In this crash course, I want to tackle all things risk as it relates to the world of options. In doing so, I want to work our way from the less risky option strategies slowly but surely all the way up to the more risky option strategies. And if you guys hang with me all the way to the very end, then I'm going to walk you through step by step a truly risk-free strategy.
That's right: no downside, only upside. [Music] Hey, Jim Schultz here with you guys, and welcome to the Options Risk Crash Course. In this crash course, I want to tackle all things risk as it relates to the world of options.
But before we get into all that, I want to take a couple of minutes and dispel a commonly quoted myth that I see getting regurgitated over and over again in the options world. Every time I hear it, I just shake my head; every time I read it, it just makes my blood boil. The myth goes a little something like this: as soon as the word "options" is introduced into any trading or investing conversation, the immediate connection is ultra-high risk, mega-max leverage—like ride or die, red or black, let's go!
You trade options? Oh man, you must really love swinging for the fences with wild volatility and crazy fluctuations all day, every day. Something like that.
Well, that myth exists because you can certainly use options for that purpose if you want to. If you want to load up, go all in on one trade—not a good idea, by the way—you can certainly do that. That option is available to you.
And pay attention to the financial news; I mean, you will consistently hear about option traders who hit it big overnight or lost everything in the blink of an eye in the options world. But the truth is that characterization of options is wrong because it is incomplete, at a minimum, and potentially totally inaccurate depending on the context and the circumstances. Just as easily as using options to push up your size into number of contracts or notional value way beyond what you ever can or should control, you can use options for the opposite purpose.
You can use options to reduce the overall risk in your portfolio. That's right: using options for less risk, not more risk. By doing this, the outcomes become more reliable, the ride becomes smoother, and the fluctuations become less than they would have been otherwise.
Case in point: the protective put, an option strategy that I'm going to show you, does exactly that. Most investors have a portfolio of long stocks; they're playing the market to the upside. That makes a lot of sense since historically, the market has returned, on average, around 10% per year to a long-only portfolio.
So it makes a lot of sense to carry a long-term bullish bias—absolutely. But if you do this, what are you most exposed to? Right?
What is the fly in the ointment, so to speak? It's the big outlier move to the downside, the Black Swan, if you will. So we're talking about the Internet bubble from the early 2000s, the great financial crisis from 2008, even the COVID crash from early 2020—the swift, violent moves that can wipe out years and years of appreciation in your portfolio.
These can be really tough to stomach, and this is where an option strategy like a protective put could be something to consider to essentially act as insurance against one of those big, violent moves to the downside. You buy some long puts to add to your portfolio of long stocks, most likely in a market index like SPY or QQQ. If the market does drop through your strike during the time you hold those long puts, they will gain value and hedge some of the losses you have to absorb on your long stock.
If the market doesn't drop through your strike during the time you hold those long puts, they will expire worthless, and you'll be out the premium that you paid on them. Now that is painting with a very broad brush, and we certainly skipped over some important details, but the basic idea is this: a strategy like a protective put acts like an insurance policy against extreme outlier moves against you. But at the end of the day, is a protective put a good strategy or a bad strategy for you to consider in your portfolio?
Well, if we look at this research piece that the team did back in October of 2020, it doesn't look too amazing. Studying the SPY from 2005 to 2019, on average over time, buying the 16 Delta puts for protection, your average P&L was minus $57 per trade. It only protected you 7% of the time, and your biggest winner was only a couple thousand.
So in the end, it ended up being a net negative to profitability. So it doesn't look like the protective put is a good strategy to consider implementing in your portfolio on a regular basis, but that's not even my point. I just wanted to serve up a very simple counterexample to the notion that options are ultra-high risk mega-max volatility all day, every day.
You can just as easily use options to better control your downside and better control your overall risk, which is exactly what we're going to see in episode two when we take a look at the covered call. So I'll see you guys there. So, Jim Schultz back with you guys for episode two inside of the Options Risk Crash Course.
