174 Part II: Call Option Strategies
would merely buy the October 30 call outright. However, the sale of the October 35
call against the purchase of the October 30 allows him to take aposition that will out
perform the outright purchase of the October 30, dollarwise, as long as the stock does
not rise above 36 by expiration. This fact is demonstrated by the dashed line in Figure
7-1.
Therefore, the strategist establishing the bull spread is bullish, but not overly so.
To verify that this comparison is correct, note that if one bought the October 30 call
outright for 3 points, he would have a 3-point profit at expiration if XYZ were at 36.
Both strategies have a 3-point profit at 36 at expiration. Below 36, the bull spread
does better because the sale of the October 35 call brings in the extra point of pre
mium. Above 36 at expiration, the outright purchase outperforms the bull spread,
because there is no limit on the profits that can occur in an outright purchase situa
tion.
The net investment required for abull spread is the net debit plus commissions.
Since. the spread must be transacted in amargin account, there will generally be aminimum equity requirement imposed by the brokerage firm. In addition, there may
be amaintenance requirement by some brokers. Suppose that one was establishing
10 spreads at the prices given in the example above. His investment, before com
missions, would be $2,000 ($200 per spread), plus commissions. It is asimple matter
to compute the break-even point and the maximum profit potential of acall bull
spread:
Break-even point= Lower striking price+ Net debit of spread
Maximum profit _ Higher striking _ Lower striking _ Net debit
potential - price price of spread
In the example above, the net debit was 2 points. Therefore, the break-even
point would be 30 + 2, or 32. The maximum profit potential would be 35 - 30 - 2, or
3 points. These figures agree with Table 7-1 and Figure 7-1. Commissions may rep
resent asignificant percentage of the profit and net investment, and should therefore
be calculated before establishing the position. If these commissions are included in
the net debit to establish the spread, they conveniently fit into the preceding formu
lae. Commission charges can be reduced percentagewise by spreading alarger quan
tity of calls. For this reason, it is generally advisable to spread at least 5 options at atime.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:200


Chapter 7: Bull Spreads 175
DEGREES OF AGGRESSIVENESS
AGGRESSIVE BULL SPREAD
Depending on how the bull spread is constructed, it may be an extremely aggressive
or more conservative position. The most commonly used bull spread is of the aggres
sive type; the stock is generally well below the higher striking price when the spread
is established. This aggressive bull spread generally has the ability to generate sub
stantial percentage returns if the underlying stock should rise in price far enough by
expiration. Aggressive bull spreads are most attractive when the underlying common
stock is relatively close to the lower striking price at the time the spread is established.
Abull spread established under these conditions will generally be alow-cost spread
with substantial profit potential, even after commissions are included.
EXTREMELY AGGRESSIVE BULL SPREAD
An extremely aggressive type of bull spread is the "out-of-the-money" spread. In such
aspread, both calls are out-of-the-money when the spread is established. These
spreads are extremely inexpensive to establish and have large potential profits if the
stock should climb to the higher striking price by expiration. However, they are usu
ally quite deceptive in nature. The underlying stock has only arelatively remote
chance of advancing such agreat deal by expiration, and the spreader could realize a
100% loss of his investment even if the underlying stock advances moderately, since
both calls are out-of-the-money. This spread is akin to buying adeeply out-of-the
money call as an outright speculation. It is not recommended that such astrategy be
pursued with more than avery small percentage of one'sspeculative funds.
LEAST AGGRESSIVE BULL SPREAD
Another type of bull spread can be found occasionally - the "in-the-money" spread.
In this situation, both calls are in-the-money. This is amuch less aggressive position,
since it offers alarge probability of realizing the maximum profit potential, although
that profit potential will be substantially smaller than the profit potentials offered by
the more aggressive bull spreads.
Example: XYZ is at 37 some time before expiration, and the October 30 call is at 7
while the October 35 call is at 4. Both calls are in-the-money and the spread would
cost 3 points (debit) to establish. The maximum profit potential is 2 points, but it
would be realized as long as XYZ were above 35 at expiration. That is, XYZ could fall
by 2 points and the spreader would still make his maximum profit. This is certainly amore conservative position than the aggressive spread described above. The com-

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:201


176 Part II: Call Option Strategies
mission costs in this spread would be substantially larger than those in the spreads
above, which involve less expensive options initially, and they should therefore be fig
ured into one'sprofit calculations before entering into the spread transaction. Since
this stock would have to decline 7 points to fall below 30 and cause aloss of the entire
investment, it would have to be considered arather low-probability event. This fact
adds to the less aggressive nature of this type of spread.
RANKING BULL SPREADS
To accurately compare the risk and reward potentials of the many bull spreads that
are available in agiven day, one has to use acomputer to perform the mass calcula
tions. It is possible to use astrictly arithmetic method of ranking bull spreads, but
such alist will not be as accurate as the correct method of analysis. In reality, it is
necessary to incorporate the volatility of the underlying stock, and possibly the
expected return from the spread as well, into one'scalculations. The concept of
expected return is described in detail in Chapter 28, where abull spread is used as
an example.
The exact method for using volatility and predicting an option'sprice after an
upward movement are presented later. Many data services offer such information.
However, if the reader wants to attempt asimpler method of analysis, the following
one may suffice. In any ranking of bull spreads, it is important not to rank the spreads
by their maximum potential profits at expiration. Such aranking will always give the
most weight to deeply out-of-the-money spreads, which can rarely achieve their max
imum profit potential. It would be better to screen out any spreads whose maximum
profit prices are too far away from the current stock price. Asimple method of allow
ing for astock'smovement might be to assume that the stock could, at expiration,
advance by an amount equal to twice the time value premium in an at-the-money
call. Since more volatile stocks have options with greater time value premium, this is
asimple attempt to incorporate volatility into the analysis. Also, since longer-term
options have more time value premium than do short-term options, this will allow for
larger movements during alonger time period. Percentage returns should include
commission costs. This simple analysis is not completely correct, but it may prove
useful to those traders looking for asimple arithmetic method of analysis that can be
computed quickly.
FURTHER CONSIDERATIONS
The bull spreads described in previous examples utilize the same expiration date for
both the short call and the long call. It is sometimes useful to buy acall with alonger

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:202


Chapter 7: Bull Spreads 177
time to maturity than the short call has. Such aposition is known as adiagonal bull
spread and is discussed in alater chapter.
Experienced traders often tum to bull spreads when options are expensive. The
sale of the option at the higher strike partially mitigates the cost of buying an expen
sive option at the lower strike. However, one should not always use the bull spread
approach just because the options have alot of time value premium, for he would be
giving up alot of upside profit potential in order to have ahedged position.
With most types of spreads, it is necessary for some time to pass for the spread
to become significantly profitable, even if the underlying stock moves in favor of the
spreader. For this reason, bull spreads are not for traders unless the options involved
are very short-term in nature. If aspeculator is bullishly oriented for ashort-term
upward move in an underlying stock, it is generally better for him to buy acall out
right than to establish abull spread. Since the spread differential changes mainly as
afunction of time, small movements in price by the underlying stock will not cause
much of ashort-term change in the price of the spread. However, the bull spread has
adistinct advantage over the purchase of acall if the underlying stock advances mod
erately by expiration.
In the previous example, abull spread was established by buying the XYZ
October 30 call for 3 points and simultaneously selling the October 35 call for 1 point.
This spread can be compared to the outright purchase of the XYZ October 30 alone.
There is ashort-term advantage in using the outright purchase.
Example: The underlying stock jumps from 32 to 35 in one day'stime. The October
30 would be selling for approximately 5½ points if that happened, and the outright
purchaser would be ahead by 2½ points, less one option commission. The long side
of the bull spread would do as well, of course, since it utilizes the same option, but
the short side, the October 35, would probably be selling for about 2½ points. Thus,
the bull spread would be worth 3 points in total (5½ points on the long side, less 2½
points loss on the short side). This represents a 1-point profit to the spreader, less two
option commissions, since the spread was initially established at adebit of 2 points.
Clearly, then, for the shortest time period one day - the outright purchase outper
forms the bull spread on aquick rise.
For aslightly longer time period, such as 30 days, the outright purchase still has
the advantage if the underlying stock moves up quickly. Even if the stock should
advance above 35 in 30 days, the bull spread will still have time premium in it and
thus will not yet have reached its maximum spread potential of 5 points. Recall that
the maximum potential of abull spread is always equal to the difference between the
striking prices. Clearly, the outright purchaser will do very well if the underlying
stock should advance that far in 30 days' time. When risk is considered, however, it

