© 2004 south-western publishing 1 chapter 4 option combinations and spreads
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3
Introduction
A combination is a strategy in which you are simultaneously long or short
options of different types
It seeks a trading profit rather than being motivated by a hedging or
income generation objective
4
Straddles
A straddle is the best-known option combination
You are long (short) a straddle if you own (are short) both a put and a call
with the same– Striking price
– Expiration date– Underlying security
5
Buying a Straddle
A long call is bullish A long put is bearish
Why buy a long straddle?– Whenever a situation exists when it is likely that a
stock will move sharply one way or the other but you do not know with certainty in which direction.
Examples: – On going negotiation for merger or acquisition.– Suit case in the court where no body can expect
the decision with certainty. We are sure about the price change, but we
do not know in which direction.
6
Buying a Straddle (cont’d)
The worst outcome for the straddle buyer is when both options expire worthless
– Occurs when the stock price is at-the-money– Max. Loss = Call Premium + Put Premium
The straddle buyer will lose money if MSFT closes near the striking price
– The stock must rise or fall to recover the cost of the initial position
If the stock rises, the put expires worthless, but the call is valuable
If the stock falls, the put is valuable, but the call expires worthless
Example:Example: Suppose a speculator– Buys a JAN 30 call on MSFT @ $1.20– Buys a JAN 30 put on MSFT @ $2.75
7
Buying a Straddle (cont’d)
Construct a profit and loss worksheet to form the long straddle:
Stock Price at Option Expiration
0 15 25 30 45 55
Long 30 call
@ $1.20
-1.20 -1.20 -1.20 -1.20 13.80 23.80
Long 30 put @ $2.75
27.25 12.25 2.25 -2.75 -2.75 -2.75
Net 26.05 11.05 -1.05 -3.95 11.05 21.05
8
Buying a Straddle (cont’d)
Long straddle
Stock price at option expiration
0
3.95
30
26.05
26.05 33.95
Two breakeven points
Straddle Breakeven = Strike Price ± (Call + Put Premium)
9
Writing a Straddle
Popular with speculators:– Loss limited to the Call and Put Premiums
– Profits if prices Moved up = Unlimited
Moved Down = Strike Price – (Call Premium + Put Premium)
The straddle writer wants little movement in the stock price
Writer’s Losses are potentially unlimited on the upside because the short call is uncovered
10
Writing a Straddle (cont’d)
Short straddle
Stock price at option expiration
0
26.05
30
3.95
26.05 33.95
11
Strangles
A strangle is similar to a straddle, except the puts and calls have different striking prices
Strangles are very popular with professional option traders
You are long (short) a strangle if you own (are short) both a put and a call with
– The Same Expiration Date
Underlying Security
– Different Striking Price
12
Buying a Strangle
The speculator long a strangle expects a sharp price movement either up or
down in the underlying security
With a long strangle, the most popular version involves buying a put with a
lower striking price than the call
Example:Example: Suppose a speculator:– Buys a MSFT JAN 25 put @ $0.70– Buys a MSFT JAN 30 call @ $1.20
13
Buying a Strangle (cont’d)
Long strangle
Stock price at option expiration0
1.90
25
23.10
23.10 31.9030
1st Strangle Breakeven = Call Strike Price + (Call + Put Premium)
2nd Strangle Breakeven = Put Strike Price - (Call + Put Premium)
14
Writing a Strangle
The maximum gains for the strangle writer occurs if both option expire worthless
– Occurs in the price range between the two exercise prices
– Therefore, strangle gives the writer more chances to make money on the cost of the buyer who will face
more chance to loss his premiums (within the price range between the 2 exercise prices).
The loss for the strangle writer– If Stock Price Moved Up = loss will be Unlimited.
– If Stock Price Moved Down = loss will be limited to
= Strike Price – (Put Premium + Call Premium)
15
Writing a Strangle (cont’d)
Short strangle
Stock price at option expiration0
23.10
25
1.90
23.10 31.90
30
16
Condors
A condor is a less risky version of the strangle, write & buy call & put options on the same stock
with the same expiration date, but with 4 different striking prices.
Write & Buy Call Options with 2 different exercise prices as follow:
– Exercise Price of Written Call > Exercise Price of Bought Call
– Premium of Written Call < Premium of Bought Call.
Write & Buy Put Options with 2 different exercise prices as follow:
– Exercise Price of Written Put < Exercise Price of Bought Put
– Premium of Written Put < Premium of Bought Put.
