The Options University Blog

July 31, 2006

Put Option

A put option is a contract between two parties (a buyer and a seller) whereby the buyer acquires the right but not the obligation to sell a specified stock or other underlying instrument at a specified price by a specified date.

The seller of a put option assumes the obligation of taking delivery of the stock or other underlying instrument from the buyer should the buyer wish to exercise his option. The put is known as a short instrument which means that the buyer profits from the stock going down.

For the seller to profit, the stock must not move below the strike price plus the amount of money received for the sale of the option. This point is known as the breakeven point and is calculated by adding the call’s strike price to the option’s premium. Obviously, the buyer hopes that the stock price exceeds the breakeven point.

For example, you buy the MSFT January 65 put for $2.00 because you think Microsoft is going to go down. This option gives you the right, but not the obligation to sell the stock at $65.00. in order to obtain this right, you had to spend $2.00. In order for you to make money, the stock would have to trade down below $63.00 by expiration.

This is because the stock has to trade down below the strike plus the cost of the option. If the stock traded down to $60.00, you would make $5.00 because you have the right to sell it at $65.00. However, because you paid $2.00 for the put, you must subtract that from your $5.00 profit for a total profit of $3.00. You have just made $3.00 on a $2.00 investment. Not a bad return.

The buyer of the put has limited risk and unlimited potential gain. His risk is limited only to the amount of money he spent in purchasing the put. His unlimited potential gain comes from the stocks unlimited downside potential.

The seller, on the other hand, has limited potential gain and unlimited potential loss. The seller can only gain what he was paid for the put. The unlimited risk comes from the stock price’s ability to decline during the life of the contract.

For example, if a seller sold the MSFT January 65 put for $2.00, he is giving the buyer the right to sell 100 shares (per contract) of MSFT to him at $65.00 per share at any time until the option expires.

If MSFT declines and trades down to $55.00, the seller would realize a $10.00 loss less the amount he received for the sale of the option ($2.00), for a net loss of $8.00. Meanwhile, the buyer would realize a $10.00 profit less the amount he paid for the option ($2.00), for a net gain of $8.00 per contract.

If MSFT were to trade up to $75.00, the seller would realize a $2.00 profit (the amount of money he was paid from the buyer). Meanwhile, the buyer would only lose what he paid for the option ($2.00). The seller is obligated to take delivery of the stock from the buyer at the strike price regardless of the present market price of the stock. This is why the seller receives premium for the sale.

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Vertical Spreads

A Recap with Special Insights

Vertical spreads can have various names. The same vertical spread could be called several different things by several different people. We have used two terms only: vertical call spread and vertical put spread. Each of these two spreads allows for two positions, long and short.

The long vertical call spread is constructed by buying one call option with a lower strike price while simultaneously selling another call option in the same month with a higher strike price. In a one to one ratio this trade, the long vertical call spread, is labeled a bullish trade. This means that when engaging into a long vertical call spread, the investor expects the stock to increase in value. An investor who engages in a trade with the expectation of the stock going up is said to be bullish. Thus, a long vertical call spread is a bullish trade.

For example, you are long a vertical call spread if you buy 10 August 35 calls and sell 10 August 40 calls. The proper way to describe this would be “long the August 35 – 40 call spread.” Using our previous example of the August 35 – 40 call spread, we assume that you bought the spread for $2.80. At expiration, you know that you can lose a maximum of $2.80 if the stock closes at $35.00 or below. At expiration, you will gain your maximum profit if the stock is $40.00 or over. Your maximum profit is defined as the difference between the two strikes minus the amount you paid for the spread.

Vertical spread’s maximum profit = (difference between the two strikes) – (amount paid for spread).

In this case, the difference between the two strikes equals $5.00. That $5.00 minus the $2.80 you spent on the spread leaves you with a maximum potential gain of $2.20, and represents a 78.5% return. The potential maximum loss is $2.80 or the full value of the investment.

A short vertical call spread is constructed by selling a call with a lower strike price, while simultaneously buying a call in the same month with a higher strike price. Since owning a vertical call spread created a long position for the owner, then the seller of the vertical call spread must be short. An investor who takes a short position anticipates a decrease in the price of a stock and is considered to be bearish on the stock. Thus, a short vertical call spread is considered a bearish position.

Using our example, say you are short 10 August 35 calls and long 10 August 40 calls. The short vertical spread is set up in the proper ratio and in the same month. For the sale of the spread you received $2.80. Your maximum potential gain is the $2.80 that you received from the sale and would be obtained if the stock closed $35 or below.

The maximum loss is calculated by taking the difference between the two strikes and subtracting the sales price of the spread from it. The difference between the two strikes is $5.00 (40-35). From that we subtract the price of the spread which is $2.80 and we are left with $2.20. This $2.20 is the maximum potential loss for a seller of this spread. The formula is given as: The difference between the two strikes – the price of the spread = total potential maximum loss.

