Chapter 21: Synthetic Stock Positions Created by Puts and Calls 325
Because of the advantages of the option position in not having to pay out the
dividend and also having aslightly larger profit potential from the excess time value
premium, it may often be feasible for the trader who is looking to sell stock short to
instead sell acall and buy aput. It is also important for the strategist to understand
the equivalence between the short stock position and the option position. He might
be able to substitute the option position in certain cases when the short sale of stock
is normally called for.
SPLITTING THE STRIKES
The strategist may be able to use aslight variation of the synthetic strategy to set up
an aggressive, but attractive, position. Rather than using the same striking price for
the put and call, he can use alower striking price for the put and ahigher striking
price for the call. This action of splitting apart the striking prices gives him some
room for error, while still retaining the potential for large profits.
BULLISHLY ORIENTED
If an out-of-the-money put is sold naked, and an out-of-the-money call is simultane
ously purchased, an aggressive bullish position is established - often for acredit. If
the underlying stock rises far enough, profits can be generated on both the long call
and the short put. If the stock remains relatively unchanged, the call purchase will be
aloss, but the put sale will be aprofit. The risk occurs if the underlying stock drops
in price, producing losses on both the short put and the long call.
Example: The following prices exist: XYZ is at 53, a January 50 put is selling for 2,
and a January 60 call is selling for 1. An investor who is bullish on XYZ sells the
January 50 put naked and simultaneously buys the January 60 call. This position
brings in acredit of 1 point, less commissions. There is acollateral requirement
necessary for the naked put. If XYZ is anywhere between 50 and 60 at January
expiration, both options would expire worthless, and the investor would make asmall
profit equal to the amount of the initial credit received. If XYZ rallies above 60 by
expiration, however, his potential profits are unlimited, since he owns the call at 60.
His losses could be very large if XYZ should decline well below 50 before expiration,
since he has written the naked put at 50. Table 21-3 and Figure 21-1 depict the
results at expiration of this strategy.
Essentially, the investor who uses this strategy is bullish on the underlying stock
and is attempting to buy an out-of-the-money call for free. If he is moderately wrong

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326
TABLE 21-3.
Bullishly split strikes.
XYZ Price al January 50
Expirafion
40
45
50
55
60
65
70
FIGURE 21-1.
Bullishly split strikes.
Pu! Profil
-$800
- 300
+ 200
+ 200
+ 200
+ 200
+ 200
Part Ill: Put Option Strategies
January 60 Tolal
Call Profil Profif
-$100 -$ 900
- 100 400
- 100 + 100
- 100 + 100
- 100 + 100
+ 400 + 600
+ 900 + 1,100
Stock Price at Expiration
and the underlying stock rallies only slightly or even declines slightly, he can still
make asmall profit. If he is correct, of course, large profits could be generated in arally. He may lose heavily if he is very wrong and the stock falls by alarge amount
instead of rising.
This strategy is often useful when options are overpriced. Suppose that one has
abullish opinion on the underlying stock, yet is dismayed to find that the calls are
quite expensive. If he buys one of these expensive calls, he can mitigate the expen
siveness somewhat by also selling an out-of-the-money put, which is presumably

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Chapter 21: Synthetic Stock Positions Created by Puts and Calls 327
somewhat expensive also. Thus, if he is right about the bullish attitude on the stock,
he owns acall that is more "fairly priced" because its cost was reduced by the amount
of the put sale.
BEARISHLY ORIENTED
There is acompanion strategy for the investor who is bearish on astock. He could
attempt to buy an out-of-the-money put, giving himself the opportunity for substan
tial profits in astock price decline, and could "finance" the purchase of the put by
writing an out-of-the-money call naked. The sale of the call would provide profits if
the stock stayed below the striking price of the call, but could cost him heavily if the
underlying stock rallies too far.
Example: With XYZ at 65, the bearish investor buys a February 60 put for 2 points,
and simultaneously sells a February 70 call for 3 points. These trades bring in acred
it of 1 point, less commissions. The investor must collateralize the sale of the call. If
XYZ should decline substantially by February expiration, large profits are possible
because the February 60 put is owned. Even if XYZ does not perform as expected,
but still ends up anywhere between 60 and 70 at expiration, the profit will be equal
to the initial credit because both options will expire worthless. However, if the stock
rallies above 70, unlimited losses are possible because there is anaked call at 70.
Table 21-4 and Figure 21-2 show the results of this strategy at expiration.
This is clearly an aggressively bearish strategy. The investor would like to own
an out-of-the-money put for downside potential. In addition, he sells an out-of-the
money call, normally for aprice greater than that of the purchased put. The call sale
TABLE 21-4.
Bearishly split strikes.
XYZ Price at February 60 February 70 Total
Expiration Put Profit Call Profit Profit
50 +$800 +$300 +$1, 100
55 + 300 + 300 + 600
60 - 200 + 300 + 100
65 - 200 + 300 + 100
70 - 200 + 300 + 100
75 - 200 - 200 400
80 - 200 - 700 900

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328
FIGURE 21-2.
Bearishly split strikes.
C
0
e ·15.
Xw
Part Ill: Put Option Strategies
1u +$100
w $0 I-----------'------ ................. -----
~ 60
....J
0
~ a.
Stock Price at Expiration
essentially lets him own the put for free. In fact, he can still make profits even if the
underlying stock rises slightly or only falls slightly. His risk is realized if the stock rises
above the striking price of the written call.
This strategy of splitting the strikes in abearish manner is used very frequently
in conjunction with the ownership of common stock. That is, astock owner who is
looking to protect his stock will buy an out-of-the-money put and sell an out-of-the
money call to finance the put purchase. This strategy is called a "protective collar"
and was discussed in more detail in the chapter on Put Buying in Conjunction with
Common Stock Ownership. Astrategy that is similar to these, but modifies the risk,
is presented in Chapter 23, Spreads Combining Calls and Puts.
SUMMARY
In either of these aggressive strategies, the investor must have adefinite opinion
about the future price movement of the underlying stock. He buys an out-of-the
money option to provide profit potential for that stock movement. However, an
investor can lose the entire purchase proceeds of an out-of-the-money option if the
stock does not perform as expected. An aggressive investor, who has sufficient collat
eral, might attempt to counteract this effect by also writing an out-of-the-money
option to cover the cost of the option that he bought. Then, he will not only make
money if the stock performs as expected, but he will also make money if the stock
remains relatively unchanged. He will lose quite heavily, however, if the underlying
stock goes in the opposite direction from his original anticipation. That is why he
must have adefinite opinion on the stock and also be fairly certain of his timing.

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Basic Put Spreads
Put spreading strategies do not differ substantially in theory from their accompany-
;,,..,,. ,...,,1] v-n..-a<>rl vl-..-al-arriac Rol-hh11llich nnrl hP<>rich nocitionc r>!'.ln hP r>onctn1r>tPrl with .l.J..1.5 V(A,,1.1. .;Jt'.l.'\,.,U'L.L J\...l 1.Vf,A.VoJ• .Jl.,l''\Jl,....t..1. J.J\..1..1..1..1.V.a...._ f.4.1..1..._... ,._,...,_,'-4Ji.A.V..._.,._ ,t'"-"._,..._ ... ...__..._..._...,, .._,.__...,,._ -....,..., _.._,,.._.,....,,...,._ .....,._,_....,,_ , , ,,..._.,._""-
put spreads, as was also the case with call spreads. However, because puts are more
oriented toward downward stock movement than calls are, some bearish put spread
strategies are superior to their equivalent bearish call spread strategies.
The three simplest forms of option spreads· are:
1. the bull spread,
2. the bear spread, and
3. the calendar spread.
The same types of spreads that were constructed with calls can be established with
puts, but there are some differences.
BEAR SPREAD
In acall bear spread, acall with alower striking price was sold while acall at ahigh
er striking price was bought. Similarly, aput bear spread is established by selling aput at alower strike while buying aput at ahigher strike. The put bear spread is adebit spread. This is true because aput with ahigher striking price will sell for more
than aput with alower striking price. Thus, on astock with both puts and calls trad
ing, one could set up abear spread for acredit ( using calls) or alternatively set one
up for adebit (using puts):
329

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330
Put Bear Spread
Buy XYZ January 60 put
Sell XYZ January 50 put
(debit spread)
Part Ill: Put Option Strategies
Call Bear Spread
Buy XYZ January 60 call
Sell XYZ January 50 call
(credit spread)
The put bear spread has the same sort of profit potential as the call bear spread.
There is alimited maximum potential profit, and this profit would be realized if XYZ
were below the lower striking price at expiration. The put spread would widen, in this
case, to equal the difference between the striking prices. The maximum risk is also
limited, and would be realized if XYZ were anywhere above the higher striking price
at expiration.
Example: The following prices exist:
XYZ common, 55;
XYZ January 50 put, 2; and
XYZ January 60 put, 7.
Buying the January 60 put and selling the January 50 would establish abear
spread for a 5-point debit. Table 22-1 will help verify that this is indeed abearish
position. The reader will note that Figure 22-1 has the same shape as the call bear
spread'sgraph (Figure 8-1). The investment required for this spread is the net debit,
and it must be paid in full. Notice that the maximum profit potential is realized any
where below 50 at expiration, and the maximum risk potential is realized anywhere
above 60 at expiration. The maximum risk is always equal to the initial debit required
to establish the spread plus commissions. The break-even point is 55 in this example.
The following formulae allow one to quickly compute the meaningful statistics
regarding aput bear spread.
Maximum risk = Initial debit
Maximum profit = Difference between strikes - Initial debit
Break-even price = Higher striking price - Initial debit
Put bear spreads have an advantage over call bear spreads. With puts, one is
selling an out-of-the-money option when setting up the spread. Thus, one is not risk
ing early exercise of his written option before the spread becomes profitable. For the
written put to be in-the-money, and thus in danger of being exercised, the spread
would have to be profitable, because the stock would have to be below the lower
striking price. Such is not the case with call bear spreads. In the call spread, one sells
an in-the-money call as part of the bear spread, and thus could be at risk of early exer
cise before the spread has achance to become profitable.

