the limited risk reversal (lrr) advanced management techniques october 31, 2015 presenter: web...

The Limited Risk Reversal (LRR)Advanced Management Techniques

October 31, 2015

Presenter: Web Begole

Day trading, short term trading, options trading, and futures trading are extremely risky undertakings. They generally are not appropriate for someone with limited capital, little or no trading experience, and/ or a low tolerance for risk. Never execute a trade unless you can afford to and are prepared to lose your entire investment. All trading operations involve serious risks, and you can lose your entire investment. No trades are recommendations or advice and we cannot be sued for losses of capital. All trades are for educational purposes only. Contact your broker or RIA for execution, margin, and other capital requirements. Everyone watching presentation adheres to ALL disclaimers on www.optionhacker.com and www.keeneonthemarket.com

RISK DISCLAIMER

Advanced Management of LRR’s

• Long term stock replacement strategy using Limited Risk Reversals.

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Credit Put Vertical Long Call(s) Bullish Limited Risk Reversal (LRR)

Credit Call Vertical Long Puts(s) Bearish Limited Risk Reversal (LRR)


• Let’s say in the example the deltas look like this:The 110 Calls have a delta of 0.10The 110 Puts have a delta of -0.90The 105 Puts have a delta of -0.70

• What is my net delta on the stock?

Well, I’m short 1x the 105/110 Put SpreadShort the 110 Put (Delta -0.90) = LONG .90 DeltaLong the 105 Put (Delta -0.30) = SHORT .70 DeltaTherefore in the spread I am LONG 0.20 Delta

In addition, I’m long 4x 110 CallsLong the 110 Call (Delta 0.10) = Long 0.10 Delta X 4 = 0.40 DSo in the calls I am LONG 0.40 Delta

Therefore:I am LONG 0.60 Delta in this trade currently.

That means, as the stock moves up by $1, my trade will gain in value by $60.00

• But what happens when the stock DOES move up by $1??

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• How does it work in principle?

• I’m looking to structure the trade by selling ITM Credit Spreads -- because they give me the most credit to buy the opposite options (if the options don’t work out neither would the credit spread, so why not take as much credit as possible?!) – and buy long options on the other side of the chain at the same strike as the short option of the vertical.

Ex:XYZ Trading at 100, I want to be bullish so:I sell the 105/110 Put Spread for $4.00(110 Puts for $12 - 105 Puts for $8) I buy 4x 110 Calls for $1.00 each

I place the trade for $0.00 (even money) and am risking $500.00. If the 110 calls are ever going to be profitable, so is my 105/110 short put spread.

• At no time am I ever risking any more than $500.00 even if I were to be assigned on my short option, I have the long option as part of the spread that I can exercise and bring me back to my original risk expectation.


• XYZ now trading at 101, the Deltas have shifted to the following:The 110 Calls have a delta of 0.15The 110 Puts have a delta of -0.88The 105 Puts have a delta of -0.65





That means, as the stock moves up by $1, my trade will gain in value by $83.00 5

• Let’s say in the example the deltas look like this:The 110 Calls have a delta of 0.10The 110 Puts have a delta of -0.90The 105 Puts have a delta of -0.70





That means, as the stock moves up by $1, my trade will gain in value by $60.00

• But what happens when the stock DOES move up by $1??

• But what else has happened?The 110 Calls that cost $1.00 (D 0.10) are now worth $1.10The 110 Puts that cost $12 (D -0.90) are now worth $11.10 (They lost $0.90 in value on the move)The 105 Puts that cost $8 (D -0.70) are now worth $7.30(They lost $0.70 in value on the move)

• Where are my profits??

The put spread is now worth $3.80 ($11.10-$7.30) to buy back, And the 4x calls are now worth $4.40.

If I sell the calls and buy back the spread, my net profit is $60.00 ($440-$380)

I put the trade on for $0.00, and I close it for $60credit. That’s a 12% (60/500) ROR (return on risk) in the trade.

• Alright…. So what happens if the stock jumps to 105?


• XYZ now trading at 105, the Deltas have shifted to the following:The 110 Calls have a delta of 0.25The 110 Puts have a delta of -0.75The 105 Puts have a delta of -0.50





That means, as the stock moves up by $1, my trade will gain in value by $125.00 6

• (NOTE: Due to the complexities of Theta, Gamma, Vega, I can’t calculate the exact values of deltas here and the exact returns…. The following assumes this move happens in the same day as establishment)

• But what else has happened (the stock has moved $5 since establishment)?The 110 Calls that cost $1.00 (D 0.10) are now worth $1.50The 110 Puts that cost $12 (D -0.90) are now worth $7.50 (They lost $4.50 in value on the move)The 105 Puts that cost $8 (D -0.70) are now worth $6.00(They lost $2.00 in value on the move)





• That’s a crazy profit for a trade that hasn’t even gotten above 110 yet!!


