# Option Spreads

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17-Dec-2015Category

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### Transcript of Option Spreads

SPREADS

Before We start !!!!!!!!!!!!

What are Option Spreads??????????????? Option Spreads. In options trading, anoption spreadis created by the simultaneous purchase and sale ofoptionsof the same class on the same underlying security but with different strike prices and/or expiration dates. Anyspreadthat is constructed using calls can be refered to as a callspread. In options trading, anoption spreadis created by the simultaneous purchase and sale ofoptionsof the same class on the same underlying security but with different strike prices and/or expiration dates. Anyspreadthat is constructed using calls can be referred to as a callspread.

VERTICLE SPREADSThe vertical spread is anoption spreadstrategy whereby the option trader purchases a certain number of options and simultaneously sell an equal number of options of the sameclass, sameunderlying security, sameexpiration date, but at a differentstrike price.Vertical spreads limit the risk involved in the options trade but at the same time they reduce the profit potential. They can be created with either allcallsor allputs, and can be bullish or bearish.

Bull Vertical Spreads

Bull vertical spreads are employed when the option trader is bullish on the underlying security and hence, they are designed to profit from a rise in the price of the underlying asset. They can be constructed using calls or puts and are known asbull call spreadandbull put spread respectively.While they have similar risk/reward profiles, the bull call spread is entered on a debit while the bull put spread can be established on a credit. Hence, the bull call spread is also called a verticaldebit spreadwhile the bull put spread is sometimes referred to as a verticalcredit spread.

BEAR VERTICAL SPREADS

Vertical spread option strategies are also available for the option trader who is bearish on the underlying security. Bear vertical spreads are designed to profit from a drop in the price of the underlying asset. They can be constructed using calls or puts and are known asbear call spreadandbear put spreadrespectively.While they have similar risk/reward profiles, the bear call spread is entered on a credit while the bear put spread can be established on a debit. Hence, the bear call spread is also called a verticalcredit spreadwhile the bear put spread is sometimes referred to as a verticaldebit spread.

Bull PUT Spread

The bull put spread option trading strategy is employed when the options trader thinks that the price of the underlying asset will go up moderately in the near term. The bull put spread options strategy is also known as the bull put credit spread as a credit is received upon entering the trade.

Bull put spreads can be implemented by selling a higher strikingin-the-money put optionand buying a lower strikingout-of-the-money put optionon the same underlying stockwith the sameexpiration date.

Bull Put Spread ConstructionBuy 1 OTM PutSell 1 ITM Put

Limited Upside ProfitIf the stock price closes above the higher strike price on expiration date, both options expire worthless and the bull put spread option strategy earns the maximum profit which is equal to the credit taken in when entering the position.The formula for calculating maximum profit is given below:Max Profit = Net Premium Received - Commissions PaidMax Profit Achieved When Price of Underlying >= Strike Price of Short Put

- Limited Downside RiskIf the stock price drops below the lower strike price on expiration date, then the bull put spread strategy incurs a maximum loss equal to the difference between the strike prices of the two puts minus the net credit received when putting on the trade.The formula for calculating maximum loss is given below:Max Loss = Strike Price of Short Put - Strike Price of Long Put Net Premium Received + Commissions PaidMax Loss Occurs When Price of Underlying
Breakeven Point(s)The underlier price at which break-even is achieved for the bull put spread position can be calculated using the following formula.

Bull Put Spread Example

Hassan Mujtaba believes that CIIT stock trading at $53 is going to rally soon and enters a bull put spread by buying a JULY Put options with strike price of 55 premium 2.50 per share and spent $100 and writing a JULY Puts with strike price of 57 and earned premium of 120. Thus, the trader receives a net credit of $20 when entering the spread position.Scenario AThe stock price of CIIT begins to rise and closes at $60 on expiration date. Both options expire worthless and the options trader keeps the entire credit of $20 as profit, which is also the maximum profit possible.

