A derivative is a financial instrument whose return is derived from the return on another instrument.

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Introduction

• A derivative is a financial instrument whose
  return is derived from the return on another
  instrument.
• Size of the derivatives market at year-end 2001
  3.8 trillion in market value
• All financial institutions can make some
  productive use of derivative assets
• Use of Derivatives
• Risk ManagementHedging and tuning risk to an
  acceptable level
• Speculation and tactical asset allocationMaximize
  thrust in a given asset class
• Of course, arbitrage operations from temporally
  mispriced securities
• Operational Advantages Low transaction costs,
  very liquid, can be written (short-sold) easily

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Categories of Derivatives

• Futures
• Listed, OTC futures
• Forward contracts

• Options
• Calls
• Puts

Derivatives

• Swaps
• Interest rate swap
• Foreign currency swap

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Options

• Option terminology
• price/premium
• call/put
• exchange-listed over-the-counter options
• An option is the right to either buy or sell
  something at a set price, within a set period of
  time
• The right to buy is a call option
• The right to sell is a put option
• You can exercise an option if you wish, but you
  do not have to do so

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Futures Contracts

• Futures contracts involve a promise to exchange a
  product for cash by a set delivery date. So,
  futures contracts deal with transactions that
  will be made in the future.
• A futures contract involves a process known as
  marking to market
• Money actually moves between accounts each day as
  prices move up and down
• A forward contract is functionally similar to a
  futures contract, however
• There is no marking to market
• Forward contracts are not marketable
• Exclusively over-the-counter

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Swaps

• Swaps are arrangements in which one party trades
  something with another partyi.e. cash flows
• The swap market is very large, with trillions of
  dollars outstanding
• In an interest rate swap, one firm pays a fixed
  interest rate on a sum of money and receives from
  some other firm a floating interest rate on the
  same sum
• Popular with corporate treasurers as risk
  management tools and as a convenient means of
  lowering corporate borrowing costs
• In a foreign currency swap, two firms initially
  trade one currency for another
• Subsequently, the two firms exchange interest
  payments, one based on a foreign interest rate
  and the other based on a U.S. interest rate.
  Finally, the two firms re-exchange the two
  currencies

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Product Characteristics

• Both options and futures contracts exist on a
  wide variety of assets
• Options trade on individual stocks, on market
  indexes, on metals, interest rates, or on futures
  contracts
• Futures contracts trade on products such as
  wheat, live cattle, gold, heating oil, foreign
  currency, U.S. Treasury bonds, and stock market
  indexes
• The underlying asset is that which you have the
  right to buy or sell (with options) or the
  obligation to buy or deliver (with futures)
• Listed derivatives trade on an organized exchange
  such as the Chicago Board Options Exchange or the
  Chicago Board of Trade
• OTC derivatives are customized products that
  trade off the exchange and are individually
  negotiated between two parties
• Options are securities and are regulated by the
  Securities and Exchange Commission (SEC)
• Futures contracts are regulated by the Commodity
  Futures Trading Commission (CFTC)

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Derivative Usage

• Hedging If someone bears an economic risk and
  uses the futures market to reduce that risk, the
  person is a hedger
• Speculating A person or firm who accepts the
  risk the hedger does not want to take is a
  speculator. Speculators believe the potential
  return outweighs the risk
• The primary purpose of derivatives markets is not
  speculation. Rather, they permit the transfer of
  risk between market participants as they desire
• Arbitrage is the existence of a riskless profit.
  Arbitrage opportunities are quickly exploited and
  eliminated. Persons actively engaged in seeking
  out minor pricing discrepancies are called
  arbitrageurs. Arbitrageurs keep prices in the
  marketplace efficient

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Application of Derivatives

• Risk managementThe hedgers primary motivation
  is risk management
• Someone who is bullish believes prices are going
  to rise. Someone who is bearish believes prices
  are going to fall. Then, we can tailor our risk
  exposure to any points we wish along a
  bullish/bearish continuum
• Income generation Writing an option is a way to
  generate income. It involves giving someone the
  right to purchase or sell your stock at a set
  price in exchange for an up-front fee (the option
  premium) that is yours to keep no matter what
  happens. Popular during a flat period in the
  market or when prices are trending downward
• Financial engineering refers to the practice of
  using derivatives as building blocks in the
  creation of some specialized product. Financial
  engineersSelect from a wide array of puts, calls
  futures, and other derivatives and know that
  derivatives are neutral products (neither
  inherently risky nor safe)