• I want to stop right here. As I know there are questions:

• A) Why not just buy the calls?If I buy 5x calls for $1.00 with a delta of 0.10 (I’m only risking $500!) and the stock moves to 105, what are my profits?The calls are worth $1.50 and cumulatively worth $750! But only $250 profit since I spent $500 to enter the trade.My return on risk therefore is 250/500 = 50% vs. the LRR which has a return on risk at this stage of 90% or $450 profit

• B) What about assignment risk?Even with the stock at 105, the short 110 puts (in this example) are worth $7.50, that’s a $2.50 premium to parity. So if someone were to exercise the 110 Puts they would actually lose $250 on the trade. Therefore as long as the short option retains premium there is little risk of assignment aside from someone’s fat finger.

• C) You said your math only works as if it happened the same day…. What about it taking time?Well that’s a more complicated question… but remember the main thing:Theta decay (time decay) on options happens on premium, not intrinsic (parity) value. Because I sold the spread to buy the long calls, as the calls decay in value it doesn’t ultimately hurt my chances if I’m right eventually BECAUSE the calls (in effect) cost me $0.00 and you can’t decay 0.00.

• D) How do you know something is going to go in one direction or another?There is absolutely no way to know that! I personally use my technical analysis methods to decide that, but no one KNOWS. Therefore this strategy allows me to take a position knowing that no matter what happens I can only ever lose $X (in my case $500).

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• Coming back to this now…..

• Did you notice something?

Did you notice a way to remove all risk for free?

• The put spread now costs only $1.50 to buy back and close…. That’s where my $500 risk is….

But the calls are now worth $1.50 each… and I have 4 of them…

So how about I do this:I buy back the 105/110 Put Spread for $1.50 and I sell 1x of the 110 Calls for $1.50REMOVING ALL RISK FOR $0.00

Keeping 3 calls on in XYZ for free. Now every penny their worth = profit!! And in addition, I no longer have any risk on, I own these calls for free (minus commissions) so if they go to zero – oh well!

• And then not only am I still in the trade with those calls, I can put that $500 risk into another trade for even money and do it all over again! (Note: I tend to stay away from doing it again in the same stock…. Would rather look for other pastures just in case!)

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• (NOTE: Due to the complexities of Theta, Gamma, Vega, I can’t calculate the exact values of deltas here and the exact returns…. The following assumes this move happens in the same day as establishment)

• But what else has happened (the stock has moved $5 since establishment)?The 110 Calls that cost $1.00 (D 0.10) are now worth $1.50The 110 Puts that cost $12 (D -0.90) are now worth $7.50 (They lost $4.50 in value on the move)The 105 Puts that cost $8 (D -0.70) are now worth $6.00(They lost $2.00 in value on the move)





• That’s a crazy profit for a trade that hasn’t even gotten above 110 yet!!


• What if I wanted to be even more of a clever bugger?

• Say this LRR is out in time – January or some months down the line….The stock has moved to 105, the put spread is only worth $1.50, the 4x calls I have on are $1.50 each.

What if in December the 110 Calls are trading at $0.75? What could I do?

• I could sell 2x December 110 Calls against my 4x Jan 110 Calls for NO MARGIN REQUIREMENT (ie: no risk!) and take in $1.50 credit….

Hey that’s enough to buy back the put spread for $0.00. So I do…..

Now I am in a semi-calendared spread:Short 2x Dec 110 Calls Long 4x Jan 110 Calls

• This allows me to continue to participate in upward movement for no risk, and the 2x calendars (the 2 Dec vs 2 Jan calls) also profit on the up move.

If the stock jumps to $120 where am I?

Well the calendars are worth say $1.00 (as premium remains in the January but the Decembers are at parity)Ie: Dec 110 Calls are worth $10, the Jan 110s are worth $11So I have a total of $1.00 in each calendar (ie: $200 there) and $11 in each naked call (ie: $2200 there) so a total profit of $2400 on the trade that has ZERO risk. Return on risk is incalculable because you can’t divide by zero…. 2400/0 = computer melt down.

• But if I had done the example before and taken off my risk by selling one of the calls, what would be my profit?$11 x 3 = $3300 profit. So there’s a slight disadvantage to being too cleaver….

