. Adding the cost of the option to the price of the commission.C. Subtracting the strike price from the option premium.D. Subtracting the option premium from its strike price.19. True or False: In a short put strategy, when the underlying instrument’s price falls, you make money; when it rises, you lose money.20. A short put strategy has ______________.A. Limited profit potential with limited risk.B. Limited profit potential with significant risk.C. Unlimited profit potential with significant risk.D. Unlimited profit potential with limited risk.
MEDIA ASSIGNMENTThis media assignment requires a piece of graph paper and an Internetconnection. Once your PC is booted and online, type www.cboe.cominto the Web browser, which will take you to the Chicago Board Options Exchange web site. From the CBOE home page, click on the“Trading Tools” tab, then the “Volatility Optimizer,” and then click on“Options Calculator.” Next select “American” in the style box. (Note: Iffor some reason the CBOE site is not available, readers can use any options calculator to complete this assignment.)On a piece of graph paper (or a printout of an Excel spreadsheet),create a risk graph by drawing a horizontal axis and a vertical axis.Along the horizontal axis, write the numbers 60, 65, 70, 75, 80, 85,and 90 at evenly spaced intervals. From bottom to top, write the
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numbers 0, 1, 2, . . . , 20 along the vertical axis. Now, go back to theoptions calculator.Using the chart and the options calculator, let’s create a risk curve fora long call strategy. Remember that a long call is simply the purchase of acall option. So, let’s input some variables into the calculator regarding thislong call. First, let the strike price equal 75; the volatility is 30 percent, theannual interest rate is 5 percent, and the company pays no dividend (quarterly dividend amount equals 0). Next, in the “Days Left to Expiration”box, click “Days Until Expiration” and enter the number 100. We are goingto look at an options contract with 100 days remaining until expiration,which has a strike price of 75, volatility of 30 percent, and an underlyingsecurity that pays no dividends.Now, let’s look at what happens to the call option when we changethe stock price. Enter 60 into the “Equity Price” box and look at thevalue of the call. It is worth approximately 45 cents. On the risk graph,draw a dot at the coordinate where 60 and .45 meet (estimate .45 between 0 and 1 on the lower left-hand side of the chart). Next, plug thenumber 65 into the “Equity Price” box on the options calculator and notice that the value of the long call increases to roughly 1.25. Put a dot onthe risk curve where 65 and 1.25 meet. Continue this process until youreach the stock price of 90. When you reach the final equity price valueof 90, the long call is worth roughly 16.50. Finally, connect the dots andyou have just created a risk curve for the long call. It is upwardprofit/loss line that slopes to the right.In practice, the strategist would subtract the cost of the long call fromthe risk curve to see the true profit-and-loss potential of a long call trade.In this case, we just looked at the possible changes in the option price thatresult from changes in the stock price. We did not assume we purchasedthe long call at a specific price. If we pay, for instance, $1 for the long call,we would subtract $1 from the value of the option price. So, when thestock price is $60 a share, the loss on the trade is 55 cents: (1 – .45). However, if the stock reaches $90 a share, the gain on the trade is $15.50:(16.50 – 1).Importantly, most options strategists do not create risk curves manually. Instead, traders rely on software packages to create the graphs.Nevertheless, to truly understand the reward/risk profile of an optionstrade, it is helpful to also understand how and why a risk curve has agiven shape. In sum, plotting a few simple ones like the long call willhelp the reader better understand why various risk curves look the waythey do.
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VOCABULARY LISTBreakeven
Options calculator
Chicago Board Options Exchange(CBOE)
Risk curve
Covered callCovered putLong callLong put
Risk graphRisk profileShort callShort putShort stock
Long stock
SOLUTIONS1. Every trade you place has a corresponding ______________ thatgraphically shows your potential risk and potential reward over arange of prices and time periods.Answer: D—All of the above (risk curve, risk graph, risk profile).Discussion: Risk curve, risk graph, and risk profile are often usedinterchangeably to describe a graphical representation of the risksand rewards of an options trade. Each options strategy has acorresponding risk curve that provides a simple view of the rangeof possible outcomes. We encourage options traders to focus onstrategies that have risk curves with limited risk and high rewards,and avoid risk profiles that reflect unlimited risks and limitedrewards.2. Reading a risk profile is pretty easy. The horizontal numbers atthe bottom of the chart read from left to right showing the______________.Answer: A—Market price.Discussion: On a risk curve, the horizontal line across the bottom ofthe graph reflects the market price of the underlying asset.
