missions or who have
such a large holding that their commissions are quite small on a percentage basis will
be able to profit substantially from such a strategy.
ADJUSTING WITH THE DELTA
The delta of the written calls can be used to determine the correct ratio to be used in
this ratio-adjusting defensive strategy. The basic idea is to use the call's delta to
remain as neutral as possible at all times.
Cl,apter 6: Ratio Call Writing 161
Example: An investor initially sets up a neutral 5:3 ratio of XYZ October 50 calls to
XYZ stock, as was determined previously. The stock is at 49 and the delta is .60.
Furthermore, suppose the stock rises to 57 and the call now has a delta of .80. The
neutral ratio would currently be 1/.80 ( = 1.20) or 5:4. The ratio writer could thus buy
another 100 shares of the underlying stock.
Alternatively, he might buy in one of the short calls. In this particular example,
buying in one call would produce a 4:3 ratio, which is not absolutely correct. If he
had had a larger position initially, it would be easier to adjust to fractional ratios.
When the stock declines, it is necessary to increase the ratio. This can be accom
plished by either selling more calls or selling out some of the long stock. In theory,
these adjustments could be made constantly to keep the position neutral. In practice,
one would allow for a few points of movement by the underlying stock before adjust
ing. If the underlying stock rises too far, it may be logical for the neutral strategist to
adjust by rolling up. Similarly, he would roll down if the stock fell to or below the next
lower strike. The neutral ratio in that case is determined by using the delta of the
option into which he is rolling.
Example: With XYZ at 57, an investor is contemplating rolling up to the October 60's
from his present position of long 300 shares and short 5 XYZ October 50's. If the
October 60 has a delta of .40, the neutral ratio for the October 60's is 2.5:l (1 + .40).
Since he is already long 300 shares of stock, he should now be short 7.5 calls (3 x 2.5).
Obviously, he would sell 7 or 8, probably depending on his short-term outlook for the
stock.
If one prefers to adopt an even more sophisticated approach, he can make
adjustments between striking prices by altering his stock position, and can make
adjustments by rolling up or down if the stock reaches a new striking price. For those
who prefer formulae, the following ones summarize this information:
1. When establishing a new position or when rolling up or down, at the next strike:
N b f all t 11 Round lots held long um er o c s o se =
Delta of call to be sold
Note: When establishing a new position, one must first decide how many shares
of the underlying stock he can buy before utilizing the formula; 1,000
shares would be a workable amount.
2. When adjusting between strikes by buying or selling stock:
162 Part II: Call Option Strategies
Number of
round lots = Current delta x Number of short calls - Round lots held long
to buy
Note: If a negative number results, stock should be sold, not bought.
These formulae can be verified by using the numbers from the examples above. For
example, when the delta of the October 50 was .80 with the stock at 57, it was seen
that buying 100 shares of stock would reestablish a neutral ratio.
Number of round lots to buy= .80 x 5 3 = 4- 3 = 1
Also, if the position was to be rolled up to the October 60 (delta = .40), it was seen
that 7.5 October 60's would theoretically be sold:
Number of calls to sell = __l_ = 7.5 .40
There is a more general approach to this problem, one that can be applied to
any strategy, no matter how complicated. It involves computing whether the position
is net short or net long. The net position is reduced to an equivalent number of shares
of common stock and is commonly called the "equivalent stock position" (ESP). Here
is a simple formula for the equivalent stock position of any option position:
ESP = Option quantity x Delta x Shares per option
Example: Suppose that one is long 10 XYZ July 50 calls, which currently have a delta
of .45. The option is an option on 100 shares of XYZ. Thus, the ESP can be computed:
ESP = 10 x .45 x 100 = 450 shares
This is merely saying that owning 10 of these options is equivalent to owning 450
shares of the underlying common stock, XYZ. The reader should already understand
this, in that an option with a delta of .45 would appreciate by .45 points if the com
mon stock moved up 1 dollar. Thus, 10 options would appreciate by 4.5 points, or
$450. Obviously, 450 shares of common stock would also appreciate by $450 if they
moved up by one point.
Note that there are some options - those that result from a stock split- that are
for more than 100 shares. The inclusion of the term "shares per option" in the for
mula accounts for the fact that such options are equivalent to a different amount of
stock than most options.
The ESP of an entire option and stock position can be computed, even if sev
eral different options are included in the position. The advantage of this simple cal-
Chapter 6: Ratio Call Writing 163
culation is that an entire, possibly complex option position can be reduced to one
number. The ESP shows how the position will behave for short-term market move
ments.
Look again at the previous example of a ratio write. The position was long 300
shares and short 5 options with a current delta of .80 after the stock had risen to 57.
The ESP of the 5 October 50's is short 400 shares (5 x .80 x 100 shares per option).
The position is also long 300 shares of stock, so the total ESP of this ratio write is
short 100 shares.
This figure gives the strategist a measure of perspective on his position. He now
knows that he has a position that is the equivalent of being short 100 shares of XYZ.
Perhaps he is bearish on XYZ and therefore decides to do nothing. That would be
fine; at least he knows that his positio


