© 2004 South-Western Publishing 1 Chapter 4 Option Combinations and Spreads

2 Introduction 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

3 Combinations Introduction Straddles Strangles Condors

4 Spreads Introduction Vertical spreads Vertical spreads with calls Vertical spreads with puts Calendar spreads (different expiration) Diagonal spreads (diff. exp. and striking) Butterfly spreads

5 Introduction 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

6 Vertical Spreads 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

7 Bullspread Assume a person believes MSFT stock will appreciate soon A possible strategy is to construct a vertical call bullspread and: – Buy an APR MSFT call – Write an APR MSFT call The spreader trades part of the profit potential for a reduced cost of the position.

8 Bullspread (cont’d) 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

9 Bullspread (cont’d) Construct a profit and loss worksheet to form the bullspread: Stock Price at Option Expiration Long $ Short $ Net-2 133

10 Bullspread (cont’d) Bullspread Stock price at option expiration

11 Bearspread A bearspread is the reverse of a bullspread – The maximum profit occurs with falling prices – The investor buys the option with the higher striking price and writes the option with the lower striking price – write an APR MSFT – buy an APR MSFT

12 Bearspread

13 Vertical Spreads With Puts: Bullspread Buy the option with the lower striking price and write the option with the higher one

14 Bullspread (cont’d) 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)

15 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

16 Butterfly Spreads A butterfly spread can be constructed for very little cost beyond commissions A butterfly spread can be constructed using puts and calls

17 Butterfly Spreads(cont’d) Example of a butterfly spread Stock price at option expiration 0

18 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

19 Hedge Wrapper (cont’d) The profitable stock position is transformed into a certain winner The potential for further gain is reduced

20 Hedge Wraper