O.,,er 2: Covered Call Writing
TABLE 2-26.
Two months of incremental return strategy.
Doy 1 : XYZ = 60
Sell 3 XYZ October 60's at 7
One month later: XYZ = 70
Buy back the 3 XYZ Oct 60's at 11 and
sell 5 XYZ Oct 70's at 7
Twa months later: XYZ = 80
Buy back the 5 Oct 70's at 11 and
sell 10 XYZ Oct 80's at 6
COVERED CALL WRITING SUMMARY
93
+$2, 100 credit
-$3 ,300 debit
+$3,500 credit
-$5 ,500 debit
+$6,000 credit
+$2,800 credit
This concludes the chapter on covered call writing. The strategy will be referred to
later, when compared with other strategies. Here is a brief summary of the more
important points that were discussed.
Covered call writing is a viable strategy because it reduces the risk of stock own
ership and will make one's portfolio less volatile to short-term market movements. It
should be understood, however, that covered call writing may underperform stock
ownership in general because of the fact that stocks can rise great distances, while a
covered write has limited upside profit potential. The choice of which call to write
can make for a more aggressive or more conservative write. Writing in-the-money
calls is strategically more conservative than writing out-of-the-money calls, because
of the larger amount of downside protection received. The total return concept of
covered call writing attempts to achieve the maximum balance between income from
all sources - option premiums, stock ownership, and dividend income - and down
side protection. This balance is usually realized by writing calls when the stock is near
the striking price, either slightly in- or slightly out-of-the-money.
The writer should compute various returns before entering into the position:
the return if exercised, the return if the stock is unchanged at expiration, and the
break-even point. To truly compare various writes, returns should be annualized, and
all commissions and dividends should be included in the calculations. Returns will be
increased by taking larger positions in the underlying stock - 500 or 1,000 shares.
Also, by utilizing a brokerage firm's capability to produce "net" executions, buying the
stock and selling the call at a specified net price differential, one will receive better
executions and realize higher returns in the long run.

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94 Part II: Call Option Strategies
The selection of which call to write should be made on a comparison of avail
able returns and downside protection. One can sometimes write part of his position
out-of-the-money and the other part in-the-money to force a balance between return
and protection that might not otherwise exist. Finally, one should not write against an
underlying stock if he is bearish on the stock. The writer should be slightly bullish, or
at least neutral, on the underlying stock.
Follow-up action can be as important as the selection of the initial position
itself. By rolling down if the underlying stock drops, the investor can add downside
protection and current income. If one is unwilling to limit his upside potential too
severely, he may consider rolling down only part of his call writing position. As the
written call expires, the writer should roll forward into a more distant expiration
month if the stock is relatively close to the original striking price. Higher consistent
returns are achieved in this manner, because one is not spending additional stock
commissions by letting the stock be called away. An aggressive follow-up action can
also be taken when the underlying stock rises in price: The writer can roll up to a
higher striking price. This action increases the maximum profit potential but also
exposes the position to loss if the stock should subsequently decline. One would want
to take no follow-up action and let his stock be called if it is above the striking price
and if there are better returns available elsewhere in other securities.
Covered call writing can also be done against convertible securities - bonds or
preferred stocks. These convertibles sometimes offer higher dividend yields and
therefore increase the overall return from covered writing. Also, the use of warrants
or LEAPS in place of the underlying stock may be advantageous in certain circum
stances, because the net investment is lowered while the profit potential remains the
same. Therefore, the overall return could be higher.
Finally, the larger individual stockholder or institutional investor who wants to
achieve a certain price for his stock holdings should operate his covered writing strat
egy under the incremental return concept. This will allow him to realize the full prof
it potential of his underlying stock, up to the target sale price, and to earn additional
positive income from option writing.

