Option Combinations and Spreads

1
 Combinations
• Introduction
• Straddles
• Strangles
• Condors

2
 Introduction
• A combination is a strategy in which you are
simultaneously long or short options of
different types

3
 Straddles
• A straddle is the best-known option
combination

• You are long a straddle if you own both a put

and a call with the same
– Striking price
– Expiration date
– Underlying security

4
 Straddles (cont’d)
• You are short a straddle if you are short both
a put and a call with the same
– Striking price
– Expiration date
– Underlying security

5
 Buying a Straddle
• A long call is bullish
• A long put is bearish

• Why buy a long straddle?

– Whenever a situation exists when it is likely that
a stock will move sharply one way or the other

6
 Buying a Straddle (cont’d)
• Suppose a speculator
– Buys a JAN 30 call on MSFT @ $1.20
– Buys a JAN 30 put on MSFT @ $2.75

7
 Buying a Straddle (cont’d)
• Construct a profit and loss worksheet to form the long
straddle:

Stock Price at Option Expiration

0 15 25 30 45 55

Long 30 call -1.20 -1.20 -1.20 -1.20 13.80 23.80

@ $1.20
Long 30 put 27.25 12.25 2.25 -2.75 -2.75 -2.75
@ $2.75
Net 26.05 11.05 -1.05 -3.95 11.05 21.05
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 Buying a Straddle (cont’d)
• Long straddle

Two breakeven points

26.05

30
0
Stock price at
26.05 33.95
option expiration
3.95

9
 Buying a Straddle (cont’d)
• The worst outcome for the straddle buyer is
when both options expire worthless
– Occurs when the stock price is at-the-money

• The straddle buyer will lose money if MSFT

closes near the striking price
– The stock must rise or fall to recover the cost of
the initial position

10
 Buying a Straddle (cont’d)
• If the stock rises, the put expires worthless,
but the call is valuable

• If the stock falls, the put is valuable, but the

call expires worthless

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 Writing a Straddle
• Popular with speculators

• The straddle writer wants little movement in

the stock price

• Losses are potentially unlimited on the

upside because the short call is uncovered

12
 Writing a Straddle (cont’d)
• Short straddle

3.95

30
0
Stock price at
26.05 33.95
option expiration
26.05

13
 Strangles
• A strangle is similar to a straddle, except the
puts and calls have different striking prices

• Strangles are very popular with professional

option traders

14
 Buying a Strangle
• The speculator long a strangle expects a
sharp price movement either up or down in
the underlying security

• With a long strangle, the most popular

version involves buying a put with a lower
striking price than the call

15
 Buying a Strangle (cont’d)
• Suppose a speculator:
– Buys a MSFT JAN 25 put @ $0.70
– Buys a MSFT JAN 30 call @ $1.20

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 Buying a Strangle (cont’d)
• Long strangle

23.10

Stock price at
25 30
0 option expiration
23.10 31.90

1.90

17
 Writing a Strangle
• The maximum gains for the strangle writer
occurs if both option expire worthless
– Occurs in the price range between the two
exercise prices

18
 Writing a Strangle (cont’d)
• Short strangle

1.90

Stock price at
25 30
0 option expiration
23.10 31.90

23.10

19
 Condors
• A condor is a less risky version of the
strangle, with four different striking prices

20
 Buying a Condor
• There are various ways to construct a long
condor

• The condor buyer hopes that stock prices

remain in the range between the middle two
striking prices

21
 Buying a Condor (cont’d)
• Suppose a speculator:
– Buys MSFT 25 calls @ $4.20
– Writes MSFT 27.50 calls @ $2.40
– Writes MSFT 30 puts @ $2.75
– Buys MSFT 32.50 puts @ $4.60

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 Buying a Condor (cont’d)
• Construct a profit and loss worksheet to form the long
condor:

Stock Price at Option Expiration

0 25 27.50 30 32.50 35
Buy 25 call -4.20 -4.20 -1.70 0.80 3.30 5.80
@ $4.20
Write 27.50 call 2.40 2.40 2.40 -0.10 -2.60 -5.10
@ $2.40
Write 30 put -27.25 -2.25 0.25 2.75 2.75 2.75
@ $2.75
Buy 32.50 put 27.90 2.90 0.40 -2.10 -4.60 -4.60
@ $4.60
Net -1.15 -1.15 1.35 1.35 -1.15 -1.15
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 Buying a Condor (cont’d)
• Long condor

1.35

Stock price at
25 27.50 30 32.50
0 option expiration
26.15 31.35

1.15

24
 Writing a Condor
• The condor writer makes money when prices
move sharply in either direction

• The maximum gain is limited to the premium

25
 Writing a Condor (cont’d)
• Short condor

1.35

Stock price at
27.50 30
0 option expiration
25 32.50

1.15 31.35
26.15

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 Spreads
• Introduction
• Vertical spreads
• Vertical spreads with calls
• Vertical spreads with puts
• Calendar spreads
• Diagonal spreads
• Butterfly spreads

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 Introduction
• Option spreads are strategies in which the
player is simultaneously long and short
options of the same type, but with different
– Striking prices or
– Expiration dates

28
 Vertical Spreads
• In a vertical spread, options are selected
vertically from the financial pages
– The options have the same expiration date
– The spreader will long one option and short the
other
• Vertical spreads with calls
– Bullspread
– Bearspread

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 Bullspread
• Assume a person believes MSFT stock will
appreciate soon
• A possible strategy is to construct a vertical
call bullspread and:
– Buy an APR 27.50 MSFT call
– Write an APR 32.50 MSFT call
• The spreader trades part of the profit
potential for a reduced cost of the position.

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 Bullspread (cont’d)
• With all spreads the maximum gain and loss
occur at the striking prices
– It is not necessary to consider prices outside this
range
– With a 27.50/32.50 spread, you only need to look
at the stock prices from $27.50 to $32.50

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 Bullspread (cont’d)
• Construct a profit and loss worksheet to form the
bullspread:

Stock Price at Option Expiration

0 27.50 28.50 30.50 32.50 50
Long 27.50 -3 -3 -2 0 2 19.50
call @ $3
Short 32.50 1 1 1 1 1 -16.50
call @ $1
Net -2 -2 -1 1 3 3

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 Bullspread (cont’d)
• Bullspread

Stock price at
27.50
0 option expiration
32.50

2 29.50

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 Bearspread
• A bearspread is the reverse of a bullspread
– The maximum profit occurs with falling prices
– The investor buys the option with the lower
striking price and writes the option with the
higher striking price

34
Vertical Spreads With Puts: Bullspread
• Involves using puts instead of calls

• Buy the option with the lower striking price

and write the option with the higher one

35
 Bullspread (cont’d)
• The put spread results in a credit to the
spreader’s account (credit spread)

• The call spread results in a debit to the

spreader’s account (debit spread)

36
 Bullspread (cont’d)
• A general characteristic of the call and put
bullspreads is that the profit and loss payoffs
for the two spreads are approximately the
same
– The maximum profit occurs at all stock prices
above the higher striking price
– The maximum loss occurs at stock prices below
the lower striking price

37
 Butterfly Spreads
• A butterfly spread can be constructed for
very little cost beyond commissions

• A butterfly spread can be constructed using

puts and calls

38
 Butterfly Spreads(cont’d)
• Example of a butterfly spread

Stock price at
0 option expiration

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