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:203


178 Part II: Call Option Strategies
must be pointed out that the bull spread has fewer dollars at risk and, if the under
lying stock should drop rather than rise, the bull spread will often have asmaller loss
than the outright call purchase would.
The longer it takes for the underlying stock to advance, the more the advantage
swings to the spread. Suppose XYZ does not get to 35 until expiration. In this case,
the October 30 call would be worth 5 points and the October 35 call would be worth
less. The outright purchase of the October 30 call would make a 2-point profit less
one commission, but the spread would now have a 3-point profit, less two commis
sions. Even with the increased commissions, the spreader will make more of aprof
it, both dollarwise and percentagewise.
Many traders are disappointed with the low profits available from abull spread
when the stock rises almost immediately after the position is established. One way to
partially off set the problem with the spread not widening out right away is to use agreater distance between the two strikes. When the distance is great, the spread has
room to widen out, even though it won'treach its maximum profit potential right
away. Still, since the strikes are "far apart," there is more room for the spread to
widen even if the underlying stock rises immediately.
The conclusion that can be drawn from these examples is that, in general, the
outright purchase is abetter strategy if one is looking for aquick rise by the under
lying stock. Overall, the bull spread is aless aggressive strategy than the outright pur
chase of acall. The spread will not produce as much of aprofit on ashort-term move,
or on asustained, large upward move. It will, however, outperform the outright pur
chase of acall if the stock advances slowly and moderately by expiration. Also, the
spread always involves fewer actual dollars of risk, because it requires asmaller debit
to establish initially. Table 7-2 summarizes which strategy has the upper hand for var
ious stock movements over differing time periods.
TABLE 7-2.
Bull spread and outright purchase compared.
If the underlying stock ...
Remains
Relatively Advonces Advances
Declines Unchanged Moderately Substantially
in ...
1 week Bull spread Bull spread Outright purchase Outright purchase
1 month Bull spread Bull spread Outright purchase Outright purchase
At expiration Bull spread Bull spread Bull spread Outright purchase

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:204


Chapter 7: Bull Spreads
FOLLOW-UP ACTION
179
Since the strategy has both limited profit and limited risk, it is not mandatory for the
spreader to take any follow-up action prior to expiration. If the underlying stock
advances substantially, the spreader should watch the time value premium in the
short call closely in order to close the spread if it appears that there is apossibility of
assignment. This possibility would increase substantially if the time value premium
disappeared from the short call. If the stock falls, the trader may want to close the
spread in order to limit his losses even further.
When the spread is closed, the order should also be entered as aspread trans
action. If the underlying stock has moved up in price, the order to liquidate would
be acredit spread involving two closing transactions. The maximum credit that can
be recovered from abull spread is an amount equal to the difference between the
striking prices. In the previous example, if XYZ were above 35 at expiration, one
might enter an order to liquidate the spread as follows: Buy the October 35 (it is
common practice to specify the buy side of aspread first when placing an order);
sell the October 30 at a 5-point credit. In reality, because of the difference between
bids and offers, it is quite difficult to obtain the entire 5-point credit even if expira
tion is quite near. Generally, one might ask for a 4¼ or 47/scredit. It is possible to
close the spread via exercise, although this method is normally advisable only for
traders who pay little or no commissions. If the short side of aspread is assigned,
the spreader may satisfy the assignment notice by exercising the long side of his
spread. There is no margin required to do so, but there are stock commissions
involved. Since these stock commissions to apublic customer would be substantial
ly larger than the option commissions involved in closing the spread by liquidating
the options, it is recommended that the public customer attempt to liquidate rather
than exercise.
Aminor point should be made here. Since the amount of commissions paid to
liquidate the spread would be larger if higher call prices are involved, the actual net
maximum profit point for abull spread is for the stock to be exactly at the higher
striking price at expiration. If the stock exceeds the higher striking price by agreat
deal, the gross profit will be the same (it was demonstrated earlier that this gross
profit is the same anywhere above the higher strike at expiration), but the net profit
will be slightly smaller, since the investor will pay more in commissions to liquidate
the spread.
Some spreaders prefer to buy back the short call if the underlying stock drops
in price, in order to lock in the profit on the short side. They will then hold the long
call in hopes of arise in price by the underlying stock, in order to make the long side
of the spread profitable as well. This amounts to "legging" out of the spread, although

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:205


180 Part II: Call Option Strategies
the overall increase in risk is small - the amount paid to repurchase the short call. If
he attempts to "leg" out of the spread in such amanner, the spreader should not
attempt to buy back the short call at too high aprice. If it can be repurchased at 1/sor 1/16, the spreader will be giving away virtually nothing by buying back the short call.
However, he should not be quick to repurchase it if it still has much more value than
that, unless he is closing out the entire spread. At no time should one attempt to "leg"
out after astock price increase, taking the profit on the long side and hoping for astock price decline to make the short side profitable as well. The risk is too great.
Many traders find themselves in the somewhat perplexing situation of having
seen the underlying make alarge, quick move, only to find that their spread has not
widened out much. They often try to figure out away to perhaps lock in some gains
in case the underlying subsequently drops in price, but they want to be able to wait
around for the spread to widen out more toward its maximum profit potential. There
really isn'tany hedge that can accomplish all of these things. The only position that
can lock in the profits in acall bull spread is to purchase the accompanying put bear
spread. This strategy is discussed in Chapter 23, Spreads Combining Calls and Puts.
OTHER USES OF BULL SPREADS
Superficially, the bull spread is one of the simplest forms of spreading. However, it
can be an extremely useful tool in awide variety of situations. Two such situations
were described in Chapter 3. If the outright purchaser of acall finds himself with an
unrealized loss, he may be able to substantially improve his chances of getting out
even by "rolling down" into abull spread. If, however, he has an unrealized profit, he
may be able to sell acall at the next higher strike, creating abull spread, in an attempt
to lock in some of his profit.
In asomewhat similar manner, acommon stockholder who is faced with an
unrealized loss may be able to utilize abull spread to lower the price at which he
can break even. He may often have asignificantly better chance of breaking even or
making aprofit by using options. The following example illustrates the stockholder'sstrategy.
Example: An investor buys 100 shares of XYZ at 48, and later finds himself with an
unrealized loss with the stock at 42. A 6-point rally in the stock would be necessary
in order to break even. However, if XYZ has listed options trading, he may be able to
significantly reduce his break-even price. The prices are:

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:206


Chapter 7: Bull Spreads
XYZ common, 42;
XYZ October 40, 4; and
XYZ October 45, 2.
181
The stock owner could enhance his overall position by buying one October 40 call
and selling two October 45 calls. Note that no extra money, except commissions, is
required for this transaction, because the credit received from selling two October
45'sis $400 and is equal to the cost of buying the October 40 call. However, mainte
nance and equity requirements still apply, because aspread has been established.
The resulting position does not have an uncovered, or naked, option in it. One
of the October 45 calls that was sold is covered by the underlying stock itself. The
other is part of abull spread with the October 40 call. It is not particularly important
that the resulting position is acombination of both abull spread and acovered write.
What is important is the profit characteristic of this new total position.
If XYZ should continue to decline in price and be below 40 at October expira
tion, all the calls will expire worthless, and the resulting loss to the stock owner will
be the same (except for the option commissions spent) as if he had merely held onto
his stock without having done any option trading.
Since both acovered write and abull spread are strategies with limited profit
potential, this new position obviously must have alimited profit. If XYZ is anywhere
above 45 at October expiration, the maximum profit will be realized. To determine
the size of the maximum profit, assume that XYZ is at exactly 45 at expiration. In that
case, the two short October 45'swould expire worthless and the long October 40 call
would be worth 5 points. The option trades would have resulted in a $400 profit on
the short side ($200 from each October 45 call) plus a $100 profit on the long side,
for atotal profit of $500 from the option trades. Since the stock was originally bought
at 48 in this example, the stock portion of the position is a $300 loss with XYZ at 45
at expiration. The overall profit of the position is thus $500 less $300, or $200.
For stock prices between 40 and 45 at expiration, the results are shown in
Table 7-3 and Figure 7-2. Figure 7-2 depicts the two columns from the table labeled
"Profit on Stock" and "Total Profit," so that one can visualize how the new total posi
tion compares with the original stockholder'sprofit. Several points should be noted
from either the graph or the table. First, the break-even point is lowered from 48 to
44. The new total position breaks even at 44, so that only a 2-point rally by the stock
by expiration is necessary in order to break even. The two strategies are equal at 50
at expiration. That is, the stock would have to rally more than 8 points, from 42 to
50, by expiration for the original stockholder'sposition to outperform the new posi-

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:207


182 Part II: Call Option Strategies
TABLE 7-3.
Lowering the break-even price on common stock.
XYZ Price at Profit on Profit on Short Profit on long Total
Expiration Stock October 45's October 40 Profit
35 -$1,300 +$400 -$400 -$1,300
38 - 1,000 + 400 - 400 - 1,000
40 800 + 400 - 400 800
42 600 + 400 - 200 400
43 500 + 400 - 100 200
44 400 + 400 0 0
45 300 + 400 + 100 + 200
48 0 - 200 + 400 + 200
50 + 200 - 600 + 600 + 200
tion. Below 40, the two strategies produce the same result. Finally, between 40 and
50, the new position outperforms the original stockholder'sposition.
In summary, then, the stockholder stands to gain much and gives away very lit
tle by adding the indicated options to his stock position. If the stock stabilizes at all -
anywhere between 40 and 50 in the example above - the new position would be an
improvement. Moreover, the investor can break even or make profits on asmall rally.
If the stock continues to drop heavily, nothing additional will be lost except for option
commissions. Only if the stock rallies very sharply will the stock position outperform
the total position.
This strategy- combining acovered write and abull spread - is sometimes used
as an initial ( opening) trade as well. That is, an investor who is considering buying
XYZ at 42 might decide to buy the October 40 and sell two October 45's (for even
money) at the outset. The resulting position would not be inferior to the outright pur
chase of XYZ stock, in terms of profit potential, unless XYZ rose above 46 by October
expiration.
Bull spreads may also be used as a "substitute" for covered writing. Recall from
Chapter 2 that writing against warrants can be useful because of the smaller invest
ment required, especially if the warrant was in-the-money and was not selling at
much of apremium. The same thinking applies to call options. If there is an in-the
money call with little or no time premium remaining in it, its purchase may be used
as asubstitute for buying the stock itself Of course, the call will expire, whereas the
stock will not; but the profit potential of owning adeeply in-the-money call can be