Bull Put Spread Example Cont.Scenario BIf the price of CIIT had declined to $48 instead, both options expire in-the-money.Hassan would buy the share from market at 48 and sell at 55, because he had bought put option. So he will earn (55-48) $7,but after paying premium of $2.50 he is left with $4.50. losses in the written puts = 48-57= -9, but after premium he is left with -9+3= -6. over loss would be: profit on put purchased $4.50, loss on puts written -6 total (-6+4.50)= -1.50. (40 X 1.50= 60)Total loss of $60 is the maximum loss Hassan bears.

Bear Put SpreadThe bear put spread option trading strategy is employed when the options trader thinks that the price of the underlying asset will go down moderately in the near term.Bear put spreads can be implemented by buying a higher strikingin-the-money put optionand selling a lower strikingout-of-the-money put optionof the same underlying security with the sameexpiration date.

Construction

By shorting the out-of-the-money put, the options trader reduces the cost of establishing the bearish position but forgoes the chance of making a large profit in the event that the underlying asset price plummets. The bear put spread options strategy is also know as the bear put debit spread as a debit is taken upon entering the trade.

Bear Put Spread Payoff Diagram

- Limited Downside ProfitTo reach maximum profit, the stock price need to close below thestrike priceof the out-of-the-money puts on the expiration date. Both options expire in the money but the higher strike put that was purchased will have higher intrinsic valuethan the lower strike put that was sold. Thus, maximum profit for the bear put spread option strategy is equal to the difference in strike price minus the debit taken when the position was entered.The formula for calculating maximum profit is given below:Max Profit = Strike Price of Long Put - Strike Price of Short Put - Net Premium Paid - Commissions PaidMax Profit Achieved When Price of Underlying
Limited Upside Risk & Breakeven Point(s)If the stock price rise above the in-the-money put option strike price at the expiration date, then the bear put spread strategy suffers a maximum loss equal to the debit taken when putting on the trade.The formula for calculating maximum loss is given below:Max Loss = Net Premium Paid + Commissions PaidMax Loss Occurs When Price of Underlying >= Strike Price of Long PutBreakeven Point(s)The underlier price at which break-even is achieved for the bear put spread position can be calculated using the following formula.Breakeven Point = Strike Price of Long Put - Net Premium Paid

Bear Put Spread ExampleSuppose CIIT stock is trading at $38 in June. An Hassan Murtaza bearish on CIIT decides to enter a bear put spread position by buying a JUL 40 put for $300 and sell a JUL 35 put for $100 at the same time, resulting in a net debit of $200 for entering this position.Scenario AThe price of CIIT stock subsequently drops to $34 at expiration. Both puts expire in-the-money with the JUL 40 call bought having $600 in intrinsic value and the JUL 35 call sold having $100 in intrinsic value.The spread would then have a net value of $5 (the difference in strike price). Deducting the debit taken when he placed the trade, his net profit is $300. This is also his maximum possible profit.

Bear Put Spread Example Contin.Scenario BIf the stock had rallied to $42 instead, both options expire worthless, and the options trader loses the entire debit of $200 taken to enter the trade. This is also the maximum possible loss.

Bull Call SpreadThe bull call spread option trading strategy is employed when the options trader thinks that the price of the underlying asset will go up moderately in the near term.Bull call spreads can be implemented by buying anat-the-moneycall option while simultaneously writing a higher strikingout-of-the-money call optionof the same underlying securityand the sameexpirationmonth.

CONSTRUCTIONBy shorting the out-of-the-money call, the options trader reduces the cost of establishing the bullish position but forgoes the chance of making a large profit in the event that the underlying asset price skyrockets. The bull call spread option strategy is also known as the bull call debit spread as a debit is taken upon entering the trade.

Bull Call Spread ConstructionBuy 1 ITM CallSell 1 OTM Call

Bull Call Spread Payoff Diagram

Limited Upside profitsMaximum gain is reached for the bull call spread options strategy when the stock price move above the higher strike price of the two calls and it is equal to the difference between the strike price of the two call options minus the initial debit taken to enter the position.The formula for calculating maximum profit is given below:Max Profit = Strike Price of Short Call - Strike Price of Long Call - Net Premium Paid - Commissions PaidMax Profit Achieved When Price of Underlying >= Strike Price of Short Call

- Limited Downside risk &Break Evenen PointsThe bull call spread strategy will result