option spreads

Spreads

Barrington Capital Management, Inc.A Registered Investment Advisor

(800) 944 2410 (952) 835 1000 COI THE OPTIONSINDUSTRY COUNCIL

CCOOII

Understanding and TradingOptions Spread Strategies

CCOOIIThe Options Industry Council2

Understanding and Trading Options Spread Strategies

For the sake of simplicity, the examples that follow do not take into consideration commissions and other transaction fees, tax considerations, or margin requirements, which are factors that may significantly affect the economic consequences of a given strategy. An investor should review transaction costs, margin requirements and tax considerations with a broker and tax advisor before entering into any options strategy.

Options involve risk and are not suitable for everyone. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies have been provided for you today and may be obtained from your broker, one of the exchanges or The Options Clearing Corporation, One North Wacker Drive, Suite 500, Chicago, IL 60606 or call 1-888-OPTIONS or visit www.888options.com.

Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and education purposes and are not to be construed as an endorsement, recommendation or solicitation to buy or sell securities. Supporting documentation will be supplied upon written request.

CCOOIIPresentation Outline

• Review of Basics

• Introduction to Spreads° Bull Call Spread° Bear Call Spread° Bear Put Spread° Bull Put Spread

• The Options Investigator

• Trading Spreads° Diagonal Spreads° Straddles and Strangles° Stock and Options Spreads

3

CCOOII

Review of Basics

CCOOIIUnique Aspects Of Options

• Options are

• Options buyers get° A call buyer gets ° A put buyer gets

• Options sellers get° A short call is ° A short put is

4

contracts

rightsthe right to buy

the right to sell

obligationsan obligation to sell

an obligation to buy

CCOOIIOptions Mechanics

• The exercise of a call option creates

A stock purchase transaction

• The exercise of a put option creates

A stock sale transaction

• Assignment of a call option creates

A stock sale transaction

• Assignment of a put option creates

A stock purchase transaction

5

CCOOIIOptions Require Planning 1

• If I buy an option today, do I plan to:° Sell the option?° Exercise the option?° Let it expire worthless?

• What is my back-up plan if the market goes against me?

6

CCOOIIOptions Require Planning 2

• If I sell an option today, do I plan to:° Repurchase the option?° Live with assignment?° Carry the position until expiration and hope

it expires worthless?

• What is my back-up plan if the market goes against me?

7

CCOOII

Review of Options Pricing

CCOOIIThe Impact Of Stock Price Change

STOCK PRICE

$50.00 $51.00DAYS TO EXPIRATION

90 90PRICE OF 50 CALL

$3.00

Your estimate of a new 50 Call price?

8

$3.50

Stock price up $1.00Call price increases less than $1.00(Assumes time is unchanged)

?

CCOOIIThe Impact Of Changing Time

STOCK PRICE

$50.00 $50.00DAYS TO EXPIRATION

90 45PRICE OF 50 CALL

$3.00

Your estimate of a new 50 Call price?

9

$2.00

Time decreases by 50%Call price decreases less than 50%(Assumes stock price is unchanged)

?

CCOOIIDelta

• Options prices generally change less than stock prices.

• The delta estimates how much an option’s price will change for a one-unit change in stock price.

Delta > 50% if option is I-T-M

Delta < 50% if option is O-T-M

Delta = 50% (approximately) if option is A-T-M

10

CCOOIITime Decay

• Options prices decrease as expiration approaches.

• This is known as “time decay” or “time erosion.”

• Options prices do not decrease at the same rate that time passes to expiration.

• For A-T-M options, there is less decay initially and more as expiration nears.

• For I-T-M and O-T-M options, time decay is more linear.

11

CCOOII

Introduction to Spreads

CCOOIIWhat Does “Spread” Mean?

• The term “spread” is a loosely used term than can describe any multiple-part strategy.

• Some spreads involve only options.

• Some spreads involve stocks and options.