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:208


Chapter 7: Bull Spreads
FIGURE 7-2.
Lowering the break-even price on common stock.
C:
0
I +$200
iii
(/)
$0 (/)
.:l
0
i5
e
Q.
-$800
40
Profit with Options
,
,,,' , ,
,,,'
50
Stock Price at Expiration
183
;f ,,
very similar to owning the stock. Since such acall costs less to purchase than the stock
itself would, the buyer is getting essentially the same profit or loss potential with asmaller investment. It is natural, then, to think that one might write another call -
one closer to the money- against the deeply in-the-money purchased call. This posi
tion would have profit characteristics much like acovered write, since the long call
"simulates" the purchase of stock This position really is, of course, abull spread, in
which the purchased call is well in-the-money and the written call is closer to the
money. Clearly, one would not want to put all of his money into such astrategy and
forsake covered writing, since, with bull spreads, he could be entirely wiped out in amoderate market decline. In acovered writing strategy, one still owns the stocks even
after asevere market decline. However, one may achieve something of acompromise
by investing amuch smaller amount of money in bull spreads than he might have
invested in covered writes. He can still retain the same profit potential. The balance
of the investor'sfunds could then be placed in interest-bearing securities.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:209


184
Example: The following prices exist:
XYZ common, 49;
XYZ April 50 call, 3; and
XYZ April 35 call, 14.
Part II: Call Option Strategies
Since the deeply in-the-money call has no time premium, its purchase will perform
much like the purchase of the stock until April expiration. Table 7-4 summarizes the
profit potential from the covered write or the bull spread. The profit potentials are
the same from acash covered write or the bull spread. Both would yield a $400 prof
it before commissions if XYZ were above 50 at April expiration. However, since the
bull spread requires amuch smaller investment, the spreader could put $3,500 into
interest-bearing securities. This interest could be considered the equivalent of
receiving the dividends on the stock. In any case, the spreader can lose only $1,100,
even if the stock declines substantially. The covered writer could have alarger unre
alized loss than that if XYZ were below 35 at expiration. Also, in the bull spread sit
uation, the writer can "roll down" the April 50 call if the stock declines in price, just
as he might do in acovered writing situation.
TABLE 7-4.
Results for covered write and bull spread compared.
Maximum profit potential
(stock over 50 in April)
Break-even point
Investment
Covered Write:
Buy XYZ and Sell
April 50 Coll
$ 400
46
$4,600
Bull Spread:
Buy XYZ April 35 Call and
Sell April 50 Coll
$ 400
46
$1,100
Thus, the bull spread offers the same dollar rewards, the same break-even
point, smaller commission costs, less potential risk, and interest income from the
fixed-income portion of the investment. While it is not always possible to find adeeply in-the-money call to use as a "substitute" for buying the stock, when one does
exist, the strategist should consider using the bull spread instead of the covered write.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:210


Bear Spreads
Using Call Options
Options are versatile investment vehicles. For every type of bullish position that can
be established, there is normally acorresponding bearish type of strategy. For every
neutral strategy, there is an aggressive strategy for the investor with an opposite opin
ion. One such case has already been explored in some detail; the straddle buy or
reverse hedge strategy is the opposite side of the spectrum. For many of the strate
gies to be described from this point on, there is acorresponding strategy designed for
the strategist with the opposite point of view. In this vein, abear spread is the oppo
site of abull spread.
THE BEAR SPREAD
In acall bear spread, one buys acall at acertain striking price and sells acall at alower striking price. This is avertical spread, as was the bull spread. The bear spread
tends to be profitable if the underlying stock declines in price. Llke the bull spread,
it has limited profit and loss potential. However, unlike the bull spread, the bear
spread is acredit spread when the spread is set up with call options. Since one is sell
ing the call with the lower strike, and acall at alower strike always trades at ahigh
er price than acall at ahigher strike with the same expiration, the bear spread must
be acredit position. It should be pointed out that most bearish strategies that can be
established with call options may be more advantageously constructed using put
options. Many of these same strategies are therefore discussed again in Part III.
186

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:212


Chapter 8: Bear Spreads Using Call Options 187
Example: An investor is bearish on XYZ. Using the same prices that were used for
the examples in Chapter 7, an example of abear spread can be constructed for:
XYZ common, 32;
XYZ October 30 call, 3; and
XYZ October 35 call, 1.
Abear spread would be established by buying the October 35 call and selling the
October 30 call. This would be done for a 2-point credit, before commissions. In abear spread situation, the strategist is hoping that the stock will drop in price and that
both options will expire worthless. If this happens, he will not have to pay anything
to close his spread; he will profit by the entire amount of the original credit taken in.
In this example, then, the maximum profit potential is 2 points, since that is the
amount of the initial credit. This profit would be realized if XYZ were anywhere
below 30 at expiration, because both options would expire worthless in that case.
If the spread expands in price, rather than contracts, the bear spreader will be
losing money. This expansion would occur in arising market. The maximum amount
that this spread could expand to is 5 points - the difference between the striking
prices. Hence, the most that the bear spreader would have to pay to buy back this
spread would be 5 points, resulting in amaximum potential loss of 3 points. This loss
would be realized if XYZ were anywhere above 35 at October expiration. Table 8-1
and Figure 8-1 depict the actual profit and loss potential of this example at expiration
(commissions are not included). The astute reader will note that the figures in the
table are exactly the reverse of those shown for the bull spread example in Chapter
7. Also, the profit graph of the bear spread looks like abull spread profit graph that
has been turned upside down. All bear spreads have aprofit graph with the same
shape at expiration as the graph shown in Figure 8-1.
TABLE 8-1.
Bear spread.
XYZ Price at October 30 October 35 Total
Expiration Profit Profit Profit
25 +$300 -$100 +$200
30 + 300 - 100 + 200
32 + 100 - 100 0
35 - 200 - 100 - 300
40 - 700 + 400 - 300

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:213


188
FIGURE 8-1.
Bear spread •
. § +$200
"it! -~
w
CJ) 30 ig
..J
0
:!:
ea. -$300
Part II: Call Option Strategies
Stock Price at Expiration
The break-even point, maximum profit potential, and investment required are
all quite simple computations for abear spread.
Maximum profit potential== Net credit received
Break-even point== Lower striking price + Amount of credit
Maximum Collateral investment = = risk required
Difference in
striking prices
Credit + Commissions received
In the example above, the net credit received from the sale of the October 30
call at 3 and the purchase of the October 35 call at 1 was two points. This is the max
imum profit potential. The break-even point is then easily computed as the lower
striking price, 30, plus the amount of the credit, 2, or 32. The risk is equal to the
investment. It is the difference between the striking prices - 5 points - less the net
credit received - 2 points - for atotal investment of 3 points plus commissions. Since
this spread involves acall that is not "covered" by along call with astriking price
equal to or lower than that of the short call, some brokerage firms may require ahigher maintenance requirement per spread than would be required for abull
spread. Again, since aspread must be done in amargin account, most brokerage
firms require that aminimum amount of equity be in the account as well.
Since this is acredit spread, the investor does not really "spend" any dollars to
establish the spread. The investment is really areduction in the buying power of the
customer'smargin account, but it does not actually require dollars to be spent when
the transaction is initiated.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:214


Chapter 8: Bear Spreads Using Call Options
SELECTING A BEAR SPREAD
189
Depending on where the underlying stock is trading with respect to the two striking
prices, the bear spread may be very aggressive, with ahigh profit potential, or it may
be less aggressive, with alow profit potential. If alarge credit is initially taken in,
there is obviously the potential for agood deal of profit. However, for the spread to
take in alarge credit, the underlying stock must be well above the lower striking
price. This means that arelatively substantial downward move would be necessary in
order for the maximum profit potential to be realized. Thus, alarge credit bear
spread is usually an aggressive position; the spreader needs asubstantial move by the
underlying stock in order to make his maximum profit. The probabilities of this
occurring cannot be considered large.
Aless aggressive type of bear spread is one in which the underlying stock is
actually below the lower striking price when the spread is established. The credit
received from establishing abear spread in such asituation would be small, but the
spreader would realize his maximum profit even if the underlying stock remained
unchanged or actually rose slightly in price by expiration.
Example: XYZ is trading at aprice of 25. The October 30 call might be sold for 1 ½
points and the October 35 call bought for½ point with the stock at 29. While the net
credit, and hence the maximum profit potential, is asmall dollar amount, 1 point, it
will be realized even if XYZ rises slightly by expiration, as long as it does not rise
above 30.
It is not always clear which type of spread is better, the large credit bear spread
or the small credit bear spread. One has asmall probability of making alarge profit
and the other has amuch larger probability of making amuch smaller profit. In gen
eral, bear spreads established when the underlying stock is closer to the lower strik
ing price will be the best ones. To see this, note that if abear spread is initiated when
the stock is at the higher striking price, the spreader is selling acall that has mostly
intrinsic value and little time value premium (since it is in-the-money), and is buying
acall that is nearly all time value. This is just the opposite of what the option strate
gist should be attempting to do. The basic philosophy of option strategy is to sell time
value and buy intrinsic value. For this reason, the large credit bear spread is not an
optimum strategy. It will be interesting to observe later that bear spreads with puts
are more attractive when the underlying stock is at the higher striking price!
Abear spread will not collapse right away, even if the underlying stock drops in
price. This is somewhat similar to the effect that was observed with the call bull
spreads in Chapter 7. They, too, do not accelerate to their maximum profit potential
right away. Of course, as time winds down and expiration approaches, then the spread

