35, realizing a $5 proﬁt on the stock purchase and sale). Table 6.2gives the values of both options and of the spread for various stockprices at expiration.Note that the far-right-hand column gives the value of the spreadat expiration, not the proﬁt or loss realized on the trade. To calculate this last number, the original debit of $2.50 must be subtractedfrom the ﬁnal value. This proﬁt and loss at expiration is illustratedin Figure 6.1.Bull call spreads are limited risk/limited reward positions. (Thiscannot be said of all spreads.) Some traders believe that the limitedproﬁt aspect is a sufﬁciently negative condition to warrant dismissing this type of strategy altogether. But we view it differently. In theSEBL example a spread with a maximum value of $5 was estab-
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$3
Profit/(Loss)
$2$1$0($1)($2)($3)$27.50
$30.00
$32.50
$35.00
$37.50
SEBL Price at Expiration
Figure 6.1 SEBL 30–35 Call Spread
lished for a $2.50 debit. The best-case scenario has a trader doublinghis initial outlay if the stock rises to $35, or by 10.4%. Table 6.3 looksat the upside moves necessary for the buyers of various calls to double their initial investment at option expiration.Now we can look at spreads in a totally different light: it’s a strategy that will return 100% on the initial investment if the underlyingstock is up 10.4% or more at option expiration. To achieve the samemagnitude of return with a straight call purchase requires SEBL torally more than 30%. Does this strategy now sound interesting?Table 6.3SEBL PriceNeeded atExpirationto DoublePremium
PercentageIncrease inSEBL PriceNeededto DoublePremium
Premium
SEBL PriceNeeded atExpirationto Break Even
27 1⁄2 call
$7.10
$34.60
$41.70
31.5%
30 call
$5.70
$35.70
$41.40
30.6%
32 1⁄2 call
$4.40
$36.90
$41.30
30.2%
35 call
$3.40
$38.40
$41.80
31.8%
30–35 call spread $2.50
$32.50
$35.00
10.4%
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There are some downsides to spreads. First, continuing with ourexample, a double is the best that can be expected. The second disadvantage is the way spreads behave prior to expiration. This is bestillustrated by Table 6.4, which estimates the value of the 30–35 callspread for various stock prices and at different times to expiration,assuming no changes in the options’ implied volatility.Table 6.4 is instructive in many ways. First, notice that even if SEBLrallies to $40 in a very short period of time (say 11 days after the tradewas initiated) the spread’s value only rises to $3.58. Two monthslater, with only 20 days left until expiration, the spread’s value is stillonly $4.39. Bull call spreads will trade close to their maximum theoretical value only if the options are very close to expiration, or if thestock has risen substantially above the short option’s strike price.Second, notice the impact of time decay. If SEBL remains close tounchanged, the value of the spread will change very little. At a$32.50 stock price, the spread rises very slowly in value. At a $30stock price, the spread is still worth $1.31 10 days before expiration(remember this position was established for $2.50; so after 80 days,a little over half of the spread’s value remains). The passage of timedoes not have a major impact because the spread consists of onelong and one short option. The losses due to the time decay of thelong option are largely made up by the gains on the short one.And third, although Table 6.4 assumes that the volatility assumption remains constant, it is easy to see the impact that changes in thisTable 6.4 Value of 30–35 Call SpreadSEBL Price
Days to Expiration91
80
70
60
50
40
30
20
10
0
$40
3.51
3.58
3.66
3.73
3.81
3.95
4.14
4.39
4.74
5.00
$37.50
3.17
3.21
3.26
3.30
3.42
3.56
3.72
3.94
4.32
5.00
$35
2.85
2.89
2.93
2.98
3.02
3.08
3.14
3.31
3.59
5.00
$32.50
2.41
2.42
2.43
2.43
2.43
2.44
2.46
2.46
2.48
2.50
$30
2.24
1.91
1.88
1.85
1.82
1.78
1.72
1.56
1.31
0.00
$27.50
1.57
1.54
1.47
1.38
1.29
1.18
1.05
0.80
0.48
0.00
$25
1.12
1.07
1.03
0.92
0.80
0.68
0.54