The position is also long 300 shares of stock, so the total ESP of this ratio write is
short 100 shares.
This figure gives the strategist a measure of perspective on his position. He now
knows that he has a position that is the equivalent of being short 100 shares of XYZ.
Perhaps he is bearish on XYZ and therefore decides to do nothing. That would be
fine; at least he knows that his position is short.
Normally, however, the strategist would want to adjust his position. Again
returning to the previous example, he has several choices in reducing the ESP back
to neutral. An ESP of O is considered to be a perfectly neutral position. Obviously,
one could buy 100 shares of XYZ to reduce the 100-share delta short. Or, given that
the delta of the October 50 call is .80, he could buy in 1.25 of these short calls (obvi
ously he could only buy l; fractional options cannot be purchased).
Later chapters include more discussions and examples using the ESP. It is a
vital concept that no strategist who is operating positions involving multiple options
should be without. The only requirement for calculating it is to know the delta of the
options in one's position. Those are easily obtainable from one's broker or from a
number of computer services, software programs, or Web sites.
For investors who do not have the funds or are not in a position to utilize such
a ratio adjusting strategy, there is a less time-consuming method of taking defensive
action in a ratio write.
USING STOP ORDERS AS A DEFENSIVE STRATEGY
A ratio writer can use buy or sell stops on his stock position in order to automatical
ly and unemotionally adjust the ratio of his position. This type of defensive strategy
is not an aggressive one and will provide some profits unless a whipsaw occurs in the
underlying stock.
As an example of how the use of stop orders can aid the ratio writer, let us again
assume that the same basic position was established by buying XYZ at 49 and selling
two October 50 calls at 6 points each. This produces a profit range of 37 to 63 at expi
ration. If the stock begins to move up too far or to fall too far, the ratio writer can
adjust the ratio of calls short to stock long automatically, through the use of stop
orders on his stock.
164 Part II: Call Option Strategies
Example: An investor places a "good until canceled" stop order to buy 100 shares of
XYZ at 57 at the same time that he establishes the original position. If XYZ should
get to 57, the stop would be set off and he would then own 200 shares ofXYZ and be
short 2 calls. That is, he would have a 200-share covered write of XYZ October 50
calls.
To see how such an action affects his overall profit picture, note that his average
stock cost is now 53; he paid 49 for the first 100 shares and paid 57 for the second 100
shares bought via the stop order. Since he sold the calls at 6 each, he essentially has a
covered write in which he bought stock at 53 and sold calls for 6 points. This does not
represent a lot of profit potential, but it will ensure some profit unless the stock falls
back below the new break-even point. This new break-even point is 47 - the stock
cost, 53, less the 6 points received for the call. He will realize the maximum profit
potential from the covered write as long as the stock remains above 50 until expira
tion. Since the stock is already at 57, the probabilities are relatively strong that it will
remain above 50, and even stronger that it will remain above 47, until the expiration
date. If the buy stop order was placed just above a technical resistance area, this prob
ability is even better.
Hence, the use of a buy stop order on the upside allows the ratio writer to auto
matically convert the ratio write into a covered write if the stock moves up too far.
Once the stop goes off, he has a position that will make some profit as long as the
stock does not experience a fairly substantial price reversal.
Downside protective action using a sell stop order works in a similar manner.
Example: The investor placed a "good until canceled" sell stop for 100 shares of
stock after establishing the original position. If this sell stop were placed at 41, for
example, the position would become a naked call writer's position if the stock fell to
41. At that time, the 100 shares of stock that he owned would be sold, at an 8-point
loss, but he would have the capability of making 12 points from the sale of his two
calls as long as the stock remained below 50 until expiration. In fact, his break-even
point after converting into the naked write would actually be 52 at expiration, since
at that price, the calls could be bought back for 2 points each, or 8 points total prof
it, to offset the 8-point loss on the stock. This action limits his profit potential, but
will allow him to make some profit as long as the stock does not experience a strong
price reversal and climb back above 52 by expiration.
There are several advantages for inexperienced ratio writers to using this
method of protection. First, the implementation of the protective strategies - buying
an extra 100 shares of stock if the stock moves up, or selling out the 100 shares that
are long if the stock moves down - is unemotional if the stop orders are placed at the
Chapter 6: Ratio Call Writing 165
same time that the original position is established. This prevents the writer from
attempting to impose his own market judgment in the heat of battle. That is, if XYZ
has moved up to 57, the writer who has not placed a buy stop order may be tempted
to wait just a little longer, hoping for the stock to fall in price. If the stop orders are
placed as soon as the position is established, a great deal of emotion is removed.
Second, this strategy will produce some profit - assuming that the stops are proper
ly placed as long as the stock does not whipsaw or experience a price reversal and
go back through the striking price in the other directi

