combining long and short options with different strike prices and like expi-ration  dates.  The  juxtaposition  of  long  and  short  options  results  in  a  netdebit or net credit. The net debit of a bull call spread and a bear put spreadcorrelates to the maximum amount of money that can be lost on the trade.Welcome to the world of limited-risk trading! However, the net credit of abull put spread and a bear call spread is the maximum potential reward ofthe position—a limited proﬁt. Success in this kind of trading is a balancingact.  You  have  to  balance  out  the  risk/reward  ratio  with  the  difference  be-tween the strikes—the greater the strike difference, the higher the risk.
One of the keys to understanding these managed risk spreads comesfrom grasping the concepts of intrinsic value and time value—variablesthat  provide  major  contributions  to  the  ﬂuctuating  price  of  an  option.Although  changes  in  the  underlying  asset  of  an  option  may  be  hard  toforecast, there are a few constants that inﬂuence the values of optionspremiums.  The  following  constants  provide  a  few  insights  into  why 
130
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vertical spreads offer a healthy alternative to traditional bullish and bear-ish stock trading techniques:
• Time  value  continually  evaporates  as  an  option  approaches  expira-
tion.
• OTM and ATM options have no intrinsic value—they are all time valueand therefore lose more premium as expiration approaches than ITMoptions.
• The premiums of ITM options have minimum values that change at a
slower pace than OTM and ATM options.
• Vertical spreads take advantage of the differing rates of change in the
values of the options premiums.
The four vertical spreads that we use can be broken down into twokinds of categories: debit and credit spreads, each with a bullish or bear-ish bias. The success of these strategies depends on being able to use op-tions  to  exploit  an  anticipated  directional  move  in  a  stock.  As  usual,timing is everything. To become good at forecasting the nature of a direc-tional trend, try to keep track of a stock’s support and resistance levels.Remember, a breakout beyond a stock’s trading range can happen in ei-ther  direction  at  any  time.  Limiting  your  risk  is  a  great  way  to  level  theplaying ﬁeld.
VERTICAL SPREAD MECHANICS
Vertical spreads are excellent strategies for small investors who are get-ting their feet wet for the ﬁrst time. Low risk makes these strategies invit-ing.  Although  they  combine  a  short  and  a  long  option,  the  combinedmargin is usually far less than what it would cost to trade the underlyinginstrument.  If  you  are  new  to  the  options  game,  take  the  time  to  learnthese four strategies by paper trading them ﬁrst. The rest of this chapter isdesigned to help you become familiar with these innovative strategies.
There  are  two  kinds  of  debit  spreads:  the  bull  call  spread  and  thebear put spread. As their names announce, a bull call spread is placed ina bullish market using calls and a bear put spread is placed in a bearishmarket using puts. Debit spreads use options with more than 60 days un-til expiration. The maximum risk of a debit spread is limited to the netdebit of the trade.
In contrast, the maximum proﬁt of a credit spread is limited to the netcredit  of  the  trade.  There  are  two  kinds  of  credit  spreads:  the  bull  putspread and the bear call spread. The bull put spread is placed in a bullish
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TABLE 5.1 Vertical Spread Deﬁnitions
Type
Strategy
Components
Debit
Credit
Bull call spreadBear put spread
Long lower strike call and short higher strike call(s)Long higher strike put(s) and short lower strike put(s)
Bull put spreadBear call spread
Long lower strike put(s) and short higher strike put(s)Long higher strike call(s) and short lower strike call(s)
market using puts and a bear call spread is placed in a bearish market us-ing  calls.  In  general,  credit  spreads  have  lower  commission  costs  thandebit spreads because additional commissions are avoided by simply al-lowing the options to expire worthless. Since credit spreads offer a lim-ited  proﬁt,  make  sure  that  the  credit  received  is  worth  the  risk  beforeplacing the trade.
To determine which strategy is the most appropriate, it is important toscan a variety of strike prices and premiums to ﬁnd the optimal risk-to-reward ratio. This is accomplished by calculating the maximum risk, max-imum  reward,  and  breakeven  of  each  potential  spread  to  ﬁnd  the  tradewith the best probability of proﬁtability. Choosing the type of trade (debitor credit) depends on whether you prefer to pay for a trade out-of-pocketor take the credit and ride the bear or bull all the way to expiration (seeTable 5.1).
