~ : : Option Strategies

After completing this chapter, you should be able to demonstrate

your k.nowledge of:
Whether an option strategy is bullish, bearish, or neutral
Determining the maximum gain, maximum loss, and
breakeven points for basic and cornplex strategies
The ways in which options can be used to hedge stock
positions
The identification of spreads, straddles, and cornbinations
Position and exercise limits
Margin requirements for options
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Option Strategies 17-3
lntroduction
The particular option trading strategy employed by an investor will
generally depend upon severa} factors including the individual's
investment objectives and attitude toward the underlying security. Since
an option is an asset that has a limited life, it is important to formulate an
opinion not only on the direction and extent of a stock's movement, but
also on the timing of such predictions.
This chapter will cover the option strategies most often employed by
investors. The initial focus will be on the basic strategies of buying and
writing calls and puts. The discussion will then move on to more complex
strategies involving combinations of option contracts.
Transaction costs have been excluded from all examples for purposes of
simplicity and because commission charges vary. However, both commis-
sion charges and taxes can have a great impact upon the results of a
transaction and can negate what might otherwise be an attractive strategy.
lnvestment Alternatives
Once an option position is established, there are three investment
alternatives available:
l. The position may be luidated. An option position is liquidated when
the investor engages in a closing transaction. The buyer of an option may
liquidate a position by selling the contract to another investor in the
marketplace. This will result in a profit if the amount received for the
option exceeds the original amount invested.
The writer of an option may close a position by repurchasing the contract
in the marketplace. The writer will profit if the original premium received
for the option exceeds the amount paid to repurchase the contract
2 The option may be held to expiration. When an option contract expires,
the buyer of the option loses the entire premium paid. The writer will
realize a gain equal to the premium received.
3. The option may be exercised. The buyer of an option decides whether or
not the contract will be exercised. U pon exercise, the buyer will bu y stock
from the writer (in the case of a call), or sell stock to the writer (in the case
of a put). If the option is exercised, the writer is obligated to fulfill the terms
of the contract
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Cal/ buyers are
bullish
Option Strategies 17-4
Basic Strategies
This section will discuss basic option strategies in terms of an investor's
maximum profit, maximum loss, and exercise breakeven points. Each
strategy will then be analyzed with regard to the three investment
alternatives.
Buylng Calls
The buyer of a call is bullish on the underlying security. The investor
believes that the market price of the underlying stock will increase above
the option's strike price. Since there is theoretically no limit toa stock's
price increase, the call buyer has an unlimited profit potential.
The investor can realize a profit by exercising the option at the strike price
and selling the stock at a higher price in the market. Or, because the
option's premium will reflect the increase in intrinsic value, the investor
can sell the option for a higher premium than the amount originally paid.
The call buyer's maximum loss is equal to the premium paid at the time the call is
purchased. lf the option is out-of-the-money at expiration, the buyer will
not have the opportunity to recover any part of the premium.
To break even at expiration, the investor must be able to completely
recover the premium paid to acquire the option. The option would have to
be in-the-money by an amount equal to the original premium. Therefore,
the breakeven point for the buyer of a call is the strike price of the option plus the
premium paid.
Example #1: Call Buyer
Ms. Smith purchases 1 ABC October 40 Call @ 2
l. The position is closed prior to expiration. The premium of the call option
will in crease or decrease with the movement of the underlying stock. As
the price of ABC rises, the premium of the ABC option will increase. To
detennine Ms. Smith's profit or loss for tax purposes, compare her cost to
the proceeds of the option sale.
Assume that ABC increased to $45 and the premium increased to 6 (S points
of intrinsic value and 1 point of time value). Ms. Smith sells the contract
at 6 and establishes a $400 profit for tax purposes ($600 proceeds- $200 cost).
2. The option is held to expiration. At expiration, the option' s premium will
reflect only the intrinsic value. There is no time value since time has
expired.
H the market price of ABC was $40 or below at expiration, the option would
be worthless since it would be out-of-the-money. Ms. Smith would lose
her entire $200 investment This is her maximum potentialloss.
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Put buyers are
bearish
Option Strategies 17-5
3. Tite contract is exercised. Ms. Smith may exercise her option to bu y ABC
stock at $40. Since she paid a premium of 2 for the contract, her total cost
to acquire ABC stock is $42 per share ($40 strike price + $2 premium). This
is also her breakeven point sin ce she would neither gain nor lose if she sold
the stock immediately at $42
lf the market price was greater than $42, Ms. Smith would have a profit
equal to the sale proceeds less the total cost of $42
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+300
+200
+ 100
EXAMPLE #1: CAU BUYER
BUY 1 ABC OCT 40 CALL@ 2
Unlimited
potentlal
gain
ABCat
o expiration
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S
100
200
300
Buying Puts
Loss limited to $200
premium paid
The buyer of a put is bearish on the underlying security. The investor
acquires the right to sell the underlying security at the strike price. The
right to sell becomes appealing to the owner of a put as the market price of
the underlying security drops below the strike price.
As the market price of the underlying security declines, the put buyer's
profit increases. The stock may be bought in the market at the lower market
price and sold at the higher strike price for a profit. The put buyer could
also realize a profit by selling the option for the higher premium resulting
from the decline in the stock's value.
Since the market price may only decline to zero, the put buyer's maximum
potential gain is limited to the difference between the market price of the security
and the strike price of the option, less the premium paid.
If the market price is above the strike price, the put option is out-of-the
money. lf the put is out-of-the-money at expiration, the option is
worthless and the premium will be lost. Thus, the maximum loss that the put
buyer may incur is the original premium paid.
To break even at expiration, the market price of the underlying security
must drop below the strike price by an amount equal to the original
premium paid. This would allow the investor to recover the en tire
premium. Therefore, the breakeven point for the buyer of a put is the strike price
of the option minus the premium.