• Or is there?What if by December, the stock is still below 110? Well I get to keep all four of the Jan 110 Calls for free with no risk. In this way I never had to sell any of my long calls and am able to maintain my bullish position with no risk on in the trade. 9


• Let’s look at some recent examples I’ve done:

• GOOGL Earnings trade, placed Thursday 10/22 at 11:51am, GOOGL is trading around $682

Believing that GOOGL will rally on earnings, I place the following trade:I sell the January 780/785 Put Spread, and Buy 2x the 825 Calls for $0.10debit ($10 cost to enter)My risk on the trade is $510 (5pt wide spread of risk + $10 of entry cost)My breakeven on the trade is $825.05 on January serial expiration.Between 785 and 825 at January expiration I lose $10Below 780 at January expiration I lose $510

But none of that matters….

• The next day, at 9:43am (13min into market) GOOGL is trading around $737.55I remove my risk on the trade by buying back the 780/785 Put Spread and selling ONE of the 825 Calls for a net credit of $1.27My risk in the trade is now ZERO; in fact my locked in profit on the trade is now $117 ($127-$10entry)And I keep one GOOGL Jan 825 call on for free to sell whenever I like for what ever it’s marking….

[Yes, I still have it, it’s marking $3.025 at EOD Friday 10/30] 10

• How did that happen?

Let’s look at this spread from Entry 10/22 vs Exit 10/23:

• Entry 10/22 (GOOGL @ $682.21)Mark

Jan 785 Put 107.44Jan 780 Put 102.70Jan 825 Call 2.42LRR Combo 0.10

• Exit 10/23 (GOOGL @ $737.55)Mark

Change P&L ChangeJan 785 Put 59.45 -47.99 +47.99Jan 780 Put 55.67 -47.03 -47.03Jan 825 Call 5.05 +2.63

+5.26LRR Combo 6.32 +6.22

+6.22


• Another:

• POT Earnings trade, placed Wednesday 10/28 at 3:48pm, POT is trading around $21.30

Believing that POT will sell off earnings, I place the following trade:I sell 2 of the January 20/22 Call Spreads, and Buy 4x the 19 Puts for $0.05debit ($10 cost to enter)My risk on the trade is $410 (2x 2pt wide spreads of risk + $10 of entry cost)My breakeven on the trade is $18.95 on January serial expiration.Between 19 and 20 at January expiration I lose $10Above 22 at January expiration I lose $410

But none of that matters….

• The Friday, at 3:24pm POT is trading around $20.21I reduce my risk on the trade by selling the Jan 22 Calls and buying the Jan 21 Calls and selling ONE of the 19 Puts for a net credit of $0.11My risk in the trade is now $199; in fact my locked in profit on the trade is now $117 ($200+$10-$11credit for the adjustment)And I keep three POT Jan 19 Puts on for ½ the risk I originally had.

[Yes, I still have this trade, it’s marking $1.28credit at EOD Friday 10/30] 11

• How did that happen?

Let’s look at this spread from EOD 10/28 vs EOD 10/30:

• Entry 10/22 (POT @ $21.32)Mark Delta

Jan 20 Call 1.97 0.67Jan 21 Call 1.395 0.55 Jan 22 Call 0.92 0.42Jan 19 Put 0.55 -0.24Orig LRR 0.10 -1.46 (2x20/22C + 4x19P)Adj LRR 1.05 -0.96 (2x20/21C + 3x19P)

• Exit 10/30 (POT @ $20.23)Mark Change Delta

Jan 20 Call 1.23 -0.74 0.53Jan 21 Call .775 -0.62 0.39Jan 22 Call .48 -0.44 0.28Jan 19 Put .73 +0.18 -0.34Orig LRR 1.42 +1.32 -1.64Adj LRR 1.28 +0.23 -1.30


• Now for something quite complicated:

• MSFT Swing Trade:In the middle of the Pacific Ocean (from a cruise ship for Hawaii) I decided to get long MSFT on 10/8I sold the January 45/50 Put Spread to buy 5x 52.5 Calls, at the time MSFT was trading around $47.45. I did this for a $0.45creditMy risk was $455 on the trade.

• MSFT Earnings Trade Adjustment:I returned home, MSFT was doing well, and I decided to amplify the trade for earnings coming on the 22nd. So I bought back the 45/50 Put Spread, Sold 2x of the 50/52.5 Put Spreads and bought 3 more of the 52.5 Calls for a $0.09 net debit.My risk remained was upped now to $464 because I spent $9 to make this adjustment. However, I now owned 8x 52.5 calls instead of 5x.

• First thing in the morning after earnings, I sold 1x of the 52.5 calls to buy back both of the 50/52.5 Put Spreads for a net credit of $0.35Now my risk on the trade is ZERO, in fact I’ve taken in a total profit of $71 ($45-$9+$35) and I keep 7x MSFT 52.5 Calls for free.

