Exotic Options Replication: Expiry Range Option

Discussion in 'Options' started by CPTrader, Nov 28, 2008.

  1. Hello,

    How I can replicate using exchange-traded options an expiry range option. an expiry range option is an option that is profitable if at expiry the market settles within the range. This is also done on a limited risk basis..risk limited to the initial debit.

    Generally if you expect a market will stay within a range you can sell a strangle. However, a strangle creates unlimited risk. The Expiry Range option eliminates the unlimited risk characteristic of the short strangle.

    My question: How can I replicate an expiry range option using exchange traded options?

    This question can also be answered by answering the ff two questions

    (a) how do I fully "hedge" the unlimited risk of the short strangle while still leaving room for reasonable reward or

    (b) what is a limited risk way to profit if a market is within a pre-defined range at expiration.

    Thank you.
  2. CPTrader,

    It sounds to me like you are talking about a long butterfly spread. In a Long Butterfly, you sell 2 calls or puts at the same strike and buy a lower strike wing and a higher strike wing.

    If the stock remains in a fairly close range, you can profit by the middle strike (short position) running out of value, while one of your wings maintains it's value.

    I'm not 100% sure this is what you are looking for, but it sounds like it.

    Here is a link with more info:

  3. MTE


    An iron condor or a condor achieves exactly what you want.

    An iron condor is essentially selling a strangle and then buying a wider strangle, which is equidistant to the short strangle strikes, to limit the risk. For example, you sell a 40/50 strangle and then buy a 35/55 strangle to limit your risk, which is then equal to the difference between the short and the long strike (e.g. 55-50=5 or 40-35=5) less the premium received.

    A condor is the same idea, but instead of using both calls and puts it uses only calls or only puts. So you buy the outer strike calls (puts) and sell the middle strike calls (puts).
  4. Thanks MTE.

    1. Is there any particular reason why the wider strangle must be equidistant to the short strangle strikes.

    2. What are your thoughts about using a double calendar/strangle swap instead of an iron condor. In the double calendar/strangle swap I would sell the front month strangle and then buy the next month strangle- using the same strikes across all strangles?

    3. Using the iron condor or double calendar/strangle swap...what are my risks and how can i assess at trade initiation my potential max profit/max loss.

    Thanks so much to all
  5. MTE


    1. It doesn't have to be equidistant, but then your max risk is different on each side. If you want identical max risk on each side then it has to be equidistant.

    2. Here you just add another dimension to an iron condor, i.e. cross-month volatility.

    3. In an iron condor your max risk is the difference between the strikes less premium received, that's it. In terms of greeks, you are short volatility and gamma, long theta, and approx. delta neutral at entry. Your max ptofit is the premium received.

    In a double calendar you are actually long volatility, it's not straight long though cause you are long in one month and short the other, and you can't just add up the vegas across different months. Also, your max risk is the premium paid. Your max profit depends on volatilities so you can't determine it precisely at entry.

    Essentially, an iron condor is a range trade, a double calendar is as much a range play as it is a play on volatilities across the two months, i.e. when you think that the front month is overvalued compared to the back month.
  6. Thanks, MTE....very much.

    As a practical matter I find that for the kind of wide ranges I define my risk/reward ratio is very poor e.g risking 50 points to make 5 points with iron condors. Even though there is a very high probability that I will make the 5 points i.e. keep the 5 points credit received... the poor risk/reward and the daily mark-to-market risk plus the high margin requirements make the iron condor to me a poor risk/reward proposition.

    Do I get better a risk/reward proposition with the Double Calendar?

    What's a good way to play the range while having a good risk/reward ratio; ideally I'd like to have at least 1:1.5 risk reward ratio. currently with the ranges I define, with iron condors I get 10:1 risk reward ratios....which for me is unacceptable.

    Many Thanks!
  7. MTE


    I know of no way to get a 1:1.5 risk reward ratio and a high probability on a range strategy. That's the way the range strategies work, your probability is high, but your reward is low relative to risk. You can go to higher reward, but then the probability is lower. That's the trade off.
  8. CPTrader,

    It still sounds to me like you need to consider a long butterfly for what you are asking for then. In your original post, you mention that you want the risk "done on a limited risk basis..risk limited to the initial debit."

    Long Iron Condors get a credit and then the risk is the difference between the spreads minus the credit. I'm not saying Long Iron Condors aren't useful, just that they aren't even done for initial debits.

    Also, I am surprised that you would say you can't find risk reward better then risking 50 to make 5 with a Long Iron Condor for example. Remember that a Long Iron Condor can't be loosing on both sides at once. Usually I would think you could get $5 while risking maybe 20 to 25.

    Anyways, again with a Long Butterfly, you buy it and in general that debit is the max risk assuming you don't make adjustments, etc.

    Also, as far as risk/reward ratio goes, often a person might pay $300 to get a 10 point butterfly. Therefore if the stock ended exactly at the middle strike, theoretically the profit would be $700. Of course, it would be unlikely to make that much, but you certainly aren't risking $7000 to make $700. It would be reasonable to expect decent profit if the stock was near the strike as expiration started to approach.

    Don't get me wrong - if the stock moves alot, it would be easy to lose the entire $300 initial debit, but again without adjusting, you can be certain you won't face larger losses then that.

  9. MTE



    An iron condor is a synthetic equivalent to a condor, which is done for a debit. A butterfly is a synthetic equivalent to an iron butterfly, which is done for a credit. It's all the same. This goes back directly to another thread that has been just started on the importance of synthetics.

    The only difference between a butterfly and a condor, iron or not, is that a condor has a wider range than a butterfly.

    The risk/reward depends on the range you pick, there's nothing wrong with a 50 to 5 risk reward CPTrader mentioned, it just means he (she?) is going with a very wide range. A 10-point butterfly for 300 you mention has a better risk reward, but it also has a much lower probability than a 50 to 5 spread.
  10. MTE,

    Yes, I agree with everything you said. It is really a question of how far out strike price wise does a person want to go and how much time do they want to risk the position for. Also, do they prefer to get a credit or a debit, or not care either way. This is an area where options give you options!:)

    Personally, I think it is tough in any event to predict that a stock will remain within a tight range over a given period of time. And if a person trys to do it with ETFs, etc, they will find the premiums aren't so great.

    I prefer to use Long Iron Condors when there is very little time remaining, as little as less then 1 trading day with higher priced stocks. Then, you can hope the stock remains in a channel and doesn't have any breaking news or big market movement for a day or so and make some money and I've found the risk/reward ratio isn't too bad sometimes.

    I think sometimes people overrate how easy it is to just "make money if the stock stays in a tight range". Look at a market like we're in now. Many stocks aren't close to where they had been and could either continue to plunge, or they might reverse and head up big.

    If I look at a stock like XOM, it is right at $80, but what are the odds it will be there even at Dec expiration? Probably not too good, but could it be between 75 and 85? Maybe. A long iron condor with 5 point spreads (sell 85/buy 90 calls - sell 75/buy 70 puts) would bring in close to $200 with reasonable risk, but then again, XOM was in the 60s just about a week ago, so even that range might not be big enough.

    If you tried sell 90/95 call spread and 70/65, you could get about $80 or so, but even that might not be enough, who knows?

    So yes, the risk/reward is up to the user. I wasn't necessarily saying there was anything wrong with a 5/50 ratio or whatever, just that a person should be able to find better then that if that's what they want.

    #10     Nov 29, 2008