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Chapter 22: Basic Put Spreads 331
TABLE 22-1.
Put bear spread.
XYZ Price at January 50 January 60 Total
Expiration Put Profit Put Profit Profit
40 -$800 +$1,300 +$500
45 - 300 + 800 + 500
50 + 200 + 300 + 500
55 + 200 200 0
60 + 200 700 - 500
70 + 200 700 - 500
80 + 200 700 - 500
FIGURE 22-1.
Put bear spread.
Stock Price at Expiration
Beside this difference in the probability of early exercise, the put bear spread
holds another advantage over the call bear spread. In the put spread, if the underly
ing stock drops quickly, thereby making both options in-the-rrwney, the spread will
normally widen quickly as well. This is because, as has been mentioned previously,
put options tend to lose time value premium rather quickly when they go into-the
money. In the example above, if XYZ rapidly dropped to 48, the January 60 put would
be near 12, retaining very little time premium. However, the January 50 put that is
short would also not retain much time value premium, perhaps selling at 4 points or

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332 Part Ill: Put Option Strategies
so. Thus, the spread would have widened to 8 points. Call bear spreads often do not
produce asimilar result on ashort-term downward movement. Since the call spread
involves being short acall with alower striking price, this call may actually pick up
time value premium as the stock falls close to the lower strike. Thus, even though the
call spread might have asimilar profit at expiration, it often will not perform as well
on aquick downward movement.
For these two reasons - less chance of early exercise and better profits on ashort-term movement - the put bear spread is superior to the call bear spread. Some
investors still prefer to use the call spread, since it is established for acredit and thus
does not require acash investment. This is arather weak reason to avoid the superi
or put spread and should not be an overriding consideration. Note that the margin
requirement for acall bear spread will result in areduction of one'sbuying power by
an amount approximately equal to the debit required for asimilar put bear spread.
(The margin required for acall bear spread is the difference between the striking
prices less the credit received from the spread.) Thus, the only accounts that gain any
substantial advantage from acredit spread are those that are near the minimum equi
ty requirement to begin with. For most brokerage firms, the minimum equity
requirement for spreads is $2,000.
BULL SPREAD
Abull spread can be established with put options by buying aput at alower striking
price and simultaneously selling aput with ahigher striking price. This, again, is the
same way abull spread was constructed with calls: selling the higher strike and buy
ing the lower strike.
Example: The same prices can be used:
XYZ common, 55;
XYZ January 50 put, 2; and
XYZ January 60 put, 7.
The bull spread is constructed by buying the January 50 put and selling the January
60 put. This is acredit spread. The credit is 5 points in this example. If the underly
ing stock advances by January expiration and is anywhere above 60 at that time, the
maximum profit potential of the spread will be realized. In that case, with XYZ any
where above 60, both puts would expire worthless and the spreader would make aprofit of the entire credit - 5 points in this example. Thus, the maximum profit poten
tial is limited, and the maximum profit occurs if the underlying stock rises in price

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Chapter 22: Basic Put Spreads 333
above the higher strike. These are the same qualities that were displayed by acall bull
spread (Chapter 7). The name "bull spread" is derived from the fact that this is abull
ish position: The strategist wants the underlying stock to rise in price.
The risk is limited in this spread. If the underlying stock should decline by expi
ration, the maximum loss will be realized with XYZ anywhere below 50 at that time.
The risk is 5 points in this example. To see this, note that if XYZ were anywhere below
50 at expiration, the differential between the two puts would widen to 10 points,
since that is the difference between their striking prices. Thus, the spreader would
have to pay 10 points to buy the spread back, or to close out the position. Since he
initially took in a 5-point credit, this means his loss is equal to 5 points - the 10-point
cost of closing out less the 5 points he received initially.
The investment required for abullish put spread is actually acollateral require
ment, since the spread is acredit spread. The amount of collateral required is equal
-1-r.. f-ha rliffa:rannci, hahuaan tho cfr-il;nrr r\rint::u.:- lace th.-:;). not nrorlit ror-A-iuorl fnr thA
\..Vl,,J...111._, Ul.J..J..V.lV.l.l.\..,V LIV\..VVVVJ..l '-- J.'L, oJ\..l..l.J.'-l.J.J..o .t'.l.J..\,.,VoJ J.VoJ,J I..J.J.'-' J..1.V\.. \,.,.l.V"-AJ.l.- .LVV'-'..l.Y'-'"'--4 .J..'-.-".I. .__...._.._ .......
spread. In this example, the collateral requirement is $500- the $1,000, or 10-point,
differential in the striking prices less the $500 credit received from the spread. Note
that the maximum possible loss is always equal to the collateral requirement in abull
ish put spread.
It is not difficult to calculate the break-even point in abullish spread. ·In this
example, the break-even point before commissions is 55 at expiration. With XYZ at
55 in January, the January 50 put would expire worthless and the January 60 put
would have to be bought back for 5 points. It would be 5 points in-the-money with
XYZ at 55. Thus, the spreader would break even, since he originally received 5 points
credit for the spread and would then pay out 5 points to close the spread. The fol
lowing formulae allow one to quickly compute the details of abullish put spread:
Maximum potential risk = Initial collateral requirement
= Difference in striking prices - Net credit received
Maximum potential profit= Net credit
Break-even price = Higher striking price - Net credit
CALENDAR SPREAD
In acalendar spread, anear-term option is sold and alonger-term option is bought,
both with the same striking price. This definition applies to either aput or acall cal
endar spread. In Chapter 9, it was shown that there were two philosophies available
for call calendar spreads, either neutral or bullish. Similarly, there are two philoso
phies available for put calendar spreads: neutral or bearish.

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334 Part Ill: Put Option Strategies
In aneutral calendar spread, one sets up the spread with the idea of closing the
spread when the near-term call or put expires. In this type of spread, the maximum
profit will be realized if the stock is exactly at the striking price at expiration. The
spreader is merely attempting to capitalize on the fact that the time value premium
disappears more rapidly from anear-term option than it does from alonger-term one.
Example: XYZ is at 50 and a January 50 put is selling for 2 points while an April 50
put is selling for 3 points. Aneutral calendar spread can be established for a 1-point
debit by selling the January 50 put and buying the April 50 put. The investment
required for this position is the amount of the net debit, and it must be paid for in
full. If XYZ is exactly at 50 at January expiration, the January 50 put will expire worth
less and the April 50 put will be worth about 2 points, assuming other factors are the
same. The neutral spreader would then sell the April 50 put for 2 points and take his
profit. The spreader'sprofit in this case would be one point before commissions,
because he originally paid a 1-point debit to set up the spread and then liquidates the
position by selling the April 50 put for 2 points. Since commission costs can cut into
available profits substantially, spreads should be established in alarge enough quan
tity to minimize the percentage cost of commissions. This means that at least 10
spreads should be set up initially.
In any type of calendar spread, the risk is limited to the amount of the net debit.
This maximum loss would be realized if the underlying stock moved substantially far
away from the striking price by the time the near-term option expired. If this hap
pened, both options would trade at nearly the same price and the differential would
shrink to practically nothing, the worst case for the calendar spreader. For example,
if the underlying stock drops substantially, say to 20, both the near-term and the long
term put would trade at nearly 30 points. On the other hand, if the underlying stock
rose substantially, say to 80, both puts would trade at avery low price, say 1/15 or 1/s,
and again the spread would shrink to nearly zero.
Neutral call calendar spreads are generally superior to neutral put calendar
spreads. Since the amount of time value premium is usually greater in acall option
(unless the underlying stock pays alarge dividend), the spreader who is interested in
selling time value would be better off utilizing call options.
The second philosophy of calendar spreading is amore aggressive one. With put
options, abearish strategy can be constructed using acalendar spread. In this case,
one would establish the spread with out-of-the-money puts.
Example: With XYZ at 55, one would sell the January 50 put for 1 point and buy the
April 50 put for 1 ½ points. He would then like the underlying stock to remain above
the striking price until the near-term January put expires. If this happens, he would

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Chapter 22: Basic Put Spreads 335
make the I-point profit from the sale of that put, reducing his net cost for the April
50 put to ½ point. Then, he would become bearish, hoping for the underlying stock
to decline in price substantially before April expiration in order that he might be able
to generate large profits on the April 50 put he holds.
Just as the bullish calendar spread with calls can be arelatively attractive strat
egy, so can the bearish calendar spread with puts. Granted, two criteria have to be
fulfilled in order for the position to work to the optimum: The near-term put must
expire worthless, and then the underlying stock must drop in order to generate prof
its on the long side. Although these conditions may not occur frequently, one prof
itable situation can more than make up for several losing ones. This is true because
the initial debit for abearish calendar spread is small, ½ point in the example above.
Thus, the losses will be small and the potential profits could be very large if things
work out right.
The aggressive spreader must be careful not to "leg out" of his spread, since he
could generate alarge loss by doing so. The object of the strategy is to accept arather
large number of small losses, with the idea that the infrequent large profits will more
than offset the sum of the losses. If one generates alarge loss somewhere along the
way, this may ruin the overall strategy. Also, if the underlying stock should fall to the
striking price before the near-term put expires, the spread will normally have
widened enough to produce asmall profit; that profit should be taken by closing the
spread at that time.

