Chapter 3-2 Complex Multi-Leg Strategies

Complex multi-leg options strategies involve buying and selling multiple options to construct a strategy that will meet your investment needs.  Unlike basic strategies that mostly seek to profit from moves in the underlying asset, complex strategies can be designed to profit from a wide variety of outcomes.  Some of the most common complex strategies look to profit based on volatility, the passage of time, changes in implied volatility, and even stagnation.  Multi-leg strategies are amongst the most adaptable financial instruments available and carry great appeal.  However, they also carry unique risks and it is important to know exactly how they work before putting any capital to work.  The following section will cover the risks and rewards associated with complex multi-leg options strategies and provide examples to aid your understanding.

Butterflies and Condors

Would you like to…

  • Be able to profit from range-bound markets?
  • Take advantage of high option premiums?

Butterflies and Condors spreads are trades intended to take advantage of a neutral outlook and/or high implied volatility.  They involve buying two options, at a net debit, to establish a position which profits if the underlying asset stays within a given range.  As debit positions, the maximum risk and reward are known from the outset of the trade.  The risk is equal to the debit paid for the trade, and the maximum loss is incurred if the underlying asset moves too far in either direction.  Although these strategies are considered more advanced because of the more complex construction – essentially they combine two vertical spreads, one being a credit spread and the other a debit spread – butterflies and condors have lower risk than call and put selling.

Butterfly and Condor spreads can be constructed with either calls or puts.  Long butterflies using calls involve three strikes: you buy one call at a high strike price, one call at a low strike price, and sell two calls at a middle strike price.  Thus, you are combining a vertical bull call spread and a vertical bear call spread with the short calls at the same strike.  Condors also combine a bull call spread with a bear call spread, but separate the sold calls by at least one strike price.  As a result, condors have a wider range of profit but also cost more.  Both spreads are constructed for a net debit.

Consider the following two examples:

A MSFT butterfly would be constructed by buying a 27 call, selling two 28 calls, and buying a 29 call.

A MSFT condor would be constructed by buying a 27 call, selling a 28 and a 29 call, and buying a 30 call.

Butterflies and Condors are profitable in a limited range around the strikes of the options sold.  The trade can be set up with a bullish, bearish, or neutral bias.  The spread profits from a fall in implied volatility before expiration.  In this instance, time decay is on your side and actually increases profit.  The maximum profit will occur if the underlying asset is priced at the strike price of the sold options for a butterfly, or anywhere between the two short strike prices used for the condor upon expiration.  Butterflies and Condors spreads lose money if the underlying asset moves too far in either direction.  The maximum loss is the debit paid and occurs if the underlying moves beyond the strike price of either of the long calls.

Consider the following example:

Option

Action

Option Price

Net Cost

MSFT June 27 Call

Buy 10

0.625

+ $625

MSFT June 28 Call

Sell 20

0.3

– $600

MSFT June 29 Call

Buy 10

0.225

+ $225

Total:

$250

  • With Microsoft (MSFT) stock at $27.65, a trader could establish a butterfly by purchasing 10 contracts of the June 27 and June 29 calls, while selling twenty June 28 calls for a net debit of $250.
  • The cost of the butterfly, $250, represents the maximum loss.
  • The maximum profit at expiration is $750; this will be realized if the price is right at $28.

Example of a Winning Butterfly Trade

  • Let’s say the above MSFT butterfly was bought for a net debit of $250.
  • If MSFT is $27.64 at expiration (that is, unchanged), the profit would be $401.50.
  • If MSFT is at $28.75 or $27.25 the profit would be $0.  These are the break-even points.
  • The maximum risk is the $250 we paid; this is realized if the stock price is above $29 or below $27.

This can be shown graphically:

Example of a Losing Condor Trade

Option

Action

Option Price

Net Cost

MSFT June 26 Call

Buy 10

1.25

+ $1250

MSFT June 27 Call

Sell 10

0.625

– $625

MSFT June 28 Call

Sell 10

0.3

– $300

MSFT June 29 Call

Buy 10

0.225

+ $225

Total:

$550

option-content-image-3-2-1

  • Now let’s say we bought ten contracts of the June 26 call, sold the 27 and the 28, and bought the 29 for a net debit of $350.
  • If MSFT is between $27 and $28 at expiration, the maximum profit of $450 will be realized.
  • If MSFT is at $26.55 or $28.45 then the profit is $0.  These are the break-even points.
  • The maximum risk is the $550 paid and would be realized if the stock is above $29 or below $26.