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OPTIONS
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Options Basics

• A call option gives its owner the right to buy
  it is not a promise to buy. A put option gives
  its owner the right to sell it is not a promise
  to sell.
• An American option gives its owner the right to
  exercise the option anytime prior to option
  expiration. A European option may only be
  exercised at expiration
• Options giving the right to buy or sell shares of
  stock (stock options) are the best-known options.
  An option contract is for 100 shares of stock
• The underlying asset of an index option is some
  market measure like the SP 500 index.It is
  Cash-settled
• Option characteristics
• Expiration datesThe Saturday following the third
  Friday of certain designated months for most
  options
• Striking price The predetermined transaction
  price, in multiples of 2.50 or 5, depending on
  current stock price
• Underlying Security The security the option
  gives you the right to buy or sell. Both puts and
  calls are based on 100 shares of the underlying
  security

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Opening and Closing Transactions

• The first trade someone makes in a particular
  option is an opening transaction
• When the individual subsequently closes that
  position out with a second trade, this latter
  trade is a closing transaction
• When someone buys an option as an opening
  transaction, the owner of an option will
  ultimately do one of three things with it
• Sell it to someone else
• Let it expire
• Exercise it1)Notify your broker 2) Broker
  notifies the Options Clearing Corporation who
  selects a contra party to receive the exercise
  notice
• The option premium is not a down payment on the
  purchase of the stock
• The option holder, not the option writer, decides
  when and if to exercise
• In general, you should not buy an option with the
  intent of exercising it
• When someone sells an option as an opening
  transaction, this is called writing the option
• No matter what the owner of an option does, the
  writer of the option keeps the option premium
  that he or she received when it was sold

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The Role of the Options Clearing Corporation (OCC)

• The Options Clearing Corporation (OCC)
  contributes substantially to the smooth operation
  of the options market
• It positions itself between every buyer and
  seller and acts as a guarantor of all option
  trades
• It sets minimum capital requirements and provides
  for the efficient transfer of funds among members
  as gains or losses occur

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Exchanges

• Major options exchanges in the U.S.
• Chicago Board Options Exchange (CBOE)
• American Stock Exchange (AMEX)
• Philadelphia Stock Exchange (Philly)
• Pacific Stock Exchange (PSE)
• International Securities Exchange (ISE)
• Bid Price and Ask Price
• Types of orders
• A market order and limit order ( specifies a
  particular price (or better) beyond which no
  trade is desired. It requires a time limit, such
  as for the day or good til canceled (GTC)
• Margins

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Option Terminology

• Option right to buy or sell an asset at a fixed
  price and by a specific time.
• Call Option right to buy the underlying asset.
• Put Optionthe right to sell the underlying
  asset.
• Exercise Price (Strike Price or X) Fixed price
  at which the underlying asset can be bought or
  sold.
• Option Premium (Ccall Pput) Price of the
  option itself.

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The Option Premium Intrinsic Value Time Value

• Intrinsic value is the amount that an option is
  immediately worth given the relation between the
  option striking price and the current stock price
• For a call option, intrinsic value MAX(0,stock
  price striking price)
• For a put option, intrinsic value MAX(0,striking
  price stock price)
• Intrinsic value cannot be lt zero
• Out, at and in-the -money
• An option with no intrinsic value is
  out-of-the-money
• An option whose striking price is exactly equal
  to the price of the underlying security is
  at-the-money
• Options that are almost at-the-money are
  near-the-money
• An option whose striking price is positive is
  in-the-money
• Time value is equal to the premium minus the
  intrinsic value
• As an option moves closer to expiration, its time
  value decreases (time value decay)
• AKA speculative value
• Difference between option premium and intrinsic
  value.
• Speculative value0 at maturity
• Before, speculative value the chance that the
  option will expire in-the-money e.g., the
  intrinsic value is greater than zero!