12

CCOOIIWhy Are Spreads Important?

• Spread strategies offer investors and traders unique sets of trade-offs.

• For a particular market forecast, a spread strategy may offer a better risk/reward ratio or a higher profit potential.

13

CCOOII

The Bull Call Spread

CCOOIIBull Call Spread Defined

• A bull call spread involves the purchase of one call and the sale of another call with a higher strike price. Both options have the same underlying and the same expiration date.

• Bull call spreads are also known as “debit call spreads.” They are one type of “vertical spread.”

14

CCOOIIBull Call Spread Example

With XYZ stock trading at $63.00:

(Stock forecast: Up 10% by expiration)

Buy 1 XYZ 60 Call at $5.50

Sell 1 XYZ 70 Call at $2.00

Net cost: $3.50

The “60-70 Call spread” is purchased for $3.50, or $350.00, plus commissions.

15

CCOOIIBull Call Spread –Profit/Loss Table

16

$75.00

$70.00

$65.00

$63.50

$60.00

$55.00

Stock Price60 Call

Profit/(Loss)70 Call

Profit/(Loss)Combined

Profit/(Loss)

($5.50)

($2.00)

($0.50)

$4.50

($5.50)

$2.00

$2.00

$2.00

$2.00

$2.00

$9.50 ($3.00) $6.50

($3.50)

0

$1.50

$6.50

($3.50)

CCOOIIBull Call Spread – Diagram17

5

5

55 60 65

0

–

+

10

70 75

Stock Price

CCOOIIPotential Outcomes 1

Buy 1 XYZ 60 Call at $5.50

Sell 1 XYZ 70 Call at $2.00

Net cost: $3.50

• What happens if the price of XYZ stock is below $60.00 at expiration?

• The 60 Call?

• The 70 Call?

• Final position?

18

Expires worthless

No position, 100% loss

Expires worthless

CCOOIIPotential Outcomes 2

Buy 1 XYZ 60 Call at $5.50

Sell 1 XYZ 70 Call at $2.00

Net cost: $3.50

• What happens if the price of XYZ stock is between $60.00 and $70.00 at expiration?

• The 60 Call?

• The 70 Call?

• Final position?

19

Exercised – buy stock

Expires worthless

Long stock:

effective price at $63.50

CCOOIIPotential Outcomes 3

Buy 1 XYZ 60 Call at $5.50

Sell 1 XYZ 70 Call at $2.00

Net cost: $3.50

• What happens if the price of XYZ stock is above $70.00 at expiration?

• The 60 Call?

• The 70 Call?

• Final position?

20

Exercised – buy stock

Assigned – sell stock

No position,maximum profit realized

CCOOIIPotential Outcomes At Expiration21

5

5

55 60 65

0

–

+

10

70 75

Stock Price

Both CallsExpire

60 Call Exercised70 Call Expires

60 Call Exercised70 Call Assigned

No Position Long Stock No Position

CCOOIIChoosing Between Strategies

CURRENT STOCK PRICE: $63.00

YOUR FORECAST: You believe the stock price will rise approximately 10% to $70.00 at the option’s expiration.

POSSIBLE STRATEGIES:

1) Buy (1) 60 Call at $5.50

2) Buy (1) 70 Call at $2.00

3) Buy the 60-70 Call spread at $3.50

22

CCOOIIEstimating Results23

Stock Price

60 Call

70 Call

60-70 Call Spread

Today At Expiration Profit/(Loss)

$6.50

($2.00)

$4.50

$63.00 $7.00

$5.50

$2.00

$3.50

$70.00

$10.00

0

$10.00

CCOOIISelection Considerations

The bull call spread is frequently the preferred strategy choice when the forecast predicts that a 5-10% stock price rise will occur at or near an option’s expiration date.

24

CCOOII

The Bear Call Spread

CCOOIIBear Call Spread Defined

• A bear call spread involves the sale of one call and the purchase of another call with a higher strike price. Both options have the same underlying and the same expiration date.