0.33
0.10
0.00
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pricing variable would have. A lower-volatility assumption wouldhave the same impact as the passage of time; so under a lowervolatility assumption the value of the spread 40 days before expiration would look more like the values calculated for the 30 Days toExpiration column. An increase in volatility would have the opposite effect, so that at 40 days to expiration the spread would be pricedcloser to the values given in the 50 Days to Expiration column.You may have noticed a small quirk in this last table. The spreadwas established for $2.50 when SEBL was $31.71. A quick rise to$32.50 on the day the spread is purchased results in a theoreticalvalue of $2.41, lower than the starting point. Yes, the value of thespread should be going up, but this anomaly appeared because wedid not factor in bid-ask spreads in creating the table.Maximum Theoretical ValueA bull call spread’s maximum theoretical value is equal to the difference between the two calls’ strike prices: a 30–35 call spread hasa maximum theoretical value of $5, a 105–115 spread, one of $10.Note the use of the word theoretical. Because of the options’ bid-askspreads, it is extremely unlikely that a trader will ever be able to sella spread for its maximum value. A $5 spread is more likely to besold at $4.90 when it is theoretically worth $5.This brings up the issue of exit strategy. A trader purchased theSEBL 30–35 call spread and on expiration Friday the stock is trading in the $37–$38 range. Should this trader enter a sell order at$5.00, at $4.95, or at $4.90 or should she take a totally different tack—exercise her long 30 call and wait for assignment on her short 35call? There is obviously no cost or risk in entering a sell order at $5,even though it is unlikely to be ﬁlled. But is this the best strategy?It all depends on transaction costs. Trading out of the spread willincur two option commissions. (Most brokerage ﬁrms treat spreadsas two different transactions in calculating commissions.) Exercising and waiting for assignment will incur two stock commissions.Based on our experience, commissions for stock trades tend to belower than those on options. So in many instances exercise andassignment will generate a higher proﬁt than selling the spread,even if one is able to obtain its maximum value. But to determine
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what’s best for you, you will have to compare your broker’s equityand option fees and decide accordingly.An argument often made against spreads concerns trading fees.Purchasing a spread could involve two commissions, plus an additional two to liquidate the position. If the fees are high enough, atrader ﬁnds himself in what is known in the industry as an alligatorspread—where one is eaten alive by the transaction fees. To avoidthis fate, one must deal in sufﬁcient quantities (do not attempt 1-by1 spreads) and one’s transaction costs must be toward the lower endof the fee spectrum. More important than fees are the options’ bidask spreads. A bull call spread involves two initial transactions plustwo liquidation trades, each one with a bid-ask spread. It is oftenpossible to shave a nickel or a dime on the total cost of a spread byentering the order as a package, but if the options are trading withwide bid-ask spreads, we would probably back off.Bid-ask spreads can have a much more signiﬁcant negative impacton a trade than the direct transaction costs. This is why we wouldlimit most of our spread trades to the more liquid options, where bidask spreads tend to be narrower and therefore create less slippage.Spread SelectionIf you thought call selection was confusing, take a look at choosinga call spread. With the four SEBL calls listed above, six different bullspreads can be constructed. This is also a simpliﬁed scenario since,in fact, May calls with strike prices from $5 all the way through $50were available on SEBL when we selected our example. How canthis process be simpliﬁed?Observe