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). How-ever,  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 man-ually.  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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Breakeven
Options calculator
Risk curve
Risk graph
Risk proﬁle
Short call
Short put
Short stock
Chicago Board Options Exchange(CBOE)
Covered call
Covered put
Long call
Long put
Long stock
SOLUTIONS
1. 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  a corresponding 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  limited rewards.
2. Reading  a  risk  proﬁle  is  pretty  easy.  The  horizontal  numbers  at the  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  ex-plores  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 underly-
ing 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  pre-mium. 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  the underlying asset.
11. True or False: With a long call strategy, you still have to hold margin
in 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 pre-mium 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  underlying instrument’s  price  rises,  you  make  money;  when  it  falls,  you  losemoney.Answer: False.Discussion: In  a  short  call  strategy,  when  the  underlying  instru-ment’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  pre-mium  received.  However,  if  the  underlying  asset  makes  a  movehigher,  the  short  call  strategy  will  begin  to  experience  losses.  If the  stock  makes  a  large  percentage  move  higher,  the  losses  can be signiﬁcant.
16. True  or  False:  With  a  long  put  strategy,  when  the  underlying  instru-ment’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 experi-ence 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 secu-rity 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  instru-ment’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-the-money 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 secu-rity.  In  either  case,  when  the  underlying  asset  price  rises,  the  putseller makes money. On the other hand, when the price of the under-lying 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 underly-ing 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 ASSIGNMENT
The media assignment encourages the reader to use the free options cal-culator 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
65
70
75
80
85
90
0.45
1.25
2.80
5.15
8.40
12.30
16.50
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The next step is to plot the coordinates on the risk curve. For exam-ple, 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.
20
19
18
17
16
15
14
13
12
11
10
9
8
7
6
5
4
3
2
1
60  65 
70 
75 
80  85 
90
Long Call Risk Curve
VOCABULARY DEFINITIONS
Breakeven: 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 underly-ing 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 theoreti-cal 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.
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CHAPTER 5
IntroducingVerticalSpreads
SUMMARY
In  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  tech-nique.  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 or-der 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 capi-tal, 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 EXERCISES
1. True or False: Strategic trades are typically short-term trading opportu-nities 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 bring
the 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  the
following bull call spread trade.
Long 1 December Bank Index ($BKX) 90 Call @ 7.80
Short 1 December BKX 100 Call @ 5.00
Maximum 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  the
following bull put spread trade.
Long 1 June Bank Index ($BKX) 100 Put @ 6.75
Short 1 June BKX 110 Put @ 10.50
Maximum 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  the
following bear call spread trade.
Long 1 December IBM 90 Call @ 7.00
Short 1 December IBM 80 Call @ 11.50
Maximum 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  put
spread trade.
Long 1 October IBM 95 Put @ 3.75
Short 1 October IBM 90 Put @ 2.50
Maximum reward = __________________________________________
Maximum risk = _____________________________________________
Breakeven = ________________________________________________
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MEDIA ASSIGNMENT
Vertical  spreads  offer  predetermined  risks  and  rewards.  Understandingthe risks of a trade is vital to the success of an options trader. In this exer-cise,  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 LIST
Ask
Debit spread
At-the-money (ATM)
In-the-money (ITM)
Bear call spread
Bear put spread
Bull call spread
Bull put spread
Bid
Bid-asked spread
Credit spread
SOLUTIONS
Intrinsic value
Leg in
Limit order
Out-of-the-money (OTM)
Slippage
Time value
Vertical spread
1. True or False: Strategic trades are typically short-term trading opportu-nities 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 ex-perienced  traders  like  to  use  delta  neutral  strategies  like  long  syn-thetic 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 bring
the 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  adjust-ments 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 maxi-mum 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 underly-ing 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 exam-ining 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 lim-ited 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  the
following bull call spread trade.
Long 1 December Bank Index ($BKX) 90 Call @ 7.80
Short 1 December BKX 100 Call @ 5.00Answer:
Maximum  reward  =  [(100  –  90)  –  2.80]  × 100  =  $720  [(Difference  in
strikes – 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 reward-to-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,  be-cause a bull put spread proﬁts as long as the underlying closes abovethe higher strike, this strategy can beneﬁt the trader in a large num-ber 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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