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Fade Trade

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Contrarians like to fade trade, whereby they look for prices to reverse. Sharper moves in price, whether up or down, tend to be unsustainable, which makes them prime candidates for fade trades. In these cases, the trader wants prices to change direction since the current rally or decline is expected to end or see some short-term interruption.

Option sellers use these price spikes to sell puts into weakness in the underlying asset, and sell calls into strength in the underlying asset, due to the inflated prices of the respective options.

Option buyers prefer to buy calls into weakness in the underlying asset and buy puts on strength in the underlying asset, due to the reduced prices of the respective options.

Return to the main trading glossary page to learn more terms.

Strangle – Option Strategies

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A strangle is the simultaneous purchase or sale of a call above the market and a put below the market.

Long Strangle

A long strangle involves the purchase of both an OTM put and an OTM call.  This strategy is generally utilized when the underlying stock or index is expected to make a very large move, but a direction is unknown.  By purchasing both options, the time value of both options begins to erode, so this is an approach often used when an event is expected to spark a sudden move (earnings release, economic data news, conference call, etc.).   A long strangle creates a negative Theta position.

A large move would cause the call or put to go ITM, and a move with great velocity could inflate the volatility component of price as well.  Because only one of the options (either the call or the put) can potentially expire ITM, a strangle buyer needs one option to gain more value than the other side loses in order to turn a profit.

Short Strangle

A short strangle is the sale of both an OTM put and an OTM call.  This strategy is generally utilized when the underlying stock or index is expected to stay within a price range, therefore allowing for the collection of premium on both the call and put sides.  This approach embraces the idea that the time value of both options will begin to erode, therefore creating a positive Theta position.

It’s common to sell strangles around scheduled events (such as earnings announcements) when a big move is expected and implied volatility is high and a contraction in IV is likely.  This causes rich premiums which quickly erode if price stays within the expected range.

Return to the main trading glossary page to learn more terms.

Calendar Spread – Option Strategies

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Also known as a time spread or horizontal spread, a calendar spread is a position constructed using two options of the same type (either calls or puts) where one is bought and another is sold at the same strike but for different expirations.  There are call calendar spreads and put calendar spreads.

In a calendar spread, the near-term option is sold and the back month option is bought as a hedge.  Because the back month option being bought has more time value than the near-term option being sold, a calendar spread is done for a debit.

The aim is to collect the faster decay from the short-dated option since time value erodes more quickly than in the back month option.  These are commonly used when price is expected to stagnate (non-directional) over the life of the near-term option, or when price is expected to move (directional) toward a particular strike by expiration.  The calendar spread expands, or gains value, as time passes while price stays near the strike price.

A trader could sell a naked call or a naked put if price were expected to stagnate, but those strategies lack a hedge.  In a calendar spread, the long back month option serves as a hedge, thereby limiting potential profits but also limiting risk.

Calendar spreads tend to retain at least some value even if price moves a considerable distance from the strike price.  This is because even once the near-term option expires, the long option (initially the back month option) still has time and therefore some value.  A calendar spread is net long vega, so it will benefit from an increase in implied volatility.

A reasonable profit target for a calendar spread is 50% above what was paid for the position, although some profitable calendar spreads never achieve this and others may exceed this target.

For example, a call calendar in XYZ at the $40 strike would include a short $40 call for the near-term expiration, and a long $40 call for the back month expiration.  If purchased for a $0.50 debit, then a reasonable profit target may be $0.75 (50% above the price paid).

Return to the main trading glossary page to learn more terms.

Vertical Spread – Option Strategies

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A vertical spread is the combination of a long and short option at different strikes but in the same underlying for the same expiration.

There are call vertical spreads and put vertical spreads.  A call vertical spread is the purchase of one call and the sale of another at a different strike for the same expiration.  A put vertical spread is the purchase of one put and sale of another at a different strike for the same expiration.

Vertical spreads can be bought or sold, and either strategy involves defined risk and defined profit.

Long Vertical Spread

Buying a vertical spread is a strategy commonly used when price is expected to move toward or through a specified price level.

Long Call Vertical

In the case of a long call vertical spread, price is expected to rise to or through the upper strike of the spread.  A lower-strike call option is purchased and a higher-strike call option is sold for a net debit.