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3. The vertical numbers from top to bottom show ______________.Answer: C—Profit and loss.Discussion: A risk graph shows the price of the underlying assetalong the horizontal axis and the profit or loss from the options tradealong the vertical axis. If the curve is upward sloping to the right, forinstance, the options strategy will show increasing profits as theunderlying asset price moves higher.4. Label each risk graph with the correct strategy: long stock, long call,long put, short stock, short call, short put.Answer:
Short Stock
Short Put
Short Call
Long Stock
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Long Put
Long Call
Discussion: Each strategy has a unique risk curve that visuallyprojects each trade’s profit and loss potentials. This chapter explores the risk graphs associated with some of the most basicstrategies.5. The long stock strategy provides ______________.Answer: D—Unlimited profit potential with limited risk.Discussion: Buying stocks can involve significant risks if the stockprices move lower, but the losses will be limited to the stock falling tozero. At the same time, since there is theoretically no limit to howhigh a stock can climb, the profit potential associated with holding astock is unlimited.6. A stock does not have premium or time decay. It has a ______________movement in price versus risk and reward.Answer: A—1-to-1.Discussion: Unlike an option, a stock does not include a premiumand does not suffer from time decay. Once an investor buys shares ofstock, the investor will earn $1 a share for every $1 increase in thestock price. On the other hand, if the stock falls, the investor will lose$1 a share for every $1 loss in the share price.7. True or False: In a short stock strategy, when the stock price falls,you make money; when it rises, you lose money.Answer: True.Discussion: Shorting stock is a bearish strategy that traders usewhen they expect the stock price to move lower. If the stock moveshigher, the short seller suffers losses.
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8. A short stock strategy has ______________.Answer: C—High profit potential with unlimited risk.Discussion: Selling stocks short can have significant profit potentialif the share price falls dramatically. The possible gains are limited tothe stock falling to zero. The risks associated with short selling canalso be significant. In fact, given that there is no ceiling to how high astock can climb, the risks of short selling are theoretically unlimited.9. True or False: With a long call strategy, when the price of the underlying asset rises you make money; when it falls, you lose money.Answer: True.Discussion: Call options appreciate in value as the price of theunderlying asset moves higher.10. A long call strategy has virtually ______________.Answer: D—Unlimited profit potential with limited risk.Discussion: When buying a long call, the option buyer pays a premium. If the underlying asset moves higher, the long call appreciatesin value. Furthermore, since there is theoretically no limit to howhigh an underlying asset can go, there is unlimited profit potential.However, the risk is always limited to the premium paid for theunderlying asset.11. True or False: With a long call strategy, you still have to hold marginin your account to place the trade.Answer: False.Discussion: Zero margin borrowing is allowed, which means thatyou don’t have to hold any margin in your account to place the trade.12. If you bought a September IBM 105 call for a premium of 5, your totalrisk on this trade would be ______________.Answer: C—$500 plus commissions.Discussion: The risk inherent in buying options is limited to the premium paid. In this case, a premium of 5 means a maximum risk of $500.13. The breakeven for a long call at expiration is computed by______________.Answer: A—Adding the cost of the call option to its strike price.Discussion: To find the breakeven price for a long call, you take thestrike price of the option and add the option premium. If the price of
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the underlying asset is equal to this value at expiration, the long callwill (theoretically) break even.14. True or False: With a short call strategy, when the underlyinginstrument’s price rises, you make money; when it falls, you losemoney.Answer: False.Discussion: In a short call strategy, when the underlying instrument’s price falls, you make money; when it rises, you lose money.15. A short call strategy has ______________.Answer: B—Limited profit potential with unlimited risk.Discussion: When selling calls, the profit is limited to the premium received. However, if the underlying asset makes a movehigher, the short call strategy will begin to experience losses. Ifthe stock makes a large percentage move higher, the losses canbe significant.16. True or False: With a long put strategy, when the underlying instrument’s price falls, you make money; when it rises, you lose money.Answer: True.Discussion: Long puts increase in value when the underlying assetfalls. If the underlying asset moves higher, the put option will experience a loss of value.17. A long put strategy has virtually ______________.Answer: A—Limited profit potential with limited risk.Discussion: A long put will increase in value if the underlying security moves lower. The profit can be significant if the security makesa large percentage move lower. However, since the underlying assetcannot fall below zero, the potential profits are limited. The risksinvolved are also limited and are equal to the premium paid for thelong put.18. The breakeven of a long put option by expiration is derived by______________.Answer: D—Subtracting the option premium from its strike price.Discussion: If the value of the underlying asset at expiration is equalto the strike price minus the premium, the long put breaks even.