This can be shown graphically:

option-content-image-3-2-2

Butterflies and Condors spreads:

  • Provide a known and fixed maximum gain and loss.
  • Are used in cases of high implied volatility with the expectation of range-bound underlying assets.
  • Can be implemented using either puts or calls.
  • Take advantage of high implied volatility (seen as likely to fall) and time decay.
  • Require three or four strikes and therefore are expensive in terms of commissions and/or contract fees.
  • Condors have a wider range of profit and as a result are more expensive.

Straddles and Strangles

Would you like to…

  • Be able to profit from big moves – up or down?
  • Take advantage of increasing volatility?

There are times when you just know that a big move in a stock is coming – the problem is that you don’t know which direction.  Wouldn’t it be nice to have a strategy that could profit from such moves regardless if they were up or down?  Long “straddles” and “strangles” fit the bill.  The strategies are designed to profit from volatility, sharp moves in the underlying asset either up or down.  They are constructed by buying both calls and puts on the same underlying asset.  These are some of the most expensive options strategies to construct, but the maximum risk is known and fixed.  Time decay and drops in implied volatility are the biggest threats to the strategy.

What are Straddles and Strangles?

Constructing a straddle entails buying an at-the-money call and an at-the-money put with the same strike price and expiration.  The idea is that should the underlying significantly increase or significantly decrease, one of the options will expire worthless while the other will appreciate in value enough to compensate for the loss, ideally enough to earn a profit.  A strangle takes the same approach, but uses an out-of-the-money call and an out-of-the-money put to reduce the cost.  Although this is a lower-cost trade, it requires an even greater move to be profitable.  Straddles and strangles profit most from significant moves up or down in the underlying asset, however a rise in the implied volatility will also increase the value of a straddle or strangle.  Because you are paying two premiums and thus buying time value on both sides, the stock usually has to move considerably to produce big profits.  Implementing the strategy simply involves buying a put and call with an expiration that gives the trade enough time to work.  Straddle/strangle buyers are best served by closing out their positions as expiration gets close as that is when time decay is greatest.  The final thing to consider is that the best time to buy options is when implied volatility is low.  This is particularly important when constructing straddles and strangles as they involve purchasing multiple options with no offsetting credits.  As with other long-only options strategies, the maximum risk is the sum of the premiums paid when constructing the strategy.

This strategy fails if the stock price does not move enough to offset the time decay or implied volatility falls causing the premiums to depreciate.  If the implied volatility drops the position can also lose value, even if the underlying asset moves.  This is the reason that buying straddles or strangles before earnings (or other news) can be a risky strategy.  Even if the stock moves, the drop in implied volatility that often happens after earnings are released can more than offset the gain from the move in the underlying.

Consider this example that employs a 26 straddle bought for $2.23 while the stock price was $26.25.  (Note that the option strike is unlikely to be exactly the same as the share price.) The position shows a profit if the stock price has moved beyond the strike prices used, plus or minus the debit paid to establish the call and put positions (26 +/- 2.23).  Once this has occurred most traders will look to take profits off the table as time decay will inherently decrease the value of the position as it is held longer.  Some traders may choose to sell the option that has failed (call if the stock has gone down, put if the stock has gone up) to recoup some of the premium, but this is risky if the stock reverses as you will no longer benefit from having both a call and a put.

The longer the move takes to happen, the bigger it needs to be to offset time decay in the option price.  Remember, implied volatility is a significant part of the premium paid for an option.  If implied volatility goes down the straddle will lose value and if implied volatility goes up it will gain value.  This is only the case before expiration because at expiration profit and loss is fixed.  Time is working against you with a straddle or strangle.  You have a position with significant negative Theta and every day the position is losing value due to time decay.

