e was originally sold for 7 points when the stock was at 45,
the stock experiences a rally and the following prices exist:
XYZ common, 50;
XYZ January 45 call, 7;
Cl,opter 20: The Sale of a Straddle
XYZ January 45 put, l; and
XYZ January 50 call, 3.
311
The January 50 call price is included because it will be part of the follow-up strategy.
Notice that this straddle has a considerable amount of time value premium remain
Ing in it, and thus would be rather expensive to buy back at the current time.
Suppose, however, that the straddle writer does not touch the January 45 straddle
tliat he is short, but instead buys the January 50 call for protection to the upside.
Since this call costs 3 points, he will now have a position with a total credit of 4 points.
(The straddle was originally sold for 7 points credit and he is now spending 3 points
for the call at 50.) This action of buying a call at a higher strike than the striking price
of the straddle has limited the potential loss to the upside, no matter how far the
stock might run up. If XYZ is anywhere above 50 at expiration, the put will expire
worthless and the writer will have to pay 5 points to close the call spread short
January 45, long January 50. This means that his maximum potential loss is 1 point
plus commissions if XYZ is anywhere above 50 at expiration.
In addition to being able to limit the upside loss, this type of follow-up action
still allows room for potential profits. If XYZ is anywhere between 41 and 49 at expi
ration - that is, less than 4 points away from the striking price of 45 - the writer will
he able to buy the straddle back for less than 4 points, thereby making a profit.
Thus, the straddle writer has both limited his potential losses to the upside and
also allowed room for profit potential should the underlying stock fall back in price
toward the original striking price of 45. Only severe price reversal, with the stock
falling back below 40, would cause a large loss to be taken. In fact, by the time the
stock could reverse its current strong upward momentum and fall all the way back to
40, a significant amount of time should have passed, thereby allowing the writer to
purchase the straddle back with only a relatively small amount of time premium left
in it.
This follow-up strategy has an effect on the margin requirement of the position.
When the calls are bought as protection to the upside, the writer has, for margin
purposes, a bearish spread in the calls and an uncovered put. The margin for this
position would normally be less than that required for the straddle that is 5 points
in-the-money.
A secondary move is available in this strategy.
Example: The stock continues to climb over the short term and the out-of-the
money put drops to a price of less than ½ point. The straddle writer might now
consider buying back the put, thereby leaving himself with a bear spread in the
calls. His net credit left in the position, after buying back the put at ½, would be
312 Part Ill: Put Optian Strategies
3½ points. Thus, if XYZ should reverse direction and be within 3½ points of the
striking price - that is, anywhere below 48½ - at expiration, the position will pro
duce a profit. In fact, if XYZ should be below 45 at expiration, the entire bear
spread will expire worthless and the strategist will have made a 3½-point profit.
Finally, this repurchase of the put releases the margin requirement for the naked
put, and will generally free up excess funds so that a new straddle position can be
established in another stock while the low-requirement bear spread remains in
place.
In summary, this type of follow-up action is broader in purpose than any of the
simpler buy-back strategies described earlier. It will limit the writer's loss, but not
prevent him from making a profit. Moreover, he may be able to release enough mar
gin to be able to establish a new position in another stock by buying in the uncov
ered puts at a fractional price. This would prevent him from tying up his money
completely while waiting for the original straddle to reach its expiration date. The
same type of strategy also works in a downward market. If the stock falls after the
straddle is written, one can buy the put at the next lower strike to limit the down
side risk, while still allowing for profit potential if the stock rises back to the striking
price.
EQUIVALENT STOCK POSITION FOLLOW-UP
Since there are so many follow-up strategies that can be used with the short straddle,
the one method that summarizes the situation best is again the equivalent stock posi
tion (ESP). Recall that the ESP of an option position is the multiple of the quantity
times the delta times the shares per option. The quantity is a negative number if it is
referring to a short position. Using the above scenario, an example of the ESP
method follows:
Example: As before, assume that the straddle was originally sold for 7 points, but the
stock rallied. The following prices and deltas exist:
XYZ common, 50;
XYZ Jan 45 call, 7; delta, .90;
XYZ Jan 45 put, l; delta, - .10; and
XYZ Jan 50 call, 3; delta, .60.
Assume that 8 straddles were sold initially and that each option is for 100 shares of
XYZ. The ESP of these 8 short straddles can then be computed:
Chapter 20: The Sale of a Straddle
Option
Jan 45 call
Jan 45 put
Total ESP
Position
short 8
short 8
Delta
0.90
-0.10
313
ESP
short 720 (-8 x . 9 x 1 00)
long 80 (-8 x -. 1 x 100)
short 640 shares
Obviously, the position is quite short. Unless the trader were extremely bearish
on XYZ, he should make an adjustment. The simplest adjustment would be to buy
600 shares of XYZ. Another possibility would be to buy back 7 of the short January
45 calls. Such a purchase would add a delta long of 630 shares to the position (7 x .9
x 100). This would leave the position essentially neutral. As pointed out in the previ
ous example, however, the strategist may not want t


y bearish
on XYZ, he should make an adjustment. The simplest adjustment would be to buy
600 shares of XYZ. Another possibility would be to buy back 7 of the short January
45 calls. Such a purchase would add a delta long of 630 shares to the position (7 x .9
x 100). This would leave the position essentially neutral. As pointed out in the previ
ous example, however, the strategist may not want to buy that option. If, instead, he
decided to try to buy the January 50 call to hedge the short straddle, he would have
to buy 10 of those to make the position neutral. He would buy that many because the
delta of that January 50 is 0.60; a purchase of 10 would add a delta long of 600 shares
to the position.
Even though the purchase of 10 is theoretically correct, since one is only short
8 straddles, he would probably buy only 8 January 50 calls as a practical matter.
STARTING OUT WITH THE PROTECTION IN PLACE
In certain cases, the straddle writer may be able to initially establish a position that
has no risk in one direction: He can buy an out-of-the-money put or call at the same
time the straddle is written. This accomplishes the same purposes as the follow-up
action described in the last few paragraphs, but the protective option will cost less
since it is out-of-the-money when it is purchased. There are, of course, both positive
and negative aspects involved in adding an out-of-the-money long option to the strad
dle write at the outset.
Example: Given the following prices:
XYZ, 45;
XYZ January 45 straddle, 7; and
XYZ January 50 call, 1 ½,
the upside risk will be limited. If one writes the January 45 straddle for 7 points and
buys the January 50 call for 1 ½ points, his overall credit will be 5½ points. He has no
upside risk in this position, for if XYZ should rise and be over 50 at expiration, he will
be able to close the position by buying back the call spread for 5 points. The put will
expire worthless. The out-of-the-money call has eliminated any risk above 50 on the
312 Part Ill: Put Option Strategies
3½ points. Thus, if XYZ should reverse direction and be within 3½ points of the
striking price - that is, anywhere below 48½ - at expiration, the position will pro
duce a profit. In fact, if XYZ should be below 45 at expiration, the entire bear
spread will expire worthless and the strategist will have made a 3½-point profit.
Finally, this repurchase of the put releases the margin requirement for the naked
put, and will generally free up excess funds so that a new straddle position can be
established in another stock while the low-requirement bear spread remains in
place.
In summary, this type of follow-up action is broader in purpose than any of the
simpler buy-back strategies described earlier. It will limit the writer's loss, but not
prevent him from making a profit. Moreover, he may be able to release enough mar
gin to be able to establish a new position in another stock by buying in the uncov
ered puts at a fractional price. This would prevent him from tying up his money
completely while waiting for the original straddle to reach its expiration date. The
same type of strategy also works in a downward market. If the stock falls after the
straddle is written, one can buy the put at the next lower strike to limit the down
side risk, while still allowing for profit potential if the stock rises back to the striking
price.
EQUIVALENT STOCK POSITION FOLLOW-UP
Since there are so many follow-up strategies that can be used with the short straddle,
the one method that summarizes the situation best is again the equivalent stock posi
tion (ESP). Recall that the ESP of an option position is the multiple of the quantity
times the delta times the shares per option. The quantity is a negative number if it is
referring to a short position. Using the above scenario, an example of the ESP
method follows:
Example: As before, assume that the straddle was originally sold for 7 points, but the
stock rallied. The following prices and deltas exist:
XYZ common, 50;
XYZ Jan 45 call, 7; delta, .90;
XYZ Jan 45 put, l; delta, - .10; and
XYZ Jan 50 call, 3; delta, .60.
Assume that 8 straddles were sold initially and that each option is for 100 shares of
XYZ. The ESP of these 8 short straddles can then be computed:
Chapter 20: The Sale of a Straddle
Option
Jan 45 call
Jan 45 put
Total ESP
Position
short 8
short 8
Delta
0.90
-0.10
313
ESP
short 720 (-8 x .9 x 100)
long 80 (-8 x -. 1 x 1 00)
short 640 shares
Obviously, the position is quite short. Unless the trader were extremely bearish
on XYZ, he should make an adjustment. The simplest adjustment would be to buy
600 shares of XYZ. Another possibility would be to buy back 7 of the short January
45 calls. Such a purchase would add a delta long of 630 shares to the position (7 x .9
x 100). This would leave the position essentially neutral. As pointed out in the previ
ous example, however, the strategist may not want to buy that option. If, instead, he
decided to try to buy the January 50 call to hedge the short straddle, he would have
to buy 10 of those to make the position neutral. He would buy that many because the
delta of that January 50 is 0.60; a purchase of 10 would add a delta long of 600 shares
to the position.
Even though the purchase of 10 is theoretically correct, since one is only short
8 straddles, he would probably buy only 8 January 50 calls as a practical matter.
STARTING OUT WITH THE PROTECTION IN PLACE
In certain cases, the straddle writer may be able to initially establish a position that
has no risk in one direction: He can buy an out-of-the-money put or call at the same
time the straddle is written. This accomplishes the same purposes as the follow-up
action described in the last few paragraphs, but the protective option will cost less
since it is out-of-the-money when it is purchased. There are, of course, both positive
and negative aspects involved in adding an out-of

