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Chapter 4

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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. Straddles (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 a JAN 30 call on MSFT @ $1.20 • Buys a JAN 30 put on MSFT @ $2.75

  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 26.05 30 0 Stock price at option expiration 26.05 33.95 3.95

  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 3.95 30 0 Stock price at option expiration 26.05 33.95 26.05

  16. 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

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

  19. Buying a Strangle (cont’d) • Long strangle 23.10 Stock price at option expiration 25 30 0 23.10 31.90 1.90

  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 1.90 Stock price at option expiration 25 30 0 23.10 31.90 23.10

  22. Condors • 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 25 calls @ $4.20 • Writes MSFT 27.50 calls @ $2.40 • Writes MSFT 30 puts @ $2.75 • Buys MSFT 32.50 puts @ $4.60

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

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

  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 • Vertical spreads with calls • Bullspread • Bearspread

  32. 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.

  33. 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

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

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

  36. 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

  37. 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

  38. 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)

  39. 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

  40. 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

  41. 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

  42. Calendar Spreads (cont’d) • Calendar spreaders are concerned with time decay • Options are worth more the longer they have until expiration

  43. 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

  44. Butterfly Spreads • A butterfly spread can be constructed for very little cost beyond commissions • A butterfly spread can be constructed using puts and calls

  45. Butterfly Spreads(cont’d) • Example of a butterfly spread Stock price at option expiration 0

  46. 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

  47. 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

  48. 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

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

  50. 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