BULL CALL SPREAD
The  bull  call  spread,  also  called  the  long  call  spread,  is  a  debit  strategycreated by purchasing a lower strike call and selling a higher strike callwith the same expiration dates. The shortest time left to expiration oftenprovides  the  most  leverage,  but  also  provides  less  time  to  be  right.  Thisstrategy is best implemented in a moderately bullish market. Over a lim-ited range of stock prices, your proﬁt on this strategy can increase by asmuch as 1 point for each 1-point increase in the price of the underlying as-set. However, the total investment is usually far less than the amount re-quired  to  buy  the  stock  shares.  The  bull  call  strategy  has  both  limitedproﬁt potential and limited downside risk.
The maximum risk on a bull call spread is limited to the net debit ofthe  options.  To  calculate  the  maximum  proﬁt,  multiply  the  difference  inthe strike prices of the two options by 100 and then subtract the net debit.The  maximum  proﬁt  occurs  when  the  underlying  stock  rises  above  the
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strike price of the short call causing it to be assigned and exercised. Youcan then exercise the long call, thereby purchasing the underlying stock atthe lower strike price and delivering those shares to the option holder atthe higher short price. The breakeven of a bull call spread is calculated byadding the net debit to the lower strike price.
Choosing the Options
In order to choose the options with the best probability of proﬁtability fora debit spread, it is important to balance out four factors:
1. The options need at least 60 days until expiration in order to give the
underlying stock enough time to move into a proﬁtable position.2. Keep the net debit as low as possible to make the trade worthwhile.3. Make the difference in strikes large enough to handle the net debit so
that the maximum proﬁt is worthwhile.
4. Make sure the breakeven is within the trading range of the underlying
shares.
Bull Call Spread Mechanics
With XYZ trading at $51, let’s create an example by going long 1 XYZ Sep-tember 50 Call @ 3.50 and short 1 XYZ September 55 Call @ 1.50. The dif-ference between the premium for the long 50 call and the credit receivedfrom the short 55 call leaves a net debit of 2 points. The maximum risk forthis  trade  is  the  debit  paid  for  the  spread,  or  $200:  (3.50  –  1.50) × 100  =$200. The maximum reward for the trade is calculated by subtracting thedebit paid from the differences in the strike: [(55 – 50) – 2] × 100 = $300.The breakeven on this strategy occurs when the underlying asset’s priceequals the lower strike plus the net debit. In this case, the net debit is 2points, so the breakeven is 52: (50 + 2 = 52). Thus, the trade makes money(theoretically) as long as the underlying asset closes above 52 by expira-tion. The risk proﬁle for this trade is shown in Figure 5.1.
The  risk  proﬁle  for  a  bull  call  spread  visually  reveals  the  strategy’slimited risk and proﬁt parameters. Notice how the maximum proﬁt occursat the short call strike price.
To ﬁnd a market that is appropriate for placing a bull call spread, lookfor any markets that are trending up nicely or have reached their supportlevel and are poised for a rebound. Your intention is for the market to riseas high as the strike price of the short call. That way, if the short call is ex-ercised early, you can make the maximum return on the trade by exercis-ing the long call and pocketing the difference.
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FIGURE 5.1 Bull Call Spread Risk Graph
Exiting the Position
To exit a bull call spread, it is important to monitor the daily price move-ment of the underlying stock and the ﬂuctuating options premiums. Let’sexplore what happens to the trade in the following scenarios:
• XYZ rises above the short strike (55): The short call is assignedand  you  are  obligated  to  deliver  100  shares  of  XYZ  to  the  optionholder  at  $55  a  share.  By  exercising  the  long  call,  you  can  buy  100shares of XYZ at $50 a share and pocket the difference of $500 (not in-cluding commissions). By subtracting the cost of the trade ($200), thenet proﬁt on the spread is $300—the maximum proﬁt available.
• XYZ  rises  above  the  breakeven  (52),  but  not  as  high  as  theshort  strike  (55): Offset the options by selling a 50 call at a proﬁtand buying a 55 call back at a slight loss, pocketing a small proﬁt.• XYZ  remains  below  the  breakeven  (52),  but  above  the  longstrike (50): Sell a 50 call at a proﬁt and buy a 55 call at a loss, pock-eting a small proﬁt; or wait until expiration and sell the long call at aslight  proﬁt  to  offset  the  trade’s  net  debit  and  let  the  short  optionexpire worthless.
• XYZ falls below the long strike (50): Let the options expire worth-less, or sell a 50 call prior to expiration to mitigate some of the loss.
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Bull Call Spread
Strategy: Buy  a  call  at  a  lower  strike  price.  Sell  a  call  at  a  higher  strikeprice. Both options must have identical expiration dates.
Market  Opportunity: Look  for  a  moderately  bullish  to  bullish  marketwhere you expect an increase in the price of the underlying asset abovethe price of the call option sold.
