The ZEBRA (zero extrinsic value back ratio spread) is a near-100 delta stock replacement strategy with all of the upside profit potential with a fraction of the risk compared to owning 100 shares of stock. It is constructed by purchasing two ITM (in-the-money) options and selling one same-style ATM (at-the-money) option against it to eliminate all of the extrinsic value in the two long options you’re buying.
The result is a similar setup to a married put or married call, where you are protecting your risk on 100 shares of stock by purchasing an OTM protective put or call against the shares, but the huge benefit with the ZEBRA is that you’re not paying any extrinsic value to do so:
In the example above, we obtain 99.78 deltas for $1592, compared to 100 deltas for around $22,000 if we were to buy 100 shares of SPY in a margin account.
We have an embedded stop loss below 445 over the course of the trade since the most we can lose on this trade is the debit paid. We pay zero extrinsic value for this stop loss with the ZEBRA if we ensure that our short option offsets the extrinsic value cost of the two long options completely as you see here with EXT being 2.
With this trade, we realize all of the upside of 100 shares of stock, and we avoid disaster if the market were to meltdown.
A married put consists of owning 100 shares of stock and “marrying” that position with a long put below the stock price. This results in a stop-loss on your shares below the put strike price, since the long put appreciates in value equivalent to 100 shares of short stock below the strike price at expiration.
The problem with this strategy long term is that you are consistently paying extrinsic value to buy the long put, where the call ZEBRA offers a similar risk profile without paying for that extrinsic value cost of the long put itself:
In the married put example above, we are putting up $22,000 to own 100 shares of stock, and we are purchasing the put to protect our risk below 445 just like the ZEBRA example. The difference here is that we are paying $2.34 in extrinsic value for that protection, and that means if the stock doesn’t move we are losing that value.
Additionally, the delta is significantly lower than 100 at 72.49, because we are paying so much for that long put option. On a rally, the put option will lose value, which temporarily eats away at our profit on the 100 shares of stock.
With the ZEBRA, we have no extrinsic value to lose if the trade is set up correctly, which is why the delta is much closer to 100.
A married call is constructed with 100 short shares of stock and a long OTM call to protect the risk in the short shares above the long call strike:
In the example above, we are shorting 100 shares of SPY, which requires around $22,000 in buying power, and we are purchasing a call for $0.80 to protect our upside risk above 460.
Just like the call ZEBRA and married put, we can replicate the married call risk profile with a put ZEBRA, without paying for the extrinsic value associated with the long call purchase:
In this put zebra example, we are obtaining -96.96 deltas in SPY for the next 18 days, with $1449 in risk, which stops above the 460 strike. In other words, if we see a $30 move to the upside, we only realize the risk of about half that move. If we see a $30 move to the downside within 18 days, we would make $3000 on this trade.
When setting up a ZEBRA, we want to focus on the most important aspect of the trade - removing extrinsic value from the equation. When we do this, we get as close to 100 deltas as possible, and we don’t limit ourselves in profitability if we are directionally right.
If our ZEBRA slides deeper ITM on a directional move in our favor and we paid $500 in extrinsic value on the setup because we wanted a cheaper trader, we would lose that $500 in extrinsic value as we slide deeper ITM and it would dampen our profit potential. Also, if the stock doesn’t move at all, we still lose that $500 over time as extrinsic value decays to zero.
It’s important to note that SKEW will affect the entry price of the ZEBRA since we are working with extrinsic value in the options we’re trading. SKEW represents a difference in extrinsic value with equidistant OTM options and tells us where the market perceives a potential high velocity move to be. In SPY, there is put skew, since SPY markets tend to grind higher and crash down. This means that OTM puts trade for much more than equidistant OTM calls:
As you can see in the example above, you can see that the 447 put is trading for around $2.71, where the 457 call is only trading for $1.41. Both of these options are 5 points OTM, but the put is trading for almost twice the extrinsic value.
If I’m placing a call ZEBRA, I’m going to have to slide my options deeper ITM to remove extrinsic value from the trade, which will result in a more expensive setup.
If I’m placing a put ZEBRA, I won’t have to slide my options deep ITM at all to remove the extrinsic value, since an ITM long put option will have a similar extrinsic value as the same strike OTM call option. This results in a cheaper setup than the opposing call ZEBRA.
To remove extrinsic value from a ZEBRA on the setup, just ensure that the extrinsic value you’re collecting from selling the ATM option is equivalent to the TOTAL extrinsic value you’re paying for in the 2x long options you’re buying ITM. In other words, ensure the extrinsic value associated with your long strike is ½ the premium associated with the ATM option you’re selling.
When setting up a call zebra, we are purchasing two ITM call options below the stock price and selling one ATM option to offset all extrinsic value associated with the long options. The resulting trade is a near 100 delta bullish trade that replicates 100 shares of long stock with an embedded stop-loss similar to a married put.
When setting up a put zebra, we are purchasing two ITM put options above the stock price and selling one ATM option to offset all extrinsic value associated with the long options. The resulting trade is a near -100 delta bearish trade that replicates 100 shares of short stock with an embedded stop-loss similar to a married call.
One of the big grey areas with ZEBRA stock replacement trades comes down to the expiration choice for the strategy.
The more near-term we go, the lower debit we will have to pay, and the closer our strikes will be to the stock price due to the lack of extrinsic value in near-term cycles. We don’t have to go very far ITM at all to remove all extrinsic value from the trade, and we still achieve that near 100 delta trade.
The tradeoff here is that we realize max loss much closer to the stock price, although our TOTAL max loss per trade will be significantly lower than a longer-term cycle. The more time associated with the expiration, the more the trade will feel like long stock because our debit paid upfront will be higher, the max loss will be higher, but our time to be right will be much longer than a short-term ZEBRA.
Ultimately, if the goal is to try to capture short-term movement with very limited risk, maybe a short-term ZEBRA would be our choice.
If we are trying to capture long-term taxation, or are trading a low-priced product where there isn’t much extrinsic value a few points ITM anyways, a longer-term ZEBRA may be our choice.
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