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Spreads Cotnbining
Calls and Puts
Certain types of spreads can be constructed that utilize both puts and calls. One of
these strategies has been discussed before: the butterfly spread. However, other
strategies exist that off er potentially large profits to the spreader. These other strate
gies are all variations of calendar spreads and/or straddles that involve both put and
call options.
THE BUTTERFLY SPREAD
This strategy has been described previously, although its usage in Chapter 10 was
restricted to constructing the spread with calls. Recall that the butterfly spread is aneutral position that has limited risk as well as limited profits. The position involves
three striking prices, utilizing abull spread between the lower two strikes and abear
spread between the higher two strikes. The maximum profit is realized at the middle
strike at expiration, and the maximum loss is realized if the stock is above the higher
strike or below the lower strike at expiration.
Since either abull spread or abear spread can be constructed with puts or calls,
it should be obvious that abutterfly spread ( consisting of both abull spread and abear spread) can be constructed in anumber of ways. In fact, there are four ways in
which the spread can be established. If option prices are fairly balanced - that is, the
arbitrageurs are keeping prices in line - any of the four ways will have the same
potential profits and losses at expiration of the options. However, because of the ways
in which puts and calls behave prior to their expiration, certain advantages or disad-
336

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Chapter 23: Spreads Combining Calls and Puts 331
vantages are connected with some of the methods of establishing the butterfly
spread.
Example: The following prices exist:
Strike:
Call:
Put:
XYZ common: 60
50
12
60
6
5
70
2
1 1
The method using only the calls indicates that one would buy the 50 call, sell two 60
calls, and buy the 70 call. Thus, there would be abull spread in the calls between the
50 and 60 strikes, and abear spread in the calls between the 60 and 70 strikes. In asimilar manner, one could establish abutterfly spread by combining either type of bull
spread between the 50 and 60 strikes with any type of bear spread between the 60 and
70 strikes. Some of these spreads would be credit spreads, while others would be debit
spreads. In fact, one'spersonal choice between two rather equivalent makeups of the
butterfly spread might be decided by whether there were acredit or adebit involved.
Table 23-1 summarizes the four ways in which the butterfly spread might be
constructed. In order to verify the debits and credits listed, the reader should recall
that abull spread consists of buying alower strike and selling ahigher strike, whether
puts or calls are used. Similarly, bear spreads with either puts or calls consist of buy
ing ahigher strike and selling alower strike. Note that the third choice - bull spread
with puts and bear spread with calls - is ashort straddle protected by buying the out
of-the-money put and call.
In each of the four spreads, the maximum potential profit at expiration is 8
points if the underlying stock is exactly at 60 at that time. The maximum possible loss
in any of the four spreads is 2 points, if the stock is at or above 70 at expiration or is
at or below 50 at expiration. For example, either the top line in the table, where the
spread is set up only with calls; or the bottom line, where the spread is set up only
with puts, has arisk equal to the debit involved - 2 points. The large-debit spread
(second line of table) will be able to be liquidated for aminimum of 10 points at expi
ration no matter where the stock is, so the risk is also 2 points. (It cost 12 points to
begin with.) Finally, the credit combination (third line) has amaximum buy-back of
10 points, so it also has risk of 2 points. In addition, since the striking prices are 10
points apart, the maximum potential profit is 8 points (maximum profit = striking
price differential minus maximum risk) in all the cases.

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338
TABLE 23-1.
Butterfly spread.
Bull Spread
(Buy Option at 50, ... plus ...
Sell at 60)
Calls (6 debit)
Calls (6 debit)
Puts (4 credit)
Puts (4 credit)
Bear Spread
(Buy Option at 70,
Sell at 60)
Calls (4 credit)
Puts (6 debit)
Calls (4 credit)
Puts (6 debit)
Part Ill: Put Option Strategies
Total Money
2 debit
12 debit
8 credit
2 debit
The factor that causes all these combinations to be equal in risk and reward is
the arbitrageur. If put and call prices get too far out of line, the arbitrageur can take
riskless action to force them back. This particular form of arbitrage, known as the box
spread, is described later, in Chapter 27, Arbitrage.
Even though all four ways of constructing the butterfly spread are equal at
expiration, some are superior to others for certain price movements prior to expira
tion. Recall that it was previously stated that bull spreads are best constructed with
calls, and bear spreads are best constructed with puts. Since the butterfly spread is
merely the combination of abull spread and abear spread, the best way to set up the
butterfly spread is to use calls for the bull spread and puts for the bear spread. This
combination is the one listed on the second line of Table 23-1. This strategy involves
the largest debit of the four combinations and, as aresult, many investors shun this
approach. However, all the other combinations involve selling an in-the-money put
or call at the outset, asituation that could lead to early exercise. The reader may also
recall that the credit combination, listed on the third line of Table 23-1, was previ
ously described as aprotected straddle position. That is, one sells astraddle and
simultaneously buys both an out-of-the-money put and an out-of-the-money call with
the same expiration month, as protection for the straddle. Thus, abutterfly spread is
actually the equivalent of acompletely protected straddle wiite.
Abutterfly spread is not an overly attractive strategy, although it may be useful
from time to time. The commissions required are extremely high, and there is no
chance of making alarge profit on the position. The limited risk feature is good to
have in aposition, but it alone cannot compensate for the less attractive features of
the strategy. Essentially, the strategist is looking for the stock to remain in aneutral
pattern until the options expire. If the potential profit is at least three times the max
imum 1isk (and preferably four times) and the underlying stock appears to be in trad
ing range, the strategy is feasible. Othe:nvise, it is not.

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Chapter 23: Spreads Combining Calls and Puts 339
COMBINING AN OPTION PURCHASE AND A SPREAD
It is possible to combine the purchase of acall and acredit put spread to produce aposition that behaves much like acall buy, although it has less risk over much of the
profit range. This strategy is often used when one has aquite bullish opinion regard
ing the underlying security, yet the call one wishes to purchase is "overpriced." In asimilar manner, if one is bearish on the underlying, he can sometimes combine the
purchase of aput with the sale of acall credit spread. Both approaches are described
in this section.
THE BULLISH SCENARIO
It sometimes happens that one arrives at abullish opinion regarding astock, only to
find that the options are very expensive. In fact, they may be so expensive as to pre
clude thoughts of making an outright call purchase. This might happen, for example,
if the stock has suddenly plummeted in price (perhaps during an ongoing, rapid bear
ish move by the overall stock market). To buy calls at this time would be overly risky.
If the underlying began to rally, it would often be the case that the implied volatility
of the calls would shrink, thus harming one'slong call position.
As acounter to this, it might make sense to buy the call, but at the same time
to sell aput credit spread. Recall that aput credit spread is abullish strategy.
Moreover, since it is presumed that the options are expensive on this particular stock,
the puts being used in the spread would be expensive as well. Thus, the credit
received from the spread would be slightly larger than "normal" because the options
are expensive.
Example: XYZ is selling at 100. One wishes to purchase the December 100 call as an
outright bullish speculation. That call is selling for 10. However, one determines that
the December 100 call is overpriced at these levels. (In order to make this determi
nation, one would use an option model whose techniques are described in Chapter
28 on mathematical applications.) Hence, he decides to use the following put spread
in addition to buying the December 100 call:
Sell December 90 put, 6
Buy December 80 put, 3
The sale of the put spread brings in a 3-point credit. Thus, his total expenditure for
the entire position is 7 points ( 10 for the December 100 call, less 3 credit from the sale
of the put spread). If one is correct about his bullish outlook for the stock (i.e., the
stock goes up), he can in some sense consider that he paid 7 for the call. Another way

