two main types of vertical spreads: the bull spread and the bear spread. Either one maybe constructed with puts or with calls. In fact, it is even possible toconstruct them using the underlying and options as well.Bull Spread. A bull spread is a vertical spread that is typicallyconstructed by buying a call at one strike and selling another call at a
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higher strike (both calls typically expire at the same time). The resulting position has profitability as shown in Figure 2.12. Since theprofit potential is on the upside, you need to have a somewhat bullish outlook for this spread to work, hence the name. There is bothlimited risk and limited profit potential, although the risk is equal to100 percent of the capital required—the same percentage risk asowning a call option.If the underlying is near or below the lower strike when thespread is established, the profit potential can be several times the losspotential. If the underlying is initially midway between the twostrikes, then the profit and loss potential will be approximately equal.Finally, if you establish bull spreads with the underlying at or abovethe higher strike, the risk is great in comparison to the potentialrewards, but the probability of gain is high since both options are inthe-money to begin with.One of the main reasons that traders use bull spreads instead ofjust buying calls outright is that they want to hedge their bets somewhat. This is particularly true if the options are “expensive”; thetrader feels that he is at least selling something expensive against theFigure 2.12BULL SPREAD
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expensive call that he is buying. However, he should not always usethe bull spread approach just because the options have a lot of timevalue premium, for he is giving up a lot of upside profit potential inorder to have a hedged position. If the underlying is volatile, then heshould not be queasy about having to pay for time value premium onan in-the-money option—it is probably worth it, as the implied andhistorical volatilities most likely are closely in line.Once the bull spread is established, it might not perform exactlyas you expect. Figure 2.13 shows a typical bull spread using the 80and 90 striking prices, bought when the underlying was 85—midwaybetween the two strikes. The profit potential at several intermediatepoints in time is shown: at 15 days from inception, 30 days, 45 days,and 60 days. Notice that there is very little difference in the results astime passes (until you get very close to expiration, when the profitpotential approaches the final shape of the bull spread). This phenomenon can sometimes be frustrating: if the underlying has a niceupward move shortly after you establish the spread, you will probably
Figure 2.13BULL SPREAD COMPARISON
$ Profit/Loss
60 Days
15 Days
75
80
85
15 DaysAt expiration60 Days
90
95
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AN OVERVIEW OF OPTION STRATEGIES
be disappointed in your profits at that time. This fact often causesbull spread holders to “overstay their welcome,” as they figure theywill continue to hold on for better results closer to expiration, only tosee the underlying slip back and their profits dissipate.Thus the bull spread is a low-risk- and low-profit-potential strategy—particularly if you remove it prior to expiration—but that is notwhat many traders intend when they establish it. To get a largerprofit potential, you must establish the spread with the underlyingclose to the lower strike, or merely buy the call and not use the bullspread at all.The preceding bull spread using calls always requires a debit toestablish, since the call with a lower striking price will always costmore than the call with the higher strike that is being sold. However,an equivalent position can be established using puts, and the putspread is a credit spread. The following example illustrates this fact.Example: XYZ is 55.July 50 call: 7July 60 call: 2
July 50 put: 11⁄2July 60 put: 61⁄2
Call bull spread: buy July 50 call and sell July 60 call = 5 point debit.Put bull spread: buy July 50 put and sell July 60 put = 5 point credit.