• Bear call spreads are also known as “credit call spreads.” They are one type of “vertical spread.”

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CCOOIIBear Call Spread Example

With XYZ stock trading at $63.00:

(Stock forecast: Neutral to bearish)

Sell 1 XYZ 60 Call at $5.50

Buy 1 XYZ 70 Call at $2.00

Net credit: $3.50

The “60-70 Call spread” is sold for $3.50, or $350.00, less commissions.

26

CCOOIIBear Call Spread –Profit/Loss Table

27

$75.00

$70.00

$65.00

$63.50

$60.00

$55.00

Stock Price60 Call

Profit/(Loss)70 Call

Profit/(Loss)Combined

Profit/(Loss)

$5.50

$2.00

$0.50

($4.50)

($9.50)

$5.50

($2.00)

($2.00)

($2.00)

($2.00)

$3.00

($2.00)

$3.50

0

($1.50)

($6.50)

($6.50)

$3.50

CCOOIIBear Call Spread – Diagram28

0

5

–

+

55 60 65 70 75

Stock Price

Both CallsExpire

60 Call Assigned70 Call Expires

60 Call Assigned70 Call Exercised

5

No Position Short Stock No Position

CCOOII

The Bear Put Spread

CCOOIIBear Put Spread Defined

• A bear put spread involves the purchase of one put and the sale of another put with a lower strike price. Both options have the same underlying and the same expiration date.

• Bear put spreads are also known as “debit put spreads.” They are one type of “vertical spread.”

29

CCOOIIBear Put Spread Example

With QRS stock trading at $39.00:

Buy 1 QRS 40 Put at $2.50

Sell 1 QRS 35 Put at $1.00

Net cost: $1.50

The “40-35 Put spread” is purchased for $1.50, or $150.00, plus commissions.

30

CCOOIIBear Put Spread –Profit/Loss Table

31

$45.00

$40.00

$38.50

$35.00

$30.00

Stock Price40 Put

Profit/(Loss)35 Put

Profit/(Loss)Combined

Profit/(Loss)

$7.50

$2.50

($1.00)

($2.50)

($2.50)

($4.00)

$1.00

$1.00

$1.00

$1.00

$3.50

$3.50

0

($1.50)

($1.50)

CCOOIIBear Put Spread – Diagram32

0

5

–

+

30 35

Stock Price

5

40 45

CCOOIIPotential Outcomes 1

Buy 1 QRS 40 Put at $2.50

Sell 1 QRS 35 Put at $1.00

Net cost: $1.50

• What happens if the price of QRS stock is above $40.00 at expiration?

• The 40 Put?

• The 35 Put?

• Final position?

33

Expires worthless

Expires worthless

No position, 100% loss

CCOOIIPotential Outcomes 2

Buy 1 QRS 40 Put at $2.50

Sell 1 QRS 35 Put at $1.00

Net cost: $1.50

• What happens if the price of QRS stock is between $35.00 and $40.00 at expiration?

• The 40 Put?

• The 35 Put?

• Final position?

34

Exercised – sell stock

Expires worthless

Short stock: effective price is $38.50

CCOOIIPotential Outcomes 3

Buy 1 QRS 40 Put at $2.50

Sell 1 QRS 35 Put at $1.00

Net cost: $1.50

• What happens if the price of QRS stock is below $35.00 at expiration?

• The 40 Put?

• The 35 Put?

• Final position?

35

Exercised – sell stock

Assigned – buy stock

No position, maximum profit realized

CCOOIIPossible Outcomes At Expiration36

40 Put Exercised35 Put Assigned

40 Put Exercised35 Put Expires

Both Puts Expire

0

5

–

+

30 35

Stock Price

5

40 45

No Position Short Stock No Position

CCOOIISelection Considerations

The bear put spread is frequently the preferred strategy choice when the forecast predicts that a 5-10% stock price decline will occur at or near an option’s expiration date.