We just got done with episode one, where we dispelled this notion of options being ultra-high risk mega-max leverage all day, every day because we showed a very simple example. The protective put is a way to cut the risk in your portfolio. Now, the results with the protective put, based on the tasty research, are a little problematic, so we probably want to find another option to maybe do the exact same thing, which brings us to the covered call.
Not only is a covered call a great bridge for those of you that are familiar with stock but very, very unfamiliar with options, but as we're going to see in just a few minutes, the covered call is, without argument, without dispute, a less risky position than long stock itself. That's right—crusty, stale old long stock that nobody ever thinks about being risky, like being long SPY or long QQQ or long DIA or whatever. Nobody ever thinks about that as being risky.
A covered call, as we're going to see, is less risky than that even. So, for example, you could take a stock like any stock; it could be Chipotle, it could be Tesla, it could be Microsoft. Let's take Microsoft.
If I'm looking at a bullish position in Microsoft, and I'm trying to compare, “Should I buy the stock, or should I put on a covered call position? ” Here is what we're going to see in the next few seconds: every single time, the long stock-only position is the riskier of the two. The covered call is the less risky of the two.
Again, we're just talking about a covered call and we're just talking about long stock in a stock like Microsoft. Let me show you what I mean. So, for the purposes of this illustration, I'm going to ignore the dividend that Microsoft pays just to make the numbers a bit easier to work with.
Since you own the shares in both strategies, you'd be receiving those dividends either way, so they just cancel each other out from a comparison standpoint. But if you buy 100 shares of Microsoft at $350 per share, then your risk-return profile is pretty simple and straightforward: you make money if Microsoft rises above $350, you lose money if Microsoft falls below $350, and you break even if Microsoft stays right at $350 per share. Very simple, very easy to follow.
Okay, now take a covered call where you buy the same 100 shares at $350 per share, but you also add a short call that expires in 45 days up at the $370 strike. Let's say you collect $3 for it. Here, the risk-return is similar but different in some important ways.
You still make money if Microsoft rises above $350 per share; now those gains are capped at $370, your short call strike, so you're giving up potential returns beyond that point—a negative for sure. But look at what else happens: if Microsoft falls below $350 per share, then you're going to lose on your long shares just like you would with a strictly long share position, but you're also going to be able to keep that $3 that you sold the call for if that call stays out of the money, which it will if Microsoft is moving down. So, in other words, you've capped your potential gains—that's the gotcha—but the gimme, as it relates to risk, is you now have $3 that you can use to buffer against any drops in the stock.
Similarly, if Microsoft goes nowhere and your long stock position doesn't do anything, you're also going to be able to keep that $3 in this instance too. So, you will have turned an otherwise break-even event into a profitable outcome. So hopefully now you can clearly see.
I mean, maybe the covered call is a good strategy, maybe it's a bad strategy, maybe it's something you should consider, maybe it's something you should completely discard—that's a separate discussion for another time. That's not my main point right here. Because of the credit that you collect on entry and the way and the fact that that credit can serve as a buffer against stock drops, a covered call is, by definition, a less risky position than pure, straight long stock.
So, in other words, what have you done using options? You have reduced your portfolio risk. Not ultra-high risk, not mega max leverage; you have actually taken your portfolio risk down.
Now, similar to a covered call, another strategy that you could consider would be a naked put. So here, for every 100 shares that you would normally purchase, you instead sell one out-of-the-money or maybe at-the-money naked put. Well, very much like the covered call, which was lower risk, the naked put will also be lower risk than the long stock itself.
Here's how. So, let's take Amazon, selling for $140 per share. You are considering buying 100 shares in a straightforward long stock position or selling a 130 strike put for a premium of $3.
50. If we break down the different possible outcomes, you will see how the short put comes out on top in terms of risk reduction. If Amazon rises above $140, then both positions are going to do well.
The long stock is going to profit from the stock appreciation, and the short put is going to expire worthless, so you would keep the premium that you collected on entry—easy stuff. But a rising stock isn't the scenario that we're interested in. Suppose instead that Amazon falls to $135.
If you own the shares, then you're going to have to absorb that loss dollar for dollar, so you'd be down $5 per share. But interestingly, with your short put strike at $130, a drop to $135 actually doesn't hurt the short put at all; it's still out of the money. So.