The maximum profit for the seller of a vertical call spread is attained when the price of the stock closes at or below the lower priced strike. And the maximum loss is attained when the stock closes at the higher strike.

The vertical put spread functions in much the same way as the vertical call spread just in the opposite direction. Like the vertical call spread, the construction of the vertical put is done in a one to one ratio. The vertical put spread is constructed by purchasing one put and simultaneously selling another put in the same month but in a different strike.

A long vertical put spread is considered to be a bearish trade. This means that the purchaser of a vertical put spread is expecting the stock to go down. Further, a long vertical put spread is considered a debit spread which simply means that the purchaser had to put out money to buy the spread. Now, if the stock proceeds down, the spread’s value will expand. As stated before, a spreads maximum value is equivalent to the difference between the strikes. On the other hand a spreads minimum value is $0.

In the case of a put spread, maximum value is attained when the stock trades at or below the lower strike. Conversely, a put spread’s minimum value is attained when the stock trades to the higher strike.

For example, suppose we purchase the August 50-55 put spread for$3.00. To set up this trade, we would have bought the August 55 put and sold the August 50 put. If the stock trades down to 50 or below at expiration, the spread will be worth its maximum value of $5.00 (difference between the two strikes: 55-50).

Since you bought the spread for $3.00 and it is now worth $5.00, you have a $2.00 profit which represents a 66.6% profit on your $3.00 investment.

On the downside, the most you can lose is the $3.00 you spent for the spread and this will happen if the stock closes $55 or above. If the stock was to close at $55, the August 55 put would be worthless because it would be equal to the stock price thus valueless. The August 50 put would also be worthless being that it is $5.00 out-of-the-money. The difference between these two values would obviously be $0. Below, the chart shows the value of the spread at different stock prices.

A short vertical put spread is constructed by purchasing a put with a lower strike price while simultaneously selling a put with a higher strike in the same stock in the same month and in a one to one ration. For example buying one Feb 65 put while selling one Feb 70 put or buying 10 May 20 put while selling 10 May 30 put. It is considered to be a bullish trade because the seller expects the stock to go up or increase in value. Further, it is considered a credit spread meaning that you receive cash into your account upon execution of the trade.

Say you were to sell the June 50 – 60 put spread for $5.50. As the seller, your maximum profit will be the $5.50 you received for the sale of the spread. The maximum profit will be attained if the stock closes at $60.00 or above. At that level, both the June 50 and 60 puts will be worthless because both will be out-of-the-money. Thus, the spread will have no value.

The maximum loss of the trade will be defined by the difference between the two strikes minus the amount you received from the sale of the spread. In this case, the difference between the strikes is $10.00 (60 strike – 50 strike). The spread was sold for $5.50 so $4.50 is the maximum loss of the position to the seller.

In conclusion, vertical spreads provide the buyer and the seller an excellent percentage return while, at the same time, provide limited loss scenarios. Vertical spreads allow for two types of bullish trades, the purchase of a vertical call spread or the sale of a vertical put spread. On the other hand, vertical spreads offer two bearish trades; the purchase of a vertical put spread and the sale of a vertical call spread.

So, if you want to take advantage of a directional stock movement (either up or down) but you are not interested in taking a longer term, possibly capital intensive position, then look to using the vertical spread due to its favorable risk reward scenario.

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Vertical Spreads

An Imaginary Spread Scenario

Let’s put together what we’ve been talking about, develop an imaginary spread scenario and set it in real life events.

In October, let’s say that you begin to hear about IJK stock. It looks interesting, so you then use a variety of sources to learn about IJK: news, charts, outside analysts, Internet research etc. From your investigations you decide that this stock is poised for a strong upward move and you’d like to take advantage of it.

However, each share is $50.00 and you question whether you want to put out the capital for enough shares to make the trade worthwhile.

Now is the time to investigate IJK spreads. Since you are bullish on the stock, you investigate the bullish plays of the call spreads and the put spreads. You check the pricing of both since you are aware that implied volatility and time decay will affect both your purchase price and your selling price if you decide to sell out the spread before expiration.

Let’s say that you set the spread’s maximum potential gain at $10.00 using our formula. Then you decide you want to buy a call spread, so you buy 10 IJK Nov. 50 calls and sell 10 IJK Nov 60 calls. The spread is called Nov. 50-60. The spread’s cost is $3.50, which means you pay $3500 for the trade, inexpensive when you consider that to purchase 1000 shares of IJK stock would have cost you $50,000!

Now, you wait and follow the stock price of IJK. If you hold the position to expiration, you face the following losses or gains.

First, if the stock does not move up as you expected and stays at $50 or decreases in value, your spread is worthless and you lose the $3500 that you paid for the spread. Second, if the stock begins to move up, you first recoup your investment and then move into profits. After the stock has moved up $3.50 you are at the breakeven point. Every money advance after that represents profit.