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Option Strategies 17-6
Example #2: Put Buyer
Mr. Green purchases 1 XYZ May 25 Put @ 3
1. The position is closed prior to expiration. As the price of XYZ decreases,
the put premium will increase. Mr. Green' s profit or loss is found by
subtracting the cost of the option from the premium received when the
option is sold.
Assume that the market price of XYZ declines to $21 and the premium
increases to 5 (4 points of intrinsic value and 1 point of time value). By
selling the contract at 5, Mr. Green establishes a $200 profit ($500 proceeds
- $300 cost).
lf the market price of XYZ declined to zero, the May 25 put would have a
premium of 25. This limits Mr. Green' s maximum potential gain to $2,200
($2,500 proceeds - $300 cost).
2. The option is held to expiration. lf the put option is out-of-the-money
at expiration, the option is worthless. Mr. Green would lose the original
$300 premium paid. This represents his maximum potentialloss.
3. The contract is exercised. Mr. Green may exercise his option to sell XYZ
stock at $25. Todo this, hewould buy the stock at the current market price
and then sell it (put the stock) to the writer at the strike price.
For tax purposes, the sale proceeds received would be $22 per share sin ce
he paid a premium of 3 for the contract ($25 strike price- $3 premium). This
is also his breakeven point
It would be profitable to exercise the contract if the market price was less
than $22. For example, ifMr. Green exercised his contract when the market
price of XYZ was $20, his profit would be $2 per share ($22 proceeds- $20
cost).
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EXAMPLE #2: PUT BUYER
BUY 1 XYZ MAY 25 PUT @ 3
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Writing naked calls is
the riskiest option
strategy
Uncovered cal/
writers are bearish
Option Strategies 17-7
Writing Calls
The writer of a call is obligated to sell the underlying security at the strike
price if the option is exercised. In retum for taking on this obligation, the
call writer receives the option premium. If the option expires worthless,
the writer recognizes the premium as a gain.
Call writers may be classified as being either covered or uncovered. The
covered call writer owns the stock underlying the option (ora security
convertible into the underlying stock) and is not required to make a margin
deposit. The uncovered writer does not own the underlying stock and
must meet a margin requirement. Due to this variation, the scope of these
strategies is quite different.
Writing Uncovered Calls
Uncovered call writing is also referred to as "naked" call writing. lt is
considered to be the riskiest option strategy because an uncovered call writer
is exposed to unlimited risk.
If the buyer exercises the call, the writer is obligated to deliver the
underlying stock. Since the uncovered writer does not own the stock, the
investor must first purchase it in the marketplace at the current market
price. There is no limit as to how high the price may rise.
The maximum gain an uncovered call writer can realize is the premium received
when the option is sold. The writer will keep the entire premium if the
option expires worthless. Since this would occur if the price of the
underlying stock drops below the exercise price of the option, the
uncovered call writer is considered to be bearish on the underlying
security.
To break even at expiration, the uncovered writer must be able to purchase
the stock in the market at a price equal to the proceeds of the sale.
Therefore, the breakeven point for the writer of an uncovered call is the strike
price of the option plus the premium.
Example #3: Uncovered Call Writer
Mr. Brown writes 10 uncovered GHI October 65 Calls @ 4
l. The positm is closed prior to expiration. Mr. Brown may close the
position by purchasing 10 GHI October 65 calls prior to expiration. If the
premium is less than 4, he will establish a gain. lf the premium is more than
4, there will be a loss.
2. The optms expire. lf GHI is $65 or below at expiration, the options are
out-of-the-money and worthless. Mr. Brown would recognize the entire
$4,000 premium ($400 x 10 contracts) as a gain. This is the maximum profit
that Mr. Brown can realize.
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Covered cal/ writers
own the underlying
stock
Option Strategies 17-8
3. The contracts are exercised. If the options are exercised, Mr. Brown must
sell the stock at the strike price. Todo this, he must first buy the stock at
the current market price. As the market price of GHI in creases, so does Mr.
Brown's potentialloss.
For tax purposes, the total sale proceeds Mr. Brown receives would be $69
per share. This would include the monies received from selling the stock
plus the premium income he received when the options were sold ($65
strike price + $4 premium). This also represents Mr. Brown's breakeven
point since he will not have a loss provided that Gffi does not cost more
than$69.
If GHI costs more than $69, Mr. Brown will realize a loss. For example, if
the market price of GHI was $72 when the option was exercised, Mr. Brown
would have a 3 point loss per share ($72 cost - $69 proceeds). Since there
is no limit as to how high GHI might rise, Mr. Brown has unlimited loss
potential.
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+3,000
+ 2,000
+ 1,000
o
- 1,000
2,000
3,000
-4,000
EXAMPLE #3: UNCOVERED CALL WRITER
WRITE 10 GHI OCTOBER 65 CALLS @ 4
GHiat

Maximum loss
ls unlimited
Covered Cal/ Writing
The writer of a call option who also owns the underlying stock is
considered covered. There is much less risk associated with this strategy as
compared to uncovered call writing. lf the option is exercised, the investor
does not have to go into the market and purchase the underlying stock.
The covered writer will simply deliver the shares already owned.
Writing covered calls enables investors to increase the rate of return on
their portfolios. This is accomplished by adding the premium income
received from the option t o the dividends earned on the underlying stock.
The major disadvantage to this strategy is that by agreeing to sell the stock
owned at the strike price, the covered call writer forfeits the opportunity to
make an unlimited profit if the stock's price advances. Also, the writer of a
covered call is still exposed to loss if the market price of the underlying
stock declines.
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Option Strategies 17-9
The premium the writer receives does provide sorne protection against the
stock's decline. The premium reduces the investor's cost on the stock
making the covered call writer's maximum loss potential equal to the the original
cost of the stock minus the premium.
To break even at expiration, the investor must recover the total cost of the
stock. Therefore, the original cost of the stock minus the premium received for
the option is also the covered call writer's breakeven point.