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340 Part Ill: Put Option Strategies
to look at it is this: The sale of the put spread reduces the call price down to amore
moderate level, one that might be in line with its "theoretical value." In other words,
the call would not be considered expensive if it were priced at 7 instead of 10. The sale
of the put spread can be considered away to reduce the overall cost of the call.
Of course, the sale of the put spread brings some extra risk into the position
because, if the stock were to fall dramatically, the put spread could lose 7 points ( the
width of the strikes in the spread, 10 points, less the initial credit received, 3 points).
This, added to the call'scost of 10 points, means that the entire risk here is 17 points.
In fact, that is the margin required for this spread as well. Thus, the overall spread
still has limited risk, because both the call purchase and the put credit spread are lim
ited-risk strategies. However, the total risk of the two combined is larger than for
either one separately.
Remember that one must be bullish on the underlying in order to employ this
strategy. So, if his analysis is correct, the upside is what he wants to maximize. If he
is wrong on his outlook for the stock, then he needs to employ some sort of stop-loss
measures before the maximum risk of the position is realized.
The resulting position is shown in Figure 23-1, along with two other plots. The
straight line marked "Spread at expiration" shows how the profitability of the call pur
chase combined with abull spread would look at December expiration. In addition,
there is aplot with straight lines of the purchase of the December 100 call for 10
points. That plot can be compared with the three-way spread to see where extra risk
and reward occur. Note that the three-way spread does better than the outright pur
chase of the December 100 call as long as the stock is higher than 87 at expiration.
Since the stock is initially at 100 and,since one is initially bullish on the stock, one
would have to surmise that the odds of it falling to 87 are fairly small. Thus, the three
way spread outperforms the outright purchase of the call over alarge range of stock
prices.
The final plot in Figure 23-1 is that of the three-way spread'sprofit and losses
halfway to the expiration date. You can see that it looks much like the profitability of
merely owning acall: The curve has the same shape as the call pricing curve shown
in Chapter 1.
Hence, this three-way strategy can often be more attractive and more profitable
than merely owning acall option. Remember, though, that it does increase risk and
require alarger collateral deposit than the outright purchase of the at-the-money call
would. One can experiment with this strategy, too, in that he might consider buying
an out-of-the-money call and selling aput spread that brings in enough credit to com
pletely pay for the call. In that way, he would have no risk as long as the stock
remained above the higher striking price used in the put credit spread.

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Chapter 23: Spreads Combining Calls and Puts
FIGURE 23-1.
Call buy and put credit (bull) spread.
+$2,000
+$1,000
(/J
(/J
0 ..J
0 $0 -ea.
-$1,000
-$2,000
70 80
.... ,, -----,, -=-----'
THE BEARISH SCENARIO
~ Spread at Expiration
Call Buy Only, at Expiration
341
Stock
In asimilar manner, one can construct aposition to take advantage of abearish opin
ion on astock. Again, this would be most useful when the options were overpriced
and one felt that an at-the-money put was too expensive to purchase by itself.
Example: XYZ is trading at 80, and one has adefinite bearish opinion on the stock.
However, the December 80 put, which is selling for 8, is expensive according to an
option analysis. Therefore, one might consider selling acall credit spread (out-of-the
money) to help reduce the cost of the put. The entire position would thus be:
Buy 1 December 80 put:
Sell l December 90 call:
Buy 1 December 100 call:
Total cost:
8 debit
4 credit
2 debit
6 debit ($600)
The profitability of this position is shown in Figure 23-2. The straight line on that
graph shows how the position would behave at expiration. The introduction of the
call credit spread has increased the risk to $1,600 if the stock should rally to 100 or
higher by expiration. Note that the risk is limited since both the put purchase and the
call credit spread are limited-risk strategies. The margin required would be this max
imum risk, or $1,600.

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342 Part Ill: Put Option Strategies
FIGURE 23-2.
Put buy and call credit (bear) spread.
+$1,000 Halfway to Expiration
/
Stock
0 60 110
-ea.
-$1,000 At Expiration
-$2,000
The curved line on Figure 23-2 shows how the three-way spread would behave
if one looked at it halfway to its expiration date. In that case, it has acurved appear
ance much like the outright purchase of aput option.
Thus, this strategy could be appealing to bearishly-oriented traders, especially
when the options are expensive. It might have certain advantages over an outright put
purchase in that case, but it does require alarger margin investment and has theo
retically larger risk.
A SIMPLE FOLLOW-UP ACTION
FOR BULL OR BEAR SPREADS
Another way of combining puts and calls in aspread can sometimes be used when
one has abull or bear spread already in place. Suppose that one owns acall bull
spread and the underlying stock has advanced nicely. In fact, it is above both of the
strikes used in the spread. However, as is often the case, the bull spread may not have
widened out to its maximum profit potential. One can use the puts for two purposes
at this point: (1) to determine whether the call spread is trading at a "reasonable"
value, and (2) to try to lock in some profits. First, let'slook at an example of the "rea
sonable value" verification.

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Chapter 23: Spreads Combining Calls and Puts 343
Example: Atrader buys an XYZ call bull spread for 5 points. The spread uses the
January 70 calls and the January 80 calls. Later, XYZ advances to aprice of 88, but
there is still agood deal of time remaining in the options. Perhaps the spread has
widened out only to 7 points at that time. The trader finds it somewhat disappoint
ing that the spread has not widened out to its maximum profit potential of 10 points.
However, this is afairly common occurrence with bull and bear spreads, and is one
of the factors that may make them less attractive than outright call or put purchases.
In any case, suppose the following prices exist:
January 80 put, 5
January 70 put, 2
We can use these put prices to verify that the call spread is "in line." Notice that the
put spread is 3 points and the call spread is 7 points (both are the January 70-January
80 spread). Thus, they add up to 10 points the width of the strikes. When that
occurs, we can conclude that the spreads are "in line" and are trading at theoretical
ly correct prices.
Knowing this information doesn'thelp one make any more profits, but it does
provide some verification of the prices. Many times, one feels frustrated when he
sees that acall bull spread has not widened out as he expected it to. Using the put
spread as verification can help keep the strategist "on track" so that he makes ration
al, not emotional, decisions.
Now let'slook at asimilar example, in which perhaps the puts can be used to
lock in profits on acall bull spread.
Example: Using the same bull spread as in the previous example, suppose that one
owns an XYZ call bull spread, having bought the January 70 call and sold the January
80 call for adebit of 5 points. Now assume it is approaching expiration, and the stock
is once again at 88. At this time, the spread is theoretically nearing its maximum price
of 10. However, since both calls are fairly deeply in-the-money, the market-makers
are making very wide spreads in the calls. Perhaps these are the markets, with the
stock at 88 and only aweek or two remaining until expiration:
Coll
January 70 call
January 80 call
Bid Price
17.50
8.80
Asked Price
18.50
8.20
If one were to remove this spread at market prices, he would sell his long
January 70 call for 17.50 and would buy his short January 80 call back for 8.20, acred-

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344 Part Ill: Put Option Strategies
it of 9.30. Since the maximum value of the spread is l 0, one is giving away 70 cents,
quite abit for just such ashort time remaining.
However, suppose that one looks at the puts and finds these prices:
Put
January 80 put
January 70 put
Bid Price
0.20
none
Asked Price
0.40
0.10
One could "lock in" his call spread profits by buying the January 80 put for 40 cents.
Ignoring commissions for amoment, if he bought that put and then held it along with
the call spread until expiration, he would unwind the call spread for a 10 credit at
expiration. He paid 40 cents for the put, so his net credit to exit the spread would be
9.60 - considerably better than the 9.30 he could have gotten above for the call
spread alone.
This put strategy has one big advantage: If the underlying stock should sudden
ly collapse and tumble beneath 70 - admittedly, aremote possibility - large profits
could accrue. The purchase of the January 80 put has protected the bull spread'sprofits at all prices. But below 70, the put starts to make extra money, and the spread
er could profit handsomely. Such adrop in price would only occur if some material
ly damaging news surfaced regarding X'iZ Company, but it does occasionally happen.
If one utilizes this strategy, he needs to carefully consider his commission costs
and the possibility of early assignment. For aprofessional trader, these are irrelevant,
and so the professional trader should endeavor to exit bull spreads in this manner
whenever it makes sense. However, if the public customer allows stock to be assigned
at 80 and exercises to buy stock at 70, he will have two stock commissions plus one
put option commission. That should be compared to the cost of two in-the-money
call option commissions to remove the call spread directly. Furthermore, if the pub
lic customer receives an early assignment notice on the short January 80 calls, he may
need to provide day-trade margin as he exercises his January 70 calls the next day.
Without going into as much detail, abear spread'sprofits can be locked in via asimilar strategy. Suppose that one owns a January 60 put and has sold a January 50
put to create abear spread. Later, with the stock at 45, the spreader wants to remove
the spread, but again finds that the markets for the in-the-money puts are so wide
that he cannot realize anywhere near the 10 points that the spread is theoretically
worth. He should then see what the January 50 call is selling for. If it is fractionally
priced, as it most likely will be if expiration is drawing nigh, then it can be purchased
to lock in the profits from the put spread. Again, commission costs should be con
sidered by the public customer before finalizing his strategy.