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158 Part II: Call Option Strategies
FOLLOW-UP ACTION
Aside from closing the position completely, there are three reasonable approaches to
follow-up action in a ratio writing situation. The first, and most popular, is to roll the
written calls up if the stock rises too far, or to roll down if the stock drops too far. A
second method uses the delta of the written calls. The third follow-up method is to
utilize stops on the underlying stock to alter the ratio of the position as the stock
moves either up or down. In addition to these types of defensive follow-up action, the
investor must also have a plan in mind for taking profits as the written calls approach
expiration. These types of follow-up action are discussed separately.
ROLLING UP OR DOWN AS A DEFENSIVE ACTION
The reader should already be familiar with the definition of a rolling action: The cur
rently written calls are bought back and calls at a different striking price are written.
The ratio writer can use rolling actions to his advantage to readjust his position if the
underlying stock moves to the edges of his profit range.
The reason one of the selection criteria for a ratio write was the availability of
both the next higher and next lower striking prices was to facilitate the rolling actions
that might become necessary as a follow-up measure. Since an option has its great
est time premium when the stock price and the striking price are the same, one
would normally want to roll exactly at a striking price.
Example: A ratio writer bought 100 XYZ at 49 and sold two October 50 calls at 6
points each. Subsequently, the stock drops in price and the following prices exist:
XYZ, 40; XYZ October 50, l; and XYZ October 40, 4.
One would roll down to the October 40 calls by buying back the 2 October
50's that he is short and selling 2 October 40's. In so doing, he would reestablish a
somewhat neutral position. His profit on the buy-back of the October 50 calls
would be 5 points each - they were originally sold for 6 - and he would realize a
10-point gain on the two calls. This 10-point gain effectively reduces his stock cost
from 49 to 39, so that he now has the equivalent of the following position: long 100
XYZ at 39 and short 2 XYZ October 40 calls at 4. This adjusted ratio write has a
profit range of 31 to 49 and is thus a new, neutral position with the stock currently
at 40. The investor is now in a position to make profits if XYZ remains near this
level, or to take further defensive action if the stock experiences a relatively large
change in price again.
Defensive action to the upside - rolling up -works in much the same manner.

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Chapter 6: Ratio Call Writing 159
Example: The initial position again consists of buying 100 XYZ at 49 and selling two
October 50 calls at 6. If XYZ then rose to 60, the following prices might exist: XYZ,
60; XYZ October 50, 11; and XYZ October 60, 6.
The ratio writer could thus roll this position up to reestablish a neutral profit
range. If he bought back the two October 50 calls, he would take a 5-point loss on
each one for a net loss on the calls of 10 points. This would effectively raise his stock
cost by 10 points, to a price of 59. The rolled-up position would then be long 100 XYZ
at 59 and short 2 October 60 calls at 6. This new, neutral position has a profit range
of 47 to 73 at October expiration.
In both of the examples above, the writer could have closed out the ratio write
at a very small profit of about 1 point before commissions. This would not be advis
able, because of the relatively large stock commissions, unless he expects the stock to
continue to move dramatically. Either rolling up or rolling down gives the writer a
fairly wide new profit range to work with, and he could easily expect to make more
than 1 point of profit if the underlying stock stabilizes at all.
Having to take rolling defensive action immediately after the position is estab
lished is the most detrimental case. If the stock moves very quickly after having set
up the position, there will not be much time for time value premium erosion in the
written calls, and this will make for smaller profit ranges after the roll is done. It may
be useful to use technical support and resistance levels as keys for when to take
rolling action if these levels are near the break-even points and/or striking prices.
It should be noted that this method of defensive action - rolling at or near strik
ing prices - automatically means that one is buying back little or no time premium
and is selling the greatest amount of time premium currently available. That is, if the
stock rises, the call's premium will consist mostly of intrinsic value and very little of
time premium value, since it is substantially in-the-money. Thus, the writer who rolls
up by buying back this in-the-money call is buying back mostly intrinsic value and is
selling a call at the next strike. This newly sold call consists mostly of time value. By
continually buying back "real" or intrinsic value and by selling "thin air" or time value,
the writer is taking the optimum neutral action at any given time.
If a stock undergoes a dramatic move in one direction or the other, the ratio
writer will not be able to keep pace with the dramatic movement by remaining in the
same ratio.
Example: If XYZ was originally at 49, but then undergoes a fairly straight-line move
to 80 or 90, the ratio writer who maintains a 2:1 ratio will find himself in a deplorable
situation. He will have accumulated rather substantial losses on the calls and will not
be able to compensate for these losses by the gain in the underlying stock. A similar