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


to wait just a little longer, hoping for the stock to fall in price. If the stop orders are
placed as soon as the position is established, a great deal of emotion is removed.
Second, this strategy will produce some profit - assuming that the stops are proper
ly placed as long as the stock does not whipsaw or experience a price reversal and
go back through the striking price in the other direction. Most follow-up actions in
any writing strategy, whether they involve rolling actions or the use of stops, are sub
ject to losses if the stock whipsaws back and forth.
The disadvantage to using this type of protective action is that the writer may
be tying up relatively large amounts of capital in order to make only a small profit
after the stop order is set off. However, in a diversified portfolio, only a small per
centage of the stocks may go through their stop points, thereby still allowing the ratio
writer plenty of profit potential on his other positions.
Once either the buy stop or the sell stop is set off, the writer still needs to watch
the position. His first action after one stop is touched should be to cancel the other
stop order, because the stops are good orders until they are canceled. From that time
on, the writer need do nothing if the stock does not experience a price reversal. In
fact, he would just as soon have the stock experience a greater move in the same
direction to minimize the chances of a price reversal.
If a price reversal does occur, the most conservative action is to close out the
position just after the stock crosses back through the striking price. This will normal
ly result in a small loss, but, again, it should happen in only a relatively small number
of his positions. Recall that .in a limited profit strategy such as ratio writing, it is
important to limit losses as well. If the stock does indeed whipsaw and the position is
closed, the writer will still have most of his original equity and can then reestablish a
new position in another underlying stock.
Placement of Stops. The writer would ideally like to place his stops at
prices that allow a reasonable rate of return to be made, while also having the
stops far enough away from the original striking price to reduce the chances of
a whipsaw occurring. It is a fairly simple matter to calculate the returns that
could be made, after commissions are included, if one or the other of the stops
goes off. Dividends should be included as well, since they will accrue to the
writer. If the writer is willing to accept returns as low as 5% annually for those
positions that go through their stop points, he will be able to place his stops far
ther from the original striking price. If he feels that he needs a higher return
when the stops go off, the stops must be placed closer in. As with any stock or
166 Part II: Call Option Strategies
option investment, the writer who operates in large size will experience less of a
commission charge, percentagewise. That is, the writer who is buying 500 shares
of stock and selling 10 calls to start with will be able to place his stop points far
ther out than the writer who is buying 100 shares of stock and selling 2 calls.
Technical analysis can be helpful in selecting the stop points as well. If there is
resistance overhead, the buy stop should be placed above that resistance. Similarly, if
there is support, the sell stop should be placed beneath the support point. Later,
when straddles are discussed, it will be seen that this type of strategy can be operat
ed at less of a net commission charge, since the purchase and sale of stock will not be
involved.
CLOSING OUT THE WRITE
The methods of follow-up action discussed above deal ,vith the eventuality of pre
venting losses. However, if all goes well, the ratio write will begin to accrue profits as
the stock remains relatively close to the original striking price. To retain these paper
profits that have accrued, it is necessary to move the protective action points closer
together.
Example: XYZ is at 51 after some time has passed, and the calls are at 3 points each.
The writer would, at this time, have an unrealized profit of $800 - $200 from the
stock purchase at 49, and $300 each on the two calls, which were originally sold at 6
points each. Recall that the maximum potential profit from the position, ifXYZ were
exactly at 50 at expiration, is $1,300. The writer would like to adjust the protective
points so that nearly all of the $800 paper profit might be retained while still allow
ing for the profit to grow to the $1,300 maximum.
At expiration, $800 profit would be realized ifXYZ were at 45 or at 55. This can
be verified by referring again to Table 6-1 and Figure 6-1. The 45 to 55 range is now
the area that the writer must be concerned with. The original profit range of 39 to 61
has become meaningless, since the position has performed well to this point in time.
If the writer is using the rolling method of protection, he would roll forward to the
next expiration series if the stock were to reach 45 or 55. If he is using the stop-out
method of protection, he could either close the position at 45 or 55 or he could roll
to the next expiration series and readjust his stop points. The neutral strategist using
deltas would determine the number of calls to roll forward to by using the delta of
the longer-term call.
By moving the protective action points closer together, the ratio writer can then
adjust his position while he still has a profit; he is attempting to "lock in" his profit.
As even more time passes and expiration draws nearer, it may be possible to move
Chapter 6: Ratio Call Writing 167
the protective points even closer together. Thus, as the position continues to improve
over time, the writer should be constantly "telescoping" his action points and finally
roll out to the next expiration series. This is generally the more prudent move,
because the commissions to sell sto