. . You would keep the $33.
50 in premium that you sold it for. Similarly, let's assume that Amazon drops even further, all the way down to $120. What happens now?
Well, much like the drop to $135, the long stock position has to take on the full weight of that move, which is a $20 per share drop. But the $130 put, if Amazon is at $120, that short put is only $10 in the money. So that means it only has $10 worth of intrinsic value.
Take out the $3. 50 in premium that you sold it for to begin with, and you're looking at a loss of only $6. 50—a far cry from the $20 loss that a long stockholder would have to endure.
So again, my hope is, from working through that simple illustration, that you can see the potential that is available with options to reduce your risk, as a short put is literally less risky than long stock. Now, to be fair, of course, there is a downside with this strategy; every gimme has its gotcha. Just like we saw with the covered call, your potential gains will be capped with a short put, whereas with a long stock, your potential gains are uncapped because there is no limit—there is no ceiling to how high stocks can rise.
So it's important that you understand that. But remember, our focus here is not on profitability; our focus here is not really on generating returns—that's a separate discussion for another time, possibly in altogether different crash course. What I wanted to focus on here was risk.
I wanted to focus on the options risk that exists in that product. And what do we see? We see less risk with the covered call and/or a short put, not to mention our discussion; we're just focusing on holding the options to expiration.
So any temporary changes in P&L and any fluctuations in the options price in terms of extrinsic value—that's a little bit beyond the scope of what I wanted to do here. I wanted to keep things simple; I wanted to keep things straightforward to just illustrate this idea that options and high risk are automatically connected is completely false. When they are matched for size, short puts and covered calls are less risky than long stock, for the 11th time in the last 9 and a half minutes.
Interestingly, something else that's somewhat related but maybe a little bit off the reservation: options give you buying power advantages and flexibility that stocks simply cannot deliver. As our good friend Tony Batista shows us here in his Trade Talk from 2021, where he's talking about synthetic stock positions in your portfolio. Let's take a look at synthetic stock in SPY.
Let's look at adding a long call to our strategy. Think about that for a moment: you're going to add a long call to the short 50 Delta put. Remember, you sell a put with 50 Deltas; that means selling a put is 50 long Deltas.
You buy a call at the same strike—that's 50 long Deltas, so that's 100 long Deltas. Short put, long call: same thing, synthetic stock. We can look at adding that 5 Delta put.
Look what we're trying to do here: we're trying to keep the buying power the same. On the top slide, you have a short 50 Delta put and a long 50 Delta call. In a margin account, it uses $99,000.
The debit or credit received is just about a dollar in credit—very, very small—but we have 100 shares of stock. Remember, if you're just going to buy the stock, you're going to need $38,000. Here, you only need $9,000, but we're still in a margin account.
Let's look at the IRA account. Just to refresh your memory, the short 50 Delta put and the long 50 Delta call in an IRA is going to use that $339,000. It's going to be the same debit or credit received because there's no difference in an IRA account or a margin account.
The Delta is going to be 100. Now, look at the last part of this slide: the short 50 Delta put is so far all the same; the long 50 Delta call is all the same; and now we're just adding one component, that long 5 Delta put. Look at our buying power: it goes from $39,000 to $88,000.
We give up a very small debit or credit to this; instead of having a dollar in credit, it actually costs us $0. 45 to do it. It's a debit, but look what happens: our Delta is basically the same at 95 Deltas.
So we've taken this account that could not make this trade, and all of a sudden, we've ramped it up to act just like a margin account and synthetic long stock. So, like I said in the very beginning, whether you got that YOLO trade or those diamond hands, don't look to buy fractional shares. What could you buy?
10/20 shares of SPY or any stock that you wanted to do? If you use this simple strategy, you'll be able to control 100 shares of stock. That's some pretty incredible stuff that Tony just went through, and that is what is available to you using a product like options.
But I want to focus on that too much; I want to stay somewhat focused on the task at hand, which is risk. This brings me to our very next segment inside of this crash course, where we're going to tackle defined risk strategies. I'll see you there.
