© 2002 South-Western Publishing 1

Chapter 4

Option Combinations and Spreads

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Outline

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

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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

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Combinations

Introduction Straddles Strangles Condors

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Introduction

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

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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

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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

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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

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Buying a Straddle (cont’d)

Suppose a speculator

– Buys an OCT 80 call on MSFT @ $7– Buys an OCT 80 put on MSFT @ $5 7/8

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Buying a Straddle (cont’d)

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

Stock Price at Option Expiration

0 50 75 80 90 100

Buy $80 call

@ $7

-7 -7 -7 -7 3 13

Buy $80 put

@ $5 7/8

74 1/8 -7/8 -5 5/16 -5 7/8 -5 7/8 -5 7/8

Net 67 1/8 -7 7/8 -12 5/16 -12 7/8 -2 7/8 7 1/8

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Buying a Straddle (cont’d)

Long straddle

Stock price at option expiration

0

12 7/8

80

67 1/8

67 1/8 92 7/8

Two breakeven points

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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

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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

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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

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Writing a Straddle (cont’d)

Short straddle

Stock price at option expiration

0

67 1/8

80

12 7/8

67 1/8 92 7/8

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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

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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

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Buying a Strangle (cont’d)

Suppose a speculator:

– Buys a MSFT OCT 75 put @ $3 5/8– Buys a MSFT OCT 85 call @ $5

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Buying a Strangle (cont’d)

Long strangle

Stock price at option expiration0

8 5/8

75

66 3/8

66 3/8 93 5/8

85

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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

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Writing a Strangle (cont’d)

Short strangle

Stock price at option expiration0

66 3/8

75

8 5/8

66 3/8 93 5/8

85

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Condors: Introduction

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

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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

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Buying a Condor (cont’d)

Suppose a speculator:

– Buys MSFT 75 calls @ $10– Writes MSFT 80 calls @ $7– Writes MSFT 85 puts @ $8 1/2

– Buys MSFT 90 puts @ $12 1/8

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Buying a Condor (cont’d)

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

Stock Price at Option Expiration

0 75 80 85 90 95Buy $75 call

@ $10

-10 -10 -5 0 5 10

Write $80 call

@ $7

7 7 7 2 -3 -8

Write $85 put

@ $8 1/2

-76 1/2 -1 1/2 3 1/2 8 1/2 8 1/2 8 1/2

Buy $90 put

@ $12 1/8

77 7/8 2 7/8 -2 1/8 -7 1/8 -12 1/8 -12 1/8

Net -1 5/8 -1 5/8 3 3/8 3 3/8 -1 5/8 -1 5/8

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Buying a Condor (cont’d)

Long condor

Stock price at option expiration0

1 5/8

75

3 3/8

76 5/8

85

88 3/8

80 90

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Writing a Condor

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

The maximum gain is limited to the premium

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Writing a Condor (cont’d)

Short condor

Stock price at option expiration0

3 3/8

75

1 5/8

76 5/8

85

88 3/8

80

90

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Spreads

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

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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

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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

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Vertical Spreads With Calls

Bullspread Bearspread

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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.

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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

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Bullspread (cont’d)

Construct a profit and loss worksheet to form the bullspread:

Stock Price at Option Expiration

0 85 86 88 90 100

Long $85 call

@ $5

-5 -5 -4 -2 0 10

Short $90 call

@ $3 3/8

3 3/8 3 3/8 3 3/8 3 3/8 3 3/8 -6 5/8

Net -1 5/8 -1 5/8 -5/8 1 3/8 3 3/8 3 3/8

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Bullspread (cont’d)

Bullspread

Stock price at option expiration0

1 5/8

3 3/8

90

86 5/8

85

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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

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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

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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)

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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

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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

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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

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Calendar Spreads (cont’d)

Calendar spreaders are concerned with time decay

– Options are worth more the longer they have until expiration

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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

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Butterfly Spreads

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

A butterfly spread can be constructed using puts and calls

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Butterfly Spreads(cont’d)

Example of a butterfly spread

Stock price at option expiration0

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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

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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

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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

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Hedge Wrapper (cont’d)

The profitable stock position is transformed into a certain winner

The potential for further gain is reduced

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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 $337.50 and a maximum loss of $162,50, the reward/risk ratio is 2.08

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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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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