17
Buying a Condor
There are various ways to construct a long condor
The condor buyer hopes that stock prices remain in the range between
the middle two striking prices Example:Example: Suppose a speculator:
– Buys MSFT 25 calls @ $4.20– Writes MSFT 27.50 calls @ $2.40
– Writes MSFT 30 puts @ $2.75– Buys MSFT 32.50 puts @ $4.60
18
Buying a Condor (cont’d)
Construct a profit and loss worksheet to form the long condor:
Stock Price at Option Expiration
0 25 27.50 30 32.50 35Buy 25 call
@ $4.20-4.20 -4.20 -1.70 0.80 3.30 5.80
Write 27.50 call
@ $2.40
2.40 2.40 2.40 -0.10 -2.60 -5.10
Write 30 put@ $2.75
-27.25 -2.25 0.25 2.75 2.75 2.75
Buy 32.50 put@ $4.60
27.90 2.90 0.40 -2.10 -4.60 -4.60
Net -1.15 -1.15 1.35 1.35 -1.15 -1.15
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Buying a Condor (cont’d)
Long condor
Stock price at option expiration0
1.15
25
1.35
26.15
30
31.35
27.50 32.50
20
Writing a Condor
The condor writer makes money when prices move sharply in either
direction
The maximum gain is limited to the premium
21
Writing a Condor (cont’d)
Short condor:
Stock price at option expiration0
1.15
25
1.35
26.15
30
31.35
27.50
32.50
22
Spreads
Vertical spreads
Vertical spreads with calls
Vertical spreads with puts
Calendar spreads
Diagonal spreads
Butterfly spreads
23
Introduction
Option spreads are strategies in which the player is simultaneously long and
short options of the same type, but with different
– Striking prices Vertical Spread with
– Calls or – Puts
– Expiration dates Calendar Spread
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Newspaper Option Listing
CALLS PUTS
MSFT
Strike
OCT JAN APR OCT JAN APR
28.51
20.00
8.62 8.63 8.70 ........ 0.15 0.20
28.51
22.50
6.06 6.10 6.50 0.05 0.30 0.55
28.51
25.00
3.70 4.20 4.50 0.10 0.70 1.10
28.51
27.50
1.60 2.40 3.00 0.55 1.40 2.05
28.51
30.00
0.45 1.20 1.85 2.00 2.75 3.30
28.51
32.50
0.10 0.50 1.00 4.20 4.60 5.00
25
Vertical Spreads
In a vertical spread, options are selected vertically from the financial pages
– The options have the same expiration date, but different striking prices.
– The spreader will long one option and short the other
Vertical spreads with calls– Bullspread– Bearspread
26
Bullspread
Example:Example: Assume a person believes MSFT stock will appreciateappreciate soon, currently MSFT traded at
$25 per share. A possible strategy is to construct a vertical call
bullspread and:– Buy an APR 27.50 MSFT call
– Write an APR 32.50 MSFT call The spreader trades part of the profit potential
for a reduced cost of the position. With all spreads the maximum gain and loss
occur at the striking prices– It is not necessary to consider prices outside this range– With a 27.50/32.50 spread, you only need to look at the
stock prices from $27.50 to $32.50
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Bullspread (cont’d)
Construct a profit and loss worksheet to form the bullspread:
Stock Price at Option Expiration
0 27.50 28.50 30.50 32.50 50
Long 27.50 call @ $3
-3 -3 -2 0 2 19.50
Short 32.50 call @ $1
1 1 1 1 1 -16.50
Net -2 -2 -1 1 3 3
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Bearspread
A bearspread is the reverse of a bullspread
– The maximum profit occurs with falling prices
– The investor buys the option with the lower striking price and writes the
option with the higher striking price
30
Bearspread
Example:Example: Assume a person believes MSFT stock will fail soon
A possible strategy is to construct a vertical call bearspread and:
– Write an APR 27.50 MSFT call– Buy an APR 32.50 MSFT call
The spreader trades part of the profit potential for a reduced cost of the position.