With either spread, you would make 5 points at expiration if XYZis over 60, and you would lose 5 points if XYZ were below 50 atexpiration.The advantage to credit spreads is this: in the credit spread, thebrokerage firm requires the difference in the strikes to be marginedwith collateral; then you can use the credit generated to reduce therequirement, if you want. We have already described collateral as anytype of security that you own, stocks or bonds. Most brokerage firmswill allow you to put up T-bills as collateral for the difference in thestrikes, and then they will let you put the credit from the spread ina money market fund and earn interest on it. This additional feature makes the credit form of the spread more attractive to manyinvestors.There is actually one more way to construct a position that hasthe same profit potential as a bull spread: buy the underlying stock,
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buy an out-of-the-money put (which limits downside risk), and sell anout-of-the-money call (which limits upside profit potential). This position, known as a collar, is a rather popular form of protecting astock position. It is discussed in more detail in the section on protecting a portfolio in Chapter 3. Thus, all three ways of constructing abull spread are considered to be equivalent positions.Bear Spread. The bear spread (Figure 2.14) is also a verticalspread, but it is constructed by taking the opposite actions of the bullspread: if you are using calls, you buy the call with the higher strikeand sell the call with the lower strike. This creates a spread that hasits profit potential to the downside (hence, the name bear spread).Like the other vertical spreads, it has limited profit and risk potential.When you establish a bear spread with calls, you take in a credit;so it has the advantages outlined earlier in terms of earning interestfrom the credit. The bear spread may also be constructed with puts,in which case you would have a debit spread: you would buy the putat the higher strike and sell a put at a lower strike as a hedge.Figure 2.14BEAR SPREAD
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As with the bull spread, you may use the spread because theoptions are expensive. This helps reduce the risk if things go awrybut may severely limit the profit potential over the short term if theunderlying moves in a favorable direction.Sybase, a technology stock, was trading near 45 in the spring of 1995, andthe options had become very expensive in advance of the company’s earnings report. Since technology stocks were “in favor,” there was a contingentthat thought the stock would soar if the earnings were merely “in line.” Onthe other hand, there were rumors that the earnings were going to be terrible. These two facts combined to make the options very expensive.I knew a trader who felt that earnings were going to be bad and therefore wanted to buy puts. His initial reaction was to buy the April 45 puts, orperhaps the April 40 puts, but they were extremely expensive. With Sybaseat 45, the April 40 puts were 21⁄2 with only a month remaining until expiration. Figuring that these were just too expensive, he decided that it would bebetter to pay 41⁄2 for the April 45s and then offset some of that cost by selling an out-of-the-money put. Thus, he created a bear spread—he boughtthe April 45s and sold the April 35s for a net debit of 31⁄2.Less than a week later, Sybase let the Street know that not only wouldearnings be bad, they would be terrible. The stock plunged 20 points to 23.The bear spread widened to its maximum potential—10 points (the difference in the two strikes, 45 – 35)—and the trader made 61⁄2 points on his31⁄2 investment. Not a bad trade, but nowhere near the return that he couldhave made had he merely bought the “overpriced” April 45 puts in the firstplace. They rose from 41⁄2 to 22. Using the spread cost a lot of money.
Thus, while it is sometimes attractive to use a spread to offset thecost of an expensive option, you should evaluate why the option isexpensive and how far the underlying might move. If it’s expensivebecause there is a potential for a short-term, explosive move in thestock, then a spread is probably ill-advised because the optionsdeserve to be expensive. If, on the other hand, the options seemexpensive only because the underlying has been stagnant or if a movemight be only a modest one, then a spread may be a viable strategy.For example, gold sometimes goes into tight trading ranges forextended periods, during which time the options don’t really get correspondingly cheaper. The options retain their premium becausetraders know that gold could once again become volatile at any time.
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The result of all this is that the options appear to be expensive (andthey are, in comparison to the movement in the underlying goldfutures). At times like that, bull or bear spreads are viable strategies.This same sort of relative option pricing can occur in any stock,index, or futures contract whenever the underlying price becomessluggish while the options retain their former premium levels.Credit Spread. We have already described the two basic creditspreads—the bull spread constructed with puts and the bear spreadconstructed with calls. However, “credit spreading” has taken on awider meaning in the wake of the crash of 1987 and other stockmarket gaps, which have caused ruin for many a naked optionwriter. Such trading gaps are also common in futures; so the creditspread strategy, as it is applied today, is fairly widely practiced infutures option trading also.A look at the philosophy behind the credit spread, plus some historical evidence, will help to explain the current popularity of thestrategy. Most option traders “know” that selling options is the moreprofitable way to approach option trading