76 Part 2  Options spreads Table 8.2 Long SPY June 117–119 call spread SPDR 115 116 117 117.90 118 119 120 121 Spread debit –0.90 Value of spread at expiration 0 0 0.00 0.90 1.00 2.00 2.00 2.00 Profit/loss –0.90 –0.90 –0.90 0.00 0.10 1.10 1.10 1.10 *Short call spread Neutral to bearish strategy Suppose you are neutral to bearish on the S&P 500. With 45 days till expiration, June time decay is beginning to accelerate. You would like to collect premium if the index stays in its current range or if it declines, but you don’t want to risk the unlimited loss from a short call. You may then sell the June 117 call at 2.60, and in the same transaction pay 1.70 for the June 119 call, for a net credit of 0.90 Your position is known as the short call spread because it is similar to a short call. 4 The advantage of your spread is that it has a built-in stop-loss cover at the higher strike, or 119. You may think of this spread as a potential sale of the stock at 117, and a potential buy of the stock at 119. For this risk, you collect a premium. 4 This spread is also known as the bear call spread and the short vertical call spread. 1.5 1 0.5 0 –0.5 –1 115 116 117 118 119 120 121 Figure 8.1 Expiration profit/loss relating to Table 8.2 8  Call spreads and put spreads, or one by one directional spreads 77 The expiration profit/loss of this spread is opposite to the above long call spread, but the break-even level is the same. Here, the maximum profit is the credit received from the spread, or 0.90. This profit is earned if the stock is at or below the lower strike, or 117. The maximum loss occurs if the stock is at or above the higher strike. This is calculated as the difference between strike prices minus the income from the spread, or (119 – 117) – 0.90 = 1.10. The break-even level is the same as the long call spread. This is the level at which a loss due to an increase in the stock price matches the income from the spread. The calculation is the lower strike price plus the price of the spread, or 117 + 0.90 = 117.90. Below is a summary of this spread’s expiration profit/loss: Credit from short June 117 call: 2.60 Debit from long June 119 call: –1.70 ––––– Total credit: 0.90 Maximum profit: credit from spread: 0.90 Maximum loss: (difference between strikes) – credit from spread: (119 – 117) – 0.90 = 1.10 Break-even level: lower strike + credit from spread: 117 + 0.90 = 117.90 The risk/return potential from this spread is also opposite to the long call spread, or maximum loss divided by maximum return at 1.10/0.90. Here, a risk of each $110 offers a potential return of $90. Table 8.3 shows the expiration profit/loss for this short call spread. Table 8.3 Short SPY June 117–119 call spread SPDR 115 116 117 117.90 118 119 120 121 Spread credit 0.90 Value of spread at expiration 0 0 0.00 0.90 1.00 2.00 2.00 2.00 Profit/loss 0.90 0.90 0.90 0.00 –0.10 –1.10 –1.10 –1.10 The expiration profit/loss for this spread is graphed in Figure 8.2. 78 Part 2  Options spreads *Long put spread Bearish strategy The SPDR is currently trading at 115.22, and you are bearish, short term, on the S&P 500 index. You may wish to purchase the June 113 put to profit from a downside move. With 45 days till expiration, time decay is accelerating and the implied volatility is higher than it has been recently, so an expenditure of 3.10 or $310, may seem too great. Instead, you could sell the June 111 put at 2.60, and in the same transac- tion pay 3.10 for the June 113 put, for a total debit of 0.50. Your short put then effectively finances the purchase of your long put, and minimises your exposure to the Greeks. The trade-off is that your downside profit is limited by the 111 put, but at that point you have probably captured the best part of the move. Your analysis may tell you that the SPX is supported below 111, in which case your 111 put would effectively be the level at which you take the profit from your 113 put. In this case, you are buying the June 113–111 put spread. This position is known as the long put spread because it is similar to a long put. 5 You may simply think of this spread as a potential sale of the index (the ETF) at 113, and a potential buy of the index at 111. For this profit potential you pay a premium. In order to assess the profit/loss potential of the spread at expiration, first the price of the spread is considered as a unit: 0.50. 1 0.5 0 –0.5 –1 –1.5 115 116 117 118 119 120 121 Figure 8.2 Expiration profit/loss relating to Table 8.3 5 This spread is also known as the bear put spread and the long vertical put spread. 