Hey, Jim Schultz back with you guys for episode number three of the Options Risk Crash Course. Up to this point, we have now completely dismantled the notion that risk in the world of options automatically means ultra-high risk and mega max leverage. We saw this with covered calls, and we saw this with.
. . Short puts you can actually use in the options world to reduce your portfolio risk.
Well, right now, if this is all completely new to you, I'm willing to bet that you're starting to get a little excited about the potential that is available inside the world of options because of the unique nature of this product. Whether you want to use them as a substitute for stock or as a complement to stock, the customization that is available to you in the options market is second to none; it is truly unmatched. This is where our next risk category comes into play: defined risk strategies.
You see, with defined risk strategies, not only are you going to be able to dial in your risk down to the dollar, given the nature of your risk being known and defined on order entry, but you'll now be able to choose whatever directional bias in the market you want to choose—bullish, bearish, or neutral. If you want to play the market higher, you can easily sell a short put spread. If you want to play the market lower, you can easily buy a put diagonal spread.
And if you want to play the market neutral, you can very easily set up and execute an iron condor. So not only are you able to position your portfolio however you want to, but with defined risk strategies, you can plug into the positive theta available with short options and the higher probabilities of profit that only exist with this type of product. Now, at this point, I hope you can see—maybe for the 14th or 15th time—that the automatic connection between super ultra-high risk and options is just not real.
It's just a total falsehood in terms of that always being the case. We saw it with covered calls, we saw it with short puts, and now we're seeing it with an entire category of strategies: defined risk strategies, where that is just not true. But one more thing about defined risk before we jump into the next, arguably more exciting category of undefined risk.
You might naturally be wondering at this point, "Wait a minute, Jim! You're already done with defined risk? You've barely even scratched the surface!
I mean, I'm excited, I'm ready to go! Where are the resources that I can lean on to know more and learn more about all the different defined risk strategies? " Well, for the purposes of this crash course, I really wanted to stay focused; I wanted to stay on track—two things that don't come naturally to me—on the task at hand, which was options risk and, specifically, this whole kind of myth situation and the idea of options always being categorized as high risk.
That is just not true for all the reasons that we've already talked about. But for those of you that are just starting out, we already have a host of resources available to you on the YouTube channel. I've already done six, seven, or eight different crash courses that you can check out right now.
The first one that I would check out is the full two-hour long 2023 crash course that we just did last year. That takes you from nothing to arguably a self-sufficient trader in two hours, straight through, where I cover a lot of ground. But, also, secondly, check out the strategy management crash course that is also on the YouTube channel.
That works through some of these strategies, like vertical spreads and iron condors, in much more detail. But as it relates to risk specifically, without getting into the details of a vertical spread or an iron condor or any of the strategy specifics that exist inside the structure of all the defined risk strategies, you might be wondering, "Jim, how do I know if I'm controlling my risk effectively when it comes to defined risk strategies? " Well, let's take a look.
With defined risk strategies, or really any strategies, you never want to put yourself in a position where you can't manage the trade the way it was intended to be managed. The number one way to make sure that doesn't happen is by staying small on order entry. Now, of course, you're probably wondering, "Well, how small is small?
" Well, that largely depends on your account size. Generally, starting with defined risk strategies, we aim to be between 1 to 3% of net liquidating value per position, and that will work for anyone in the, let's say, $20,000 to $100,000 account size range. If you have more than $100,000 in your account—say $200,000, $250,000, $500,000, or $1 million—then you'll likely be able to shrink your trades down even smaller, below 1% of your account at times.
And if you have less than $20,000 in your account, then you'll likely have to increase the upper end of this range, probably hitting 5, 6, 7%, or even higher at times with some of your positions. So at the end of the day, it's all really relative when it comes to position sizing, but hopefully, this gives you some concrete parameters to lean on as reference points. The main thing that we want to avoid is having one trade account for, you know, 15% or 20% or 30% or 40% of our account.