that the value of the SEBL 30–35 spread in our example,did not change very much over time. To us, this makes spreads better suited for short-term positions and only very rarely adequate forlonger-term situations. (We have a hard time justifying spreadsusing LEAPS, for example.)In selecting the strike prices for a spread, we ﬁrst look at sellingour target. If you have reason to believe SEBL is poised to rally to$40, you probably do not want to write the 35 call, as this eliminatesany possible gains from the stock above $35. Remember that bywriting a call with a higher strike price you are in fact selecting a
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point above which you will no longer participate in the stock’sappreciation. You are willing to give up any further upside inexchange for a reduced cost of entry into the position.Once the upper band of the spread is selected, look for a spreadthat creates an acceptable risk-reward ratio. Above, we purchased a$5 spread for $2.50, a 1-to-1 risk-reward ratio. We could have alsopurchased the 32 1⁄2–35 spread for $1.20 (lower than 1-to-1 riskreward) or the 27 1⁄2–35 spread for $3.90 (higher than 1-to-1 riskreward). We do not like to risk more than the strategy’s potentialreturn, but many seasoned traders have no objection to risking morethan they can gain on a spread trade. Spreads with extremely favorable risk-reward ratios (say, 1 to 10) will also have a very low probability of reaching their maximum theoretical value.Entering OrdersMost brokerage ﬁrms will let you enter a spread order as a spread.For the SEBL example above, the standard verbal order would be:“Buy 5 SEBL May 30 calls, and sell 5 SEBL May 35 calls for a netdebit of $2.50.” By entering a spread order as a package you will notend up with half your position—bought the 30s, couldn’t sell the35s or, worse, wrote the 35s, couldn’t buy the 30s. And by setting alimit to the debit you are willing to pay, you become indifferent tothe individual option prices, as long as you pay no more than $2.50net. If your order is ﬁlled and you paid $5.80 for the 30 calls butwrote the 35s at $3.30, it should be all the same to you.One fact to keep in mind when you are looking at options quotes.Say the 30 call is offered at $5.70 and the 35 call is bid at $3.20. Youenter your order, willing to pay $2.50. Nothing happens. You checkwith your broker and get a “nothing done” response. Why aren’tyou getting ﬁlled? The two options prices you are seeing on yourcomputer could be coming from two different exchanges: the 30 callis offered in Chicago, the 35 call is bid in Philadelphia. This is arecurring problem with options listed on multiple exchanges butbrokerage ﬁrms and the exchanges are addressing this issue. Weadmit that at times we have been tempted to leg into spreads—toexecute one leg and hope we can enter the second order before themarkets moved. We don’t recommend this maneuver, but if you doleg into a spread, always execute the buy order ﬁrst.
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Bear Put SpreadsThis strategy, the mirror image of the preceding one, consists in purchasing a put option and writing a different put with the same expiration date but a lower strike price. Bear put spreads are a low-costalternative to the straight purchase of put options and are usuallyused with high-volatility options.As an example, look at the following Emulex (EMLX) 67-day putoptions:April 30 put:April 32 1⁄2 put:April 35 put:April 37 1⁄2 put:April 40 put:
$1.50–$1.65$2.20–$2.40$2.80–$3.10$3.70–$4.00$4.90–$5.10
With EMLX trading at $41.33, a trader who is bearish on this stockover the short term might hesitate to simply buy puts. The at-themoney puts are offered at $5.10, a premium equal to more than 12%of the stock price! But a possible put spread would be to buy theApril 40 put at $5.10 and simultaneously write the April 32 1⁄2 put at$2.20, for a net debit of $2.90. Table 6.5 calculates this put spread’sproﬁt and loss at expiration for various ending stock prices.