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Chapter 23: Spreads Combining Calls and Puts 345
THREE USEFUL BUT COMPLEX STRATEGIES
The three strategies presented in this section are all designed to limit risk while
allowing for large potential profits if correct market conditions develop. Each is acombination strategy - that is, it involves both puts and calls and each is acalendar
strategy, in which near-term options are sold and longer-term options are bought. (Afourth strategy that is similar in nature to those about to be discussed is presented in
the next chapter.) Although all of these are somewhat complex and are for the most
advanced strategist, they do provide attractive risk/reward opportunities. In addition,
the strategies can be employed by the public customer; they are not designed strict
ly for professionals. All three strategies are described conceptually in this section;
specific selection criteria are presented in the next section.
A TWO-PRONGED ATTACK {THE CALENDAR COMBINATION}
Abullish calendar spread was shown to be arather attractive strategy. Abullish call
calendar spread is established with out-of-the-money calls for arelatively small debit.
If the near-term call expires worthless and the stock then rises substantially before
the longer-term call expires, the profits could potentially be large. In any case, the
risk is limited to the small debit required to establish the spread. In asimilar man
ner, the bearish calendar spread that uses put options can be an attractive strategy
as well. In this strategy, one would set up the spread with out-of-the-money puts. He
would then want the near-term put to expire worthless, followed by asubstantial drop
in the stock price in order to profit on the longer-term put.
Since both strategies are attractive by themselves, the combination of the two
should be attractive as well. That is, with astock midway between two striking prices,
one might set up abullish out-of-the-money call calendar spread and simultaneously
establish abearish out-of-the-money put calendar spread. If the stock remains rela
tively stable, both near-term options would expire worthless. Then asubstantial stock
price movement in either direction could produce large profits. With this strategy,
the spreader does not care which direction the stock moves after the near options
expire worthless; he only hopes that the stock becomes volatile and moves alarge dis
tance in either direction.
Example: Suppose that the following prices exist three months before the January
options expire:
January 70 call: 3
April 70 call: 5
XYZ common: 65
January 60 put: 2
April 60 put: 3

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346 Part Ill: Put Option Strategies
The bullish portion of this combination of calendar spreads would be set up by sell
ing the shorter-term January 70 call for 3 points and simultaneously buying the
longer-term April 70 call for 5 points. This portion of the spread requires a 2-point
debit. The bearish portion of the spread would be constructed using the puts. The
near-term January 60 put would be sold for 2 points, while the longer-term April 60
put would be bought for 3. Thus, the put portion of the spread is a I-point debit.
Overall, then, the combination of the calendar spreads requires a 3-point debit, plus
commissions. This debit is the required investment; no additional collateral is
required. Since there are four options involved, the commission cost will be large.
Again, establishing the spreads in quantity can reduce the percentage cost of com
missions.
Note that all the options involved in this position are initially out-of-the-money.
The stock is below the striking price of the calls and is above the striking price of the
puts. One has sold anear-term put and call combination and purchased alonger-term
combination. For nomenclature purposes, this strategy is called a "calendar combi
nation."
There are avariety of possible outcomes from this position. First, it should be
understood that the risk is limited to the amount of the initial debit, 3 points in this
example. If the underlying stock should rise dramatically or fall dramatically before
the near-term options expire, both the call spread and the put spread will shrink to
nearly nothing. This would be the least desirable result. In actual practice, the spread
would probably have asmall positive differential left even after apremature move by
the underlying stock, so that the probability of aloss of the entire debit would be
small.
If the near-term options both expire worthless, aprofit will generally exist at
that time.
Example: IfXYZ were still at 65 at January expiration in the prior example, the posi
tion should be profitable at that time. The January call and put would expire worth
less with XYZ at 65, and the April options might be worth atotal of 5 points. The
spread could thus be closed for aprofit with XYZ at 65 in January, since the April
options could be sold for 5 points and the initial "cost" of the spread was only 3 points.
Although commissions would substantially reduce this 2-point gross profit, there
would still be agood percentage profit on the overall position. If the strategist decides
to take his profit at this time, he would be operating in aconservative manner.
However, the strategist may want to be more aggressive and hold onto the April
combination in hopes that the stock might experience asubstantial movement before
those options expire. Should this occur, the potential profits could be quite large.

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Chapter 23: Spreads Combining Calls and Puts 347
Example: If the stock were to undergo avery bullish move and rise to 100 before
April expiration, the April 70 call could be sold for 30 points. (The April 60 put would
expire worthless in that case.) Alternatively, if the stock plunged to 30 by April expi
ration, the put at 60 could be sold for 30 points while the call expired worthless. In
either case, the strategist would have made asubstantial profit on his initial 3-point
investment.
It may be somewhat difficult for the strategist to decide what he wants to do
after the near-term options expire worthless. He may be torn between taking the lim
ited profit that is at hand or holding onto the combination that he owns in hopes of
larger profits. Areasonable approach for the strategist to take is to do nothing imme
diately after the near-term options expire worthless. He can hold the longer-term
options for some time before they will decay enough to produce aloss in the posi
tion. Referring again to the previous example, when the January options expire
worthless, the strategist then owns the April combination, which is worth 5 points at
that time. He can continue to hold the April options for perhaps 6 or 8 weeks before
they decay to avalue of 3 points, even if the stock remains close to 65. At this point,
the position could be closed for anet loss of the .commission costs involved in the var
ious transactions.
As ageneral rule, one should be willing to hold the combination, even if this
means that he lets asmall profit decay into aloss. The reason for this is that one
should give himself the maximum opportunity to realize large profits. He will proba
bly sustain anumber of small losses by doing this, but by giving himself the oppor
tunity for large profits, he has areasonable chance of having the profits outdistance
the losses.
There is atime to take small profits in this strategy. This would be when either
the puts or the calls were slightly in-the-money as the near-term options expire.
Example: IfXYZ moved to 71 just as the January options were expiring, the call por
tion of the spread should be closed. The January 70 call could be bought back for 1
point and the April 70 call would probably be worth about 5 points. Thus, the call
portion of the spread could be "sold" for 4 points, enough to cover the entire cost of
the position. The April 60 put would not have much value with the stock at 71, but it
should be held just in case the stock should experience alarge price decline. Similar
results would occur on the put side of the spread if the underlying stock were slight
ly in-the-money, say at 58 or 59, at January expiration. At no time does the strategist
want to risk being assigned on an option that he is short, so he must always close the
portion of the position that is in-the-money at near-term expiration. This is only nec
essary, of course, if the stock has risen above the striking price of the calls or has fall
en below the striking price of the puts.

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348 Part Ill: Put Option Strategies
In summary, this is areasonable strategy if one operates it over aperiod of time
long enough to encompass several market cycles. The strategist must be careful not
to place alarge portion of his trading capital in the strategy, however, since even
though the losses are limited, they still represent his entire net investment. Avaria
tion of this strategy, whereby one sells more options than he buys, is described in the
next chapter.
THE CALENDAR STRADDLE
Another strategy that combines calendar spreads on both put and call options can be
constructed by selling anear-term straddle and simultaneously purchasing alonger
term straddle. Since the time value premium of the near-term straddle will decrease
more rapidly than that of the longer-term straddle, one could make profits on alim
ited investment. This strategy is somewhat inferior to the one described in the pre
vious section, but it is interesting enough to examine.
Example: Suppose that three months before January expiration, the following prices
exist:
XYZ common: 40
January 40 straddle: 5 April 40 straddle: 7
Acalendar spread of the straddles could be established by selling the January 40
straddle and simultaneously buying the April 40 straddle. This would involve acost
of 2 points, or the debit of the transaction, plus commissions.
The risk is limited to the amount of this debit up until {he time the near-term
straddle expires. That is, even if XYZ moves up in price by asubstantial amount or
declines in price by asubstantial amount, the worst that can happen is that the dif
ference between the straddle prices shrinks to zero. This could cause one to lose an
amount equal to his original debit, plus commissions. This limit on the risk applies
only until the near-term options expire. If the strategist decides to buy back the near
term straddle and continue to hold the longer-term one, his risk then increases by the
cost of buying back the near-term straddle.
Example: XYZ is at 43 when the January options expire. The January 40 call can now
be bought back for 3 points. The put expires worthless; so the whole straddle was
closed out for 3 points. The April 40 straddle might be selling for 6 points at that
time. If the strategist wants to hold on to the April straddle, in hopes that the stock
might experience alarge price swing, he is free to do so after buying back the January

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Chapter 23: Spreads Combining Calls and Puts 349
40 straddle. However, he has now invested atotal of 5 points in the position: the orig
inal 2-point debit plus the 3 points that he paid to buy back the January 40 straddle.
Hence, his risk has increased to 5 points. If XYZ were to be at exactly 40 at April expi
ration, he would lose the entire 5 points. While the probability of losing the entire 5
points must be considered small, there is asubstantial chance that he might lose
more than 2 points his original debit. Thus, he has increased his risk by buying back
the near-term straddle and continuing to hold the longer-term one.
This is actually aneutral strategy. Recall that when calendar spreads were dis
cussed previously, it was pointed out that one establishes aneutral calendar spread
with the stock near the striking price. This is true for either acall calendar spread or
aput calendar spread. This strategy - acalendar spread with straddles is merely the
combination of aneutral call calendar spread and aneutral put calendar spread.
Moreover, recall that the neutral calendar spreader generally establishes the position
with the intention of closing it out once the near-term option expires. He is mainly
interested in selling time in an attempt to capitalize on the fact that anear-term
option loses time value premium more rapidly than alonger-term option does. The
straddle calendar spread should be treated in the same manner. It is generally best
to close it out at near-term expiration. If the stock is near the striking price at that
time, aprofit will generally result. To verify this, refer again to the prices in the pre
ceding paragraph, with XYZ at 43 at January expiration. The January 40 straddle can
be bought back for 3 points and the April 40 straddle can be sold for 6. Thus, the dif
ferential between the two straddles has widened to 3 points. Since the original dif
ferential was 2 points, this represents aprofit to the strategist.
The maximum profit would be realized if XYZ were exactly at the striking price
at near-term expiration. In this case, the January 40 straddle could be bought back
for avery small fraction and the April 40 straddle might be worth about 5 points. The
differential would have widened from the original 2 points to nearly 5 points in this
case.
This strategy is inferior to the one described in the previous section (the "calen
dar combination"). In order to have achance for unlimited profits, the investor must
increase his net debit by the cost of buying back the near-term straddle.
Consequently, this strategy should be used only in cases when the near-term straddle
appears to be extremely overpriced. Furthermore, the position should be closed at
near-term expiration unless the stock is so close to the striking price at that time that
the near-term straddle can be bought back for afractional price. This fractional buy
back would then give the strategist the opportunity to make large potential profits
with only asmall increase in his risk. This situation of being able to buy back the near
term straddle at afractional price will occur very infrequently, much more infre-

