# Guys did I miss something in this options trade?



## mswiggs (31 January 2006)

Hey all,
I went to put on an options trade but they wouldnt let me, because they were saying that the margins would have been to much for my account. Anyway here are the details:

CBA Febuary options

Spot 44.57 
Sell 43.00 call @ 1.75
Buy 43.00 put @ .30 
Buy 44.50 call @ .67 
Sell 44.50 put @ 1.06

net credit of 1.84, which makes up for the premium margin. going to the asx margin estimator, the risk margin had a maximum over the interval "things" of .019. So if i did this once there would be 1840.00 of premium margin and a maximum according to the asx margin calculator of $19.00 risk margin wherever the stock moves. 

I take the veiwpoint that this is a trade with a 43.00 synthetic short constructed at a intrinsic cost of .12 , and a synthetic 44.40 long constucted at a .46, hence with a locked in profit of .36 or $360.00 .

The broker wouldnt allow me to put this on because he was saying that the margin required would be twice as much as the premium margin. I dont know , is there something missing in my understanding?

Also this was going to be my 4th trade on options so i am still trying to learn it all. 

Thanks for any comments Mick


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## chromatic (31 January 2006)

Hi Mick,

I haven't seen any brokers that actually want ACH margins for written put positions. Some want 50% of the whole exposure for the written put e.g. in your case, it's 44.50 * 50% or some, like Comsec do the following
Risk Margin = Risk Margin calculated at a minimum of 16.6%
Margin = (Risk Margin + Premium) * 1.5
That is, Comsec calculates risk margins assuming the underlying swings +- 16.6%! 
I also think that your going to pay brokerage on each leg of your setup and then brokerage to close the position = around $240 or so which may or may not matter depending on how many contracts you were trading.

Cheers,

chromatic


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## sails (31 January 2006)

Hi Mick,

Margins aside, just wondering if you are aware that CBA pays dividends in February (their website suggests the 20th) which can potentially turn this seemingly attractive "locked-in" profit into a trap for the unwary.   Will explain to the best of my understanding...

If CBA falls and is well below your 43 sold call strike at close on the day before ex-dividend then, all things being equal, the profit should be yours to keep (less fees).  

HOWEVER, if CBA is trading above your sold call strike of 43 at close of the day before ex-dividend day, you will almost certainly be assigned leaving you short stock on ex-dividend day leaving you liable for the dividend.  Last dividend was $1.12 and the one before that was 85c.  You would still be able to use the 34c (46-12=34c) to offset, but if you are planning to put this on with some size, it could potentially do a lot of damage.

If you are assigned before that critical "day before ex-div" - this is not so much of an issue (unless your broker charges unreal fees as some do) - you still have time to close it out before ex-dividend day.  

It appears that very few options seminars actually teach this - I originally learned it from other forums and when checking with my broker found out it is true. If you decide to go ahead with the trade, just be aware that the short calls will need to be watched and any necessary action taken on them prior to ex-div day if they are under threat of assignment.

Have you read Charles Cottle's free e-book "Coulda, Woulda, Shoulda". It is a fairly complex type of trade you are getting into seeing it is only your 4th trade, so you should have no trouble getting your head around Charles book and I think you might find it helpful with these types of box and synthetic trades.

Cheers,
Margaret.


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## mswiggs (1 February 2006)

Hey thanks for replies,

Chromatic, I am with Avcol Stockbroking im not sure exactly what their margin requirements are but with other trades i have put on with written puts and calls, I have compared the margin they require with the margin from the asx estimator and they are fairly close, not exactly but within 10%, and i think another more experienced trader uses avcol for this reason. So with regards to this being the reason for why i wasnt allowed to execute this trade I dont see why. The boker was taking the veiw that the bought options formed a long strangle and the short options form the short strangle. Also with brokerage. it is going to be a killer I was expecting to do this more than once, atleast 5 times, and am interested in US options for this purpose but im not sure they would let me write options due to my limited experience. 

Sails, Thanks with the suggestion regarding dividend payment. I was aware that Cba was paying a dividend in Febuary but I couldnt quite comprehend exactly what would happen around ex-dividend day. So I thought instead of leaving it until expiry I would close it on the day before ex dividend day. I put the numbers into hoadley strategy modeler and if i did this once, theta would initially be $12.00 and two weeks later theta woud be $20.00 . So according to the maximum risk margin of $15, quoted by the asx margin estimator, this would still be a good return on investment. Also I have read parts (that I can understand) of coulda woulda shoulda and is definitely well worth the money  . 

Well I guess if I want to find out if the strategy will work ill have to save up for the 2x risk margin so they will let me do it :s .