because (1) time decayworks in their favor and (2) everyone says option buyers lose a lot ofmoney. These are popular misconceptions that aren’t always true.Many novice traders are convinced that professionals sell optionsalmost exclusively, so they want to do what the “pros” do (it is mypersonal experience, however, that most professional tradersattempt to establish a net long option position if they can).The main problem with selling naked options is that there isunlimited risk—or, at least, very large risk—if the underlying experiences a sudden move or gap opening. After the crash of 1987,when many naked put sellers were carried out on their shields, thelimited risk nature of the credit spread caused it to gain tremendously in popularity.Another problem with selling naked options is that, assuming youpass the suitability tests and have enough equity in your account, brokers want collateral of 20 percent of the value of a stock or 15 percent of the value of an index in order to allow you to sell a nakedoption. With OEX at 600, this is a requirement of $9,000 to write the600 call or put naked (15 times $600). The higher that OEX rises, thegreater will be the requirement, as it is recalculated each day by your
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brokerage firm. However, the requirement for a credit spread is onlythe difference in the strikes, less any credit received; thus a 10-pointcredit spread in OEX would require less than $1,000 apiece to establish—quite a savings over the $9,000 for a naked option.Of course, the profitability of the sale of an option is reduced bybuying the other option that creates the credit spread. This is a negative to some traders; but considering the reduction of capitalrequired and the lessening of ultimate risk, it is often seen as a worthwhile cost.Do credit spreads really win 90 percent of the time? I haveseen proponents of the credit spread advise establishing the spreadwith extremely far out-of-the-money options so that there is a verylarge chance of making money. For example, with OEX at 475 atthe beginning of April, they might recommend the April 450–460 put spread for a half credit ($50). The probability of OEX falling15 points in two weeks is small. Therefore, they reason, there is agood chance of making money. In fact, this type of spread has beenvery consistently profitable since the crash—the length of the currentbull market.But what’s the real risk of the spread? It’s that OEX could fall to450 or lower, thereby causing a loss of $950. So you’re risking$950 to make $50, but the probability of making the $50 is fargreater than that of losing the $950. Let’s just say that there’s a 95percent chance that the options will expire worthless and a 5 percentchance that the maximum loss is realized. These are not the truemathematical numbers, and we haven’t allowed for any possibility ofOEX being between 450 and 460 at expiration, but they will sufficefor this simple example. So we have a 95 percent chance of making$50, which means our expected gain is $47.50 ($50 × 0.95), and a5 percent chance of losing $950—a $47.50 loss! Therefore, ourexpected result is that we would make nothing and lose our commissions if we operated the strategy long enough.Proponents of the strategy usually counter by saying that theywould never let the spread lose its maximum amount—that theywould close it out if OEX fell to some predetermined level, usuallybefore either option gets to be an in-the-money option. This tacticmeans that they might only lose a point or less on the spread if theyhad to buy it back prematurely.
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Mathematics would then tell us that they have greatly reduced theprobability of both options expiring worthless because there is amuch greater chance that OEX could fall to 460 at any time beforeexpiration than there is that it would be below 450 at expiration. Sonow, maybe there’s a 70 percent chance of making $50 and a 30percent chance of losing $100—again, not much better than aneven-money proposition after commissions are included.Why does the math seem to belie actual fact? The math says“don’t waste your time with these spreads,” while in actual fact, theyhave been very profitable. For one thing, the math is assuming a random market, and we have been in a mostly bullish market for the pastseveral years. However, this doesn’t mean the math is wrong. If youwere to flip a coin 100 times and got 90 heads, would you say thatthe probability of getting heads on the next toss was greater than 50percent? You might, but you would be wrong—it’s still 50 percent.In much the same manner, the credit spread strategy can besummed up. It doesn’t have any theoretical edge, even though manypeople will tell you that it does; but if you want the reduced-risk feature and the increased leverage offered by the lower collateral requirements, then it is an attractive, but not necessarily statistically superior,alternative to naked option writing. At the end of this section on linear spreads, we discuss when a spread is statistically attractive.
Calendar SpreadsA calendar spread is also called a time spread because one is theoretically attempting to spread time and not price (although price isstill a factor in how the spread behaves). A calendar spread in stockoptions consists of buying an option that expires in a certain futuremonth and selling an option, with the same striking price, thatexpires in a closer month. For example, if the current month is April,then buying an IBM July 80 call and selling an IBM May 80 callwould be a calendar spread. As time passes and May expirationapproaches, time decay will begin to weigh more heavily against theMay 80 call that is short than it does on the July call that is held long.As that happens, the spread will make money if the underlying isnear the striking price.