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160 Part II: Call Option Strategies
situation could arise to the downside. If:X'YZ were to plunge from 49 to 20, the ratio
writer would make a good deal of profit from the calls by rolling down, but may still
have a larger loss in the stock itself than the call profits can compensate for.
Many ratio writers who are large enough to diversify their positions into a num
ber of stocks will continue to maintain 2:1 ratios on all their positions and will simply
close out a position that has gotten out of hand by running dramatically to the upside
or to the downside. These traders believe that the chances of such a dramatic move
occurring are small, and that they will take the infrequent losses in such cases in
order to be basically neutral on the other stocks in their portfolios.
There is, however, a way to combat this sort of dramatic move. This is done by
altering the ratio of the covered write as the stock moves either up or down. For
example, as the underlying stock moves up dramatically in price, the ratio writer can
decrease the number of calls outstanding against his long stock each time he rolls.
Eventually, the ratio might decrease as far as 1:1, which is nothing more than a cov
ered writing situation. As long as the stock continues to move in the same upward
direction, the ratio writer who is decreasing his ratio of calls outstanding will be giv
ing more and more weight to the stock gains in the ratio write and less and less weight
to the call losses. It is interesting to note that this decreasing ratio effect can also be
produced by buying extra shares of stock at each new striking price as the stock
moves up, and simultaneously keeping the number of outstanding calls written con
stant. In either case, the ratio of calls outstanding to stock owned is reduced.
When the stock moves down dramatically, a similar action can be taken to
increase the number of calls written to stock owned. Normally, as the stock falls, one
would sell out some of his long stock and roll the calls down. Eventually, after the
stock falls far enough, he would be in a naked writing position. The idea is the same
here: As the stock falls, more weight is given to the call profits and less weight is given
to the stock losses that are accumulating.
This sort of strategy is more oriented to extremely large investors or to firm
traders, market-makers, and the like. Commissions will be exorbitant if frequent rolls
are to be made, and only those investors who pay very small commissions or who have
such a large holding that their commissions are quite small on a percentage basis will
be able to profit substantially from such a strategy.
ADJUSTING WITH THE DELTA
The delta of the written calls can be used to determine the correct ratio to be used in
this ratio-adjusting defensive strategy. The basic idea is to use the call's delta to
remain as neutral as possible at all times.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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Chapter 11: Ratio Call Spreads 215
These two philosophies are not mutually exclusive. The strategist who uses ratio
spreads without regard for whether they are debit or credit spreads will generally
have a broader array of spreads to choose from and will also be able to assume a more
neutral posture on the stock. The spreader who insists on generating credits only will
be forced to establish spreads on which his return will be slightly smaller if the under
lying stock remains relatively unchanged. However, he will not have to worry about
downside defensive action, since he has no risk to the downside. The third philoso
phy, the "delta spread," is described after the next section, in which the uses of ratios
other than 2: 1 are described.
ALTERING THE RATIO
Under either of the two philosophies discussed above, the strategist may find that a
3:1 ratio or a 3:2 ratio better suits his purposes than the 2:1 ratio. It is not common
to write in a ratio of greater than 4: 1 because of the large increase in upside risk at
such high ratios. The higher the ratio that is used, the higher will be the credits of
the spread. This means that the profits to the downside will be greater if the stock
collapses. The lower the ratio that is used, the higher the upside break-even point will
be, thereby reducing upside risk.
Example: If the same prices are used as in the initial example in this chapter, it will
be possible to demonstrate these facts using three different ratios (Table 11-3):
XYZ common, 44;
XYZ April 40 call, 5; and
XYZ April 45 call, 3.
TABLE 11-3.
Comparison of three ratios.
Price of spread
(downside risk)
Upside break-even
Downside break-even
Maximum profit
3:2 Ratio:
Buy 2 April 40's
Sell 3 April 45's
1 debit
54
401/2
9
2:1 Ratio: 3:1 Ratio:
By 1 April 40 Buy 1 April 40
Sell 2 April 45's Sell 3 April 45's
1 credit 4 credit
51 49½
None None
6 9

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220 Part II: Call Option Strategies
Example: Early in this chapter, when selection criteria were described, a neutral
ratio was determined to be 16:10, with XYZ at 44. Suppose, after establishing the
spread, that the common rallied to 4 7. One could use the current deltas to adjust.
This information is summarized in Table 11-4. The current neutral ratio is approxi
mately 14:10. Thus, two of the short April 45's could be bought closing. In practice,
one usually decreases his ratio by adding to the long side. Consequently, one would
buy two April 40's, decreasing his overall ratio to 16:12, which is 1.33 and is close to
the actual neutral ratio of 1.38. The position would therefore be delta-neutral once
more.
An alternative way of looking at this is to use the equivalent stock position
(ESP), which, for any option, is the multiple of the quantity times the delta times the
shares per option. The last three lines of Table 11-4 show the ESP for each call and
for the position as a whole. Initially, the position has an ESP of 0, indicating that it is
perfectly delta-neutral. In the current situation, however, the position is delta short
140 shares. Thus, one could adjust the position to be delta-neutral by buying 140
shares of XYZ. If he wanted to use the options rather than the stock, he could buy
two April 45's, which would add a delta long of 130 ESP (2 x .65 x 100), leaving the
position delta short 10 shares, which is very near neutral. As pointed out in the above
paragraph, the spreader probably should buy the call with the most intrinsic value -
the April 40. Each one of these has an ESP of 90 (1 x .9 x 100). Thus, if one were
bought, the position would be delta short 50 shares; if two were bought, the total
position would be delta long 40 shares. It would be a matter of individual preference
whether the spreader wanted to be long or short the "odd lot" of 40 or 50 shares,
respectively.
TABLE 11-4.
Original and current prices and deltas.
XYZ common
April 40 call
April 45 call
April 40 delta
April 45 delta
Neutral ratio
April 40 ESP
April 45 ESP
Total ESP
Original Situation
44
5
3
.80
.50
16:10 (.80/.50)
800 long (l Ox .8 x 100)
800 shrt ( 16 x .5 x l 00)
0 (neutral)
Current Situation
47
8
5
.90
.65
14:10 (.90/.65 = 1.38)
900 long (10 x .9 x 100)
l ,040 shrt ( 16 x .65 x l 00)
140 shrt