Table 6.5EMLXPrice atExpiration
Value ofLong40 Put
Value ofShort32 1⁄2 Put
Value of32 1⁄2 –40Put Spread
Proﬁt/(Loss)
$42.50
$0
$0
$0
($2.90)
$40
$0
$0
$0
($2.90)
$37.50
$2.50
$0
$2.50
($0.40)
$35
$5
$0
$5
$2.10
$32.50
$7.50
$0
$7.50
$4.60
$30
$10
($2.50)
$7.50
$4.60
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The Options Strategist
Table 6.6Long 35 Put
Long 32 1⁄2 –40 Put Spread
Cost
$2.90
$2.90
Risk
$2.90
$2.90
EMLX Price to Break Even
$32.10
$37.10
EMLX Price to Double
$29.20
$34.20
Maximum Proﬁt
$32.10
$4.60
EMLX Price for $4.60 Proﬁt
$27.50
$32.50
Once again, we created a position with limited risk (the initialdebit paid) and limited proﬁt potential (the theoretical maximumvalue of the spread, $7.50, less the initial debit of $2.90, or $4.60).An alternative to the 32 1⁄2 – 40 put spread would be the straightpurchase of the April 35 put, which is offered at $3.10 but which wewill assume can be purchased at $2.90. Table 6.6 compares the profitability of this put purchase to that of the 32 1⁄2 –40 put spread.The advantages of the spread are evident in the preceding table:for the same initial investment, the spread provides a higherbreakeven price, a higher price where the initial investment doubles, and a higher point where the value of the position reaches $7.50and generates a $4.60 proﬁt. (We are dealing with puts here, sohigher is better.) The glaring disadvantage of the spread is its limited proﬁt potential.The other negatives of the spread are the same as those we outlined for the bull call spread strategy: the spread’s value will notchange dramatically, even if the underlying falls quickly, and thespread’s maximum value can only be attained at or near expirationor if the stock falls signiﬁcantly below the short put’s strike price.This is shown in Figure 6.2, which illustrates the value of the 32 1⁄2–40put spread at three points in time: the day the position is initiated(67 days before expiration), 10 days prior to expiration, and atexpiration.Note that since Figure 6.2 illustrates the bear put spread’s value,the initial cost of $2.90 must be subtracted to calculate the strategy’sproﬁt and loss.
Value of Spread
Advanced Trading Strategies
$8$7$6$5$4$3$2$1$0($1)
137
67 Days10 DaysExp.
$25
$30
$35
$40
$45
EMLX Price
Figure 6.2 EMLX 32 1⁄2 –40 Put Spread
Our comments about limiting spread transactions to optionsclasses that are highly liquid are equally valid for bear put spreads,as are our comments about exiting a position through exercise andassignment. There is also the risk of early assignment on the shortput position. This risk was explained in Chapter 4, but we also notethat for the short put to be assigned early the underlying stockwould have to be trading substantially below this put’s exerciseprice. This means that the stock has behaved as expected and thestrategy is proﬁtable. If the short put is assigned, a trader can thenexercise the long put to ﬂatten out the position. Because of the overnight delay in being notiﬁed of an assignment, there will be a difference of one business day in the settlement of the two stock trades.The trader who is advised on a Tuesday morning that her short putposition has been assigned must pay for this stock on Thursday (theholder of the put exercised it on Monday, and so settlement is threebusiness days later). If she turns around and exercises her long putimmediately (on Tuesday), the sale of the stock through exercise willsettle on Friday, three business days later.
Credit SpreadsBull call and bear put are both debit spreads. Each has an equivalent credit spread, the topic of this section.
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The Options Strategist
Bull Put SpreadsOur SEBL example was built around a 30–35 call spread. In addition to the calls, the following puts were listed for trading:SEBL:May 27 1⁄2 put:May 30 put:May 32 1⁄2 put:May 35 put:
$31.71$2.65–$2.80$3.70–$3.80$4.90–$5.10$6.30–$6.50