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Sometimes calendar spreads are also called horizontal spreads toindicate that spread is across various expiration months, to differentialfrom vertical spreads, where the spread is across various strikes.The true spread trader will remove the position at or before Mayexpiration, as he is interested in the characteristics of the spreaditself—it will widen if the underlying remains near the striking price,and it will shrink if the underlying moves too far away from the striking price. This profitability, at near-term expiration, is shown in Figure 2.15. The spread has both limited profit potential and limitedrisk, with the risk being limited to the amount initially paid for thespread (a feature similar to the vertical spreads described earlier).A more aggressive tack would be to continue to hold the longcalls after the short calls have expired. This is not a recommendedmethod of approaching the calendar spread strategy.One of the biggest differences between stock (or index) optionsand futures options is that the expiration months are not necessarilydirectly related in futures options. Therefore, you must be carefulwhen constructing calendar spreads with futures options. For example, there may be options on March Swiss franc futures and on June
Figure 2.15CALENDAR SPREAD
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Swiss franc futures. If you buy a June option and sell a March option,you do not necessarily have a calendar spread in the same sense thatyou do in the IBM example. The reason that this is true is that thereare two distinct futures underlying the two Swiss franc options—theJune contract and the March contract. Whereas in the IBM example,only IBM stock underlies both of the options in the calendar spread.While it is true that the March Swiss franc futures and the JuneSwiss franc futures are related, they do not necessarily move in concert. In fact, in some futures—particularly those with actual commodities underlying them, such as grains and oil—the spreadbetween the two futures contracts can vary substantially. This variation in the spread will cause the related options to behave in a manner that is not what one is used to seeing in calendar spreads onstocks or indices. It can even cause the option values to invert to thepoint where the near-term option sells for a higher price than thelonger-term option. An example may be useful.Example: Assume it is currently February, and you notice that March Swissfranc (SF) options are expensive with respect to June Swiss franc options.Therefore, you want to establish a calendar spread. The following pricesmight exist:March SF futures: 77.00March 78 call: 1.00
June SF futures: 78.00June 78 call: 3.00June 79 call: 2.00
Your initial reaction might be to try to establish a calendar spread bybuying the June 78 call and selling the March 78 call. However, eventhough the strikes are the same for each call—78.00—the March call is onepoint out-of-the-money, while the June call is at-the-money. This increasesthe debit that you must initially pay for the spread and actually makes it abullish position. A more neutral calendar spread would be to use calls thatare equally out-of-the-money to begin with: buy the June 79 call and sell theMarch 78 call. Both options are one point out-of-the-money.Even in that case, though, the spreader is subject to the vagaries of therelative movements of the March and June SF futures. For example, if interest rates in the United States or in Switzerland were to change, then theprice differential between the two futures contracts themselves would surelychange as well.
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Currency futures have serial options. Therefore, there would alsobe SF options that expire in both April and May. Moreover, theactual futures contract that underlies those serial options would bethe June futures contract. Thus, you could construct a true calendarspread if you were to buy June SF calls and sell April or May SF calls.In that case, the only variable involved in the option spread would betime, for the same contract—the June SF futures contract—underliesboth options.
Diagonal SpreadsDiagonal spreads are a combination of vertical and calendar spreads.The long and the short option in a diagonal spread have both different strikes and different expiration months. Usually, the diagonalspread is used in lieu of the vertical spread if you feel that it may takesome time before the underlying makes its ultimate move.Suppose that you’re interested in establishing a bull spread. However, you also notice that the near-term options are quite expensive incomparison to the longer-term options. This type of situation oftenoccurs in a fast-moving stock, or in rumor situations. So, instead ofmerely buying a bull spread, the trader might decide to diagonalizethe spread not only to still have some bullish potential, but also tohave the benefit of the time decay of the short-term option.NCR Corp., a computer company, was the recipient of a takeover bid fromAT&T in December 1990. Several factors were at work after the bid wasmade. First, the stock didn’t advance to its full potential because of antitrustconcerns. In addition, there were indications that the bid might be raised, sothe near-term options were more expensive—on a relative basis. This presented an excellent opportunity for a diagonal spread. The following pricesexisted at the time:NCR: 90NCR Jan 90 call: 31⁄2NCR Jan 95 call: 2
NCR March 90 call: 5NCR March 95 call: 3
Many risk arb traders who understood options were fairly certain thatthe deal would go through, but they thought there might be some delay.
