Chapter 4

Option
Combinations and
Spreads

1 © 2004 South-Western Publishing

 Outline
 Introduction
 Combinations
 Spreads
 Nonstandard spreads
 Combined call writing
 Margin considerations
 Evaluating 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
 Introduction
 A combination is a strategy in which you
are simultaneously long or short options of
different types

5
 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

6
 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

7
 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

8
 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

9
 Buying a Straddle (cont’d)
 Construct a profit and loss worksheet to form the
long straddle:
Stock Price at Option Expiration

0 15 25 30 45 55

Long 30 call -1.20 -1.20 -1.20 -1.20 13.80 23.80

@ $1.20
Long 30 put 27.25 12.25 2.25 -2.75 -2.75 -2.75
@ $2.75
Net 26.05 11.05 -1.05 -3.95 11.05 21.05
10
 Buying a Straddle (cont’d)
 Long straddle
Two breakeven points
26.05

30
0
Stock price at
26.05 33.95
option expiration
3.95

11
 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

12
 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

13
 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

14
 Writing a Straddle (cont’d)
 Short straddle

3.95

30
0
Stock price at
26.05 33.95
option expiration
26.05

15
 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

16
 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

17
 Buying a Strangle (cont’d)
 Suppose a speculator:
– Buys a MSFT JAN 25 put @ $0.70
– Buys a MSFT JAN 30 call @ $1.20

18
 Buying a Strangle (cont’d)
 Long strangle

23.10

Stock price at
25 30
0 option expiration
23.10 31.90

1.90

19
 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

20
 Writing a Strangle (cont’d)
 Short strangle

1.90

Stock price at
25 30
0 option expiration
23.10 31.90

23.10

21
 Condors
 A condor is a less risky version of the
strangle, with four different striking prices

22
 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

23
 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

24
 Buying a Condor (cont’d)
 Construct a profit and loss worksheet to form the
long condor:
Stock Price at Option Expiration
0 25 27.50 30 32.50 35
Buy 25 call -4.20 -4.20 -1.70 0.80 3.30 5.80
@ $4.20
Write 27.50 call 2.40 2.40 2.40 -0.10 -2.60 -5.10
@ $2.40
Write 30 put -27.25 -2.25 0.25 2.75 2.75 2.75
@ $2.75
Buy 32.50 put 27.90 2.90 0.40 -2.10 -4.60 -4.60
@ $4.60
25 Net -1.15 -1.15 1.35 1.35 -1.15 -1.15
 Buying a Condor (cont’d)
 Long condor

1.35

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

1.15

26
 Writing a Condor
 The condor writer makes money when
prices move sharply in either direction

 The maximum gain is limited to the

premium

27
 Writing a Condor (cont’d)
 Short condor

1.35

27.50 30
Stock price at
0 option expiration
25 32.50

1.15 31.35
26.15

28
 Spreads
 Introduction
 Vertical spreads
 Vertical spreads with calls
 Vertical spreads with puts
 Calendar spreads
 Diagonal spreads
 Butterfly spreads

29
 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

30
 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

31
 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.

32
 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

33
 Bullspread (cont’d)
 Construct a profit and loss worksheet to form the
bullspread:

Stock Price at Option Expiration

0 27.50 28.50 30.50 32.50 50
Long 27.50 -3 -3 -2 0 2 19.50
call @ $3
Short 32.50 1 1 1 1 1 -16.50
call @ $1
Net -2 -2 -1 1 3 3

34
 Bullspread (cont’d)
 Bullspread

Stock price at
27.50
0 option expiration
32.50

2 29.50

35
 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

36
 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

37
 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)

38
 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

39
 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

40
 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

41
 Calendar Spreads (cont’d)
 Calendar spreaders are concerned with
time decay
– Options are worth more the longer they have
until expiration

42
 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

43
 Butterfly Spreads
 A butterfly spread can be constructed for
very little cost beyond commissions

 A butterfly spread can be constructed using

puts and calls

44
 Butterfly Spreads(cont’d)
 Example of a butterfly spread

Stock price at
0 option expiration

45
 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

46
 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

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 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

48
 Hedge Wrapper (cont’d)
 The profitable stock position is transformed
into a certain winner

 The potential for further gain is reduced

49
 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

50
 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

51
 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

52
 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

53
 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)

54
 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

55
 Margin Requirements on
Spreads
 All spreads must be done in a margin
account

 More lenient than those for uncovered

options

 You must pay for the long side in full

56
 Margin Requirements on
Spreads (cont’d)
 You must deposit the amount by which the
long put (or short call) exercise price is below
the short put (or long call) exercise price
 A general spread margin rule:
– For a debit spread, deposit the net cost of the
spread
– For a credit spread, deposit the different between
the option striking prices

57
 Margin Requirements on
Covered Calls
 There is no margin requirement when
writing covered calls

 Brokerage firms may restrict clients’ ability

to sell shares of the underlying stock

58
 Evaluating Spreads:
Introduction
 Spreads and combinations are
– Bullish,
– Bearish, or
– Neutral

 You must decide on your outlook for the

market before deciding on a strategy

59
 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
debt and others a credit

60
 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 $300.00 and a maximum loss of
$200.00, the reward/risk ratio is 1.50

61
 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

62
 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

63
 Determining the Appropriate
Strategy: Some Final Thoughts
 The basic steps involved in any decision
making process:
– Learn the fundamentals
– Gather information
– Evaluate alternatives
– Make a decision

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