A trader bullish on this stock can create a position equivalent tothe call spread by writing the May 35 put at $6.30 and purchasingthe May 30 put at $3.80, initiating the spread for a $2.50 credit. Let’sﬁrst analyze this position in terms of rights and obligations.The spread involves writing the May 35 put: this means the traderassumes the obligation to purchase SEBL at $35. In itself, this shortoption has all the risk of a long stock position. But the spread’s second leg is buying the May 30 put, giving the trader the right to sellshares of SEBL at $30. This is, in fact, a protective put on a stock thatthe trader does not own but that he could eventually own if his shortput position is assigned. So the worst-case scenario in our exampleis for the trader to be obligated to buy SEBL at $35 (on assignmentof the short put) and to turn around and sell these shares at $30 (byexercising the long put). Buying a stock at $35 and selling it at $30results in a $5 loss, which is reduced by the $2.50 credit receivedwhen the position was initiated. So the worst-case scenario turnsout to be a loss of $2.50.The best-case scenario occurs if SEBL rallies past $35 and both putoptions expire worthless. The trader then keeps the initial credit of$2.50, and this represents his maximum proﬁt potential. The proﬁtand loss on this spread is identical to that on the 30–35 call spreadearlier in this chapter: $2.50 proﬁt if the stock is above $35 at optionexpiration and a maximum loss of $2.50 if SEBL is below $30 at expiration. This is why we refer to the spreads as equivalent.The spreads may be equivalent, but they are not identical. Froma theoretical viewpoint the two strategies have the same proﬁt-andloss potential, realized under the same conditions. In real life a fewpractical factors come into play. The ﬁrst difference is that the bullcall spread requires the trader to pay the initial $2.50 debit, whereas
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139
the bull put spread generates a $2.50 credit. Isn’t it always better toreceive money than to pay it out? Yes, the $2.50 will be credited toyour account, where it will earn interest or can be used to purchasea Treasury bill. If one takes into account the fact that buying the bullcall spread reduces one’s account balance by $2.50, the differencebetween the two strategies is actually the interest earned on $5. So$5 invested for 91 days at 2% (T-bills were yielding around 1.7%when we looked up this example, but we prefer round numbers)will generate nearly $0.03 in interest income. We doubt this will tipthe scales one way or the other.A second, more substantial, difference is that the bull put spreadmust be margined. The worst-case scenario is a $5 loss on the purchase and sale of the underlying stock, and therefore a $5 margin isrequired. In other words your brokerage ﬁrm does not want to haveto phone you up and ask for more money. The margin requirementcan be cash, but it can also be the loan value of other securities inyour account. If the spread is margined with cash, the $2.50 creditreceived when the position is initiated can be applied toward thetotal margin required of $5.A third minor difference is exiting the position if everything hasgone the right way. To realize the maximum proﬁt with a bull callspread, the position must be sold at its maximum theoretical value,which is difﬁcult, or it must be collapsed by exercise and assignment, which incurs two transaction fees. With the bull put spread,if the underlying stock has risen above the upper strike price, nothing needs to be done because both puts expire worthless and thetrader pockets the initial credit—a slight advantage in favor of theput spread. On the other hand, if the stock does not perform, thebull call spread buyer need do nothing, unless he can recoup partof the initial investment by selling the spread for a residual amount.The bull put spread will have to be covered at some point, if thestock has not met expectations. It is possible to have to pay morethan $5 to cover a $5 spread because of the options’ bid-ask spreads.Also, as puts go further in-the-money, they have a tendency tobecome illiquid, and this is reﬂected in wider bid-ask spreads.The last real-world difference is the risk of early assignment. Withthe bull call spread, the short option is the one furthest out-of-themoney (the one with the higher strike price). If a trader getsassigned on this short call, it is because the underlying has risen
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The Options Strategist
sharply, the strategy has worked well, and the position can be closedout by exercising the long call. With the bull put spread, the shortput will always go in-the-money before the long one (it has thehigher strike price). Early assignment is also more frequent with putoptions, as discussed in Chapter 4. It is also possible for the shortput to be assigned early when the long put is still out-of-the-money.For example, with the underlying at $31, the short 35 put could beassigned and the long 30 put is out-of-the-money, so it does notmake economic sense to exit the position by exercising the long 30put.Bear Call SpreadsAn alternative to the bear put spread on EMLX is to create an equivalent position using calls. The following were listed at the same timeas the puts in the example above:EMLX:April 30 call:April 32 1⁄2 call:April 35 call:April 37 1⁄2 call:April 40 call:
