Welcome to the TD Waterhouse Options Guide
This guide will address the buying and selling of exchange traded options. In particular, it will review why people buy and sell options and the advantages and disadvantages of various option investment alternatives. In addition, it will also look at different ways to measure an option's value, including some fairly sophisticated sensitivity measures, so you can determine the relative risk of your investment. Finally, this guide will examine various types of options trading strategies including spreads, combinations and straddles.
Options Guide Table of Contents
- Basic Option Terminology
- Basic Characteristics of the OptionContract
- Why Trade in Options?
- Advantages & Disadvantages of Various Option Investment Alternatives
- Measuring Option Value & Risk
- Special Risks of Index Options
- Factors Influencing Option Prices
- Strategies for Reducing Portfolio Risk
- Investment Strategies
- Long Call (Very Bullish)
- Long Put (Very Bearish)
- Short Call (Bearish/Neutral)
- Short Put (Bullish/Neutral)
- Covered Call Write (Neutral)
- Bear Call Spread (Bearish/Neutral)
- Bear Put Spread (Bearish)
- Bull Call Spread (Bullish)
- Bull Put Spread (Bullish/Neutral)
- Long Combination/Straddle (Neutral ~ Expecting High Volatility)
- Short Combination/Straddle (Neutral ~ Expecting Low Volatility)
- Other Spreading Strategies
- Criticisms of Bullish and Bearish Combinations and Straddles
1. Basic Option Terminology
- Options are contracts that derive their value from underlying interests like stocks and bonds.
- Calls give holders the right to buy underlying interests.
- Puts give holders the right to sell underlying interests.
- Underlying interest is the security on which the option is written.
- When an option contract is first created, it is termed an Opening Transaction.
- A Closing Transaction is the term used when an option contract is eliminated through a secondary transaction.
- Strike (Exercise) Price is the price at which the underlying interest can be bought or sold.
- When you buy an option, as an opening transaction, you are the Buyer or Holder. Holders have the right to buy the underlying interest at the strike price (with a Call), or sell the underlying interest at the strike price (with a Put).
- When you sell an option, as an opening transaction, you are the Seller or Writer. Writers are obligated to buy the underlying interest at the strike price (with a Put) or sell the underlying interest at the strike price (with a Call) if the contract is exercised.
- Premium is the price the buyer pays to the seller for the option contract.
- Expiry Date is the date on which the contract ceases to exist.
- Exercise Style is either European (can only be exercised on the expiry date), or American (can be exercised on any trading day prior to the expiry date).
- Options are At-the Money when the market price of the underlying interest is equal to its strike price.
- Options are In-the-Money when the price of the underlying interest is above the Call's strike price, or below the Put's strike price.
- Options are Out-of-the-Money when the price of the underlying interest is below the Call's strike price, or above the Put's strike price.
- The Multiplier is the term given to the number of units of the underlying interest that make up one option contract.
2. Basic Characteristics of the Option Contract
- Can be Very Risky
- No Privileges of Ownership
- Standardized Units of Trading and Expiration Cycles
Because of their flexibility, options can provide investors with
a chance to realize almost any strategic goal, from managing risk to enhancing
leverage. Unfortunately, options can be very risky. Before investing in options, it's important to understand the strategies you can use to limit this risk.
Holders should also realize that options pay no interest or
dividends, have no voting rights, and no privileges of ownership. They are
available from TD Waterhouse on a wide variety of investment vehicles, including
stocks, bonds, gold and market indices.
While many factors have contributed to the success of exchange-traded
options in North America, standardization of key option features (including
exercise prices, trading cycles, and expiration months) is one of the most
important as it has contributed to the viability of a secondary options market.
Standardization of an option contract does not mean that all option
contracts based on a specific underlying interest are the same size. What it
does mean is that all contracts traded on a specific exchange and cleared
through a specific clearing corporation are all of the same size. Prior to the
emergence of exchange-traded options, OTC options were created on an individual
basis with terms unique to the holder and writer, and often involved odd amounts
of shares or units of the underlying interest. Standardization of contract size,
however, contributed to the growing development and popularity of
exchange-traded options.
For equity options, a 100 share (board lot) contract size
applies to all markets except in the event of a stock split (in which case the
contracts are altered to adjust for the split).
For index options, which are cash-settled, the contract size is determined
by multiplying the premium by an index multiplier, which is usually $100.
