Phil McD

During one's lucubrations on the state of the markets perhaps it would be good to consider options as a way to deal with the current volatility. In particular, option spreads can help to manage the risk of a position. Given the current volatility, risk management can be a valuable thing.

One spread to consider is a volatility spread. The mechanics are simple. Buy two out of the money calls for 2. Sell one at the money call for 5. You now have a net cash credit of 1 point ($100). You will also have to maintain margin of $500 for the one call you have sold, assuming the strike prices are 5 points apart.

Assuming some realistic Greeks you might have the following:

Q Option Pr delta vega

b 2 Nov 69c 2 .32 8.5

s 1 Nov 64c 5 -.59 -10

Net 1 .05 7

In the short run you have a slightly bullish spread with an overall delta of about 5%. The spread will benefit from volatility as evidenced by the net vega of 7.

The spread will make a profit of 1 anywhere from 64 down to zero so you are protected from banking Armageddon. Small losses will occur between 64 and 69. The max loss will be at 69 and will be limited to 4 points. Above 69 the two calls will kick in (less the short one call) and the spread will become increasingly profitable with no upside profit limit.

If one believes that the banking system is set for a domino collapse scenario then a similar spread can be done with puts. Sell 1 at the money put and buy 2 out of the money for a net credit. Then the spread will have unfettered profit potential all the way down to zero. It will lose a small amount if the underlying closes out between the strike prices. The spread also will enjoy a small fixed profit in the amount of the net credit anywhere above the upper strike price.

Dr. McDonnell is the author of Optimal Portfolio Modeling, Wiley, 2008


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