Chapter 4
Option
Combinations and
Spreads
1
© 2002 South-Western Publishing
‘Rolling’ Trading Strategies
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Rolling down/out/up - possible action as
part of re-evaluating one’s option position
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Rolling down - closing your position and reestablishing a new one with a lower strike price
e.g. Long call position - re-establish new one at
a lower strike
Rolling out - closing your existing position and
re-establishing a new one with a longer
expiration e.g. Similar to above situation
Rolling up - closing out your existing position
and re-establishing a new one with a higher
strike price
Rolling Trading Strategies
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3
Rolling up and out
Rolling down and out
Should be viewed as a new investment
position with a new stock price and time
outlook as opposed to a continuation of the
initial position
Chapter 4 Outline
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4
Spreads
Nonstandard spreads
Combined call writing
Combinations
Margin considerations
Evaluating spreads
Introduction
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Previous chapters focused on
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5
Speculating
Income generation
Hedging
Other strategies are available that seek a
trading profit rather than being motivated
by a hedging or income generation
objective
Trading Considerations
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What is your outlook for the stock and over
what time frame?
Are you interested in ultimately acquiring the
stock?
Do you own the stock now - are there dividend
considerations?
Where do you expect the profit to come from stock movement or a net credit position from
the sale of options?
Option Pricing - implied volatility
Introduction
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Option spreads are strategies in which the
player is simultaneously long and short
options of the same type, but with different
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Striking prices or
Expiration dates
the ‘spreader’ establishes a known
maximum profit or loss potential between
either the two strike prices or the two
expiration dates
Spreads
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Price or Vertical spreads
Vertical spreads with calls
Vertical spreads with puts
Calendar spreads
Diagonal spreads
Butterfly spreads
Price Spreads (also known as
Vertical Spreads)
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In a price/vertical spread, options are
selected vertically from the financial pages
i.e. Different strike prices
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The options have the same expiration date
The spreader will long one option and short the
other
Price Spreads With Calls
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Bullspread
Bearspread
Bullspread or Bull Call Spread
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Assume a person believes MSFT stock will
appreciate soon
A possible strategy is to construct a vertical
call bullspread and:
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Buy an OCT 85 MSFT call
Write an OCT 90 MSFT call
The spreader trades part of the profit
potential for a reduced cost of the position.
Bullspread (cont’d)
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With all spreads the maximum gain and
loss occur at the striking prices
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It is not necessary to consider prices outside
this range
With an 85/90 spread, you only need to look at
the stock prices from $85 to $90
Bullspread (cont’d)

Construct a profit and loss worksheet to form the
bullspread:
Stock Price at Option Expiration
13
0
85
86
88
90
100
Long $85 call
@ $5
-5
-5
-4
-2
0
10
Short $90 call
@ $3 3/8
3 3/8
3 3/8
3 3/8
3 3/8
3 3/8
-6 5/8
Net
-1 5/8
-1 5/8
-5/8
1 3/8
3 3/8
3 3/8
Bullspread (cont’d)
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Bullspread
3 3/8
Stock price at
option expiration
85
0
90
1 5/8
14
86 5/8
Bearspread or Bear Call Spread
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A bearspread is the reverse of a bullspread
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The maximum profit occurs with falling prices
The investor buys the option with the higher
striking price and writes the option with the
lower striking price
Profit from the sale of the call w/o risk of a sharp
run up in the price of the stock
Price Spreads With Puts:
Bullspread or Bull Put Spread
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Involves using puts instead of calls
Buy the option with the lower striking price
and write the option with the higher one
 Profit stems from the spread of the two
options
…….but profit still only is generated if the
stock moves up (bull put spread)
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Bullspread (cont’d)
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The put spread results in a credit to the
spreader’s account (credit spread)
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The call spread results in a debit to the
spreader’s account (debit spread)
Bullspread (cont’d)
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A general characteristic of the call and put
bullspreads is that the profit and loss
payoffs for the two spreads are
approximately the same
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The maximum profit occurs at all stock prices
above the higher striking price
The maximum loss occurs at stock prices below
the lower striking price
Calendar (or Time) Spreads
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In a calendar spread, options are chosen
horizontally from a given row in the
financial pages
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The trading objective is to take advantage
of the ‘time decay’ factor.