re time passes and expiration draws nearer, it may be possible to move
Chapter 6: Ratio Call Writing 167
the protective points even closer together. Thus, as the position continues to improve
over time, the writer should be constantly "telescoping" his action points and finally
roll out to the next expiration series. This is generally the more prudent move,
because the commissions to sell stock to close the position and then buy another
stock to establish yet another position may prove to be prohibitive. In summary, then,
as a ratio write nears expiration, the writer should be concerned with an ever-nar
rowing range within which his profits can grow but outside of which his profits could
dissipate if he does not take action.
COMMENTS ON DELTA-NEUTRAL TRADING
Since the concept of delta-neutral positions was introduced in this chapter, this is
an appropriate time to discuss them in a general way. Essentially, a delta-neutral
position is a hedged position in which at least two securities are used - two or more
different options, or at least one option plus the underlying. The deltas of the two
securities offset each other so that the position starts out with an "equivalent stock
position" (ESP) of 0. Another term for ESP is "position delta." Thus, in theory,
there is no price risk to begin with; the position is neutral with respect to price
movement of the underlying. That definition lasts for about a nanosecond.
As soon as time passes, or the stock moves, or implied volatility changes, the
deltas change and therefore the position is no longer delta-neutral. Many people
seem to have the feeling that a delta-neutral position is somehow one in which it is
easy to make money without predicting the price direction of the underlying. That is
not true.
Delta-neutral trading is not "easy": Either (1) one assumes some price risk as
soon as the stock begins to move, or (2) one keeps constantly adjusting his deltas to
keep them neutral. Method 2 is not feasible for public traders because of commis
sions. It is even difficult for market-makers, who pay no commissions. Most public
practitioners of delta-neutral trading establish a neutral position, but then refrain
from adjusting it too often.
A common mistake that novice traders make with delta-neutral trading is to
short options in a neutral manner, figuring that they have little exposure to price
change because the position is delta-neutral. However, a sizeable move by the under
lying (which often happens in a short period of time) ruins the neutrality of the posi
tion and inevitably costs the trader a lot of money. A simple example: If one sells a
naked straddle (i.e., he sells a naked put and a naked call with both having the same
striking price) with the stock initially just below the strike price, that's a delta-ne~tral
168 Part II: Call Option Strategies
position. However, the position has naked options on both sides, and therefore has
tremendous liability.
In practice, professionals watch more than just the delta; they also watch other
measures of the risk of a position. Even then, price and volatility changes can cause
problems. Advanced risk concepts are addressed more fully in the chapter on
Advanced Concepts.
SUMMARY
Ratio writing is a viable, neutral strategy that can be employed with differing levels
of sophistication. The initial ratio of short calls to long stock can be selected simplis
tically by comparing one's opinion for the underlying stock with projected break-even
points from the position. In a more sophisticated manner, the delta of the written
calls can be used to determine the ratio.
Since the strategy has potentially large losses either to the upside or the down
side, follow-up action is mandatory. This action can be taken by simple methods such
as rolling up or down in a constant ratio, or by placing stop orders on the underlying
stock. A more sophisticated technique involves using the delta of the option to either
adjust the stock position or roll to another call. By using the delta, a theoretically neu
tral position can be maintained at all times.
Ratio writing is a relatively sophisticated strategy that involves selling naked
calls. It is therefore not suitable for all investors. Its attractiveness lies in the fact that
vast quantities of time value premium are sold and the strategy is profitable for the
most probable price outcomes of the underlying stock. It has a relatively large prob
ability of making a limited profit, if the position can be held until expiration without
frequent adjustment.
AN INTRODUCTION TO CALL SPREAD STRATEGIES
A spread is a transaction in which one simultaneously buys one option and sells
another option, with different terms, on the same underlying security. In a call
spread, the options are all calls. The basic idea behind spreading is that the strategist
is using the sale of one call to reduce the risk of buying another call. The short call in
a spread is considered covered, for margin purposes, only if the long call has an expi
ration date equal to or longer than the short call. Before delving into the individual
types of spreads, it may be beneficial to cover some general facts that pertain to most
spread situations.
Chapter 6: Ratio Call Writing 169
All spreads fall into three broad categories: vertical, horizontal, or diagonal. A
vertical spread is one in which the calls involved have the same expiration date but
different striking prices. An example might be to buy the XYZ October 30 and sell
the October 35 simultaneously. A horizontal spread is one in which the calls have the
same striking price but different expiration dates. This is a horizontal spread: Sell the
XYZ January 35 and buy the XYZ April 35. A diagonal spread is any combination of
vertical and horizontal and may involve calls that have different expiration dates as
well as different striking prices. These three names that classify the spreads can be
rela