The probabilities are going to work out over time, but man, when you push all your chips in the middle so heavily on one outcome, that is just a recipe for disaster. So that is how options risk relates to defined risk strategy, specifically as it relates to position sizing, which I would argue is the most important risk metric because that is what you can control on order entry. What I want to do now, though, is to transition into everybody's favorite: undefined risk strategies.
I'll see you there! Hey, Jim Schz back with. .
. You guys, for episode number four, or the fourth segment inside of this options risk crash course, by now you're probably getting pretty clear on the concept of the customization that is available with options and how you can begin to build out these uniquely customized portfolios to fit whatever your objectives might be, from a risk standpoint, even from a return standpoint. There are so many different ways that you can go in the world of options.
Well, now what I want to do is move on to the other side of the fence when it comes to risk and exposure. We just covered defined risk strategies; let's now turn our attention to undefined risk strategies. As soon as you heard that, your initial reaction was probably like, "Yep, here it is!
He waited until we were 30 minutes in, and now here comes the bait and switch. Here comes the old ROP Adobe; we're going maximum swings, ultra max leverage. " Well, again, to be clear, yes, you can do that.
If you want to do that, you can do that. I do not think it's a good idea; I do not think you should do that, but you can do that. That is the flexibility and the versatility that is available inside of the options market.
What I want to focus on is another side to the undefined risk strategy category that is maybe more appealing to all of my risk-averse brethren who might be watching the show, and what we're going to see might very well surprise you. Now, just to make sure that we're all on the same page, undefined risk strategies, or naked strategies, are option strategies where there is no safety net built into the strategy. If there is a big move in the market, you are going to be exposed to the entirety of that move.
You're not going to have your losses capped at a certain level like you would with a defined risk strategy, like a vertical spread or an iron condor. Now, that might sound like an incredibly high-risk endeavor, and in a sense it is, because on a case-by-case basis when you take a naked option strategy and compare it to a defined risk options strategy, you're not going to have the capped losses on the undefined risk strategy that you do have on the defined risk strategy. So from a maximum loss standpoint, yes, it can look a lot riskier, and by definition it is.
But here's what might surprise you: two things, actually. Well, first, we've already seen that there are plenty of times when undefined risk strategies are less risky than stock itself. Here's what I mean: recall how we just looked at a naked short put relative to straight long stock back in episode number three, and the naked short put came out on top in terms of risk control.
Well, a naked short put is by definition an undefined risk position; you are essentially exposed to unlimited potential losses on the downside. Yes, technically, the stock is bounded by zero, but if you're selling puts in Apple or IBM or IWM, those stocks aren't going to zero anytime soon. What I think is interesting is that most people holding long stock in Apple or IBM or IWM, they don't ever think about their stock going to zero.
Theoretically, it certainly could, and they probably know that, but practically, that's just not on people's radar. And I think this is the correct way to look at it: most people think about a 5%, 10%, or 20% drop as being pretty much the worst-case scenario, and I think that is completely fair. But for whatever reason, and this gets back to the myth that we kind of kicked off this course with, the same perspective of zero not being a practical outcome just isn't applied to an undefined risk option strategy, even one like a naked short put.
Even though long stock is just as much undefined risk as a naked short put is, in fact, it's riskier than a naked short put for all the reasons that we unpacked back in episode number three. So again, from a purely risk-centered perspective, undefined risk strategies can be less risky than long stock. But here's another thing that is almost certainly going to surprise you: undefined risk strategies can even be less risky than defined risk strategies.
Here's what I mean. This is something that the research team at Tasty has looked at in a number of ways, but recently, back in an options Jive from early 2023, what the research team was able to show was that on paper, short strangles could have an unlimited loss. So it makes sense that you earn higher returns with short strangles relative to iron condors.
But by using a similar amount of capital in both strategies, the portfolio with iron condors actually generated higher volatility over the long term than the portfolio with short strangles. That's right: more risk and more volatility with defined risk than you saw with undefined risk! I mean, that is a crazy, crazy result, is it not?