As for standard expirations, it's important to understand that each option
class (which are options listed on the same underlying interest) has several
different option series, which are identified as calls or puts by their symbol,
expiration month, and strike price. All option series with the same expiration
month have the same expiration date and expiration time.
For example, exchange-traded equity, index and most debt options expire on
the Saturday immediately following the third Friday of the expiration month.
3. Why Trade in Options?
Depending on whether you are a holder or writer, the reasons for
investing in options could include the following:
Leverage:
For call holders, you can benefit from an increase in
the market value of the underlying security over the lifetime of the option at a
cost which is far less than the cost of buying the stock outright. You can also
use the cost savings to invest in short-term fixed-income securities, thereby
earning an immediate return on your investment.
Limited Risk:
If the price of the underlying security falls instead of
rises, a call holder's maximum loss will be limited to the premium he or she
paid for the option, plus any transaction or commission costs.
To Fix a Future Price:
For call holders, options allow you to fix the
future price of the underlying interest so you can fund your purchase out of
future cash flow. For put writers, locking-in a cost that is below market value
can give you the opportunity to acquire the underlying interest at a fixed cost
if the option is exercised.
Diversification:
Investors can hold calls on several underlying interests
to diversify their opportunities for capital gain. That way, the call holder has
a better chance of profiting, even if the underlying interests fail to rise on
some of his or her calls.
Insurance Against Market Drops:
An investor who expects short term
declines in a specific interest or market can hold a put on it and then sell the
put at a profit or exercise it in the event of a drop in price. A similar
strategy for protecting against price drops is to sell calls on the underlying.
Additional Income:
Writers of puts and calls benefit from income received
as a premium, which becomes pure profit if the option is never exercised.
4. Advantages & Disadvantages of Various Option Investment Alternatives
- Equities
- Indices ~ European vs. American Style
- Bonds / Debt
- Precious Metals
Most investors are probably familiar with Equity Options, where the
underlying interests are shares of a corporation. What you may not realize is it was the rapid success of equity options that led to the creation of non-equity options. Listed puts and calls are now available on all sorts of underlying interests, including indices and debt instruments. We're going to examine the three most popular non-equity options, which are index options, bond options, and precious metal options.
The basic differences between equity and non-equity options are
that some non-equity options are cash settled, while all equity options allow
physical delivery settlement of the underlying shares. Similarly, some
non-equity options have a European exercise style, which means they can only be
exercised on their expiration date. Most equity options, on the other hand, are
American style, which means they can be exercised on any trading day prior to
their expiration date. Finally, the minimum margin requirements for equity and
non-equity options are generally different.
Index Options are the most popular non-equity options, especially because
their low cost allows investors a very broad market exposure. Despite that,
investors should be aware of certain index option characteristics. First, the
component stocks of an underlying index are an important strategic
consideration. For investors looking to participate in the overall market, you
should choose an index with well-balanced underlying equities, not one heavily
weighted in only one or two industries. Second, investors who are looking for a
hedging strategy should find an index that has equities closely resembling their
portfolio holdings.
Bond or Debt Options are also popular investment alternatives
because they allow retail investors to participate in a market that was
previously out of reach in terms of cost and trading potential. Investing in
Government of Canada bond options gives investors the opportunity to participate
in the bond market without incurring unacceptable levels of risk.
Bond option strategies are generally used by investors to profit from (or
hedge against) changes in interest rates. If your objective is to profit from a
decline in interest rates, you would hold bond calls or write bond puts.
Conversely, if you wanted to profit from a rise in rates, you would hold bond
puts or write bond calls. If you're using bond options to hedge against changes
in interest rates, you should realize that you can't achieve a perfect hedge
unless the underlying interest being hedged is exactly the same as the
underlying of the put contract.
Finally, Precious Metal Options are options where the underlying interest
is generally gold. These options aren't as popular as the other types,
especially because the price of the underlying interest tends to be more
volatile and cyclical. You would be more likely to use precious metal options if
you wanted to hedge against fluctuations in the price of an underlying metal
that you own, or if you wanted to profit from anticipated changes in the price
of the underlying. Of course, adopting a purely profit-oriented approach is
considered speculative, and could be quite risky.
Although TD Waterhouse can facilitate options trading in Canadian and US
stocks, bonds, most market indices, and gold, we do not arrange options on
futures contracts or currencies.
