Option Spreads Intro

Presented at

ABQ Market Traders Meetup

June 26, 2013

By Ted Heath

Introduction to Option Spreads

• There are many different kinds of Option Spreads

• Traders like Option Spread because there is less risk involved. In fact, for most Option Spreads you know up front your max loss and max gain.

• They all involve Buying and Selling more than one option (usually in the same brokerage transaction)

Vertical Option Spreads

• The most commonly used Option Spreads are Vertical Option Spreads

• They are called Vertical because they involve Buying and Selling a Call or Buying and Selling a Put for the same stock and the same expiration date.

Types of Vertical Option Spreads

• Bull Call Spread (Debit Spread)

• Bull Put Spread (Credit Spread)

• Bear Call Spread (Credit Spread)

• Bear Put Spread (Debit Spread)

Debit = You Buy It Credit = You Sell It

MORE Definitions?

• Terms you need to know:– Strike Price– Intrinsic Value– Extrinsic Value– In The Money (ITM)– At The Money (ATM)– Out of The Money (OTM)

IBM Options Expiring 08/17/2013

Strike Price

The price of the stock at which option is written. It may above, below, or at the current price of the stock.

Intrinsic Value • The amount the Option is “In The Money”

and is the difference between the Strike Price and the Current Market Price of the underlying asset.

• For a Call– Strike Price LESS than the Stock Price

• Intrinsic Value = Stock Price – Strike Price

• For a Put– Strike Price Greater than the Stock Price

• Intrinsic Value = Strike Price – Stock Price

Extrinsic Value

• Extrinsic Value (EV) is calculated by the Black Scholes formula and is a decaying asset. EV is the difference between an option’s price and its Intrinsic Value and will be worth $0.00 at expiration.

In The Money (ITM)

• An ITM Option has Intrinsic Value

• ITM Calls– Options which have a Strike Price LESS

THAN the Current Stock Price

• ITM Puts– Options which have a Strike Price GREATER

THAN the Current Stock Price

At The Money (ATM)

• An ATM Option has no Intrinsic Value

• ATM Calls– Options which have a Strike Price EQUAL TO

the Current Stock Price

• ATM Puts– Options which have a Strike Price EQUAL TO

the Current Stock Price

Out of The Money

• An OTM Option has no Intrinsic Value

• OTM Calls– Options which have a Strike Price GREATER

THAN the Current Stock Price

• OTM Puts– Options which have a Strike Price LESS

THAN the Current Stock Price

IBM Options Expiring 08/17/2013

Remember

• Types of Vertical Option Spreads

• Bull Call Spread (Debit Spread)

• Bull Put Spread (Credit Spread)

• Bear Call Spread (Credit Spread)

• Bear Put Spread (Debit Spread)

Debit = You Buy It Credit = You Sell It

Bull Call Spread

• Generally used when we anticipate profiting from a mild rise in a particular stock while maintaining a lower-risk profile than owning the stock or a straight call option

• Involves buying lower strike calls while at the same time selling an equal number of higher strike calls of the same stock with the same expiration

UNH Chart

Bull Call UNHBuy Sep 55 Call Sell Sep 70 Call

UNH SEP 55/70 Bull Call Risk Graph

Profit/Loss Bull Call UNH

Bull Put Spread

• Generally used when we anticipate profiting from a mild rise in a particular stock while maintaining a lower-risk profile than owning the stock or a straight call option

• Involves buying lower strike Put Options while at the same time selling an equal number of higher strike Puts of the same stock with the same expiration

Bull Put UNH Buy Sep 57.5 Put Sell Sep 60 Put

UNH SEP 57.5/60 Bull Put Risk Graph

Profit/Loss Bull Put UNH

Bear Put Spread

• Generally used when there is anticipation from a mild decline in a particular stock while maintaining a lower risk profile as opposed to shorting a stock or buying a straight put option.

• Involves buying higher strike Put Options while at the same time selling an equal number of lower strike Puts of the same stock with the same expiration

IBM Chart

Bear Put IBMBuy Aug 210 Put Sell Aug 195 Put

IBM Aug 210/195 Bear Put Risk Graph

Profit Loss Bear Put IBM

Bear Call Spread

• Generally used when there is anticipation from a mild decline in a particular stock while maintaining a lower risk profile as opposed to shorting a stock or buying a straight put option.

• Involves buying higher strike Call Options while at the same time selling an equal number of lower strike Calls of the same stock with the same expiration

Bear Call IBMBuy Aug 220 Call Sell Aug 215 Call

IBM SEP 57.5/60 Bear CallRisk Graph

Profit Loss Bear Call IBM

Horizontal CallCalendar Spread

• The Horizontal Call Calendar Spread is generally used when there is anticipation of profiting from stagnation or bullish rise in a particular stock. In the simplest terms, it involves simultaneously buying long term call options while selling an equal number of short term call options with the same strike price.

Horizontal Call Calendar Guidelines

• Buy to open ATM or OTM call options with 3-6 months or more until expiration.

• Sell to open an equal number of short term (2-6 weeks out expiration) call options at the same Strike Price as the ones you are buying,

• Make sure the premium you receive is worth selling (> or = 10% of cost of ones bought). (This is a debit spread)

Horizontal Call CalendarProcess

• Sell Close in 2-6 Weeks out expiration Options

• Buy 3-6 Month out expiration Options

• If Close in Option is In The Money (ITM), roll to next month

• If Close in Option is Out of The Money (OTM) let it expire and sell next month Option at same Strike Price

• Repeat until reach expiration month of Option bought

• If market turns or gain is good enough close out

Example GOOG 875 Horizontal Calls

• Sell Buy Net Grand Net• Jun @15.04 Cr Sep @ 42.23 Dr 27.19 Dr 27.19 Dr• Jul @ 31.60 Cr Jun @ 16.10 Dr 15.50 Cr 11.69 Dr• Sep @ 54.20 Cr Jul @ 30.20 Dr 24.00 Cr 23.41 Cr

• Net Gain = $2341