Chapter 4

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: Suppose a speculator • Buys a JAN 30 call on MSFT @ $1.20 • Buys a JAN 30 put on MSFT @ $2.75

7. Buying a Straddle (cont’d) • Construct a profit and loss worksheet to form the long straddle:

8. Buying a Straddle (cont’d) • Long straddle Two breakeven points 26.05 30 0 Stock price at option expiration 26.05 33.95 3.95 • 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 3.95 30 0 Stock price at option expiration 26.05 33.95 26.05

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: Suppose a speculator: • Buys a MSFT JAN 25 put @ $0.70 • Buys a MSFT JAN 30 call @ $1.20

13. Buying a Strangle (cont’d) • Long strangle 23.10 Stock price at option expiration 25 30 0 23.10 31.90 1.90 1st Strangle Breakeven = Call Strike Price + (Call + Put Premium) 2nd 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 beUnlimited. • If Stock Price Moved Down = loss will belimited to = Strike Price – (Put Premium + Call Premium)

15. Writing a Strangle (cont’d) • Short strangle 1.90 Stock price at option expiration 25 30 0 23.10 31.90 23.10

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: Suppose a speculator: • Buys MSFT 25 calls @ $4.20 • Writes MSFT 27.50 calls @ $2.40 • Writes MSFT 30 puts @ $2.75 • Buys MSFT 32.50 puts @ $4.60

18. Buying a Condor (cont’d) • Construct a profit and loss worksheet to form the long condor:

19. Buying a Condor (cont’d) • Long condor 1.35 Stock price at option expiration 25 27.50 32.50 30 0 26.15 31.35 1.15

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: 1.35 Stock price at option expiration 27.50 30 0 25 32.50 1.15 31.35 26.15

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

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: 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 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. • 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:

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

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: Assume a person believes MSFT stock will fail soon • A possible strategy is to construct a vertical call bearspread and: • Write an APR 27.50 MSFT call • Buy an APR 32.50 MSFT call • The spreader trades part of the profit potential for a reduced cost of the position. • With Bearspreads: • The maximum gain = PS,C – PL,C • The maximum loss = XS + PS – (XL – PL) • 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:

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

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 + 0.20(Stock Price) – (Out-of-Money Amount) or Premium + 0.10(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