I mean, that's very, very, very surprising stuff. So don't ever just take it as given that undefined risk strategies are automatically riskier than stock— we have already seen that's not true. But also, don't take it as a given that undefined risk strategies are necessarily riskier than defined risk strategies when you equate for size and buying power and look within the context of an overall portfolio.
As we just saw from that study, that just might not be the case. So again, the potential that is available with options, from a risk standpoint alone, the customization, the strategic elements, the ability to build the exact portfolio that you want, is unmatched. Yes, you can use options to gamble.
Yes, you. . .
Can use options to go "ride or die" on this one trade in Tesla, or this one trade in Chipotle, or this one trade in McDonald's; you can certainly do that, just like you can do it with any other asset. And you can bet your bottom biscuit that your portfolio results are going to swing around like a fence off its hinges; you can be assured of that. But if you want to take a long-term approach to building wealth, controlling your risk, and customizing your portfolio in a way that you simply cannot do with stock alone, you can do that too.
All right, so now we have completely and utterly dismantled the myth that options are automatically high risk. I think that's fair. We've also now talked about covered calls and short puts, and defined risk strategies and undefined risk strategies.
Again, go look at those other option crash courses that I referenced; they will be a great supplement to what we talked about here. But now, it is time—yes, it is time—for me to deliver on my promise that I would show you how to set up a totally risk-free strategy. So let's do it!
Jim Schultz back with you guys for the final installment, the final little segment of this options risk crash course. We've done it all to this point: we've done defined risk, we've done undefined risk, we've done covered calls, we've done naked puts, we've been myth-busting— we've done it all. It's now time to move to the final step.
Right? We talked about the myths related to risk, we talked about defined risk, we talked about undefined risk, we talked about risk mitigation. Can we actually get to a stage of risk elimination?
Is that possible? In short, yes. And just as I promised I would do, I'm going to show you exactly how to set up a riskless options trade.
Now, to be clear, this is going to be a riskless trade, but you haven't discovered the Holy Grail here on YouTube, on the internet, or on the TastyLive Network. I'm not about to give you the PIN number to the ATM of just endless stacks of cash; that's not going to happen. There are a few qualifiers that we have to unpack around this riskless options position.
Again, it's almost like every "gimme"—there's a "gotcha. " Even the riskless "gimmies" are going to have at least one "gotcha" attached to those, guys. But still, what I'm going to show you how to do is take an existing position, and given a certain set of circumstances that exist in the marketplace, turn it into a risk-free position.
The strategy to do this is called a "free butterfly. " Now, to fully understand how to build a free butterfly, we have to first familiarize ourselves with two other strategies: the regular standard butterfly and the ratio spread. So let's hop into the TastyTrade platform together, and I'll show you how these guys shake out.
All right, so here we are. We are inside of the TastyTrade platform; we are inside of the portfolio that I use for "From Theory to Practice"—shameless plug—Monday through Friday at 2:00 Eastern Time. Well, let's take a look at Disney, and let's use Disney for the purposes of our example, kind of working through a butterfly, ratio spread, and then a free butterfly.
Now, the IV rank of 15—this is probably not the greatest example for selling premium, like a butterfly or ratio spread, but it'll work for the illustration and for our purposes here today with a free butterfly. Okay, so let's go into the trade page, and let's open up the January cycle with 30 days to go, and let's start with a very standard, straightforward, plain vanilla butterfly spread in Disney. Let's say that we were going to put on a butterfly spread slightly to the downside in Disney.
Now, I'm not going to work through all the inner workings of butterflies and ratios; that's not the purpose of what we're doing here. But we do need to make sure that we are up to speed on some of the basics. So, if I were to buy a butterfly using put options on the right-hand side of the screen, I'm going to buy—these are your puts; these are your calls.
I'm going to buy a 93 put, let's say I'm going to sell the 91 put, and I'm going to buy the 89 put. Now, of course, I need to go back in and double up on my 91 put to create a butterfly, so you can clearly see that this is a standard $2 wide butterfly. It's a 25 cent debit to put this strategy on, and if we move on over to the curve view, we can get a visual look at what this looks like from a P&L standpoint.