8  Call spreads and put spreads, or one by one directional spreads 79 At expiration, the maximum profit is gained if the stock is at or below the lower strike, or 111. This is calculated as the difference between strike prices minus the cost of the spread, or (113 – 111) – 0.50 = 1.50. The maximum loss is taken if the stock is at or above the higher strike, or 113, at expiration. This is calculated simply as the cost of the spread, or 0.50 . The break-even level is the level at which a decline in the stock pays for the cost of the spread. This is calculated as the higher strike minus the cost of the spread, or 113 – 0.50 = 112.50. The expiration profit/loss is summa- rised as follows: Debit from long June 113 put: –3.10 Credit from short June 111 put: 2.60 ––––– Total debit: –0.50 Maximum profit: difference between strikes – cost of spread: (113 – 111) – 0.50 = 1.50 Maximum loss: cost of spread: 0.50 Break-even level: higher strike – cost of spread: 113 – 0.50 = 112.50 The risk/return potential of this spread is maximum loss divided by maxi- mum profit, or 0.50/1.50. In other words you are risking $0.33 for each potential profit of $1.00, or a risk/return ratio of 1/3. 6 In tabular form the expiration profit/loss is as in Table 8.4. Table 8.4 Long SPY June 113–111 put spread Microsoft 109 110 111 112 112.50 113 114 115 Spread debit –0.50 Value of spread at expiration 2 2 2 1 0.50 0 0 0 Profit/loss 1.50 1.50 1.50 0.50 0 –0.50 –0.50 –0.50 6 This is a more justifiable R/R than we had with the 117–119 call spread. The reason why this put spread is cheaper than the call spread is because of the steep put skew. We’ll dis- cuss this later. 80 Part 2  Options spreads In graphic terms, the profit/loss of this spread is illustrated in Figure 8.3. *Short put spread Neutral to bullish strategy On the other hand, suppose that you are neutral to bullish on the SPX or the SPDR. Your analysis tells you that it is oversold, or that earnings prospects are better than expected. You would like to sell a put in order to profit either from time decay if the index stabilises or from a decline in the put’s value if the index rallies. At the same time, you do not want the exposure of a naked short put. You may then sell the June 113 put at 3.10, and in the same transaction pay 2.60 for the June 111 put, for a net credit of 0.50. This position is known as the short put spread because it is similar to a short put. 7 The advantage of this spread is that if the stock declines, a possible loss is cut at the lower strike, or 111. You may think of this spread as a potential buy of the stock at the higher strike, or 113, and a potential sale of the stock at the lower strike, or 111. For this potential risk you collect a premium. The expiration profit/loss of this short put spread is exactly opposite to the former long put spread. The maximum profit is earned if the stock is at or above the higher strike, or 113. This amount is simply the premium col- lected for the spread, or 0.50. The maximum loss occurs if the stock is at or below the lower strike, or 111. This is calculated as the difference between the strike prices minus the income from the spread: (113 – 111) – 0.50 = 1.50. 1.5 2 1 0.5 0 –0.5 –1 109 110 111 112 113 114 115 Figure 8.3 Expiration profit/loss relating to Table 8.4 7 This spread is also known as the bull put spread and the short vertical put spread. 8  Call spreads and put spreads, or one by one directional spreads 81 The break-even level is the level at which a decline in the stock matches the spread income. This is calculated as the higher strike minus the price of the spread, or 113 – 0.50 = 112.50. The profit/loss at expiration is summarised as follows: Credit from short June 113 put: 3.10 Debit from long June 111 put: –2.60 ––––– Total credit from spread: 0.50 Maximum profit: credit from spread: 0.50 Maximum loss: difference between strikes – credit from spread: (113 – 111) – 0.50 = 1.50 Break-even level: higher strike – credit from spread: 113 – 0.50 = 112.50 The risk/return potential for this spread is also opposite to the long put spread, at maximum loss divided by maximum profit, or 1.50/0.50. Here, you risk 3.0 to make 1.00. 8 In tabular form the expiration profit/loss is shown in Table 8.5. Table 8.5 Short SPY June 113–111 put spread SPY 109 110 111 112 112.5 113 114 115 Spread credit 0.50 Value of spread at expiration –2 –2 –2 –1 –0.50 0 0 0 Profit/loss –1.50 –1.50 –1.50 –0.50 0 0.50 0.50 0.50 The graph of the profit/loss position at expiration is shown in Figure 8.4. Long versus short call and put spreads So far we have seen that both a long call spread and a short put spread profit from an upside move. Likewise both a long put spread and a short 8 I wouldn’t, but many do because supposedly ‘It’ll never happen’. 