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:
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:
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:
- Buy an in-the-money call - that is, a call in which the strike price is lower than the stock's spot price.
- 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
Figure 8.6: Bull Spread
- 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:
- Buy an out-of-the-money call.
- Sell an in-the-money call.
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.
, 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.