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Chapter 11: Ratio Call Spreads 221
The ESP method is merely a confirmation of the other method. Either one
works well. The spreader should become familiar with the ESP method because, in
a position with many different options, it reduces the exposure of the entire position
to a single number.
TAKING PROFITS
In addition to defensive action, the spreader may find that he can close the spread
early to take a profit or to limit losses. If enough time has passed and the underlying
stock is close to the maximum profit point - the higher striking price - the spreader
may want to consider closing the spread and taking his profit. Similarly, if the under
lying stock is somewhere between the two strikes as expiration draws near, the writer
will normally find himself with a profit as the long call retains some intrinsic value
and the short calls are nearly worthless. If at this time one feels that there is little to
gain (a price decline might wipe out the long call value), he should close the spread
and take his profit.
SUMMARY
Ratio spreads can be an attractive strategy, similar in some ways to ratio writing. Both
strategies offer a large probability of making a limited profit. The ratio spread has
limited downside risk, or possibly no downside risk at all. In addition, if the long
call(s) in the spread can be bought with little or no time value premium in them, the
ratio spread becomes a superior strategy to the ratio write. One can adjust the ratio
used to reflect his opinion of the underlying stock or to make a neutral profit range
if desired. The ratio adjustment can be accomplished by using the deltas of the
options. In a broad sense, this is one of the more attractive forms of spreading, since
the strategist is buying mostly intrinsic value and is selling a relatively large amount
of time value.

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Cotnbining Calendar
and Ratio Spreads
The previous chapters on spreading introduced the basic types of spreads. The sim
plest forms of bull spreads, bear spreads, or calendar spreads can often be combined
to produce a position with a more attractive potential. The butterfly spread, which is
a combination of a bull spread and a bear spread, is an example of such a combina
tion. The next three chapters are devoted to describing other combinations of
spreads, wherein the strategist not only mixes basic strategies ..:... bull, bear, and calen
dar - but uses varying expiration dates as well. Although they may seem overly com
plicated at first glance, these combinations are often employed by professionals in the
field.
RATIO CALENDAR SPREAD
The ratio cdendar spread is a combination of the techniques used in the calendar
and ratio spreads. Recall that one philosophy of the calendar spread strategy was to
sell the near-term call and buy a longer-term call, with both being out-of-the-money.
This is a bullish calendar spread. If the underlying stock never advances, the spread
er loses the entire amount of the relatively small debit that he paid for the spread.
However, if the stock advances after the near-term call expires worthless, large prof
its are possible. It was stated that this bullish calendar spread philosophy had a small
probability of attaining large profits, and that the few profits could easily exceed the
preponderance of small losses.
The ratio calendar spread is an attempt to raise the probabilities while allowing
for large potential profits. In the ratio calendar spread, one sells a number of near-
222