If I click on my curve view and I click on my analysis tab and I move this kind of right-hand menu over (because I don't really need that right now), you can see that this is what—I'll even zoom in a little bit here. And we move over—this is what a standard butterfly—let me center it even a little bit better—this is what a standard butterfly is going to look like. Right?
You want to pin the short strike; you're profitable around the short strike, but you essentially have risk on both sides of the market in terms of this is where you would lose the debit that you pay. So, this is a very standard butterfly; this is how standard butterflies are set up, and this is what they look like on the P&L graph. Okay, so let's go back to the table view now and let's look at this butterfly a little bit more closely if you… Take a look at the different strikes that you have.
You have one long strike, you have two short strikes. Actually, I should do it over here. You have one long strike, you have two short strikes, you have one long strike again.
This is a very standard, plain vanilla, Betty Crocker butterfly; something we use all the time. If you wanted to instead do a ratio spread in Disney, a ratio spread is nothing more than a butterfly where the last wing is missing. So, "last," in this case, is going to be the further out-of-the-money butterfly—sorry, the further out-of-the-money wing, I should say.
So, that would mean I keep my 93 strike in place, I keep my 91 strikes in place, and then I delete this bottom wing, this 89 strike, leaving me with a classic 1 by 2 ratio spread. So, let me go ahead and right-click on this to delete the leg 93, 91, 1 by 2 ratio spread, and look at what has happened to the debit. Now, I'm on a 45 net credit.
This is the key to understanding not only butterfly spreads and ratio spreads, but how we are going to eventually migrate to this free butterfly debit paid on a butterfly credit received on a ratio spread. But look even more closely at the difference between these two strategies. All I've done is eliminate this 89 strike.
We'll look at the cost of the 89 strike; it's around, you know, the bid is 71 cents, the offer is 74 cents, so it's somewhere around, I don't know, 72 or 73 cents. Well, look at what happens if I bring the butterfly back into the mix. Look at what happens to my credit/debit.
I buy my 89 strike; now I'm at a 26-cent debit. If I eliminate that strike, I'm back to a 46, 47-cent credit. The difference between those two numbers is equal to the cost of the missing wing, so to speak.
And that should make perfect sense because that's what we're doing—we're buying that extra wing to keep the butterfly intact and not have the undefined risk of a ratio spread. Now, again, I don't want to work through the undefined risk and the defined risk of butterflies and ratios; I want to kind of stay on point in terms of getting us to the free butterfly. But can you see the difference between the two?
Because this difference, this 72 or 73 cents, is the difference between, again, the debit paid on the butterfly. Now it's 28 cents; the markets are open, so these prices are obviously moving. But if I delete that now, I'm at a 45 credit; that difference is this cost that you see right here.
All right, so right now to create this butterfly spread, I need to pay, again, about a 27-cent debit. Okay, so this is clearly not free. We saw the risk on the curve view, but what if I start with a ratio spread with a 46-cent credit?
What if I start with this strategy and then I let the market do its thing? I let time go by; I let the market dynamics kind of move around. And what is likely to happen if the market stays where it is or Disney moves higher?
What is likely to happen to the cost of this 89 put, the missing wing on the butterfly? This cost is going to go down. Now, how do I know it's going to go down?
How am I certain that it's going to go down? If the market rallies or if the market even stays right where it is, it's going to go down more quickly if the market rallies. It'll go down a lot more slowly if the market stays where it is, but it will go down.
I know this is the case because all of these options that you see on this side of the market, on the put side, they're all out of the money. Right? The 93, 91, 89, even the 86, 83—whatever—these are all out of the money.
So, the prices are 100% extrinsic value. Well, I know that as time goes by, there's downward pressure on extrinsic value. I also know that if the market rallies and Disney prints 94, 95, 96, 97, then these strikes are going to be further out of the money.
Well, what do we know about further out-of-the-money strikes? They have less extrinsic value than the closer-to-the-money strikes. You can even see this for yourself right now if you look at, like, an 84 strike at 20 cents relative to an 89 strike at 73 cents.
