. The breakeven occurs when the underlying asset’sprice equals the higher strike price minus the net credit. In this case, thebreakeven equals 45.50: (50 – 4.50 = 45.50).
This trade makes the maximum proﬁt if XYZ closes at or above 50 atexpiration.  You  get  to  keep  a  lesser  portion  if  the  trade  closes  between45.50 and 50. As long as XYZ closes above the breakeven point of 45.50,you won’t lose money. The maximum risk is calculated by subtracting thenet credit from the difference between strike prices multiplied by 100. Inthis trade the maximum risk is $50: (50 – 45) – 4.50 × 100 = $50. Therefore,if  XYZ  closes  below  45,  you  lose  $50.  The  risk  proﬁle  for  this  bull  putspread example is shown in Figure 5.5.
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FIGURE 5.5 Bull Put Spread Risk Graph
The risk proﬁle of a bull put spread slants upward from left to rightdisplaying its bullish bias. If the underlying shares rise to the price of theshort  put,  the  trade  reaches  its  maximum  proﬁt  potential.  Conversely,  ifthe price of the underlying stock falls to the strike price of the long put,the  maximum  limited  loss  occurs.  Always  monitor  the  underlying  stockfor a reversal or a breakout to avoid the maximum loss.
Exiting the Trade
To exit a bull put spread, you have to monitor the daily price movement ofthe underlying stock and the ﬂuctuating options premiums. Although eachtrade is unique, let’s explore what happens to the trade in the example inthe following scenarios:
• XYZ  rises  above  the  short  strike  (50): Let  the  options  expireworthless and keep the maximum credit received when the trade wasinitiated ($450).
• XYZ  stays  above  the  breakeven  (45.50),  but  does  not  riseabove the short strike (50): The short put is assigned and you areobligated to purchase 100 shares of XYZ from the option holder at $50a share. You can sell the shares at the current price, which is abovethe strike price of the long put and incur a small loss that can be offset
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by the initial credit received. You can also offset the long put by sell-ing it to garner an additional proﬁt.
• XYZ  falls  below  the  breakeven  (45.50),  but  stays  above  thelong strike (45): Once again, the short put is assigned and you areobligated to purchase 100 shares of XYZ from the option holder at $50a share. You can sell the shares at the current price, which is slightlyabove  the  strike  price  of  the  long  put.  In  this  case,  the  loss  on  theshares will not be balanced out by the credit received. Selling the longput may bring in additional money to mitigate some of the loss.
• XYZ falls below the long strike (45): The short put is assigned andyou are obligated to purchase 100 shares of XYZ from the option holderat $50 a share. You can now exercise the long put to sell the shares at $45each, incurring the maximum loss of $500, which is balanced by the $450credit received at initiation for a total loss of $50 (plus commissions).
Bull Put Spread Case Study
A bull put spread is a credit strategy that beneﬁts when the underlying se-curity  trades  sideways  or  higher.  Stocks  often  hit  support,  which  sendsthe stock higher. At these times, using an at-the-money credit spread canbring  in  proﬁts.  A  credit  spread  proﬁts  if  the  stock  moves  in  two  of  thepossible three directions a stock can move. Both a bear call spread and abull put spread beneﬁt from sideways movement, with the former beneﬁt-ing from a down move and the latter from an up move.
A bull put spread consists of selling a put and buying a lower strikeput. The sale of the higher strike put brings in premium, which is largerthan the cost of purchasing the lower strike put. What we then have is a
Bull Put Spread
Strategy: Buy  a  put  at  a  lower  strike  price.  Sell  a  put  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 strike price of the put option sold.Maximum Risk: Limited. (Difference in strikes – net credit) × 100.
Maximum Proﬁt: Limited to the net credit received. Proﬁt is made whenthe market closes above the strike price of the short put option. This is acredit trade when initiated.
Breakeven: Higher put strike price – net credit received.
Margin: Required. Amount subject to broker’s discretion.
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limited  risk/limited  reward  strategy.  Unlike  a  debit  spread,  though,  therisk is often higher than the reward while the odds of success are usuallyvery high.
On December 11, 2003, shares of Inco Limited (N) formed a bullish for-mation. The stock closed the session at $34.86, but it looked as if the stockwould move higher and use $35 as support. Using this forecast, a bull putcredit spread could have been implemented. Since a credit spread beneﬁtsfrom time decay, it’s usually best to use front month options. However, theDecember option had just six days left, so we would have used the Januaryoptions. By selling the January 35 put for 1.65 and buying the January 30put for 0.35, this bear call spread would have brought in a credit of $1.30per contract. The risk graph for this trade is shown in Figure 5.6.
