Annuities and Other Retirement Products: Designing the Payout Phase (Directions in Development)_6

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Annuities and Other Retirement Products: Designing the Payout Phase (Directions in Development)_6 O ptions spreads 1 22 P art 2  Using the previous set of Marks and Spencer April options: M&S at 350.60 30 days until April expiry 310.00 320.00 330.00 340.00 350.00 360.00 370.00 380.00 Strike 17.00 11.25 6.75 3.75 2.00 April calls 1.00 2.00 3.75 6.25 10.25 16.25 April puts Here, you could pay 21.50 for the 350 straddle, and sell the 330–370 strangle at 7.50, for a net debit of 14. This is similar to paying 7.5 for the 350–370 call spread plus paying 6.5 for the 350-330 put spread. Like the long call spread and the long put spread, the distance between strikes of the long iron butterfly can be varied in order to adjust the risk/ return potential. Practically speaking, underlyings do not move to zero or infinity within the life of an options contract; there are always levels of sup- port and resistance. It is realistic to place the short wings of this spread at these levels. The above choice of strikes views support/resistance at approxi- mately 6 per cent below or above the current price. This is a large but very possible move for Marks and Spencer. If you choose this strategy in the first place, then you are expecting something out of the ordinary to happen. Note that the above strikes are widely separated, and as a result the strad- dle component has a large exposure to the Greeks. This spread has a better return potential when the implied is increasing. A profit/loss summary at expiry is as follows: Debit from April 350 straddle: –21.50 Credit from April 330–370 strangle: 7.50 –––––– Total debit: 14.00 Upside break-even level: straddle strike plus spread debit: 350 + 14 = 364 Downside break-even level: straddle strike minus spread debit: 350 – 14 = 336 Maximum upside profit: highest strike minus middle strike minus spread debit: 370 – 350 – 14 = 6 Maximum downside profit: middle strike minus lowest strike minus spread debit: 350 – 330 – 14 = 6 Maximum loss: cost of spread: 14 I ron butterflies and iron condors: combining straddles and strangles 12 1 23  The risk/return ratio of this spread is 14/6, or 2.3/1, or £2.30 potential risk for each potential return of £1. Admittedly, this is not an optimum risk/ return ratio, but it is better than that of the long 350 straddle if you expect the stock to range at a maximum of 6 per cent. And when a risk/return ratio looks this unfavourable, then you need to consider doing the opposite side of the trade (see below). The expiry profit/loss for this spread is shown in Table 12.1. Table 12.1 Marks and Spencer long April 330–350–370 iron butterfly 310 320 326 340 350 360 364 370 380 M&S –14 ----------------------------------------------------------------- Spread debit 20 20 14 10 0 10 14 20 20 Value of spread at expiry 6 6 0 -4 –14 –4 0 6 6 Profit/loss In graphic form, the profit/loss at expiry is as shown in Figure 12.1. Suppose you think that the upside potential for the stock is greater than its downside potential. You might create a long broken iron butterfly by sub- stituting a short April 380 call at 2 for the short April 370 call at 3.75. Your spread debit increases to 15.75, but your profit potential is now 8.25 greater. Alternatively, you might create a three-way spread by paying 21.5 for the April 350 straddle, and selling only the April 340 put at 6.25 for a total debit of 15.25. Here, your upside profit potential is unlimited. 10 5 0 310 320 330 340 350 360 370 380 390 –5 –10 –15 Expiration profit/loss relating to Table 12.1 Figure 12.1 O ptions spreads 1 24 P art 2  *Short iron butterfly For stationary markets Suppose premium levels are high and trending downwar ...