Part XII · Strategy atlas · Chapter 12B

Novice strategies

Single options and simple spreads

1 · How to read an entry

Each entry opens with a card that gives the legs, the view, the maximum profit and loss, the breakeven and the net Greeks at entry. The prose after it covers the regime the strategy fits, how it fails and a worked example. It adds the dealer's side where that says something new.

The cards use one notation. $S$ is the underlying's price now and $S_T$ its price at expiry, $K$ is the strike and $P$ the premium, each per share or per index point. For positions that hold shares, $B$ is the cost basis, the price you paid per share. The Greeks are delta, gamma, theta and vega (Chapter 5C). A plus sign means the position gains when that quantity rises. A contract's dollars are the quote times $100: 100 shares for SPY, or $100 per index point for SPX (Chapter 5A).

The dealer who takes the other side of your trade holds your position with every sign flipped, then hedges it (Chapter 6B). Where you are long gamma, the dealer is short gamma, and so on through each Greek.

The premiums in the worked examples are round, illustrative numbers, chosen so the arithmetic is easy to follow, and each example stands alone. Rather than quotes, they are numbers that sit well below what a pricing model gives at the volatilities they state. At 18% implied volatility, with interest ignored, the Black-Scholes model of Chapter 5C prices the first example's 30-day 6,050 SPX call near $100, not $35. A price of $35 corresponds to an implied volatility of about 8%. The formulas hold at any premium, though a real breakeven lies further from the strike than the examples suggest.

2 · Long call

The dealer who sold this call is short the call, which leaves the dealer short delta, short gamma and long theta. The dealer buys shares at once to hedge the delta and keeps re-hedging as the price moves (Chapter 6C). Structurally, your long call pays the dealer to manufacture upside convexity for you out of the underlying.

The long call fits best in a low-IV regime, where your directional thesis exceeds the implied move. It fits worst when IV is high, because you pay an inflated premium that decays quickly. It fails in three ways, two of which can strike even when your view of direction is right:

• An IV crush after the expected catalyst arrives: you are right on direction but lose on vega.
• Time decay that accelerates in the final two weeks before expiry.
• A move the wrong way, which leaves the call to expire worthless.

Drag the days left toward zero, and the call's value sinks onto its expiry payoff. Then set SPX then to 6,050 and add a 40% IV crush: a 50-point rise that was worth $510 now loses $1,090.

IV at entry

8.2%

days left

15

IV crush

none

SPX then

6,150

premium P = $35.0 ($3,500)

breakeven at expiry = 6,085

breakeven, 15 days left = 6,039

P&L then, 15 days left = +$7,370

P&L at expiry = +$6,500

3 · Long put

The long put fits best as a hedge in mid-IV regimes. As a standalone directional bet it needs significant downside conviction, enough to overcome the negative drift built into option premiums (Chapter 10C). It fails in three ways, one from how puts are priced and two from how the index behaves:

• Volatility skew makes out-of-the-money (OTM) puts typically expensive relative to OTM calls (Chapter 5G).
• Structural mean reversion in calm regimes pulls the index back from its dips.
• Equity drift over multi-week horizons works against you, since the index tends to rise.

4 · Covered call

The P&L has a slope of +1 below the strike, where you hold the shares, and 0 above it, where the sold call cancels them.

The maximum loss is bounded but potentially enormous in dollars. A 100-share SPY position at $580 has about $58,000 of downside before the premium offsets any of it. Calling a covered call "limited risk" beside a naked short call is fair. Treating it as a small-risk position is not.

The dealer is long the call you sold, which leaves the dealer long delta, long gamma and short theta. To hedge the growing delta, the dealer sells shares as the underlying rises. In aggregate, that hedging contributes to the mean-reverting character of positive gamma exposure (GEX, Chapter 8D).

The covered call fits sideways or slowly rising markets. It fits worst in strong bull markets, where you cap your upside far below where the stock actually goes.

It needs shares to cover, so it runs only on single stocks and exchange-traded funds (ETFs) you can own: SPY, QQQ, IWM, AAPL, NVDA and so on. You cannot run a covered call on SPX, XSP, NDX or RUT, which are cash-settled indexes with no shares to own. The cash-settled equivalent of "I would sell at a higher level" is a cash-secured short call, a naked call against cash collateral. Its loss is unbounded, a fundamentally different risk profile from a covered call. Do not conflate the two.

5 · Cash-secured put

A cash-secured put has the payoff of a short put, with the obligation to buy at the strike fully funded in cash. Its maximum loss is bounded but very large in dollars: a 570-strike SPY cash-secured put has a notional maximum loss near $57,000 per contract. The loss is capped, not small. "Defined risk" is a claim relative to a naked call's exposure, not a license to size the position as if it were tiny (Chapter 13C covers sizing).

It fits sideways or slowly rising markets, where the put expires worthless. Run systematically on XSP, it is the canonical vehicle for harvesting the variance risk premium (VRP, Chapter 10C). It fits worst in a strong fall, when the put is exercised and you are left long stock that is underwater.

The failure modes are those of the covered call, because the two have identical payoffs under put-call parity (Chapter 5F). One sizing trap belongs to this entry. Traders see "bounded loss" and size by the credit collected, reasoning "I collected $400, so my risk is $400", rather than by the actual distance to their stop. The right anchor for size is the notional, or the loss at your stop level, not the option premium.

For American retail traders, run this on XSP rather than SPY, to get the Section 1256 60/40 tax treatment (Chapter 2E). The pre-tax arithmetic is identical, while the after-tax result is dramatically better on XSP. XSP puts settle in cash, so an assignment below the strike costs cash instead of delivering shares (Chapter 12H).

6 · Protective put

A protective put insures shares you hold: below the strike the put pays back every further dollar the shares lose, so the loss stops growing at $(B - K) + P$. By put-call parity, shares plus a put have the payoff of a long call at the same strike plus cash (Chapter 5F).

The protective put fits best when you have an asymmetric concern about a specific event, such as earnings, a Federal Reserve (FOMC) meeting or a geopolitical risk, and want capped downside through it. It fits worst as a continuous overlay, because the cost of rolling puts over long horizons is significant.

7 · Check yourself