• At the end of the day, I decide to sell all 7 calls for a credit of $2.51 each (or a total credit of $1757)

• $1757 + $71 = $1828 profits on the trade having never had more than $464 risk at any moment. Return on risk therefore was 1828/464 = 394% 12


• GE Swing Trade:In the middle of the Pacific Ocean (from a cruise ship for Hawaii) I decided to get long GE on 10/8I sold the January 25/30 Put Spread to buy 7x 30 Calls, at the time GE was trading around $28.03. I did this for a $0.07 debitMy risk was $507 on the trade.

• GE Adjustment #1:I returned home, GE was doing well, and I decided to adjust the trade. So on 10/19 I bought back the Jan 25 put and sold the Jan 27 Put. This cost me $0.27debit to adjustMy risk on the trade is now $334 (so I lowered my risk a bit even though it cost me some money to do so)

• GE Adjustment #2:Getting a bit antsy I decide later in the day to calendarize this trade a bit. I sold 6x of the Nov 30 calls (against the 7x I’m long, so no additional margin required) and use the money to buy 3x more of the Jan 30 calls. I do this for a 0.03credit * 3 = $9 credit total.My risk is now $325 and I am now long 10x of the Jan 30 calls. (and short 6x Nov 30 calls)

• GE Adjustment #3:On 10/22 I decide to amplify a bit more and I sell 4x Nov 30 calls and buy 2x Jan 30 calls for an additional $0.05credit * 2 = $10creditMy risk is now $315 and I am now long 12x of the Jan 30 calls (and short 10x Nov 30 calls)

• GE Adjustment #4:On 10/29 I decide to remove my risk entirely on the trade and I sell 2x of the Jan 30 calls to buy back the 27/30 Put Spread for $0.00My risk is now only $15 on the trade (that’s all I’ve spent to have the position on)I am long 10x Jan 30 calls and short 10x Nov 30 calls.

• I still have this trade on, currently marking $0.31credit * 10 = $310 credit to close. My goal is for GE to stay below 30 by November expiration and either buy back all the Nov calls for the price of selling 1 Jan call, or let them roll off worthless and keep the Jan 30 calls on for free.

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• Isn’t LRR trading risky?!

• I spoke to a friend of mine who is the manager of a large bank that has a trading division and I told him this strategy and he said “Yeah, that’s pretty common, and we would call that an extremely conservative strategy…” I asked him then about what about just buying calls or puts naked “That’s pretty aggressive, we like that but our risk management team would be all over it.”

So I ask you… what’s risky?

• Well let’s look again at GE for a second… On 10/8 (when I established the trade) the Jan 30 Calls were trading at 0.32. Say I put down $500ish risk and bought 15x of the callsBy EOD 10/29 (the day of the last adjustment I made) they were worth 0.635 which is not quite double.

Adjustments aside, let’s look at the two comparativelyCost Risk Credit to Close P&L on 10/29

15x Jan 30 Calls $4.80 $480 $9.525 $952.50 - $480 = $472.50LRR (25/30P 7x 30C) $0.07 $507 $3.075 $307.50 - $7 = $300.50

GOTCHA!

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• On 10/8 (when I established the trade) the Jan 30 Calls were trading at 0.32. Say I put down $500ish risk and bought 15x of the callsBy EOD 10/29 (the day of the last adjustment I made) they were worth 0.635 which is not quite double.



GOTCHA!

• Let’s look at EOD 10/30 (the next day)Cost Risk Credit to Close P&L on 10/30

P&L Change15x Jan 30 Calls $4.80 $480 $7.275 $727.50 - $480 = $247.50

-$225.00 (-24%)LRR (25/30P 7x 30C) $0.07 $507 $1.79 $179 - $7 = $172.00

-$128.50 (-42%) GOTCHA!

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• So then why did my friend say LRR is conservative and buying calls is risky???Well I’m not done yet…. There’s still 2 ½ months to go in this trade.

