ZEBRA: A Lower-Cost Option Spread To Simulate A Long Stock Position

Earn your options trading stripes with ZEBRA spreads

I’m already long NVIDIA (NVDA). Earnings are coming up on August 23 and I’m looking for a way to add to my position. But at $446.80 as of August 4, this getting to be an expensive stock in terms of dollars per share. It’s well more than doubled over the past year:

I often trade options, selling calls against stock or selling puts to initiate long positions. But options represent 100-share contracts, and 100 shares can get expensive for a stock at this price level.

Yes, I realize the real value of a company is its market cap, but there’s a big difference for some traders using options on a $50 stock than one that sells for close to ten times that price.

This is why many traders use options to create positions that substitute for long positions (or even short positions) that don’t tie up significant capital. And given that NVDA options often trade at relatively high levels of implied volatility, it’s a good candidate for selling calls against existing positions.

There are several ways to use options to be long the equivalent of 100 shares with less capital. In this article, I am going to compare two of them ­­­– buying a deep-in-the-money call vs. a ZEBRA spread.

Meet the zero extrinsic back ratio spread (ZEBRA)

The term “Zero Extrinsic Back Ratio spread” doesn’t exactly roll off the tip of your tongue, so it’s known by the acronym ZEBRA.

Curious about who named this spread, I asked Tom Sosnoff, co-CEO and a host at tastylive, about it. As it turns out, two of his co-hosts, Liz Dierking and Jenny Andrews (who host The LIZ & JNY Show), first coined this acronym. So a shout out to Liz and Jenny for having some fun describing a somewhat complex spread!

So what does “ZEBRA” mean? Let’s break it down:

• This is a ratio spread because you buy a different number of options than you sell.
• This is a back spread because you buy more options than you sell, not less.
• The “zero extrinsic” part describes how the spread is used to minimize buying too much extrinsic value

Getting more intrinsic value for your money

Normally when I sell options, I want to be selling extrinsic value because that’s the premium that decays over time.

But when buying options, I want to minimize that and get as much intrinsic value as possible.

To see what I mean by this, let’s take a look at some NVDA options as of August 4 that expire in November (105 days)

• If you look at an-in-the-money call option, say the 390 strike, it sells for $84.75, but given the stock was trading at $446.80, it’s intrinsic value at the time was $56.75. Only $28.00 was extrinsic value – about one-third the price of the option, and about 6% of the price of the stock.
• Moving up the option chain, closer to the money, the 420 call was selling for $66.20. Its extrinsic value was $39.40 is about 60% of the price of the option and about 8% the price of the stock.
• And for the slightly out-of-the-money 450 call, it has no intrinsic value, so its entire price of $51.85 is extrinsic value, about 11% the price of the stock.

You can see that although a call option may be less expensive overall, more of the price reflects extrinsic value.

To see how this pattern looks across this expiration series, this chart shows the “moneyness” of the call options and the extrinsic value of each as a percentage of NVIDIA’s stock price.

It’s clear that extrinsic value is highest for at-the-money strikes and lower the further the strike price is from being near-the-money.

And here’s a similar chart that shows the deltas of these options, which will be important in setting up a ZEBRA spread.

Setting up a ZEBRA

As of August 4, I could have bought 100 shares of the stock for $44,680. Obviously, that gives you a 100-delta position.

Or I might have purchased a deep-in-the-money call. Traders may differ on how far down the option chain you have to go to be “deep,” but I’m going to consider 98 deltas close enough to 100 to be deep enough

This turns out to be the 240-strike call with a price of $212. Given the intrinsic value of that option is $208.80, only $5.20 of that is intrinsic value – about 1.1% of the stock price.

The cost of the option is less than half the cost of the stock is less than half the cost of the stock itself, and I’m getting pretty close to 100 deltas.

But you can pay less for those 100 deltas.

Let’s say I buy two 75-delta calls and sell one call of about 50 deltas. That means I’d be buying 150 deltas and short about 50 for a new 100-delta position (approximately)

So to set up a Zebra trade I would:

• Buy two Nov. 390 calls at $84.63 each for a total of $169.26. Each of those calls has an extrinsic value of $27.83, so I am paying a total of $55.66 in extrinsic value for those two 75-delta calls.
• Sell one Nov. 445 call for a $54.15 credit. That call is slightly in the money (by $1.80), so I am selling $52.35 in extrinsic value.

Combined, my net debit would be $115.11. That’s a lot less than the $212.00 I would pay for the deep-in-the-money call. And that $55.66 I would pay in extrinsic value for those 75-delta calls is offset by the $52.35 I’d collect for selling the short call. No, not quite zero, but pretty close!

Here’s a summary of these trades alternative:

Click to enlarge

The value of the ZEBRA may fluctuate as time to expiration nears depending on volatility. Time and volatility don’t impact deep-in-the money options as much (as long as they stay deep). This chart shows the P&L at expiration for both – and how the long stock position would fare:

The ZEBRA gives you the same return as the other strategies if the stock stays above the short strike.

And yes, you are risking less because the maximum loss is the debit paid, which is a lot less for the ZEBRA.

But there’s a catch…

Another tastylive host, Dr. Jim Schultz, is known for his adage, “For every gimme, there’s a gotcha.” True enough. The market doesn’t give anything away for free.

• The “gimme” part? Paying less for the ZEBRA and risking less capital.
• The “gotcha” part? If NVDA falls, the ZEBRA spread loses value at a faster rate than the deep-the-money call.

You can see that in the chart above, but to see it more clearly, here’s the same scenario, but in terms of return on investment:

The way the losses grow a lot more rapidly to the downside means it’s important to think ahead when you might close a position to limit your losses. And that’s even more important as expiration nears.

But the chart also shows how we get another “gimme.” The ZEBRA can deliver a higher ROI if the stock rises because you pay less to open the position.

You can use this strategy on other stocks with decent option liquidity. If it’s profitable, you can then sell higher calls against the position to collect more premium and take advantage of time decay if you decide to do so.

And if the stock continues to move in your favor, you can usually roll out a ZEBRA into another expiration to continue to profit – and add even more stripes to your options trading expertise.