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


that
has no risk in one direction: He can buy an out-of-the-money put or call at the same
time the straddle is written. This accomplishes the same purposes as the follow-up
action described in the last few paragraphs, but the protective option will cost less
since it is out-of-the-money when it is purchased. There are, of course, both positive
and negative aspects involved in adding an out-of-the-money long option to the strad
dle write at the outset.
Example: Given the following prices:
XYZ, 45;
XYZ January 45 straddle, 7; and
XYZ January 50 call, 1 ½,
the upside risk will be limited. If one writes the January 45 straddle for 7 points and
buys the January 50 call for 1 ½ points, his overall credit will be 5½ points. He has no
upside risk in this position, for if XYZ should rise and be over 50 at expiration, he will
be able to close the position by buying back the call spread for 5 points. The put will
expire worthless. The out-of-the-money call has eliminated any risk above 50 on the
314 Part Ill: Put Option Strategies
position. Another advantage of buying the protection initially is that one is protected
if the stock should experience a gap opening or a trading halt. Ifhe already owns the
protection, such stock price movement in the direction of the protection is of little
consequence. However, if he was planning to buy the protection as a follow-up
action, the sudden surge in the stock price may ruin his strategy.
The overall profit potential of this position is smaller than that of the normal
straddle write, since the premium paid for the long call will be lost if the stock is
below 50 at expiration. However, the automatic risk-limiting feature of the long call
may prove to be worth more than the decrease in profit potential. The strategist has
peace of mind in a rally and does not have to worry about unlimited losses accruing
to the upside.
Downside protection for a straddle writer can be achieved in a similar manner
by buying an out-of-the-money put at the outset.
Example: With XYZ at 45, one might write the January 45 straddle for 7 and buy a
January 40 put for I point if he is concerned about the stock dropping in price.
It should now be fairly easy to see that the straddle writer could limit risk in
either direction by initially buying both an out-of-the-money call and an out-of-the
money put at the same time that the straddle is written. The major benefit in doing
this is that risk is limited in either direction. Moreover, the margin requirements are
significantly reduced, since the whole position consists of a call spread and a put
spread. There are no longer any naked options. The detriment of buying protection
on both sides initially is that commission costs increase and the overall profit poten
tial of the straddle write is reduced, perhaps significantly, by the cost of two long
options. Therefore, one must evaluate whether the cost of the protection is too large
in comparison to what is received for the straddle write. This completely protected
strategy can be very attractive when available, and it is described again in Chapter 23,
Spreads Combining Calls and Puts.
In summary, any strategy in which the straddle writer also decides to buy pro
tection presents both advantages and disadvantages. Obviously, the risk-limiting fea
ture of the purchased options is an advantage. However, the seller of options does not
like to purchase pure time value premium as protection at any time. He would gen
erally prefer to buy intrinsic value. The reader will note that, in each of the protec
tive buying strategies discussed above, the purchased option has a large amount of
time value premium left in it. Therefore, the writer must often try to strike a delicate
balance between trying to limit his risk on one hand and trying to hold down the
expenses of buying long options on the other hand. In the final analysis, however, the
risk must be limited regardless of the cost.
314 Part Ill: Put Option Strategies
position. Another advantage of buying the protection initially is that one is protected
if the stock should experience a gap opening or a trading halt. If he already owns the
protection, such stock price movement in the direction of the protection is of little
consequence. However, if he was planning to buy the protection as a follow-up
action, the sudden surge in the stock price may ruin his strategy.
The overall profit potential of this position is smaller than that of the normal
straddle write, since the premium paid for the long call will be lost if the stock is
below 50 at expiration. However, the automatic risk-limiting feature of the long call
may prove to be worth more than the decrease in profit potential. The strategist has
peace of mind in a rally and does not have to worry about unlimited losses accruing
to the upside.
Downside protection for a straddle writer can be achieved in a similar manner
by buying an out-of-the-money put at the outset.
Example: With XYZ at 45, one might write the January 45 straddle for 7 and buy a
January 40 put for l point if he is concerned about the stock dropping in price.
It should now be fairly easy to see that the straddle writer could limit risk in
either direction by initially buying both an out-of-the-money call and an out-of-the
money put at the same time that the straddle is written. The major benefit in doing
this is that risk is limited in either direction. Moreover, the margin requirements are
significantly reduced, since the whole position consists of a call spread and a put
spread. There are no longer any naked options. The detriment of buying protection
on both sides initially is that commission costs increase and the overall profit poten
tial of the straddle write is reduced, perhaps significantly, by the cost of two long
options. Therefore, one must evaluate whether the cost of the protection is too large
in comparison to what is received for the straddle write. T


ead. There are no longer any naked options. The detriment of buying protection
on both sides initially is that commission costs increase and the overall profit poten
tial of the straddle write is reduced, perhaps significantly, by the cost of two long
options. Therefore, one must evaluate whether the cost of the protection is too large
in comparison to what is received for the straddle write. This completely protected
strategy can be very attractive when available, and it is described again in Chapter 23,
Spreads Combining Calls and Puts.
In summary, any strategy in which the straddle writer also decides to buy pro
tection presents both advantages and disadvantages. Obviously, the risk-limiting fea
ture of the purchased options is an advantage. However, the seller of options does not
like to purchase pure time value premium as protection at any time. He would gen
erally prefer to buy intrinsic value. The reader will note that, in each of the protec
tive buying strategies discussed above, the purchased option has a large amount of
time value premium left in it. Therefore, the ·writer must often try to strike a delicate
balance between trying to limit his risk on one hand and trying to hold down the
expenses of buying long options on the other hand. In the final analysis, however, the
risk must be limited regardless of the cost.
314 Part Ill: Put Option Strategies
position. Another advantage of buying the protection initially is that one is protected
if the stock should expe1ience a gap opening or a trading halt. If he already owns the
protection, such stock price movement in the direction of the protection is of little
consequence. However, if he was planning to buy the protection as a follow-up
action, the sudden surge in the stock price may ruin his strategy.
The overall profit potential of this position is smaller than that of the normal
straddle write, since the premium paid for the long call will be lost if the stock is
below 50 at ex-piration. However, the automatic risk-limiting feature of the long call
may prove to be worth more than the decrease in profit potential. The strategist has
peace of mind in a rally and does not have to worry about unlimited losses accruing
to the upside.
Downside protection for a straddle writer can be achieved in a similar manner
by buying an out-of-the-money put at the outset.
Example: With XYZ at 45, one might write the January 45 straddle for 7 and buy a
January 40 put for l point if he is concerned about the stock dropping in price.
It should now be fairly easy to see that the straddle writer could limit risk in
either direction by initially buying both an out-of-the-money call and an out-of-the
money put at the same time that the straddle is written. The major benefit in doing
this is that risk is limited in either direction. Moreover, the margin requirements are
significantly reduced, since the whole position consists of a call spread and a put
spread. There are no longer any naked options. The detriment of buying protection
on both sides initially is that commission costs increase and the overall profit poten
tial of the straddle write is reduced, perhaps significantly, by the cost of two long
options. Therefore, one must evaluate whether the cost of the protection is too large
in comparison to what is received for the straddle write. This completely protected
strategy can be very attractive when available, and it is described again in Chapter 23,
Spreads Combining Calls and Puts.
In summary, any strategy in which the straddle writer also decides to buy pro
tection presents both advantages and disadvantages. Obviously, the risk-limiting fea
ture of the purchased options is an advantage. However, the seller of options does not
like to purchase pure time value premium as protection at any time. He would gen
erally prefer to buy intrinsic value. The reader will note that, in each of the protec
tive buying strategies discussed above, the purchased option has a large amount of
time value premium left in it. Therefore, the writer must often try to strike a delicate
balance between trying to limit his risk on one hand and trying to hold down the
expenses of buying long options on the other hand. In the final analysis, however, the
risk must be limited regardless of the cost.
Chapter 20: The Sale of a Straddle 315
STRANGLE (COMBINATION) WRITING
Recall that a strangle is any position involving both puts and calls, when there is some
difference in the terms of the options. Commonly, the puts and calls will have the
same expiration date but differing striking prices. A strangle write is usually estab
lished by selling both an out-of-the-money put and an out-of-the-money call with the
stock approximately centered between the two striking prices. In this way, the naked
option writer can remain neutral on the outlook for the underlying stock, even when
the stock is not near a striking price.
This strategy is quite similar to straddle writing, except that the strangle
writer makes his maximum profit over a much wider range than the straddle
writer does. In this or any other naked writing strategy, the most money that the
strategist can make is the amount of the premium received. The straddle writer
has only a minute chance of making a profit of the entire straddle premium, since
the stock would have to be exactly at the striking price at expiration in order for
both the written put and call to expire worthless. The strangle writer will make his
maximum profit potential if the stock is anywhere between the two strikes at expi
ration, because both options will expire worthless in that case. This strategy is
equivalent to the variable ratio write described previously in Chapter 6 on ratio
call writing.
Example: Given the following prices:
XYZ common, 65;
XYZ January 70 call, 4; and
XYZ January 60 put, 3,
a strangle write would be established by selling the January 70 call and the January
60 put.