5. Measuring Option Value & Risk
- Risk of Loss
- Special Risks of Index Options
- Factors Influencing Option Prices
- Strategies for Reducing Risk
Many investors steer clear of options trading because they are
unfamiliar with the mechanics involved or are concerned about risk. Indeed, a
high degree of risk may be involved in the purchase and sale of options,
depending on how and why options are used.
It is for this reason that you should understand the different
options trading strategies available, as well as the different types of risk you
may be exposed to. While the rewards of option trading often outweigh the risks,
there are several risks you should be aware of:
Options have only a limited life. Because of that, option holders run the
risk of losing their entire investment in a relatively short period of time.
For option writers, the risks are even greater. Many people who write
calls are uncovered, which means they don't own the underlying interest. Call
writers can incur large losses if the price of the underlying interest rises
above the exercise price, forcing them to buy the interest at a high market
price but sell it for much lower.
Similarly, put writers who don't protect themselves by selling a short
position in the underlying interest may suffer a loss if the price of the
underlying interest falls below the option's exercise price. In such a
situation, the put writer will have to buy the underlying interest at a price
above current market value, thereby incurring a loss.
When trading in US options, the transactions are often carried
out in US dollars which would expose you to risks from fluctuations in the
foreign exchange market. Furthermore, transactions that involve holding and
writing multiple options in combination, or holding and writing options in
combination with buying or selling short on the underlying interests present
additional risks.
6. Special Risks of Index Options
- Difficulties with Cash Settlement
- Timing Risks
- Imperfect Hedge
- If Trading is Interrupted
In addition to the risks just described which apply generally to
the holding and writing of options, there are additional risks unique to trading in index options.
Because the exercise of index options is settled in cash,
writers can't cover their potential settlement obligation in advance as it may
be impossible to replicate the necessary offsetting position using the
underlying index.
Investors with spread positions and certain other multiple option
strategies are also exposed to a timing risk with index options. That's because
there is generally a one-day time lag between the time that a holder exercises
the option and a writer gets notice of an exercise assignment. Index option
writers are required to pay cash based on the closing index value on the
exercise date, not on the assignment date. Admittedly, this risk is somewhat
alleviated by the use of European-style options.
As discussed earlier, investors intending to use index options to hedge
against the market risk associated with investing in one or more individual
stocks should recognize that this results in a very imperfect hedge. Unless the
underlying index closely matches an investor's portfolio, it may not serve to
protect against market declines at all.
Finally, if trading is interrupted in stocks that account for a
substantial portion of the value of an index, the trading of options on that
index will ordinarily be halted. If this happens, index option investors may be
unable to close out their positions and could face substantial losses if the
underlying index moves adversely before trading resumes.
7. Factors Influencing Option Prices
- Intrinsic Value
- Time Value
- Volatility
- Direction of the Market
- Put / Call Parity
- Black-Scholes Option Pricing Model
- Sensitivity Measures
By making yourself familiar with the factors influencing option
prices, you will be able to make informed decisions about which option
investment strategies will work for you.
The relationship between the market price of the underlying
interest and the exercise price of the option is a major determinant of the
option price. For example, assume ABCD shares were trading at $30, ABCD Apr. 25
calls would have an Intrinsic Value of $5 per share (which is equal to their
in-the-money amount). Conversely, if ABCD stock was trading at $20, ABCD Apr. 25
puts would have an intrinsic value of $5 per share. All else being equal,
options that have an intrinsic value are clearly worth more than options that
are at-the-money or out-of-the-money.
An option's Time Value is equal to its current premium minus the
in-the-money amount. As an example, let's assume ABCD stock was trading at $30
and you buy one ABCD Apr. 25 call for $6. As we just saw, your call would have an
intrinsic value of $5, and its time value would be $1 (premium - intrinsic
value). Time value relates solely to the call holder's belief that the market
price of the underlying interest will rise, or to the put holder's belief that
the market price of the underlying interest will decline, before the option
expires. Normally, option holders will pay a higher time value when the
expiration date is a long time away. However, as the expiration date approaches
the time value is constantly being eroded and eventually declines to zero on the
expiration date.
The Volatility of the underlying interest's market price also
affects the price of the option. Options on an underlying interest whose market
price fluctuates widely over the short term command high premiums because option
holders have a higher possibility of profiting from their investment. However,
options on less volatile underlying interests will command lower premiums.