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:215


190 Part II: Call Option Strategies
will approach its maximum profit potential. This is important to understand because,
if one is expecting aquick move down by the underlying stock, he might need to use
acall bear spread in which the lower strike is actually somewhat deeply in-the
money, while the upper strike is out-of-the-money. In this case, the in-the-money call
will decline in value as the stock moves down, even if that downward move happens
immediately. Meanwhile, the out-of-the-money long call protects against adisastrous
upside breakout by the stock. This type of bear spread is really akin to selling adeep
in-the-money call for its raw downside profit potential and buying an out-of-the
money call merely as disaster insurance.
FOLLOW-UP ACTION
Follow-up strategies are not difficult, in general, for bear spreads. The major thing
that the strategist must be aware of is impending assignment of the short call. If the
short side of the spread is in-the-money and has no time premium remaining, the
spread should be closed regardless of how much time remains until expiration. This
disappearance of time value premium could be caused either by the stock being
significantly above the striking price of the stock call, or by an impending dividend
payment. In either case, the spread should be closed to avoid assignment and the
resultant large commission costs on stock transactions. Note that the large credit
bear spread (one established with the stock well above the lower striking price) is
dangerous from the viewpoint of early assignment, since the time value premium
in the call will be small to begin with.
SUMMARY
The call bear spread is abearishly oriented strategy. Since the spread is acredit
spread, requiring only areduction in buying power but no actual layout of cash to
establish, it is amoderately popular strategy. The bear spread using calls may not be
the optimum type of bearish spread that is available; abear spread using put options
maybe.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:216


Calendar Spreads
Acalendar spread, also frequently called atime spread, involves the sale of one
option and the simultaneous purchase of amore distant option, both with the same
striking price. In the broad definition, the calendar spread is ahorizontal spread. The
neutral philosophy for using calendar spreads is that time will erode the value of the
near-term option at afaster rate than it will the far-term option. If this happens, the
spread will widen and aprofit may result at near-term expiration. With call options,
one may construct amore aggressive, bullish calendar spread. Both types of spreads
are discussed.
Example: The following prices exist sometime in late January:
XYZ:50
April 50 Call
(3-month call)
5
July 50 Call
(6-month call)
8
October 50 Call
(9-month call)
10
If one sells the April 50 call and buys the July 50 at the same time, he will pay adebit
of 3 points - the difference in the call prices plus commissions. That is, his invest
ment is the net debit of the spread plus commissions. Furthermore, suppose that in 3
months, at April expiration, XYZ is unchanged at 50. Then the 3-month call should
be worth 5 points, and the 6-month call should be worth 8 points, as they were pre
viously, all other factors being equal.
XYZ:50
April 50 Call
(Expiring)
0
July 50 Call
(3-month call)
5
October 50 Call
(6-month call)
8
191

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:217


192 Part II: Call Option Strategies
The spread between the April 50 and the July 50 has now widened to 5 points. Since
the spread cost 3 points originally, this widening effect has produced a 2-point prof
it. The spread could be closed at this time in order to realize the profit, or the spread
er may decide to continue to hold the July 50 call that he is long. By continuing to
hold the July 50 call, he is risking the profits that have accrued to date, but he could
profit handsomely if the underlying stock rises in price over the next 3 months,
before July expiration.
It is not necessary for the underlying stock to be exactly at the striking price of
the options at near-term expiration for aprofit to result. In fact, some profit can be
made in arange that extends both below and above the striking price. The risk in this
type of position is that the stock will drop agreat deal or rise agreat deal, in which
case the spread between the two options will shrink and the spreader will lose money.
Since the spread between two calls at the same strike cannot shrink to less than zero,
however, the risk is limited to the amount of the original debit spent to establish the
spread, plus commissions.
THE NEUTRAL CALENDAR SPREAD
As mentioned earlier, the calendar spreader can either have aneutral outlook on the
stock or he can construct the spread for an aggressively bullish outlook. The neutral
outlook is described first. The calendar spread that is established when the underly
ing stock is at or near the striking price of the options used is aneutral spread. The
strategist is interested in selling time and not in predicting the direction of the under
lying stock. If the stock is relatively unchanged when the near-term option expires,
the neutral spread will make aprofit. In aneutral spread, one should initially have
the intent of closing the spread by the time the near-tenn option expires.
Let us again tum to our example calendar spread described earlier in order to
more accurately demonstrate the potential risks and rewards from that spread when
the near-term, April, call expires. To do this, it is necessary to estimate the price of the
July 50 call at that time. Notice that, with XYZ at 50 at expiration, the results agree
with the less detailed example presented earlier. The graph shown in Figure 9-1 is the
"total profit" from Table 9-1. The graph is acurved rather than straight line, since the
July 50 call still has time premium. There is aslightly bullish bias to this graph: The
profit range extends slightly farther above the striking price than it does below the
striking price. This is due to the fact that the spread is acall spread. If puts had been
used, the profit range would have abearish bias. The total width of the profit range is
afunction of the volatility of the underlying stock, since that will determine the price

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:218


Chapter 9: Calendar Spreads
FIGURE 9-1.
Calendar spread at near-term expiration.
C:
i +$200
$
1i:i
~
0
~ o. -$300
Stock Price at Expiration
TABLE 9-1.
Estimated profit or losses at April expiration.
XYZ Stock April 50 April 50 July 50
Price Price Profit Price
40 0 +$500 1/2
45 0 + 500 21/2
48 0 + 500 4
50 0 + 500 5
52 2 + 300 6
55 5 0 8
60 10 - 500 l 01/2
193
July 50 Total
Profit Profit
-$750 -$250
- 550 - 50
- 400 + 100
- 300 + 200
- 200 + 100
0 0
+ 250 - 250
of the remaining long call at expiration, as well as afunction of the time remaining to
near-term expiration.
Table 9-1 and Figure 9-1 clearly depict several of the more significant aspects
of the calendar spread. There is arange within which the spread is profitable at near
term expiration. That range would appear to be about 46 to 55 in the example.
Outside that range, losses can occur, but they are limited to the amount of the initial
debit. Notice in the example that the stock would have to be well below 40 or well

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:219


194 Part II: Call Option Strategies
above 60 for the maximum loss to occur. Even if the stock is at 40 or 60, there is some
time premium left in the longer-term option, and the loss is not quite as large as the
maximum possible loss of $300.
This type of calendar spread has limited profits and relatively large commission
costs. It is generally best to establish such aspread 8 to 12 weeks before the near
term option expires. If this is done, one is capitalizing on the maximum rate of decay
of the near-term option with respect to the longer-term option. That is, when acall
has less than 8 weeks of life, the rate of decay of its time value premium increases
substantially with respect to the longer-term options on the same stock.
THE EFFECT OF VOLATILITY
The implied volatility of the options (and hence the actual volatility of the underly
ing stock) will have an effect on the calendar spread. As volatility increases, the
spread widens; as volatility contracts, the spread shrinks. This is important to know.
In effect, buying acalendar spread is an antivolatility strategy: One wants the under
lying to remain somewhat unchanged. Sometimes, calendar spreads look especially
attractive when the underlying stock is volatile. However, this can be misleading for
two reasons. First of all, since the stock is volatile, there is agreater chance that it will
move outside of the profit area. Second, if the stock does stabilize and trades in arange near the striking price, the spread will lose value because of the decrease in
volatility. That loss may be greater than the gain from time decay!
FOLLOW-UP ACTION
Ideally, the spreader would like to have the stock be just below the striking price
when the near-term call expires. If this happens, he can close the spread with only
one commission cost, that of selling out the long call. If the calls are in-the-money at
the expiration date, he will, of course, have to pay two commissions to close the
spread. As with all spread positions, the order to close the spread should be placed
as asingle order. "Legging" out of aspread is highly risky and is not recommended.
Prior to expiration, the spreader should close the spread if the near-term short
call is trading at parity. He does this to avoid assignment. Being called out of spread
position is devastating from the viewpoint of the stock commissions involved for the
public customer. The near-term call would not normally be trading at parity until
quite close to the last day of trading, unless the stock has undergone asubstantial rise
in price.
In the case of an early downside breakout by the underlying stock, the spread
er has several choices. He could immediately close the spread and take asmall loss

