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Nov 3, 2021

10 Essential Things to Know About the ZEBRA Options Strategy

By:Mike Butler

The ZEBRA options strategy, also known as the Zero Extrinsic Back Ratio, allows traders to replicate a stock position with more cost efficiency and less risk. However, there are a few things to keep in mind if using a stock substitution strategy. Here are the top ten notable takeaways for trading ZEBRAs.

1. Traders can achieve 100 deltas with a fraction of the risk compared to owning 100 shares of stock

One of the most beneficial aspects of the ZEBRA options stock replacement strategy, regardless of whether it is a bearish or bullish setup, is that it is a defined risk debit trade. No matter where the stock goes, your max loss is only the debit paid upfront if all options expire OTM. This is drastically different from being short or long stock, since a stock can go to $0 and does not have an upside cap. 100 shares of stock give you 100 deltas, which is right around where the ZEBRA deltas are as well, as you can see in the example below.

This ZEBRA has a max loss of $25.28 which is the debit paid, where owning 100 shares of SPY would be around $45,800 if it were to go to $0. For this reason, it can be an efficient way to achieve 100 deltas without all the risk of 100 shares of stock.

2. It is a similar risk profile to a married put/call without the extrinsic value payment

When you dig into ZEBRAs further, you’ll notice that if your long strikes move OTM at expiration, the risk flattens out. This is the same idea as owning 100 shares of stock and purchasing a protective OTM put to define your risk, or being short 100 shares of stock and purchasing a protective OTM call to define your risk. The key difference here is that you are purchasing these OTM options for an extrinsic value debit when pairing them with shares, where the ZEBRA trade already has this stop loss embedded, without the extrinsic value payment.

In the example below, you are purchasing 100 shares of SPY stock and purchasing the 445 put for $2.60, which means you have a decaying extrinsic value of $260. The max loss is a little lower here compared to the ZEBRA, but the buying power requirement is $23,000 compared to the $2528 ZEBRA requirement.

3. ZEBRAs can be long or short term trades

When deciding on an expiration date for a ZEBRA, focus on how far you have to slide the long options ITM to remove all extrinsic value from the trade. Near-term expirations will be cheaper because the entire expiration will not have as much extrinsic value as a further-dated cycle. In the example below, you have the leverage of 100 shares of SPY stock for 1 day, and your max loss is only $337, although that max loss is realized if SPY is below $456, which is close to the current price of $458.

4. Long-term ZEBRAs are more expensive but offer more time to end in a positive result

    Long-term ZEBRAs will be more expensive but will have more time for the trade to work out in your favor, and where you realize max loss will be further from the current stock price since your long strikes will be deeper ITM. This means you have a lower chance of realizing max loss with a long-term ZEBRA compared to a short-term ZEBRA.

    5. Short-term ZEBRAs are cheaper than the long term alternative but have little time to garner a positive result

      Short-term ZEBRAs have a lower max loss and less time to work out in your favor, but where you reach max loss will be closer to the current stock price because your long strikes will not be deep ITM at all. This means you have a higher chance of realizing max loss with a short-term ZEBRA compared to a long-term ZEBRA.

      6. SKEW plays a role in the entry price of the ZEBRA options strategy

      SKEW represents an asymmetric distribution of extrinsic value premium across option strikes. It tells traders where the market perceives the velocity of a big move to be. In other words, if SPY is trading at $457, and the 447 strike put is trading for $2.87 but the $467 strike call is only trading for $1.39, there is an aggressive put skew in this market since the puts are trading for much more than the calls, even though we’re looking at strikes that are the same distance OTM.

      In this environment, put ZEBRAs will be cheaper to set up than call ZEBRAs, since extrinsic value drops off quickly on the ITM put side compared to the ITM call side. This doesn’t mean the trade will work out, as you still need a directional move, but the trade will be cheaper to set up on the put side in this environment.

      7. If you are placing a ZEBRA on the skewed side where extrinsic value premium is rich, the trade will cost more to enter because you have to slide your long options deeper ITM to remove the extrinsic value

      Most ETFs like QQQ and SPY will have put skew, so call ZEBRAs will be more expensive to set up with zero extrinsic value than put ZEBRAs, simply because the velocity in these products is perceived to be to the downside.

      In other “meme” stocks like AMC & GME, you may find call skew as the upside is where the velocity of a big move is perceived to be. In these products, a put ZEBRA will be more expensive to set up than a call ZEBRA.

      8. If you are placing a ZEBRA on the non-skewed side where extrinsic value premium is cheap, the trade will cost less to enter because you don’t have to slide your long options deep ITM at all to remove the extrinsic value

      If you are aware of skewed extrinsic value premium, and your directional assumption aligns with the non-skewed side, you will have a cheaper setup than going with the other direction. In products like SPY or QQQ, this means a put ZEBRA will be cheaper to set up with zero extrinsic value than a call ZEBRA.

      9. Buying power requirements on ZEBRA trades are fractions of the requirement compared to 100 shares of long/short stock

      Since you are trading options contracts and not stock, the most you can lose is the debit paid for the ZEBRA. If there is a huge move against you, your risk is capped, where 100 shares of stock would see losses equivalent to the move.

      10. Removing extrinsic value from a ZEBRA simply means that your short option offsets all of the extrinsic value in the 2x long options you purchase

      The easiest way to ensure you have zero extrinsic value on your ZEBRA is to pay attention to the extrinsic value column on the tastyworks platform. You can clearly see the extrinsic value you are collecting for selling 1 ATM option, and you want to pay no more than half that extrinsic value for each of the 2 long options that are ITM. If you are collecting $1000 in extrinsic value for selling the ATM option, you want to limit your extrinsic value payment to $500 for each of the long options to ensure a zero extrinsic value ZEBRA trade.

      Want to setup and trade a ZEBRA? Create a tastyworks account or log in (learn more about opening an account at tastyworks)
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