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Intrinsic Value of Option

• Value if option is exercised immediately
  Intrinsic value
• Call option MAX(0,S-X)
• Put option MAX(0,X-S)
• In-the-money
• Call SgtX
• Put XgtS
• Out-of-the-money
• Call SltX
• Put XltS
• At-the-money XS

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Illustration Assume that you bought a call
option 3 months ago at 10 with a strike at 100
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Illustration 2 Assume that you sold a call
option 3 months ago at 10 with a strike at 100
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Expiration Date Payoffs to Long and Short Call
Positions
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Illustration 3 Assume that you bought a put
option 3 months ago at 10 with a strike at 100
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Illustration 4 Assume that you sold a put option
3 months ago at 10 with a strike at 100
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Expiration Date Payoffs to Long and Short Put
Positions
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Portfolio Risk Management

• Rational
• How
• Narrowing the distribution
• Diversification between classes
• Beta positioning
• Skewing the distribution to the left with
  Options
• Covered call
• Escrowed puts
• 90/10
• Protective puts

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Put-Call-Spot Parity
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Put-Call-Spot Parity
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Put-Call-Spot Parity

• S P - C X(1 Rf)-T
• where
• Rf the annualized risk-free rate
• T the time to maturity in years
• Let X(1 Rf)-T the proceed of a T-bill with a
  face value of X
• Then
• (long stock) (long put) - (short call) (long
  T-bill)

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Creating Synthetic SecuritiesUsing Put-Call
Parity

• T-billS P - C
• Put X(1 Rf)-T - S C
• Call S P - X(1 Rf)-T
• Stock X(1 Rf)-T - P C

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Questions

• How can the put-call parity be used in the risk
  management framework?
• Determine the payoff of a position that
  consists of a long position in a put and a
  futures contract and a short position in a call
  (same exercise and maturity for the options same
  underlying asset for the futures)
• How can you use this information for risk
  management purpose?

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Combinations of Options

• Hedging
• Protective put
• Covered call
• Covering a Short position

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Protecting Portfolio Value with Put Options

• Protective puts
• Hedges downside losses
• Protective putSPCT-bill
• Example
• Portfolio value 100 million
• 3-month put quote on Nasdaq10052.96 (spot4000,
  strike4000)
• 1 Nasdaq contract is based on a price of 400,000
  (index price x 100400,000) the premium costs
  5,296 for 1 contract(100 x 52.6)
• you need 250 contracts ( to hedge/ of 1
  contract 100M/0.4M)
• 3-month put premium 1.324 million (250 x 52.96
  X100)

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Expiration Date Value of a Protective Put Position
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Simulated Portfolio Return Distributions
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Questions

• What would happen to our protected position, if
  we bought
• OTM puts?
• ITM puts?

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Another Example Protective Put

• RATIONAL Investors may anticipate
• a decline in the value of an
• Investment but cannot
• conveniently sell.
• OPERATION
• LONG PUT LONG STOCK
• INITIALLY,
• -So-Po
• AT MATURITY
• S(T)MAX(X-S(T),0)
• PROFIT (AT MATURITY)
• S(T)MAX(X-S(T),0)-So-Po
• EXAMPLE purchased Microsoft for 28.51 and a
  Microsoft APR 25 put for 1.10
• BREAKEVEN
• IF S(T)ltX, S(T)X-S(T)-So-Po0 ?NO SOLUTIONS FOR
  S(T)
• IF S(T)gtX, S(T)-So-Po0?S(T)SoPo28.511.129.61
  
• IN SUM
• -The maximum loss is 4.61
• -The maximum loss occurs at all stock prices of
  25 or below

S(T)? Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration
S(T)? 0 5 15 25 30 40
S(T)-So -28.51 -23.51 -13.51 -3.51 1.49 11.49
MAX(X-S(T),0)-Co 23.90 18.90 8.90 -1.10 -1.10 -1.10
PROFIT -4.61 -4.61 -4.61 -4.61 0.39 10.39
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Logic Behind the Protective Put

• A protective put is like an insurance policy
• You can choose how much protection you want
• The put premium is what you pay to make large
  losses impossible
• The striking price puts a lower limit on your
  maximum possible loss?Like the deductible in car
  insurance
• The more protection you want, the higher the
  premium you are going to pay
• A protective put is an example of a synthetic
  call

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Altering Portfolio Payoffs with Call Options

• Covered calls
• Call writer owns the stock S-CT-bill - P
• Benefits
• If you wish, the cash received from the sell of
  the calls shifts the downside potential up this
  is a dangerous strategy that may be used to
  profit in a neutral-bearish and low volatility
  market
• Danger
• Prices could fall very very badly.