Mick


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## mswiggs (5 February 2006)

howdy 


			
				mswiggs said:
			
		

> Well I guess if I want to find out if the strategy will work ill have to save up for the 2x *risk * margin so they will let me do it :s .
> 
> Mick




Sorry meant to be premium margin not risk margin, also does anyone have any comments regarding the risks of this strategy and if it is to risky for someone of my experience?

Here are the reasons for putting on the trade:
Limit of risk due being synthetically long and synthetically short which counters any directional risk.

Being able to take advantage of a volitility disparity between puts and calls, where puts where more "expensive" than calls.

Return on investment, according to risk margin calculations the largest amount of capital I would have to use would be $19.00 (however to be conservative, the asx margin estimator discloses that its estimates are most likely within 10% of the actual amount used by ACH, therefore i will add 10% to the estimation, $20.90),however this excludes brokerage which account for approximately 50% of gross profit expenses leaving 50% of the gross profit as net profit.

There is one main risk and that is if puts continue to become more expensive in terms of implied volitility, which would increase premium margin and put the strategy at a loss if I had to liquidate the position.

Also the other risk, the reason behind this thread, is if the margin estimates are entirely wrong, according to the broker they are, and should be more than 100times my estimate required :s . 

The numbers:
No. of times:5 * 4 contracts 
Initial Capital: $20.90 * 5 = $82.50 plus brokerage? $347.50
Initial Brokerage:
1750 * 5 *1.1% = 96.25
1060* 5 *1.1% =  58.30
$44
$44
$243.00 (atleast someones makin money )

Estimated gross profit: $340 * 5= $1700.00 if left until expiry
however because i intend on exiting before expiry theta will be used where theta will be an estimate of (14.75 * 5 =$73.75) * 14 days until day before ex div. = $1032.50 (which leaves more than $600.00 for the last 3 days :s maybe i underestimated any comments?) 

For the moment I use the figure of $1032.50 as gross profit.

Net Profit= 1032.50 - 243.00*2 = $546.50
ROI=546.50/347.50 = 157% return :s 

Ok problems:

Exercise of options: If the sold put was exercised then the position would be exited at a net profit, because the intrinsic value(profit) would be rocognised, however in the case that either of the other three options still open would cause the trade to go into a loss, then i would sell the exercised put again and keep the trade open until the next event. In the case that the call is exercised the I would apply the same process, however it is more likely that the option would have to be sold again to keep the trade open because there is less time value to be gained from the sold call.

Also for one of the options to be exercised the price would have to move deeply past the strikes. Which would bring the trade into profit quicker (because of gamma?) 

Well I hope thats it *yawn* any comments/ tips much appreciated.

Mick 

Also as of Friday 

Risk margin is -$577.00 (according to asx margin estimator), which means it actually reduces the amount of premium margin required to hold the trade open ( i think) and can be used to offset other open positions that have margins (it think).

And premium margin is $9000.00 compared to $9200.00, which recognises $200.00 of gross profit. however i expect this to fluctuate back and forth.

Cheers Mick


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## sails (6 February 2006)

Mick, the following is my understanding of the situation:



			
				mswiggs said:
			
		

> Here are the reasons for putting on the trade:
> Limit of risk due being synthetically long and synthetically short which counters any directional risk.



Also known as a "box" trade - normally no directional risk and cannot lose or make money unless there is an arbitrage opportunity which, as I understand it, is extremely rare as the market makers do not give money away   .  I believe there is software out there is constantly scanning for such opportunities and they execute trades at lightning speed - so even if there is artbitrage, the opportunities disappear very quickly.  If ever you see a box trade with a seemingly risk free profit, always look for the catch.



> Being able to take advantage of a volitility disparity between puts and calls, where puts where more "expensive" than calls.



This is the catch as I understand, it is not volatility disparity but the dividend.  During the cum-dividend period, the dividend is factored into the puts and calls making the puts more expensive and the calls cheaper, hence the disparity.  ITM (in-the-money) puts usually have the entire dividend added into their pricing.  



> Return on investment, according to risk margin calculations the largest amount of capital I would have to use would be $19.00 (however to be conservative, the asx margin estimator discloses that its estimates are most likely within 10% of the actual amount used by ACH, therefore i will add 10% to the estimation, $20.90),however this excludes brokerage which account for approximately 50% of gross profit expenses leaving 50% of the gross profit as net profit.



I rarely use credit spreads, so not sure of margin requirements.  Have you also calculated the cost of brokerage should you need to close some or all the position or if you are assigned on one side?  



> There is one main risk and that is if puts continue to become more expensive in terms of implied volitility, which would increase premium margin and put the strategy at a loss if I had to liquidate the position.