strikes at expi
ration, because both options will expire worthless in that case. This strategy is
equivalent to the variable ratio write described previously in Chapter 6 on ratio
call writing.
Example: Given the following prices:
XYZ common, 65;
XYZ January 70 call, 4; and
XYZ January 60 put, 3,
a strangle write would be established by selling the January 70 call and the January
60 put. IfXYZ is anywhere between 60 and 70 at January expiration, both options will
expire worthless and the strangle writer will make a profit of 7 points, the amount of
the original credit taken in. If XYZ is above 70 at expiration, the strategist will have
to pay something to buy back the call. For example, if XYZ is at 77 at expiration, the
January 70 call will have to be bought back for 7 points, thereby creating a break-even
situation. To the downside, if XYZ were at 53 at expiration, the January 60 put would
have to be bought back for 7 points, thereby defining that as the downside break
even point. Table 20-3 and Figure 20-3 outline the potential results of this strangle
write. The profit range in this example is quite wide, extending from 53 on the down
side to 77 on the upside. With the stock presently at 65, this is a relatively neutral
position.
316
TABLE 20-3.
Results of a combination write.
Stock Price at Coll
Expiration Profit
40 +$ 400
50 + 400
53 + 400
57 + 400
60 + 400
65 + 400
70 + 400
73 + 100
77 300
80 600
90 - 1,600
FIGURE 20-3.
Sale of a combination.
C:
~ +$700
·5.
X
UJ
rn
en en
0 ....I
ci
e a..
$0
Put
Profit
$1,700
700
400
0
+ 300
+ 300
+ 300
+ 300
+ 300
+ 300
+ 300
Stock Price at Expiration
Part Ill: Put Option Strategies
Total
Profit
-$1,300
300
0
+ 400
+ 700
+ 700
+ 700
+ 400
0
300
- 1,300
At first glance, this may seem to be a more conservative strategy than straddle
writing, because the profit range is wider and the stock needs to move a great deal to
reach the break-even points. In the absence of follow-up action, this is a true obser
vation. However, if the stock begins to rise quickly or to drop dramatically, the stran
gle writer often has little recourse but to buy back the in-the-money option in order
Chapter 20: The Sale of a Straddle 317
to limit his losses. This can, as has been shown previously, entail a purchase price
involving excess amounts of time value premium, thereby generating a significant
loss.
The only other alternative that is available to the strangle writer ( outside of
attempting to trade out of the position) is to convert the position into a straddle if the
stock reaches either break-even point.
Example: IfXYZ rose to 70 or 71 in the previous example, the January 70 put would
be sold. Depending on the amount of collateral available, the January 60 put may or
may not be bought back when the January 70 put is sold. This action of converting
the strangle write into a straddle write will work out well if the stock stabilizes. It
will also lessen the pain if the stock continues to rise. However, if the stock revers
es direction, the January 70 put write will prove to be unprofitable. Technical analy
sis of the underlying stock may prove to be of some help in deciding whether or not
to convert the strangle write into a straddle. If there appears to be a relatively large
chance that the stock could fall back in price, it is probably not worthwhile to roll
the put up.
This example of a strangle write is one in which the writer received a large
amount of premium for selling the put and the call. Many times, however, an aggres
sive strangle writer is tempted to sell two out-of-the-money options that have only a
short life remaining. These options would generally be sold at fractional prices. This
can be an extremely aggressive strategy at times, for if the underlying stock should
move quickly in either direction through a striking price, there is little the strangle
writer can do. He must buy in the options to limit his loss. Nevertheless, this type of
strangle writing - selling short-term, fractionally priced, out-of-the-money options -
appeals to many writers. This is a similar philosophy to that of the naked call writer
described in Chapter 5, who writes calls that are nearly restricted, figuring there will
be a large probability that the option will expire worthless. It also has the same risk:
A large price change or gap opening can cause such devastating losses that many
profitable trades are wiped away. Selling fractionally priced combinations is a poor
strategy and should be avoided.
Before leaving the topic of strangle writing, it may be useful to determine how
the margin requirements apply to a strangle write. Recall that the margin require
ment for writing a straddle is 20% of the stock price plus the price of either the put
or the call, whichever is in-the-money. In a strangle write, however, both options may
be out-of-the-money, as in the example above. When this is the case, the straddle
writer is allowed to deduct the smaller out-of-the-money amount from his require
ment. Thus, if XYZ were at 68 and the January 60 put and the January 70 call had
been written, the collateral requirement would be 20% of the stock price, plus the
318 Part Ill: Put Option Strategies
call premium, less $200 - the lesser out-of-the-money amount. The call is 2 points
out-of-the-money and the put is 8 points out-of-the-money. Actually, the true collat
eral requirement for any write involving both puts and calls - straddle write or stran
gle write - is the greater of the requirement on the put or the call, plus the amount by
which the other option is in-the-nwney. The last phrase, the amount by which the
other option is in-the-money, applies to a situation in which a strangle had been con
structed by selling two in-the-money options. This is a less popular strategy, since the
writer generally receives less time value premium by writing two in-the-money
options. An


rement on the put or the call, plus the amount by
which the other option is in-the-nwney. The last phrase, the amount by which the
other option is in-the-money, applies to a situation in which a strangle had been con
structed by selling two in-the-money options. This is a less popular strategy, since the
writer generally receives less time value premium by writing two in-the-money
options. An example of an in-the-money strangle is to sell the January 60 call and the
January 70 put with the stock at 65.
FURTHER COMMENTS ON UNCOVERED STRADDLE
AND STRANGLE WRITING
When ratio writing was discussed, it was noted that it was a strategy with a high prob
ability of making a limited profit. Since the straddle write is equivalent to the ratio
write and the strangle write is equivalent to the variable ratio write, the same state
ment applies to these strategies. The practitioner of straddle and strangle writing
must realize, however, that protective follow-up action is mandatory in limiting loss
es in a very volatile market. There are other techniques that the straddle writer can
sometimes use to help reduce his risk.
It has often been mentioned that puts lose their time value premium more
quickly when they become in-the-money options than calls do. One can often con
struct a neutral position by writing an extra put or two. That is, if one sells 5 or 6 puts
and 4 calls 'Ai.th the same terms, he may often have created a more neutral position
than a straddle write. If the stock moves up and the call picks up time premium in a
bullish market, the extra puts 'Aill help to offset the negative effect of the calls. On
the other hand, if the stock drops, the 5 or 6 puts will not hold as much time premi
um as the 4 calls are losing - again a neutral, standoff position. If the stock begins to
drop too much, the writer can always balance out the position by selling another call
or two. The advantage of writing an extra put or two is that it counterbalances the
straddle writer's most severe enemy: a quick, extremely bullish rise by the underly
ing stock.
USING THE DELTAS
This analysis, that adding an extra short put creates a neutral position, can be sub
stantiated more rigorously. Recall that a ratio writer or ratio spreader can use the
Chapter 20: The Sale of a Straddle 319
deltas of the options involved in his position to determine a neutral ratio. The strad
dle writer can do the same thing, of course. It was stated that the difference between
a call's delta and a put' s delta is approximately one. Using the same prices as in the
previous straddle writing example, and assuming the call's delta to be .60, a neutral
ratio can be determined.
Prices
XYZ common:
XYZ January 45 call:
XYZ January 45 put:
45
4
3
Deltas
.60
-.40 (.60 - 1)
The put has a negative delta, to indicate that the put and the underlying stock are
inversely related. A neutral ratio is determined by dividing the call's delta by the put's
delta and ignoring the minus sign. The resultant ratio - 1.5:1 (.60/.40) in this case -
is the ratio of puts to sell for each call that is sold. Thus, one should sell 3 puts and
sell 2 calls to establish a neutral position. The reader may wonder if the assumption
that an at-the-money call has a delta of .60 is a fair one. It generally is, although very
long-term calls will have higher at-the-money deltas, and very short-term calls will
have deltas near .50. Consequently, a 3:2 ratio is often a neutral one. When neutral
ratios were discussed with respect to ratio writing, it was mentioned that selling 5
calls and buying 300 shares of stock often results in neutral ratio. The reader should
note that a straddle constructed by selling 3 puts and 2 calls is equivalent to the ratio
write in which one sells 5 calls and buys 300 shares of stock.
If a straddle writer is going to use the deltas to determine his neutral ratio, he
should compute each one at the time of his initial investment, of course, rather than
relying on a generality such as that 3 puts and 2 calls often result in a neutral posi
tion. The deltas can be used as a follow-up action, by adjusting the ratio to remain
neutral after a move by the underlying stock.
AVOID EXCESS TRADING
In any of the straddle and strangle writing strategies described above, too much fol
low-up action can be detrimental because of the commission costs involved. Thus,
although it is important to take protective action, the straddle writer should plan in
advance to make the minimum number of strategic moves to protect himself. That is
why buying protection is often useful; not only does it limit the risk in the direction
that the stock is moving, but it also involves only one additional option commission.
In fact, if it is feasible, buying protection at the outset is often a better strategy than
protecting as a secondary action.
320 Part Ill: Put Option Strategies
An extension of this concept of trying to avoid too much follow-up action is that
the strategist should not attempt to anticipate movement in an underlying stock. For
example, if the straddle writer has planned to take defensive action should the stock
reach 50, he should not anticipate by taking action with the stock at 48 or 49. It is
possible that the stock could retreat back down; then the writer would have taken a
defensive action that not only cost him commissions, but reduced his profit potential.
Of course, there is a little trader in everyone, and the temptation to anticipate (or to
wait too long) is always there. Unless there are very strong technical reasons for doing
so, the strategist should resist the temptation to trade, and should operate his strate
gy according to his original plan. The ratio writer may actually have an advantage in
this respect, because he can use buy and sell stops on the underlying stock to remove
the emotion from his follow-up strategy. This technique was described in Chapter 6
on ratio call writing. Unfortuna