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Example

• A fund manager writes covered calls against the
  100 million fund and receives the premium of
  2.813 million,
• The calls have been chosen so that the strike is
  100 million (ATM)
• if your portfolio follows the NASDAQ100, which
  is quoted at 4000, a 3-month at-the money
  option (strike is 4000) is priced at 112.52.
• 1 contract is 100 times the index, so a call with
  a strike at 4000 correspond to 400,000 and is
  priced at 11,252.
• You need to cover 100,000,000 thus, you need
  250 contracts (100m/0.4), which cost in total
  2.813 M (11,252 x 250).
• .

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Altering Portfolio Payoffs with Call Options
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Questions

• What are the advantages of a covered call
  strategy?
• Under what circumstance(s) would you use a
  covered call strategy Vs. a protective put
  strategy?
• Your portfolio is not traded in the option
  market only index options are traded. How would
  set the number of puts to buy or calls to sell in
  practice?

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HEDGING Covered Calls

• Rational Useful for investors anticipating a
  drop in the market but unwilling to sell the
  shares now
• Operation Long stock and short call
• Initially -SoCo
• At maturity S(T)-Max(S(T)-X,0)
• Profit at maturity -SoCoS(T)-Max(S(T)-X,0)
• Example Write a JAN 30 covered call on Microsoft
  _at_ 1.20 buy stock _at_ 28.51
• Break-even -SoCoS(T)-Max(S(T)-X,0)0
• If SltX, -SoCoS(T)0?S(T)So-C028.51-1.2027.31
• If SgtX, -SoCoS(T)-S(T)X0?No solution
• In sum The call premium cushions the loss. This
  is a synthetic short put.

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HEDGING Covering a short position

• Rational Call options can be used to provide a
  hedge against losses resulting from rising
  security prices?The potential for unlimited
  losses is eliminated
• Operation Short stock and long call
• Initially So-Co
• At maturity -S(T)Max(S(T)-X,0)
• Profit at maturity So-Co -S(T)Max(S(T)-X,0)
• Example Assume you short sold Microsoft for
  28.51and purchased an APR 35 call at 0.50 in
  addition to the short sale
• Breakeven So-Co -S(T)Max(S(T)-X,0)0
• If SltX, So-Co -S(T)0?S(T)So-Co28.51-0.528.01
• If SgtX, So-Co -S(T)S(T)-X0?No Solution
• In sum
• This is a synthetic put Many investors prefer
  the put
• The loss is limited to the option premium
• Buying a put requires less capital than margin
  requirements

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Bottom-lineEscrowed puts - writing put options
and investing in Treasury bills an amount equal
to the discounted strike price of the puts.
?(X-P)90/10 strategy- A method of investment in
which one places approximately 90 of his funds
in risk-free, interest-bearing assets such as
Treasury bills, and buys options with the
remainder 10.?XC
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Why Options Are a Good Idea

• Increased risk
• Instantaneous information
• Portfolio risk management
• Risk transfer
• Financial leverage
• Income generation

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Generate income with options Writing Calls

• Attractive way to generate income with
  foundations, pension funds, and other portfolios.
  Also, very popular activity with individual
  investors. Writing calls may not be appropriate
  when option premiums are very low (duh!) and the
  option is very long-term.
• Example of Covered calls You bought 300 shares
  of Microsoft at 22. You write three JAN 30 calls
  _at_ 1.20, or 120.00 on 100 shares.
• Profit Equation -SoCoS(T)-Max(S(T)-X,0)
• Breakeven -SoCoS(T)-Max(S(T)-X,0)0? Solution
  when S(T)ltX, that is S(T)So-Co22-1.220.8
• Observation same as short put?If prices advance
  above the striking price of 30, your stock will
  be called away and you must sell it to the owner
  of the call option for 30 per share, despite the
  current stock price. If Microsoft trades for 30,
  you will have made a good profit, since the stock
  price has risen substantially. Additionally, you
  retain the option premium.
• Writing Naked Calls are very risky due to the
  potential for unlimited losses
• Example of naked calls It is now September 15 a
  SEP 35 MSFT call exists with a premium of 0.05
  the SEP 35 MSFT call expires on September 19
  Microsoft currently trades at 28.51.A brokerage
  firm feels it is extremely unlikely that MSFT
  stock will rise to 35 per share in ten days. The
  firm decides to write 100 SEP 35 calls. The firm
  receives 0.05 x 10,000 500 now. If the stock
  price stays below 35, nothing else happens. If
  the stock were to rise dramatically, the firm
  could sustain a large loss.
• Profit EquationCo-Max(S(T)-X,0)
• Breakeven Co-Max(S(T)-X,0)0, when
  S(T)gtX,S(T)XCo350.0535.05