The profit and losses from a long straddle/strangle can be shown graphically:

option-content-image-3-2-3

Note that in both cases the maximum loss is defined and occurs if the underlying stock does not move at all.  Also, notice that the straddle becomes profitable before the strangle, and both strategies only become profitable with a breakout in either direction.

Example of a Winning Trade

  • Intel (INTC) bounces off a low in November while implied volatility stays low.  Ideally we want to buy straddles on low implied volatility.
  • Time decay is the opponent of the straddle, and greatest in the last month before expiration, so we need to give the position enough time to work out.  In this case, with implied volatility at 30% we would buy options three months out, choosing the February 25 calls and puts to build the straddle.
  • The February 25 call is bought for $1.00 and the Feb 25 put is bought for $1.25 for a net credit of $2.25.
  • Within two weeks the stock rose to $28 and implied volatility went up to 34%.  The call tripled in value while the put lost much of its value.
  • To exit the position the straddle can be sold in its entirety for a nice gain.  When a position doubles in value we generally consider closing half the position so that no matter what happens next we would break even at worst.
  • Alternately, the call could have been sold and the put held in case there was a pullback.  For the sake of the example let’s say the stock fell as low as $19 before the February expiration.  In this case, holding the put would have resulted in a 300% gain.

The price action in the previous example will look something like this:

option-content-image-3-2-4

Example of a Losing Trade

  • The trade explained in the previous example would not have worked out as well if we had bought the straddle with near-month expirations.
  • Two things work against us when buying straddles- implied volatility can decline and time decay can eat away at the position.
  • Let’s say that when INTC bounced off of its low in November it broke out to a multiyear high.  Enticed by current moves, many options traders ignore implied volatility and buy out-of-the-money options in the near months.
  • With the stock at $26.50 and the implied volatility at 41% we could have bought the December 27 calls and puts to build the straddle.
  • Say the price did move up to $27.50, but with time decay and the drop in implied volatility the position showed a loss.
  • The price then fell and took the straddle value down to a 50% loss.  At that point we would have exited the trade since we generally believe that any position should be closed when it loses 50% of its value.

The price action in the previous example will look something like this:

option-content-image-3-2-4

What are Short Straddles?

Short straddles are the inverse of long straddles- they are designed to profit from stability in the underlying asset.  Constructing a short straddle entails selling an at-the-money call and an at-the-money put with the same strike price and expiration.  Short straddles are tempting because they involve collecting a large amount of premiums upfront, but they are amongst the highest risk strategies in the options world.  This is because short straddles involve the writing of two naked options.  As we’ve mentioned earlier, naked call options are the riskiest options available as the losses on them are theoretically unlimited.  Short straddles are also paradoxical in nature because the best time to sell options is when implied volatility is high, thus commanding the greatest premium but also carrying the highest risk.  It is for these reasons that most investors choose to avoid short straddles entirely.

This can be shown graphically:

option-content-image-3-2-6

Note that in both cases the maximum gain is defined and occurs if the underlying stock does not move at all.  The strangle remains profitable over a greater range of prices than the straddle.  Both strategies lose if the underlying stock experiences an increase in volatility.

Example of a Winning Short Straddle Trade

  • GOOG lands at a support area at $500 and implied volatility remains high.
  • The February 500 put is sold for $10 and the February 500 call is sold for $15 for a net credit of $25.
  • Over the next month, GOOG bounces around and settles at $505.
  • The put expires worthless.  The call is assigned; you purchase the shares for $505 and sell them to the call holder for $500 for a difference of $5.
  • Profit for the strategy as a whole is $20.

Example of a Losing Short Straddle Trade

  • GOOG lands at a support area at $500 and implied volatility remains high.
  • The February 500 put is sold for $10 and the February 500 call is sold for $15 for a net credit of $25.
  • Two weeks into the trade GOOG releases news that they are lowering earnings estimates for the next quarter.  GOOG plummets to $450 overnight.
  • The call is now worthless.  The put is assigned; you are forced to buy the shares for $450 and sell them to the put holder for $500 for a difference of $50.
  • The initial $25 credit is offset by the loss on the put assignment; thus the total loss for the strategy is $25.

Questions