At any time until expiration, you can sell out of the spread but what you receive for the price may be influenced by implied volatility and time decay and that will change your profit or loss. If you hold the spread until expiration and your bullish lean proves true, your maximum profit on your $3500 investment is $6500.

You paid $3500 for the spread and received $10,000 at expiration with the stock at $60.00. That represents a $6500 profit which is a 186% return.

If you had invested $50,000 for 1000 shares of IJK and at expiration sold the stock for $60,000, your profit is $10,000 for a 20% return.

For many investors the reward/risk scenario of the spread is attractive because investors can limit the capital at risk and the time of risk/reward exposure. The spread also offers protection if your lean is bullish or bearish. Finally, the spread has the potential of a large percentage return on investment.

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Vertical Spreads

Time Decay and Volatility Trading Opportunities

When vertical spreads are mentioned, they quite often come with monickers such as “bull” and “bear”. This lends most to think of vertical spreads as directional plays which is true. However, vertical spreads can be used to take advantage of two other potential trading opportunities – time decay and volatility movement.

If you are looking for a fully hedged way to take advantage of time decay, a vertical spread can be an excellent tool. Knowing a little about them now, you will recall that a vertical spread has a limited profit potential but also a limited loss scenario for both the buyer and the seller. So, how do we use this covered trade to take advantage of time decay.

At-the-money options have more extrinsic value than their similar month in-the-money or out-of-the-money options. Since it is an option’s extrinsic value that decays away over time, you could set up a vertical spread by selling an at-the-money option and buying either the out-of-the-money option (creating a credit spread) or buying an in-the-money option (creating a debit spread). If the stock holds tight to the out-of-the-money option, the option’s extrinsic value will decay away at a faster rate than either the in-the-money option or the out-of-the-moneyoption due to the fact that the at-the-money option has more total extrinsic value to decay in the same amount of time as the others.

Creating the vertical spread by selling an at-the-money option and buying an out-of-the-money or in-the-money option as a hedge looks like a good idea, but now there are a couple choices. Should you do the put spread or the call spread? Should you buy it or sell it? The decision of what to do from here should first be based on which way you think the stock will move. Although you are playing for time decay and you are assuming an overall lack of movement, you can’t expect the stock not to move at all.So even though you are playing time decay, you still want to form an opinion about in which direction the stock is most likely to move. By doing this, you’ve now give yourself another way of making the trade profitable. You are playing for a lack of movement but now you can still win if you pick the right direction. This scenario presents you with two ways to win and only one to lose.

Now that you have picked which at-the-money strike you are going to sell and you’ve picked your anticipated stock position you still have a decision to make. Do you do the call vertical spread or the put vertical spread? Remember both the vertical call spread and a vertical put spread allow you to participate in either stock direction. For the bulls, you can buy a vertical call spread or sell a vertical if you think that the stock will go up. For the bears, you can buy a vertical put spread or sell a vertical call spread. For each direction there are two choices to decide from. One is a purchase, one is a sale. The best way to decide which to do, other than your own style or comfort ability is a simple risk/reward analysis.

By selecting an at-the-money option to sell as part of a vertical spread, an investor can execute a time decay play with a hedged position.

Much in the same way that a vertical spread can be used as a time decay play, it can be used as a volatility play. We stated earlier that an at-the-money option has more extrinsic value than any other option in its expiration month. This is due to a number of contributing factors including time but it is in no small way due to volatility. Volatility is a huge component of an option’s extrinsic value. An option’s dollar sensitivity to movements in implied volatility is known as vega. Obviously, an at-the-money option will have a higher vega (volatility sensitivity) then will an in-the-money or out-of-the-money option in the same month.

As volatility increases, the at-the-money option will increase in price to a greater degree than will an in-the-money or out-of-the-money option in the same month. As volatility increases, the at-the-money option will increase in price to a greater degree then will an in-the-money or out-of-the-money option whose vega’s will be less. Conversely, the at-the-money option will lose value at a greater rate than an in-the-money or out-of-the-money option should implied volatility decrease. The question now is how to use the vertical spread to take advantage of anticipated movements in implied volatility. Remember, the vertical spread affords you the luxury of being hedged on either side of the trade – both as a buyer and a seller of the spread.

So, if you think that implied volatility is likely to increase, you can set up a vertical spread by buying an at-the-money option and selling either the in-the-money or out-of-the-money option against it. Conversely, if you feel implied volatility will decrease; you can set up a vertical spread by selling an at-the-money option and buy either an out-of-the-money or an in-the-money option against it.

As to how to set it up, you would follow the same guidelines as you would for setting up a vertical spread to take advantage of time decay. Decide which direction you feel the stock would most likely move. If you feel the stock would most likely rise, you will have to decide between buying a vertical call spread and selling a vertical put spread.

