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Chapter 4

Chapter 4. Option Combinations and Spreads. Outline. Introduction Combinations Spreads Nonstandard spreads Combined call writing Margin considerations Evaluating spreads. Introduction. Previous chapters focused on Speculating Income generation Hedging

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Chapter 4

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

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

  11. Buying a Straddle (cont’d) • Long straddle Two breakeven points 67 1/8 80 0 Stock price at option expiration 67 1/8 92 7/8 12 7/8

  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 12 7/8 80 0 Stock price at option expiration 67 1/8 92 7/8 67 1/8

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

  19. Buying a Strangle (cont’d) • Long strangle 66 3/8 Stock price at option expiration 75 85 0 66 3/8 93 5/8 8 5/8

  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 8 5/8 Stock price at option expiration 75 85 0 66 3/8 93 5/8 66 3/8

  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 calls @ $10 • Writes MSFT 80 calls @ $7 • Writes MSFT 85 puts @ $8 1/2 • Buys MSFT 90 puts @ $12 1/8

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

  26. Buying a Condor (cont’d) • Long condor 3 3/8 Stock price at option expiration 75 80 90 85 0 76 5/8 88 3/8 1 5/8

  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 1 5/8 Stock price at option expiration 80 85 0 75 90 3 3/8 88 3/8 76 5/8

  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:

  36. Bullspread (cont’d) • Bullspread 3 3/8 Stock price at option expiration 85 0 90 1 5/8 86 5/8

  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

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