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Generate income with Puts

• A naked put means a short put by itself. A
  covered put means the combination of a short put
  and a short stock position?A short stock position
  would cushion losses from a short put Short
  stock short put short call
• Put overwriting involves owning shares of stock
  and simultaneously writing put options against
  these shares.
• Both positions are bullish
• Appropriate for a portfolio manager who needs to
  generate additional income but does not want to
  write calls for fear of opportunity losses in a
  bull market
• Example investor simultaneously buys shares of
  MSFT at 28.51 and writes an OCT 30 MSFT put for
  2

Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration
0 15 25 28.255 30 35
Buy stock _at_ 28.51 -28.51 -13.51 -3.51 -0.255 1.49 6.49
Write 30 put _at_ 2 -28.00 -13.00 -3.00 0.255 2.00 2.00
Net -56.51 -26.51 -6.51 0.00 3.49 8.49
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Adding A Put to an Existing Stock Position

• Assume an investor Bought MSFT _at_ 22 and Buys an
  APR 25 MSFT put _at_ 1.10The stock price is
  currently 28.51

Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration
0 10 25 30 35 40
Long stock _at_ 22 -22 -12 3 8 13 18
Long 25 put _at_ 1.10 23.90 13.90 -1.10 -1.10 -1.10 -1.10
Net 1.90 1.90 1.90 6.90 11.90 16.90
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Writing A Call Against an Existing Stock Position

• Assume an investor Bought MSFT _at_ 22 and Writes a
  JAN 30 call _at_ 1.20The stock price is currently
  28.51

9.20
0
Stock price at option expiration
30
20.80
20.80
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Writing Calls to Improve on the Market
Writing calls to improve on the market Investors
owning stock may be able to increase the amount
they receive from the sale of their stock by
writing deep-in-the-money calls against their
stock position

• Writing Deep-in-the-Money Microsoft Calls Example
• Assume an institution holds 10,000 shares of
  MSFT. The current market price is 28.51. OCT 20
  call options are available _at_ 8.62.
• The institution could sell the stock outright
  for a total of 285,100. Alternatively, the
  portfolio manager could write 100 OCT 20 calls on
  MSFT, resulting in total premium of 86,200. If
  the calls are exercised on expiration Friday, the
  institution would have to sell MSFT stock for a
  total of 200,000. Thus, the total received by
  writing the calls is 286,200, 1,100 more than
  selling the stock outright.
• Though, there is risk associated with writing
  deep-in-the-money calls
• It is possible that Microsoft could fall deep
  below the striking price
• It may not be possible to actually trade the
  options listed

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Writing Puts to Improve on the Market

• Writing puts to improve on the market
• An institution could write deep-in-the-money puts
  when it wishes to buy stock to reduce the
  purchase price

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Speculating with options

• Playing with expected volatility and expected
  changes in market conditions.

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Sample of quoted options with 6 months maturity
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Terminal payoff for Long straddle (CP) and short
straddle (-C-P) same maturity and strike price
(call 2 and Put 2)
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Buying a Straddle an other example

• A long call is bullish A long put is bearish
• Why buy a long straddle?
• Whenever a situation exists when it is likely
  that a stock will move sharply one way or the
  other
• Suppose a speculator
• Buys a JAN 30 call on MSFT _at_ 1.20
• Buys a JAN 30 put on MSFT _at_ 2.75
• Equation Max(S(T)-X,0)-CoMax(X-S(T),0)-Po
• BreakevenMax(S(T)-X,0)-CoMax(X-S(T),0)-Po0
• 2 cases
• (1) SltX, then -CoX-S(T)-Po0 ?S(T)-CoX-Po-1.2
  30-2.7526.05
• (2) SgtX, then S(T)-X-Co-Po0? S(T)XCoPo301.2
  2.7533.95
• The worst outcome for the straddle buyer is when
  both options expire worthless. It occurs when the
  stock price is at-the-money. So the straddle
  buyer will lose money if stock closes near the
  striking price

Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration
0 15 25 30 45 55
Long 30 call -1.20 -1.20 -1.20 -1.20 13.80 23.80
Long 30 put 27.25 12.25 2.25 -2.75 -2.75 -2.75
Net 26.05 11.05 -1.05 -3.95 11.05 21.05
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Writing a Straddle

• The straddle writer wants little movement in the
  stock price. Losses are potentially unlimited on
  the upside because the short call is uncovered

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Strangles

• A strangle is similar to a straddle, except the
  puts and calls have different striking prices.The
  speculator long a strangle expects a sharp price
  movement either up or down in the underlying
  security
• With a long strangle, the most popular version
  involves buying a put with a lower striking price
  than the call
• Suppose a speculator
• Buys a MSFT JAN 25 put _at_ 0.70
• Buys a MSFT JAN 30 call _at_ 1.20

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Writing a Strangle

• The maximum gains for the strangle writer occurs
  if both option expire worthless. It occurs in the
  price range between the two exercise prices.

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Condors
Long Condor

• A condor is a less risky version of the strangle,
  with four different striking prices
• The condor buyer hopes that stock prices remain
  in the range between the middle two striking
  prices
• Buyer
• Buys MSFT 25 calls _at_ 4.20
• Writes MSFT 27.50 calls _at_ 2.40
• Writes MSFT 30 puts _at_ 2.75
• Buys MSFT 32.50 puts _at_ 4.60
• Seller
• writes MSFT 25 calls _at_ 4.20
• buys MSFT 27.50 calls _at_ 2.40
• buys MSFT 30 puts _at_ 2.75
• writess MSFT 32.50 puts _at_ 4.60

Short Condor
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Long Strap 2 C P (same maturity and strike)
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Spreads

• Option spreads are strategies in which the player
  is simultaneously long and short options of the
  same type, but with different
• Striking prices or possibly expiration dates
• In a vertical spread, options are selected
  vertically from the financial pages
• The options have the same expiration date
• The spreader will long one option and short the
  other
• Vertical spreads with calls
• Bullspread
• Bearspread

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Bull spread buy call no 1 (in-the money) and
sell call no 3 (out-the money)
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Comparing the Bull Money Spread and Long Call
Positions
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Bear Spreadbuy put no 3 (in-the money) and
sell put no l (out-the money).
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Bullspread another example

• Assume a person believes MSFT stock will
  appreciate soon?A possible strategy is to
  construct a vertical call bullspread
• Buy an APR 27.50 MSFT call
• Write an APR 32.50 MSFT call
• The spreader trades part of the profit potential
  for a reduced cost of the position.
• With all spreads the maximum gain and loss occur
  at the striking prices
• It is not necessary to consider prices outside
  this range
• With a 27.50/32.50 spread, you only need to look
  at the stock prices from 27.50 to 32.50

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Bullspread (contd)

• Construct a profit and loss worksheet to form the
  bullspread

Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration Stock Price at Option Expiration
0 27.50 28.50 30.50 32.50 50
Long 27.50 call _at_ 3 -3 -3 -2 0 2 19.50
Short 32.50 call _at_ 1 1 1 1 1 1 -16.50
Net -2 -2 -1 1 3 3
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Bearspread

• A bearspread is the reverse of a bullspread
• The maximum profit occurs with falling prices
• The investor buys the option with the lower
  striking price and writes the option with the
  higher striking price

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Vertical Spreads With Puts Bullspread

• Involves using puts instead of calls. Buy the
  option with the lower striking price and write
  the option with the higher one
• The put spread results in a credit to the
  spreaders account (credit spread)
• The call spread results in a debit to the
  spreaders account (debit spread)
• A general characteristic of the call and put
  bullspreads is that the profit and loss payoffs
  for the two spreads are approximately the same
• The maximum profit occurs at all stock prices
  above the higher striking price
• The maximum loss occurs at stock prices below the
  lower striking price