Either way, the spread will have to be constructed with the at-the-money option being long if you feel volatility will increase or short if you feel volatility will decrease. If you feel the stock would most likely fall, you will have to decide between buying a vertical put spread and selling a vertical call spread. Again, either way, the spread will have to be constructed with the short option being the at-the-money.

As you can see, the vertical spread does not have to be used only in directional scenarios. It is very versatile allowing the investor several choices among a diverse group of potential uses. It also affords limited risk, albeit limited profit potential, to both the buyer and the seller.

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Vertical Spreads

Getting Out or Rolling the Position

The selection and management of a vertical spread are only two-thirds of the game. Closing out, rolling or morphing the position has to be analyzed and executed with the same due diligence as was used in the selection and management processes.

Looking at the closing out of a vertical call spread, we find there are three possible outcomes that must be addressed. The spread can finish out-of-the-money and valueless. For a call spread, this scenario occurs when the stock closes at or below the lower strike of the spread. In this scenario, in order to close out the spread, one would just let it expire. Both options finish out of the money so no residual position will be left over.

If the spread finishes fully in the money, (at maximum value) that is with both options in-the-money, then both options will be exercised. You will exercise your long call and your short call will be assigned. They will cancel each other out and you will be left with no residual position. This scenario occurs when the stock price closes lower than the lower strike call involved in the spread.

The difficult scenario is when the stock closes in between the two strikes of the spread. This scenario, the closing of the stock between the two strikes creates a situation where one strike winds up being in-the-money while the other ends up out-of-the-money.

When both options expire in-the-money, they are both exercised-one creating a long stock option, the other creating a short position thus canceling each other out. This is not the case here. Here, one option, the one that is in-the-money will leave a residual stock position and since the other option is out-of-the-money, it will not be able to be used to offset the residual stock position created by the expiring in-the-money option.

There are two actions that could be taken. Choice number one involves trading out of the spread on expiration Friday just before the close. Because of the bid/ask spread of the two options, you will probably have to give away some of your profits in order to close out the position. Giving up a portion of the profits may be the best thing to do in order to avoid naked, unlimited risk.

If you only trade out of the in-the-money option, you run the risk (albeit short-lived because you are doing this late on expiration day of the expiring month) that the stock moves adversely and the out-of-the-money option suddenly becomes in-the-money. If that happens, you will now be naked the residual stock position. Of course, if there is still time, you could always trade out of the option then but that is very risky. However, if the stock is at a relatively safe distance from the out-of-the-money you may want to just close out the in-the-money option and let the out-of-the money option expire worthless.

The two factors that must be considered are: the combination of the distance of the strike from the stock price in relation to the short amount of time for the stock to get there, and the amount of money saved by not buying back the out-of-the-money option. Remember, this is being done at the very end of the day on expiration day. These options only have minutes of life left.So, knowing this, the risk is somewhat mitigated, but still there none the less.

The catch is the proximity of the stock to the out-of-the-money option. If the stock is close to the out-of-the-money option, you would be best advised to trade out of the spread entirely.

Again, as stated before, if the stock closes either with the spread fully in-the-money, or fully out-of-the-money, the position will adjust itself through the exercise process leaving no residual position. If the stock price finishes between the two strikes, there will be a residual position. We discussed above how to trade out of this position. Your second choice is not to trade out and allow yourself to go through the expirationprocess. You must remember that if you are going to accept a residual stock position, you must be able to afford it.

Then, if you have 10 July 50 calls and you exercise them you will be receiving 1000 shares of stock at $50.00 per share. Thus, you must have $50,000.00 of cash and/or margin in your account to receive the stock. If you do not have enough cash and/or margin to accept delivery of the stock, then you must trade out of the position before it expires.

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Vertical Spreads

Factors That Affect Spread Pricing

The determination of pricing as described above works in most cases but please be aware that this assumes that the implied volatility in both the 35 and 40 calls is the same. Most of the time, these two options will have a slightly different implied volatility.

This intra-month difference in implied volatility values through different strikes is known as a vertical volatility skew. The reason the markets run volatility skews is to make sure that out-of-the-money options have enough premium in them to justify the individual option’s risk/reward scenario. Volatility skewness will be covered in more depth in the future releases where we will cover the Option Pricing Model and the Greeks.

For now, it is enough to know that there is a volatility skew, but as long as it is a tight skew (little deviation of implied volatility from strike to strike) the values should hold pretty consistent in our previous examples.

Whatever factors effect the vertical spread, they are contingent on where the stock is in relation to the spread. Changes in implied volatility affect the price of a spread as stated above but the position of the stock in relation to the strikes of the spread are a key determinate of price.