ontal spread is one in which the calls have the
same striking price but different expiration dates. This is a horizontal spread: Sell the
XYZ January 35 and buy the XYZ April 35. A diagonal spread is any combination of
vertical and horizontal and may involve calls that have different expiration dates as
well as different striking prices. These three names that classify the spreads can be
related to the way option prices are listed in any newspaper summary of closing
option prices. A vertical spread involves two options from the same column in a news
paper listing. Newspaper columns run vertically. A horizontal spread involves two
calls whose prices are listed in the same row in a newspaper listing; rows are hori
zontal. This relationship to the listing format in newspapers is not important, but it is
an easy way to remember what vertical spreads and horizontal spreads are. There are
many types of vertical and horizontal spreads, and several of them are discussed in
detail in later chapters.
SPREAD ORDER
The term "spread" designates not only a type of strategy, but a type of order as well.
All spread transactions in which both sides of the spread are opening (initial) trans
actions must be done in a margin account. This means that the customer must gen
erally maintain a minimum equity in the account, normally $2,000. Some brokerage
houses may also have a maintenance requirement, or "kicker."
It is possible to transact a spread in a cash account, but one of the sides must be
a closing transaction. In fact, many of the follow-up actions taken in the covered writ
ing strategy are actually spread transactions. Suppose a covered writer is currently
short one XYZ April call against 100 shares of the underlying stock. If he wants to roll
forward to the July 35 call, he will be buying back the April 35 and selling the July 35
simultaneously. This is a spread transaction, technically, since one call is being bought
and the other is being sold. However, in this transaction, the buy side is a closing
transaction and the sell side is an opening transaction. This type of spread could be
done in a cash account. Whenever a covered writer is rolling - up, down, or fmward
he should place the order as a spread order to facilitate a better price execution.
The spreads discussed in the following chapters are predominantly spread
strategies, ones in which both sides of the spread are opening transactions. These are
designed to have their own profit and risk potentials, and are not merely follow-up
actions to some previously discussed strategy.
170 Part II: Call Option Strategies
When a spread order is entered, the options being bought and sold must be
specified. Two other items must be specified as well: the price at which the spread is
to be executed, and whether that price is a credit or a debit. If the total price of the
spread results in a cash inflow to the spread strategist, the spread is a credit spread.
This merely means that the sell side of the spread brings in a higher price than is paid
for the buy side of the spread. If the reverse is true - that is, there is a cash outflow
from the spread transaction - the spread is said to be a debit spread. This means that
the buy side of the spread costs more than is received from the sell side. It is also
common to refer to the purchased side of the spread as the long side and to refer to
the written side of the spread as the short side.
The price at which a certain spread can be executed is generally not the differ
ence between the last sale prices of the two options involved in the spread.
Example: An investor wants to buy an XYZ October 30 and simultaneously sell an
XYZ October 35 call. If the last sale price of the October 30 was 4 points and the last
sale price of the October 35 was 2 points, it does not necessarily mean that the spread
could be done for a 2-point debit (the difference in the last sale prices). In fact, the
only way to detennine the market price for a spread transaction is to know what the
bid and asked prices of the options involved are. Suppose the following quotes are
available on these two calls:
October 30 call
October 35 call
Bid
37/s
F/s
Asked
41/s
2
Lost Sole
4
2
Since the spread in question involves buying the October 30 call and selling the
October 35, the spreader will, at market, have to pay 41/s for the October 30 ( the asked
or offering quote) and will receive only F/s (the bid quote) for the October 35. This
results in a debit of 2¼ points, significantly more than the 2-point difference in the
last sale prices. Of course, one is free to specify any price he wants for any type of
transaction. One might enter this spread order at a 21/s-point debit and could have a
reasonable chance of having the order filled if the floor broker can do better than the
bid side on the October 35 or better than the offering side on the October 30.
The point to be learned here is that one cannot assume that last sale prices are
indicative of the price at which a spread transaction can be executed. This makes
computer analysis of spread transactions via closing price data somewhat difficult.
Some computer data services offer (generally at a higher cost) closing bid and asked
prices as well as closing sale prices. If a strategist is forced to operate with closing
O,apter 6: Ratio Call Writing 171
prices only, however, he should attempt to build some screens into his output to allow
for the fact that last sale prices might not be indicative of the price at which the
spread can be executed. One simple method for screening is to look only at relative
ly liquid options - that is, those that have traded a substantial number of contracts
during the previous trading day. If an option is experiencing a great deal of trading
activity, there is a much better chance that the current quote is "tight," meaning that
the bid and offering prices are quite close to the last sale price.


xecuted. One simple method for screening is to look only at relative
ly liquid options - that is, those that have traded a substantial number of contracts
during the previous trading day. If an option is experiencing a great deal of trading
activity, there is a much better chance that the current quote is "tight," meaning that
the bid and offering prices are quite close to the last sale price.
In the early days of listed options, it was somewhat common practice to "leg"
into a spread. That is, the strategist would place separate buy and sell orders for the
two transactions comprising his spread. As the listed markets have developed, adding
depth and liquidity, it is generally a poor idea to leg into a spread. If the floor broker
handling the transaction knows the entire transaction, he has a much better chance
of "splitting a quote," buying on the bid, or selling on the offering. Splitting a quote
merely means executing at a price that is between the current bid and asked prices.
For example, if the bid is 37/s and the offering is 41/s, a transaction at a price of 4
would be "splitting the quote."
The public customer must be aware that spread transactions may involve sub
stantially higher commission costs, because there are twice as many calls involved in
any one transaction. Some brokers offer slightly lower rates for spread transactions,
but these are not nearly as low as spreads in commodity trading, for example.
CHAPTER 7
Bull Spreads
The bull spread is one of the most popular forms of spreading. In this type of spread,
one buys a call at a certain striking price and sells a call at a higher striking price.
Generally, both options have the same expiration date. This is a vertical spread. A bull
spread tends to be profitable if the underlying stock rrwves up in price; hence, it is a
bullish position. The spread has both limited profit potential and limited risk.
Although both can be substantial percentagewise, the risk can never exceed the net
investment. In fact, a bull spread requires a smaller dollar investment and therefore
has a smaller maximum dollar loss potential than does an outright call purchase of a
similar call.
Example: The following prices exist:
XYZ common, 32;
XYZ October 30 call, 3; and
XYZ October 35 call, 1.
A bull spread would be established by buying the October 30 call and simultaneous
ly selling the October 35 call. Assume that this could be done at the indicated 2-point
debit. A call bull spread is always a debit transaction, since the call with the lower
striking price must always trade for more than a call with a higher price, if both have
the same expiration date. Table 7-1 and Figure 7-1 depict the results of this transac
tion at expiration. The indicated call profits or losses would be realized if the calls
were liquidated at parity at expiration. Note that the spread has a maximum profit
and this profit is realized if the stock is anywhere above the higher striking price at
expiration. The maxipmm loss is realized if the stock is anywhere below the lower
strike at expiration, and is equal to the net investment, 2 points in this example.
172
Chapter 7: Bull Spreads 173
Moreover, there is a break-even point that always lies between the two striking prices
at expiration. In this example, the break-even point is 32. All bull spreads have prof
it graphs with the same shape as the one shown in Figure 7-1 when the expiration
dates are the same for both calls.
The investor who establishes this position is bullish on the underlying stock, but
is generally looking for a way to hedge himself. If he were rampantly bullish, he
TABLE 7-1.
Results at expiration of bull spread.
XYZ Price of
Expiration
25
30
32
35
40
45
FIGURE 7-1.
Bull spread.
c: +$300
.Q
~
-~
w
October 30
Profit
-$ 300
- 300
100
+ 200
+ 700
+ 1,200
October 35
Profit
+$100
+ 100
+ 100
+ 100
- 400
- 900
,,
,,,'
;ff
,,,'
,,'
iii
~
,,,,'
$01---------'----J...__.... _ ___. _____ _
30 3:?,,' 35
0 ::: -$200
e 0..-$300
, ,
..------,,,,,'
Call Purchase
•-----------,'
Stock Price at Expiration
Total
Profit
-$200
- 200
0
+ 300
+ 300
+ 300
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 a position 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 a bull spread is the net debit plus commissions.
Since. the spread must be transacted in a margin account, there will generally be a
minimum equity requirement imposed by the brokerage firm. In addition, there may
be a maintenance 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 a simple matter
to compute the break-even point and the maximum profit potential of a call 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,