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19. True or False: In a short put strategy, when the underlying instrument’s price falls, you make money; when it rises, you lose money.Answer: False.Discussion: Selling a put is a bullish strategy that profits when theprice of the underlying asset moves higher. Oftentimes, the goal inshorting a put is to collect the premium and see the option expireworthless, which allows the put writer to keep the credit receivedfrom selling the put. The put will expire worthless if it is out-of-themoney at expiration and this will occur if the price of the underlyingasset rises above the put strike price. At other times, put sellers hopeto have the put assigned and take ownership of the underlying security. In either case, when the underlying asset price rises, the putseller makes money. On the other hand, when the price of the underlying asset falls, money will most likely be lost.20. A short put strategy has ______________.Answer: B—Limited profit potential with significant risk.Discussion: Naked put selling involves significant risk if the underlying asset makes a large percentage move lower. While the risks arelimited to the underlying instrument falling to zero, the short putstrategy is still a very high risk aproach. The profit is also limited andis equal to the premium received for selling the put.
MEDIA ASSIGNMENTThe media assignment encourages the reader to use the free options calculator at the Chicago Board Options Exchange web site to create a riskcurve. Plugging the various stock prices into the calculator produces thefollowing values. For instance, with the stock at $80 a share, the long callwould be worth $8.40.Stock Price
Call Option Price
60
0.45
65
1.25
70
2.80
75
5.15
80
8.40
85
12.30
90
16.50
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The next step is to plot the coordinates on the risk curve. For example, the first dot (in the lower left-hand corner of the risk graph) appearswhere the stock price equals $60 a share and the option is worth 45 cents.As we can see, the risk curve of the long call is upward sloping to theright. In later chapters, we will see how to repeat the same analysis usingmore complex strategies.201918171615141312111098765432160
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70
75
80
85
90
Long Call Risk Curve
VOCABULARY DEFINITIONSBreakeven: The point where a position shows no profits and no losses.For example, if an investor sells a stock for the same price that was paid,she will break even.Chicago Board Options Exchange (CBOE): Established in 1973, theCBOE was the first organized options exchange in the United States.Covered call: A strategy that involves buying stock shares and sellingcalls. If the calls are assigned, the investor must relinquish the shares. Thecovered call can be established as one position or calls can be sold againstan existing stock position.
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Covered put: A strategy that involves selling one put against the shortsale of 100 shares of stock.Long call: The purchase of a call option in anticipation that the underlying asset will rise in price.Long put: The purchase of a put option in anticipation that the underlyingasset will decline.Long stock: A bullish strategy that involves buying and holding shares ofstock. If you buy 100 shares of XYZ, you are long XYZ.Options calculator: A tool used by options traders to compute theoretical prices, volatility, delta, and the other so-called Greeks.Risk curve, risk graph, and/or risk profile: A graphical representationof risk and reward on a given trade as prices change.Short call: A bearish strategy that involves selling a call option to collectthe premium.Short put: A bullish strategy that involves selling a put option to collectthe premium.Short stock: Selling shares of stock in anticipation that the price willgo down.
CHAPTER 5
IntroducingVerticalSpreads
SUMMARYIn this chapter, the reader delves into the world of vertical spreads. Thefollowing four strategies are examined in depth: bull call, bull put, bearcall, and bear put. An example of each strategy is included to enable thereader to witness a hands-on illustration of each specific trading technique. These strategies are used to limit risk, yet they still allow optiontraders to make nice profits.Bull call and bear put spreads are debit strategies that use optionswith at least 90 days to expiration. Bear call and bull put spreads are creditstrategies that use options that expire in less than 45 days. Since spreadsinvolve the buying and selling of options, understanding the dynamic ofthe bid-ask spread is vital to your success. In order to pay the price you arewilling to spend when placing a vertical spread, it’s best to use a limit order inside the bid-ask spread.Vertical spreads are great strategies to get started with as you learnthe options game. However, since paper trading various vertical spreadscan enable options traders to learn how to trade without losing real capital, these limited risk strategies should be paper traded before real moneyis put into action. After developing a strong understanding of verticalspread mechanics, a trader can use a small amount of capital to place alimited risk trade in the marketplace. Although unlimited profits cannot bemade trading vertical spreads, risks are minimized, allowing traders tostay in the game longer.