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They have the same striking price
The spreader will long one option and short the
other
Options are worth more the longer they have
until expiration
Calendar Spreads (cont’d)
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Calendar spreads are either bullspreads or
bearspreads
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In a bullspread, the spreader will buy a call with
a distant expiration and write a call that is near
expiration
In a bearspread, the spreader will buy a call that
is near expiration and write a call with a distant
expiration
Diagonal Spreads
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A diagonal spread involves options from
different expiration months and with
different striking prices
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They are chosen diagonally from the option
listing in the financial pages
Diagonal spreads can be bullish or bearish
Butterfly Spreads
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A butterfly spread can be constructed for very little
cost beyond commissions
A butterfly spread can be constructed using puts
and calls
A butterfly spread does not technically meet the
definition of a spread in that it can involve both
puts and calls (combination)
Volatility of the stock price is the main driver of the
profit/loss potential with this option strategy
Butterfly Spreads(cont’d)
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Example of a butterfly spread
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75
0
76
-1
23
85
80
84
Stock price at
option expiration
Nonstandard Spreads:
Ratio Spreads
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A ratio spread is a variation on bullspreads
and bearspreads
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Instead of “long one, short one,” ratio spreads
involve an unequal number of long and short
options
E.g., a call bullspread is a call ratio spread if it
involves writing more than one call at a higher
striking price
Ratio Backspreads
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A ratio backspread is constructed the
opposite of ratio spreads
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Call bearspreads are transformed into call ratio
backspreads by adding to the long call position
Put bullspreads are transformed into put ratio
backspreads by adding more long puts
Nonstandard Spreads:
Hedge Wrapper (collar)
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A hedge wrapper involves writing a covered call
and buying a put
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Useful if a stock you own has appreciated and is expected
to appreciate further with a temporary decline
An alternative to selling the stock or creating a protective
put
The maximum profit occurs once the stock price
rises to the striking price of the call
The lowest return occurs if the stock falls to the
striking price of the put or below
Hedge Wrapper (cont’d)
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The profitable stock position is transformed
into a certain winner- locking in a defined
gain
The potential for further gain is reduced
Nonstandard Spreads:
Combined Call Writing
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In combined call writing, the investor writes
calls using more than one striking price
An alternative to other covered call
strategies
The combined write is a compromise
between income and potential for further
price appreciation
Combinations
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Straddles
Strangles
Condors
A combination is defined as a strategy in
which you are simultaneously long or short
options of different types
Straddles
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A straddle is the best-known option
combination
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You are long a straddle if you own both a
put and a call with the same
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Striking price
Expiration date
Underlying security
Straddles
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You are short a straddle if you are short
both a put and a call with the same
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Striking price
Expiration date
Underlying security
Buying a Straddle
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A long call is bullish
A long put is bearish
Why buy a long straddle?
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Whenever a situation exists when it is likely that
a stock will move sharply one way or the other
Very Speculative - typically a situation
where a company is involved in a lawsuit or
takeover - unclear how the situation will be
resolved.
Buying a Straddle (cont’d)
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Suppose a speculator
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Buys an OCT 80 call on MSFT @ $7
Buys an OCT 80 put on MSFT @ $5 7/8
Buying a Straddle (cont’d)
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Construct a profit and loss worksheet to form the
long straddle:
Stock Price at Option Expiration
34
0
50
75
80
90
100
Buy $80 call
@ $7
-7
-7
-7
-7
3
13
Buy $80 put
@ $5 7/8
74 1/8
-7/8
-5 5/16
-5 7/8
-5 7/8
-5 7/8
Net
67 1/8
-7 7/8
-12 5/16
-12 7/8
-2 7/8
7 1/8
Buying a Straddle (cont’d)
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Long straddle
Two breakeven points
67 1/8
80
0
67 1/8
12 7/8
35
92 7/8
Stock price at
option expiration
Buying a Straddle (cont’d)
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The worst outcome for the straddle buyer is
when both options expire worthless
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The straddle buyer will lose money if MSFT
closes near the striking price
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Occurs when the stock price is at-the-money
The stock must rise or fall to recover the cost of
the initial position
Buying a Straddle (cont’d)
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If the stock rises, the put expires worthless,
but the call is valuable
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If the stock falls, the put is valuable, but the
call expires worthless
Writing a Straddle
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Popular with speculators
The straddle writer wants little movement in
the stock price
Losses are potentially unlimited on the
upside because the short call is uncovered
Writing a Straddle (cont’d)
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Short straddle
12 7/8
80
0
67 1/8
67 1/8
39
92 7/8
Stock price at
option expiration
Strangles: Introduction
40
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A strangle is similar to a straddle, except
the puts and calls have different striking
prices
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Strangles are more popular due to the
smaller capital investment and the max.
