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