37

CCOOII

The Bull Put Spread

CCOOIIBull Put Spread Defined

• A bull put spread involves the sale of one put and the purchase of another put with a lower strike price. Both options have the same underlying and the same expiration date.

• Bull put spreads are also known as “credit put spreads.” They are one type of “vertical spread.”

38

CCOOIIBull Put Spread Example

With QRS stock trading at $39.00:

Sell 1 QRS 40 Put at $2.50

Buy 1 QRS 35 Put at $1.00

Net credit: $1.50

The “40-35 Put spread” is sold for $1.50, or $150.00, less commissions.

39

CCOOIIBull Put Spread –Profit/Loss Table

40

$45.00

$40.00

$38.50

$35.00

$30.00

Stock Price40 Put

Profit/(Loss)35 Put

Profit/(Loss)Combined

Profit/(Loss)

($7.50)

($2.50)

$1.00

$2.50

$2.50

$4.00

($1.00)

($1.00)

($1.00)

($1.00)

($3.50)

($3.50)

0

$1.50

$1.50

CCOOIIBull Put Spread – Diagram41

40 Put Assigned35 Put Exercised

40 Put Assigned35 Put Expires

Both Puts Expire

0

5

–

+

30 35

Stock Price

5

40 45

No Position Short Stock No Position

CCOOIISelection Considerations

• Debit spreads are frequently the preferred strategy choice when the forecast predicts a 5-10% price change in a stock price at or near the option’s expiration date.

• Credit spreads are a limited-risk method of attempting to profit from selling options.

42

Intermission

COI THE OPTIONSINDUSTRY COUNCIL

After the Break:

•Using The Options Investigator

•Pricing Behavior of Spreads

•Other Options-Only Spreads

•Spreads Involving Stocks and Options

1-888-OPTIONSwww.888options.com

CCOOII

Introduction to The Options Investigator

CCOOIIThe Options Investigator43

Learn about strategies

Learn through tutorials

Simulate positions

CCOOIIThe Options Investigator44

Start with settings

Enter the necessary inputs

Click “OK” to continue

CCOOII

Long the 60 CallShort the 65 Call

Enter the position: Bull Call spread

The Options Investigator45

The actual prices

Net delta and dollars are calculated

CCOOIIGraph As Of Today46

When you click “Proceed,” you will see the graph of the position as of today.

CCOOII

If you change the strike date or stock price, the Options Investigator will show you a graph for that information.

Graph at Expiration – or Any Date47

CCOOIIThe Option Investigator

• Read about individual topics

• Study strategies

• Simulate positions and options prices

48

Practice first!

CCOOII

Comparing Spreads

CCOOIIWhy Are TheseDiagrams Similar?

What does this mean for your trading?

49

Debit Call Spread Credit Put Spread

CCOOIIThese Also Appear Similar!50

Credit Call Spread Debit Put Spread

CCOOII

Pricing Behavior

CCOOIIPricing Behavior

Delta

Buy 1 XYZ 60 Call at $5.50 + 0.65

Sell 1 XYZ 70 Call at $2.00 – 0.25

Net: $3.50 + 0.40

This spread will increase or decrease in price the same as 40 shares of stock.

51

Assumes XYZ stock is trading at $63.00.

note:

CCOOII

OPTION

= Option’s Price

Stock Price

Strike Price

Time to Expiration

Interest Rates and Dividend

Volatility

Impact Of Changing Volatility

INSURANCE POLICY

Asset Value

Deductible

Time Period

Interest Rates

Risk

= Premium

52

CCOOIIImpact Of Changing Volatility

• As risk perceptions change, insurance premiums and options’ prices change.

• Volatility in options’ prices is known as “implied volatility.”

• Implied volatility can change before or after news events (e.g., earnings).