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Chapter 12: Combining Calendar and Ratio Spreads 223
term calls while buyingfewer of the intermediate-term or long-term calls. Since more
calls are being sold than are being bought, naked options are involved. It is often pos
sible to set up a ratio calendar spread for a credit, meaning that if the underlying
stock never rallies above the strike, the strategist will still make money. However,
since naked calls are involved, the collateral requirements for participating in this
strategy may be large.
Example: As in the bullish calendar spreads described in Chapter 9, the prices are:
XYZ common, 45;
XYZ April 50 call, l; and
XYZ July 50 call, l½.
In the bullish calendar spread strategy, one July 50 is bought for each April 50 sold.
This means that the spread is established for a debit of½ point and that the invest
ment is $50 per spread, plus commissions. The strategist using the ratio calendar
/ spread has essentially the same philosophy as the bullish calendar spreader: The
stock will remain below 50 until April expiration and may then rally. The ratio calen
dar spread might be set up as follows:
Buy 1 XYZ July 50 call at l½
Sell 2 XYZ April 50 calls at 1 each
Net
l½ debit
2 credit
½ credit
Although there is no cash involved in setting up the ratio spread since it is done for
a credit, there is a collateral requirement for the naked April 50 call.
If the stock remains below 50 until April expiration, the long call - the July 50
- will be owned free. After that, no matter what happens to the underlying stock, the
spread cannot lose money. In fact, if the underlying stock advances dramatically after
near-term expiration, large profits will accrue as the July 50 call increases in value. Of
course, this is entirely dependent on the near-term call expiring worthless. If the
underlying stock should rally above 50 before the April calls expire, the ratio calen
dar spread is in danger of losing a large amount of money because of the naked calls,
and defensive action must be taken. Follow-up actions are described later.
The collateral required for the ratio calendar spread is equal to the amount of
collateral required for the naked calls less the credit taken in for the spread. Since
naked calls will be marked to market as the stock moves up, it is always best to allow
enough collateral to get to a defensive action point. In the example above, suppose
that one felt he would definitely be taking defensive action if the stock rallied to 53

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224 Part II: Call Option Strategies
before April expiration. He should then figure his collateral requirement as if the
stock were at 53, regardless of what the collateral requirement is at the current time.
This is a prudent tactic whenever naked options are involved, since the strategist will
never be forced into an unwanted close-out before his defensive action point is
reached. The collateral required for this example would then be as follows, assuming
the call is trading at 3½:
20% of 53
Call premium
Less initial credit
Total collateral to set aside
$1,060
+ 350
-___fill
$1,360
The strategist is not really "investing" anything in this strategy, because his require
ment is in the form of collateral, not cash. That is, his current portfolio assets need
not be disturbed to set up this spread, although losses would, of course, create deb
its in the account. Many naked option strategies are similar in this respect, and the
strategist may earn additional money from the collateral value of his portfolio with
out disturbing the portfolio itself. However, he should take care to operate such
strategies in a conservative manner, since any income earned is "free," but losses may
force him to disturb his portfolio. In light of this fact, it is always difficult to compute
returns on investment in a strategy that requires only collateral to operate. One can,
of course, compute the return on the maximum collateral required during the life of
the position. The large investor participating in such a strategy should be satisfied
with any sort of positive return.
Returning to the example above, the strategist would make his $50 credit, less
commissions, if the underlying stock remained below 50 until July expiration. It is not
possible to determine the results to the upside so definitively. If the April 50 calls
expire worthless and then the stock rallies, the potential profits are limited only by
time. The case in which the stock rallies before April expiration is of the most con
cern. If the stock rallies immediately, the spread will undoubtedly show a loss. If the
stock rallies to 50 more slowly, but still before April expiration, it is possible that the
spread will not have changed much. Using the same example, suppose that XYZ ral
lies to 50 with only a few weeks of life remaining in the April 50 calls. Then the April
50 calls might be selling at l ½ while the July 50 call might be selling at 3. The ratio
spread could be closed for even money at that point; the cost of buying back the 2
April 50's would equal the credit received from selling the one July 50. He would thus
make½ point, less commissions, on the entire spread transaction. Finally, at the expi
ration date of the April 50 calls, one can estimate where he would break even.
Suppose one estimated that the July 50 call would be selling for 5½ points if XYZ
were at 53 at April expiration. Since the April 50 calls would be selling for 3 at that

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Chapter 12: Combining Calendar and Ratio Spreads 227
itself is a rather high-probability event, because the stock is initially below the strik
ing price. In addition, the spread can make large potential profits if the stock rallies
after the near-term calls expire. Although this is a much less probable event, the prof
its that can accrue add to the expected return of the spread. The only time the spread
loses is when the stock rallies quickly, and the strategist should close out the spread
in that case to limit losses.
Although Table 12-2 is not mathematically definitive, it can be seen that this
strategy has a positive expected return. Small profits occur more frequently than
small losses do, and sometimes large profits can occur. These expected outcomes,
when coupled with the fact that the strategist may utilize collateral such as stocks,
bonds, or government securities to set up these spreads, demonstrate that this is a
viable strategy for the advanced investor.
TABLE 12-2.
Profitability of ratio calendar spreading.
Event
Stock never rallies above
strike
Stock rallies above strike in a
short time
Stock rallies above strike after
near-term call expires
Outcome
Small profit.
Small loss if defensive
action employed
Large potential profit
DELTA-NEUTRAL CALENDAR SPREADS
Probability
Large probability
Small probability
Small probability
The preceding discussion dealt with a specific kind of ratio calendar spread, the out
of-the-money call spread. A more accurate ratio can be constructed using the deltas
of the calls involved, similar to the ratio spreads in Chapter 11. The spread can be
created with either out-of-the-money calls or in-the-money calls. The former has
naked calls, while the latter has extra long calls. Both types of ratio calendars are
described.
In either case, the number of calls to sell for each one purchased is determined
by dividing the delta of the long call by the delta of the short call. This is the same
for any ratio spread, not just calendars.
Example: Suppose XYZ is trading at 45 and one is considering using the July 50 call
and the April 50 call to establish a ratio calendar spread. This is the same situation

