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Chapter 4

Chapter 4. Option Combinations and Spreads. 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. Combinations. Introduction

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Chapter 4

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  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 27.50 MSFT call • Write an APR 32.50 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:

  10. Bullspread (cont’d) • Bullspread 3 Stock price at option expiration 27.50 0 32.50 2 29.50

  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 27.50 MSFT call@3 • buy an APR 32.50 MSFT call@1

  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

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