com
missions, would be $2,000 ($200 per spread), plus commissions. It is a simple matter
to compute the break-even point and the maximum profit potential of a call 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 a significant 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 a larger quan
tity of calls. For this reason, it is generally advisable to spread at least 5 options at a
time.
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.
A bull spread established under these conditions will generally be a low-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
a spread, 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 a relatively remote
chance of advancing such a great 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 a deeply out-of-the
money call as an outright speculation. It is not recommended that such a strategy be
pursued with more than a very small percentage of one's speculative 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 a much less aggressive position,
since it offers a large 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 a
more conservative position than the aggressive spread described above. The com-
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's profit calculations before entering into the spread transaction. Since
this stock would have to decline 7 points to fall below 30 and cause a loss of the entire
investment, it would have to be considered a rather 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 a given day, one has to use a computer to perform the mass calcula
tions. It is possible to use a strictly arithmetic method of ranking bull spreads, but
such a list 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's calculations. The concept of
expected return is described in detail in Chapter 28, where a bull spread is used as
an example.
The exact method for using volatility and predicting an option's price after an
upward movement are presented later. Many data services offer such information.
However, if the reader wants to attempt a simpler 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 a ranking 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. A simple method of allow
ing for a stock's movement 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
a simple 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 a longer time period. Percentage ret


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
a simple 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 a longer 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 a simple 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 a call with a longer
Chapter 7: Bull Spreads 177
time to maturity than the short call has. Such a position is known as a diagonal bull
spread and is discussed in a later 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 a lot of time value premium, for he would be
giving up a lot of upside profit potential in order to have a hedged 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 a speculator is bullishly oriented for a short-term
upward move in an underlying stock, it is generally better for him to buy a call out
right than to establish a bull spread. Since the spread differential changes mainly as
a function of time, small movements in price by the underlying stock will not cause
much of a short-term change in the price of the spread. However, the bull spread has
a distinct advantage over the purchase of a call if the underlying stock advances mod
erately by expiration.
In the previous example, a bull 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 a short-term advantage in using the outright purchase.
Example: The underlying stock jumps from 32 to 35 in one day's time. 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 a debit of 2 points.
Clearly, then, for the shortest time period one day - the outright purchase outper
forms the bull spread on a quick rise.
For a slightly 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 a bull 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
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 a smaller 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 a prof
it, both dollarwise and percentagewise.
Many traders are disappointed with the low profits available from a bull 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 a
greater distance between the two strikes. When the distance is great, the spread has
room to widen out, even though it won't reach 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 a better strategy if one is looking for a quick rise by the under
lying stock. Overall, the bull spread is a less aggressive strategy than the outright pur
chase of a call. The spread will not produce as much of a profit on a short-term move,
or on a sustained, large upward move. It will, however, outperform the outright pur
chase of a call if the stock advances slowly and moderately by expiration. Also, the
spread always involves fewer actual dollars of risk, because it requires a smaller debit
to establish initially. Table 7-2 summarizes which strategy has the upper hand for var
ious stock movements over differing time per