gain occurs over a wider trading range
Buying a Strangle
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The speculator long a strangle expects a
sharp price movement either up or down in
the underlying security
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Suppose a speculator:
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Buys a MSFT OCT 75 put @ $3 5/8
Buys a MSFT OCT 85 call @ $5
Buying a Strangle (cont’d)
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Long strangle
66 3/8
75
Stock price at
option expiration
85
0
66 3/8
8 5/8
42
93 5/8
Writing a Strangle
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The maximum gains for the strangle writer
occurs if both option expire worthless
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Occurs in the price range between the two
exercise prices
similar to writing a straddle
some movement in the stock price results in the
max. Profit
maximum profit is somewhat reduced from the
straddle
Writing a Strangle (cont’d)
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Short strangle
8 5/8
75
Stock price at
option expiration
85
0
66 3/8
66 3/8
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93 5/8
Condors: Introduction
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A condor is a less risky version of the
strangle, with four different striking prices
It is somewhat of a hybrid between a
combination and a spread
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‘spread like’ because of the defined window of
profit or loss
‘combination like’ because it involves both puts
and calls
Buying a Condor
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There are various ways to construct a long
condor
The condor buyer hopes that stock prices
remain in the range between the middle two
striking prices
the outside strike prices protect against
stock movements - either up or down
Buying a Condor (cont’d)
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Suppose a speculator:
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Buys MSFT 75 calls @ $10
Writes MSFT 80 calls @ $7
Writes MSFT 85 puts @ $8 1/2
Buys MSFT 90 puts @ $12 1/8
Buying a Condor (cont’d)
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Construct a profit and loss worksheet to form the
long condor:
Stock Price at Option Expiration
48
0
75
80
85
90
95
Buy $75 call
@ $10
-10
-10
-5
0
5
10
Write $80 call
@ $7
7
7
7
2
-3
-8
Write $85 put
@ $8 1/2
-76 1/2
-1 1/2
3 1/2
8 1/2
8 1/2
8 1/2
Buy $90 put
@ $12 1/8
77 7/8
2 7/8
-2 1/8
-7 1/8
-12 1/8
-12 1/8
Net
-1 5/8
-1 5/8
3 3/8
3 3/8
-1 5/8
-1 5/8
Buying a Condor (cont’d)
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Long condor
3 3/8
75
80
85
0
76 5/8
1 5/8
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88 3/8
90
Stock price at
option expiration
Writing a Condor
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The condor writer makes money when
prices move sharply in either direction
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The maximum gain is limited to the
premium
Writing a Condor (cont’d)
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Short condor
1 5/8
80
Stock price at
option expiration
85
0
75
3 3/8
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76 5/8
90
88 3/8
Margin Considerations
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Introduction
Margin requirements on long puts or calls
Margin requirements on short puts or calls
Margin requirements on spreads
Margin requirements on covered calls
Margin Considerations:
Introduction
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Necessity to post margin is an important
consideration in spreading
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The speculator in short options must have
sufficient equity in his or her brokerage account
before the option positions can be assumed
Margin Requirements on Long
Puts or Calls
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There is no requirement to advance any
sum of money - other than the option
premium and the commission required - to
long calls or puts
Can borrow up to 25% of the cost of the
option position from a brokerage firm if the
option has at least nine months until
expiration
Margin Requirements on Short
Puts or Calls
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For uncovered calls on common stock, the
initial margin requirement is the greater of
Premium + 0.20(Stock Price) – (Out-of-Money Amount) or
Premium + 0.10(Stock Price)
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Margin Requirements on Short
Puts or Calls (cont’d)
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For uncovered puts on common stock, the
initial margin requirement is 10% of the
exercise price
Margin Requirements on
Spreads
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All spreads must be done in a margin
account
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More lenient than those for uncovered
options
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You must pay for the long side in full
Margin Requirements on
Spreads (cont’d)
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You must deposit the amount by which the
long put (or short call) exercise price is
below the short put (or long call) exercise
price
A general spread margin rule:
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For a debit spread, deposit the net cost of the
spread
For a credit spread, deposit the different
between the option striking prices
Margin Requirements on
Covered Calls (cont’d)
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There is no margin requirement when
writing covered calls
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Brokerage firms may restrict clients’ ability
to sell shares of the underlying stock
Evaluating Spreads
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Spreads and combinations are
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Bullish,
Bearish, or
Neutral
You must decide on your outlook for the
market before deciding on a strategy
Evaluating Spreads:
The Debit/Credit Issue
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An outlay requires a debit
An inflow generates a credit
There are several strategies that may serve
a particular end, and some will involve a
debit and others a credit
Evaluating Spreads:
The Reward/Risk Ratio
62
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Examine the maximum gain relative to the
maximum loss

E.g., if a call bullspread has a maximum
gain of $337.50 and a maximum loss of
$162.50, the reward/risk ratio is 2.08
Evaluating Spreads:
The “Movement to Loss” Issue
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The magnitude of stock price movement
necessary for a position to become
unprofitable can be used to evaluate
spreads
Evaluating Spreads:
Specify A Limit Price
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In spreads:
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You want to obtain a high price for the options
you sell
You want to pay a low price for the options you
buy
Specify a dollar amount for the debit or
credit at which you are willing to trade