82 Part 2  Options spreads call spread profit from a downside move. The question may arise as to which one is preferable. The basic difference is that of buying or selling premium, and the trade-offs are similar to straight long or short positions in calls or puts. If a long and a short spread are both out-of-the-money and equidistant from the underlying, the maximum profit of the long spread is greater than the maximum profit of the short spread, but the short spread has the greater probability to profit. The probability of either spread expiring in the money can be approxi- mated by the delta of the strike that is nearest the underlying. In the above examples, both the 117 call and the 113 put have a delta that is approxi- mately 0.40. If the index has a 40 per cent probability of moving to a strike in either direction, then the direction which is short has a 60 per cent probability of collecting its premium. The maximum loss, however, is greater with the short spread. The maximum profit, of course, favours the long spread, and this is a fair return for an outcome that is less probable. Premium sellers often short out-of-the-money spreads that are at a safe distance from the underlying because these spreads have limited risk. Premium buyers, however, can afford to place their position closer to the underlying because the cost of the spread is less than the cost of a straight call or put. Which strikes? Call spreads and put spreads can be created with any two strikes. Of course, there are trade-offs. (They don’t call them ‘options’ for nothing.) 0.5 1 0 –0.5 –1 –1.5 –2 109 110 111 112 113 114 115 Figure 8.4 Expiration profit/loss relating to Table 8.5 8  Call spreads and put spreads, or one by one directional spreads 83 If you spread the strikes, then you get a greater profit range but you pay more. You need to do technical analysis to determine which strikes to spread. Also, call spreads and put spreads can be any distance from the underlying. The trade-offs are similar to those between straight out-of-the- money and at-the-money calls or puts. The further a spread is from the underlying, the less cost or income it has, and the less probability it has of becoming in-the-money. 1×1s and volatility skews In the stock or bond markets, the out-of-the-money put spread often costs less than the equidistant out-of-the-money call spread. This is because the lower strike put is priced higher than the higher strike call, although they are the same distance from the underlying. In the above example, the 111 put is 2.60 while the 119 call is 1.70. This is a function of what are known as volatility skews, which are discussed in Part 3. In commodities, however, the call spreads are often cheaper than the equi- distant put spreads because there is a positive call skew. But don’t be bewildered at this point. If you spread 1×1s then you minimise your exposure to the skews. Long call spreads and long put spreads are the safest way to trade options. A final note The difference between a spread and a straight call or put is that the spread’s maximum profit/loss can be quantified at the outset. For the longs, the cost of the spread is the maximum loss, and if the trader is good with technicals, he can pick his levels. For the shorts, these spreads allow for premium selling with a built-in stop-loss order. On a risk/return basis they can be recommended to everyone, especially beginners. Long call spreads and long put spreads are the safest way to trade options 9 One by two directional spreads There are other ways of financing the purchase of a directional position. Those that we will discuss in this chapter are variations of the long call and put spreads. Again, they involve buying an option to take advantage of a chosen market direction. But instead of selling one, they sell two options at the strike price that is more distant from the underlying. The spreads in this chapter are suitable for slowly trending markets, and they are unsuitable for markets that are trending rapidly higher or lower, or volatile markets that are subject to sudden shifts in direction. Long one by two call spread Bullish strategy The long one by two call spread is a long call spread with an additional short call at the higher strike. If XYZ is at 100, you could buy one 105 call and sell two 115 calls in the same transaction. This spread is also known as the one by two ratio call spread or the one by two vertical call spread. In order to trade this spread, your outlook should call for the underlying to increase to a level that is near, but not substantially above, the higher strike. This spread, like the long call spread, has its maximum profit if the underlying is at the higher strike at expiration. It is less costly than the long call spread because it is financed by an extra short call. But because of the extra short call, this spread has the potential for unlimited loss if the underlying rallies substantially. The extra short call includes added expo- sure to the Greeks. [...]