Maximum Risk: Limited to the net debit paid for the spread. Maximum riskresults when the market closes at or below the strike price of the long call.Maximum Proﬁt: Limited. (Difference in strike prices – net debit paid) ×100. Proﬁt results when the market closes above the breakeven.
Breakeven: Strike price of lower call + net debit paid.
Margin: Required. Amount subject to broker’s discretion.
Bull Call Spread Case Study
A bull call spread is used when a trader is moderately bullish on a stock orindex. By using a spread, the up-front cost to enter the trade is lower, butthe offset is that the maximum reward is limited. Even so, when we ex-pect to sell a stock at a given price anyway, it makes sense to lower thecost and thereby limit the risk to a manageable amount.
A bull call spread consists of buying a call and selling a higher strikecall. The sale of the higher strike call brings in premium to offset the costof buying the lower strike call. What we then have is a limited risk, limitedreward strategy.
On October 24, 2003, the Semiconductor HOLDRS (SMH) put in a bot-tom formation. This was a good time to enter a bull call spread on SMHshares, looking for about a 6-point move in the shares. As of the close onthis day, SMH shares were priced at $38.55. The January 40 calls could bepurchased for $2.05 and the January 45 call could be sold for $0.50. Thisleft us with a debit of $1.55 a contract to enter a bull call spread. The riskgraph for this trade is shown in Figure 5.2.
When trading a bull call spread, it’s best to see a 2-to-1 reward-to-riskratio. This trade meets this qualiﬁcation. The maximum reward is calcu-lated  by  subtracting  the  net  debit  (1.55)  from  the  difference  betweenstrikes (45 – 40 = 5) and then multiplying this number by 100. Thus, themaximum reward on this trade is $345: (5 – 1.55) × 100 = $345. By enter-ing ﬁve contracts, this trade would have cost $775, with a maximum re-ward of $1,725. The breakeven point is found by adding the net debit tothe lower strike price. In this case, the breakeven is 41.55: (40 + 1.55 =41.55). The risk graph of this trade is shown in Figure 5.2.
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Today: 84 days left 56 days left 28 days leftExpiry:  0 days left
Close= 
38.55
000,1
0
tiforP
20 
25 
30 
35 
40 
45 
50 
55
FIGURE 5.2 Risk Graph of Bull Call Spread on SMH (Source: OptioneticsPlatinum © 2004)
On  November  7,  2003,  shares  of  SMH  closed  at  $43.99  after  tradingslightly  higher  during  the  session.  Since  $44  was  our  price  target,  wecould have sold on this day for nearly a 100 percent proﬁt. The January 40call  could  be  sold  for  $5.30  and  the  January  45  call  could  be  purchasedback for $2.40. This equates to credit of $2.90 a share, but we then need tosubtract  the  initial  debit  of  $1.55.  Thus,  our  total  proﬁt  was  $135  a  con-tract, or $675 overall.
Though buying a call outright would have created a larger proﬁt, therisk also would have been greater. If SMH shares had fallen lower follow-ing  the  entry  into  this  trade,  a  bull  call  spread  would  have  seen  a  muchsmaller loss than a straight call.
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Bull Call Spread Case Study
Strategy: With  the  security  trading  at  $38.55  a  share  on  October  24,2003, buy 5 January 40 calls @ 2.05 and sell 5 January 45 calls @ .50 onSemiconductor HOLDRS (SMH).
Market Opportunity: Expect a move higher in shares following a bouncefrom support.Maximum Risk: Limited to initial net debit of $775: [(2.05 – .50) × 5] × 100.Maximum Proﬁt: (Difference in strikes – net debit) × 100. In this exam-ple, the maximum proﬁt is $1,725 and the actual realized proﬁt is $675.
Breakeven: Lower strike + net debit paid. In this case, the breakeven is41.55: (40 + 1.55).
BEAR PUT SPREAD
A bear put spread, or long put spread, is a debit spread that is created bypurchasing a put with a higher strike price and selling a put with a lowerstrike price. Both options must expire in the same month. This is a bearishstrategy and should be implemented when you expect the market to closebelow the strike price of the short put option—the point of maximum re-ward (at expiration).
This  high-leverage  strategy  works  over  a  limited  range  of  stock  andfutures prices. Your proﬁt on this strategy can increase by as much as 1point for each 1-point decrease in the price of the underlying asset. Onceagain, the total investment is usually far less than that required to shortsell  the  stock.  The  bear  put  spread  has  both  limited  proﬁt  potential  andlimited upside risk. Puts with the shortest time left to expiration usuallyprovide the most leverage, but also reduce the time frame you have for themarket to move to the maximum reward strike price.