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228 Part II: Call Option Strategies
that was described earlier in this chapter. Furthermore, assume that the deltas of the
calls in question are .25 for the July and .15 for the April. Given that information, one
can compute the neutral ratio to be 1.667 to 1 (.25/.15). That is, one would sell 1.667
calls for each one he bought; restated, he would sell 5 for each 3 bought.
This out-of-the-money neutral calendar is typical. One normally sells more calls
than he buys to establish a neutral calendar when the calls are out-of-the-money. The
ramifications of this strategy have already been described in this chapter. Follow-up
strategy is slightly different, though, and is described later.
THE IN-THE-MONEY CALENDAR SPREAD
When the calls are in-the-money, the neutral spread has a distinctly different look.
An example will help in describing the situation.
Example: XYZ is trading at 49, and one wants to establish a neutral calendar spread
using the July 45 and April 45 calls. The deltas of these in-the-money calls are .8 for
the April and .7 for the July. Note that for in-the-rrwney calls, a shorter-term call has
a higher delta than a longer-term call.
The neutral ratio for this in-the-money spread would be .875 to 1 (.7/.8). This
means that .875 calls would be sold for each one bought; restated, 7 calls would be
sold and 8 bought. Thus, the spreader is buying more calls than he is selling when
establishing an in-the-money neutral calendar. In some sense, one is establishing
some "regular'' calendar spreads (seven of them, in this example) and simultaneous
ly buying a few extra long calls to go along with them ( one extra long call, in this
example).
This type of position can be quite attractive. First of all, there is no risk to the
upside as there is with the out-of-the-money calendar; the in-the-money calendar
would make money, because there are extra long calls in the position. Thus, if there
were to be a large gap to the upside in XYZ perhaps caused by a takeover attempt
- the in-the-money calendar would make money. If, on the other hand, XYZ stays in
the same area, then the regular calendar spread portion of the strategy will make
money. Even though the extra call would probably lose some time value premium in
that event, the other seven spreads would make a large enough profit to easily com
pensate for the loss on the one long call. The least desirable result would be for XYZ
to drop precipitously. However, in that case, the loss is limited to the amount of the
initial debit of the spread. Even in the case of XYZ dropping, though, follow-up
action can be taken. There are no naked calls to margin with this strategy, making it
attractive to many smaller investors. In the above example, one would need to pay for
the entire debit of the position, but there would be no further requirements.

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Chapter 12: Combining Calendar and Ratio Spreads
FOLLOW-UP ACTION
229
If one decides to preserve a neutral strategy with follow-up action in either type of
ratio call calendar, he would merely need to look at the deltas of the calls and keep
the ratio neutral. Doing so might mean that one would switch from one type of cal
endar spread to the other, from the out-of-the-money with naked calls to the in-the
money with extra long calls, or vice versa. For example, if XYZ started at 45, as in the
first example, one would have sold more calls than he bought. If XYZ then rallied
above 50, he would have to move his position into the in-the-money ratio and get
long more calls than he is short.
While such follow-up action is strategically correct maintaining the neutral
ratio - it might not make sense practically, especially if the size of the original spread
were small. If one had originally sold 5 and bought 3, he would be better to adhere
to the follow-up strategy outlined earlier in this chapter. The spread is not large
enough to dictate adjusting via the delta-neutral ratios. If, however, a large trader had
originally sold 500 calls and bought 300, then he has enough profitability in the
spread to make several adjustments along the way.
In a similar manner, the spreader who had established a small in-the-money cal
endar might decide not to bother rationing the spread if the stock dropped below the
strike. He knows his risk is limited to his initial debit, and that would be small for a
small spread. He might not want to introduce naked options into the position if XYZ
declines. However, if the same spread were established by a large trader, it should be
adjusted because of the greater tolerance of the spread to being adjusted, merely
because of its size.