... less costly, and it is to buy an out-of -the- money option that is the same distance from the two short options as they are from the long option For example, if the spread is long one 105 call and short two 115 calls, and if XYZ rallies to 115, then the solution is to buy one 125 call Likewise, if the spread is long one 95 put and short two 85 puts, and if XYZ breaks to 85, then the solution is to buy one... points to 5.00 points We have also placed our break-even point further from the underlying How to manage the risk of the long ladder The risk of the long ladder is managed similarly to that of the long one by two If the underlying suddenly moves to the short strike that was formerly furthest out-of -the- money, the first solution is to buy back that strike The second solution is to buy the out-of -the- money... from the ladder as the three options in the ladder are from each other For example, if the ladder is long one 105 call, short one 110 call and short one 115 call, and if XYZ quickly rallies to 115, then the solution is to buy one 120 call Likewise, if the ladder is long one 95 put, short one 90 put and short one 85 put, and if XYZ suddenly breaks to 85, then the solution is to buy one 80 put In the. .. makes a sudden move to the short strike, with no sign of a retracement, the spread becomes subject to the delta and vega risk of the extra short option It is then advisable to cover the risk of this option There are two practical solutions: O The first is simply to buy back the extra short This cuts the loss on the position and leaves a net long call or put spread with limited risk O The second solution... analysis, etc: in other words, the basics of options I also increased our brokers’ knowledge, but mostly in terms of applications (Brokers seldom want to know about theory.) Then together we devised trade recommendations which the brokers passed on to their clients The clients did well One of them took one of our recommendations and bought a Bund put ladder at just the right time The Greeks and the levels... spread at the same strike This profit is calculated as the difference between the strike prices less the cost of the spread, or 60 – 55 – 0.77 = 4.23 Because of the extra short call there are two break-even levels The lower break-even level is, like the long call spread, the lower strike price plus the cost of the spread, or 55 + 0.77 = 55.77 The upper break-even level is the maximum profit plus the higher... more than the two above because the two options sold are the least expensive, but it has the greatest profit potential It also has the least potential risk because its upper break-even level is the furthest from the underlying Just remember that the major risk of the ladder lies with the extra short option Comparing call spreads, 1×2s and ladders At this point, it will be constructive to compare the data... from the spreads already discussed We want to examine costs, profit potentials, risks and break-even levels If we examine the call spreads, then we can apply the conclusions to the put spreads Refer to the table of Coca-Cola options above Coca-Cola at 52.67 August options, 100 days until expiration Try to develop your options awareness by taking a few minutes to analyse the data in Table 9.5 Compare the. .. data in Table 9.5 Compare the costs or incomes to the potential profits, and compare the potential profits to the upper break-even levels, etc The most risk averse spreads are obviously the two one by one call spreads Concerning the others, if the market moves in the direction of your short strike you may have to cover simply out of worry It is much easier to make trading decisions when your judgement... Here, the spread trades for a net debit of –0.89 At expiration, the maximum profit is earned when the stock closes between the lower two strikes, 45–40 In this case, because of the small spread debit, this profit is calculated as the difference between the higher two strikes minus the cost of the spread, or (50 – 45) – 0.89 = 4.11 The upper break-even level is the highest strike minus the cost of the . expiration): Strike 40 42 .50 45 47 .50 50 52 .50 55 57 .50 60 August calls 4.04 2 .52 1. 45 0.79 0.34 August puts 0.34 0.47 0.82 1.30 2. 05 2.90 Here, you could pay 1. 45 for one August 55 call and sell two August. 55 .00 57 .50 –60.00 call ladder Coca- Cola 52 .50 55 .00 55 .32 57 .50 60.00 62.18 65. 00 (above) Spread debit –0.32 Value of one by one spread at expiration 0.00 0.00 0.32 2 .50 2 .50 2 .50 2 .50 . 1 05 call and short two 1 15 calls, and if XYZ rallies to 1 15, then the solution is to buy one 1 25 call. Likewise, if the spread is long one 95 put and short two 85 puts, and if XYZ breaks to