53

CCOOIIImpact Of Changing Volatility54

Stock Price $63.00 $63.00

Implied Volatility 40% 30%

60 Call $5.50 $4.00 ($1.50)

70 Call $2.00 $1.00 ($1.00)

60-70 Spread $3.50 $3.00 ($0.50)

INITIAL ESTIMATE CHANGE

CCOOIITrading Scenario – Changing Volatility

• Starco will report earnings in seven days.

• Options implied volatility of 55% is above the historical norm of 35%.

• You predict that Starco will rise 15% on the earnings announcement, but you also believe that implied volatility will decline to 40%.

55

CCOOIITrading Scenario – Changing Volatility

56

Stock Price $44.00 $50.00

Days to Expiration 40 33

Implied Volatility 55% 40%

45 Call $2.80

50 Call $1.30

45-50 Spread $1.50

INITIAL ESTIMATE % CHANGE

$5.60 100%

$2.30 80%

$3.30 120%

CCOOIIOptions Prices AndSpreads – Summary

• Vertical spreads give traders alternatives to outright long and short options positions.

• Vertical options spreads are frequently less sensitive to changes in implied volatility than outright long or short options positions.

57

CCOOII

Diagonal Spreads

CCOOIIDiagonal Spread Defined

• A diagonal spread with calls involves the purchase of one call and the sale of another call with a higher or lower strike price and an earlier expiration date. Both calls have the same underlying.

• A diagonal spread with puts involves the purchase of one put and the sale of another put with a lower or higher strike price and an earlier expiration date. Both puts have the same underlying.

58

CCOOIIDiagonal Spread Example

With IRT stock trading at $83.00:

Buy 1 IRT LEAPS® 75 Call at $10.50

Sell 1 IRT 30-day 85 Call at $ 1.90

Net cost: $ 8.60

The “diagonal spread” is purchased for $8.60, or $860.00, plus commissions.

59

CCOOII

Max profit atstrike priceBelow strike, lossfrom long call canexceed profit ofshort call

Diagonal Call Spread AtExpiration Of Short-Term Option

60

0

5

–

+

75 80

5

85 90 95

Above strike,call loses timevalue

CCOOIIDiagonal Call Spread AtExpiration Of Short-Term Option

• Short options can be assigned at any time! A short stock position will be created if stock is not owned.

• Assignment of a short call in a diagonal spread might lead to a margin call and/or additional costs.

• Special approval from your broker might be required.

61

CCOOII

Straddles and Strangles

CCOOIILong Straddle Defined

A long straddle involves the purchase of one call and one put with the same strike price. Both options have the same underlying and the same expiration date.

62

CCOOIILong Straddle Example

With LMN stock trading at $50.00:

Buy 1 LMN 50 Call at $3.20

Buy 1 LMN 50 Put at $3.00

Net cost: $6.20

The “50 straddle” is purchased for $6.20, or $620.00, plus commissions.

63

CCOOIILong Straddle –Profit/Loss Table

64

$60.00

$55.00

$50.00

$45.00

$40.00

Stock Price50 Call

Profit/(Loss)50 Put

Profit/(Loss)Combined

Profit/(Loss)

($3.20)

($3.20)

($3.20)

$1.80

$6.80

$7.00

$2.00

($3.00)

($3.00)

($3.00)

$3.80

($1.20)

($6.20)

($1.20)

$3.80

CCOOIILong Straddle – Diagram65

0

5

–

+

40 45

5

50 55 60

Short Stock50 Call Expires50 Put Exercised

Long Stock50 Call Exercised50 Put Expires

CCOOIIPricing Behavior OfLong Straddles

66

Stock Price $50.00 $60.00 20%

Days to Expiration 60 32

50 Call $3.20 $10.20 220%

50 Put $3.00 $ 0.15 (95%)

50 Straddle $6.20 $10.35 67%

INITIAL ESTIMATE % CHANGE

CCOOIILong Strangle Defined

A long strangle involves the purchase of one call and one put with a lower strike price. Both options have the same underlying and the same expiration date.

