Chapter Four
Option Combinations and Spreads
Multiple Choice
1. Which of the following is most equivalent to writing a straddle?
a. buy stock, write two calls
b. buy stock, buy one put
c. short stock, buy one call
d. short stock, buy one put
ANSWER: A
2. The convergence phenomenon works most to the advantage of the
a. straddle buyer.
b. straddle writer.
c. put writer.
d. call writer.
ANSWER: B
3. A special feature of long butterfly spreads that attracts some speculators is the fact that they
a. sometimes appear to require no cash outlay.
b. have special margin requirements.
c. do not experience time value decay.
d. require a minimum of commission expense.
ANSWER: A
4. Which of the following is true regarding combined call writing?
a. The striking price is always above the stock price.
b. The striking price is always at or below the stock price.
c. There is more than one striking price.
d. There is a “synthetic” striking price created.
ANSWER: C
5. Which of the following is true regarding debit spreads?
a. They are a characteristic of call bull spreads.
b. They are a characteristic of all bull spreads.
c. They result in a cash inflow to your account.
d. They are a characteristic of all butterfly spreads.
ANSWER: A
6. Which of the following has the potential to lose the most money?
a. a long butterfly spread
b. a short strangle
c. a long strangle
d. a long condor
ANSWER: B
7. While of the following is a characteristic of a short condor?
a. It has four striking prices.
b. It is constructed with either puts or calls, but not both.
c. It has an unlimited maximum loss.
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Chapter 4. Option Combinations and Spreads
d. It is the addition of two bull spreads, one with calls and one with puts.
ANSWER: A
8. Which of the following terms is out of place?
a. time spread
b. calendar spread
c. horizontal spread
d. diagonal spread
ANSWER: D
9. Which of the following people would benefit most from time value decay?
a. someone with a put bull spread
b. someone with a call bull spread
c. someone with a long straddle
d. someone with a protective put
ANSWER: A
10. Which of the following is true regarding a hedge wrapper?
a. It often locks in a certain gain while foregoing some potential profits.
b. It reduces downside risk while leaving upside potential unlimited.
c. It involves buying a straddle while you are long the stock.
d. It can involve potentially unlimited losses.
ANSWER: A
11. Which of the following is most similar to writing a covered call?
a. writing a naked call
b. buying a protective put
c. writing a put and buying the stock
d. writing a put
ANSWER: D
12. Which of the following is false regarding debit spreads?
a. They are a characteristic of call bull spreads.
b. They are a characteristic of all bull spreads.
c. They result in a cash outlay from your account.
d. One example might be a long butterfly spread.
ANSWER: B
Short Answer/Problem
1. Suppose you buy 100 shares of EK at 79, and simultaneously write a MAR 80 straddle for $6.
Draw a profit/loss diagram and label all significant points.
7
76 ½
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Chapter 4. Option Combinations and Spreads
80
153
2. A butterfly spread involves writing two call options at one striking price, buying one call option
at a lower striking price, and buying one call option at a higher striking price.
Suppose you did this using JUN 300 calls ($4 ¼ each), JUN 305 calls ($2 ½), and JUN 310
calls ($1).
a. What is the maximum possible gain from this strategy?
b. What is the maximum possible loss?
c. What is the gain or loss if, at expiration, the underlying security sells for exactly 302?
ANSWER:
a.
b.
c.
$4 ¾
$¼
– 2 ¼ + 5 – 1 = $1 ¾ gain
3. A butterfly spread involves writing two call options at one striking price, buying one call option
at a lower striking price, and buying one call option at a higher striking price.
Suppose you did this using JUN 30 calls ($2 ¼ each), JUN 35 calls ($1 ¼), and JUN 40 calls
($ ½).
a.
What is the maximum possible gain from this strategy?
b.
What is the maximum possible loss?
c.
What is the gain or loss if, at expiration the underlying security sells for
exactly $32?
ANSWER:
a.
4¾
b.
¼
c.
–¼+2½-½=1¾
4. Suppose an investor does the following:
 Buys an OEX MAY 305 call option for $1;
 Writes an OEX MAY 300 call option for 1 7/8;
 Buys an OEX MAY 265 put option for 1 ½ ;
 Writes an OEX MAY 270 put option for 2 5/8.
These four positions mean that the investor has established a bear spread with the calls and a
bull spread with the puts.
Chapter 4. Option Combinations and Spreads
a. Fill in the profit/loss table below:
265
270
275
280
285
290
295
300
305
Buy May 305 call @ $1
Write May 300 call @ 1 7/8
Buy May 265 put @ 1 1/2
Write MAY 270 put @ 2 5/8
Net gain/loss
b. What are your maximum profit and your maximum loss with this strategy?
ANSWER:
a.
265
-1
Buy May 305 call @ $1
Write May 300 call @ 1 7/8 1 7/8
-1 ½
Buy May 265 put @ 1 1/2
Write MAY 270 put @ 2 5/8 -2 3/8
Net gain/loss -3
270
-1
1 7/8
-1 ½
2 5/8
2
275
-1
1 7/8
-1 ½
2 5/8
2
280
-1
1 7/8
-1 ½
2 5/8
2
285
-1
1 7/8
-1 ½
2 5/8
2
290
-1
1 7/8
-1 ½
2 5/8
2
295
-1
1 7/8
-1 ½
2 5/8
2
300
-1
1 7/8
-1 ½
2 5/8
2
305
-1
1 7/8
-1 ½
2 5/8
-3
b. The maximum gain is $2 at stock prices between 270 and 300; the maximum loss is $3 at prices
below 265 or above 305.
5. Comment of the accuracy of the following statement: “A person who owns 100 shares of stock
and writes two calls against it has essentially written a straddle.”
ANSWER:
The profit and loss diagram for a long stock position and two short calls is essentially the same as
a short straddle.
6. In the article “Further Evidence of the Influence of Option Expiration on the Underlying
Common Stock” by Strong and Andrew there is discussion of the “convergence phenomenon.”
What is the convergence phenomenon? If the phenomenon still exists, what options strategy
should be particularly attractive near option expiration?
ANSWER:
The convergence phenomenon refers to the alleged tendency for stock prices to move toward an
option striking price in the last few days before option expiration. If this occurs, writing straddles
should be especially attractive as the greatest profit occurs when the underlying asset closes at
the straddle striking price.
7. Construct a bull spread using the following options:
APR 40 put $ 2 ½
APR 45 put @ $6
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Chapter 4. Option Combinations and Spreads
ANSWER:
Buy
40 put
Write
45 put
Total
40
-2½
41
-2½
42
-2½
43
-2½
44
-2½
45
-2½
1
2
3
4
5
6
-1½
-½
½
1½
2½
3½