al reasons for doing
so, the strategist should resist the temptation to trade, and should operate his strate
gy according to his original plan. The ratio writer may actually have an advantage in
this respect, because he can use buy and sell stops on the underlying stock to remove
the emotion from his follow-up strategy. This technique was described in Chapter 6
on ratio call writing. Unfortunately, no such emotionless technique exists for the
straddle or strangle writer.
USING THE CREDITS
In previous chapters, it was mentioned that the sale of uncovered options does not
require any cash investment on the pait of the strategist. He may use the collateral
value of his present portfolio to finance the sale of naked options. Moreover, once he
sells the uncovered options, he can take the premium dollars that he has brought in
from the sales to buy fixed-income securities, such as Treasury bills. The same state
ments naturally apply to the straddle writing and strangle writing strategies. However,
the strategist should not be overly obsessed with continuing to maintain a credit bal
ance in his positions, nor should he strive to hold onto the Treasury bills at all costs. If
one's follow-up actions dictate that he must take a debit to avoid losses or that he
should sell out his Treasury bills to keep a credit, he should by all means do so.
Synthetic Stock Positions
Created by Puts and Calls
It is possible for a strategist to establish a position that is essentially the same as a
stock position, and he can do this using only options. The option position generally
requires a smaller margin investment and may have other residual benefits over sim
ply buying stock or selling stock short. In brief, the strategies are summarized by:
1. Buy call and sell put instead of buying stock.
2. Buy put and sell call instead of selling stock short.
SYNTHETIC LONG STOCK
When one buys a call and sells a put at the same strike, he sets up a position that is
equivalent to owning the stock. His position is sometimes called "synthetic" long
stock.
Example: To verify that this option position acts much like a long stock position
would, suppose that the following prices exist:
XYZ common, 50;
XYZ January 50 call, 5; and
XYZ January 50 put, 4.
If one were bullish on XYZ and wanted to buy stock at 50, he might consider the
alternative strategy of buying the January 50 call and selling (uncovered) the January
321
322 Part Ill: Put Option Strategies
50 put. By using the option strategy, the investor has nearly the same profit and loss
potential as the stock buyer, as shown in Table 21-1. The two right-hand columns of
the table compare the results of the option strategy with the results that would be
obtained by merely owning the stock at .50.
The table shows that the result of the option strategy is exactly $100 less than
the stock results for any price at expiration. Thus, the "synthetic" long stock and the
actual long stock have nearly the same profit and loss potentials. The reason there is
a difference in the results of the two equivalent positions lies in the fact that the
option strategist had to pay 1 point of time premium in order to set up his position.
This time premium represents the $100 by which the "synthetic" position underper
forms the actual stock position at expiration. Note that, with XYZ at 50, both the put
and the call are completely composed of time value premium initially. The synthetic
position consists of paying out 5 points of time premium for the call and receiving in
4 points of time premium for the put. The net time premium is thus a 1-point pay
out.
The reason one would consider using the synthetic long stock position rather
than the stock position itself is that the synthetic position may require a much small
er investment than buying the stock would require. The purchase of the stock
requires $5,000 in a cash account or $2,500 in a margin account (if the margin rate is
50%). However, the synthetic position requires only a $100 debit plus a collateral
requirement - 20% of the stock price, plus the put premium, minus the difference
between the striking price and the stock price. The balance, invested in short-term
funds, would earn enough money, theoretically, to offset the $100 paid for the syn
thetic position. In this example, the collateral requirement would be 20% of $5,000,
or $1,000, plus the $400 put premium, plus the $100 debit incurred by paying 5 for
the call and only receiving 4 for the put. This is a total of $1,500 initially. There is no
TABLE 21·1.
Synthetic long stock position.
XYZ Price at January 50 January 50 Total Option Long Stock
Expiration Call Result Put Result Result Result
40 -$500 -$600 -$1, 100 -$1,000
45 - 500 - 100 600 500
50 - 500 + 400 100 0
55 0 + 400 + 400 + 500
60 + 500 + 400 + 900 + 1,000
Chapter 21: Synthetic Stock Positions Created by Puts and Calls 323
initial difference between the stock price and the striking price. Of course, this col
lateral requirement would increase if the stock fell in price, and would decrease if the
stock rose in price, since there is a naked put. Also notice that buying stock creates a
$5,000 debit in the account, whereas the option strategy's debit is $100; the rest is a
collateral requirement, not a cash requirement.
The effect of this reduction in margin required is that some leverage is obtained
in the position. If XYZ rose to 60, the stock position profit would be $1,000 for a
return of 40% on margin ($1,000/$2,500). With the option strategy, the percentage
return would be higher. The profit would be $900 and the return thus 60%
($900/$1,500). Of course, leverage works to the downside as well, so that the percent
risk is also greater in the option strategy.
The synthetic stock strategy is generally not applied merely as an alternative to
buying stock. Besides possibly having a smaller profit potential, the option strategist
does not collect dividen


urn would be higher. The profit would be $900 and the return thus 60%
($900/$1,500). Of course, leverage works to the downside as well, so that the percent
risk is also greater in the option strategy.
The synthetic stock strategy is generally not applied merely as an alternative to
buying stock. Besides possibly having a smaller profit potential, the option strategist
does not collect dividends, whereas the stock owner does. However, the strategist is
able to earn interest on the funds that he did not spend for stock ownership. It is
important for the strategist to understand that a long call plus a short put is equiva
lent to long stock. It thus may be possible for the strategist to substitute the synthet
ic option position in certain option strategies that normally call for the purchase of
stock
SYNTHETIC SHORT SALE
A position that is equivalent to the short sale of the underlying stock can be estab
lished by selling a call and simultaneously buying a put. This alternative option strat
egy, in general, offers significant benefits when compared with selling the stock short.
Using the prices above - XYZ at 50, January 50 call at 5, and January 50 put at 4 -
Table 21-2 depicts the potential profits and losses at January expiration.
Both the option position and the short stock position have similar results: large
potential profits if the stock declines and unlimited losses if the underlying stock rises
in price. However, the option strategy does better than the stock position, because
the option strategist is getting the benefit of the time value premium. Again, this is
because the call has more time value premium than the put, which works to the
option strategist's advantage in this case, when he is selling the call and buying the
put.
Two important factors make the option strategy preferable to the short sale of
stock: (1) There is no need to borrow stock, and (2) there is no need for an uptick.
When one sells stock short, he must first borrow the stock from someone who owns
it. This procedure is handled by one's brokerage firm's stock loan department. If, for
324 Part Ill: Put Option Strategies
TABLE 21-2.
Synthetic short sale position.
XYZ Price at January 50 January 50 Total Option Short Stock
Expiration Coll Result Put Result Result Result
40 +$500 +$600 +$1, 100 +$1,000
45 + 500 + 100 + 600 + 500
50 + 500 - 400 + 100 0
55 0 - 400 400 500
60 - 500 - 400 900 - 1,000
some reason, no one who owns the stock wants to loan it out, then a short sale can
not be executed. In addition, both the NYSE and NASDAQ require that a stock
being sold short must be sold on an uptick. That is, the price of the short sale must
be higher than the previous sale. This rule was introduced (for the NYSE) years ago
in order to prevent traders from slamming the market down in a "bear raid."
With the option "synthetic short sale" strategy, however, one does not have to
worry about either of these factors. First, calls can be sold short at will; there is no
need to borrow anything. Also, calls can be sold short (and puts bought) even though
the underlying stock might be trading on a minus tick (a downtick). Many profes
sional traders use the "synthetic short sale" strategy because it allows them to get
equivalently short the stock in a very timely manner. If one wants to short stock, and
if he has not previously arranged to borrow it, then some time is wasted while one's
broker checks with the stock loan department in order to make sure that the stock
can indeed be borrowed.
There is a caveat, however. If one sells calls on a stock that cannot be borrowed,
then he must be sure to avoid assignment. For if one is assigned a call, then he too
will be short the stock. If the stock cannot be borrowed, the broker will buy him in.
Thus, in situations in which the stock might be difficult to borrow, one should use a
striking price such that the call is out-of-the-money when sold initially. This will
decrease, but not eliminate, the possibility of early assignment.
Leverage is a factor in this strategy also. The short seller would need $2,500 to
collateralize this position, assuming that the margin rate is 50%. The option strategist
initially only needs 20% of the stock price, plus the call price, less the credit received,
for a $1,400 requirement. Moreover, one of the major disadvantages that was men
tioned with the synthetic long stock position is not a disadvantage in the synthetic
short sale strategy: The option trader does not have to pay out dividends on the
options, but the short seller of stock must.
Chapter 21: Synthetic Stock Positions Created by Puts and Calls 325
Because of the advantages of the option position in not having to pay out the
dividend and also having a slightly larger profit potential from the excess time value
premium, it may often be feasible for the trader who is looking to sell stock short to
instead sell a call and buy a put. It is also important for the strategist to understand
the equivalence between the short stock position and the option position. He might
be able to substitute the option position in certain cases when the short sale of stock
is normally called for.
SPLITTING THE STRIKES
The strategist may be able to use a slight variation of the synthetic strategy to set up
an aggressive, but attractive, position. Rather than using the same striking price for
the put and call, he can use a lower striking price for the put and a higher striking
price for the call. This action of splitting apart the striking prices gives him some
room for error, while still retaining the potential for large profits.
BULLISHLY ORIENTED
If an out-of-the-money put is sold naked, and an out-of-the-money call is simultane
ously purchased, an aggressive bullish position is established - often for a credit. If
the underlying stock rises far enough, profits can be generated on both the long call
and the short put. If the stock remains relati