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Reverse Spreads
In general, when a strategy has the term "reverse" in its name, the strategy is the
opposite of a more commonly used strategy. The reader should be familiar with this
nomenclature from the earlier discussions comparing ratio writing (buying stock and
selling calls) with reverse hedging (shorting stock and buying calls). If the reverse
strategy is sufficiently well-known, it usually acquires a name of its own. For exam
ple, the bear spread is really the reverse of the bull spread, but the bear spread is a
popular enough strategy in its own right to have acquired a shorter, unique name.
REVERSE CALENDAR SPREAD
The reverse calendar spread is an infrequently used strategy, at least for public cus
tomers trading stock or index options, because of the margin requirements. However,
even then, it does have a place in the arsenal of the option strategist. Meanwhile, pro
fessionals and futures option traders use the strategy with more frequency because
the margin treatment is more favorable for them.
As its name implies, the reverse calendar spread is a position that is just the
opposite of a "normal" calendar spread. In the reverse calendar spread, one sells a
long-term call option and simultaneously buys a shorter-term call option. The spread
can be constructed with puts as well, as will be shown in a later chapter. Both calls
have the same striking price.
This strategy will make money if one of two things happens: Either (1) the stock
price moves away from the striking price by a great deal, or (2) the inplied volatility
of the options involved in the spread shrinks. For readers familiar with the "normal"
calendar spread strategy, the first way to profit should be obvious, because a "normal"
230

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Chapter 13: Reverse Spreads 231
calendar spread makes the most money if the stock is right at the strike price at expi
ration, and it loses money if the stock rises or falls too far.
As with any spread involving options expiring in differing months, it is common
practice to look at the profitability of the position at or before the near-term expira
tion. An example will show how this strategy can profit.
Example: Suppose the current month is April and that XYZ is trading at 80.
Furthermore, suppose that XYZ's options are quite expensive, and one believes the
underlying stock will be volatile. A reverse calendar spread would be a way to profit
from these assumptions. The following prices exist:
XYZ December 80 call: 12
XYZ July 80 call: 7
A reverse calendar spread is established by selling the December 80 call for 12
points, and buying the July 80 call for 7, a net credit of 5 points for the spread.
If, later, XYZ falls dramatically, both call options will be nearly worthless and the
spread could be bought back for a price well below 5. For example, if XYZ were to
fall to 50 in a month or so, the July 80 call would be nearly worthless and the
December 80 call could be bought back for about a point. Thus, the spread would
have shrunk from its initial price of 5 to a price of about 1, a profit of 4 points.
The other way to make money would be for implied volatility to decrease.
Suppose implied volatility dropped after a month had passed. Then the spread might
be worth something like 4 points - an unrealized profit of about 1 point, since it was
sold for a price of 5 initially.
The profit graph in Figure 13-1 shows the profitability of the reverse calendar.
There are two lines on the graph, both of which depict the results at the expiration
of the near-term option (the July 80 call in the above example). The lower line shows
where profits and losses would occur if implied volatility remained unchanged. You
can see that the position could profit if XYZ were to rise above 98 or fall below 70.
In addition, the higher curve on the graph shows where profits would lie if implied
volatility fell prior to expiration of the near-term options. In that case, additional prof
its would accrue, as depicted on the graph.
So there are two ways to make money with this strategy, and it is therefore best
to establish it when implied volatility is high and the underlying has a tendency to be
volatile.
The problem with this spread, for stock and index option traders, is that the call
that is sold is considered to be naked. This is preposterous, of course, since the short
term call is a perfectly valid hedge until it expires. Yet the margin requirements
remain onerous. When they were overhauled recently, this glaring inefficiency was

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232 Part II: Call Option Strategies
Figure 13-1 •
Calendar spread sale at near-term expiration.
$400
$300
Implied Volatility
Lower
$200 \
f/)
$100 f/)
0
~
$0 50 60 110 120
a. -$100
-$200
-$300
Implied Volatility
-$400 Remains High
-$500
Underlying Price
allowed to stand because none of the member firms cared about changing it. Still, if
one has excess collateral - perhaps from a large stock portfolio - and is interested in
generating excess income in a hedged manner, then the strategy might be applicable
for him as well. Futures option traders receive more favorable margin requirements,
and it thus might be a more economical strategy for them.
REVERSE RATIO SPREAD (BACKSPREAD)
A more popular reverse strategy is the reverse ratio call spread, which is comrrwnly
known as a backspread. In this type of spread, one would sell a call at one striking
price and then would buy several calls at a higher striking price. This is exactly the
opposite of the ratio spread described in Chapter 11. Some traders refer to any
spread with unlimited profit potential on at least one side as a backspread. Thus, in
most backspreading strategies, the spreader wants the stock to rrwve dramatically. He
does not generally care whether it moves up or down. Recall that in the reverse
hedge strategy (similar to a straddle buy) described in Chapter 4, the strategist had
the potential for large profits if the stock moved either up or down by a great deal.
In the backspread strategy discussed here, large potential profits exist if the stock
moves up dramatically, but there is limited profit potential to the downside.
Example: XYZ is selling for 43 and the July 40 call is at 4, with the July 45 call at l.
A reverse ratio spread would be established as follows: ·