• What is my break even on the two?Cost Risk Breakeven at Jan Exp

15x Jan 30 Calls @.32 $4.80 $480 $30.32LRR (25/30P 7x 30C) $0.07 $507 $30.07

• So the breakeven is lower…. What about if GE expires at $31 at expiration?Cost Risk P&L if $31 on Exp

15x Jan 30 Calls @.32 $4.80 $480 $1500 - $480 = +$1020LRR (25/30P 7x 30C) $0.07 $507 $700 - $7 = +$693

• How about if GE expires at $29?Cost Risk P&L if $29 on Exp

15x Jan 30 Calls @.32 $4.80 $480 $0 - $480 = -$480LRR (25/30P 7x 30C) $0.07 $507 -$100 - $7 = -$107

• How about $30?Cost Risk P&L if $29 on Exp

15x Jan 30 Calls @.32 $4.80 $480 $0 - $480 = -$480LRR (25/30P 7x 30C) $0.07 $507 $0 - $7 = -$7

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• On 10/8 (when I established the trade) the Jan 30 Calls were trading at 0.32. Say I put down $500ish risk and bought 15x of the callsBy EOD 10/29 (the day of the last adjustment I made) they were worth 0.635 which is not quite double.



GOTCHA!

• Let’s look at EOD 10/30 (the next day)Cost Risk Credit to Close P&L on 10/30

P&L Change15x Jan 30 Calls $4.80 $480 $7.275 $727.50 - $480 = $247.50

-$225.00LRR (25/30P 7x 30C) $0.07 $507 $1.79 $179 - $7 = $172.00

-$128.50 GOTCHA!

• With 7/10 (70%) the amount of calls on, my loss is only 57% (128.50/225) of the same loss of being simply long the calls. That’s a 13% retaining of gains due to volatility and time decay.

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• Maybe that didn’t convince you – thinking only in terms of risk/loss isn’t as fun as profits….

• So let’s look at the GOOGL earnings trade:On 10/22 when I put the trade on, the 825 calls ended the day marking $2.425Say I put on ~$500 risk on the trade and bought 2x the 825 calls at the EOD 10/30 they’re worth $3.025, not quite 25% gains…

• Adjustments aside, let’s look at the two comparativelyCost Risk Credit to Close P&L on 10/30


Woohooo!

• With adjustments included, remember that I took in $1.27credit to close the risk, and currently have 1x call remaining worth $3.025Net P&L at EOD 10/30 therefore is $127 - $10 + $302.50 = $419.50 and still going…….

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• Alright Web, one more question… what about the moment you exited… on the highs… how was that looking?

• Adjustments aside, let’s look at the two comparativelyCost Risk Credit to Close P&L on 10/23

(on the open)2x Jan 825 Calls $4.85 $485 $10.10 $1010 - $485 = $525.00LRR (780/785P 2x 825C) $0.10 $510 $6.32 $632 - $10 = $622.00

Woohooo!

• With adjustments included, remember that I took in $1.27credit to close the risk, and currently have 1x call remaining worth $3.025Net P&L at EOD 10/30 therefore is $127 - $10 + $302.50 = $419.50 and still going with zero risk…….

• One more thing to think about. One great rule of thumb for options trading / earnings trading is to take half off at a double. If I buy two options for $485 total and I can sell one of them for $485 or better, I receive my capital risk back. So lets look at that strategy vs. the LRR:

Cost Risk Credit to Remove Risk P&L on-going2x Jan 825 Calls $4.85 $485 $505$505 - $485 = $20 + $302.50LRR (780/785P 2x 825C) $0.10 $510 $127 $127 - $10 = $117 + $302.50 Woohooo!

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• The takeaways:

• Do not allow yourself to be intimidated by the “complexity” of the trade. It is nothing more than Selling a Credit Spread to Finance Long Options both with the same directional bias.

• Using this structure I can give myself more time in the trade because it diminishes the theta burn – so I typically put these trades on 3-4 months out in time. The faster the stock moves in my direction, the more profits I’ll make, however even if it takes time I won’t be suffering from the options simply decaying.Ex: If I buy 1x 4 month OTM call option on XYZ, say the 120 @ $3.00, what is my breakeven on the trade? $123 on expiration.If I use an LRR selling the 115/120 Put Spread, Buying 2x 120 Calls for $0.00, what’s my breakeven on the trade? $120 on expiration.If XYZ is at $125 on expiration, what are the P&L’s?Option only: +$200, LRR: +$1,000

• With the LRR, just like long options, there’s very little to “fix” if the trade goes against me, the LRR allows me to establish my “stop loss” on entry. I can do a 5pt spread to risk $500, a 10pt spread to risk $1000, a 1pt spread to risk $100, a 2pt spread to risk $200, etc. The amount of risk I take has a direct impact on the profits I can make because it will determine the amount of long options I can buy.

• Advanced management of these trades allow me to “futz” with the trade (which all of us active traders are want to do) without destroying profit potential. This trade structure allows me to remove risk in the trade, getting my capital buying power back and putting on a new trade without the worry of perhaps closing out of this trade pre-maturely.

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Q & A With Web

the limited risk reversal (lrr) advanced management techniques october 31, 2015 presenter: web...

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