Volatility

To get a good feel for volatility’s effect on vertical spreads, we will look at three different spreads, against three differentimplied volatilities while keeping the stock price constant at 67 ½. The three spreads we will be looking at will be the 60 – 65 call spread, the 65- 70 call spread and the 70 – 75 call spread.

Looking at the in-the-money spread (June 60 – 65) we see that as volatility increases, the value of the spread decreases. This is because with the increased volatility, the stock will have a greater tendency to move around and that will bring a higher likelihood of the stock moving to a price where the June 60 – 65 call spread will no longer be in-the-money.

To adjust for higher volatility risk, the spread will have less value. The rule of thumb is that as volatility increases, the value of in-the-money vertical spreads decrease. Vice-versa, as volatility decreases, an in-the-money vertical spread’s value increases.

The at-the-money vertical spread (June 65 – 70) will see very little effect with the change in volatility. With the stock price located equidistant from the two strikes, each strike’s volatility component will be very similar. Thus, when volatility increases both options will increase equally. Being long one and short the other, the increase in values will offset each other so the spreads value will hold pretty constant. The rule of thumb is that when volatility increases or decreases, the value of an at-the-money vertical spread will stay reasonably constant.

The out-of-the-money vertical spread (June 70 – 75) has the opposite effect of the in-the-money vertical spread (June 60 – 65). As volatility increases, the value of the out-of-the-money vertical spread will increase. This is because the increase in volatility assumes that the stock price will be more likely to move and thus the out-of-the-money vertical call spread will be more likely to finish in-the-money.

Because of the increased potential of this spread’s ability to finish in-the-money, the value of the spread will increase. However, if volatility decreases, the value of the spread will decrease. The rule of thumb is that when volatility increases, an out-of-the-money vertical spread’s value increases. When volatility decreases, the spread’s value decreases.

When trying to estimate how your spread will change in price with volatility movement, you must understand how the price and delta of both of your options, (the long option and the short option) will act.

It bears repeating again that each spread is different and will act differently depending on where the stock is in relation to the spread and what implied volatility does.

A good rule of thumb is that when volatility increases, spreads crunch to their median value. For example, the median value of afive dollar spread will be $2.50 while a $10.00 spread will havea $5.00 median value. Crunching to the median value means that a $5.00 spread that has a medium value over $2.50 will lose value and head toward the median price. That happens with an increase in volatility. Meanwhile, that increased implied volatility will make a spread with a value less than $2.50 increase in value, heading up toward median value. When implied volatility decreases, the value of a $5.00 spread will move away from the median price of $2.50. So, when implied volatility decreases, all the spreads valued above $2.50 will increase in value toward maximum value, while spreads valued below $2.50 will lose value and head toward $0.

Time effects the spread differently depending on where the stockis. As an example, we will look at the QCOM 65 – 70 call spread.We view the spread over time and across three different stock prices. First, let’s look at the spread’s reaction to thepassing of time with the stock price of $65.50.

With the stock at $65.50, the spread has $.50 of intrinsic value. Holding the stock price frozen at $65.50 until expirationthe spread would be worth $.50. As seen by the table above, the spread loses value as time passes and decreases in value toward it’s $.50 intrinsic value.

Next, we will look at the 65 – 70 spread’s reaction to the passage of time with the stock priced at $67.50.

As you can see, with the stock price located directly in between the two strikes, the price of the spread holds at approximately $2.50 throughout the passing of time. As a rule of thumb, time has very little effect on a vertical spread when the stock pricelies half-way (equidistant) between the two strikes of the spread.

Now, we set the stock price at $69.50 and observe how the spread reacts over time.

The chart shows that as time passes, this spread increases in value. With the stock at $69.50, the spread has an intrinsic value of $4.50. If the stock held at $69.50 until expiration, the spread would be worth $4.50 because that is the amount of intrinsic value the spread has. As time passes, the spread’s value will increase to finally reach $4.50 at expiration.

In conclusion, time’s effect on a vertical spread is contingent on where the stock is in relation to the spread.

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Vertical Spreads

Spread Prices

During the life of a vertical call spread, the spread will trade between its minimum and maximum values (between 0 and the difference between the two strikes). In the case of a vertical call spread, the spread will trade closer to zero when the stock trades closer to or lower than the lower strike price. The spread will trade closer to maximum value when the stock trades closer to or higher than the higher strike price.

A general rule of thumb is: if the stock price is located evenly between the two strike prices, the vertical spread should be worth roughly half of the value of the distance between the two strikes. This will be true for vertical put spreads as well as call spreads. From this rule, we can roughly estimate the vertical spread’s price per different stock prices.For vertical call spreads, if the spread is worth roughly half of the difference between the two strikes with the stock price directly between the two strikes, then as the stock falls to lower strike and beyond, the spreads value will decrease and move closer to $0. Time left until expiration and volatility will dictate how close and how quickly it will approach $0. On the other side, as the stock climbs toward and above the upper strike, the spreads value will increase toward its maximum valuedescribed by the difference between the two strikes.

