Wednesday, February 25, 2009

Options Are Building Blocks

In many options manuals or books, when discussing option spreads or complex strategies, the vernacular used in describing them is that of building or constructing an options trade. These terms help convey the notion that options are building blocks. If I wanted to be successful in building a structure with blocks, I must first be familiar with the characteristics of each individual block, such as a triangle, circle, or square. Upon reaching a solid understanding of the basic blocks, I can then begin to map out the best way to combine the blocks to construct a more complex structure, such as a house or castle. In the same vein, there are core building blocks one must master with options trading, prior to jumping into trading advanced spreads such as condors and butterflies. All too often new traders want to jump into spread trades, without first achieving a sufficient knowledge of call and put options. That’s the equivalent of wanting to construct a castle, without first knowing the difference between a triangle and a square. You can try, but don’t be surprised if your castle looks more like a shack.

Within the options market, call and put options are the two basic blocks used to construct more advanced trades. Moreover, there are two actions we can take with these two blocks, bringing us to a total of four core blocks we can utilize.

Bullish: Long Calls, Short Puts
Bearish: Long Puts, Short Calls

Now, if we add in the actions we can take in the equities market, namely, buy and short stock, that brings us to a total of six building blocks or actions we can utilize to build a trade:

Bullish: Long Calls, Short Puts, Long Stock
Bearish: Long Puts, Short Calls, Short Stock

Every equities or options trade you see will be a combination of one of these six blocks. There are literally hundreds of varying strategies constructed with these blocks. Whether you’re just venturing into the options arena, or are a seasoned veteran, memorizing the characteristics of these six blocks will no doubt make you a better trader. Once that’s accomplished, spread trades should be much easier to grasp. One way to simplify a spread is to picture it as the sum of its parts.

To illustrate the concept let’s analyze a spread trade which involves two building blocks. Suppose stock XYZ is trading at $50 and we enter a bull put spread by simultaneously buying a 45 put and selling a 50 put. Now, even if we had no idea what a bull put spread was, we could simply break down the spread into its respective building blocks to determine the risk-reward characteristics of the trade. The two building blocks are a long put and a short put. The short 50 put obligates us to buy stock at $50 and the long 45 put gives us the right to sell the stock at $45. Reviewing these rights and obligations inherent with the two blocks enables us to determine our maximum risk is $5.

Perhaps the greatest benefit to understanding options as building blocks is aiding in reading risk graphs. Each of the six core building blocks has their own respective risk graphs. Therefore, spread trades are simply a combination of the risk graphs of the individual blocks. For example, a bull put spread is constructed by selling a higher strike put and simultaneously buying a lower strike put. Thus, its risk graph is the combination of the individual risk graphs of a long and short put.

In addition to the bull put spread there are many other multi-leg option trades that combine two, three, and sometimes four of the building blocks. Shown in this light, options spreads should be much easier to understand.



Jim Brown said...

On the other, and for some odd reason,I started to gain a much better understanding of the vertical spreads only after doing a couple of iron condors and double diagonals. ITM, OTM vertical spreads, one's teaching it this way, one's teaching it that way. That muddled the waters for me for sometime. We all think differently, thank goodness!!!...and this of course is not to detract from your excellent article. REALLY appreciate your clarity.

Tyler said...

Great point Jim. Even if a trader comes to a point where they've internalized the basic building blocks, it doesn't guarantee you'll nail down complex trades without some effort. There is no substitute for experience.... If there were, I'd put bottle it up, sell it, and be a billionaire.

Uriel Apeiron said...

"The short 50 put obligates us to buy stock at $50 and the long 45 put gives us the right to sell the stock at $45. Reviewing these rights and obligations inherent with the two blocks enables us to determine our maximum risk is $5."

Why do we want to sell the stock for less than we're buying it?

The third picture doesn't zoom like the short and long pictures.


Tyler Craig said...

Hey Todd,

We don't want to sell the stock for less than we're buying it. I was explaining the worst case scenario when trading bull put spreads. In the 50-45 put spread example if the stock dropped significantly (let's say to zero), our maximum risk is $5. Though the short 50 put obligates us to BUY shares at $50, the long 45 put grants the right to sell shares at $45. Thus, we can't lose more than $5 no matter how far the stock drops.

The ideal scenario is to have the stock remain above $50 so both puts expire worthless allowing us to keep the net credit received in the trade.

The purpose of the exercise was to simply show how you can add short puts with long puts to create a spread.

Not sure what you mean when you say "zoom".

Hope that helps-

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Excellent material