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QUESTIONS AND EXERCISES1. True or False: Strategic trades are typically short-term trading opportunities geared especially for day traders and short-term traders who donot have the opportunity to monitor the markets very closely each day.2. True or False: Long-term trades take a while to blossom and bearfruit, which gives the long-term trader more time to develop the artof patience.3. Delta neutral trades are hedged when the total position delta equals______________.A. +100.B. –100.C. +50.D. –50.E. Zero.4. Adjustments are made by ______________ in such a way as to bringthe overall trade back to delta neutral.A. Buying instruments.B. Selling instruments.C. Buying or selling instruments.D. Exiting the trade.5. The ______________ is a high-leverage strategy consisting of goinglong one call at a lower strike price and short one call at a higherstrike price.A. Bear call spread.B. Bear put spread.C. Bull call spread.D. Bull put spread.6. The bull call spread has ______________.A. Limited profit potential with limited risk.B. Limited profit potential with unlimited risk.C. Unlimited profit potential with unlimited risk.D. Unlimited profit potential with limited risk.
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7. Calculate the maximum reward and risk and the breakeven for thefollowing bull call spread trade.Long 1 December Bank Index ($BKX) 90 Call @ 7.80Short 1 December BKX 100 Call @ 5.00Maximum reward = __________________________________________Maximum risk = _____________________________________________Breakeven = ________________________________________________8. In a ______________, you buy the lower strike put and sell the higherstrike put using the same number of options.A. Bear call spread.B. Bear put spread.C. Bull call spread.D. Bull put spread.9. A bull put spread has a ______________.A. Limited profit potential with limited risk.B. Limited profit potential with unlimited risk.C. Unlimited profit potential with unlimited risk.D. Unlimited profit potential with limited risk.10. Calculate the maximum reward and risk and the breakeven for thefollowing bull put spread trade.Long 1 June Bank Index ($BKX) 100 Put @ 6.75Short 1 June BKX 110 Put @ 10.50Maximum reward = __________________________________________Maximum risk = _____________________________________________Breakeven = ________________________________________________11. In a ______________, you sell the lower strike call and buy the higherstrike call using the same number of options.A. Bear call spread.B. Bear put spread.C. Bull call spread.D. Bull put spread.
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12. A bear call spread has a ______________.A. Limited profit potential with limited risk.B. Limited profit potential with unlimited risk.C. Unlimited profit potential with unlimited risk.D. Unlimited profit potential with limited risk.13. Calculate the maximum reward and risk and the breakeven for thefollowing bear call spread trade.Long 1 December IBM 90 Call @ 7.00Short 1 December IBM 80 Call @ 11.50Maximum reward = __________________________________________Maximum risk = _____________________________________________Breakeven = ________________________________________________14. In a ______________, you buy a higher strike price put and sell alower strike price put.A. Covered write.B. Bear call spread.C. Bear put spread.D. Bull call spread.E. Bull put spread.15. A bear put spread has a ______________.A. Limited profit potential with limited risk.B. Limited profit potential with unlimited risk.C. Unlimited profit potential with unlimited risk.D. Unlimited profit potential with limited risk.16. Calculate the maximum reward and risk for the following bear putspread trade.Long 1 October IBM 95 Put @ 3.75Short 1 October IBM 90 Put @ 2.50Maximum reward = __________________________________________Maximum risk = _____________________________________________Breakeven = ________________________________________________
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MEDIA ASSIGNMENTVertical spreads offer predetermined risks and rewards. Understandingthe risks of a trade is vital to the success of an options trader. In this exercise, using the Internet take the time to create various trades with theircorresponding risk graphs of the four different types of trades mentionedin this chapter. We will discuss risk graphs in more detail later, but searchthe Internet and the Optionetics site to learn all you can about the riskgraphs for the four types of trades talked about in this chapter: bull callspread, bear put spread, bull put spread, and bear call spread.