room for error, while still retaining the potential for large profits.
BULLISHLY ORIENTED
If an out-of-the-money put is sold naked, and an out-of-the-money call is simultane
ously purchased, an aggressive bullish position is established - often for a credit. If
the underlying stock rises far enough, profits can be generated on both the long call
and the short put. If the stock remains relatively unchanged, the call purchase will be
a loss, but the put sale will be a profit. The risk occurs if the underlying stock drops
in price, producing losses on both the short put and the long call.
Example: The following prices exist: XYZ is at 53, a January 50 put is selling for 2,
and a January 60 call is selling for 1. An investor who is bullish on XYZ sells the
January 50 put naked and simultaneously buys the January 60 call. This position
brings in a credit of 1 point, less commissions. There is a collateral requirement
necessary for the naked put. If XYZ is anywhere between 50 and 60 at January
expiration, both options would expire worthless, and the investor would make a small
profit equal to the amount of the initial credit received. If XYZ rallies above 60 by
expiration, however, his potential profits are unlimited, since he owns the call at 60.
His losses could be very large if XYZ should decline well below 50 before expiration,
since he has written the naked put at 50. Table 21-3 and Figure 21-1 depict the
results at expiration of this strategy.
Essentially, the investor who uses this strategy is bullish on the underlying stock
and is attempting to buy an out-of-the-money call for free. If he is moderately wrong
326
TABLE 21-3.
Bullishly split strikes.
XYZ Price al January 50
Expirafion
40
45
50
55
60
65
70
FIGURE 21-1.
Bullishly split strikes.
Pu! Profil
-$800
- 300
+ 200
+ 200
+ 200
+ 200
+ 200
Part Ill: Put Option Strategies
January 60 Tolal
Call Profil Profif
-$100 -$ 900
- 100 400
- 100 + 100
- 100 + 100
- 100 + 100
+ 400 + 600
+ 900 + 1,100
Stock Price at Expiration
and the underlying stock rallies only slightly or even declines slightly, he can still
make a small profit. If he is correct, of course, large profits could be generated in a
rally. He may lose heavily if he is very wrong and the stock falls by a large amount
instead of rising.
This strategy is often useful when options are overpriced. Suppose that one has
a bullish opinion on the underlying stock, yet is dismayed to find that the calls are
quite expensive. If he buys one of these expensive calls, he can mitigate the expen
siveness somewhat by also selling an out-of-the-money put, which is presumably
Chapter 21: Synthetic Stock Positions Created by Puts and Calls 327
somewhat expensive also. Thus, if he is right about the bullish attitude on the stock,
he owns a call that is more "fairly priced" because its cost was reduced by the amount
of the put sale.
BEARISHLY ORIENTED
There is a companion strategy for the investor who is bearish on a stock. He could
attempt to buy an out-of-the-money put, giving himself the opportunity for substan
tial profits in a stock price decline, and could "finance" the purchase of the put by
writing an out-of-the-money call naked. The sale of the call would provide profits if
the stock stayed below the striking price of the call, but could cost him heavily if the
underlying stock rallies too far.
Example: With XYZ at 65, the bearish investor buys a February 60 put for 2 points,
and simultaneously sells a February 70 call for 3 points. These trades bring in a cred
it of 1 point, less commissions. The investor must collateralize the sale of the call. If
XYZ should decline substantially by February expiration, large profits are possible
because the February 60 put is owned. Even if XYZ does not perform as expected,
but still ends up anywhere between 60 and 70 at expiration, the profit will be equal
to the initial credit because both options will expire worthless. However, if the stock
rallies above 70, unlimited losses are possible because there is a naked call at 70.
Table 21-4 and Figure 21-2 show the results of this strategy at expiration.
This is clearly an aggressively bearish strategy. The investor would like to own
an out-of-the-money put for downside potential. In addition, he sells an out-of-the
money call, normally for a price greater than that of the purchased put. The call sale
TABLE 21-4.
Bearishly split strikes.
XYZ Price at February 60 February 70 Total
Expiration Put Profit Call Profit Profit
50 +$800 +$300 +$1, 100
55 + 300 + 300 + 600
60 - 200 + 300 + 100
65 - 200 + 300 + 100
70 - 200 + 300 + 100
75 - 200 - 200 400
80 - 200 - 700 900
328
FIGURE 21-2.
Bearishly split strikes.
C
0
e ·15.
X
w
Part Ill: Put Option Strategies
1u +$100
w $0 I-----------'------ ................. -----
~ 60
....J
0
~ a.
Stock Price at Expiration
essentially lets him own the put for free. In fact, he can still make profits even if the
underlying stock rises slightly or only falls slightly. His risk is realized if the stock rises
above the striking price of the written call.
This strategy of splitting the strikes in a bearish manner is used very frequently
in conjunction with the ownership of common stock. That is, a stock owner who is
looking to protect his stock will buy an out-of-the-money put and sell an out-of-the
money call to finance the put purchase. This strategy is called a "protective collar"
and was discussed in more detail in the chapter on Put Buying in Conjunction with
Common Stock Ownership. A strategy that is similar to these, but modifies the risk,
is presented in Chapter 23, Spreads Combining Calls and Puts.
SUMMARY
In either of these aggressive strategies, the investor must have a definite opinion
about the future price movement of the underlying stock. He buys an out-of-the
money option to provide profit potential for that stock movement. However, an
investor can los


ership. A strategy that is similar to these, but modifies the risk,
is presented in Chapter 23, Spreads Combining Calls and Puts.
SUMMARY
In either of these aggressive strategies, the investor must have a definite opinion
about the future price movement of the underlying stock. He buys an out-of-the
money option to provide profit potential for that stock movement. However, an
investor can lose the entire purchase proceeds of an out-of-the-money option if the
stock does not perform as expected. An aggressive investor, who has sufficient collat
eral, might attempt to counteract this effect by also writing an out-of-the-money
option to cover the cost of the option that he bought. Then, he will not only make
money if the stock performs as expected, but he will also make money if the stock
remains relatively unchanged. He will lose quite heavily, however, if the underlying
stock goes in the opposite direction from his original anticipation. That is why he
must have a definite opinion on the stock and also be fairly certain of his timing.
Basic Put Spreads
Put spreading strategies do not differ substantially in theory from their accompany-
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put spreads, as was also the case with call spreads. However, because puts are more
oriented toward downward stock movement than calls are, some bearish put spread
strategies are superior to their equivalent bearish call spread strategies.
The three simplest forms of option spreads· are:
1. the bull spread,
2. the bear spread, and
3. the calendar spread.
The same types of spreads that were constructed with calls can be established with
puts, but there are some differences.
BEAR SPREAD
In a call bear spread, a call with a lower striking price was sold while a call at a high
er striking price was bought. Similarly, a put bear spread is established by selling a
put at a lower strike while buying a put at a higher strike. The put bear spread is a
debit spread. This is true because a put with a higher striking price will sell for more
than a put with a lower striking price. Thus, on a stock with both puts and calls trad
ing, one could set up a bear spread for a credit ( using calls) or alternatively set one
up for a debit (using puts):
329
330
Put Bear Spread
Buy XYZ January 60 put
Sell XYZ January 50 put
(debit spread)
Part Ill: Put Option Strategies
Call Bear Spread
Buy XYZ January 60 call
Sell XYZ January 50 call
(credit spread)
The put bear spread has the same sort of profit potential as the call bear spread.
There is a limited maximum potential profit, and this profit would be realized if XYZ
were below the lower striking price at expiration. The put spread would widen, in this
case, to equal the difference between the striking prices. The maximum risk is also
limited, and would be realized if XYZ were anywhere above the higher striking price
at expiration.
Example: The following prices exist:
XYZ common, 55;
XYZ January 50 put, 2; and
XYZ January 60 put, 7.
Buying the January 60 put and selling the January 50 would establish a bear
spread for a 5-point debit. Table 22-1 will help verify that this is indeed a bearish
position. The reader will note that Figure 22-1 has the same shape as the call bear
spread's graph (Figure 8-1). The investment required for this spread is the net debit,
and it must be paid in full. Notice that the maximum profit potential is realized any
where below 50 at expiration, and the maximum risk potential is realized anywhere
above 60 at expiration. The maximum risk is always equal to the initial debit required
to establish the spread plus commissions. The break-even point is 55 in this example.
The following formulae allow one to quickly compute the meaningful statistics
regarding a put bear spread.
Maximum risk = Initial debit
Maximum profit = Difference between strikes - Initial debit
Break-even price = Higher striking price - Initial debit
Put bear spreads have an advantage over call bear spreads. With puts, one is
selling an out-of-the-money option when setting up the spread. Thus, one is not risk
ing early exercise of his written option before the spread becomes profitable. For the
written put to be in-the-money, and thus in danger of being exercised, the spread
would have to be profitable, because the stock would have to be below the lower
striking price. Such is not the case with call bear spreads. In the call spread, one sells
an in-the-money call as part of the bear spread, and thus could be at risk of early exer
cise before the spread has a chance to become profitable.
Chapter 22: Basic Put Spreads 331
TABLE 22-1.
Put bear spread.
XYZ Price at January 50 January 60 Total
Expiration Put Profit Put Profit Profit
40 -$800 +$1,300 +$500
45 - 300 + 800 + 500
50 + 200 + 300 + 500
55 + 200 200 0
60 + 200 700 - 500
70 + 200 700 - 500
80 + 200 700 - 500
FIGURE 22-1.
Put bear spread.
Stock Price at Expiration
Beside this difference in the probability of early exercise, the put bear spread
holds another advantage over the call bear spread. In the put spread, if the underly
ing stock drops quickly, thereby making both options in-the-rrwney, the spread will
normally widen quickly as well. This is because, as has been mentioned previously,
put options tend to lose time value premium rather quickly when they go into-the
money. In the example above, if XYZ rapidly dropped to 48, the January 60 put would
be near 12, retaining very little time premium. However, the January 50 put that is
short would also not retain much time value premium, perhaps selling at 4 points or
332