Example #4: Covered Call Writer
Ms. Barton has the following positions in her account:
Bought 1,000 shares of DEF @ 47
Wrote 10 DEF October 50 Calls @ 2
1. 11re position is closed prior to expiration. Ms. Barton may clase the
position by purchasing 10 DEF October 50 calls prior to expiration. lf the
premium at that time is less than 2, she will establish a gain. lf the premium
is more than 2, she will incur a loss on the options. Regardless of the profit
or loss on her options, Ms. Barton still owns the stock when the option
position is liquidated.
lf the market price drops, Ms. Barton will profit on her options. However,
she is exposed toa loss on the stock owned. Her breakeven point is 45 ( cost
of stock- premium received).
2. 11re options expire. lf the market price of DEF is less than the strike price,
the options are out-of-the-money. At expiration, the options will be
worthless. Ms. Barton recognizes the premiums received ($2,000) as a gain.
She still owns the stock which provides the potential for further gains if
the stock goes up, as well as dividend in come.
3. 11re contracts are exercised. If the options are exercised, Ms. Barton must
sell her shares at the $50 strike price. Sin ce she also received the premium
for the options, her sale proceeds for tax purposes are equal to $52 ($50
strike price + $2 premium).
By writing the options, Ms. Barton guaranteed herself a profit of 5 points
($52 proceeds- $47 cost) if the calls were exercised. The disadvantage is
that until the options expire, this represents her maximum gain potential.
For example, if DEF increased to 58 and the options were exercised, Ms.
Barton would be obligated to deliver the stock at the strike price of $50.
She would eam $3 on the sale of the stock plus the $2 premium for a total
of5 points.
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Uncovered put
writers are bullish
Optlon Strategies 17-1 O
EXAMPLE #4: COVERED CALL WRITER
WRITE 10 DEF OCTOBER 50 CALLS @ 2
OWN 1,000 SHARES OF DEF@ 47
lf the calls are exercised,
maximum gain ls $5,000
p +5,000
Breakeven
R +4,000

o
+3,000
F
+2,000
1
T
+1,000
DEF at
o
expiratlon
-1,000
51 52 53 54 55
L
-2,000
o
-3,000
S
-4,000
As the stock declines
S
-5,000
below 45, investor is
exposed to loss
Writing Puts
The writer of a put is obligated to buy the underlying security at the strike
price if the option is exercised. In return for assuming this obligation, the
put writer receives the premium. If the put expires worthless, the writer
recognizes the premium as a gain.
The put writer must designate the position as being either covered or
uncovered. A put is considered covered if the writer is short the
underlying security or has cash in the account equal to the total exercise
price. The uncovered writer must meet a margin requirement.
Writing Uncovered Puts
The uncovered put writer's maximum potential profit is the premium received
when the option is sold. If the option is out-of-the-money at expiration, it
will expire worthless and the writer will retain the en tire premium. This
will occur if the price of the underlying stock is above the exercise price of
the option. Therefore, the writer of an uncovered put is considered to be
bullish on the underlying security.
If the market pr ice decreases below the strike price, the option may be
exercised and the investor must bu y the stock at the strike price. The
writer's cost for tax purposes will be equal to the price of the stock less the
premium received for the option.
The writer will break even if the investor can sell the stock in the market
for an amount equal to the cost. Therefore, the uncovered put writer's
brellkeven point is the strike price of the option minus the premium received.
The put writer is exposed to a potentialloss if the market price of the stock
is lower than the investor's cost. Since the market price cannot drop below
zero, the uncovered put writer's maximum loss is the strike price of the option
minus the premium received.
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Option Strategies 17-11
Example #5: Uncovered Put Writer
Ms. Hall writes 10 uncovered RST October 60 Puts @ 3
1. Tite position is e lo sed prior to expiration. Ms. Hall may el ose the position
by purchasing 10 RST October 60 puts prior to expiration. lf the premium
is less than 3, she will establish a gain. lf the premium is more than 3, there
will be a loss.
2. Tite options expire. If RST is $60 or above at expiration, the options are
out-of-the-money and worthless. Ms. Hall would recognize the entire
$3,000 premium ($300 x 10 contracts) as a gain. This is her maximum profit
3. Tite contracts are exercised. lf the options are exercised, Ms. Hall must
buy the stock at the strike price. She would have a loss if the market price
of the stock was below her acquisition cost Thus, as the market price of
RST decreases, Ms. Hall's potentialloss increases.
For tax purposes, Ms. Hall's acquisition cost of the stock is $57 ($60 strike
price- 3 point premium received). This would also be her breakeven point
lf RST is less than 57 and the stock was immediately sold, she would realize
a loss. Sin ce the stock cannot decline below zero, her maximum loss on the
ten contracts is $57,000.
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+5,000
+3,000
+1.000
EXAMPLE #5: UNCOVERED PUT WRITER
WRITE 10 RST OCTOBER 60 PUTS@ 3
Breakeven
polnt ls 57
Maximum galn is $3,000
premium received
o ~ ~
1 - - - - - - . - - . . . . . . . , . . - ~ - - , - . . , . . . . . . . . , . . . . - ....... --expiratlon
1,000
3,000
5,000
-57,000
Covered Put Writing
The writer of a put option who is also short the underlying stock is
considered covered. By writing the put option, the investor generates
premium income for the portfolio.
The option premium also offsets sorne loss should the stock's price increase
by adding to the investor's short sale proceeds. This makes the breakeven
point for the covered put writer equal to the short sale price plus the premium.
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Option Strategles 1712
The covered put writer's loss potential is unlimited. lf the price of the short
stock should increase, there is no limit as to how high it can rise. Also, if
the price of the short stock declines below the strike price of the option,
the gain from the short sale is offset by the loss from the option position.