67

CCOOIILong Strangle Example

With LMN stock trading at $50.00:

Buy 1 LMN 55 Call at $1.40

Buy 1 LMN 45 Put at $1.05

Net cost: $2.45

The “45-55 strangle” is purchased for $2.45, or $245.00, plus commissions.

68

CCOOIILong Strangle –Profit/Loss Table

69

$60.00

$55.00

$50.00

$45.00

$40.00

Stock Price55 Call

Profit/(Loss)45 Put

Profit/(Loss)Combined

Profit/(Loss)

($1.40)

($1.40)

($1.40)

($1.40)

$3.60

$3.95

($1.05)

($1.05)

($1.05)

($1.05)

$2.55

($2.45)

($2.45)

($2.45)

$2.55

CCOOIILong Strangle – Diagram70

0

5

–

+

40 45

5

50 55 60

55 Call Expires45 Put Exercised

Both OptionsExpire

55 Call Exercised45 Put Expires

Short Stock No Position Long Stock

CCOOIIPricing Behavior OfLong Strangles

71

Stock Price $50.00 $60.00 20%

Days to Expiration 60 32

55 Call $1.40 $5.90 320%

45 Put $1.05 $ 0 (100%)

45-55 Strangle $2.45 $5.90 140%

INITIAL ESTIMATE % CHANGE

CCOOIIStraddles Versus Strangles

• Straddles° Higher cost and lower leverage° Breakeven points closer together° Less chance of 100% loss

• Strangles° Lower cost and higher leverage° Breakeven points farther apart° Greater chance of 100% loss

72

CCOOII

Stock and Options Spreads

CCOOIIStock And Options Spreads

• Options can be used in many ways to enhance or protect a stock position.

• Buy stock, sell straddle (or strangle)° Leveraged income for aggressive traders

• Buy stock with ratio call spread° Adds leverage without increasing risk

• Buy stock and sell call spread° Brings in premium with limited risk

• Buy stock and buy put spread° Provides limited protection at a lower cost

73

CCOOIIBuy Stock, Sell StrangleDefined

• The purchase of stock is combined with the sale of both an out-of-the-money call and an out-of-the-money put.

• Two options premiums are received, but upside profit potential is limited; and downside risk is increased.

74

CCOOIIBuy Stock, Sell StrangleExample

With FGH stock trading at $62.00:

Buy 100 Shares FGH at $62.00

Sell 1 FGH 65 Call at $ 2.50

Sell 1 FGH 60 Put at $ 2.00

Net investment: $57.50

75

CCOOIIShort Strangle –Profit/Loss Table

76

$70.00

$65.00

$62.00

$60.00

$55.00

$50.00

Stock Price Stock 65 CallProfit/(Loss

)

60 PutProfit/(Loss

)

CombinedProfit/(Loss)

$8.00

$3.00

0

($2.00)

($7.00)

($12.00)

($2.50)

$2.50

$2.50

$2.50

$2.50

$2.50

$2.00

$2.00

$2.00

$2.00

($3.00)

($8.00)

$7.50

$7.50

$4.50

$2.50

($7.50)

($17.50)

CCOOIIBuy Stock, Sell Strangle –Diagram

77

0

10

–

+

55 60

10

65 70

65 Call Expires60 Put Assigned

Long 100 65 Call Assigned

60 Put Expires

Long 200 No Position

CCOOIISelection Considerations

• Buy stock, sell strangle is appropriate for a neutral market forecast.

• Special approval from your broker may be required to sell puts.

• Upside profit potential is limited to the strike price of the short call.

• Downside losses are leveraged below the strike price of the short put.

78

CCOOIISummary

• Spread strategies offer investors and traders additional alternatives.

• Understanding short-term options price behavior is essential.

• Vertical spreads are usually less sensitive to changes in implied volatility than outright long or short options positions.

79

Thank you for attending!

Visit the OIC Web site at www.888options.com