as well. This is because, as has been mentioned previously,
put options tend to lose time value premium rather quickly when they go into-the
money. In the example above, if XYZ rapidly dropped to 48, the January 60 put would
be near 12, retaining very little time premium. However, the January 50 put that is
short would also not retain much time value premium, perhaps selling at 4 points or
332 Part Ill: Put Option Strategies
so. Thus, the spread would have widened to 8 points. Call bear spreads often do not
produce a similar result on a short-term downward movement. Since the call spread
involves being short a call with a lower striking price, this call may actually pick up
time value premium as the stock falls close to the lower strike. Thus, even though the
call spread might have a similar profit at expiration, it often will not perform as well
on a quick downward movement.
For these two reasons - less chance of early exercise and better profits on a
short-term movement - the put bear spread is superior to the call bear spread. Some
investors still prefer to use the call spread, since it is established for a credit and thus
does not require a cash investment. This is a rather weak reason to avoid the superi
or put spread and should not be an overriding consideration. Note that the margin
requirement for a call bear spread will result in a reduction of one's buying power by
an amount approximately equal to the debit required for a similar put bear spread.
(The margin required for a call bear spread is the difference between the striking
prices less the credit received from the spread.) Thus, the only accounts that gain any
substantial advantage from a credit spread are those that are near the minimum equi
ty requirement to begin with. For most brokerage firms, the minimum equity
requirement for spreads is $2,000.
BULL SPREAD
A bull spread can be established with put options by buying a put at a lower striking
price and simultaneously selling a put with a higher striking price. This, again, is the
same way a bull spread was constructed with calls: selling the higher strike and buy
ing the lower strike.
Example: The same prices can be used:
XYZ common, 55;
XYZ January 50 put, 2; and
XYZ January 60 put, 7.
The bull spread is constructed by buying the January 50 put and selling the January
60 put. This is a credit spread. The credit is 5 points in this example. If the underly
ing stock advances by January expiration and is anywhere above 60 at that time, the
maximum profit potential of the spread will be realized. In that case, with XYZ any
where above 60, both puts would expire worthless and the spreader would make a
profit of the entire credit - 5 points in this example. Thus, the maximum profit poten
tial is limited, and the maximum profit occurs if the underlying stock rises in price
Chapter 22: Basic Put Spreads 333
above the higher strike. These are the same qualities that were displayed by a call bull
spread (Chapter 7). The name "bull spread" is derived from the fact that this is a bull
ish position: The strategist wants the underlying stock to rise in price.
The risk is limited in this spread. If the underlying stock should decline by expi
ration, the maximum loss will be realized with XYZ anywhere below 50 at that time.
The risk is 5 points in this example. To see this, note that if XYZ were anywhere below
50 at expiration, the differential between the two puts would widen to 10 points,
since that is the difference between their striking prices. Thus, the spreader would
have to pay 10 points to buy the spread back, or to close out the position. Since he
initially took in a 5-point credit, this means his loss is equal to 5 points - the 10-point
cost of closing out less the 5 points he received initially.
The investment required for a bullish put spread is actually a collateral require
ment, since the spread is a credit spread. The amount of collateral required is equal
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\..V l,,J...111._, Ul.J..J..V.lV.l.l.\..,V LIV\..VVVVJ..l '-- J.'L, oJ\..l..l.J.'-l.J.J..o .t'.l.J..\,.,VoJ J.VoJ,J I..J.J.'-' J..1.V\.. \,.,.l.V"-AJ.l.- .LVV'-'..l.Y'-'"'--4 .J..'-.-".I. .__...._.._ .......
spread. In this example, the collateral requirement is $500- the $1,000, or 10-point,
differential in the striking prices less the $500 credit received from the spread. Note
that the maximum possible loss is always equal to the collateral requirement in a bull
ish put spread.
It is not difficult to calculate the break-even point in a bullish spread. ·In this
example, the break-even point before commissions is 55 at expiration. With XYZ at
55 in January, the January 50 put would expire worthless and the January 60 put
would have to be bought back for 5 points. It would be 5 points in-the-money with
XYZ at 55. Thus, the spreader would break even, since he originally received 5 points
credit for the spread and would then pay out 5 points to close the spread. The fol
lowing formulae allow one to quickly compute the details of a bullish put spread:
Maximum potential risk = Initial collateral requirement
= Difference in striking prices - Net credit received
Maximum potential profit= Net credit
Break-even price = Higher striking price - Net credit
CALENDAR SPREAD
In a calendar spread, a near-term option is sold and a longer-term option is bought,
both with the same striking price. This definition applies to either a put or a call cal
endar spread. In Chapter 9, it was shown that there were two philosophies available
for call calendar spreads, either neutral or bullish. Similarly, there are two philoso
phies available for put calendar spreads: neutral or bearish.
334 Part Ill: Put Option Strategies
In a neutral calendar spread, one sets up the spread with the idea of closing the
spread when the near-term call or put expires. In this type of spread, t


it was shown that there were two philosophies available
for call calendar spreads, either neutral or bullish. Similarly, there are two philoso
phies available for put calendar spreads: neutral or bearish.
334 Part Ill: Put Option Strategies
In a neutral calendar spread, one sets up the spread with the idea of closing the
spread when the near-term call or put expires. In this type of spread, the maximum
profit will be realized if the stock is exactly at the striking price at expiration. The
spreader is merely attempting to capitalize on the fact that the time value premium
disappears more rapidly from a near-term option than it does from a longer-term one.
Example: XYZ is at 50 and a January 50 put is selling for 2 points while an April 50
put is selling for 3 points. A neutral calendar spread can be established for a 1-point
debit by selling the January 50 put and buying the April 50 put. The investment
required for this position is the amount of the net debit, and it must be paid for in
full. If XYZ is exactly at 50 at January expiration, the January 50 put will expire worth
less and the April 50 put will be worth about 2 points, assuming other factors are the
same. The neutral spreader would then sell the April 50 put for 2 points and take his
profit. The spreader's profit in this case would be one point before commissions,
because he originally paid a 1-point debit to set up the spread and then liquidates the
position by selling the April 50 put for 2 points. Since commission costs can cut into
available profits substantially, spreads should be established in a large enough quan
tity to minimize the percentage cost of commissions. This means that at least 10
spreads should be set up initially.
In any type of calendar spread, the risk is limited to the amount of the net debit.
This maximum loss would be realized if the underlying stock moved substantially far
away from the striking price by the time the near-term option expired. If this hap
pened, both options would trade at nearly the same price and the differential would
shrink to practically nothing, the worst case for the calendar spreader. For example,
if the underlying stock drops substantially, say to 20, both the near-term and the long
term put would trade at nearly 30 points. On the other hand, if the underlying stock
rose substantially, say to 80, both puts would trade at a very low price, say 1/15 or 1/s,
and again the spread would shrink to nearly zero.
Neutral call calendar spreads are generally superior to neutral put calendar
spreads. Since the amount of time value premium is usually greater in a call option
(unless the underlying stock pays a large dividend), the spreader who is interested in
selling time value would be better off utilizing call options.
The second philosophy of calendar spreading is a more aggressive one. With put
options, a bearish strategy can be constructed using a calendar spread. In this case,
one would establish the spread with out-of-the-money puts.
Example: With XYZ at 55, one would sell the January 50 put for 1 point and buy the
April 50 put for 1 ½ points. He would then like the underlying stock to remain above
the striking price until the near-term January put expires. If this happens, he would
Chapter 22: Basic Put Spreads 335
make the I-point profit from the sale of that put, reducing his net cost for the April
50 put to ½ point. Then, he would become bearish, hoping for the underlying stock
to decline in price substantially before April expiration in order that he might be able
to generate large profits on the April 50 put he holds.
Just as the bullish calendar spread with calls can be a relatively attractive strat
egy, so can the bearish calendar spread with puts. Granted, two criteria have to be
fulfilled in order for the position to work to the optimum: The near-term put must
expire worthless, and then the underlying stock must drop in order to generate prof
its on the long side. Although these conditions may not occur frequently, one prof
itable situation can more than make up for several losing ones. This is true because
the initial debit for a bearish calendar spread is small, ½ point in the example above.
Thus, the losses will be small and the potential profits could be very large if things
work out right.
The aggressive spreader must be careful not to "leg out" of his spread, since he
could generate a large loss by doing so. The object of the strategy is to accept a rather
large number of small losses, with the idea that the infrequent large profits will more
than offset the sum of the losses. If one generates a large loss somewhere along the
way, this may ruin the overall strategy. Also, if the underlying stock should fall to the
striking price before the near-term put expires, the spread will normally have
widened enough to produce a small profit; that profit should be taken by closing the
spread at that time.
Spreads Cotnbining
Calls and Puts
Certain types of spreads can be constructed that utilize both puts and calls. One of
these strategies has been discussed before: the butterfly spread. However, other
strategies exist that off er potentially large profits to the spreader. These other strate
gies are all variations of calendar spreads and/or straddles that involve both put and
call options.
THE BUTTERFLY SPREAD
This strategy has been described previously, although its usage in Chapter 10 was
restricted to constructing the spread with calls. Recall that the butterfly spread is a
neutral position that has limited risk as well as limited profits. The position involves
three striking prices, utilizing a bull spread between the lower two strikes and a bear
spread between the higher two strikes. The maximum profit is realized at the middle
strike at expiration, and the maximum loss is realized if the stock is above the higher
strike or below the lower strike at expiration.
Since either a bull spread or a bear sp


