for the stagnate market.
Now that you understand the theory, lets look at a HYPOTHETICAL scenario that you can follow using a household stock name, with a hypothetical chart and hypothetical numbers.
The HYPOTHETICAL Example
CHART 1: Hypothetical chart of YAHOO
We will assume that Yahoo is hypothetically trading at 34.75
Let's take a look at this strategy using the issue Yahoo. For this transaction, we will be looking at the March series. We will put on the following credit spreads:
Buy (Long) Yahoo MAR 40 call @ 0.30 = $30 Debit
Sell (Short) Yahoo MAR 37.50 call @ 0.90 = $90 Credit
This gives a NET CREDIT of $0.60 = $60
We will be selling 20 contracts so our Net Credit = $1,200
Sell (Short) Yahoo MAR 32.50 put @ $0.60 = $60 Credit
Buy (Long) Yahoo MAR 30 put @ $0.20 = $20 Debit
This gives us a NET CREDIT of $0.40 = $40
We will be selling 20 contracts on the put side as well for a Net Credit = $800
Our total credit from both spreads is $2,000
Our net positions should look like the following:
10 Buy (Long) Yahoo MAR 40 call @ 0.30 = $30 Debit
10 Sell (Short) Yahoo MAR 37.50 call @ 0.90 = $90 Credit
10 Sell (Short) Yahoo MAR 32.50 put @ $0.60 = $60 Credit
10 Buy (Long) Yahoo MAR 30 put @ $0.20 = $20 Debit
TOTAL NET CREDIT = $2,000
In addition lets see what are maximum gain, maximum loss, breakeven and margin requirements look like after we have successfully put on this trade.
FIGURE 1: Combination Double Credit Spread AKA "The Iron Condor"