the combo. Put-call parity doesn’t matter because of
the particular situation that C is in. Market makers know
that, and you’d better, too. If you were to try to sell the
stock short and buy that combo, you probably couldn’t sell
the stock because it’s too hard to borrow, and if you
bought the combo, you’d probably be assigned immediately on the short put. If you couldn’t short the stock and
you get long stock from the put assignment, you’re not
locking in anything—you’re just long a bunch of C that you
might not want.
So, if put-call parity ties the same strike call and put
together, the box spread ties options together from one
strike to another. A box is long the combo at one strike and
short it at another strike. It doesn’t have much sensitivity
to changes in the stock price, because it’s both long and
short synthetic stock. At expiration, a box will be worth
the difference between the strikes.
Back to AAPL. With 25 days to expiration, the 120 call
is worth 6.80 and the 120 put is 6. 28; the 115 call is
worth 9.70 and the 115 put is 4. 17. If I sell the 120 call
for 6.80, buy the 120 put for 6. 28, buy the 115 call for
9.70, and sell the 115 put for 4. 18, I would spend 5.00.
The box is trading where it should be.
So, understanding that, you look at a few boxes out
there and notice right before a quarterly expiration that a
SPY 78/80 box is $2.30 bid with the SPY at $79. Hey! If I
sell that box at $2.30, and it’s going to be worth $2.00 at
expiration, I can lock in that 0.30 as profit. The genius is
back! You sell the 78 call, buy the 78 put, buy the 80 call,
and sell the 80 put, and go to bed proud of yourself. The
next morning, you fire up the thinkorswim trading platform, and you see that you’re short SPY shares.
Hmm...how’d that happen? You then see you’ve been
assigned on the short 78 calls.
What you didn’t know is that the SPY pays a dividend
quarterly, and goes ex-dividend at each quarterly expiration. A trader who’s long an in-the-money call may exercise that call to get long stock as of the ex-date, and be
eligible to receive the dividend. You’re short stock on the
ex-date, so you have to pay the dividend. No worries, you
think, the dividend I pay will be offset by the 0.30 credit I
sold the box over parity for. So, how much is the dividend?
$0.50. Sorry, Charlie, you lose $20 for each box you sold.
And because you thought it was such a steal, you sold a
pile of them, and losing a big pile of twenties can take you
out of business. Don’t let that happen to you.
THE JELLY ROLL
Finally, options at different expirations are tied together
by what I call the “jelly roll” to distinguish it from the “roll”
that you’d do in calendar spreads (see “Lip-Smackin’ Good
Rolls” in this issue). A jelly roll is long a combo in one expi-
ration and short a combo in another expiration. And the
value of synthetic stock in one month and synthetic stock
in another has to do with the cost of carry for the amount
of time between expirations.
35/360 X 120 X .0025 = $.029
That’s approximately the difference between the price
of the synthetic stock in the first expiration and the synthetic stock in the second. Jelly rolls never really get out of
line, unless, of course, there’s something that only savvy
A dividend coming in between the expirations can
make the jelly roll look like a good deal when it really isn’t,
but even worse is something like the VIX options (see the
VIX Special in thinkMoney/05 for details). In the early fall
of 2008, the back-month VIX combos were trading much
lower than the front-month combos. If you didn’t understand the peculiarities of VIX options, you might have sold
the front month and bought the back month thinking it
was cheap compared to some theoretical carry charge.
But when the market crashed, the front-month VIX combos skyrocketed. The back-month combos went higher,
but the spread between them doubled and even tripled.
Some retail accounts were slaughtered by that trade.
A good rule of thumb trading options is if something
looks too good to be true (i.e., “free money”), chances are,
it is. Being a savvy trader, you can not only avoid being
suckered by these types of trades, but now you can
understand how they work. And once that happens,
you’re not going to be suckered again.
The information contained in this article is
not intended to be investment advice and
is for illustrative purposes only. Multiple
option strategies such as those discussed
in this article will have additional costs
due to the additional strikes traded. Be
sure to understand all risks involved with
each strategy, including commission
costs, before attempting to place any
trade. Be aware that assignment on short
option strategies discussed in this article
could lead to unwanted long or short
positions on the underlying security. Customers must consider all relevant risk factors, including their own personal
financial situations, before trading.
Options involve risk and are not suitable
for all investors. A copy of Characteristics
and Risks of Standardized Options can be
obtained by contacting Scott Garland at
773.435.3270 or 600 W. Chicago Ave.,
Suite 100, Chicago, IL 60654.