well as limited profits. The position involves
three striking prices, utilizing a bull spread between the lower two strikes and a bear
spread between the higher two strikes. The maximum profit is realized at the middle
strike at expiration, and the maximum loss is realized if the stock is above the higher
strike or below the lower strike at expiration.
Since either a bull spread or a bear spread can be constructed with puts or calls,
it should be obvious that a butterfly spread ( consisting of both a bull spread and a
bear spread) can be constructed in a number of ways. In fact, there are four ways in
which the spread can be established. If option prices are fairly balanced - that is, the
arbitrageurs are keeping prices in line - any of the four ways will have the same
potential profits and losses at expiration of the options. However, because of the ways
in which puts and calls behave prior to their expiration, certain advantages or disad-
336
Chapter 23: Spreads Combining Calls and Puts 331
vantages are connected with some of the methods of establishing the butterfly
spread.
Example: The following prices exist:
Strike:
Call:
Put:
XYZ common: 60
50
12
60
6
5
70
2
1 1
The method using only the calls indicates that one would buy the 50 call, sell two 60
calls, and buy the 70 call. Thus, there would be a bull spread in the calls between the
50 and 60 strikes, and a bear spread in the calls between the 60 and 70 strikes. In a
similar manner, one could establish a butterfly spread by combining either type of bull
spread between the 50 and 60 strikes with any type of bear spread between the 60 and
70 strikes. Some of these spreads would be credit spreads, while others would be debit
spreads. In fact, one's personal choice between two rather equivalent makeups of the
butterfly spread might be decided by whether there were a credit or a debit involved.
Table 23-1 summarizes the four ways in which the butterfly spread might be
constructed. In order to verify the debits and credits listed, the reader should recall
that a bull spread consists of buying a lower strike and selling a higher strike, whether
puts or calls are used. Similarly, bear spreads with either puts or calls consist of buy
ing a higher strike and selling a lower strike. Note that the third choice - bull spread
with puts and bear spread with calls - is a short straddle protected by buying the out
of-the-money put and call.
In each of the four spreads, the maximum potential profit at expiration is 8
points if the underlying stock is exactly at 60 at that time. The maximum possible loss
in any of the four spreads is 2 points, if the stock is at or above 70 at expiration or is
at or below 50 at expiration. For example, either the top line in the table, where the
spread is set up only with calls; or the bottom line, where the spread is set up only
with puts, has a risk equal to the debit involved - 2 points. The large-debit spread
(second line of table) will be able to be liquidated for a minimum of 10 points at expi
ration no matter where the stock is, so the risk is also 2 points. (It cost 12 points to
begin with.) Finally, the credit combination (third line) has a maximum buy-back of
10 points, so it also has risk of 2 points. In addition, since the striking prices are 10
points apart, the maximum potential profit is 8 points (maximum profit = striking
price differential minus maximum risk) in all the cases.
338
TABLE 23-1.
Butterfly spread.
Bull Spread
(Buy Option at 50, ... plus ...
Sell at 60)
Calls (6 debit)
Calls (6 debit)
Puts (4 credit)
Puts (4 credit)
Bear Spread
(Buy Option at 70,
Sell at 60)
Calls (4 credit)
Puts (6 debit)
Calls (4 credit)
Puts (6 debit)
Part Ill: Put Option Strategies
Total Money
2 debit
12 debit
8 credit
2 debit
The factor that causes all these combinations to be equal in risk and reward is
the arbitrageur. If put and call prices get too far out of line, the arbitrageur can take
riskless action to force them back. This particular form of arbitrage, known as the box
spread, is described later, in Chapter 27, Arbitrage.
Even though all four ways of constructing the butterfly spread are equal at
expiration, some are superior to others for certain price movements prior to expira
tion. Recall that it was previously stated that bull spreads are best constructed with
calls, and bear spreads are best constructed with puts. Since the butterfly spread is
merely the combination of a bull spread and a bear spread, the best way to set up the
butterfly spread is to use calls for the bull spread and puts for the bear spread. This
combination is the one listed on the second line of Table 23-1. This strategy involves
the largest debit of the four combinations and, as a result, many investors shun this
approach. However, all the other combinations involve selling an in-the-money put
or call at the outset, a situation that could lead to early exercise. The reader may also
recall that the credit combination, listed on the third line of Table 23-1, was previ
ously described as a protected straddle position. That is, one sells a straddle and
simultaneously buys both an out-of-the-money put and an out-of-the-money call with
the same expiration month, as protection for the straddle. Thus, a butterfly spread is
actually the equivalent of a completely protected straddle wiite.
A butterfly spread is not an overly attractive strategy, although it may be useful
from time to time. The commissions required are extremely high, and there is no
chance of making a large profit on the position. The limited risk feature is good to
have in a position, but it alone cannot compensate for the less attractive features of
the strategy. Essentially, the strategist is looking for the stock to remain in a neutral
pattern until the options expire. If the potential profit is at least three times the max
imum 1isk (and preferably four times) and the under


of making a large profit on the position. The limited risk feature is good to
have in a position, but it alone cannot compensate for the less attractive features of
the strategy. Essentially, the strategist is looking for the stock to remain in a neutral
pattern until the options expire. If the potential profit is at least three times the max
imum 1isk (and preferably four times) and the underlying stock appears to be in trad
ing range, the strategy is feasible. Othe:nvise, it is not.
Chapter 23: Spreads Combining Calls and Puts 339
COMBINING AN OPTION PURCHASE AND A SPREAD
It is possible to combine the purchase of a call and a credit put spread to produce a
position that behaves much like a call buy, although it has less risk over much of the
profit range. This strategy is often used when one has a quite bullish opinion regard
ing the underlying security, yet the call one wishes to purchase is "overpriced." In a
similar manner, if one is bearish on the underlying, he can sometimes combine the
purchase of a put with the sale of a call credit spread. Both approaches are described
in this section.
THE BULLISH SCENARIO
It sometimes happens that one arrives at a bullish opinion regarding a stock, only to
find that the options are very expensive. In fact, they may be so expensive as to pre
clude thoughts of making an outright call purchase. This might happen, for example,
if the stock has suddenly plummeted in price (perhaps during an ongoing, rapid bear
ish move by the overall stock market). To buy calls at this time would be overly risky.
If the underlying began to rally, it would often be the case that the implied volatility
of the calls would shrink, thus harming one's long call position.
As a counter to this, it might make sense to buy the call, but at the same time
to sell a put credit spread. Recall that a put credit spread is a bullish strategy.
Moreover, since it is presumed that the options are expensive on this particular stock,
the puts being used in the spread would be expensive as well. Thus, the credit
received from the spread would be slightly larger than "normal" because the options
are expensive.
Example: XYZ is selling at 100. One wishes to purchase the December 100 call as an
outright bullish speculation. That call is selling for 10. However, one determines that
the December 100 call is overpriced at these levels. (In order to make this determi
nation, one would use an option model whose techniques are described in Chapter
28 on mathematical applications.) Hence, he decides to use the following put spread
in addition to buying the December 100 call:
Sell December 90 put, 6
Buy December 80 put, 3
The sale of the put spread brings in a 3-point credit. Thus, his total expenditure for
the entire position is 7 points ( 10 for the December 100 call, less 3 credit from the sale
of the put spread). If one is correct about his bullish outlook for the stock (i.e., the
stock goes up), he can in some sense consider that he paid 7 for the call. Another way
340 Part Ill: Put Option Strategies
to look at it is this: The sale of the put spread reduces the call price down to a more
moderate level, one that might be in line with its "theoretical value." In other words,
the call would not be considered expensive if it were priced at 7 instead of 10. The sale
of the put spread can be considered a way to reduce the overall cost of the call.
Of course, the sale of the put spread brings some extra risk into the position
because, if the stock were to fall dramatically, the put spread could lose 7 points ( the
width of the strikes in the spread, 10 points, less the initial credit received, 3 points).
This, added to the call's cost of 10 points, means that the entire risk here is 17 points.
In fact, that is the margin required for this spread as well. Thus, the overall spread
still has limited risk, because both the call purchase and the put credit spread are lim
ited-risk strategies. However, the total risk of the two combined is larger than for
either one separately.
Remember that one must be bullish on the underlying in order to employ this
strategy. So, if his analysis is correct, the upside is what he wants to maximize. If he
is wrong on his outlook for the stock, then he needs to employ some sort of stop-loss
measures before the maximum risk of the position is realized.
The resulting position is shown in Figure 23-1, along with two other plots. The
straight line marked "Spread at expiration" shows how the profitability of the call pur
chase combined with a bull spread would look at December expiration. In addition,
there is a plot with straight lines of the purchase of the December 100 call for 10
points. That plot can be compared with the three-way spread to see where extra risk
and reward occur. Note that the three-way spread does better than the outright pur
chase of the December 100 call as long as the stock is higher than 87 at expiration.
Since the stock is initially at 100 and,since one is initially bullish on the stock, one
would have to surmise that the odds of it falling to 87 are fairly small. Thus, the three
way spread outperforms the outright purchase of the call over a large range of stock
prices.
The final plot in Figure 23-1 is that of the three-way spread's profit and losses
halfway to the expiration date. You can see that it looks much like the profitability of
merely owning a call: The curve has the same shape as the call pricing curve shown
in Chapter 1.
Hence, this three-way strategy can often be more attractive and more profitable
than merely owning a call option. Remember, though, that it does increase risk and
require a larger collateral deposit than the outright purchase of the at-the-money call
would. One can experiment with this strategy, too, in that he might consider buying
an out-of-the-money call and selling a put spread that brings in enough credit to com
pletely pay for the call. In that way,