Example #6: Covered Put Writer
Mr. Jones has the following positions in bis account:
Sold 100 shares of MNO short @ 35
Wrote 1 MNO October 30 Put @ 3
l. The option position is closed priorto expiration. Mr. Jones may close the
option position prior to expiration by purchasing 1 MNO October 30 put
lf the premium is less than 3, he will establish a gain. If the premium is
more than 3, Mr. Jones will have a loss.
Regardless of the profit or loss on the options, Mr. Jones is still short the
stock at 35. He is exposed to an unlimited loss should the stock increase
above $38 (short sale price plus the premium). This is also bis breakeven
point
2. The option expires. lf the market price is greater than the strike price at
expiration, the put is out-of-the-money. The option is worthless and Mr.
Jones recognizes the $300 premium received as a gain.
3. The contract is exercised. If the put is exercised, Mr. Jones must buy
MNO at the strike price of $30. The 3-point premium received reduces bis
purchase price for tax purposes to $27.
Mr. Jones will use the money received from the short sale to buy MNO
stock. Since Mr. Jones received $35 from the short sale and only has to
spend $27 to buy the stock, he is left with an 8-point profit This is bis
maximum profit if the option is exercised.
+800
p
A +600
o
F + 400
1
T +200
EXAMPLE #6: COVERED PUT WRITER
WRITE 1 MNO OCTOBER 30 PUT@ 3
SHORT 100 SHARES OF MNO @ 35
0 ~ ~ ~ ~ ~ ~ ~
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200
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Maxlmum
loss ls
unllmlted
MNOat
explratlon
The breakeven point
is93
Option Strategies 17-13
Hedging Strategies
Many investors use option contracts to hedge long or short positions on
the underlying stock. The examples that follow illustrate this concept.
Example #7: Protective Put Purchase
Ms. Johnson purchases 100 shares of ABC@ 91. As protection against a
price decline, she also buys 1 ABC November 90 put@ 2. This increases
her cost basis on the stock to $93.
The purchase of the put guarantees Ms. Johnson a sale price of $90 for the
stock. If the option is exercised, her potential loss is limited to 3 points
($9,300 cost- $9,000 proceeds). If she chose not to exercise the option and
ABC stockfell below $90,losses in the stock could be offset by gains in the
put option premium.
As the stock increases in price, the put goes further out-of-the-money.
Sin ce the total outlay for this position is 91 for the stock and 2 for the put,
93 becomes the breakeven point Once the stock increases above 93, the
investor will have a profit
ABC's
Market
Price
99
96

90
87
84
Buy 100 ABC @ 91
Buy 1 ABC November 90 Put @ 2
Put's
Intrinsic
Value
o
o
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o
3
6
Profit or Profit or
Loss on Loss on
the Stock the Put
+800
+500
+200
- 100
-400
- 700
-200
-200
-200
-200
+100
+400
Example #8: Protective Call Purchase
Total
Profit
or Loss
+600
+300
o
-300
-300
-300
Mr. Kimball is short 100 shares of XYZ@ 48. He buys 1 XYZ November SO
call @ 3 to protect against an increase in the price of XYZ stock. This
decreases his sale proceeds to $45.
The purchase of the call guarantees Mr. Kimball a purchase price of $50 for
the stock if the option is exercised. His potentialloss is limited toS points
($5,000 cost- $4,500 proceeds). Also, if XYZ increases above $50 and Mr.
Kimball chooses not to exercise the option,losses in the short stock position
may be offset by gains in the call option.
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The breakeven point
is45
Option Strategies 17-14
As the stock' s price decreases, the call goes further out-of-the-money. The
breakeven point is 45 ($48 short sale price - 3 call premium paid). Once the
stock price drops below $45, the investor will have a profit on the overall
position.
Short 100 XYZ @ 48
Bu y 1 XYZ N ovember 50 Call @ 3
XYZ's Call's Profit or Profit or Total
Market Intrinsic Loss on Loss on Profit
Price Value the Stock the Call or Loss
60 10 - 1,200 +700 500
55 S 700 +200 500
so o 200 - 300 500
'i$1
::: .....::.::
o + 300 - 300 o
40 o
+
800 - 300 +
500
35 o +1,300 - 300 +1,000
30 o +1,800 - 300 + 1,500
Complex Strategies
Certain option strategies are more complex than the simple purchase or sale
of call or put option contracts. These strategies include spreads, straddles,
and combinations.
Spreads
A spread offers the investor the opportunity to limit losses on an option
position in exchange for a limited gain potential. lt involves the
simultaneous purchase and sale of option contracts of the same class, on
the same underlying security. The expiration month andlor strike price
will be different. lt is this difference that classifies the type of spread
crea te d.
Price (Vertical) Spread: the options are of the same class and have the same
expiration month but the strike prices are different.
Buy 10 ABC March 30 Calls
Write 10 ABC March 40 Calls
Calendar (Horizontal) Spread: the options are of the same class and have
the same strike price but the expiration months are different.
Buy 10 ABC March 30 Calls
Write 10 ABC June 30 Calls
Diagonal Spread: the options are of the same class but have different strike
prices and different expiration months.
Buy 10 ABC March 30 Calls
Write 10 ABC June 40 Calls
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To be profitable, debit
spreads must widen
To be profitab/e, credit
spreads must narrow
Option Strategies 17-15
Debit and Credit Spreads
When a spread is created, the investor pays the premium for the option
purchased and receives the premium for the option sold. This will result in
a debit or credit in the customer's account.
The investor anticipates that the difference between the premiums of the two
options (the spread) will either widen or narrow. The spread between the
premiums may never grow wider than the difference between the strike
prices of the options. The spread's narrowest point occurs if both options
expire worthless.
In anticipation of the spread widening (the difference between the premiums
increasing), the investor will buy the option with the higher premium and
sell the option with the lower premium. This creates a debit spread.
Debit Spread: the option purchased costs more than the premium received
from the option sold.