m move,
or on a sustained, large upward move. It will, however, outperform the outright pur
chase of a call if the stock advances slowly and moderately by expiration. Also, the
spread always involves fewer actual dollars of risk, because it requires a smaller 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
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 a possibility 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 a spread trans
action. If the underlying stock has moved up in price, the order to liquidate would
be a credit spread involving two closing transactions. The maximum credit that can
be recovered from a bull 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 a spread 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/s credit. 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 a spread 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 a public 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.
A minor 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 a bull spread is for the stock to be exactly at the higher
striking price at expiration. If the stock exceeds the higher striking price by a great
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 a rise 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
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 a manner, the spreader should not
attempt to buy back the short call at too high a price. If it can be repurchased at 1/s
or 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 a stock price increase, taking the profit on the long side and hoping for a
stock 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 a large, quick move, only to find that their spread has not
widened out much. They often try to figure out a way 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't any hedge that can accomplish all of these things. The only position that
can lock in the profits in a call 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 a wide variety of situations. Two such situations
were described in Chapter 3. If the outright purchaser of a call finds himself with an
unrealized loss, he may be able to substantially improve his chances of getting out
even by "rolling down" into a bull spread. If, however, he has an unrealized profit, he
may be able to sell a call at the next higher strike, creating a bull spread, in an attempt
to lock in some of his profit.
In a somewhat similar manner, a common stockholder who is faced with an
unrealized loss may be able to utilize a bull spread to lower the price at which he
can break even.


getting out
even by "rolling down" into a bull spread. If, however, he has an unrealized profit, he
may be able to sell a call at the next higher strike, creating a bull spread, in an attempt
to lock in some of his profit.
In a somewhat similar manner, a common stockholder who is faced with an
unrealized loss may be able to utilize a bull spread to lower the price at which he
can break even. He may often have a significantly better chance of breaking even or
making a profit by using options. The following example illustrates the stockholder's
strategy.
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:
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's is $400 and is equal to the cost of buying the October 40 call. However, mainte
nance and equity requirements still apply, because a spread 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 a bull spread with the October 40 call. It is not particularly important
that the resulting position is a combination of both a bull spread and a covered 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 a covered write and a bull spread are strategies with limited profit
potential, this new position obviously must have a limited 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's would 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 a total 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's profit. 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's position to outperform the new posi-
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's position.
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 a small 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 a covered write and a bull 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 a premium. 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 a substitute for buying the stock itself Of course, the call will expire, whereas the
stock will not; but the profit potential of owning a deeply in-the-money call can be
Chapter 7: Bull Spreads
FIGURE 7-2.
Lowering the break-even price on common stock.
C:


g 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 a substitute for buying the stock itself Of course, the call will expire, whereas the
stock will not; but the profit potential of owning a deeply in-the-money call can be
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 a call costs less to purchase than the stock
itself would, the buyer is getting essentially the same profit or loss potential with a
smaller 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 a covered write, since the long call
"simulates" the purchase of stock This position really is, of course, a bull 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 a strategy and
forsake covered writing, since, with bull spreads, he could be entirely wiped out in a
moderate market decline. In a covered writing strategy, one still owns the stocks even
after a severe market decline. However, one may achieve something of a compromise
by investing a much 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's funds could then be placed in interest-bearing securities.
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 a cash 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 a much 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 a larger 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 a covered 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 a
deeply 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.
Chapter 7: Bull Spreads
SUMMARY
185
The bull spread is one of the simplest and most popular forms of spreading. It will
generally perform best in a moderately bullish environment. A bull spread will not
widen out to its maximum profit potential right away, though; so for short-term
trades, the outright purchase of a call is a better choice. The bull spread can also be
applied for more sophisticated purposes in a far wider range of situations than mere
ly wanting to attempt to capitalize on a moderate advance by the underlying stock.
Both call buyers and stock buyers may be able to use bull spreads to "roll down" and
produce lower break-even points for their positions. The covered writer may also be
able to use bull spreads as a substitute for covered writes in certain situations in
which a deeply in-the-money call exists.
Bear Spreads
Using Call Options
Options are versatile investment vehicles. For every type of bullish position that can
be established, there is normally a corresponding 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 a corresponding strategy designed for
the strategist with the opposite point of view. In this vein, a bear spread is the oppo
site of a bull spread.
THE BEAR SPREAD
In a call bear spread, one buys a call at a certain striking price and sells a call at a
lower striking price. This is a vertical 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 a credit spread when the spread is set up with call options. Since one is sell
ing the call with the lower strike, and a call at a lower strike always trades at a high
er price than a call at a higher strike with the same expiration, the bear spread must
be a credit 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
Chap


