OPTION STRATEGIES

I. Hedging Stock Positions with Options

• Long stock + short call(aka Covered Call)
• Short stock + long call
• Long stock + long put(aka Protective Put)
• Short stock + short put(aka Covered Put)

Strategies used for Hedging

Writing covered calls(long stock + short call)

→ Strategy: Limited hedge + income

Writing covered puts(short stock + short put)

→ Strategy: Limited hedge + income

Strategies used to protect a purchase

Buying a put to protect a long stock position(long stock + long put, aka “Protective Put”)

→ Strategy: Fully hedged

Buying a call to protect a short stock position(short stock + long call)

→ Strategy: Fully hedged

II. Straddles, Combinations and Spreads

Straddles:

A straddle means buying a call and a put, or selling a call and a put with the SAME underlying security, SAME strike price and SAME expiration date. ALL must be the same, if not, it`s not a straddle. Investors buying or writing a straddle do it speculating on the volatility of the underlying security. The buyer of a straddle expects the price of the stock to be volatile. The seller of a straddle expects stability.

It`s always gonna be a call + put(long call + short put OR short call + long put).

→ Long Straddle: Betting on big movements so price goes beyond breakeven prices. You hope that the stock will rise above or fall below breakeven(volatility)

→ Short Straddle: Betting on no movements so price stays within breakeven prices range. You hope that the stock will stay between breakevens(stability)

Combinations:

It`s the same as a straddle but contracts will have DIFFERENT exercise prices AND/OR different expiration dates(breakeven, maximum gain and maximum loss are all calculated the same as a straddle)

It`s always gonna be a call + put(long call + short put OR short call + long put).

Spreads:

A spread means a purchase and sale of two calls or two puts, on the same underlying security. Spreads are meant for protection, you want to do one thing with one option, but you have another option just in case the stock goes the other way. With spreads you have the opportunity to limit your losses in exchange for a limited gain potential.

Now, the first classification of a spread is whether the two options are calls(call spread) or puts(put spread).

After realizing what kind of a spread it is, we move to look at the differences between the two options based on strike price and/or expiration.

Price Spread(aka Vertical Spread): When the two options have the SAME expiration month but DIFFERENT strike prices.

Buy 1 XYZ June 30 call

Sell 1 XYZ June 40 call

Time Spread(aka Calendar Spread, Horizontal Spread): When the options have the SAME strike price but DIFFERENT expiration months.

Buy 1 XYZ June 30 call

Sell 1 XYZ July 30 call

Diagonal Spread: Exactly, you thought it right, what else could it be but a mix of the other two? It`s when the options have DIFFERENT strike prices AND DIFFERENT expiration months.

Buy 1 XYZ June 30 call

Sell 1 XYZ July 40 call

 

 

Analyzing Spreads:

Now, to go just a little bit deeper into classifying options, when a spread is created, the investor pays the premium for the option purchased and at the same time receives the premium for the option that is sold. You are either gonna have a net debit(money out) or a net credit(money in) situation. Let`s look at this more closely. We are only gonna be talking about Price Spreads for now, they are more common and easier to understand. I`ll go into Time Spreads and Diagonal Spreads perhaps in another more advanced tutorial.

 

Net Credit Spreads: When an investor buys an option with a lower premium and sells an option with a higher premium.

 

Maximum gain = net credit(when both options expire)

Maximum loss = difference between strike prices – net credit(premium)

Breakeven = lower strike + net premium(for call spreads)

= high strike – net premium(for put spreads)

Profitability = credit spreads narrow

*Note: For all credit spreads, maximum gain and loss are the same for call spreads and put spreads.

 

 

Ex.

Buy 1 XYZ June 60 call @ 1

Sell 1 XYZ June 55 call @ 4

Money out: $1/share

Money in: $4/share

Net credit: $3/share

Max. gain = 4 – 1 = 3(credit) = $300

Max loss = (60-55) – (4-1) = 5 – 3 = 2(credit) = $200

Breakeven = 55 + (4-1) = 55 + 3 = 58

 

We could also say that the investor is a net seller. We already know by now that the maximum gain for a seller is the premium received. This also applies to net credit spreads. The maximum gain is the net credit, in this example $3/share, or $300.