Buy 10 ABC March 30 calls @ 3
Write 10 ABC March 35 calls @ 1
Net amount owed (debit) 2
In anticipation of the spread narrowing (the difference between the
premiums decreasing), the investor will buy the option with the lower
premium and sell the option with the higher premium. This creates a
credit spread.
Credit Spread: the option sold generates a premium that is greater than the
cost of the option purchased.
Buy 10 XYZ May 25 calls @ 1
Write 10 XYZ May 20 calls @!
Net amount received (credit) 3
Analyzing Spreads
There are many factors that need to be analyzed in order to understand
spread strategies. For each of the strategies that follow, the points that will
be addressed are:
whether the spread is for a debit or credit
whether the investor is bullish or bearish
the maximum potential profit
the maximum potentialloss
the breakeven point
Cal/ Debit Spread
In a call debit spread, the investor buys the call with the lower strike price
and writes the call with the higher strike price. The call purchased will have
a higher premium than the call written. This will result in a net debit.
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Cal/ deblt spreads
are bullish
Option Strategies 17-16
An investor using this strategy is bullish on the underlying security. An
increase in the underlying stock causes an increase in the call premiums.
The spread between the premiums will widen.
Example #9: Call Debit Spread
Bu y 10 ABC May 80 Calls @ 9
Write 10 ABC May 90 Calls @ 5
This spread is executed for a net debit of 4 (9 point premium paid- 5 point
premium received). The investor must pay $4,000 (4 point debit x 10
contracts). The investor will have a profit if the spread between the
premiums widens and will ha ve a loss if the spread narrows.
The breakeven point for a call debit spread is the lower strike price plus
the net debit. If ABC is $84 at expiration, the May 80 calls may be sold for
their 4 point ($4,000) intrinsic value. The May 90 calls are worthless. The
investor will be able to recover the original $4,000 de bit paid for the spread
and break even.
As ABC drops below $84, the spread becomes unprofitable. lf ABC is $80
or less at expiration, both options are out-of-the-money and worthless.
The investor loses the $4,000 debit paid forthe spread. This is the maximum
loss that the investor can sustain.
As ABC rises above $84, the spread becomes profitable. The spread reaches
its maximum profit potential if ABC is $90 or more. For example, if ABC is
$95, the May 80 calls will be sold for$15,000 (15 points in-the- money) while
the May 90 calls will be repurchased for $5,000 (S points in-the-money). By
liquidating the spread, the investor receives $10,000 ($15,000 - $5,000).
However, after subtracting the cost of the spread ($4,000), the investor's
profit is $6,000.
In summary, the investor will profit if the market price goes above $84. The
investor ceases to make additional profit above $90. The entire $4,000
investment will be lost if ABC declines to $80 or below at expiration.
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S
+6,000
+4,000
+2,000
2,000
-4,000

EXAMPLE #9: CAU DEBIT SPREAD
BUY 10 ABC MAY 80 CALLS @ 9
WRITE 10 ABC MAY 90 CALLS@ 5
Breakeven
point is 84
Maxlmum loss
occurs lf ABC is
80 or less
"'
Maximum galn occurs
lf ABC is 90 or greater
Securities Training Corporation . All Rights Reserved.
Cal/ credit spreads
are bearish
Option Strategies 17-17
Cal/ Credit Spread
An investor creating a call credit spread will huy the call with the higher
strike price and write the call with the lower strike price. The call
purchased will have a lower premium than the call written. The result will
be a net credit.
The investor using this strategy is bearish on the underlying security. A
decrease in the underlying stock will cause the call premiums to decrease
and the spread to narrow.
Example #10: Call Credit Spread
Bu y 10 ABC May 90 Calls @ 5
Write 10 ABC May 80 Calls @ 9
This spread is executed for a net credit of 4 (9 point premium received - 5
point premium paid). The investor receives $4,000 (4 point credit x 10
contacts). The investor will profit as the spread between the premiums
narrows and will have a loss if the spread widens.
The breakeven point for a call credit spread is the lower strike price plus
the net credit If ABC is at $84 at expiration, the May 90 calls are worthless.
The May 80 calls will be repurchased for their 4 point ($4,000) intrinsic
value. This cost offsets the $4,000 credit received for the spread causing
the investor to break even.
As ABC drops below $84, the spread becomes profitable. If ABC is $80 or
less at expiration, both options are out-of-the-money and worthless. The
investorwould recognize the $4,000 credit received as a profit This is the
maximum potential gain.
As ABC rises above $84, the spread becomes unprofitable. If ABC is $90 or
more at expiration, the spread reaches its maximum loss potential of $6,000.
The maximum loss is found by deducting the $4,000 credit received from
the $10,000 difference between the strike prices.
In summary, the investorwill profit if the market price declines below $84.
The maximum. profit is recognized if ABC declines to $80 or below at
expiration. The investor ceases to make additional profit below $80.
EXAMPLE #10: CALL CREDIT SPREAD
BUY 10 ABC MAY 90 CAllS@ S
WRITE 10 ABC MAY 80 CALLS@ 9
Maximum galn occurs if
p +6.000 ABC is 80 or less
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S
90
ABCat
expiration
Copyright@ Securities Training Corporation. All Rights Reserved.
Put debit spreads
arebearish
Option Strategies 17-18
Put Debit Spread
In a put debit spread, the investor buys the put with the higher strike price
and writes the put with the lower strike price. This will result in a net
de bit.
An investor using this strategy is bearish on the underlying security. A
decrease in the underlying stock causes an in crease in the put premiums.
The spread between the premiums will widen.
Example #11: Put Debit Spread
Bu y 10 XYZ Sept 65 Puts @ 8
Write 10 XYZ Sept 55 Puts@ 1
This spread is executed for a net debit of 7 (8 point premium paid- 1 point
premium received). The investor must pay $7,000 (7 point debit x 10
contracts). The investor will profit if the spread widens.