$41.33$12.80–$13.20$10.90–$11.30$9.20–$9.60$7.60–$8.00$6.30–$6.50
To initiate a bear call spread write the April 32 1⁄2 call at $10.90 andpurchase the April 40 call at $6.50, for a net credit of $4.40. The bestcase scenario is for EMLX to drop below $32.50 by April expiration,in which case both call options would expire worthless, generatinga proﬁt of $4.40.To understand the worst-case scenario, think in terms of rightsand obligations. Writing the 32 1⁄2 call creates the obligation to delivershares of EMLX at $32.50, an obligation with theoretically unlimitedrisk. Purchasing the 40 call limits this risk and creates a situationwhere if shares have to be sold at $32.50 they can always be purchased at $40, creating a $7.50 loss on the shares’ purchase and sale.This loss is reduced by the $4.40 credit generated when entering intothe position, for a worst-case loss of $3.10.You will have noticed that this proﬁt-and-loss proﬁle is slightlydifferent from the one obtained with the bear put spread: $4.40 ver-
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141
sus $4.60 proﬁt potential, and $3.10 versus $2.90 worst-case scenario.Half of this difference can be explained by the wider bid-ask spreadon the 32 1⁄2 calls, the other half by slight moment-to-moment ﬂuctuations in the options’ premiums. Life on the trading ﬂoor is notalways textbook perfect.This bear call spread is equivalent to the bear put spreaddescribed earlier, with once again some real-life differences: cash inversus cash out, the cost of exiting if the strategy works accordingto plan, and the risk of early assignment on the short option (eventhough this tends to be minimal in the case of call options).One last note on equivalent strategies: for two strategies to bedeemed equivalent, whether two bull or two bear spreads, the expiration date and the two strike prices of the long and short optionsmust be identical. Otherwise we are faced with an apples-to-orangescomparison.
Buying VolatilityWe have heard the following reasoning on many occasions: “I amconvinced that XYZ stock is about to move one way or another, soif I buy both a call and a put I can’t lose: If the stock goes up, I’llmake money on the call. If the stock goes down, I’ll make moneyon the put. What could go wrong with this strategy?”Some people would say nothing could go right with this strategy:If the stock goes up, the investor will lose money on the put. If itgoes down, he will lose money on the call.As in most cases, the truth lies somewhere in the middle. The purchase of a call and a put option, both with the same expiration dateand the same strike price, is known as buying a straddle. Tradersthink of this as buying volatility. You don’t care what the stock does,as long as it does it a lot. The gains on your one proﬁtable optionhave to more than make up your losses on the other.The traditional illustration of straddle goes along these lines: youare looking at the shares of Genentech (DNA) now trading at $50.03and expect these to move up or down signiﬁcantly over the nextcouple of weeks. You purchase a 31-day 50 call at $2.70 and a 31-day50 put at $2.65, for a total cost of $5.35. Table 6.7 gives the value andthe proﬁtability of your straddle trade at option expiration.
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The Options Strategist
Table 6.7DNA atExpiration
Value of50 Call
Value of50 Put
Value of50 Straddle
Proﬁt/(Loss)
$60
$10
$0
$10
$4.65
$57.50
$7.50
$0
$7.50
$2.15
$55
$5
$0
$5
($0.35)
$52.50
$2.50
$0
$2.50
($2.85)
$50
$0
$0
$0
($5.35)
$47.50
$0
$2.50
$2.50
($2.85)
$45
$0
$5
$5
($0.35)
$42.50
$0
$7.50
$7.50
$2.15
$40
$0
$10
$10
$4.65
The value of the straddle is simply the value of the put added tothe value of the call. By expiration, DNA has to either move above$55 or below $45 for this strategy to be proﬁtable. The proﬁt-andloss graph gives this strategy its name and is illustrated in Figure 6.3.The foregoing analysis has one severe limitation: it tells us a lotabout the straddle’s proﬁtability, but only at expiration. What if thetrader intends to hold this position only for one week or two—or
$6
Profit/(Loss)
$4$2$0($2)($4)($6)$40
$45
$50DNA Price at Expiration
Figure 6.3 Long DNA 50 Straddle
$55
$60
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Advanced Trading Strategies
$58
$52$50$48$46
DNA Price
$56$54
$44$42$4030
25
20
15
10
5
0
Days to Expiration
Figure 6.4 DNA 50 Straddle: Breakeven