© 2002 South-Western Publishing 1 Chapter 4 Option Combinations and Spreads

2 Outline Introduction Combinations Spreads Nonstandard spreads Combined call writing Margin considerations Evaluating spreads

3 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

4 Combinations Introduction Straddles Strangles Condors

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

6 Straddles 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

7 Introduction (cont’d) You are short a straddle if you are short both a put and a call with the same – Striking price – Expiration date – Underlying security

8 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

9 Buying a Straddle (cont’d) Suppose a speculator – Buys an OCT 80 call on $7 – Buys an OCT 80 put on $5 7/8

10 Buying a Straddle (cont’d) Construct a profit and loss worksheet to form the long straddle: Stock Price at Option Expiration Buy $80 $ Buy $80 $5 7/8 74 1/8 - 7/8 -5 5/ /8 Net67 1/8 -7 7/ / /8 -2 7/8 7 1/8

11 Buying a Straddle (cont’d) Long straddle Stock price at option expiration / /8 92 7/8 Two breakeven points

12 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 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

13 Buying a Straddle (cont’d) 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

14 Writing a Straddle 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

15 Writing a Straddle (cont’d) Short straddle Stock price at option expiration / /8 67 1/8 92 7/8

16 Strangles: Introduction A strangle is similar to a straddle, except the puts and calls have different striking prices Strangles are very popular with professional option traders

17 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

18 Buying a Strangle (cont’d) Suppose a speculator: – Buys a MSFT OCT 75 $3 5/8 – Buys a MSFT OCT 85 $5

19 Buying a Strangle (cont’d) Long strangle Stock price at option expiration 0 8 5/ /8 93 5/8 85

20 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

21 Writing a Strangle (cont’d) Short strangle Stock price at option expiration / /8 66 3/8 93 5/8 85

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

23 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

24 Buying a Condor (cont’d) Suppose a speculator: – Buys MSFT 75 $10 – Writes MSFT 80 $7 – Writes MSFT 85 $8 1/2 – Buys MSFT 90 $12 1/8

25 Buying a Condor (cont’d) Construct a profit and loss worksheet to form the long condor: Stock Price at Option Expiration Buy $75 $ Write $80 $ Write $85 $8 1/ /2 -1 1/2 3 1/2 8 1/2 Buy $90 $12 1/8 77 7/8 2 7/8 -2 1/8 -7 1/ /8 Net-1 5/8 3 3/8 -1 5/8

26 Buying a Condor (cont’d) Long condor Stock price at option expiration 0 1 5/ /8 76 5/ /8 8090

27 Writing a Condor The condor writer makes money when prices move sharply in either direction The maximum gain is limited to the premium

28 Writing a Condor (cont’d) Short condor Stock price at option expiration 0 3 3/ /8 76 5/ /

29 Spreads Introduction Vertical spreads Vertical spreads with calls Vertical spreads with puts Calendar spreads Diagonal spreads Butterfly spreads

30 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

31 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

32 Vertical Spreads With Calls Bullspread Bearspread

33 Bullspread Assume a person believes MSFT stock will appreciate soon A possible strategy is to construct a vertical call bullspread and: – Buy an OCT 85 MSFT call – Write an OCT 90 MSFT call The spreader trades part of the profit potential for a reduced cost of the position.

34 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 an 85/90 spread, you only need to look at the stock prices from $85 to $90

35 Bullspread (cont’d) Construct a profit and loss worksheet to form the bullspread: Stock Price at Option Expiration Long $85 $ Short $90 $3 3/8 3 3/8 -6 5/8 Net-1 5/8 - 5/8 1 3/8 3 3/8

36 Bullspread (cont’d) Bullspread Stock price at option expiration 0 1 5/8 3 3/ /8 85

37 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

38 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

39 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)

40 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

41 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

42 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

43 Calendar Spreads (cont’d) Calendar spreaders are concerned with time decay – Options are worth more the longer they have until expiration

44 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

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

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

47 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

48 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

49 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

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

51 Nonstandard Spreads: 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

52 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

53 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

54 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

55 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)

56 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

57 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

58 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

59 Margin Requirements on Covered Calls (cont’d) There is no margin requirement when writing covered calls Brokerage firms may restrict clients’ ability to sell shares of the underlying stock

60 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

61 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

62 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 $162,50, the reward/risk ratio is 2.08

63 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

64 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

65 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