Chapter 4

1. Chapter 4 Option Combinations and Spreads

2. ‘Rolling’ Trading Strategies • Rolling down/out/up - possible action as part of re-evaluating one’s option position • Rolling down - closing your position and re-establishing a new one with a lower strike price e.g. Long call position - re-establish new one at a lower strike • Rolling out - closing your existing position and re-establishing a new one with a longer expiration e.g. Similar to above situation • Rolling up - closing out your existing position and re-establishing a new one with a higher strike price

3. Rolling Trading Strategies • Rolling up and out • Rolling down and out • Should be viewed as a new investment position with a new stock price and time outlook as opposed to a continuation of the initial position

4. Chapter 4 Outline • Spreads • Nonstandard spreads • Combined call writing • Evaluating spreads • Combinations • Margin considerations

5. 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

6. Trading Considerations • What is your outlook for the stock and over what time frame? • Are you interested in ultimately acquiring the stock? • Do you own the stock now - are there dividend considerations? • Where do you expect the profit to come from - stock movement or a net credit position from the sale of options? • Option Pricing - implied volatility

7. Spreads • 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 • the ‘spreader’ establishes a known maximum profit or loss potential between either the two strike prices or the two expiration dates…or combination thereof • Spreads are also known as ‘collars’

8. Spreads • Price or Vertical spreads • Vertical spreads with calls • Vertical spreads with puts • Calendar spreads • Diagonal spreads • Butterfly spreads

9. Price Spreads (also known as Vertical Spreads & ‘Money Spreads’ ) • In a price/vertical spread, options are selected vertically from the financial pages i.e. Different strike prices • The options have the same expiration date • The spreader will long one option and short the other …..risk reduction strategy relative to a pure call or put option

10. Price Spreads With Calls • Bullspread • Bearspread

11. Bullspread or Bull Call Spread • 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.

12. 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

13. Bullspread (cont’d) • Construct a profit and loss worksheet to form the bullspread:

14. Bullspread (cont’d) • Bullspread 3.38 Stock price at option expiration 85 0 90 1.62 86.62

15. Bearspread or Bear Call Spread • 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 • Profit from the sale of the call w/o risk of a sharp run up in the price of the stock

16. Price Spreads With Puts: Bullspread or Bull Put Spread • Involves using puts instead of calls • Buy the option with the lower striking price and write the option with the higher one • Profit stems from the spread of the two options …….but profit still only is generated if the stock moves up (bull put spread)

17. 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)

18. 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

19. Calendar (or Time) 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 • The trading objective is to take advantage of the ‘time decay’ factor. • Options are worth more the longer they have until expiration

20. 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…..taking advantage of the greater time value

21. 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

22. Butterfly Spreads • A butterfly spread can be constructed for very little cost beyond commissions • A butterfly spread can be constructed using puts and calls • A butterfly spread does not technically meet the definition of a spread in that it can involve both puts and calls (combination) • Volatility of the stock price is the main driver of the profit/loss potential with this option strategy

23. Butterfly Spreads(cont’d) • Example of a butterfly spread 4 Stock price at option expiration 75 85 0 76 80 84 -1

24. 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

25. 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

26. Nonstandard Spreads: Hedge Wrapper (collar) • 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

27. Hedge Wrapper (cont’d) • The profitable stock position is transformed into a certain winner- locking in a defined gain • The potential for further gain is reduced

28. 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

29. Evaluating Spreads • Spreads and combinations are • Bullish, • Bearish, or • Neutral • You must decide on your outlook for the market before deciding on a strategy

30. 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 debit and others a credit • 3 considerations: • Risk/reward ratio • Movement to loss • Limit price

31. 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

32. 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

33. 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

34. Combinations • Straddles • Strangles • Condors • A combination is defined as a strategy in which you are simultaneously long or short options of different types

35. 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

36. Straddles • You are short a straddle if you are short both a put and a call with the same • Striking price • Expiration date • Underlying security

37. 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 • Very Speculative - typically a situation where a company is involved in a lawsuit or takeover - unclear how the situation will be resolved.

38. Buying a Straddle (cont’d) • Suppose a speculator • Buys an OCT 80 call on MSFT @ $7 • Buys an OCT 80 put on MSFT @ $5.88

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

40. Buying a Straddle (cont’d) • Long straddle Two breakeven points 67.12 80 0 Stock price at option expiration 67.12 92.88 12.88

41. 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

42. 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

43. 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

44. Writing a Straddle (cont’d) • Short straddle 12.88 80 0 Stock price at option expiration 67.12 92.88 67.12

45. Strangles: Introduction • A strangle is similar to a straddle, except the puts and calls have different striking prices • Strangles are more popular due to the smaller capital investment and the max. gain occurs over a wider trading range

46. Buying a Strangle • The speculator long a strangle expects a sharp price movement either up or down in the underlying security • Suppose a speculator: • Buys a MSFT OCT 75 put @ $3.62 • Buys a MSFT OCT 85 call @ $5

47. Buying a Strangle (cont’d) • Long strangle 66.38 Stock price at option expiration 75 85 0 66.38 93.62 8.62

48. 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 • similar to writing a straddle • some movement in the stock price results in the max. Profit • maximum profit is somewhat reduced from the straddle

49. Writing a Strangle (cont’d) • Short strangle 8.62 Stock price at option expiration 75 85 0 66.38 93.62 66.38

50. Condors: Introduction • A condor is a less risky version of the strangle, with four different striking prices • It is somewhat of a hybrid between a combination and a spread • ‘spread like’ because of the defined window of profit or loss • ‘combination like’ because it involves both puts and calls