Today: 36 days left 24 days left 12 days leftExpiry:  0 days left
Close= 
34.86
tiforP
0
000,1–
20 
25 
30 
35 
40 
45 
50 
FIGURE 5.6 Risk Graph of Bull Put Spread on N (Source: Optionetics Platinum © 2004)
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Bull Put Spread Case Study
Strategy:  With  the  security  trading  at  $34.86  a  share  on  December  12,2003, sell 5 January 35 puts @ 1.65 and buy 5 January 30 puts @ 0.35 onInco Limited (N).
Market Opportunity: Expect a moderate move higher in the underlyingor at least consolidation above $35.Maximum  Risk: (Difference  in  strikes  –  net  credit)  ×  100.  In  this  case,$370: [(35 – 30) – 1.30] × 100 or $1,850 for 5 contracts.Maximum Proﬁt: Net credit received. In this case, $650: (5 × 1.30) × 100.
Breakeven: Higher  strike  minus  the  initial  credit  per  contract.  In  thiscase, 33.70: (35 – 1.30).
This bullish credit spread would see the maximum proﬁt achieved aslong as shares of N were at or above $35 on February 20, which was op-tions  expiration.  The  maximum  risk  is  calculated  by  subtracting  the  netcredit per contract of $1.30 from the difference between strikes (30 – 25 =5). Therefore, the maximum risk is $370 per contract [(5 – 1.30) × 100 =$370] or $1,850 for ﬁve contracts. The breakeven is calculated by subtract-ing the net credit of 1.30 from the higher strike of 35. Thus, the breakevenfor this trade was at $33.70. Once again, let’s assume the trade consists ofﬁve contracts for a maximum proﬁt of $650.
Shares of N did indeed move higher from this point, leaving the traderwith  the  maximum  proﬁt  of  $650.  In  this  example,  the  trader  had  to  donothing but watch the options close worthless, leaving the entire credit inthe trader’s account.
BEAR CALL SPREAD
A  bear  call  spread  consists  of  selling  a  lower  strike  call  and  buying  ahigher strike call using the same number of options and identical expira-tion dates. This is a credit trade when initiated and makes money whenthe  market  closes  below  the  strike  of  the  short  option.  This  strategy  isused when you have a bearish view of a market. It offers a limited proﬁtpotential  with  limited  risk.  The  maximum  reward  is  achieved  when  theclosing  price  of  the  underlying  security  is  below  the  lower  strike  call,yielding  the  full  net  credit  for  the  trade.  Therefore,  this  trade  should  beimplemented  by  selling  options  that  have  a  high  probability  of  expiringworthless so you can keep the net credit.
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The maximum risk is equal to the difference between strike prices mi-nus the net credit times 100. The maximum risk occurs when the stock orfutures  contract  closes  at  or  above  the  strike  price  of  the  option  pur-chased.  This  means  that  the  short  option  will  have  increased  in  valuewhile  the  one  purchased  has  not  increased  in  value  as  much.  Thebreakeven is calculated by adding the strike price of the lower call to thenet credit received.
Bear Call Spread Example
Let’s  say  XYZ  is  trading  at  $51  and  you  think  it’s  ready  for  a  correction.You decide to initiate a bear call spread by going short 1 XYZ June 50 Call@ 3.50 and long 1 XYZ June 55 Call @ 1.00. When you initiate this trade,you  receive  a  credit  of  2.50,  or  $250  per  contract:  (3.50  –  1.00)  × 100  =$250. This is the maximum reward that would be earned at expiration ifXYZ closes at or below $50 per share.
Since  the  maximum  risk  is  equal  to  the  difference  between  strikeprices minus the net credit, the most you can lose in this example is $250:(55  –  50)  –  2.50  × 100  =  $250.  Maximum  risk  occurs  if  XYZ  closes  at  orabove 55. The short option would have a value of 5: (55 – 50 = 5). The long55  call  would  expire  worthless;  therefore,  your  position  would  lose  5points, or $500 if the position closes at the higher strike price. However,you  received  a  credit  of  $250;  therefore,  your  risk  is  a  net  $250:  ($500  –$250  =  $250).  The  breakeven  on  this  trade  occurs  when  the  underlyingstock price equals the lower strike price plus the net credit. In this trade,the  breakeven  is  52.50:  (50  +  2.50  =  52.50).  The  trade  breaks  even  ormakes money as long as XYZ does not go above 52.50 at expiration. Therisk graph of this trade is shown in Figure 5.7.