The breakeven point for a put de bit spread is the higher strike price minus
the net debit. lf XYZ is $58 at expiration, the Sept 55 puts are worthless and
the Sept 65 puts m ay be sold for their 7 poin t ($7,000) in trinsic val u e. The
investor will be able to recover the original $7,000 debit paid for the spread
and break even.
As XYZ rises above $58, the spread becomes unprofitable. If XYZ is $65 or
more at expiration, both options are out-of-the-money and worthless. The
investor loses the $7,000 debit paid for the spread. This is the maximum
loss that the investor can sustain.
As XYZ drops below $58, the spread becomes profitable. The spread
reaches its maximum profit poten tia! if XYZ is $55 or less. Por example, if
XYZis$50, theSept65putswillbe sold for$15,000 (15 pointsin-the-money)
while the Sept 55 puts will be repurchased for $5,000 (5 points
in-the-money). By liquidating the spread, the investor receives $10,000
($15,000- $5,000). However, after subtracting the cost ofthe spread ($7,000),
the investor's profit is $3,000.
Insummary, the investorwill profitif the market pricedeclines below$58.
The investor ceases to make additional profit below $55. The en tire $7,000
investment is lost if XYZ increases to $65 or above.
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+3.000
3.000
6 5.000
S
-7.000
S
EXAMPLE #11: PUT DEBITSPREAD
BUY 10 X'fZ SEPT 65 PUTS@ 8
WRITE 10 XYZ SEPT 55 PUTS@ 1
Maxlmum galn
occurs lf XVZ is
55orless
Maximum loss
occurs W ){'(Z 1s
65ormore
Copyright ICi Securities Training Corporation. All Rights Reserved.
Put credit spreads
are bullish
Option Strategies 17-19
Put Credit Spread
An investor creating a put credit spread will buy the put with the lower
strike price and write the put with the higher strike price. The result will
be a n et ere di t.
An investor using this strategy is bullish. As the underlying stock
increases, the put premiums decrease. This causes the spread between the
premiums to narrow.
Example #12: Put Credit Spread
Buy 10 XYZ Sept 55 Puts @ 1
Write 10 XYZ Sept 65 Puts @ 8
This spread is executed for a net credit of 7 (8 point premium received - 1
point premium paid). The investor receives $7,000 (7 point credit x 10
contracts). The investor will profit if the spread narrows.
The breakeven point for a put credit spread is the higher strike price minus
the net credit If XYZ is $58 at expiration, the Sept 65 puts may be
repurchased for their 7 point ($7,000) intrinsic value. The Sept 55 puts are
worthless. The investor must spend the original $7,000 credit received to
liquidate the spread and will break even.
As XYZ rises above $58, the spread becomes profitable. If XYZ is $65 or
more at expiration, both options are out-of-the-money and worthless. The
investor realizes the $7,000 credit received for the spread as a profit This
is the maximum potential gain.
As XYZ drops below $58, the spread becomes unprofitable. If XYZ is $55
or less at expiration, the spread reaches its maximum width and maximum
loss of $3,000. The maximum loss is found by deducting the $7,000 credit
received from the $10,000 difference between the strike prices.
In summary, the investorwill profit if the market price goes above $58. The
maximum profit occurs if XYZ is $65 or above at expiration. The investor
ce ases to make additional profit above $65.
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+7,000
+5,000
+3,000
o
-3,000
5,000
7,000
EXAMPLE #12: PUT CREDIT SPREAD
BUY 10 X:VZ SEPT 55 PUTS @ 1
WAITE 10 X:VZ SEPT 65 PUTS@ B
Maximum gain
occurs if 'XYZ is
65ormore
65
Maximum loss occurs
lf x:fZ is 55 or less
Copyright C Securities Training Corporation. All Rights Reserved.
XXZat
expiration
Buyers of straddles
expect volatility
Option Strategles 17-20
Straddles
A straddle involves the purchase of a call and a put or the sale of a call and
a put on the same underlying security. The exercise price and the expira-
tion date will also be the same. If the investor buys both options, it is
called a long straddle. If the investor writes the options, it is called a short
straddle.
Long Straddle Short Straddle
Buy 10 ABC May 60 Calls
Buy 10 ABC May 60 Puts
Write 10 ABC May 40 Calls
Write 10 ABC May 40 Puts
The investor buying or writing the straddle is speculating on the volatility
of the underlying security. The buyer of the straddle expects the
underlying stock to be volatile. The writer of the straddle expects little
or no volatility.
Buying Straddles
The investor who buys a straddle anticipates a substantial movement in the
price of the underlying security but is uncertain as to the direction of the
movement. A long straddle gives the investor the opportunity to profit if
the underlying security increases or decreases.
The call portian of the straddle will appreciate if the underlying stock
increases. The put portion of the straddle will appreciate as the underlying
stock decreases. However, the long straddle will only be profitable if the
movement in the underlying stock exceeds the combined premiums paid for
the options. To find the breakeven points, the total premium paid for the
straddle must be added to and subtracted from the strike price.
Example #13: Assume that the market price of ABC is 60. The investor
expects ABC to be volatile but is uncertain of the direction of the
movement The investor enters an order to bu y 10 ABC May 60 straddles
which is executed as follows:
Buy 10 ABC May 60 Calls @ 3
Buy 10 ABC May 60 Puts @ 2
The investor will pay a combined
premium of S ($5,000).
The breakeven point for the call is 65
($60 strike price + 5 point combined
premium). The breakeven point for the
put is 55 ($60 strike price - 5 point
combined premium).
lf the market price of ABC goes above
$65 or below $55, the buyer of the
straddle will make a profit, as follows:
EXAMPLE #13: LONG STRADDLES
BUY 10 ABC MAY 60 CALLS@ 3
BUY 10 ABC MAY 60 PUTS @ 2
1 Unlimited profit potential if ABC > 65
65 Breakeven Polnt
Loss Range
Breakeven Point
Maximum gain ls $55,000 if ABC < 55
o
Copyright <O Securities Tralning Corporation. All Rights Reserved.