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So they chose the diagonal spread: buying March 90 calls and selling Jan95 calls. Indeed, there was a delay, and NCR was still trading at 88 whenthe Jan 95 calls expired worthless. The arbs then were able to sell Feb 95calls to further reduce the cost of the March 90 calls that they held. Those,too, expired worthless, and many arbs then just held onto their long calls.Eventually, the government acquiesced, and the stock moved up to 100 inearly March, bringing good profits to both bull spreads and outright longpositions.Things got even better, as there were more delays and the arbsrepeated the whole process with long June 100 calls and short April 105calls (and then May 105 calls when those expired). In this entire situation,the diagonal spread was best.
This example also demonstrates the second step in a diagonalspread if things work out right: if the underlying remains fairly stableuntil the short-term call expires worthless, then you can sell an outof-the-money call expiring in the next month to further reduce thecost of the option that you continue to hold. If there is initially onlyone month between the expirations of the calls in the spread (as inthe NCR example), then there is only one additional opportunity tosell an out-of-the-money call against the one you already own. However, if there were several months between the two options’ expirations when the spread is first established, then there can benumerous opportunities to continue to sell premium against the callthat continues to be held long. Of course, once the stock makes alarge move in either direction, the spread will more or less reach itsmaximum potential or maximum loss, and there will be no furtheropportunities to sell short-term premium.In summary, diagonal spreads can be an attractive alternative tovertical spreads, especially if the near-term options are expensivewith respect to the longer-term options. This applies to any underlying—stock, index, or futures contract.
When Spreads Are AttractiveAt the beginning of the section on spreads, we stated that one of themain reasons traders enter into spreads is to reduce the risk of a
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single-sided position. This is especially true for naked option sellers;the large risk that naked option writing entails can be tempered byusing a credit spread instead.There is another consideration in any spread, and that is the relative pricing of the two options involved in the spread. If the optionbeing purchased is “underpriced” with respect to the one being sold,then the spread has a statistical “edge” to it. When viewed from thisperspective, spread trading becomes a strategy unto itself and is onethat has a mathematical advantage.Grain futures call options—particularly corn and soybeans—have a natural tendency to be more expensive, on a relative basis, the farther theyare out-of-the-money. Thus, if you buy an at-the-money soybean call andsell an out-of-the-money soybean call, which is a simple bull spread, youhave a nice statistical advantage. You’re buying something that is“cheaper” than the thing you’re selling. Of course, you could still losemoney if soybeans declined in price, since the initial spread’s debit would belost. Thus, an “edge” doesn’t guarantee a profit, but it does mean that youhave a better than even chance of making money if you pursue the samesituation many times.
This soybean situation described how a debit spread might havean advantage. This advantage can sometimes exist with creditspreads as well, and would increase their attractiveness in thosecases. For example, ever since the crash, out-of-the-money OEXcalls have been less expensive than at-the-money OEX calls; so acredit call spread (which is a bear spread) has had a built-in edge, statistically. However, since the market basically went up for the next13 years, the OEX bear credit spread was not particularly profitable.In fact, many statistically oriented traders recognize the problemwith applying statistics to spreads that have a price bias, such as vertical spreads do. For no matter how favorably priced the options arein a vertical spread, you still need the underlying to move in a favorable direction in order to make money. Other spread strategies wereborn from this, many of which involve ratio writes or ratio spreads.We discuss those as the last section in this chapter. Their applicationas neutral spreads is reserved for a later chapter.