For vertical put spreads, as the stock price decreases toward the lower strike price, the spread will increase in value and approach its maximum value as defined by the difference between the two strikes. As the stock price increases toward the higher strike, the spread will decrease in value and will approach $0. Again, time until expiration and volatility will determine how quickly and how close the spread will approach $0.

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Vertical Spreads

Cost Relationship between Corresponding Put Spreads and Call Spreads

We have demonstrated that vertical spreads have intrinsic value,and that we can roughly determine their value by comparing stockprice to strike prices. There is another relationship that can help investors determine value. That is the relationship that exists between corresponding vertical spreads.

When we use the term corresponding we mean the same month, the same strikes in the same stock. The only difference is between calls and puts. For example, the XYZ Sept. 30 – 35 vertical callspreads’ corresponding spread would be the XYZ Sept. 30 – 35 vertical put spread. Similarly, the ABC June 70 – 80 put spreads’ corresponding spread would be the ABC June 70 –80 call spread.

The importance of understanding the relationship of corresponding vertical spreads is that the sum of a vertical call spread and its corresponding vertical put spread is going to be equal to the difference between the two strikes.

If the April 30 – 35 call spread trades at $2.00, then the April30 – 35 put spread will be worth $3.00. Let’s review this. The difference of the two strikes is $5.00 and the cost of the call spread is $2.00. That means the cost of the put spread will be $3.00.

From this we can calculate the price of any spread. Pick any vertical spread. Now, calculate the value of a vertical call spread or a vertical put spread. Once you’ve done that, calculate the value of its corresponding vertical spread. Add the two spreads together and see if that sum is equal to the difference between the two strikes. Perform the calculations several times on different vertical spreads. Try it on $5, $10 and even $15 spreads.

It is not necessary to understand the rationale for why this works at this time. It will be covered in a future Options University release. For now, it is important to understand that these spreads are related and the price of one can help you calculate the price of the other.

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Vertical Spreads

Vertical Call Spread and Vertical Put Spread Value

Any spread that has intrinsic value is considered in-the-money. How can you identify the value of a vertical call spread or a vertical put spread? Compare the stock price to the strike prices.

Look at any vertical call spread. If the stock price is above the lower strike of the spread, then the spread is in-the-money.For example, in the Feb. 50 – 55 call spread, if the stock is trading at $52.00, then the spread would be in-the-money by $2. This is because if the spread expired today, the Feb. 50 calls would finish $2.00 in-the-money. The Feb. 55 calls would finish worthless because they are out-of-the-money. The spread, however, would be in-the-money with a value of $2.00.

The rule is similar for determining whether or not a spread is out-of-the-money. If the stock price is lower then the lower strike of the spread, then the spread is out-of-the-money. Again, looking at the Feb. 50 – 55 call spread, if the spread expired today and the stock price closed at $48.00, (lower than the lower strike) then the spread would be out-of-the-money, thus the spread will be out-of-the-money. And, of course, if thestock is trading at the same price as the lower strike price, then the spread will be considered at-the-money.

For vertical put spreads, a spread is determined to be in-the-money if the stock price is lower than the higher of the two strikes of the spread. For example, let’s look at the Sept. 40 – 45 put spread. If the stock were to close at $42.00 on expiration day, the Feb. 45 put would end up in-the-money and worth $3.00. The Feb 40 puts would be out-of-the-money creating a $3.00 intrinsic value for the spread. Since the spread has an intrinsic value, it is in-the-money.

A vertical put spread is considered to be out-of-the-money if the stock price is higher than the higher strike of the spread. So, going back to our Sept. 40 – 45 put spread example, if the stock was to close at a price of $46.00 (higher than the higher strike) then both the Sept. 40 and 45 put will expire worthless.Thus the spread will be worthless and out-of-the-money.

A vertical put spread is considered at-the-money when the stock price is equal to the higher strike price.

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July 24, 2006

Vertical Spreads

Intrinsic Value and the Vertical Spread

In looking at vertical spreads, an investor must take note of the fact that vertical spreads have an intrinsic value. This means that a vertical spread can be considered to be “in-the-money”. If a vertical spread has an intrinsic value then it can also have an extrinsic value. The maximum extrinsic value in a spread will deviate from spread to spread based on several factors. However, the maximum intrinsic value will equal the exact difference between the strikes at expiration as stated earlier. During a vertical spread’s life, its price will fluctuate between 0 and the value of the difference between the two strikes. The price of the spread, at any given time can be determined by the location of the stock and the time until expiration. At expiration, of course, all that will be left in terms of value for the two options will be the intrinsic value of each. Thus, the value of the spread will be the difference between each option’s intrinsic value at expiration.