Writers of straddles
are neutral
Maximum profit on call side = Unlimited
Maximum profit on put side = $55,000
Option Strategies 17-21
The maximum loss is S ($5,000). This would occur if ABC is $60 at
expiration (causing both options to expire worthless).
Writing Straddles
The investor who writes a straddle expects small fluctuations in the market
price of the underlying stock. The investor is considered to have a neutral
attitude. The straddle writer seeks to generate income from both the call
and put premiums.
The breakeven points for the seller of a straddle are the same as for the
buyer. However, the seller of the straddle profits if the rnarket price stays
within the range of these breakeven points.
Example #14: Assume that the rnarket price of XYZ is $40. The investor
feels that XYZ will not be volatile over the upcorning rnonths. The investor
enters an order to write 10 XYZ May 40 straddles which is executed as
follows:
Write 10 XYZ May 40 Calls @ 4
Write 10 XYZ May 40 Puts @ 2
The investor will receive a combined
premium of 6 ($6,000).
The breakeven point for the call is 46 ($40
strike price + 6 point combined prernium).
The breakeven point for the put is 34 ($40
strike price - 6 point combined prernium).
The maximurn gain is 6 ($6,000). This
occurs if the rnarket price of XYZ is $40 at
expiration ( causing both options to expire
worthless).
lf the market price of XYZ goes above $46
or below $34, the writer of the straddle will
have a loss, as follows:
Maximum loss on the call side === Unlimited
Maxirnum loss on the put side = $34,000
EXAMPLE #14: SHORT STRADDLES
WRITE 1 O XYZ MAY 40 CALLS @ 4
WRITE 10 XYZ MAY 40 PUTS @ 2
l Unlimited loss potential if XYZ > 46
46 Breakeven Point
Profit Range
1
34 Breakeven Point
1 Loss limited to $34,000 if XYZ < 34
o
Copyright@ Securities Training Corporation. All Rights Reserved.
Option Strategies 17 22
Combinations
Like a straddle, a combination is also a strategy for speculating on the
volatility of the underlying stock. A combination is similar to a straddle in
that it involves buying or writing a call anda put on the same underlying
stock. However, the contracts will ha ve different exercise prices and/ or
different expiration months. Below is an example of a long combination:
Buy 5 DEP May 50 Calls@ 3
Buy 5 DEP May 40 Puts @ 1
The calculation for breakeven points, maximum gains, and maximum losses
on combinations are calculated in the same manner as straddles.
Por the above example, the total combined premium is 4. The breakeven
points are $54 (call strike price of $50 plus 4) and $36 (put strike price of $40
minus 4). This strategy will be profitable if DEP increases above $54 or
decreases below $36.
Other Considerations Regarding Option Strategies
Additional considerations when choosing an option strategy include tax
implications, position and exercise limits, and margin requirements. Option
taxation will be covered in Chapter 19.
Position and Exercise Limits
The Options Clearing Corporation and the options exchanges limit the
number of contracts that an investor, or group of investors acting in concert,
can accumulate on the same underlying security. These position limits differ
for each underlying stock.
A stock is assigned a maximum limit based on trading volume and outstanding
shares. The status of the underlying security is reviewed every six months to
determine what limit applies.
The same numericallimits apply to exercise limits. An exercise limit is the
maximum number of contracts an individual may exercise within five
consecutive business days.
The limitations apply to contracts on the same side of the market. The
bullish side of the market includes long calls and short puts. The bearish
side of the market includes long puts and short calls.
Bullish
Long Calls
Short Puts
Bearish
Long Puts
Short Calls
Por example: An investor owning 10,500 ABC calls when 10,500 contracts
is the position limit for ABC, has reached the maximum on the bullish
(long) side of the market. The investor may not buy additional ABC calls or
write any ABC puts.
Copyright Securities Training Corporation. All Rights Reservad.
Option Strategies 1723
Since these limits apply to each underlying security, the investor is
allowed to purchase calls or write puts on any other underlying stock. The
investor is also permitted to buy up to 10,500 ABC puts or write up to
10,500 ABC calls since these transactions are on the other side of the
market.
Margin Requirements
Options contracts are subject to the margin requirements set forth by the
Federal Reserve Board under Regulation T. They are also subject to the
maintenance requirements of the exchanges and each brokerage firm.
Discussed below are the mnimum requirements of the exchanges. How-
ever, most firms require that customers meet their in-house standards which
are considerably higher.
Buying Options
According to Regulation T, options have no loan value. The buyer of an
option must deposit the full purchase price, regardless of whether the option
is purchased in a cash or margin account.
Customers must pay for purchases in cash or margin accounts by the second
business day after the regular-way settlement date for corporate securities.
Therefore, while member firms must settle the transaction with the OCC by
the business day following the trade date, customers have five business days
in which to pay. Member firms are permitted to require a deposit from their
customers prior to the Regulation T payment date.
Writing Covered Cal/s
An investor writing a covered call may transact business in either a cash or
margin account. To be covered, a call writer must:
own the underlying stock;
own securities convertible into the underlying stock; or
produce an escrow receipt showing that the stock is on deposit ata bank
and will be delivered if the call is exercised.
Each 100 shares owned covers one contract. The securities covering the
option, or the escrow receipt from a bank, must be deposited into the
customer's account.
The writer of a covered call need not deposit margin for the option.
However, the position covering the option may require a margin deposit.
The premium received from the option may be used to pay the margin
required for the covering securi ty.
Copyright Securities Training Corporation. All Rights Reserved.
Option Strategies 17-24
For example: An investor executes the following transactions in a margin
account when Regulation T is 50%:
Buys 100 shares of ABC @ 58
Writes 1 ABC October 60 Call @ 2
The total purchase price of the stock is $5,800. The margin required for the
stock is $2,900 (50% x $5,800). However, sin ce the investor received a $200
premium for the call, only $2,700 needs to be deposited.