VOCABULARY LISTAsk
Debit spread
At-the-money (ATM)
In-the-money (ITM)
Bear call spread
Intrinsic value
Bear put spread
Leg in
Bull call spread
Limit order
Bull put spread
Out-of-the-money (OTM)
Bid
Slippage
Bid-asked spread
Time value
Credit spread
Vertical spread
SOLUTIONS1. True or False: Strategic trades are typically short-term trading opportunities geared especially for day traders and short-term traders who donot have the opportunity to monitor the markets very closely each day.Answer: False.Discussion: Strategic trades are short-term trading opportunitiesthat are geared for traders who do have the time to monitor themarkets closely each day.2. True or False: Long-term trades take a while to blossom and bearfruit, which gives the long-term trader more time to develop the artof patience.Answer: True.
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Discussion: There is a place for long-term trades, especially forthose who cannot spend a lot of time watching the market. Thelonger-term the trade, the more fundamental analysis comes intoplay. However, technical analysis can still be used for entry and exitpoints. Though long-term trades provide more leeway to be right, atrader should still stick with appropriate exit points.3. Delta neutral trades are hedged when the total position delta equals______________.Answer: E—Zero.Discussion: As the name implies, we want to have the overall deltaas close to zero as possible for delta neutral trades. When the deltastrays from zero, a trade is then showing a directional bias. Many experienced traders like to use delta neutral strategies like long synthetic straddles so adjustments can be made along the way to bring inadditional profits and return the trade to delta neutral.4. Adjustments are made by ______________ in such a way as to bringthe overall trade back to delta neutral.Answer: C—Buying or selling instruments.Discussion: In this chapter, the main text discusses the given deltafor different types of securities and options. By understanding theapproximate delta for an option, traders can make adjustments thatshift the trade back to delta neutral. For example, if a syntheticstraddle has moved higher and you are long the stock and long twoATM puts, you would have a few choices: You could sell shares ofstock to bring in some profits or add more puts. Of course, alwaysview a risk graph before making a final decision on what adjustments should be made.5. The ______________ is a high-leverage strategy consisting of goinglong one call at a lower strike price and short one call at a higherstrike price.Answer: C—Bull call spread.Discussion: By purchasing a lower strike call and selling a higherstrike call, a trader creates a debit strategy, which becomes the maximum risk in the trade. The cost of the trade is lowered by selling thehigher strike call, although the reward is also limited. Using a bull callspread allows a trader to be wrong about the direction of the underlying security yet experience only a minor loss.
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6. The bull call spread has ______________.Answer: A—Limited profit potential with limited risk.Discussion: Many new traders do not initially understand the benefitsof a bull call spread because the reward is limited. However, by examining various outcomes for a bull call spread, a trader will see how thisstrategy provides downside protection. Most successful traders have aspecific profit goal in mind, so it usually isn’t a big issue to have limited rewards. If a trader expects the underlying to rise sharply, then astraight call or a fairly wide bull call spread should be used.7. Calculate the maximum reward and risk and the breakeven for thefollowing bull call spread trade.Long 1 December Bank Index ($BKX) 90 Call @ 7.80Short 1 December BKX 100 Call @ 5.00Answer:Maximum reward = [(100 – 90) – 2.80] × 100 = $720 [(Difference instrikes – net debit) × 100].Maximum risk = (7.80 – 5.00) × 100 = $280 (Net debit).Breakeven = (90 + 2.80) = 92.80 (Lower strike price + net debit).Discussion: The maximum risk is always the net debit for a bull callspread. We normally want to see a maximum profit that is at leasttwice as high as the maximum risk. Thus, if we spend $150 for a bullcall spread, we want to be able to possibly make at least $300. Atrader should always create a risk graph before entering a trade tosee where the maximum reward, maximum risk, and breakevenpoints fall. Traders can create bull call spreads that have large rewardto-risk ratios; but if the breakeven needs to see a very large move,this might tell us that the trade is not worth it.8. In a ______________, you buy the lower strike put and sell the higherstrike put using the same number of options.Answer: D—Bull put spread.Discussion: A bull put spread is a credit spread composed of sellingthe higher strike put and buying the lower strike put. However, because a bull put spread profits as long as the underlying closes abovethe higher strike, this strategy can benefit the trader in a large number of situations. In general, if we sell an ATM put, the underlying cantrade sideways or higher and we still would receive the maximumprofit (the net credit). The high probability of success does comewith higher risk in the event the underlying moves lower.