The  risk  graph  of  a  bear  call  spread  slants  downward  from  left  toright, displaying its bearish bias. If the underlying shares fall to the strikeprice  of  the  short  call,  the  trade  reaches  its  maximum  proﬁt  potential.Conversely, if the price of the underlying shares rises to the strike price ofthe long call, the maximum limited loss occurs. Always monitor the under-lying shares for a reversal or a breakout to avoid incurring a loss.
Exiting the Trade
• XYZ  rises  above  the  long  strike  (55): The short call is assignedand  you  are  obligated  to  deliver  100  shares  of  XYZ  to  the  optionholder  at  $50  per  share.  By  exercising  the  long  call,  you  can  turnaround  and  buy  those  shares  at  $55  each,  thereby  losing  $500.  Thisloss is mitigated by the initial $250 credit received for a total loss of$250 (not including commissions).
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FIGURE 5.7 Bear Call Spread Risk Graph
• XYZ  falls  below  the  long  strike  (55),  but  not  below  thebreakeven (52.50): The short call is assigned and you are obligatedto deliver 100 shares of XYZ to the option holder at $50 a share by pur-chasing XYZ at the current price. This loss is mitigated by the initial$250 credit received. You can also sell the 55 call to offset and furtherreduce the loss.
• XYZ falls below the breakeven (52.50), but not as low as theshort strike (50): The short call is assigned and you are obligated todeliver 100 shares of XYZ to the option holder at $50 a share by pur-chasing XYZ at the current price. The loss is offset by the initial $250credit received. Selling the 55 call can bring in some additional moneyto offset the loss.
• XYZ  falls  below  the  short  strike  (50): Let  the  options  expire
worthless to make the maximum proﬁt of $250.
Bear Call Spread Case Study
A bear call spread is a credit strategy that beneﬁts from the underlying se-curity trading sideways or lower. Stocks often run into resistance, whichimpedes  higher  movement.  At  these  times,  using  an  at-the-money  creditspread can bring in proﬁts. A credit spread proﬁts if the stock moves in
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Bear Call Spread
Strategy: Buy  a  call  at  a  higher  strike  price.  Sell  a  call  at  a  lower  strikeprice. Both options must have identical expiration dates
Market  Opportunity: Look  for  a  moderately  bearish  to  bearish  marketwhere  you  expect  a  decrease  in  the  price  of  the  underlying  asset  belowthe strike price of the call option sold.Maximum Risk: Limited. (Difference in strikes – net credit) × 100. Maxi-mum risk results when the market closes at or above the strike price ofthe long option.
Maximum  Proﬁt: Limited  to  the  net  credit  received.  Maximum  proﬁt  ismade  when  the  market  closes  below  the  strike  price  of  the  short  calls.This is a credit trade when initiated.
Breakeven: Strike price of lower call + net credit received.
Margin: Required. Amount subject to broker’s discretion.
two of the possible three directions a stock can move. A bear call spreadbeneﬁts from sideways movement as well as a decline in prices.
Let’s review: A bear call spread consists of selling a call and buying alower strike call. The sale of the higher strike call brings in premium thatis larger than the amount it costs to buy the lower strike call, thereby cre-ating  a  limited  risk/limited  reward  strategy.  However,  unlike  a  debitspread, the potential loss on a credit spread is almost always higher thanthe potential proﬁt. However, the odds of success are very high, which iswhy these strategies are worthy of additional study.
On  September  23,  2003,  shares  of  Monster  Worldwide  (MNST)  wereshowing bearish tendencies. The stock closed the session on September24 at $27.74 and it looked likely that $25 would be broken. During the nextsession, it was possible to enter a bear call spread for a nice credit. Sincea credit spread beneﬁts from time decay, it’s important to use front monthoptions. By selling the October 25 call for 3.10 and buying the October 30call for 0.70, this bear call spread would have brought in a credit of $2.40per contract. The maximum risk would be $2.60 per contract, which is arather good reward-to-risk ratio for a credit spread. The risk graph for thistrade is shown in Figure 5.8.
In  two  out  of  every  three  cases,  credit  spreads  expire  with  thetrader  keeping  the  entire  credit.  This  is  because  traders  of  bear  callspreads  proﬁt  if  the  stock  stays  constant  or  moves  down.  For  this  ex-ample, the maximum reward is the credit received, which for ﬁve con-tracts would be $1,200. The maximum risk is found by subtracting thecredit  per  contract  from  the  difference  between  strikes  (30  –  25  =  5).
