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

2 Options Combinations Introduction Straddles Strangles Condors

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 $1.20 – Buys a JAN 30 put on $2.75

7 Buying a Straddle (cont’d) Construct a profit and loss worksheet to form the long straddle: Stock Price at Option Expiration Long 30 $ Long 30 $ Net

8 Buying a Straddle (cont’d) Long straddle Stock price at option expiration 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

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 $0.70 – Buys a MSFT JAN 30 $1.20

13 Buying a Strangle (cont’d) Long strangle Stock price at option expiration st Strangle Breakeven = Call Strike Price + (Call + Put Premium) 2 nd 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 expiration

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 $4.20 – Writes MSFT $2.40 – Writes MSFT 30 $2.75 – Buys MSFT $4.60

18 Buying a Condor (cont’d) Construct a profit and loss worksheet to form the long condor: Stock Price at Option Expiration Buy 25 $ Write $ Write 30 $ Buy $ Net

19 Buying a Condor (cont’d) Long condor Stock price at option expiration

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 expiration

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

24 Newspaper Option Listing CALLSPUTS MSFTStrikeOCTJANAPROCTJANAPR

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: appreciate Example: Assume a person believes MSFT stock will appreciate soon, currently MSFT traded at $25 per share. 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. 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

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

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

29 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 MSFT call – Buy an APR MSFT call The spreader trades part of the profit potential for a reduced cost of the position. With Bearspreads: – The maximum gain = P S,C – P L,C – The maximum loss = X S + P S – (X L – P L ) – 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 Short $ Long $ Net221-3

32 Bearspread (cont’d) Bearspread Stock price at option expiration

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

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

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 (Stock Price) – (Out-of-Money Amount) or Premium (Stock Price)

50 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 $ 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

58 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

59 Determining the Appropriate Strategy: Some Final Thoughts The basic steps involved in any decision making process: – Learn the fundamentals – Gather information – Evaluate alternatives – Make a decision