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9. A bull put spread has a ______________.Answer: A—Limited profit potential with limited risk.Discussion: Just like a debit spread, a credit spread has limited reward and limited risk. However, a bull put spread’s higher probability of success also means a larger risk. Nonetheless, the risk islimited and credit spread traders can make substantial profits usingthis strategy.10. Calculate the maximum reward and risk and the breakeven for thefollowing bull put spread trade.Long 1 June Bank Index ($BKX) 100 Put @ 6.75Short 1 June BKX 110 Put @ 10.50Answer:Maximum reward = (10.50 – 6.75) × 100 = $375 (Net credit).Maximum risk = [(110 – 100) – 3.75] × 100 = $625 [(Difference instrikes – net credit)] × 100].Breakeven = 110 – 3.75 = 106.25 (Higher strike price – net credit).Discussion: A bull put spread is created by combining the sale of ahigher strike put with the purchase of a lower strike put. The goal isto see the underlying asset move higher and for both puts to expireworthless. If so, the strategist will keep the net credit, which is alsothe maximum reward. Since a credit spread has a higher successrate than a debit spread, the amount at risk normally will often behigher than the possible reward. However, over time, a creditspread trader should see substantially more wins than losses. Aswith any strategy, it is important to look at a risk graph of the tradebefore entering to make sure the reward, risk, and breakeven all fityour outlook for the stock.11. In a ______________, you sell the lower strike call and buy the higherstrike call using the same number of options.Answer: A—Bear call spread.Discussion: As the name implies, a bear call spread is bearish in nature, but uses calls to create a credit. As long as the underlying security closes at expiration below the lower strike call, the entire netpremium becomes a profit. This means that we can enter a bear callspread when we think the stock is going to trade sideways or moveslightly lower by expiration.
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12. A bear call spread has a ______________.Answer: A—Limited profit potential with limited risk.Discussion: I believe in limiting risk in every situation, and for this reason I never suggest selling naked options. Instead of selling a nakedcall, you may want to consider limiting your risk by entering a creditspread. Yes, the reward is also lowered, but this keeps a trader in thegame without losing large amounts of capital on a trade gone bad.13. Calculate the maximum reward and risk and the breakeven for thefollowing bear call spread trade.Long 1 December IBM 90 Call @ 7.00Short 1 December IBM 80 Call @ 11.50Answer:Maximum reward = (11.50 – 7.00) × 100 = $450 (Net credit).Maximum risk = [(90 – 80) – 4.50] × 100 = $550 [(Difference betweenstrikes – net credit) × 100].Breakeven = 80 + 4.50 = 84.50 (Lower strike price + net credit).Discussion: If IBM were to close at or below $80 at expiration, thenthis trade would achieve a maximum profit of $450. The maximumprofit is equal to the credit received. The risk is calculated by subtracting the net credit from the distance between strikes. The breakeven isfound by adding the net credit received to the lower strike. In thiscase, we need IBM to close at $84.50 or below to see a profit.14. In a ______________, you buy a higher strike price put and sell alower strike price put.Answer: C—Bear put spread.Discussion: Using bear and put together conveys the bearish bias of adebit spread. The idea is that we can lower the cost of buying astraight put by selling a lower strike put. Though this limits the maximum profit, it also lessens the trade’s risk. If the underlying moveshigher, a spread is going to see a much smaller loss than a straight put.15. A bear put spread has a ______________.Answer: A—Limited profit potential with limited risk.Discussion: Sale of a lower strike put lowers the initial debit, butalso reduces the reward. A straight put makes money as the underlying falls all the way to zero. However, a bear put spread is a limited
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reward, limited risk strategy. If you expect the stock to fall sharply,you might be better served using a straight put. If you predetermineyour exit price, then using a debit spread might work best.16. Calculate the maximum reward and risk for the following bear putspread trade.Long 1 October IBM 95 Put @ 3.75Short 1 October IBM 90 Put @ 2.50Maximum reward = [(95 – 90) – 1.25] × 100 = $375 [(Difference instrikes – net debit) × 100].Maximum