The maximum risk of a bear put spread is limited to the net debit ofthe trade. The maximum proﬁt depends on the difference in strike pricesminus the net debit. It is important to ﬁnd a combination of options thatprovides a high enough proﬁt-to-risk ratio to make the spread worthwhile.
Bear Put Spread Mechanics
With XYZ currently trading at $56, let’s create a bull put spread by goinglong 1 XYZ September 55 Put @ 2 and short 1 XYZ September 50 Put @ .50.The difference between the long 55 put premium of 2 ($200) and the creditreceived for the short 50 put (.50 or $50) is a net debit of $150. The netdebit is the maximum risk for a bear put spread. The maximum reward for
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the  trade  is  calculated  by  subtracting  the  net  debit  paid  from  the  differ-ence between strike prices: (55 – 50) – 1.50 × 100 = $350. Even though thereward is limited to $350, the sale of the 50 put has lowered the breakevenon this position. The breakeven occurs when the underlying asset’s priceequals  the  higher  strike  price  minus  the  net  debit.  In  this  case,  thebreakeven would be 53.50: (55 – 1.50 = 53.50). The risk graph for this tradeis shown in Figure 5.3.
The  risk  proﬁle  (see  Figure  5.3)  of  a  bear  put  spread  slants  upwardfrom  right  to  left,  displaying  its  bearish  bias.  Once  the  underlying  stockfalls to the price of the short put, the trade reaches its maximum proﬁt po-tential. Conversely, if the price of the underlying stock rises to the strikeprice  of  the  long  put,  you  will  lose  the  maximum  limited  amount.  Onceagain, it is important to monitor this trade for a reversal or a breakout toavoid losing the maximum amount.
Exiting the Trade
To exit a bear put spread, you have to monitor the daily price movementof  the  underlying  stock  and  the  ﬂuctuating  options  premiums.  Let’s  ex-plore what you can do to proﬁt on a bear put spread if one of the followingscenarios occurs.
FIGURE 5.3 Bear Put Spread Risk Graph
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Bear Put Spread
Strategy: Buy a higher strike put and sell a lower strike put with the sameexpiration date.
Market Opportunity: Look for a bearish market where you anticipate amodest  decrease  in  the  price  of  the  underlying  asset  below  the  strikeprice of the short put option.
Maximum Risk: Limited to the net debit paid.Maximum Proﬁt: Limited. (Difference in strike prices – net debit) × 100.
Breakeven: Higher put strike price – net debit paid.
Margin: Required. Amount subject to broker’s discretion.
• XYZ falls below the short strike (50): The short put is assignedand you are obligated to purchase 100 shares of XYZ from the optionholder at $50 a share. By exercising the long put, you can turn aroundand  sell  those  shares  at  $55  a  share  and  pocket  the  difference  of$500.  By  subtracting  the  cost  of  the  trade  ($150),  the  proﬁt  on  thespread is $350—the maximum proﬁt available.
• XYZ falls below the breakeven (53.50), but not as low as theshort strike (50): Offset the trade by selling a 55 put at a proﬁt andbuying a 50 put at a loss, pocketing a small proﬁt.
• XYZ  remains  above  the  breakeven  (53.50),  but  below  thelong strike (55): Sell a 55 put at a proﬁt and buy a 50 put at a loss,pocketing  a  small  proﬁt,  or  wait  until  expiration  and  sell  the  longput at a slight proﬁt to offset the trade’s net debit and let the shortoption expire worthless.
• XYZ  rises  above  the  long  strike  (55): Let  the  options  expireworthless, or sell the 55 put at expiration to mitigate some of the loss.
Bear Put Spread Case Study
A bear put spread is used when a trader is moderately bearish on a stockor index. By using a spread, the up-front cost to enter the trade is lower,but the offset is that the maximum reward is also lower. Even so, when weexpect  to  cover  short  stock  at  a  given  price  anyway,  it  makes  sense  tolower our cost.
A bear put spread consists of buying a put and selling a lower strikeput. The sale of the lower strike put brings in premium to offset the cost ofbuying the higher strike put. What we then have is a limited risk, limitedreward strategy.
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On June 5, 2003, shares of Cigna (CI) were showing bearish tenden-cies. The stock closed the session on June 5 at $52 and a trader might haveanticipated a move lower to support near $40. The move was expected tooccur within the next few months, so a trader could have used the Octo-ber options. By purchasing a 50 put and selling a 40 put, the trader wouldhave entered a bear put spread for a total of $3.05 per contract. The longput  would  have  cost  $4.00  and  the  short  put  could  have  been  sold  for$0.95. In this case, let’s assume the trader decides to place a trade for ﬁvebull call spreads. The risk graph for this trade is shown in Figure 5.4.