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:220


Chapter 9: Calendar Spreads 195
on the position. Another choice is to leave the spread alone until the near-term call
expires and then to hope for apartial recovery from the stock in order to be able to
recover some value from the long side of the spread. Such aholding action is often
better than the immediate close-out, because the expense of buying back the short
call can be quite large percentagewise. Ariskier downside defensive action is to sell
out the long call if the stock begins to break down heavily. In this way, the spreader
recovers something from the long side of his spread immediately, and then looks for
the stock to remain depressed so that the short side of the spread will expire worth
less. This action requires that one have enough collateral available to margin the
resulting naked call, often an amount substantially in excess of the original debit paid
for the spread. Moreover, if the underlying stock should reverse direction and rally
back to or above the striking price, the short side of the spread is naked and could
produce substantial losses. The risk assumed by such afollow-up violates the initial
neutral premise of the spread, and should therefore be avoided. Of these three types
of downside defensive action, the easiest and rrwst conservative one is to do nothing
at all, letting the short call expire worthless and then hoping for arecovery by the
underlying stock. If this tack is taken, the risk remains fixed at the original debit paid
for the spread, and occasionally arally may produce large profits on the long call.
Although this rally is anonfrequent event, it generally costs the spreader very little
to allow himself the opportunity to take advantage of such arally if it should occur.
In fact, the strategist can employ aslight modification of this sort of action, even
if the spread is not at alarge loss. If the underlying stock is moderately below the
striking price at near-term expiration, the short option will expire worthless and the
spreader will be left holding the long option. He could sell the long side immediate
ly and perhaps take asmall gain or loss. However, it is often areasonable strategy to
sell out aportion of the long side - recovering all or asubstantial portion of the ini
tial investment - and hold the remainder. If the stock rises, the remaining long posi
tion may appreciate substantially. Although this sort of action deviates from the true
nature of the time spread, it is not overly risky.
An early breakout to the upside by the underlying stock is generally handled in
much the same way as adownside breakout. Doing nothing is often the best course
of action. If the underlying stock rallies shortly after the spread is established, the
spread will shrink by asmall amount, but not substantially, because both options will
hold premium in arally. If the spreader were to rush in to close the position, he
would be paying commissions on two rather expensive options. He will usually do
better to wait and give himself as much of achance for areversal as possible. In fact,
even at near-term expiration, there will normally be some time premium left in the
long option so that the maximum loss would not have to be realized. Ahighly risk
oriented upside defensive action is to cover the short call on atechnical breakout and

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:221


196 Part II: Call Option Strategies
continue to hold the long call. This can become disastrous if the breakout fails and
the stock drops, possibly resulting in losses far in excess of the original debit.
Therefore, this action cannot be considered anything but extremely aggressive and
illogical for the neutral strategist.
If abreakout does not occur, the spreader will normally be making unrealized
profits as time passes. Should this be the case, he may want to set some mental stop
out points for himself. For example, if the underlying stock is quite close to the strik
ing price with only two weeks to go, there will be some more profit potential left in
the spread, but the spreader should be ready to close the position quickly if the stock
begins to get too far away from the striking price. In this manner, he can leave room
for more profits to accrue, but he is also attempting to protect the profits that have
already built up. This is somewhat similar to the action that the ratio writer takes
when he narrows the range of his action points as more and more time passes.
THE BULLISH CALENDAR SPREAD
Aless neutral and more bullish type of calendar spread is preferred by the more
aggressive investor. In abullish calendar spread, one sells the near-term call and buys
alonger-term call, but he does this when the underlying stock is some distance below
the striking price of the calls. This type of position has the attractive features of low
dollar investment and large potential profits. Of course, there is risk involved as well.
Example: One might set up abullish calendar spread in the following manner:
XYZ common, 45;
sell the XYZ April 50 for l; and
buy the XYZ July 50 for 1 ½.
This investor ideally wants two things to happen. First, he would like the near
term call to expire worthless. That is why the bullish calendar spread is established
with out-of-the-money calls: to increase the chances of the short call expiring worth
less. If this happens, the investor will then own the longer-term call at anet cost of
his original debit. In this example, his original debit was only ½ of apoint to create
the spread. If the April 50 call expires worthless, the investor will own the July 50 call
at anet cost of ½ point, plus commissions.
The investor now needs asecond criterion to be fulfilled: The stock must rise in
price by the time the July 50 call expires. In this example, even if XYZ were to rally
to only 52 between April and July, the July 50 call could be sold for at least 2 points.
This represents asubstantial percentage gain, because the cost of the call has been

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:222


Chapter 9: Calendar Spreads 197
reduced to ¼ point. Thus, there is the potential for large profits in bullish calendar
spreads if the underlying stock rallies above the striking price before the longer-term
call expires, provided that the short-term call has already expired worthless.
What chance does the investor have that both ideal conditions will occur? There
is areasonably good chance that the written call will expire worthless, since it is ashort-term call and the stock is below the striking price to start with. If the stock falls,
or even rises alittle - up to, but not above, the striking price the first condition will
have been met. It is the second condition, arally above the striking price by the
underlying stock before the longer-term expiration date, that normally presents the
biggest problem. The chances of this happening are usually small, but the rewards
can be large when it does happen. Thus, this strategy offers asmall probability of
making alarge profit. In fact, one large profit can easily offset several losses, because
the losses are small, dollarwise. Even if the stock remains depressed and the July 50
call in the example expires worthless, the loss is limited to the initial debit of¼ point.
Of course, this loss represents 100% of the initial investment, so one cannot put all
his money into bullish calendar spreads.
This strategy is areasonable way to speculate, provided that the spreader
adheres to the following criteria when establishing the spread:
1. Select underlying stocks that are volatile enough to move above the striking price
within the allotted time. Bullish calendar spreads may appear to be very "cheap"
on nonvolatile stocks that are well below the striking price. But if alarge stock
move, say 20%, is required in only afew months, the spread is not worthwhile for
anonvolatile stock.
2. Do not use options more than one striking price above the current market. For
example, if XYZ were 26, use the 30 strike, not the 35 strike, since the chances
of arally to 30 are many times greater than the chances of arally to 35.
3. Do not invest alarge percentage of available trading capital in bullish calendar
spreads. Since these are such low-cost spreads, one should be able to follow this
rule easily and still diversify into several positions.
FOLLOW-UP ACTION
If the underlying stock should rally before the near-term call expires, the bullish cal
endar spreader must never consider "legging" out of the spread, or consider cover
ing the short call at aloss and attempting to ride the long call. Either action could
turn the initial small, limited loss into adisastrous loss. Since the strategy hinges on

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:223


198 Part II: Call Option Strategies
the fact that all the losses will be small and the infrequent large profits will be able
to overcome these small losses, one should do nothing to jeopardize the strategy and
possibly generate alarge loss.
The only reasonable sort of follow-up action that the bullish calendar spreader
can take in advance of expiration is to close the spread if the underlying stock has
moved up in price and the spread has widened to become profitable. This might
occur if the stock moves up to the striking price after some time has passed. In the
example above, if XYZ moved up to 50 with amonth or so of life left in the April 50
call, the call might be selling for I½ while the July 50 call might be selling for 3
points. Thus, the spread could be closed at I½ points, representing a I-point gain
over the initial debit of 1/2 point. Two commissions would have to be paid to close
the spread, of course, but there would still be anet profit in the spread.
USING ALL THREE EXPIRATION SERIES
In either the neutral calendar spread or the bullish calendar spread, the investor has
three choices of which months to use. He could sell the nearest-term call and buy the
intermediate-term call. This is usually the most common way to set up these spreads.
However, there is no rule that prevents him from selling the intermediate-term and
buying the longest-term, or possibly selling the near-term and buying the long-term.
Any of these situations would still be calendar spreads.
Some proponents of calendar spreads prefer initially to sell the near-term and
buy the long-term call. Then, if the near-term call expires worthless, they have an
opportunity to sell the intermediate-term call if they so desire.
Example: An investor establishes acalendar spread by selling the April 50 call and
buying the October 50 call. The April call would have less than 3 months remaining
and the October call would be the long-term call. At April expiration, if XYZ is below
50, the April call will expire worthless. At that time, the July 50 call could be sold
against the October 50 that is held long, thereby creating another calendar spread
with no additional commission cost on the long side.
The advantage of this type of strategy is that it is possible for the two sales (April
50 and July 50 in this example) to actually bring in more credits than were spent for
the one purchase (October 50). Thus, the spreader might be able to create aposition
in which he has aguaranteed profit. That is, if the sum of his transactions is actually
acredit, he cannot lose money in the spread (provided that he does not attempt to
"leg" out of the spread). The disadvantage of using the long-term call in the calendar
spread is that the initial debit is larger, and therefore more dollars are initially at risk.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:224