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RATIO STRATEGIESRatio WritingThe most basic form of “ratio” strategy is the call ratio write. In thisstrategy, you buy or own a certain quantity of the underlying andthen sell a number of calls representing a greater number of sharesthan you own. Thus, you have naked call options in this strategy. Assuch, it is considered a relatively sophisticated strategy, as it has theoretically unlimited upside risk.The strategy has a profit graph as shown in Figure 2.16. It hasboth an upside and a downside break-even point and can makemoney anywhere in between, with the point of greatest profit atexpiration being at the striking price of the written options. You mayrecognize this as the same shape as a naked straddle write; and sincethe two strategies have the same shape to their profit graph, they areequivalent.Ratio call writing was the predecessor strategy to naked straddleselling—at least as far as listed option markets go—because thereFigure 2.16RATIO CALL WRITE
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AN OVERVIEW OF OPTION STRATEGIES
were listed calls for several years before there were listed puts. Thestrategy is considered to be a “neutral” strategy because you makemoney if the stock stays in a trading range.You can also construct a ratio write by shorting the underlyingand selling two puts. This is a rarely practiced form of the ratio write;but if you think about the shape of the profit graph, you will realize itis the same as the one shown earlier. For stock options, the put ratiowrite is inferior to the call ratio write unless you are a professionaland are able to earn interest on the credit balance generated by yourshort sale. For futures options, the call ratio write and the put ratiowrite should produce identical profit potential, although calls areoften more liquid than puts, so this fact may also favor the call ratiowrite in any market.
Ratio SpreadsWhen the number of options that you buy in a spread differs fromthe number of options that you sell, you have a ratio spread of oneform or another. As with other option strategies, the various types ofratio spreads have acquired their own names in order for traders andstrategists to be able to quickly identify the profitability of the strategymerely by hearing its name.
Call Ratio Spreads. In a call ratio spread, one typically buys callsat a lower strike and then sells a greater number of calls at a higherstrike. The credit brought in from the sale of the extra calls generallycovers all, or nearly all, of the cost of the calls being purchased.This strategy has little, if any, downside risk—equal only to theinitial debit of the spread plus commissions. If the spread was initiallyestablished for a credit, then there is no downside risk. As with theratio write, the point of maximum profitability at expiration is atthe striking price of the written options; and a profit can be had allthe way up to the upside break-even point. Beyond that point, thereare theoretically unlimited losses if the underlying were to rise toofar, too fast, because there are naked calls involved in this strategy.These points are all shown in Figure 2.17.
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Figure 2.17CALL RATIO SPREAD
This strategy is one that is favored by many traders over the ratiowrite because there is only risk on one side of the spread (the upside).Thus, it is easier to monitor. Moreover, if the underlying is initially ator below the lower strike in the spread, you often have a profit bythe time it rises to the higher strike. In that case, many traders preferto take their profit at that time rather than waiting until expiration.Ratio spreads are often attractive in futures options due to the fact that outof-the-money calls are more expensive than at-the-money calls. This gives abuilt-in edge to the strategist who is using a call ratio spread. In the spring of1993, gold futures were languishing in the $330-an-ounce neighborhood.However, professionals were amassing call ratio spreads by buying goldJune 340 calls and selling enough June 360 calls to cover their costs. Theywere essentially buying one June 340 call for every two June 360s theysold. Thus, they had positions with no risk unless gold rose to nearly 380before June expiration. In the spring and summer of that year, gold had animpressive rally that eventually carried to $400 an ounce. The rally wasmethodical, however, and not too explosive—the perfect scenario for theratio spread. For as gold rose to 360, the long calls were worth over $20apiece, since they were 20 points in the money, while the short calls were
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worth only $5 or $6. Thus, the traders were able to remove their entireposition for a nice profit—selling their longs for 20 and buying back the twoshort for 6 each, leaving them with an $8 credit for each spread. Eventhough gold eventually traded higher, the traders had taken their profits andmoved on to other situations.
This tale illustrates the real beauty of the call ratio spread: youcan lay back with little or no downside risk (although capital is tiedup; but that capital can be in the form of T-bills, so it at least earnsinterest). Then, if the underlying makes a move, you have a niceopportunity to exit with a profit. The danger is that the upward moveby the underlying will be an explosive one and that you will not havea chance to remove your spread when it trades through the higherstrike. This is especially true if there are gap or limit moves that occurwhen the underlying nears the point where you intended to takeprofits. Even in that less-than-desirable case, however, the ratiospreader is not in terrible straits. As long as you protect againstunlimited upside losses, which would occur if the underlying rosethrough the upside break-even point of the spread, this strategyshould produce profits over the course of time. In one sense, this isan even more favorable strategy with futures options than it is withstock or index options, because of SPAN margin computations thatare available for futures traders.Put Ratio Spreads. A similar strategy can be constructed withput options, only with puts you buy a put with a higher strike and sella greater number of puts with a lower strike. Again, the sales offsetmost or all of the cost of the purch