Series 7

Derivatives - Spread Option Strategies

The put and call are the building blocks of option strategy. As speculative and risky as they might seem - and some investors do nothing but speculate in them all day long - options were originally intended to reduce risk in an overall portfolio. If you have a large exposure to a company's share price, it is nice to have a put as insurance in case the stock craters.

Calls and puts used in tandem, though, create new ways to hedge a position:

Spreads
A spread is a position consisting of the purchase of an option and the sale of another option on the same underlying security with a different strike price or expiration date.

This is often done in lieu of covering a call. As discussed earlier, covering mitigates a lot of the risk of writing a call - risk which is otherwise unlimited. But covering does tie up a lot of capital that could be productive in some other way. A spread has the same risk-reducing effect as covering, but it is more cost-effective.

There are three kinds of spreads you need to know:
  1. Bull spread
  2. Bear spread
  3. Time spread
Bull and bear spreads are known collectively as "money spreads".
  • Bull Spreads are strategies designed to profit if the price of the underlying stock goes up. It is a two-step process:
    1. Buy an in-the-money call - that is, a call in which the strike price is lower than the stock's spot price.
    2. Sell an out-of-the-money call - that is, a call in which the strike price is higher than the stock's spot price.
This is a complicated strategy, so let's work with the simple example from the call and put diagrams. You start by buying an in-the-money call: 1 MNO May 95 call @ 4, assuming the spot price is now $98. Then you sell an out-of-the-money call: say 1 MNO May 100 call @ 2:
Figure 8.5: Bull Spread

It may not be immediately obvious from this chart, but the investor benefits from a higher share price and has some exposure - but less exposure - to a drop in share price. At least the diagram illustrates why it is called a "spread". Adding up the data from the long call and the data from the short call should clarify the situation:

Figure 8.6: Bull Spread

Clearly, there is a limited upside to this strategy as compared to the long call alone, but the bull spread allows you a broader range of values at which you will realize a profit, your risk of loss is minimized, and selling the short call greatly reduces your net costs.
  • Bear Spreads are strategies designed to profit if the price of the underlying stock goes down. It is mechanically similar to a bull spread, except the investor goes long on the out-of-the-money position and short on the in-the-money position, which is the exact opposite of the bull spread. These are the two steps to follow:
    1. Buy an out-of-the-money call.
    2. Sell an in-the-money call.

Look Out!
Here is an interesting conceptual point to remember: anything you can do with a call, you can do with a put. You can create a bear spread just as well by selling an out-of-the-money put and buying an in-the-money put. You can create a bull spread by selling an in-the-money put and buying an out-of-the-money put.

  • Time spreads
, sometimes called calendar or horizontal spreads, are positions consisting of the simultaneous purchase of one option and sale of another option with a different expiration date on the same underlying security.
  • This allows you either to create a hedge position or to speculate on the rate at which the market price of the options will decline as they approach the expiration date.




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