$2,900 margin required for the stock
- 200 premium received from the call
$2,700 cash to be deposi ted
Wrlting Covered Puts
To be considered covered, a put writer must:
deposit cash with the firm equal to the aggregate strike price;
deliver a Ietter guaranteeing that cash equal to the aggregate strike
price is on deposit ata bank (this letter must be issued by the bank); or
be short the underlying security.
The writer of a put covered by cash ora bank guarantee letter may execute
the trade in a cash or margin account. However, a put covered by short
stock may only be written in a margin account.
Each 100 shares that the customer is short covers one put contract. When
selling stock short to cover a put, the put premium may be used to pay the
margin requirement on the short sale.
For example: An investor executes the following transactions in a margin
account Regulation T is 50%:
Sells short 100 shares of XYZ @ 75
Writes 1 XYZ March 70 Put@ 3
The margin requirement for the short sale is $3,750 ($7,500 short sale
proceeds x 50%). The premium received from the put option reduces the
required deposit to $3,450:
$3,750 short sale margin requirement
- 300 put premium received
$3,450 cash to be deposited
Writing Uncovered Options
Uncovered option writers must deposit margin to secure their positions.
Short uncovered options may only be carried in a margin account. The
CBOE and other exchanges require at Ieast $2,000 of initial equity to effect
transactions in a new margin account. Maintenance margin requirements
apply thereafter.
Copyright @ Securities Training Corporation. All Rights Reserved.
Option Strategies 17-25
The basic margin requirement for an uncovered call or put option is:
The current premium
+ 20% of the current market value of the underlying stock
- any amount that the contract is out-of-the-money
The mnimum requirement is:
The current premium
+ 10% of the current market value of the underlying stock
Spread Margin
Spreads may only be executed in a margin account. If the spread is considered
covered, there is no margin requirement. Customers entering into uncovered
spread positions must deposit margin.
Covered Cal/ Spreads
A call spread will be considered covered if the long option expires at the
same time orla ter than the short option, and the exercise price of the long
option is equal to or less than the exercise price of the short option.
For example: Mr. Green enters into the following spread position:
Buy 1 RFQ March 30 Call @ 6
Sell 1 RFQ March 40 Call @ 3
Mr. Green has the obligation to sell the stock at $40 if the March 40 call is
exercised. Since he also has the right to bu y the stock ata lower price ($30)
by exercising the March 30 call, the spread is covered. There would be no
margin requirement. However, Mr. Green would have to deposit the
difference between his cost of $600 for the March 30 call and the $300 he
received for selling the March 40 call.
Covered Put Spreads
A put spread will be considered covered if the long option expires at the
same time or la ter than the short option. The exercise price of the long option
must also be equal to or greater than the exercise price of the short option.
For example: Ms. Hall enters into the following spread position:
Buy 1 STC April40 Put@ 5
Sell1 STC April 30 Put@ 2
This would be a covered spread. If the short put is exercised, Ms. Hall
would be obligated to purchase 100 shares ofSTC at $30 a share. She could
sell these shares at $40 a share by exercising her long put. There would be
no margin requirement. However, Ms. Hall would have to deposit the
difference between her $500 cost for the April 40 put and the $200 she
received for selling the April30 put.
Margin for Stradd/es and Combinations
The buyer of a straddle or combination must pay for the options in full .
The position will not have loan value in a margin account.
Copyright Securities Training Corporation. All Rights Reserved.
Summary of Strategies
Buying Options
BUYING CALLS
Option Strategies 17 26
BUYING PUTS
Maximum Gain = unlimited
Maximum Loss = premium
Breakeven = strike + premium
Maxmum Gain = strike - premum
Maximum Loss = premium
Breakeven = strike - premium
Writing Options
WRITING UNCOVERED CALLS
Maximum Gain = premium
Maximum Loss = unlimited
Breakeven = strike + premium
WRITING COVERED CALLS
WRITING UNCOVERED PUTS
Maximum Gain = premium
Maximum Loss = strike - premium
Breakeven = strike - premium
Maximum Gain = strike + premium - cost of stock
Maximum Loss = cost of stock - premium
Breakeven = cost of stock - premium
WRITING COVERED PUTS
Maximum Gain = short stock proceeds + premium - strike
Maximum Loss = unlimited
Breakeven = short stock proceeds + premium
Protective Purchases
BUYING A PUT TO PROTECT A LONG STOCK POSITION
Maximum Gain = unlimited
Maximum Loss = cost of stock + premium - strike
Breakeven = cost of stock + premium
BUYING A CALL TO PROTECT A SHORT STOCK POSITON
Maximum Gain = short sale price - premium
Maximum Loss = strike + premium - short sale price
Breakeven = short sale price - premium
Copyright Securities Training Corporation. All Rights Reserved.
Spreads
CALL DEBIT SPREAD
Maximum Gain = difference in strikes - net debit
Maximum Loss = net debit
Breakeven = lower strike + net debit
CALL CREDIT SPREAD
Maximum Gain = net credit
Maximum Loss = difference in strikes - net credit
Breakeven = lower strike + net credit
PUT DEBIT SPREAD
Maximum Gain = difference in strikes - net debit
Maximum Loss = net debit
Breakeven = higher strike - net debit
PUT CREDIT SPREAD
Maximum Gain = net credit
Maximum Loss = difference in strikes - net credit
Breakeven = higher strike - net credit
Combinations
LONG STRADDLE & COMBINATION
Maximum Gain for Call = unlimited
Maximum Gain for Put = strike - combined premium
Maximum Loss = combined premium
Breakeven = strike combined premium
SHORT STRADDLE & COMBINATION
Maximum Gain = combined premium
Maximum Loss for Call = unlimited
Maximum Loss for Put = strike - combined premium
Breakeven = strike combined premium
Copyright Securittes Traintng Corporation. All Rights Reserved.
Option Strategies 1727