Chapter 4
Option
Combinations and
Spreads
1
© 2004 South-Western Publishing
Introduction
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Previous chapters focused on
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Speculating
Income generation
Hedging
Other strategies are available that seek a
trading profit rather than being motivated
by a hedging or income generation
objective
Combinations
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3
Introduction
Straddles
Strangles
Condors
Introduction
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4
A combination is 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
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 (cont’d)
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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
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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
Buying a Straddle (cont’d)

Suppose a speculator
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Buys a JAN 30 call on MSFT @ $1.20
Buys a JAN 30 put on MSFT @ $2.75
Buying a Straddle (cont’d)

Construct a profit and loss worksheet to form the
long straddle:
Stock Price at Option Expiration
9
0
15
25
30
45
55
Long 30 call
@ $1.20
-1.20
-1.20
-1.20
-1.20
13.80
23.80
Long 30 put
@ $2.75
27.25
12.25
2.25
-2.75
-2.75
-2.75
Net
26.05
11.05
-1.05
-3.95
11.05
21.05
Buying a Straddle (cont’d)

Long straddle
Two breakeven points
26.05
30
0
26.05
3.95
10
33.95
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)
12

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
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Losses are potentially unlimited on the
upside because the short call is uncovered
Writing a Straddle (cont’d)
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Short straddle
3.95
30
0
26.05
26.05
14
33.95
Stock price at
option expiration
Strangles
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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 very popular with
professional option traders
Buying a Strangle
16

The speculator long a strangle expects a
sharp price movement either up or down in
the underlying security

With a long strangle, the most popular
version involves buying a put with a lower
striking price than the call
Buying a Strangle (cont’d)

Suppose a speculator:
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Buys a MSFT JAN 25 put @ $0.70
Buys a MSFT JAN 30 call @ $1.20
Buying a Strangle (cont’d)
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Long strangle
23.10
25
Stock price at
option expiration
30
0
23.10
1.90
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31.90
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
Writing a Strangle (cont’d)
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Short strangle
1.90
25
Stock price at
option expiration
30
0
23.10
23.10
20
31.90
Condors
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A condor is a less risky version of the
strangle, with four different striking prices
Buying a Condor
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
There are various ways to construct a long
condor
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The condor buyer hopes that stock prices
remain in the range between the middle two
striking prices
Buying a Condor (cont’d)
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Suppose a speculator:
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Buys MSFT 25 calls @ $4.20
Writes MSFT 27.50 calls @ $2.40
Writes MSFT 30 puts @ $2.75
Buys MSFT 32.50 puts @ $4.60
Buying a Condor (cont’d)

Construct a profit and loss worksheet to form the
long condor:
Stock Price at Option Expiration
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0
25
27.50
30
32.50
35
Buy 25 call
@ $4.20
-4.20
-4.20
-1.70
0.80
3.30
5.80
Write 27.50 call
@ $2.40
2.40
2.40
2.40
-0.10
-2.60
-5.10
Write 30 put
@ $2.75
-27.25
-2.25
0.25
2.75
2.75
2.75
Buy 32.50 put
@ $4.60
27.90
2.90
0.40
-2.10
-4.60
-4.60
Net
-1.15
-1.15
1.35
1.35
-1.15
-1.15
Buying a Condor (cont’d)

Long condor
1.35
25
27.50
30
0
26.15
1.15
25
31.35
32.50
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
1.35
27.50
Stock price at
option expiration
30
0
25
1.15
27
26.15
32.50
31.35
Spreads
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Introduction
Vertical spreads
Vertical spreads with calls
Vertical spreads with puts
Calendar spreads
Diagonal spreads
Butterfly spreads
Introduction

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
Vertical Spreads
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In a vertical spread, options are selected
vertically from the financial pages
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Vertical spreads with calls
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The options have the same expiration date
The spreader will long one option and short the
other
Bullspread
Bearspread
Bullspread
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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 APR 27.50 MSFT call
Write an APR 32.50 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 a 27.50/32.50 spread, you only need to look
at the stock prices from $27.50 to $32.50
Bullspread (cont’d)

Construct a profit and loss worksheet to form the
bullspread:
Stock Price at Option Expiration
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0
27.50
28.50
30.50
32.50
50
Long 27.50
call @ $3
-3
-3
-2
0
2
19.50
Short 32.50
call @ $1
1
1
1
1
1
-16.50
Net
-2
-2
-1
1
3
3
Bullspread (cont’d)
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Bullspread
3
Stock price at
option expiration
27.50
0
32.50
2
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29.50
Bearspread
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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 lower
striking price and writes the option with the
higher striking price
Vertical Spreads With Puts:
Bullspread
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
Involves using puts instead of calls
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Buy the option with the lower striking price
and write the option with the higher one
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 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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They have the same striking price
The spreader will long one option and short the
other
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
Calendar Spreads (cont’d)
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Calendar spreaders are concerned with
time decay
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Options are worth more the longer they have
until 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
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A butterfly spread can be constructed using
puts and calls
Butterfly Spreads(cont’d)
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Example of a butterfly spread
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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
Nonstandard Spreads:
Hedge Wrapper
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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
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The potential for further gain is reduced
Hedge Wraper
Hedge wraper
80
60
40
20
0
L46stock
L75put@3.75
Sh90call@3.5
Hedge Wrapper
-20
-40
-60
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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
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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:
Introduction
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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
debt and others a credit
Evaluating Spreads:
The Reward/Risk Ratio
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
Examine the maximum gain relative to the
maximum loss

E.g., if a call bullspread has a maximum
gain of $300.00 and a maximum loss of
$200.00, the reward/risk ratio is 1.50
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
Determining the Appropriate
Strategy: Some Final Thoughts

The basic steps involved in any decision
making process:
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Learn the fundamentals
Gather information
Evaluate alternatives
Make a decision