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Chapter 13: Reverse Spreads
Buy 2 July 45 calls at 1 each
Sell 1 July 40 call at 4
Net
2 debit
4 credit
2 credit
233
These spreads are generally established for credits. In fact, if the spread cannot
be initiated at a credit, it is usually not attractive. If the underlying stock drops in
price and is below 40 at July expiration, all the calls will expire worthless and the
strategist will make a profit equal to his initial credit. The maximum downside poten
tial of the reverse ratio spread is equal to the initial credit received. On the other
hand, if the stock rallies substantially, the potential upside profits are unlimited, since
the spreader owns more calls than he is short. Simplistically, the investor is bullish
and is buying out-of the-money calls but is simultaneously hedging himself by selling
another call. He can profit if the stock rises in price, as he thought it would, but he
also profits if the stock collapses and all the calls expire worthless.
This strategy has limited risk. With most spreads, the maximum loss is attained
at expiration at the striking price of the purchased call. This is a true statement for
backspreads.
Example: IfXYZ is at exactly 45 at July expiration, the July 45 calls will expire worth
less for a loss of $200 and the July 40 call will have to be bought back for 5 points, a
$100 loss on that call. The total loss would thus be $300, and this is the most that can
be lost in this example. If the underlying stock should rally dramatically, this strategy
has unlimited profit potential, since there are two long calls for each short one. In
fact, one can always compute the upside break-even point at expiration. That break
even point happens to be 48 in this example. At 48 at July expiration, each July 45
call would be worth 3 points, for a net gain of $400 on the two of them. The July 40
call would be worth 8 with the stock at 48 at expiration, representing a $400 loss on
that call. Thus, the gain and the loss are offsetting and the spread breaks even, except
for commissions, at 48 at expiration. If the stock is higher than 48 at July expiration,
profits will result.
Table 13-1 and Figure 13-2 depict the potential profits and losses from this
example of a reverse ratio spread. Note that the profit graph is exactly like the prof
it graph of a ratio spread that has been rotated around the stock price axis. Refer to
Figure 11-1 for a graph of the ratio spread. There is actually a range outside of which
profits can be made - below 42 or above 48 in this example. The maximum loss
occurs at the striking price of the purchased calls, or 45, at expiration.
There are no naked calls in this strategy, so the investment is relatively small.
The strategy is actually a long call added to a bear spread. In this example, the bear

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CH.APTER 14
Diagonalizing a Spread
When one uses both different striking prices and different expiration dates in a
spread, it is a diagonal spread. Generally, the long side of the spread would expire
later than the short side of the spread. Note that this is within the definition of a
spread for margin purposes: The long side must have a maturity equal to or longer
than the maturity of the short side. With the exception of calendar spreads, all the
previous chapters on spreads have described ones in which the expiration dates of the
short call and the long call were the same. However, any of these spreads can be diag
onalized; one can replace the long call in any spread with one expiring at a later date.
In general, diagonalizing a spread in this manner makes it slightly rrwre bear
ish at near-term expiration. This can be seen by observing what would happen if the
stock fell or rose substantially. If the stock falls, the long side of the spread will retain
some value because of its longer maturity. Thus, a diagonal spread will generally do
better to the downside than will a regular spread. If the stock rises substantially, all
calls will come to parity. Thus, there is no advantage in the long-term call; it will be
selling for approximately the same price as the purchased call in a normal spread.
However, since the strategist had to pay more originally for the longer-term call, his
upside profits would not be as great.
A diagonalized position has an advantage in that one can reestablish the posi
tion if the written calls expire worthless in the spread. Thus, the increased cost of
buying a longer-term call initially may prove to be a savings if one can write against
it twice. These tactics are described for various spread strategies.
THE DIAGONAL BULL SPREAD
A vertical call bull spread consists of buying a call at a lower striking price and sell
ing a call at a higher striking price, both with the same expiration date. The diagonal
236

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