more profitable
than merely owning a call option. Remember, though, that it does increase risk and
require a larger collateral deposit than the outright purchase of the at-the-money call
would. One can experiment with this strategy, too, in that he might consider buying
an out-of-the-money call and selling a put spread that brings in enough credit to com
pletely pay for the call. In that way, he would have no risk as long as the stock
remained above the higher striking price used in the put credit spread.
Chapter 23: Spreads Combining Calls and Puts
FIGURE 23-1.
Call buy and put credit (bull) spread.
+$2,000
+$1,000
(/J
(/J
0 ..J
0 $0 -e a.
-$1,000
-$2,000
70 80
.... ,, -----,, -=-----'
THE BEARISH SCENARIO
~ Spread at Expiration
Call Buy Only, at Expiration
341
Stock
In a similar manner, one can construct a position to take advantage of a bearish opin
ion on a stock. Again, this would be most useful when the options were overpriced
and one felt that an at-the-money put was too expensive to purchase by itself.
Example: XYZ is trading at 80, and one has a definite bearish opinion on the stock.
However, the December 80 put, which is selling for 8, is expensive according to an
option analysis. Therefore, one might consider selling a call credit spread (out-of-the
money) to help reduce the cost of the put. The entire position would thus be:
Buy 1 December 80 put:
Sell l December 90 call:
Buy 1 December 100 call:
Total cost:
8 debit
4 credit
2 debit
6 debit ($600)
The profitability of this position is shown in Figure 23-2. The straight line on that
graph shows how the position would behave at expiration. The introduction of the
call credit spread has increased the risk to $1,600 if the stock should rally to 100 or
higher by expiration. Note that the risk is limited since both the put purchase and the
call credit spread are limited-risk strategies. The margin required would be this max
imum risk, or $1,600.
342 Part Ill: Put Option Strategies
FIGURE 23-2.
Put buy and call credit (bear) spread.
+$1,000 Halfway to Expiration
/
Stock
0 60 110
-e a.
-$1,000 At Expiration
-$2,000
The curved line on Figure 23-2 shows how the three-way spread would behave
if one looked at it halfway to its expiration date. In that case, it has a curved appear
ance much like the outright purchase of a put option.
Thus, this strategy could be appealing to bearishly-oriented traders, especially
when the options are expensive. It might have certain advantages over an outright put
purchase in that case, but it does require a larger margin investment and has theo
retically larger risk.
A SIMPLE FOLLOW-UP ACTION
FOR BULL OR BEAR SPREADS
Another way of combining puts and calls in a spread can sometimes be used when
one has a bull or bear spread already in place. Suppose that one owns a call bull
spread and the underlying stock has advanced nicely. In fact, it is above both of the
strikes used in the spread. However, as is often the case, the bull spread may not have
widened out to its maximum profit potential. One can use the puts for two purposes
at this point: (1) to determine whether the call spread is trading at a "reasonable"
value, and (2) to try to lock in some profits. First, let's look at an example of the "rea
sonable value" verification.
Chapter 23: Spreads Combining Calls and Puts 343
Example: A trader buys an XYZ call bull spread for 5 points. The spread uses the
January 70 calls and the January 80 calls. Later, XYZ advances to a price of 88, but
there is still a good deal of time remaining in the options. Perhaps the spread has
widened out only to 7 points at that time. The trader finds it somewhat disappoint
ing that the spread has not widened out to its maximum profit potential of 10 points.
However, this is a fairly common occurrence with bull and bear spreads, and is one
of the factors that may make them less attractive than outright call or put purchases.
In any case, suppose the following prices exist:
January 80 put, 5
January 70 put, 2
We can use these put prices to verify that the call spread is "in line." Notice that the
put spread is 3 points and the call spread is 7 points (both are the January 70-January
80 spread). Thus, they add up to 10 points the width of the strikes. When that
occurs, we can conclude that the spreads are "in line" and are trading at theoretical
ly correct prices.
Knowing this information doesn't help one make any more profits, but it does
provide some verification of the prices. Many times, one feels frustrated when he
sees that a call bull spread has not widened out as he expected it to. Using the put
spread as verification can help keep the strategist "on track" so that he makes ration
al, not emotional, decisions.
Now let's look at a similar example, in which perhaps the puts can be used to
lock in profits on a call bull spread.
Example: Using the same bull spread as in the previous example, suppose that one
owns an XYZ call bull spread, having bought the January 70 call and sold the January
80 call for a debit of 5 points. Now assume it is approaching expiration, and the stock
is once again at 88. At this time, the spread is theoretically nearing its maximum price
of 10. However, since both calls are fairly deeply in-the-money, the market-makers
are making very wide spreads in the calls. Perhaps these are the markets, with the
stock at 88 and only a week or two remaining until expiration:
Coll
January 70 call
January 80 call
Bid Price
17.50
8.80
Asked Price
18.50
8.20
If one were to remove this spread at market prices, he would sell his long
January 70 call for 17.50 and would buy his short January 80 call back for 8.20, a cred-
344 Part Ill: Put Option Strategies
it of 9.30. Since the maximum value of the spread is l 0, one is giving away 70 cents,
quite a bit for just such a short time remaining.
However, suppose that one looks at the puts and finds these prices:
Pu


to remove this spread at market prices, he would sell his long
January 70 call for 17.50 and would buy his short January 80 call back for 8.20, a cred-
344 Part Ill: Put Option Strategies
it of 9.30. Since the maximum value of the spread is l 0, one is giving away 70 cents,
quite a bit for just such a short time remaining.
However, suppose that one looks at the puts and finds these prices:
Put
January 80 put
January 70 put
Bid Price
0.20
none
Asked Price
0.40
0.10
One could "lock in" his call spread profits by buying the January 80 put for 40 cents.
Ignoring commissions for a moment, if he bought that put and then held it along with
the call spread until expiration, he would unwind the call spread for a 10 credit at
expiration. He paid 40 cents for the put, so his net credit to exit the spread would be
9.60 - considerably better than the 9.30 he could have gotten above for the call
spread alone.
This put strategy has one big advantage: If the underlying stock should sudden
ly collapse and tumble beneath 70 - admittedly, a remote possibility - large profits
could accrue. The purchase of the January 80 put has protected the bull spread's
profits at all prices. But below 70, the put starts to make extra money, and the spread
er could profit handsomely. Such a drop in price would only occur if some material
ly damaging news surfaced regarding X'iZ Company, but it does occasionally happen.
If one utilizes this strategy, he needs to carefully consider his commission costs
and the possibility of early assignment. For a professional trader, these are irrelevant,
and so the professional trader should endeavor to exit bull spreads in this manner
whenever it makes sense. However, if the public customer allows stock to be assigned
at 80 and exercises to buy stock at 70, he will have two stock commissions plus one
put option commission. That should be compared to the cost of two in-the-money
call option commissions to remove the call spread directly. Furthermore, if the pub
lic customer receives an early assignment notice on the short January 80 calls, he may
need to provide day-trade margin as he exercises his January 70 calls the next day.
Without going into as much detail, a bear spread's profits can be locked in via a
similar strategy. Suppose that one owns a January 60 put and has sold a January 50
put to create a bear spread. Later, with the stock at 45, the spreader wants to remove
the spread, but again finds that the markets for the in-the-money puts are so wide
that he cannot realize anywhere near the 10 points that the spread is theoretically
worth. He should then see what the January 50 call is selling for. If it is fractionally
priced, as it most likely will be if expiration is drawing nigh, then it can be purchased
to lock in the profits from the put spread. Again, commission costs should be con
sidered by the public customer before finalizing his strategy.
Chapter 23: Spreads Combining Calls and Puts 345
THREE USEFUL BUT COMPLEX STRATEGIES
The three strategies presented in this section are all designed to limit risk while
allowing for large potential profits if correct market conditions develop. Each is a
combination strategy - that is, it involves both puts and calls and each is a calendar
strategy, in which near-term options are sold and longer-term options are bought. (A
fourth strategy that is similar in nature to those about to be discussed is presented in
the next chapter.) Although all of these are somewhat complex and are for the most
advanced strategist, they do provide attractive risk/reward opportunities. In addition,
the strategies can be employed by the public customer; they are not designed strict
ly for professionals. All three strategies are described conceptually in this section;
specific selection criteria are presented in the next section.
A TWO-PRONGED ATTACK {THE CALENDAR COMBINATION}
A bullish calendar spread was shown to be a rather attractive strategy. A bullish call
calendar spread is established with out-of-the-money calls for a relatively small debit.
If the near-term call expires worthless and the stock then rises substantially before
the longer-term call expires, the profits could potentially be large. In any case, the
risk is limited to the small debit required to establish the spread. In a similar man
ner, the bearish calendar spread that uses put options can be an attractive strategy
as well. In this strategy, one would set up the spread with out-of-the-money puts. He
would then want the near-term put to expire worthless, followed by a substantial drop
in the stock price in order to profit on the longer-term put.
Since both strategies are attractive by themselves, the combination of the two
should be attractive as well. That is, with a stock midway between two striking prices,
one might set up a bullish out-of-the-money call calendar spread and simultaneously
establish a bearish out-of-the-money put calendar spread. If the stock remains rela
tively stable, both near-term options would expire worthless. Then a substantial stock
price movement in either direction could produce large profits. With this strategy,
the spreader does not care which direction the stock moves after the near options
expire worthless; he only hopes that the stock becomes volatile and moves a large dis
tance in either direction.
Example: Suppose that the following prices exist three months before the January
options expire:
January 70 call: 3
April 70 call: 5
XYZ common: 65
January 60 put: 2
April 60 put: 3
346 Part Ill: Put Option Strategies
The bullish portion of this combination of calendar spreads would be set up by sell
ing the shorter-term January 70 call for 3 points and simultaneously buying the
longer-term April 70 call for 5 points. This portion of the spread requires a 2-point
debit. The bearish portion of the spread would be constructed using the puts. The
near-term January 60 put would be sold f