If the market rallies, this 89 strike is going to be headed in the direction of the 84 strike, the 85 strike, the 83 strike, where the cost of the option is going to decrease. And if you think about it, this should make perfect sense as the only difference between a standard butterfly and a ratio spread is that last wing, that missing wing, so to speak, when you're looking at a ratio spread having come from a butterfly. So, the only difference between the credit on a ratio spread and the debit on a butterfly is going to be the cost of that missing wing.
Okay, so now think about the fact that you're collecting a credit on your ratio. You would have to pay a debit to complete the ratio and turn it into a butterfly. What if there came a point—you can't do it now because if you buy that missing wing, it's going to turn it into a debit— but what if at some point in the future the market dynamics changed such that you could actually buy that missing wing for less than… The credit that you collect right now on the ratio spread: what would happen if you were able to do that?
That's right, you will have created a free butterfly, just like this. Okay, let's push this idea one step further. Remember, if I put this ratio spread on, I have 47 cents in my back pocket, right?
I have a 47-cent credit to work with. If I buy the butterfly today, if I complete the butterfly and pay, you know, 73-74 cents for this 89 strike, this is going to be a net debit. But what if I put the ratio spread on and then I wait?
I give the market a chance to move. Maybe the market starts to rally. Maybe Disney catches a little bit of a bid.
Let's say this cost drops down to 55 cents, 50 cents, 45 cents, 40 cents. Let's say a week and a half from now, or two weeks from now, I look up at this 89 strike, and it's not 73-74; it's actually 40. I could then go in, buy this 89 strike for 40 cents, and what will have happened?
Remember, I have 48—no, 50 cents—in my back pocket. I have 50 cents in my back pocket. I pay 40 cents for this 89 strike to complete my butterfly.
I will have a butterfly on where I didn't pay a 25-cent debit because, again, we did this in pieces over time. I will have actually collected a 10-cent credit, so I change my net debit to a net credit. Look at the P&L graph for this.
This, my friends, is a free butterfly. There is no scenario where you lose money; you only make a little on the outside of the butterfly or you make a lot around the short strike. Now again, how did this happen?
Well, I had to wait, right? I had to take on the risk of the ratio spread. I had to assume the undefined risk of the ratio spread.
So again, this can't be free from the start; sadly, that doesn't exist. But if I utilize a ratio spread (a very common strategy that we use all the time), there will be many, many, many times when, if the market accommodates you and moves in the direction that you want—which in this case, with the put ratio spread, would be Disney actually going higher—then you're going to see the cost on that last put, which in this case was the 89 put, dry up and decrease. And then, if you want to, you're going to have the opportunity to butterfly this thing off and put yourself in a situation where you cannot lose money.
You can't lose money; you're only going to make. Your worst-case scenario is you keep your 10-cent credit. That's your worst-case scenario because, again, remember, we put the ratio spread on for 50 cents, and then we went back in two weeks later, two and a half weeks later, or whatever, and we bought the missing wing not for 77 cents but for 40.
So the net credit/debit is a 10-cent credit, and you have a free butterfly. Pretty wild, is it not? I mean, is that not crazy that you can take an existing position?
Again, sadly we can't do this on order entry because if we could do that, then we wouldn't have to worry about anything ever. But if you can take an existing position and turn it into a riskless position, that is a very interesting and unique little tool to have in your toolbox: a riskless strategy with no downside and only potential upside. If that doesn't put the final nail in the coffin that options are automatically high-risk, I don't know what will.
And, guys, just like that, we have finished the options risk crash course. I really hope that this brought some value to you in some way, whether you watched the whole thing through or you just bounced around to the different chapters that made the most sense to you. However you accessed this content, I'm so thankful; I'm so humbled that so many of you took time out of your day, your week, your schedule, to hang with us and spend time with us.
So thank you, because it's only because of you that we can do what we do. So thank you, thank you, thank you! If I can ever help you in any way personally, please reach out to me.
My email is jschultz@tasty. com, or we can connect on Twitter: I am @JSchultzF3. I would love to hear from you guys on there as well.
So I guess this means I will see you guys next time!
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