The Options “Lego” Game
All market neutral combinations are made of the same four base options strategies. Some call them the “Fantastic Four” or the “Fab Four”, themselves grouped into Vertical and Horizontal Spreads. In the OM introductory course (schedule to be confirmed), we shall review their behaviour i.e. how their “Greek signature” indicates their suitability in different market situations.
As mentioned before, all courses are available in French and English and cover most of the Options Industry Council syllabus (click here to return to the page on Options Basics or here for CBOE courses). Also note that OM is a Capital Discussions partner where you can find classes and resources such as a Beginner’s Weekly course.
The fundamental options strategies are as follows:
Vertical spreads use different put or call strikes of the underlying on the same maturity date (expiration). Since OM focuses essentially on non-directional trading, individual debit or credit spreads are only used for Delta or Vega adjustments in an existing strategy.
Although they both look quite similar i.e. a Butterfly looks like the narrowest possible Condor with shorts on the same strike, they do have slightly different characteristics. Note that a common butterfly adjustment consists of rolling either side up or down, and the end figure is a condor sometimes also called a “split strike butterfly” ! Why so ? Most probably because options traders most often have a definite preference for a specific trading style, and contrary to beginners’ expectations, trading a butterfly is not as close as trading a condor as one would think.
In both cases here shown we already notice a skew as a call spread is not the mirror image of a put spread.
More info on Butterflies here, and on Condors here. Please check the Options Industry Council for further details as traders are sometimes confused whether they actually buy or sell a particular combination.
2) Horizontal Spreads (Calendar & Diagonal)
Horizontal spreads, also called Time Spreads use same (Calendars) or different (Diagonals) put or call strikes but on different maturities. As OM focuses on income trading i.e. with time (or Theta) on your side, the short leg always precedes the long leg i.e. sell near term, and buy longer term. This means that we BUY butterflies or calendars and not the opposite. The OM community may wish to explore other trading strategies of course (short calendars, short butterflies etc.).
All the above options strategies have a number of variants, in particular the Diagonal trade which can be a Credit or Debit trade. Also Diagonals are more directional. The course will describe subtleties of those trades which often have some directional component, yet not as definite as bull or bear spreads (except for the Diagonal). It must be noted that Double Diagonals may look deceptively simple. The Fundamental Strategy course may be followed later by an advanced course, or the OM Community may pick it up from there !
More info on Calendars here.
IMPORTANT NOTE: We have to insist again on one important aspect: each construction, each “Lego” element has its own Greek signature, its own pros and cons in a market environment, price range and volatility. It is essential to fully understand the risk and reward attached to the overall strategy, both statically when the the position is entered as well as at adjustment time.
Brokers and options analysis platforms often have tools to scan and detect trading opportunities for a particular market outlook. At this stage, we can recommend Options Guide Strategy Finder to better select a given strategy for a given market outlook.
Note that OM focuses only on a few proven strategies like the Weirdor or the M3, as described on the Programme page. Options are such a versatile field that it is impossible to cover more specific setup, that are in our view restricted to more advanced traders.
To learn more
Do not hesitate to contact us at any time for a personal assessment and programme.
- Parkwood Capital produced an interesting video on Delta-Neutral approaches.
- Capital Discussions, our partner site.
- YouTube video from Sheridan Mentoring a little verbose on the “Fantastic Four”. No affiliation or recommendation whatsoever.
- And to avoid (undue) advertising expressly for Dan Sheridan, let’s also mention Tony Sizemore, a great options trader and coach in Florida, albeit for more advanced traders (in our view).
This post is also available in: French