One would realize the maximum gain if both options expired worthless. If both options were trading at-the money or out-of-the-money at expiration(in our example, a market price of 55 or below for XYZ stock), their premiums would be zero. When you bought the options they were worth something, thus you paying $1/share for the June 60 call and receiving $4/share when you sold the June 55 call, but now both their premiums are worth zero, so you get to keep the whole net credit you collected. For this reason it is said that to become profitable, credit spreads NARROW, and the investors that choose a credit spread expects NARROWING. They want to see the premiums go to zero, or see the options expire worthless, that`s the only way they are gonna get the most money, keeping the whole net credit amount.

But now let`s see an example where the credit spread narrows but the actual gain is somewhat less than the maximum of three points. Let`s say the stock is up 2 points, and it`s now trading at 57 and the investor chooses to close out the positions at intrinsic value.  The June  60 call is out-of-the-money and has no intrinsic value, but the June 55 call is in-the-money by 2 points and closing that position at intrinsic value would be a cost of $2 per share.

Sell to close 1 XYZ June 60 call  @ 0  →(money in = $0)

Buy to close 1 XYZ June 55 call @ 2   →(money out = $2/share)

Premium difference = $2/share

 

Ok now, there he closed out the positions, let`s see how he did from the difference of premiums, here`s the original transaction so you remember:

 

Buy 1 XYZ June 60 call @ 1

Sell 1 XYZ June 55 call @ 4

 

Paid Received

60 call        100          0

55 call        200 400

300      400 = +100

Explanation: When he first bought the 60 call he paid $100 and to close that position he had to sell the call but it didn`t have any intrinsic value so he didn`t receive any money. When he first sold the call he received $4oo and when he bought the call to close that position he paid $2oo(the premium at the time was 2). If you add up all that he paid($300), then add up all that he received($400), the difference between what he paid and received is $100. He received more than he paid so he had a profit of $100. The spread did narrow and you did make money. Another easier way to recognize that the spread narrowed is looking at the original net credit(4-1=3) and then  looking at the one when you closed the position(2-0=2), then you take the difference from both(3-2) and you end up with 1. Exactly what you had as profit, $100. Notice that the original credit of 3 points has narrowed to a final spread of 2. It is no coincidence that the difference between $3 and $2 is $1 and you`re up $100 dollars.

Important info to remember:

Desired direction: It will be determined by the option with the largest premium.  But first you have to know if it`s a call or a put spread.

Buy 1 XYZ June 60 call @ 1

Sell 1 XYZ June 55 call @ 4

In this case the spread is a call spread, and the short call has the largest premium. What happens when you short a call? You`re bearish. You want the stock to go down cuz otherwise the buyer of the call is gonna exercise his right to buy and you could have a loss, so this spread is bearish. On the other hand, if this would`ve been a put spread, then in this case the short put would`ve had the largest premium thus the investor would be bullish.

Breakeven point: For price spreads one thing to remember is that the breakeven is always gonna be between the two strike prices.

Call spread: Lower strike price + net premium

Buy ABC Sep 60 call @ 1

Sell ABC Sep 55 call @ 3

BE = 55 + (3-1) = 55 +2 = 57

Put spread: Higher strike price – net premium

Buy ABC Sep 180 put @ 8

Sell ABC Sep 170 put @ 14

BE = 180 – (14-8) = 180 – 6 = 174

 

Maximum gain/maximum loss:

 

Net Debit Spreads: When an investor buys an option with a higher premium and sells an option with a lower premium.

Maximum gain = difference in strike prices – net debit(both options in-the-money)

Maximum loss =  net debit

Breakeven = lower strike + net premium(for call spreads)

= higher strike – net premium(for put spreads)

Profitability = debit spreads widen

*Note: For all debit spreads, maximum gain and loss are the same for call spreads and put spreads.

Ex.

 

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Credit Spread:

Maximum gain = net credit(when both options expire)

Maximum loss = difference between strike prices – net credit(premium)

Breakeven = lower strike + net premium(for call spreads)

= high strike – net premium(for put spreads)

Profitability = credit spreads narrow

*Note: For all credit spreads, maximum gain and loss are the same for call spreads and put spreads.

Debit Spread:

Maximum gain = difference in strike prices – net debit(both options in-the-money)

Maximum loss =  net debit

Breakeven = lower strike + net premium(for call spreads)

= higher strike – net premium(for put spreads)

Profitability = debit spreads widen

*Note: For all debit spreads, maximum gain and loss are the same for call spreads and put spreads.