With Bearspreads: – The maximum gain = PS,C – PL,C
– The maximum loss = XS + PS – (XL – PL) – All the maximum gain and loss occur outside the
striking prices
31
Bearspread (cont’d)
Construct a profit and loss worksheet to form the bearspread:
Stock Price at Option Expiration
0 27.50 28.50 30.50 32.50 50
Short 27.50 call @ $3
3 3 2 0 -2 -19.50
Long 32.50 call @ $1
-1 -1 -1 -1 -1 16.50
Net 2 2 1 -1 -3 -3
33
Vertical Spreads With Puts: Bullspread
Involves using puts instead of calls
Buy the option with the lower striking price and write the option with the
higher one
The put spread results in a credit to the spreader’s account (credit spread)
The call spread results in a debit to the spreader’s account (debit spread)
34
Bullspread (cont’d)
A general characteristic of the call and put bullspreads is that the profit and loss payoffs for the two spreads
are approximately the same– The maximum profit occurs at all stock
prices above the higher striking price– The maximum loss occurs at stock prices
below the lower striking price
35
Calendar Spreads
In a calendar spread, options are chosen horizontally from a given row
in the financial pages– They have the same striking price
– The spreader will long one option and short the other
36
Calendar Spreads (cont’d)
Calendar spreads are either bullspreads or bearspreads
– In a bullspread, the spreader will buy a call with a distant expiration and write a
call that is near expiration– In a bearspread, the spreader will buy a
call that is near expiration and write a call with a distant expiration
37
Calendar Spreads (cont’d)
Calendar spreaders are concerned with time decay
– Options are worth more the longer they have until expiration
38
Diagonal Spreads
A diagonal spread involves options from different expiration months and
with different striking prices– They are chosen diagonally from the
option listing in the financial pages
Diagonal spreads can be bullish or bearish
39
Butterfly Spreads
A butterfly spread can be constructed for very little cost
beyond commissions
A butterfly spread can be constructed using puts and calls
41
Nonstandard Spreads: Ratio Spreads
A ratio spread is a variation on bullspreads and bearspreads
– Instead of “long one, short one,” ratio spreads involve an unequal number of
long and short options– E.g., a call bullspread is a call ratio
spread if it involves writing more than one call at a higher striking price
42
Nonstandard Spreads:Ratio Backspreads
A ratio backspread is constructed the opposite of ratio spreads
– Call bearspreads are transformed into call ratio backspreads by adding to the
long call position– Put bullspreads are transformed into put
ratio backspreads by adding more long puts
43
Nonstandard Spreads: Hedge Wrapper
A hedge wrapper involves writing a covered call and buying a put
– Useful if a stock you own has appreciated and is expected to appreciate further with a temporary
decline– An alternative to selling the stock or creating a
protective put The maximum profit occurs once the stock
price rises to the striking price of the call The lowest return occurs if the stock falls to
the striking price of the put or below
44
Hedge Wrapper (cont’d)
The profitable stock position is transformed into a certain winner
The potential for further gain is reduced
45
Combined Call Writing
In combined call writing, the investor writes calls using more than
one striking price An alternative to other covered call
strategies The combined write is a compromise
between income and potential for further price appreciation
46
Margin Considerations
Introduction Margin requirements on long puts or
calls Margin requirements on short puts
or calls Margin requirements on spreads Margin requirements on covered
calls
47
Margin Considerations: Introduction
Necessity to post margin is an important consideration in spreading
– The speculator in short options must have sufficient equity in his or her
brokerage account before the option positions can be assumed
48
Margin Requirements on Long Puts or Calls
There is no requirement to advance any sum of money - other than the
option premium and the commission required - to long calls or puts
Can borrow up to 25% of the cost of the option position from a brokerage
firm if the option has at least nine months until expiration
49
Margin Requirements on Short Puts or Calls
For uncovered calls on common stock, the initial margin requirement
is the greater of
Premium + 0.20(Stock Price) – (Out-of-Money Amount) or
Premium + 0.10(Stock Price)
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Margin Requirements on Short Puts or Calls (cont’d)
For uncovered puts on common stock, the initial margin requirement
is 10% of the exercise price
51
Margin Requirements on Spreads
All spreads must be done in a margin account
More lenient than those for uncovered options
You must pay for the long side in full
52
Margin Requirements on Spreads (cont’d)
You must deposit the amount by which the long put (or short call)
exercise price is below the short put (or long call) exercise price
A general spread margin rule:– For a debit spread, deposit the net cost of
the spread– For a credit spread, deposit the different
between the option striking prices
53
Margin Requirements on Covered Calls
There is no margin requirement when writing covered calls
Brokerage firms may restrict clients’ ability to sell shares of the
underlying stock
54
Evaluating Spreads: Introduction
Spreads and combinations are– Bullish,
– Bearish, or– Neutral
You must decide on your outlook for the market before deciding on a
strategy
55
Evaluating Spreads: The Debit/Credit Issue
An outlay requires a debit An inflow generates a credit
There are several strategies that may serve a particular end, and some will
involve a debt and others a credit
56
Evaluating Spreads: The Reward/Risk Ratio
Examine the maximum gain relative to the maximum loss
E.g., if a call bullspread has a maximum gain of $300.00 and a
maximum loss of $200.00, the reward/risk ratio is 1.50
57
Evaluating Spreads: The “Movement to Loss” Issue
The magnitude of stock price movement necessary for a position to
become unprofitable can be used to evaluate spreads
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Evaluating Spreads: Specify A Limit Price
In spreads:– You want to obtain a high price for the
options you sell– You want to pay a low price for the
options you buy
Specify a dollar amount for the debit or credit at which you are willing to
trade
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