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Today: 23 days left 16 days left 8 days leftExpiry:  0 days left
Close= 
25.93
000,1
0
tiforP
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FIGURE 5.8 Risk Graph of Bear Call Spread on MNST (Source: OptioneticsPlatinum © 2004)
Thus, the maximum risk is $260 per contract [(5 – 2.40) × 100 = $260)]or $1,300 for ﬁve contracts, and the reward/risk ratio is 0.92 to 1.00. Thebreakeven is determined by adding the initial credit to the lower strike,or 27.40: (25 + 2.40 = 27.40).
So  let’s  take  a  look  at  what  happened  in  the  real  world.  Shares  ofMNST  traded  near  $25  for  the  next  week,  but  on  October  10,  they  shotsharply  higher.  However,  the  upper  strike  was  not  penetrated,  with  thehigh  of  the  session  coming  at  $29.35.  During  the  next  week,  shares  ofMNST fell and on expiration Friday, October 17, the stock traded as low as$25 and the short call could have been purchased back for anywhere from$0.25  to  $1.70.  In  this  case,  the  October  25  call  was  purchased  back  for$0.45, leaving a proﬁt of $195 per contract or $975 for all ﬁve contracts.
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Bear Call Spread Case Study
Strategy: With  the  security  trading  near  $27  a  share  on  September  24,2003, sell 5 October 25 calls @ 3.10 and buy 5 October 30 calls @ 0.70 onMonster Worldwide (MNST).
Market Opportunity: Expect a moderate decline in the underlying stockprice.Maximum  Risk: (Difference  in  strikes  × 100)  –  net  credit.  In  this  case,$1,300: 5 × {[(30 – 25) × 100] – 240} = $1,300.
Maximum  Proﬁt: Net  credit  =  Short  premium  –  long  premium.  In  thiscase, $1,200: 5 × (3.10 – .70) = $1,200.
Breakeven: Lower strike plus the initial credit per contract. In this case,27.40: (25 + 2.40).
GETTING FILLED
Now that you’ve been introduced to spread trading, there are a few me-chanical realities that must be dealt with—namely, getting your spread or-der  ﬁlled  at  a  price  you  can  live  with.  There  are  many  factors  involvedbetween the time you hit the send button and the time you receive conﬁr-mation that your spread has been “ﬁlled.” Before you hit send, make sureyou assess the bid/ask price of the spread. The bid is the highest price aprospective buyer (trader or dealer) is prepared to pay for a speciﬁed timefor a trading unit of a speciﬁed security. Thus, the bid is also the price atwhich an investor can sell to a broker-dealer. The ask is the lowest priceacceptable to a prospective seller (trader or dealer) of the same security.The  ask,  therefore,  is  the  price  at  which  an  investor  can  buy  from  abroker-dealer. Together, the bid and ask prices constitute a quotation orquote  and  the  difference  between  the  two  prices  is  the  bid-ask  spread.Sometimes you may have a hard time cutting the bid/ask on a spread, andeven  miss  getting  ﬁlled  at  or  above  the  asking  price.  What  I’m  talkingabout is a common occurrence that goes something like this:
You like stock XYZ, which is trading at 110. You decide you’d like togo four months out on the 100/120 bull call spread. The bid on the spreadis  5.50  and  the  ask  is  6.50.  In  other  words,  if  you  owned  the  spread,  itwould have a selling value of 5.50. If you were buying the spread it wouldhave an asking price of 6.50. Not wanting to pay what the market is ask-ing, you put in a limit order of 6 on the buy side, meaning that you’ll payup to $600 for the spread. As the day wears on, you check your accountonline  and  see  you  haven’t  been  ﬁlled.  The  stock  dips  some,  and  youcheck the bid/ask on the spread again; it’s now 5.75 bid, 6.75 ask. Still youhaven’t been ﬁlled, and you’re feeling frustrated! What’s going on?
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Here’s the explanation: In order to complete a spread as a single transac-tion, the traders on the ﬂoor must ﬁnd market makers to match up both sidesof the spread in a single transaction. There has to be someone willing to sella 100 call while someone else buys a 120 call. This is a much more difﬁculttask than simply selling or buying calls as individual transactions. So, eventhough you may only be trying to cut the bid/ask by a small amount, it can bedifﬁcult to get a market maker to take this as a combination order. This is es-pecially  true  in  fast  moving  markets  where  scores  are  being  reeled  off  inhundreds of individual contracts. Now the trader who has your ticket has themarket maker stop, calculate the net amounts, and then make a decision.