Because vertical spreads have an intrinsic value, the term “moneyness” can be applied to them. Moneyness refers to whether or not and by how much an option, or a vertical spread, may be in-the-money or out-of-the-money. This is a term used mostly by floor traders, but is worth noting here.

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Vertical Spreads

Construction of a Vertical Spread

A vertical spread is constructed by the purchase of a call (or put) and the sale of a call (or put) in the same stock and in the same month. The only difference between the two options is the strike price. For instance, a vertical spread can be constructed by purchasing the IBM June 55 call while selling the June IBM 60 call. This trade would be called the IBM June 55 – 60 call spread. Similarly, a purchase of the IBM July 45 put and sale of the IBM July 60 put would be called the IBM July 45 – 60 put spread.

The key to the construction of vertical spreads is that you choose the options that are in the same stock, same month, but different strikes and in a 1 to 1 ratio. That is, you must purchase one option for every one you sell or sell one option for every one you buy.

Value and the Vertical Spread

A vertical spread’s maximum value is the difference between the two strikes. For example, the maximum value of the June 55 – 60 call spread is $5.00. [60 – 55] = $5.

Using the June 55 – 60 call spread example, we will set the date to June expiration on Friday. On that day, all the June options will expire and the options will be worth parity, as all of the extrinsic value will have eroded away.

Where does the spread get its value? Basically, from its two components – the call (or put) you buy or the call (or put) you sell. Let’s look at the spread’s value with a couple of different closing stock prices. If the stock closes at $55, then both the 55 strike and the 60 strike will be out of the money and thus worthless. The value of the spread will be zero as both options are worth $0. If the stock closes at $57.50, the June 55 calls will be worth $2.50. The June 60 calls will be out of the money and thus worthless, therefore the spread will be worth $2.50 (June 55 call $ 2.50 – June 60 call $0).

If the stock closes at $60.00, then the June 55 calls will be worth $5.00. Meanwhile, the June 60 calls will be worth $0. This means that the spread will be worth $5.00 (June 55 call $ 5.00 – June 60 call $0). This is the maximum value of the spread. Note that the maximum value is identical to the difference between the strikes.

As the stock goes higher, the June 60 call becomes in-the-money and gains intrinsic value. Now, for every penny that the stock increases in value, the June 55 calls and June 60 calls gain value equally, keeping the $5.00 spread between the two strikes constant.

The difference between the strikes is the maximum value of all vertical spreads regardless of the distance between the two strikes. It does not matter whether the spread is $5.00 wide, $10.00 wide, $20.00 wide, or even $50.00 wide; its maximum value is the difference between the two strikes. Further, the vertical spread’s maximum value (the difference between the two strikes) holds true for vertical put spreads as well as vertical call spreads. Look at our other example, the July 45 – 60 put spread.

Again we set time forward to Friday, July expiration. We set the stock closing price at $60.00. At $60.00, both the July 45 puts and the July 60 puts will be out of the money and thus worthless. With both the July 45 puts and July 60 puts worthless, the spread is also worthless (July 60 put $0 – July 45 put $0). If the stock finishes at $52.50, then the July 60 puts will be worth $7.50 while the July 45 puts will still be worthless. In this scenario the July 45 – 60 put spread will be worth $7.50 (July 60 puts $7.50 – July 45 puts $0). If the stock finishes at $45.00, then the July 60 puts will be worth $15.00 while the July 45 puts will be worth $0.

At this level, the spread will be worth $15.00 (July 60 puts $15.00 – July 45 puts $0). This is the maximum value of the spread. As you can see it is identical to the $15.00 difference between the strikes. As the stock goes lower, the July 45 puts become in-the-money and gain intrinsic value. Now, for every penny that the stock decreases in value, the July 60 puts and the July 45 puts will gain value equally, keeping the $15.00 spread between the two strikes constant.

As stated, the maximum value of a vertical spread is the difference between the two strikes while the minimum value of the spread is, of course, $0. This means that in this strategy, both the buyer and the seller have a limited, fixed maximum loss. The buyer can only lose what he spent. So, if the buyer spent $2.20 to purchase the August 35 – 40 call spread, the most he can lose is the $2.20 he spent.

For the seller, the maximum loss is the difference between the maximum value of the spread (difference between the strikes) and the amount of money received for the sale of the spread. For example, if you were to sell the August 35 – 40 call spread for $2.20 then your maximum loss will be $2.80. Remember, the maximum value of the spread is the difference between the two strikes or $5.00 (40 – 35).

The difference between the maximum value of the spread ($5.00) and the amount the seller received for the sale ($2.20) leaves a $2.80 maximum loss.

In conclusion, it is important to understand and remember that vertical spreads have both a limited profit and a limited loss scenario for both the buyer and the seller.