Chapter 9: Calendar Spreads 199
If the underlying stock moves substantially up or down in the first 3 months, the
spreader could realize alarger dollar loss with the October/ April spread because his
loss will approach the initial debit.
The remaining combination of the expiration series is to initially buy the
longest-term call and sell the intermediate-term call against it. This combination will
generally require the smallest initial debit, but there is not much profit potential in
the spread until the intermediate-term expiration date draws near. Thus, there is alot of time for the underlying stock to move some distance away from the initial strik
ing price. For this reason, this is generally an inferior approach to calendar spread
ing.
SUMMARY
Calendar spreading is alow-dollar-cost strategy that is anonaggressive approach, pro
vided that the spreader does not invest alarge percentage of his trading capital in the
strategy, and provided that he does not attempt to "leg" into or out of the spreads.
The neutral calendar spread is one in which the strategist is mainly selling time; he
is attempting to capitalize on the known fact that the near-term call will lose time pre
mium more rapidly than will alonger-term call. Amore aggressive approach is the
bullish calendar spread, in which the speculator is essentially trying to reduce the net
cost of alonger-term call by the amount of credits taken in from the sale of anearer
term call. This bullish strategy requires that the near-term call expire worthless and
then that the underlying stock rise in price. In either strategy, the most common
approach is to sell the nearest-term call and buy the intermediate-term call.
However, it may sometimes prove advantageous to sell the near-term and buy the
longest-term initially, with the intention of letting the near-term expire and then pos
sibly writing against the longer-term call asecond time.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:225


. CHAPTER 10
The Butterfly Spread
The recipient of one of the more exotic names given to spread positions, the butter
fly spread is aneutral position that is acombination of both abull spread and abear
spread. This spread is for the neutral strategist, one who thinks the underlying stock
will not experience much of anet rise or decline by expiration. It generally requires
only asmall investment and has limited risk. Although profits are limited as well, they
are larger than the potential risk. For this reason, the butterfly spread is aviable strat
egy. However, it is costly in terms of commissions. In this chapter, the strategy is
explained using only calls. The strategy can also be implemented using acombination
of puts and calls, or with puts only, as will be demonstrated later.
There are three striking prices involved in abutterfiy spread. Using only calls,
the butterfly spread consists of buying one call at the lowest striking price, selling two
calls at the middle striking price, and buying one call at the highest striking price. The
following example will demonstrate how the butterfly spread works.
Example: Abutterfly spread is established by buying a July 50 call for 12, selling 2
July 60 calls for 6 each, and buying a July 70 call for 3. The spread requires arela
tively low debit of $300 (Table 10-1), although there are four option commissions
involved and these may represent asubstantial percentage of the net investment. As
usual, the maximum amount of profit is realized at the striking price of the written
calls. With most types of spreads, this is auseful fact to remember, for it can aid in
quick computation of the potential of the spread. In this example, if the stock were
at the striking price of the written options at expiration (60), the two July 60'sthat are
short would expire worthless for a $1,200 gain. The long July 70 call would expire
worthless for a $300 loss, and the long July 50 call would be worth 10 points, for a
$200 loss on that call. The sum of the gains and losses would thus be a $700 gain, less
commissions. This is the maximum profit potential of the spread.
200

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:226


Chapter 10: The Butterfly Spread
TABLE 10-1.
Butterfly spread example.
Current prices:
XYZ common:
XYZ July 50 call:
XYZ July 60 call:
XYZ July 70 call:
Butterfly spread:
Buy 1 July 50 call
Sell 2 July 60 calls
Buy 1 July 70 call
Net debit
60
12
6
3
$1 ,200 debit
$1,200 credit
$300 debit
$300 (plus commissions)
201
The risk is limited in abutterfly spread, both to the upside and to the downside,
and is equal to the amount of the net debit required to establish the spread. In the
example above, the risk is limited to $300 plus commissions.
Table 10-2 and Figure 10-1 depict the results of this butterfly spread at various
prices at expiration. The profit graph resembles that of aratio write, except that the
loss is limited on both the upside and the downside. There is aprofit range within
which the butterfly spread makes money - 53 to 67 in the example, before commis
sions are included. Outside this profit range, losses will occur at expiration, but these
losses are limited to the amount of the original debit plus commissions.
In accordance with more lenient margin requirements passed in 2000, the
investment required for abutterfly spread is equal to the net debit expended, which
is the risk in the spread. When the options expire in the same month and the strik
ing prices are evenly spaced (the spacing is 10 points in this example), the following
formulae can be used to quickly compute the important details of the butterfly
spread:
Net investment= Net debit of the spread
Maximum profit = Distance between strikes - Net debit
Downside break-even= Lowest strike+ Net debit
Upside break-even= Highest strike - Net debit
In the example, the distance between strikes is 10 points, the net debit is 3
points (before commissions), the lowest strike used is 50, and the highest strike is 70.
These formulae would then yield the following results for this example spread.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:227


Chapter 10: The Butterfly Spread 203
Note that all of these answers agree with the results that were previously obtained by
analyzing the example spread in detail.
In this example, the maximum profit potential is $700, the maximum risk is
$300, and the investment required is also $300, commissions excluded. In percent
age terms, this means that the butterfly spread has aloss limited to about 100% of
capital invested and could make profits of nearly 133% in this case. These represent
an attractive risk/reward relationship. This is, however, just an example, and two fac
tors that exist in the actual marketplace may greatly affect these numbers. First, com
missions are large; it is possible that eight commissions might have to be paid to
establish and liquidate the spread. Second, depending on the level of premiums to
be found in the market at any point in time, it may not be possible to establish aspread for adebit as low as 3 points when the strikes are 10 points apart.
SELECTING THE SPREAD
Ideally, one would want to establish abutterfly spread at as small of adebit as pos
sible in order to limit his risk to asmall amount, although that risk is still equal to
100% of the dollars invested in the spread. One would also like to have the stock be
near the middle striking price to begin with, because he will then be in his maximum
profit area if the stock remains relatively unchanged. Unfortunately, it is difficult to
satisfy both conditions simultaneously.
The smallest-debit butterfly spreads are those in which the stock is some dis
tance away from the middle striking price. To see this, note that if the stock were
well above the middle strike and all the options were at parity, the net debit would
be zero. Although no one would attempt to establish abutterfly spread with parity
options because of the risk of early assignment, it may be somewhat useful to try to
obtain asmall debit by taking an opinion on the underlying stock. For example, if
the stock is close to the higher striking price, the debit would be small normally, but
the investor would have to be somewhat bearish on the underlying stock in order to
maximize his profit; that is, the stock would have to decline in price from the upper
striking price to the middle striking price for the maximum profit to be realized. An
analogous situation exists when the underlying stock is originally close to the lower
striking price. The investor could establish the spread for asmall debit in this case
also, but he would now have to be somewhat bullish on the underlying stock in order
to attempt to realize his maximum profit.
Example: XYZ is at 70. One may be able to establish alow-debit butterfly spread
with the 50's, 60's, and 70'sif the following prices exist:

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:229


204
XYZ common, 70;
XYZ July 50, 20;
XYZ July 60, 12; and
XYZ July 70, 5.
Part II: Call Option Strategies
The butterfly spread would require adebit of only $100 plus commissions to estab
lish, because the cost of the calls at the higher and lower strike is 25 points, and a 24-
point credit would be obtained by selling two calls at the middle strike. This is indeed
alow-cost butterfly spread, but the stock will have to move down in price for much
of aprofit to be realized. The maximum profit of $900 less commissions would be
realized at 60 at expiration. The strategist would have to be bearish on XYZ to want
to establish such aspread.
Without the aid of an example, the reader should be able to determine that if
XYZ were originally at 50, alow-cost butterfly spread could be established by buying
the 50, selling two 60's, and buying a 70. In this case, however, the investor would
have to be bullish on the stock, because he would want it to move up to 60 by expi
ration in order for the maximum profit to be realized.
In general, then, if the butterfly spread is to be established at an extremely low
debit, the spreader will have to make adecision as to whether he wants to be bullish
or bearish on the underlying stock. Many strategists prefer to remain as neutral as
possible on the underlying stock at all times in any strategy. This philosophy would
lead to slightly higher debits, such as the $300 debit in the example at the beginning
of this chapter, but would theoretically have abetter chance of making money
because there would be aprofit if the stock remained relatively unchanged, the most
probable occurrence.
In either philosophy, there are other considerations for the butterfly spread.
The best butterfly spreads are generally found on the more expensive and/or more
volatile stocks that have striking prices spaced 10 or 20 points apart. In these situa
tions, the maximum profit is large enough to overcome the weight of the commission
costs involved in the butterfly spread. When one establishes butterfly spreads on
lower-priced stocks whose striking prices are only 5 points apart, he is normally put
ting himself at adisadvantage unless the debit is extremely small. One exception to
this rule is that attractive situations are often found on higher-priced stocks with
striking prices 5 points apart (50, 55, and 60, for example). They do exist from time
to time.
In analyzing butterfly spreads, one commonly works with closing prices. It was
mentioned earlier that using closing prices for analysis can prove somewhat mislead
ing, since the actual execution will have to be done at bid and asked prices, and these