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Calendar Spreads

• In a calendar spread, options are chosen
  horizontally from a given row in the financial
  pages
• They have the same striking price
• The spreader will long one option and short the
  other
• Calendar spreads are either bullspreads or
  bearspreads
• In a bullspread, the spreader will buy a call
  with a distant expiration and write a call that
  is near expiration
• In a bearspread, the spreader will buy a call
  that is near expiration and write a call with a
  distant expiration
• Calendar spreaders are concerned with time decay
• Options are worth more the longer they have until
  expiration

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Diagonal Spreads

• A diagonal spread involves options from different
  expiration months and with different striking
  prices
• They are chosen diagonally from the option
  listing in the financial pages
• Diagonal spreads can be bullish or bearish

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Butterfly Spreads

• A butterfly spread can be constructed for very
  little cost beyond commissions
• A butterfly spread can be constructed using puts
  and calls

Stock price at option expiration
0
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Nonstandard Spreads Ratio Spreads

• A ratio spread is a variation on bullspreads and
  bearspreads
• Instead of long one, short one, ratio spreads
  involve an unequal number of long and short
  options
• E.g., a call bullspread is a call ratio spread if
  it involves writing more than one call at a
  higher striking price

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Nonstandard Spreads Ratio Backspreads

• A ratio backspread is constructed the opposite of
  ratio spreads
• Call bearspreads are transformed into call ratio
  backspreads by adding to the long call position
• Put bullspreads are transformed into put ratio
  backspreads by adding more long puts

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Nonstandard SpreadsHedge Wrapper

• A hedge wrapper involves writing a covered call
  and buying a put
• Useful if a stock you own has appreciated and is
  expected to appreciate further with a temporary
  decline
• An alternative to selling the stock or creating a
  protective put
• The maximum profit occurs once the stock price
  rises to the striking price of the call
• The lowest return occurs if the stock falls to
  the striking price of the put or below
• The profitable stock position is transformed into
  a certain winner
• The potential for further gain is reduced

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Combined Call Writing

• In combined call writing, the investor writes
  calls using more than one striking price
• An alternative to other covered call strategies
• The combined write is a compromise between income
  and potential for further price appreciation

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Margin Considerations

• Necessity to post margin is an important
  consideration in spreading The speculator in
  short options must have sufficient equity in his
  or her brokerage account before the option
  positions can be assumed
• There is no requirement to advance any sum of
  money - other than the option premium and the
  commission required - to long calls or puts
• Can borrow up to 25 of the cost of the option
  position from a brokerage firm if the option has
  at least nine months until expiration
• For uncovered calls on common stock, the initial
  margin requirement is the greater of
• Premium 0.10(Stock Price)
• For uncovered puts on common stock, the initial
  margin requirement is 10 of the exercise price

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Margin Requirements on Spreads

• All spreads must be done in a margin account
• More lenient than those for uncovered options
• You must pay for the long side in full
• You must deposit the amount by which the long put
  (or short call) exercise price is below the short
  put (or long call) exercise price
• A general spread margin rule
• For a debit spread, deposit the net cost of the
  spread
• For a credit spread, deposit the different
  between the option striking prices

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Margin Requirements on Covered Calls

• There is no margin requirement when writing
  covered calls
• Brokerage firms may restrict clients ability to
  sell shares of the underlying stock

85
Evaluating Spreads Introduction

• Spreads and combinations are
• Bullish,
• Bearish, or
• Neutral
• You must decide on your outlook for the market
  before deciding on a strategy

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Evaluating Spreads The Debit/Credit Issue

• An outlay requires a debit
• An inflow generates a credit
• There are several strategies that may serve a
  particular end, and some will involve a debt and
  others a credit

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Evaluating Spreads The Reward/Risk Ratio

• Examine the maximum gain relative to the maximum
  loss
• E.g., if a call bullspread has a maximum gain of
  300.00 and a maximum loss of 200.00, the
  reward/risk ratio is 1.50

88
Evaluating Spreads The Movement to Loss Issue

• The magnitude of stock price movement necessary
  for a position to become unprofitable can be used
  to evaluate spreads

89
Evaluating Spreads Specify A Limit Price

• In spreads
• You want to obtain a high price for the options
  you sell
• You want to pay a low price for the options you
  buy
• Specify a dollar amount for the debit or credit
  at which you are willing to trade

90
Determining the Appropriate Strategy Some Final
Thoughts

• The basic steps involved in any decision making
  process
• Learn the fundamentals
• Gather information
• Evaluate alternatives
• Make a decision