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Vertical Spreads

There are two main types of vertical spreads. There is the vertical call spread and the vertical put spread. Each spread allows you to do two things. First, you can buy it, making you long the vertical spread. Second, you can sell it making you short the vertical spread. Both can be employed to take advantage of directional stock plays. When we use the term “directional stock play,” we refer to using vertical spreads to capitalize on anticipated stock movements either up or down.

A bull spread is used when the investor feels that a stock is most likely to go up. As we recall, “bullish” means to have a positive outlook on a stock’s future movement. There are two ways to set up a bull spread. The first is with the use of calls. In this case, a bullish investor would buy a vertical call spread (bull call spread). This is accomplished by buying a call with a lower strike price and selling a call with a higher strike price.

The second way to construct a bull spread is with the use of puts. A bullish investor could sell a vertical put spread (bull put spread) hoping to profit from an increase in the stock’s value. The investor would sell a put with a higher strike price and buy a put with a lower strike price.

To recap, if you feel a stock will be increasing in value, you may put on a bull spread by either buying a vertical call spread (bull call spread) or selling a vertical put spread (bull put spread)

A bear spread, however, is used when, you the investor, feels a stock is likely to trade down. Remember, “bearish” means that one’s outlook on the future movement of the stock is negative. To take advantage of this expected downward movement, the investor would put on a bear spread. This can be done in either of two ways.

First, the investor can do it using puts. The purchase of a vertical put spread (bear put spread) can be accomplished by purchasing a put with a higher priced strike and selling a put with a lower priced strike.

The second way an investor can construct a bear spread is by using calls, specifically, by selling a vertical call spread (bear call spread). You do this by selling a call with a lower strike price and purchasing a call with a higher strike price.

So if you think that a stock is likely to decrease in value, you sell a vertical call spread (bear call spread) or purchase a vertical put spread (bear put spread).

Finally, there are two fundamentals that are universal to all vertical spreads. These fundamentals are critical to understanding the foundation of the vertical spread strategy: (1) you can determine a vertical spread’s maximum value by taking note of the difference between the two strikes and (2) vertical spreads have intrinsic value.

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Option Spread Trading

We have demonstrated how well options function in unison with a stock position. They enhance potential gains, provide profit protection and limit the risk of the entire investment. They enable us to manage risk in a single stock as well as an entire portfolio. But, as good as options are in conjunction with stocks, they can be even better when traded against each other.

Spreads are strategies that do not involve the use of any security other than another option. Their positives are that they are inexpensive, offer protection for both buyer and seller and are in effect automatically hedged trades.

Spreads can provide large percentage returns with low risk and can be entered into with small capital outlay. A spread involves the purchase of one option in conjunction with the sale of another option. There are many types of spreads. Some take advantage of stock movements while others are set up to take advantage of movements in implied volatility and even time decay. There are calendar or time spreads, diagonal spreads, ratio spreads and also vertical spreads, which we will discuss in depth here.

Spreads are more advanced and sophisticated than the strategies discussed in our beginner product “OPTIONS 101.” Where certain spreads, like 1 to 1 vertical spreads, can be less risky than a buy-write, there are more variables to consider and control which makes trading the spread more complicated.

When you trade a spread you are dealing with three elements: the spread as a whole (which you can buy or sell) and its component parts – the option you buy and the option you sell.

Although the cost of most spreads is relatively inexpensive to initiate, they can provide a large percentage return and there is protection (limits) to both sides of the trade. Therefore, even experienced investors can profit from learning about spreads and their investment potential.

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Time/Diagonal Spreads

Closing the Time Spread Position

It is important to remember that the time spread will leave you with several potential positions that can be altered by other options or stock in numerous ways. There are a number of decisions you must make to clarify your understanding and goals.

First, it is important to understand what position you are going to be left with when the near month option expires.

Second, you must form your opinion of what you think the stock is going to do (formulate a bullish or bearish lean) and then figure out the best way to take advantage of that opinion.

Next, you must figure out how to adjust your present position and change it into an advantageous position for a profitable outcome. That might mean selling out of the position totally. Your changes to the position must not only be correct, but also done in the most efficient, cost-effective manner including keeping commission prices down.

It is also important to note that you should make sure to go from a hedged position to another hedged position to ensure proper risk management.

Concluding Thoughts

The time spread is an excellent strategy for premium sellers who want to capture premium in a hedged way. It is best used in stagnant periods when a stock is likely to remain in a tight price range. It is less expensive and less risky than most other premium collecting strategies thus is friendlier to investors who are short on capital and experience. It can also be used to take advantage of volatility changes and even some directional stock movements.

The time spread can leave you with a residual naked position that needs to be managed for risk at expiration of the front month option. As always, it is important to fully understand the risks and rewards of the strategy and the potential risks and solutions of the residual position before executing the strategy.

The residual position does allow you many choices including closing out the position totally, or continuing the position by combining it with either stock or another option to create a new position that fits the investor’s new expectations for the stock.

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