Because you are in a box spread, IV should be fully hedged, so I can't see that you would see any change to your position due to IV fluctuations.  When the dividend is announced at earnings, if it is different to what the market is expecting, then that will be more likely affect the pricing of the spread and not IV.



> Also the other risk, the reason behind this thread, is if the margin estimates are entirely wrong, according to the broker they are, and should be more than 100times my estimate required :s .
> 
> The numbers:
> No. of times:5 * 4 contracts
> ...



I am not sure whether the options will actually conform to your calculations - I would suggest that you continue to track this trade and see what actually happens. 



> Exercise of options: If the sold put was exercised then the position would be exited at a net profit, because the intrinsic value(profit) would be rocognised, however in the case that either of the other three options still open would cause the trade to go into a loss, then i would sell the exercised put again and keep the trade open until the next event.  In the case that the call is exercised the I would apply the same process, however it is more likely that the option would have to be sold again to keep the trade open because there is less time value to be gained from the sold call.



This would leave you long or short the shares leaving you in a similar position.  Problem is that you are more likely to be assigned the short calls before the dividend and be liable to pay the dividend - and then be assigned the short puts after the dividend - and you miss out on receiving the dividend.



> Also for one of the options to be exercised the price would have to move deeply past the strikes. Which would bring the trade into profit quicker (because of gamma?)



Assignment is usually more to do with the dividends than anything else in this situation.  As I mentioned before, it is possible to keep the profit IF CBA is BELOW your $43 strike by ex-dividend day.



> Also as of Friday Risk margin is -$577.00 (according to asx margin estimator), which means it actually reduces the amount of premium margin required to hold the trade open ( i think) and can be used to offset other open positions that have margins (it think).
> 
> And premium margin is $9000.00 compared to $9200.00, which recognises $200.00 of gross profit. however i expect this to fluctuate back and forth.



Yes, the spread has shown some profit as CBA moved down - keep watching it closely and see how it continues to behave - great learning experience  

To my understanding, it is fairly easy to summarize:  it is the dividends that are causing the disparity you have found and you can usually only win on a trade like this IF the underlying falls below the sold call strike by the day before ex-dividend.

Hope this helps!

Margaret.


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## wayneL (6 February 2006)

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 for you Margaret.

Great post.


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## sails (6 February 2006)

wayneL said:
			
		

> A
> 
> 
> 
> ...




Thanks Wayne   

How about that Mick - the info has just been OK'd by the resident options guru


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## mswiggs (6 February 2006)

Thanks Sails,
Think I found a part of my brain i didnt know about, nice star also  hehe, also "Problem is that you are more likely to be assigned the short calls before the dividend and be liable to pay the dividend" I dont understand this I think its something i havent come across, I factored in brokerage for exit by doubling the initial brokerage, of course the brokerage could be more than this but should be a reasonable estimate.  Also I put the numbers into the modeller and theta is negative :s . Hmm lucky the broker didnt put the spread on    

Cheers Mick


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## sails (6 February 2006)

mswiggs said:
			
		

> Thanks Sails,
> "Problem is that you are more likely to be assigned the short calls before the dividend and be liable to pay the dividend" I dont understand this I think its something i havent come across



I was never taught this in an options course, but fortunately I learned about it from others who shared their grief on a US forum - I then checked with my broker and sent an email to the ASX - both confirmed that it was also applicable here in Australia.  So it pays to be very careful with short calls as ex-div approaches!

Lets say CBA pays a $1 dividend and you find yourself assigned on the day before ex-dividend (the exercising party informs their broker the day before ex-dividend day so that they own the shares the next day.  Then you are notified by your broker the next morning leaving you technically "short stock".  Using your trade as an example, the broker would most probably deduct $1*5000 = $5000 from your account (check with your broker to see how they handle it).  Of course you would have your 34c*5000 = $1700 locked-in profit so your total loss would be $3,300 plus 2 lots of brokerage on the shares and any other brokerage incurred on the option trades.  

Cheers,
Margaret.


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## wayneL (7 February 2006)

sails said:
			
		

> ....the resident options guru




Lets just say I learned how to dodge bullets before actually getting hit by one


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## sails (7 February 2006)

wayneL said:
			
		

> Lets just say I learned how to dodge bullets before actually getting hit by one




That sums up options trading pretty well


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## Magdoran (1 June 2006)

I agree with Wayne, Margaret’s post is excellent.  Just thought I’d reproduce my reply to Mick in another forum (he’s probably forgotten about) for interest:



Hello Mick,


I’ve considered your position here, and came to the conclusion that you would have been required to deposit two margin amounts with most brokers.