The lower-strike call gains value as price rises because it is long deltas, but the higher-strike call option loses value as price rises because it is short deltas.  The lower-strike call is either ITM or closest to the money, making it more directionally sensitive to moves in the underlying asset price (stock prices) vs. the higher-strike call.  For this reason, the long lower-strike call carries more deltas than the short higher-strike call negative deltas, giving the long call vertical spread positive deltas as a combined position.

The spread can only lose the amount paid for the spread, which defines the risk.  The spread can only gain the width of the spread minus the credit collected, which defines the potential profit.

Long call verticals are typically bought with the long option being ITM or ATM with an expectation of price rallying to or through the short strike.  This is a bullish strategy designed to limit risk to the debit paid with potential for the spread to expand to the width of the strikes.

Long Put Vertical

In the case of a long put vertical spread, price is expected to decline to or through the lower strike of the spread.  A higher-strike put option is purchased and a lower-strike put option is sold for a net debit.

The higher-strike put gains value as price declines because it is short deltas, but the lower-strike put option loses value as price decline because it is long deltas.  The higher-strike put is either ITM or closest to the money, making it more directionally sensitive to moves in the underlying asset price (stock prices) vs. the lower-strike put.  For this reason, the long higher-strike put carries more negative deltas than the short lower-strike put positive deltas, giving the long put vertical spread negative deltas as a combined position.  The spread can only lose the amount paid for the spread, which defines the risk.  The spread can only gain the width of the spread minus the credit collected, which defines the potential profit.

Long put verticals are typically bought with the long option being ITM or ATM with an expectation of price declining to or through the short strike.  This is a bearish strategy designed to limit risk to the debit paid with potential for the spread to expand to the width of the strikes.

Short Vertical Spread

Selling a vertical spread is a strategy commonly used when price is expected to move away from a specified price level.

Short Call Vertical

In the case of a short call vertical spread, price is expected to decline away from the lower (short) strike of the spread.  A higher-strike call option is purchased and a lower-strike call option is sold for a net credit.

The lower-strike call loses value (benefits the spread) as price declines because it is short deltas, and the higher-strike call option loses value as price declines because it is long deltas.  The lower-strike call is either OTM or closest to the money, making it more directionally sensitive to moves in the underlying asset price (stock prices) vs. the higher-strike call.  For this reason, the long lower-strike call carries more negative deltas than the higher-strike call positive deltas, giving the short call vertical spread negative or short deltas as a combined position.  The paired position can only lose the width of the spread minus the credit collected at entry, which defines the risk.  The spread has a max gain of the credit collected, which can only erode to $0, which defines the potential profit.

Short call verticals are typically sold with the short option being ATM or OTM with an expectation of price staying beneath the short strike.  This is a bearish strategy designed to collect premium but limit upside risk in the event of a sharp advance in share prices.

Short Put Vertical

In the case of a short put vertical spread, price is expected to advance away from the higher (short) strike of the spread.  A lower-strike put option is purchased and a higher-strike put option is sold for a net credit.

The higher-strike put loses value (benefits the spread) as price advances because it is long deltas, and the lower-strike put option loses value as price advances because it is short deltas.  The higher-strike put is either OTM or closest to the money, making it more directionally sensitive to moves in the underlying asset price (stock prices) vs. the lower-strike put.  For this reason, the short higher-strike put carries more positive deltas than the lower-strike put negative deltas, giving the short put vertical spread positive or long deltas as a combined position.  The paired position can only lose the width of the spread minus the credit collected at entry, which defines the risk.  The spread has a max gain of the credit collected, which can only erode to $0, which defines the potential profit.

Short put verticals are typically sold with the short option being ATM or OTM with an expectation of price staying above the short strike.  This is a bullish strategy designed to collect premium but limit downside risk in the event of a sharp decline in share prices.

Return to the main trading glossary page to learn more terms.

Jade Lizard – Option Strategies

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A jade lizard is a short OTM call spread paired with an OTM naked put.

The aim of a jade lizard is to collect enough premium to offset the width of the call spread, thereby eliminating upside risk.

For example, a jade lizard in XYZ might be established by selling the $10 put as well as the $14/15 call vertical spread.  Because the call vertical spread is $1 wide, this trade would need to collect at least $1 in total premium in order to eliminate that upside risk.  This leaves only downside risk, making it a bullish trade.

Jade lizards should not be done in stocks you are unwilling to own, as you may be assigned long stock if the short put goes ITM, thereby creating undefined downside risk.

Return to the main trading glossary page to learn more terms.

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