Introduction Combinations Spreads Nonstandard spreads

Introduction

• Introduction

• Combinations

• Spreads

• Nonstandard spreads

• Combined call writing

• Margin considerations

• Evaluating spreads

Previous chapters focused on

• Previous chapters focused on

• Speculating
• Income generation
• Hedging

• Other strategies are available that seek a trading profit rather than being motivated by a hedging or income generation objective

Introduction

• Introduction

• Straddles

• Strangles

• Condors

A combination is a strategy in which you are simultaneously long or short options of different types

• A combination is a strategy in which you are simultaneously long or short options of different types

A straddle is the best-known option combination

• A straddle is the best-known option combination

• You are long a straddle if you own both a put and a call with the same

• Striking price
• Expiration date
• Underlying security

You are short a straddle if you are short both a put and a call with the same

• You are short a straddle if you are short both a put and a call with the same

• Striking price
• Expiration date
• Underlying security

A long call is bullish

• 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

Suppose a speculator

• Suppose a speculator

• Buys a JAN 30 call on MSFT @ $1.20
• Buys a JAN 30 put on MSFT @ $2.75

Construct a profit and loss worksheet to form the long straddle:

• Construct a profit and loss worksheet to form the long straddle:

Long straddle

• Long straddle

The worst outcome for the straddle buyer is when both options expire worthless

• The worst outcome for the straddle buyer is when both options expire worthless

• Occurs when the stock price is at-the-money

• 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 rises, the put expires worthless, but the call is valuable

• If the stock falls, the put is valuable, but the call expires worthless

Popular with speculators

• Popular with speculators

• The straddle writer wants little movement in the stock price

• Losses are potentially unlimited on the upside because the short call is uncovered

Short straddle

• Short straddle

A strangle is similar to a straddle, except the puts and calls have different striking prices

• A strangle is similar to a straddle, except the puts and calls have different striking prices

• Strangles are very popular with professional option traders

The speculator long a strangle expects a sharp price movement either up or down in the underlying security

• 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

Suppose a speculator:

• Suppose a speculator:

• Buys a MSFT JAN 25 put @ $0.70
• Buys a MSFT JAN 30 call @ $1.20

Long strangle

• Long strangle

The maximum gains for the strangle writer occurs if both option expire worthless

• The maximum gains for the strangle writer occurs if both option expire worthless

• Occurs in the price range between the two exercise prices

Short strangle

• Short strangle

A condor is a less risky version of the strangle, with four different striking prices

• A condor is a less risky version of the strangle, with four different striking prices

There are various ways to construct a long 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

Suppose a speculator:

• 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

Construct a profit and loss worksheet to form the long condor:

• Construct a profit and loss worksheet to form the long condor:

Long condor

• Long condor

The condor writer makes money when prices move sharply in either direction

• The condor writer makes money when prices move sharply in either direction

• The maximum gain is limited to the premium

Short condor

• Short condor

Introduction

• Introduction

• Vertical spreads

• Vertical spreads with calls

• Vertical spreads with puts

• Calendar spreads

• Diagonal spreads

• Butterfly spreads

Option spreads are strategies in which the player is simultaneously long and short options of the same type, but with different

• Option spreads are strategies in which the player is simultaneously long and short options of the same type, but with different

• Striking prices or
• Expiration dates

In a vertical spread, options are selected vertically from the financial pages

• In a vertical spread, options are selected vertically from the financial pages

• The options have the same expiration date
• The spreader will long one option and short the other

• Vertical spreads with calls

• Bullspread
• Bearspread

Assume a person believes MSFT stock will appreciate soon

• Assume a person believes MSFT stock will appreciate soon

• 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

• 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

Construct a profit and loss worksheet to form the bullspread:

• Construct a profit and loss worksheet to form the bullspread:

Bullspread

• Bullspread

A bearspread is the reverse of a bullspread

• 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

Involves using puts instead of calls

• 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 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)

A general characteristic of the call and put bullspreads is that the profit and loss payoffs for the two spreads are approximately the same

• 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

In a calendar spread, options are chosen horizontally from a given row in the financial pages

• 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

Calendar spreads are either bullspreads or bearspreads

• 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

Calendar spreaders are concerned with time decay

• Calendar spreaders are concerned with time decay

• Options are worth more the longer they have until expiration

A diagonal spread involves options from different expiration months and with different striking prices

• 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

A butterfly spread can be constructed for very little cost beyond commissions

• A butterfly spread can be constructed for very little cost beyond commissions

• A butterfly spread can be constructed using puts and calls

Example of a butterfly spread

• Example of a butterfly spread

A ratio spread is a variation on bullspreads and bearspreads

• 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

A ratio backspread is constructed the opposite of ratio spreads

• 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

A hedge wrapper involves writing a covered call and buying a put

• 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

The profitable stock position is transformed into a certain winner

• The profitable stock position is transformed into a certain winner

• The potential for further gain is reduced

In combined call writing, the investor writes calls using more than one striking price

• 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

Introduction

• Introduction

• Margin requirements on long puts or calls

• Margin requirements on short puts or calls

• Margin requirements on spreads

• Margin requirements on covered calls

Necessity to post margin is an important consideration in spreading

• 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

There is no requirement to advance any sum of money - other than the option premium and the commission required - to long calls or puts

• 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

For uncovered calls on common stock, the initial margin requirement is the greater of

• 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)

For uncovered puts on common stock, the initial margin requirement is 10% of the exercise price

• For uncovered puts on common stock, the initial margin requirement is 10% of the exercise price

All spreads must be done in a margin account

• 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

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

• 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

There is no margin requirement when writing covered calls

• There is no margin requirement when writing covered calls

• Brokerage firms may restrict clients’ ability to sell shares of the underlying stock

Spreads and combinations are

• Spreads and combinations are

• Bullish,
• Bearish, or
• Neutral

• You must decide on your outlook for the market before deciding on a strategy

An outlay requires a debit

• 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

Examine the maximum gain relative to the maximum loss

• 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

The magnitude of stock price movement necessary for a position to become unprofitable can be used to evaluate spreads

• The magnitude of stock price movement necessary for a position to become unprofitable can be used to evaluate spreads

In spreads:

• 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

The basic steps involved in any decision making process:

• The basic steps involved in any decision making process:

• Learn the fundamentals
• Gather information
• Evaluate alternatives
• Make a decision