I had an interesting and frustrating event a few months back that willshed some light on this topic. I wanted the August YHOO 55/65 bull callspread at 5.50. The bid/ask was approximately 5 and 6, so I was trying toshave a small amount, half a point. Hours went by and I checked again.YHOO  had  dipped  intraday  as  I  expected,  and  I  was  looking  for  my  ﬁllconﬁrmation. The ask was now 5.75 and I still didn’t have my order ﬁlled! Ihad the head of my brokerage ofﬁce call down to the ﬂoor and I learnedthat in a fast moving market (as it was) no one wants to stop to calculate aspread when individual calls and puts are ﬂying back and forth in lots of20, 50, or 100 contracts on a stock like YHOO. I could have legged in, but Ihave a rule that I trade a vertical spread only as a limit order on the cost ofthe overall spread—no legging in. So I missed the trade.
However, sometimes this situation can work to your advantage. Let’s sayyou offer 8.50 on a spread that was bid/ask at 7.50 and 9.50. Then the under-lying stock, XYZ, starts to fall; the ask on the spread had fallen to 7.75. Youdecide to cancel and try the trade again when it’s on the way up. You holdyour breath, hoping you didn’t already get ﬁlled as the asking price passeddown through your offer of 8.50. Sure enough, you get your cancel conﬁrma-tion in a little while and breathe a sigh of relief. Sure, XYZ will likely comeback, but it would be better to place the bull call spread buy on the way upthan on the way down—unless you’re speciﬁcally targeting a certain price.
One more piece of advice: Don’t chase the market. I sometimes wish Ihad raised my offer on YHOO; but I won on that transaction anyway be-cause  I  stuck  to  my  principles.  Besides,  the  money  I  would  have  put  inYHOO is working for me in another trade. If you wish to leg in (buying thelower call, then selling the higher call), be sure you’ve solidly conﬁrmedthe market direction ﬁrst.
BID-ASK SPREAD: A CLOSER LOOK
From the ﬁrst moment we are exposed to a real options quote, we realizethat options do not trade at just one price. There is a bid price and an ask
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(or offer) price. For example, the Cisco (CSCO) October 20 calls do nottrade  for  55  cents.  Instead,  you  may  see  a  quote  similar  to  this:  CSCO22.50 Calls: .50–.60.
In this example of the CSCO 22.50 calls, $.50 is the bid and $.60 is theask (or offer). That means that everyone who is interested in selling CSCO22.50 calls can do so at $.50 and all interested buyers of CSCO 22.50 callscan own them for $.60. Since we are not market makers, in order to guar-antee ourselves a ﬁll, we must pay the ask and sell the bid.
To illustrate the meaning of these two prices, imagine walking into acar dealership. A dealer has two prices on a car. There is a dealer invoiceand a sticker price. A car dealer is willing to buy cars for dealer invoice,and is happy when they’re sold at sticker price. Unless the dealer is tryingto pad the sales numbers to meet some quota, we will not be lucky enoughto drive a car off a lot for dealer invoice. However, in buying cars as wellas in trading options, we try our best not to pay sticker price. Of course,this means the dealer can refuse to sell us the car, just as a market makercan refuse to trade with us. Only by paying the full no-haggle price can webe assured a ﬁll on a trade.
In  trading  options,  the  reality  is  that  while  the  quoted  best  ask  inCSCO 22.50 calls may read $.60, someone in the CSCO pit may be willingto sell those calls for less. A car dealer may be willing to sell you a car forless than sticker price, but why pass on the chance that you or someoneelse might pay full fare? So the ask price will remain $.60 until someonetests it—namely with a limit order between the two amounts that deﬁnethe bid/ask spread.
A limit order is an order to buy or sell a ﬁnancial instrument (stock,option, etc.) at or below a speciﬁed price. For instance, you could tell abroker to “Buy me one January XYZ call at $8 or less” or “Sell 100 sharesof XYZ at $20 or better.”
I bring up the example of CSCO because of the incredible liquidity inthat stock. That liquidity in the stock and in its corresponding options al-lows the bid-ask spread to be very tight—10 cents wide, in this case. Sothe question then arises: Is there anything that keeps the market makersfrom creating wider spreads? In the case of less liquid stocks, is there achance that spreads can become too wide? Is there anything to protect usfrom abusively wide spreads? Actually, there is! It may not seem like it attimes, but there exist legal width limits for options. This practice was in-stituted by the exchanges to keep the market makers in check and to en-tice