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350 Part Ill: Put Option Strategies
quently than the case in which both the out-of-the-money put and call expire worth
less in the previous strategy. Thus, the "calendar combination" strategy will afford the
spreader more opportunities for large profits, and will also never force him to
increase his risk.
OWNING A ✓,,FREE" COMBINATION (THE ""DIAGONAL
BUTTERFLY SPREAD")
The strategies described in the previous sections are established for debits. This
means that even if the near-term options expire worthless, the strategist still has risk.
The long options he then holds could proceed to expire worthless as well, thereby
leaving him with an overall loss equal to his original debit. There is another strategy
involving both put and call options that gives the strategist the opportunity to own a
"free" combination. That is, the profits from the near-term options could equal or
exceed the entire cost of his long-term options.
This strategy consists of selling anear-term straddle and simultaneously pur
chasing both alonger-term, out-of the-money call and alonger-term, out-of the
money put. This differs from the protected straddle write previously described in that
the long options have amore distant maturity than do the short options.
Example:
XYZ common: 40
April 35 put:
January 40 straddle:
April 45 call:
If one were to sell the short-term January 40 straddle for 7 points and simultaneous
ly purchase the out-of-the-money put and call combination -April 35 put and April
45 call - he would establish acredit spread. The credit for the position is 3 points less
commissions, since 7 points are brought in from the straddle sale and 4 points are
paid for the out-of-the-money combination. Note that the position technically con
sists of abearish spread in the calls - buy the higher strike and sell the lower strike -
coupled with abullish spread in the puts - buy the lower strike and sell the higher
strike. The investment required is in the form of collateral since both spreads are
credit spreads, and is equal to the differential in the striking prices, less the net cred
it received. In this example, then, the investment would be 10 points for the striking
price differential (5 points for the calls and 5 points for the puts) less the 3-point
credit received, for atotal collateral requirement of $700, plus commissions.

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Chapter 23: Spreads Combining Calls and Puts 351
The potential results from this position may vary widely. However, the risk is
limited before near-tenn expiration. If the underlying stock should advance substan
tially before January expiration, the puts would be nearly worthless and the calls
would both be trading near parity. With the calls at parity, the strategist would have
to pay, at most, 5 points to close the call spread, since the striking prices of the calls
are 5 points apart. In asimilar manner, if the underlying stock had declined substan
tially before the near-term January options expired, the calls would be nearly worth
less and the puts would be at parity. Again, it would cost amaximum of 5 points to
close the put spread, since the difference in the striking prices of the puts is also 5
points. The worst result would be a 2-point loss in this example - 3 points of credit
were initially received, and the most that the strategist would have to pay to close the
position is 5 points. This is the theoretical risk. In actual practice, it is very unlikely
that the calls would trade as much as 5 points apart, even if the underlying stock
advanced by alarge amount, because the longer-term call should retain some small
time value premium even if it is deeply in-the-money. Asimilar analysis might apply
to the puts. The risk can always be quickly computed as being equal to the difference
between two contiguous striking prices ( two strikes next to each other), less the net
credit received.
The strategist'sobjective with this position is to be able to buy back the near
tenn straddle for aprice less than the original credit received. If he can do this, he
will own the longer-term combination for free.
Example: Near January expiration, the strategist is able to repurchase the January 40
straddle for 2 points. Since he initially received a 3-point credit and is then able to
buy back the written straddle for 2 points, he is left with an overall credit in the posi
tion of 1 point, less commissions. Once he has done this, the strategist retains the
long options, the April 35 put and April 45 call. If the underlying stock should then
advance substantially or decline substantially, he could make very large profits.
However, even if the long combination expires worthless, the strategist still makes aprofit, since he was able to buy the straddle back for less than the amount of the orig
inal credit.
In this example, the strategist'sobjective is to buy back the January 40 straddle
for less than 3 points, since that is the amount of the initial credit. At expiration, this
would mean that the stock would have to be between 37 and 43 for the buy-back to
be made for 3 points or less. Although it is possible, certainly, that the stock will be
in this fairly narrow range at near-term expiration, it is not probable. However, the
strategist who is willing to add to his risk slightly can often achieve the same result by
"legging out" of the January 40 straddle. It has repeatedly been stated that one should

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352 Part Ill: Put Option Strategies
not attempt to leg out of aspread, but this is an exception to that rule, since one owns
along combination and therefore is protected; he is not subjecting himself to large
risks by attempting to "leg out" of the straddle he has written.
Example: XYZ rallies before January expiration and the January 40 put drops to aprice of ½ during the rally. Even though there is time remaining until expiration, the
strategist might decide to buy back the put at ½. This could potentially increase his
overall risk by ½ point if the stock continues to rise. However, if the stock then
reversed itself and fell, he could attempt to buy the call back at 2½ points or less. In
this manner, he would still achieve his objective of buying the short-term straddle
back for 3 points or less. In fact, he might be able to close both sides of the straddle
well before near-term expiration if the underlying stock first moves quickly in one
direction and then reverses direction by alarge amount.
The maximum risk and the optimum potential objectives have been described,
but interim results might also be considered in this strategy.
Example: XYZ is at 44 at January expiration. The January 40 straddle must be bought
back for 4 points. This means that the long combination will not be owned free, but
will have acost of Ipoint plus commissions. The strategist must decide at this time
if he wants to hold on to the April options or if he wants to sell them, possibly pro
ducing asmall overall profit on the entire position. There is no ironclad rule in this
type of situation. If the decision is made to hold on to the longer-term options, the
strategist realizes that he has assumed additional risk by doing so. Nevertheless, he
may decide that it is worth owning the long combination at arelatively low cost. The
cost in this example would be Ipoint plus commissions, since he paid 4 points to buy
back the straddle after only taking in a 3-point credit initially. The more ex.pensive the
buy-back of the near-term straddle is, the more the strategist should be readily will
ing to sell his long options at the same time. For example, if XYZ were at 48 at
January expiration and the January 40 straddle had to be bought back for 8 points,
there should be no question that he should simultaneously sell his April options as
well. The most difficult decisions come when the stock is just outside the optimum
buy-back area at near-term expiration. In this example, the strategist would have afairly difficult decision if XYZ were in the 44 to 45 area or in the 35 to 36 area at
January expiration.
The reader may recall that, in Chapter 14 on diagonalizing aspread, it was men
tioned that one is sometimes able to own acall free by entering into adiagonal cred
it spread. Adiagonal bear spread was given as an example. The same thing happens
to be true of adiagonal bullish put spread, since that is acredit spread as well. The

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Chapter 23: Spreads Combining Calls and Puts 3S3
strategy discussed in this section is merely acombination of adiagonal bearish call
spread and adiagonal bullish put spread and is known as a "diagonal butterfly
spread." The same concept that was described in Chapter 14 - being able to make
more on the short-term call than one originally paid for the long-term call - applies
here as well. One enters into acredit position with the hope of being able to buy back
the near-term written options for aprofit greater than the cost of the long options. If
he is able to do this, he will own options for free and could make large profits if the
underlying stock moves substantially in either direction. Even if the stock does not
move after the buy-back, he still has no risk. The risk occurs prior to the expiration
of the near-term options, but this risk is limited. As aresult, this is an attractive strat
egy that, when operated over aperiod of market cycles, should produce some large
profits. Ideally, these profits would offset any small losses that had to be taken. Since
large commission costs are involved in this strategy, the strategist is reminded that
establishing the spreads in quantity can help to reduce the percentage effect of the
commissions.
SELECTING THE SPREADS
Now that the concepts of these three strategies have been laid out, let us define
selection criteria for them. The "calendar combination" is the easiest of these strate
gies to spot. One would like to have the stock nearly halfway between two striking
prices. The most attractive positions can normally be found when the striking prices
are at least 10 points apart and the underlying stock is relatively volatile. The opti
mum time to establish the "calendar combination" is two or three months before the
near-term options expire. Additionally, one would like the sum of the prices of the
near-term options to be equal to at least one-half of the cost of the longer-term
options. In the example given in the previous section on the "calendar combination,"
the near-term combination was sold for 5 points, and the longer-term combination
was bought for 8 points. Thus, the near-term combination was worth more than one
half of the cost of the longer-term combination. These five criteria can be summa
rized as follows:
1. Relatively volatile stock.
2. Stock price nearly midway between two strikes.
3. Striking prices at least 10 points apart.
4. Two or three months remaining until near-term expiration.
5. Price of near-term combination greater than one-half the price of the longer
term combination.