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:230


Chapter 10: The Butterfly Spread 205
may differ somewhat from closing prices. Normally, this difference is small, but since
there are three different calls involved in abutterfly spread, the difference could be
substantial. Therefore, it is usually necessary to check the appropriate bid and asked
price for each call before entering the spread, in order to be able to place areason
able debit on the order. As with other types of spreads, the butterfly spread order can
be placed as one order.
Before moving on to discuss follow-up action, it may be worthwhile to describe
atactic for stocks with 5 points between striking prices. For example, the butterfly
spreader might work with strikes of 45, 50, and 60. If he sets up the usual type of but
terfly spread, he would end up with aposition that has too much risk near 60 and very
little or none at all near 45. If this is what he wants, fine; but if he wants to remain
neutral, the standard type of butterfly spread will have to be modified slightly.
Example: The following prices exist:
XYZ common, 50;
July 45 call, 7;
July 50 call, 5; and
July 60 call, 2.
The normal type of butterfly spread- buying one 45, selling two 50's, and buying one
60 - can actually be done for acredit of 1 point. However, the profitability is no
longer symmetric about the middle striking price. In this example, the investor can
not lose to the downside because, even if the stock collapses and all the calls expire
worthless, he will still make his I-point credit. However, to the upside, there is risk:
If XYZ is anywhere above 60 at expiration, the risk is 4 points. This is no longer aneu
tral position. The fact that the lower strike is only 5 points from the middle strike
while the higher strike is 10 points away has made this asomewhat bearish position.
If the spreader wants to be neutral and still use these striking prices, he will have to
put on two bull spreads and only one bear spread. That is, he should:
Buy 2 July 45's:
Sell 3 July 50's:
Buy 1 July 60:
$1,400 debit
$1,500 credit
$200 debit
This position now has anet debit of $100 but has abetter balance of risk at either
end. If XYZ drops and is below 45 at expiration, the spreader will lose his $100 ini
tial debit. But now, if XYZ is at or above 60 at expiration, he will lose $100 in that
range also. Thus, by establishing two bull spreads with a 5-point difference between

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:231


206 Part II: Call Option Strategies
strikes versus one bear spread with a IO-point difference between strikes, the risk has
been balanced at both ends. When one uses strike prices that are not evenly spaced
apart, his margin requirement increases substantially. In such acase, one has to mar
gin the individual component spreads separately. Therefore, in this example, he
would have to pay for the two bull spreads ( $200 each, for atotal of $400) and then
margin the additional call bear spread ($700: the $1,000 difference in the strikes, less
the $300 credit taken in for that portion of the spread). Hence, in this example, the
margin requirement would be $1,100, even though the risk is only $100. Technically,
of that $1,100 requirement, the spread trader pays out only $100 in cash (the actual
debit of the spread), and the rest of the requirement can be satisfied with excess
equity in his account.
The same analysis obviously applies whenever 5-point striking price intervals
exist. There are numerous combinations that could be worked out for lower-priced
stocks by merely skipping over astriking price ( using the 25's, 30's, and 40's, for exam
ple). Although there are not normally many stocks trading over $100 per share, the
same analysis is applicable using 130's, 140's, and 160's, for example.
FOLLOW-UP ACTION
Since the butterfly spread has limited risk by its construction, there is usually little
that the spreader has to do in the way of follow-up action other than avoiding early
exercise or possibly dosing out the position early to take profits or limit losses even
further. The only part of the spread that is subject to assignment is the call at the mid
dle strike. If this call trades at or near parity, in-the-money, the spread should be
closed. This may happen before expiration if the underlying stock is about to go ex
dividend. It should be noted that accepting assignment will not increase the risk of
the spread (because any short calls assigned would still be protected by the remain
ing long calls). However, the margin requirement would change substantially, since
one would now have asynthetic put (long calls, short stock) in place. Plus, there may
be more onerous commissions for trading stock. Therefore, it is usually wise to avoid
assignment in abutterfly spread, or in any spread, for that matter.
If the stock is near the middle strike after areasonable amount of time has
passed, an unrealized profit will begin to accrue to the spreader. If one feels that the
underlying stock is about to move away from the middle striking price and thereby
jeopardize these profits, it may be advantageous to close the spread to take the avail
able profit. Be certain to include commission costs when determining if an unreal
ized profit exists. As ageneral rule of thumb, if one is doing 10 spreads at atime, he

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:232


Chapter 10: Tire Butterfly Spread 207
can estimate that the commission cost for each option is about 1/spoint. That is, if one
has 10 butterfly spreads and the spread is currently at 6 points, he could figure that
he would net about 5½ points after commissions to close the spread. This 1/sestimate
is only valid if the spreader has at least 10 options at each strike involved in aspread.
Normally, one would not close the spread early to limit losses, since these loss
es are limited to the original net debit in any case. However, if the original debit was
large and the stock is beginning to break out above the higher strike or to break down
below the lower strike, the spreader may want to close the spread to limit losses even
further.
It has been repeatedly stated that one should not attempt to ''leg" out of aspread because of the risk that is incurred if one is wrong. However, there is amethod of legging out of abutterfly spread that is acceptable and may even be pru
dent. Since the spread consists of both abull spread and abear spread, it may often
be the case that the stock experiences arelatively substantial move in one direction
or the other during the life of the butterfly spread, and that the bull spread portion
or the bear spread portion could be closed out near their maximum profit potentials.
If this situation arises, the spreader may want to take advantage of it in order to be
able to profit more if the underlying stock reverses direction and comes back into the
profit range.
Exampk: This strategy can be explained by using the initial example from this chap
ter and then assuming that the stock falls from 60 to 45. Recall that this spread was
initially established with a 3-point debit and amaximum profit potential of 7 points.
The profit range was 53 to 67 at July expiration. However, arather unpleasant situa
tion has occurred: The stock has fallen quickly and is below the profit range. If the
spreader does nothing and keeps the spread on, he will lose 3 points at most if the
stock remains below 50 until July expiration. However, by increasing his risk slightly,
he may be able to improve his position. Notice in Table 10-3 that the bear spread por
tion of the overall spread - short July 60, long July 70 - has very nearly reached its
maximum potential. The bear spread could be bought back for ½ point total (pay 1
point to buy back the July 60 and receive½ point from selling out the July 70). Thus,
the spreader could convert the butterfly spread to abull spread by spending ½ point.
What would such an action do to his overall position? First, his risk would be
increased by the ½ point spent to close the bear spread. That is, if XYZ continues to
remain below 50 until July expiration, he would now lose 3½ rather than 3 points,
plus commissions in either case. He has, however, potentially helped his chances of
realizing something close to the maximum profit available from the original butterfly
spread.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:233


208 Part II: Call Option Strategies
TABLE 10-3.
Initial spread and current prices.
Initial Spread Current Prices
XYZ common: 60 XYZ common: 45
July 50 call: 12 July 50 call: 2
July 60 call: 6 July 60 call: 1
July 70 call: 3 July 70 call: 1/2
After buying back the bear spread, he is left with the following bull spread:
Long July 50 call _ Ntdb·t 3u, . thlall ee 1 ,2 pom s Sort Ju y 60 c
He has abull spread at the total cost paid to date - 3½ points. From the earlier dis
cussion of bull spreads, the reader should know that the break-even point for this
position is 53½ at expiration, and it could make a 6½ point profit if XYZ is anywhere
over 60 at July expiration. Hence, the break-even point for the position was raised
from 53 to 53½ by the expense of the ½ point to buy back the bear spread. However,
if the stock should rally back above 60, the strategist will be making aprofit nearly
equal to the original maximum profit that he was aiming for (7 points). Moreover, this
profit is now available anywhere over 60, not just exactly at 60 as it was in the origi
nal position. Although the chances of such arally cannot be considered great, it does
not cost the spreader much to restructure himself into aposition with amuch broad
er maximum profit area.
Asimilar situation is available if the underlying stock moves up in price. In that
case, the bull spread may be able to be removed at nearly its maximum profit poten
tial, thereby leaving abear spread. Again, suppose that the same initial spread was
established but that XYZ has risen to 75. When the underlying stock advances sub
stantially, the bull spread portion of the butterfly spread may expand to near its max
imum potential. Since the strikes are 10 points apart in this bull spread, the widest it
can grow to is 10 points. At the prices shown in Table 10-4, the bull spread - long
July 50 and short July 60 - has grown to 9½ points. Thus, the bull spread position
could be removed within ½ point of its maximum profit potential and the original
butterfly spread would become abear spread. Note that the closing of the bull spread
portion generates a 9½ point credit: The July 50 is sold at 25½ and the July 60 is
bought back at 16. The original butterfly spread was established at a 3-point debit, so
the net position is the remaining position:

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:234


Chapter 10: The BatterRy Spread 209
Long July 70 call .
Short July 60 call - Net credit 6½ points
This bear spread has amaximum profit potential of 6½ points anywhere below 60 at
July expiration. The maximum risk is 3½ points anywhere above 70 at expiration.
Thus, the original butterfly spread was again converted into aposition such that astock price reversal to any price below 60 could produce something close to the max
imum profit. Moreover, the risk was only increased by an additional ½ point.
TABLE 10-4.
Initial spread and new current prices.
Initiol Spread
XYZ common: 60
XYZ July 50 call: 12
July 60 call: 6
July 70 call: 3
SUMMARY
Current Prices
XYZ common:
July 50 call:
July 60 call:
July 70 call:
75
251/2
16
7
The butterfly spread is aviable, low-cost strategy with both limited profit potential
and limited risk. It is actually acombination of abull spread and abear spread, and
involves using three striking prices. The risk is limited should the underlying stock
fall below the lowest strike or rise above the highest strike. The maximum profit is
obtained at the middle strike. One can keep his initial debits to aminimum by ini
tially assuming abullish or bearish posture on the underlying stock. If he would
rather remain neutral, he will normally have to pay aslightly larger debit to establish
the spread, but may have abetter chance of making money. If the underlying stock
experiences alarge move in one direction or the other prior to expiration, the spread
er may want to close the profitable side of his butterfly spread near its maximum
profit potential in order to be able to capitalize on astock price reversal, should one
occur.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:235