So, why is this the case? This is because you were attempting to enter two credit positions; basically a bull put spread, and a bear call spread simultaneously.

Interestingly, these are usually directional or neutral positions looking for the sold option to expire worthless, or sufficiently lose value by theta decay faster than the hedged bought option does.

Essentially in this case you were selling in the money options, and hedging these sold options by buying protection at strikes that were less in the money to the sold positions. 

Since the options in this case had less than 30 days till expiry when you were attempting to enter this position, and that the sold positions were well in the money, there was a high probability of exercise the closer time approached expiry.  Usually you would look to sell more at the money looking to maximise premium.  

There are considerable risks selling credit positions too far in the money, that as time nears expiry, your bought position will have eroded faster in time value than the sold position (particularly if the protective position is out of the money), and that you may be excercised.

Also, even if you sold at the money or slightly out or the money options, you would still have to deposit a margin.

How is the margin determined? Determine the difference between the sold position and the bought position (43.00 for the sold call, and 44.50 for the bought call, = 1.50 spread). Then find the credit amount (sold – bought) 1.75 – 0.67 = 1.08 credit. Since the spread is 1.50, less the credit 1.08, the margin required would be 0.42 to cover for the maximum loss possible (maximum reward would be 1.08).

Do the same for the puts (44.50 sold put, 43.00 bought put = 1.50 spread), credit of 0.76 (1.06 – 0.30), tally the spread 1.50 less credit 0.76 yields margin of 0.74 (maximum reward 0.76).

Total the two collateral requirements (margin) calls 0.42 + 0.74 = $1.16 (this is per each 4 legged contract – ie if you did 10 contracts per leg, you’d need 10 X 1.16 X 1000 = $11,600 to trade 4 lots of 10 contracts plus brokerage on top of this. For a single contract (4X1) you would need $1,160, plus brokerage for each leg).

You probably could not have traded this position as a synthetic long/short since you would be trading essentially naked positions, and the margin requirement would have been considerably more if you broke these positions into two individual trades not using the bull put and bear call approach.

The real danger you run into here is being exercised at an unfavourable time for one leg, making a loss, and then having the remaining position move unfavourably too, making a significant or major loss. You are really looking for no real movement at all. Or both positions in this case could be in the money towards expiry, and this can get messy if exercised before you can wind out the position.

I note that you were attempting to lock in an arbitrage profit. The problem is the spreads and skews like this can be complex, and really needed to move in your favour to get set, and that during the trade, that the above negative scenarios did not eventuate. Looks good on paper, but certainly little added extra’s such as dividends can be a problem on the call side if you get exercised before the ex div day, and end up owing the dividend.


Hope this sheds some extra light on the subject.


Magdoran


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## mre83 (6 September 2006)

Hey Magdoran

Just a quick question regarding your margin calculation in the $1,160 example. Is that the same for all brokers or do some brokers calculate differently. Thnaks

Mre


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## NettAssets (6 September 2006)

mre83 said:
			
		

> Hey Magdoran
> 
> Just a quick question regarding your margin calculation in the $1,160 example. Is that the same for all brokers or do some brokers calculate differently. Thnaks
> 
> Mre




Just a note from personal experience.
For credit spreads E*Trade use the whole of the short leg as the debit position showing in the account regardless of the cover by long options.
This effectively blocks your account from internet trades unless you are fully cash covered.
They will allow you to trade up to the level that Magdoran has calculated but only by phone  - at internet rates.
John


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## Magdoran (6 September 2006)

mre83 said:
			
		

> Hey Magdoran
> 
> Just a quick question regarding your margin calculation in the $1,160 example. Is that the same for all brokers or do some brokers calculate differently. Thnaks
> 
> Mre



Hello Mre,


Good question, and one NettAssets has helped to address by giving a real example of a particular broker.

Simple answer is it depends on each individual broker’s policy, and some brokers are not really geared for complex spreads.  The way I structured the above scenario would probably be the best way to explain the strategy requirements to a broker to ensure that the collateral was not some huge amount (if the position was alternatively assessed as an essentially naked strategy).

Currently many Australian brokers would require a phone call to set up this kind of trade, but some brokers look like they are setting up automated capacity to do complex trades.  I know that it is possible currently to use OptionsXpress to do the two legs as suggested above through their automated system, and the collateral would be calculated as above.

However, each broker will differ based on their level of sophistication, and it is worthwhile clarifying their approaches to determine if they can deliver reasonable services to your needs based on the way you want to trade (you could treat them like an employee, if they don’t perform, consider hiring someone else).  You may have to call your current broker, and find a level 2 person and explain the mechanics for them to accept the margin set up depending on who your broker is.

Hope this helps.


Regards


Magdoran


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