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354 Part Ill: Put Option Strategies
Even though five criteria have been stated, it is relatively easy to find aposition that
satisfies all five conditions. The strategist may also be able to rely upon technical
input. If the stock seems to be in anear-term trading range, the position may be more
attractive, for that would indicate that the chances of the near-term combination
expiring worthless are enhanced.
The "calendar straddle" is astrategy that looks deceptively attractive. As the
reader should know by now, options do not decay in alinear fashion. Instead, options
tend to hold time value premium until they get quite close to expiration, when the
time value premium disappears at afast rate. Consequently, the sale of anear-term
straddle and the simultaneous purchase of alonger-term straddle often appear to be
attractive because the debit seems small. Again, certain criteria can be set forth that
will aid in selecting areasonably attractive position. The stock should be at or very
near the striking price when the position is established. Since this is basically aneu
tral strategy, one that offers the largest potential profits at near-term expiration, one
should want to sell the most time premium possible. This is why the stock must be
near the striking price initially. The underlying stock does not have to be avolatile
one, although volatile stocks will most easily satisfy the next two criteria. The near
term credit should be at least two-thirds of the longer-term debit. In the example
used to explain this strategy, the near-term straddle was sold for 5, while the longer
term straddle was bought for 7 points. Thus, the near-term straddle was worth more
than two-thirds of the longer-term straddle'sprice. Finally, the position should be
established with two to four months remaining until near-term expiration. If positions
with alonger time remaining are used, there is asignificant probability that the
underlying stock will have moved some distance away from the striking price by the
time the near-term options expire. Summarizing, the three criteria for a "calendar
straddle" are:
1. Stock near striking price initially.
2. Two to four months remaining until near-term expiration.
3. Near-term straddle price at least two-thirds of longer-term straddle price.
The "diagonal butterfly" is the most difficult of these three types of positions to
locate. Again, one would like the stock to be near the middle striking price when the
position is established. Also, one would like the underlying stock to be somewhat
volatile, since there is the possibility that long-term options will be owned for free. If
this comes to pass, the strategist wants the stock to be capable of alarge move in
order to have achance of generating large profits. The most restrictive criterion -:
one that will eliminate all but afew possibilities on adaily basis - is that the near
term straddle price should be at least one and one-half times that of the longer-term,

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Chapter 23: Spreads Combining Calls and Puts 355
out-of-the-money combination. By adhering to this criterion, one gives himself area
sonable chance of being able to buy the near-term straddle back for aprice low
enough to result in owning the longer-term options for free. In the example used to
describe this strategy, the near-term straddle was sold for 7 while the out-of-the
money, longer-term combination cost 4 points. This satisfies the criterion. Finally,
one should limit his possible risk before near-term expiration. Recall that the risk is
equal to the difference between any two contiguous striking prices, less the net cred
it received. In the example, the risk would be 5 minus 3, or 2 points. The risk should
always be less than the credit taken in. This precludes selling anear-term straddle at
80 for 4 points and buying the put at 60 and the call at 100 for acombined cost of 1
point. Although the credit is substantially more than one and one-half times the cost
of the long combination, the risk would be ridiculously high. The risk, in fact, is 20
points ( the difference between two contiguous striking prices) less the 3 points cred
it, or 17 points - much too high.
The criteria can be summarized as follows:
1. Stock near middle striking price initially.
2. Three to four months to near-term expiration.
3. Price of written straddle at least one and one-half times that of the cost of the
longer-term, out-of-the-money combination.
4. Risk before near-term expiration less than the net credit received.
One way in which the strategist may notice this type of position is when he sees arel
atively short-term straddle selling at what seems to be an outrageously high price.
Professionals, who often have agood feel for astock'sshort-term potential, will some
times bid up straddles when the stock is about to make avolatile move. This will
cause the near-term straddles to be very overpriced. When astraddle seller notices
that aparticular straddle looks too attractive as asale, he should consider establish
ing adiagonal butterfly spread instead. He still sells the overpriced straddle, but also
buys alonger-term, out-of-the-money combination as ahedge against alarge loss.
Both factions can be right. Perhaps the stock will experience avery short-term
volatile movement, proving that the professionals were correct. However, this will
not worry the strategist holding adiagonal butterfly, for he has limited risk. Once the
short-term move is over, the stock may drift back toward the original strike, allowing
the near-term straddle to be bought back at alow price - the eventual objective of
the strategist utilizing the diagonal butterfly spread.
These are admittedly three quite complex strategies and thus are not to be
attempted by anovice investor. If one wants to gain experience in how he would
operate such astrategy, it would be far better to operate a "paper strategy" for a

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356 Part Ill: Put Option Strategies
while. That is, one would not actually make investments, but would instead follow
prices in the newspaper and make day-to-day decisions without actual risk. This will
allow the inexperienced strategist to gain afeel for how these complex strategies per
form over aparticular time period. The astute investor can, of course, obtain price
history information and track anumber of market cycles in this same way.
SUMMARY
Puts and call can be combined to make some very attractive positions. The addition
of acall or put credit spread to the outright purchase of aput or call can enhance the
overall profitability of the position, especially if the options are expensive. In addi
tion, three advanced strategies were presented that combined puts and calls at vari
ous expiration dates. These three various types of strategies that involve calendar
combinations of puts and calls may all be attractive. One should be especially alert
for these types of positions when near-term calls are overpriced. Typically, this would
be during, or just after, abullish period in the stock market. For nomenclature pur
poses, these three strategies are called the "calendar combination," the "calendar
straddle," and the "diagonal butterfly."
All three strategies offer the possibility of large potential profits if the underly
ing stock remains relatively stable until the near-term options expire. In addition, all
three strategies have limited risk, even if the underlying stock should move explo
sively in either direction prior to near-term expiration. If an intermediate result
occurs - for example, the stock moves amoderate distance in either direction before
near-term expiration - it is still possible to realize alimited profit in any of the strate
gies, because of the fact that the time premiums decay much more rapidly in the
near-term options than they do in the longer-term options.
The three strategies have many things in common, but each has its own advan
tages and disadvantages. The "diagonal butterfly" is the only one of the three strate
gies whereby the strategist has apossibility of owning free options. Admittedly, the
probability of actually being able to own the options completely for free is small.
However, there is arelatively large probability that one can substantially reduce the
cost of the long options. The "calendar combination," the first of the three strategies
discussed, offers the largest probability of capturing the entire near-term premium.
This is because both near-term options are out-of-the-money to begin with. The "cal
endar straddle" offers the largest potential profits at near-term expiration. That is, if
the stock is relatively unchanged from the time the position was established until the
time the near-term options expire, the "calendar straddle" will show the best profit
of the three strategies at that time.

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Chapter 23: Spreads Combining Calls and l'uts 357
Looking at the negative side, the "calendar straddle" is the least attractive of the
three strategies, primarily because one is forced to increase his risk after near-term
expiration, if he wants to continue to hold the longer-term options. It is often diffi
cult to find a "diagonal butterfly" that offers enough credit to make the position
attractive. Finally, the "calendar combination" has the largest probability oflosing the
entire debit eventually, because one may find that the longer-term options expire
worthless also. (They are out-of-the-money to begin with, just as the near-term
options were.)
The strategist will not normally be able to find alarge number of these positions
available at attractive price levels at any particular time in the market. However, since
they are attractive strategies with little or no margin collateral requirements, the
strategist should constantly be looking for these types of positions. Acertain amount
of cash or collateral should be reserved for the specific purpose of utilizing it for
these types of positions - perhaps 15 to 20% of one'sdollars.

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Ratio Spreads Using Puts
The put option spreader may want to sell more puts than he owns. This creates aratio
spread. Basically, two types of put ratio spreads may prove to be attractive: the stan
dard ratio put spread and the ratio calendar spread using puts. Both strategies are
designed for the more aggressive investor; when operated properly, both can present
attractive reward opportunities.
THE RATIO PUT SPREAD
This strategy is designed for aneutral to slightly bearish outlook on the underlying
stock. In aratio put spread, one buys anumber of puts at ahigher strike and sells
more puts at alower strike. This position involves naked puts, since one is short more
puts than he is long. There is limited upside risk in the position, but the downside risk
can be very large. The maximum profit can be obtained if the stock is exactly at the
striking price of the written puts at expiration.
Example: Given the following:
XYZ common, 50;
XYZ January 45 put, 2; and
XYZ January 50 put, 4.
Aratio put spread might be established by buying one January 50 put and simulta
neously selling two January 45 puts. Since one would be paying $400 for the pur
chased put and would be collecting $400 from the sale of the two out-of-the-money
puts, the spread could be done for even money. There is no upside risk in this posi
tion. If XYZ should rally and be above 50 at January expiration, all the puts would
358