Ratio Call Spreads
Aratio call spread is aneutral strategy in which one buys anumber of calls at alower
strike and sells more calls at ahigher strike. It is somewhat similar to aratio write in
concept, although the spread has less downside risk and normally requires asmaller
investment than does aratio write. The ratio spread and ratio write are similar in that
both involve uncovered calls, and both have profit ranges within which aprofit can
be made at expiration. Other comparisons are demonstrated throughout the chapter.
Example: The following prices exist:
XYZ common, 44;
XYZ April 40 call, 5; and
XYZ April 45 call, 3.
A 2:1 ratio call spread could be established by buying one April 40 call and simulta
neously selling two April 45's. This spread would be done for acredit of 1 point - the
sale of the two April 45'sbringing in 6 points and the purchase of the April 40 cost
ing 5 points. This spread can be entered as one spread order, specifying the net cred
it or debit for the position. In this case, the spread would be entered at anet credit
of 1 point.
Ratio spreads, unlike ratio writes, have arelatively small, limited downside risk.
In fact, if the spread is established at an initial credit, there is no downside risk at all.
In aratio spread, the profit or loss at expiration is constant below the lower striking
price, because both options would be worthless in that area. In the example above, if
XYZ is below 40 at April expiration, all the options would expire worthless and the
spreader would have made aprofit of his initial I-point credit, less commissions. This
I-point gain would occur anywhere below 40 at expiration; it is aconstant.
210

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:236


Chapter 11: Ratio Call Spreads 211
The maximum profit at expiration for aratio spread occurs if the stock is exact
ly at the striking price of the written options. This is true for nearly all types of strate
gies involving written options. In the example, if XYZ were at 45 at April expiration,
the April 45 calls would expire worthless for again of $600 on the two of them, and
the April 40 call would be worth 5 points, resulting in no gain or loss on that call.
Thus, the total profit would be $600 less commissions.
The greatest risk in aratio call spread lies to the upside, where the loss may the
oretically be unlimited. The upside break-even point in this example is 51, as shown
in Table 11-1. The table and Figure 11-1 illustrate the statements made in the pre
ceding paragraphs.
In a 2:1 ratio spread, two calls are sold for each one purchased. The maximum
profit amount and the upside break-even point can easily be computed by using the
following formulae:
Points of maximum profit = Initial credit + Difference between strikes or
= Difference between strikes - Initial debit
Upside break-even point= Higher strike price+ Points of maximum profit
In the preceding example, the initial credit was 1 point, so the points of maxi
mum profit = 1 + 5 = 6, or $600. The upside break-even point is then 45 + 6, or 51.
This agrees with the results determined earlier. Note that if the spread is established
at adebit rather than acredit, the debit is subtracted from the striking price differ
ential to determine the points of maximum profit.
Many neutral investors prefer ratio spreads over ratio writes for two reasons:
TABLE 11-1.
Ratio call spread.
XYZ Price of April 40 Coll April 45 Coll Total
Expiration Profits Profits Profits
35 -$ 500 +$ 600 +$100
40 - 500 + 600 + 100
42 - 300 + 600 + 300
45 0 + 600 + 600
48 + 300 0 + 300
51 + 600 - 600 0
55 +1,000 -1,400 - 400
60 + 1,500 -2,400 - 900

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:237


212 Part II: Call Option Strategies
FIGURE 11 • 1.
Ratio call spread (2: 1 ).
Stock Price at Expiration
1. The downside risk or gain is predetermined in the ratio spread at expiration, and
therefore the position does not require much monitoring on the downside.
2. The margin investment required for aratio spread is normally smaller than that
required for aratio write, since on the long side one is buying acall rather than
buying the common stock itself.
For margin purposes, aratio spread is really the combination of abull spread
and anaked call write. There is no margin requirement for abull spread other than
the net debit to establish the bull spread. The net investment for the ratio spread is
thus equal to the collateral required for the naked calls in the spread plus or minus
the net debit or credit of the spread. In the example above, there is one naked call.
The requirement for the naked call is 20% of the stock price plus the call premium,
less the out-of-the-money amount. So the requirement in the example would be 20%
of 44, or $880, plus the call premium of $300, less the one point that the stock is
below the striking price - a $1,080 requirement for the naked call. Since the spread
was established at acredit of one point, this credit can also be applied against the ini
tial requirement, thereby reducing that requirement to $980. Since there is anaked
call in this spread, there will be amark to market if the stock moves up. Just as was
recommended for the ratio write, it is recommended that the ratio spreader allow at
least enough collateral to reach the upside break-even point. Since the upside break
even point is 51 in this example, the spreader should allow 20% of 51, or $1,020, plus

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:238


Chapter 11: Ratio Call Spreads 213
the 6 points that the call would be worth less the 1-point initial net credit - atotal of
$1,520 for this spread ($1,020 + $600 - $100).
DIFFERING PHILOSOPHIES
For many strategies, there is more than one philosophy of how to implement the
strategy. Ratio spreads are no exception, with three philosophies being predominant.
One philosophy holds that ratio spreading is quite similar to ratio writing - that one
should be looking for opportunities to purchase an in-the-money call with little or no
time premium in it so that the ratio spread simulates the profit opportunities from
the ratio write as closely as possible with asmaller investment. The ratio spreads
established under this philosophy may have rather large debits if the purchased call
is substantially in-the-money. Another philosophy of ratio spreading is that spreads
should be established for credits so that there is no chance of losing money on the
downside. Both philosophies have merit and both are described. Athird philosophy,
called the "delta spread," is more concerned with neutrality, regardless of the initial
debit or credit. It is also described.
RATIO SPREAD AS RATIO WRITE
There are several spread strategies similar to strategies that involve common stock. In
this case, the ratio spread is similar to the ratio write. Whenever such asimilarity
exists, it may be possible for the strategist to buy an in-the-money call with little or no
time premium as asubstitute for buying the common stock. This was seen earlier in
the covered call writing strategy, where it was shown that the purchase of in-the
money calls or warrants might be aviable substitute for the purchase of stock. If one
is able to buy an in-the-rrwney call as asubstitute for the stock, he will not affect his
profit potential substantially. When comparing aratio spread to aratio write, the max
imum profit potential and the profit range are reduced by the time value premium
paid for the long call. If this call is at parity (the time value premium is thus zero), the
ratio spread and the ratio write have exactly the same profit potential. Moreover, the
net investment is reduced and there is less downside risk should the stock fall in price
below the striking price of the purchased call. The spread also involves smaller com
mission costs than does the ratio write, which involves astock purchase. The ratio
writer does receive stock dividends, if any are paid, whereas the spreader does not.
Example: XYZ is at 50, and an XYZ July 40 call is selling for 11 while an XYZ July 50
call is selling for 5. Table 11-2 compares the important points between the ratio write
and the ratio spread.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:239


214
TABLE 11-2.
Ratio write and ratio spread compared.
Profit range
Maximum profit
Downside risk
Upside risk
Initial investment
Ratio Write:
Buy XYZ of 50 and
Sell 2 July SO'sat 5
40 to 60
10 points
40 points
40 points
$3,000
Part II: Call Option Strategies
Ratio Spread:
Buy 1 July 40 of 11 and
Sell 2 July SO'sat 5
41 to 59
9 points
1 point
Unlimited
$1,600
In Chapter 6, it was pointed out that ratio writing was one of the better strate
gies from aprobability of profit viewpoint. That is, the profit potential conforms well
to the expected movement of the underlying stock. The same statement holds true
for ratio spreads as substitutes for ratio writes. In fact, the ratio spread may often be
abetter position than the ratio write itself, when the long call can be purchased with
little or no time value premium in it.
RATIO SPREAD FOR CREDITS
The second philosophy of ratio spreads is to establish them only for credits.
Strategists who follow this philosophy generally want asecond criterion fulfilled also:
that the underlying stock be below the striking price of the written calls when the
spread is established. In fact, the farther the stock is below the strike, the more
attractive the spread would be. This type of ratio spread has no downside risk
because, even if the stock collapses, the spreader will still make aprofit equal to the
initial credit received. This application of the ratio spread strategy is actually asub
case of the application discussed above. That is, it may be possible both to buy along
call for little or no time premium, thereby simulating aratio write, and also to be able
to set up the position for acredit.
Since the underlying stock is generally below the maximum profit point when
one establishes aratio spread for acredit, this is actually amildly bullish position.
The investor would want the stock to move up slightly in order for his maximum prof
it potential to be realized. Of course, the position does have unlimited upside risk, so
it is not an overly bullish strategy.

eBooks\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012)\Lawrence G. McMillan - Options as a Strategic Investment_ Fifth Edition-Prentice Hall Press (2012).pdf#page:240