Just like a bull call spread, we want to see a reward-to-risk ratio of atleast 2-to-1. For this trade, the maximum risk is the initial debit of $305, or$1,525 for 5 contracts. The maximum reward is calculated by subtracting
Today: 134 days left        Close =            52.0090 days left 45 days leftExpiry:  0 days left
000,3
000,2
tiforP
000,1
0
000,1–
40 
   50 
        60
FIGURE 5.4 Risk Graph of Bear Put Spread on CI (Source: Optionetics Platinum © 2004)
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Bear Put Spread Case Study
Strategy: With the security trading at $41.04 a share on June 5, 2003, buy5 October 50 puts @ 4.00 and sell 5 October 40 puts @ .95 on Cigna (CI).
Market Opportunity: Expect a moderate decline in the price of the un-derlying stock.Maximum  Risk: Limited  to  initial  net  debit.  In  this  case,  $1,525:  [5  ×(4 – .95)] × 100.Maximum Proﬁt: (Difference in strikes – net debit) × 100. In this exam-ple, the maximum risk is $3,475 and the actual realized proﬁt is $1,875.
Breakeven: Upper  strike  minus  the  net  debit  paid.  In  this  case,  thebreakeven is 46.95: (50 – 3.05).
the debit (3.05) from the difference in strike prices (50 – 40 = 10). Thus,the  maximum  reward  of  this  trade  is  $695:  (10  –  3.05)  × 100  =  $695  percontract, or $3,475 for all ﬁve contracts. This creates a reward-to-risk ratioof 2.28 to 1 (6.95/3.05).
On July 15, 2003, shares of CI closed at $41.04, leaving this trade witha very nice gain. Though the price target of $40 hadn’t quite been reached,the trade was up more than 100 percent and this would have been a goodtime to take proﬁts. The October 50 put could be sold for $9.50 and theOctober 40 put could be purchased back for $2.70. This equates to a creditof $6.80 a share, but we then need to subtract out the initial debit of $3.05.Thus, our total proﬁt was $3.75 a share, $375 a contract, and $1,875 for allﬁve contracts—a gain of 123 percent.
Though buying a put outright would have created a larger proﬁt, therisk also would have been greater. If CI shares had risen following the en-try into this trade, a bear put spread would have seen a much smaller lossthan a straight put.
BULL PUT SPREAD
A  bull  put  spread  is  a  credit  spread  created  by  the  purchase  of  a  lowerstrike put and the sale of a higher strike put using the same number of op-tions  and  identical  expirations.  The  maximum  reward  of  this  strategy  islimited to the credit received from the net premiums and occurs when themarket  closes  above  the  strike  price  of  the  short  put  option.  Therefore,this strategy is implemented when you are bullish and expect the marketto close above the strike price of the put option sold.
The maximum proﬁt of a bull put spread is limited to the net credit
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received on the trade. The maximum risk is calculated by subtracting thenet credit from the difference in strikes and then multiplying this numberby  100.  The  breakeven  of  a  bull  put  spread  is  calculated  by  subtractingthe net credit from the higher strike put.
Choosing the Options
In order to choose the options with the best probability of proﬁtability fora credit spread—bull put and bear call spreads—it is important to balanceout ﬁve factors:
1. The proﬁt on these strategies depends on the options expiring worth-less; therefore, it is best to use options with 45 days or less until expi-ration to give the underlying stock less time to move into a positionwhere the short put will be assigned and the maximum loss occur.2. Since the maximum proﬁt is limited to the net credit initially received,
keep the net credit high enough to make the trade worthwhile.
3. Keep  the  short  strike  at-the-money—try  to  avoid  selling  an  in-the-
money put.
4. The  difference  between  strikes  must  be  small  enough  so  that  the
maximum risk is low enough to make the trade worthwhile.
5. Make sure the breakeven is within the underlying shares’ trading range.
Bull Put Spread Mechanics
Let’s  say  you  are  bullish  on  XYZ,  currently  trading  at  44.  You  expect  amove  upward  for  a  close  above  50  by  next  month.  To  initiate  a  bull  putspread, you sell a higher strike XYZ June 50 put at $7.50 and purchase alower strike XYZ June 45 put at $3. Both strikes are close enough to allowXYZ to reach the projected strike price of 50. Remember, the object of thisstrategy is to have both options expire worthless and be able to keep thenet credit. In this example, the maximum reward is the net credit of 4.50,or $450 per contract