d a call at a lower strike always trades at a high
er price than a call at a higher strike with the same expiration, the bear spread must
be a credit 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
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 a bear spread can be constructed for:
XYZ common, 32;
XYZ October 30 call, 3; and
XYZ October 35 call, 1.
A bear 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 a
bear 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 a rising 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 a maximum 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 a bull spread profit graph that
has been turned upside down. All bear spreads have a profit 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
188
FIGURE 8-1.
Bear spread •
. § +$200
"it! -~
w
CJ) 30 ig
..J
0
:!:
e a. -$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 a bear 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 a total investment of 3 points plus commissions. Since
this spread involves a call that is not "covered" by a long call with a striking price
equal to or lower than that of the short call, some brokerage firms may require a
higher maintenance requirement per spread than would be required for a bull
spread. Again, since a spread must be done in a margin account, most brokerage
firms require that a minimum amount of equity be in the account as well.
Since this is a credit spread, the investor does not really "spend" any dollars to
establish the spread. The investment is really a reduction in the buying power of the
customer's margin account, but it does not actually require dollars to be spent when
the transaction is initiated.
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 a high profit potential, or it may
be less aggressive, with a low profit potential. If a large credit is initially taken in,
there is obviously the potential for a good deal of profit. However, for the spread to
take in a large credit, the underlying stock must be well above the lower striking
price. This means that a relatively substantial downward move would be necessary in
order for the maximum profit potential to be realized. Thus, a large credit bear
spread is usually an aggressive position; the spreader needs a substantial move by the
underlying stock in order to make his maximum profit. The probabilities of this
occurring cannot be considered large.
A less 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 a bear spread in such a situation 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 a price 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 a small 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 s


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 a small 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 a small probability of making a large profit
and the other has a much larger probability of making a much 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 a bear spread is initiated when
the stock is at the higher striking price, the spreader is selling a call that has mostly
intrinsic value and little time value premium (since it is in-the-money), and is buying
a call 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!
A bear 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
190 Part II: Call Option Strategies
will approach its maximum profit potential. This is important to understand because,
if one is expecting a quick move down by the underlying stock, he might need to use
a call 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 a disastrous
upside breakout by the stock. This type of bear spread is really akin to selling a deep
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 a bearishly oriented strategy. Since the spread is a credit
spread, requiring only a reduction in buying power but no actual layout of cash to
establish, it is a moderately popular strategy. The bear spread using calls may not be
the optimum type of bearish spread that is available; a bear spread using put options
maybe.
Calendar Spreads
A calendar spread, also frequently called a time spread, involves the sale of one
option and the simultaneous purchase of a more distant option, both with the same
striking price. In the broad definition, the calendar spread is a horizontal spread. The
neutral philosophy for using calendar spreads is that time will erode the value of the
near-term option at a faster rate than it will the far-term option. If this happens, the
spread will widen and a profit may result at near-term expiration. With call options,
one may construct a more 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 a debit
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
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 a profit to result. In fact, some profit can be
made in a range that extends both below and above the striking price. The risk in this
type of position is that the stock will drop a great deal or rise a g


ock 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 a profit to result. In fact, some profit can be
made in a range that extends both below and above the striking price. The risk in this
type of position is that the stock will drop a great deal or rise a great 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 a neutral 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 a neutral 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 a profit. In a neutral 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 a curved rather than straight line, since the
July 50 call still has time premium. There is a slightly 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 a call spread. If puts had been
used, the profit range would have a bearish bias. The total width of the profit range is
a function of the volatility of the underlying stock, since that will determine the price
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 a function 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 a range 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
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 a spread 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 a call
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 a calendar 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 a greater chance that it will
move outside of the profit area. Second, if the stock does stabilize and trades in a
range 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 a single order. "Legging" out of a spread 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 a


iration, 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 a substantial 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 a small loss
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 a partial recovery from the stock in order to be able to
recover some value from the long side of the spread. Such a holding action is often
better than the immediate close-out, because the expense of buying back the short
call can be quite large percentagewise. A riskier 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 a follow-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 a recovery by the
underlying stock. If this tack is taken, the risk remains fixed at the original debit paid
for the spread, and occasionally a rally may produce large profits on the long call.
Although this rally is a nonfrequent event, it generally costs the spreader very little
to allow himself the opportunity to take advantage of such a rally if it should occur.
In fact, the strategist can employ a slight modification of this sort of action, even
if the spread is not at a large 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 a small gain or loss. However, it is often a reasonable strategy to
sell out a portion of the long side - recovering all or a substantial 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 a downside 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 a small amount, but not substantially, because both options will
hold premium in a rally. 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 a chance for a reversal 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. A highly risk
oriented upside defensive action is to cover the short call on a technical breakout and
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 a breakout 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
A less neutral and more bullish type of calendar spread is preferred by the more
aggressive investor. In a bullish calendar spread, one sells the near-term call and buys
a longer-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 a bullish 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 long


anner:
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 a net cost of
his original debit. In this example, his original debit was only ½ of a point to create
the spread. If the April 50 call expires worthless, the investor will own the July 50 call
at a net cost of ½ point, plus commissions.
The investor now needs a second 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 a substantial percentage gain, because the cost of the call has been
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 a reasonably good chance that the written call will expire worthless, since it is a
short-term call and the stock is below the striking price to start with. If the stock falls,
or even rises a little - up to, but not above, the striking price the first condition will
have been met. It is the second condition, a rally 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 a small probability of
making a large 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 a reasonable 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 a large stock
move, say 20%, is required in only a few months, the spread is not worthwhile for
a nonvolatile 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 a rally to 30 are many times greater than the chances of a rally to 35.
3. Do not invest a large 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 a loss and attempting to ride the long call. Either action could
turn the initial small, limited loss into a disastrous loss. Since the strategy hinges on
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 a large 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 a month 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 a net 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 a calendar 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