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Cl,apter 24: Ratio Spreads Using Puts 359
expire worthless and the result would be aloss of commissions. However, there is
downside risk. If XYZ should fall by agreat deal, one would have to pay much more
to buy back the two short puts than he would receive from selling out the one long
put. The maximum profit would be realized if XYZ were at 45 at expiration, since the
short puts would expire worthless, but the long January 50 put would be worth 5
points and could be sold at that price. Table 24-1 and Figure 24-1 summarize the
position. Note that there is arange within which the position is profitable - 40 to 50
in this example. If XYZ is above 40 and below 50 at January expiration, there will be
some profit, before commissions, from the spread. Below 40 at expiration, losses will
be generated and, although these losses are limited by the fact that astock cannot
decline in price below zero, these losses could become very large. There is no upside
risk, however, as was pointed out earlier. The following formulae summarize the sit
uation for any put ratio spread:
Maximum upside risk
Maximum profit
potential
= Net debit of spread (no upside risk if done for
acredit)
= Striking price differential x Number of long
puts - Net debit (or plus net credit)
Downside break-even price = Lower strike price - Maximum profit potential +
Number of naked puts
The investment required for the put ratio spread consists of the collateral
requirement necessary for anaked put, plus or minus the credit or debit of the entire
position. Since the collateral requirement for anaked option is 20% of the stock
TABLE 24-1.
Ratio put spread.
XYZ Price at Long January 50 Short 2 January 45 Total
Expiration Put Profit Put Profit Profit
20 +$2,600 -$4,600 -$2,000
30 + 1,600 - 2,600 - 1,000
40 + 600 600 0
42 + 400 200 + 200
45 + 100 + 400 + 500
48 200 + 400 + 200
50 400 + 400 0
60 400 + 400 0

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360
FIGURE 24-1.
Ratio put spread.
+$500
C:
0
~ ·5.
Xwiil
(/) $0 (/)
0 ....I
0
ea.
Part Ill: Put Option Strategies
Stock Price at Expiration
price, plus the premium, minus the amount by which the option is out-of-the-money,
the actual dollar requirement in this example would be $700 (20% of $5,000, plus the
$200 premium, minus the $500 by which the January 45 put is out-of-the-money). As
with all types of naked writing positions, the strategist should allow enough collater
al for an adverse stock move to occur. This will allow enough room for stock move
ment without forcing early liquidation of the position due to amargin call. If, in this
example, the strategist felt that he might stay with the position until the stock
declined to 39, he should allow $1,380 in collateral (20% of $3,900 plus the $600 in
the-money amount).
The ratio put spread is generally most attractive when the underlying stock is
initially between the two striking prices. That is, if XYZ were somewhere between 45
and 50, one might find the ratio put spread used in the example attractive. If the
stock is initially below the lower striking price, aratio put spread is not as attractive,
since the stock is already too close to the downside risk point. Alternatively, if the
stock is too far above the striking price of the written calls, one would normally have
to pay alarge debit to establish the position. Although one could eliminate the debit
by writing four or five short options to each put bought, large ratios have extraordi
narily large downside risk and are therefore very aggressive.
Follow-up action is rather simple in the ratio put spread. There is very little that
one need do, except for closing the position if the stock breaks below the downside
break-even point. Since put options tend to lose time value premium rather quickly
after they become in-the-money options, there is not normally an opportunity to roll

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Chapter 24: Ratio Spreads Using Puts 361
down. Rather, one should be able to close the position with the puts close to parity if
the stock breaks below the downside break-even point. The spreader may want to buy
in additional long puts, as was described for call spreads in Chapter 11, but this is not
as advantageous in the put spread because of the time value premium shrinkage.
This strategy may prove psychologically pleasing to the less experienced
investor because he will not lose money on an upward move by the underlying stock.
Many of the ratio strategies that involve call options have upside risk, and alarge
number of investors do not like to lose money when stocks move up. Thus, although
these investors might be attracted to ratio strategies because of the possibility of col
lecting the profits on the sale of multiple out-of-the-money options, they may often
prefer ratio put spreads to ratio call spreads because of the small upside risk in the
put strategy.
USING DELTAS
The "delta spread" concept can also be used for establishing and adjusting neutral
ratio put spreads. The delta spread was first described in Chapter 11. Aneutral put
spread can be constructed by using the deltas of the two put options involved in the
spread. The neutral ratio is determined by dividing the delta of the put at the higher
strike by the delta of the put at the lower strike. Referring to the previous example,
suppose the delta of the January 45 put is -.30 and the delta of the January 50 put is
-.50. Then aneutral ratio would be 1.67 (-.50 divided by -.30). That is, 1.67 puts
would be sold for each put bought. One might thus sell 5 January 45 puts and buy 3
January 50 puts.
This type of spread would not change much in price for small fluctuations in the
underlying stock price. However, as time passes, the preponderance of time value
premium sold via the January 45 puts would begin to tum aprofit. As the underlying
stock moves up or down by more than asmall distance, the neutral ratio between the
two puts will change. The spreader can adjust his position back into aneutral one by
selling more January 45'sor buying more January 50's.
THE RATIO PUT CALENDAR SPREAD
The ratio put calendar spread consists of buying alonger-term put and selling alarg
er quantity of shorter-term puts, all with the same striking price. The position is gen
erally established with out-of-the-money puts that is, the stock is above the striking
price - so that there is agreater probability that the near-term puts will expire worth-

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362 Part Ill: Put Option Strategies
less. Also, the position should be established for acredit, such that the money
brought in from the sale of the near-term puts more than covers the cost of the
longer-term put. If this is done and the near-term puts expire worthless, the strate
gist will then own the longer-term put free, and large profits could result if the stock
subsequently experiences asizable downward movement.
Example: If XYZ were at 55, and the January 50 put was at 1 ½ with the April 50 at
2, one could establish aratio put calendar spread by buying the April 50 and selling
two January 50 puts. This is acredit position, because the sale of the two January 50
puts would bring in $300 while the cost of the April 50 put is only $200. If the stock
remains above 50 until January expiration, the January 50 puts will expire worthless
and the April 50 put will be owned for free. In fact, even if the April 50 put should
then expire worthless, the strategist will make asmall profit on the overall position in
the amount of his original credit - $100 - less commissions. However, after the
Januarys have expired worthless, if XYZ should drop dramatically to 25 or 20, avery
large profit would accrue on the April 50 put that is still owned.
The risk in the position could be very large if the stock should drop well below
50 before the January puts expire. For example, if XYZ fell to 30 prior to January
expiration, one would have to pay $4,000 to buy back the January 50 puts and would
receive only $2,000 from selling out his long April 50 put. This would represent arather large loss. Of course, this type of tragedy can be avoided by taking appropri
ate follow-up action. Nomwlly, one would close the position if the stock fell rrwre than
8 to 10% below the striking price before the near-term puts expire.
As with any type of ratio position, naked options are involved. This increases the
collateral requirement for the position and also means that the strategist should allow
enough collateral in order for the follow-up action point to be reached. In this exam
ple, the initial requirement would be $750 (20% of $5,500, plus the $150 January
premium, less the $500 by which the naked January 50 put is out-of-the-money).
However, if the strategist decides that he will hold the position until XYZ falls to 46,
he should allow $1,320 in collateral (20% of $4,600 plus the $400 in-the-money
amount). Of course, the $100 credit, less commissions, generated by the initial posi
tion can be applied against these collateral requirements.
This strategy is asensible one for the investor who is willing to accept the risk of
writing anaked put. Since the position should be established with the stock above the
striking price of the put options, there is areasonable chance that the near-term puts
will expire worthless. This means that some profit will be generated, and that the
profit could be large if the stock should then experience alarge downward move
before the longer-term puts expire. One should take care, however, to limit his losses

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Chapter 24: Ratio Spreads Using Puts 363
before near-term expiration, since the eventual large profits will be able to overcome
aseries of small losses, but could not overcome apreponderance oflarge losses.
RATIO PUt CALENDARS
Using the deltas of the puts in the spread, the strategist can construct aneutral posi
tion. If the puts are initially out-of-the-money, then the neutral spread generally
involves selling more puts than one buys. Another type of ratioed put calendar can
be constructed with in-the-money puts. As with the companion in-the-money spread
with calls, one would buy more puts than he sells in order to create aneutral ratio.
In either case, the delta of the put to be purchased is divided by the delta of the
put to be sold. The result is the neutral ratio, which is used to determine how many
puts to sell for each one purchased.
Example: Consider the out-of-the-money case. XYZ is trading at 59. The January 50
put has adelta of 0.10 and the April 50 put has adelta of -0.17. If acalendar spread
is to be established, one would be buying the April 50 and selling the January 50.
Thus, the neutral ratio would be calculated as 1.7 to 1 (-0.17/-0.10). Seventeen puts
would be sold for every 10 purchased.
This spread has naked puts and therefore has large risk if the underlying stock
declines too far. However, follow-up action could be taken if the stock dropped in an
orderly manner. Such action would be designed to limit the downside risk.
Conversely, the calendar spread using in-the-money puts would normally have
one buying more options than he is selling. An example using deltas will demonstrate
this fact:
Example: XYZ is at 59. The January 60 put has adelta of -0.45 and the April 60 put
has adelta of -0.40. It is normal for shorter-term, in-the-money options to have adelta that is larger (in absolute terms) than longer-term, in-the-money options.
The neutral ratio for this spread would be 0.889 (-0.40/-0.45). That is, one
would sell only 0.889 puts for each one he bought. Alternatively stated, he would sell
8 and buy 9.
Aspread of this type has no naked puts and therefore does have large downside
profit potential. If the stock should rise too far, the loss is limited to the initial debit
of the spread. The optimum result would occur if the stock were at the strike at expi
ration because, even though the excess long put would lose money in that case, the
spreads involving the other puts would overcome that small loss.
Another risk of the in-the-money put spread is that one might be assigned
rather quickly if the stock should drop. In fact, one must be careful not to establish

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