Finally, investors should understand the concept of Put / Call Parity when
determining the relative price of options. This concept states that if you buy a
stock, buy a put, and sell a call with the same strike price and expiration
date, you should receive the same rate of return as a Treasury Bill with the
same maturity. If this relationship does not hold, an arbitrage opportunity
exists, which generally means that the option is not optimally priced.
Since the options market was established, several models have been
proposed to help investors determine the optimal pricing of an option. The model
used most frequently is called the Black-Scholes Option Pricing Model, which
takes several key factors into account, including the risk-free rate, remaining
time to expiry, the option's strike price, the market price of the underlying,
and volatility.
One of the benefits from the Black-Scholes Model is the
determination of an option's Delta or its Hedge Ratio. The Delta is a
sensitivity measure that indicates how much the price of an option is expected
to change, given short-term price movement in the underlying interest. The more
intrinsic value there is in an option's premium, the higher an option's delta
will be. It is, however, important to note that an option's delta is not a
static number and is only accurate at the moment of its calculation.
Other sensitivity measures include the Gamma, which measures the rate of
change in an option's Delta given a change in the underlying's market price.
The Rho is the rate of change in an option's price to a change in interest
rates. An increase in interest rates increases the market price of a call and
decreases the price of a put. This sensitivity increases as the option goes
deeper into the money. The time to expiration also affects the sensitivity of
the Rho -- it is more sensitive the longer the time to expiry.
An option's Vega or Kappa is the rate of change of an option's price to
the volatility in the market price of the underlying interest. The vega
measurement is the same for puts and calls, and is at its most sensitive when an
option is close to or at-the-money. Sensitivity is also increased when the
option is long-term.
Finally, the Theta measure describes an option's change in value as the
option gets closer to expiry. As the option gets closer to expiry, the theta
rises dramatically, indicating a decay in value.
8. Strategies for Reducing Portfolio Risk
- Writing Covered Calls
- Holding Protective Puts
- Holding Index Puts
- Holding Protective Calls
Despite the risks associated with options trading, there are
ways to manage the risk. Aside from understanding the factors influencing option
prices, it's also important to familiarize yourself with certain basic
strategies you can use to reduce your downside risk or decrease the volatility
of your portfolio.
As mentioned earlier, a major risk of option trading arises when
you write uncovered options. One way to minimize this type of risk is by writing
"Covered Calls", which are calls against an underlying interest that
you already own.
If we look at just equity options, you would generally write covered calls
against your own stock if you expect the share price to decline in the short
term, or if you don't anticipate an advance in the share price and hope to gain
some additional income.
For example, let's say you own ABCD stock currently trading at $25 and you
write a call with a $25 strike price with a $5 premium. If the stock price drops
to $20, your entire loss on the investment will be covered by your premium. Of
course, if the stock drops below $20, you will still suffer any loss beyond
that. The downside of this strategy is that, if ABCD stock rises above $25 and
the option holder exercises the option, you will be limited to receiving only
$25 per share plus your premium.
Another way to manage the risk of a long stock position is by
holding "Protective Puts", which are puts against stocks you already
own. You would hold a protective put if you wanted to maintain your exposure to
the upside of your stock while protecting yourself completely against a possible
decline in price. If you hold a protective put, the stock can decline to zero
during the term of the contract and you'll lose nothing but the premium you paid
for the put contract.
For example, if you own ABCD stock when it's trading at $25 and you're
worried about a short-term correction, you may be able to buy a put with a $25
strike price at a cost of $4 per share. If the stock drops to zero, you've
protected yourself against the decline except for the $4 premium. If the stock
rises to $45 you will enjoy the benefit of that rise, minus the $4 premium you
paid.
Another strategy for minimizing portfolio risk is to hold "Index Puts".
You would hold index puts if you wanted to protect your portfolio from possible
price declines, but you weren't willing to sell the securities or incur the cost
of holding several individual put contracts.
Index puts give you the right to sell a given index at a fixed exercise
price. If share prices decline, your portfolio losses should be approximately
offset by a corresponding gain from the sale or exercise of your index puts. If
share prices advance, your stock portfolio should increase in value while the
put options expire worthless.
The efficiency of this type of hedge depends on how representative your
portfolio is to a given index. If you're only holding a few stocks, or if you're
only concerned about a few stocks in a broad portfolio, it may make more sense
to purchase individual put contracts against each stock.
Finally, you can hedge against a short position by holding "Protective
Calls". For example, if you short sell 100 ABCD shares at $30, you can buy
one ABCD Apr 30 call at a premium of, say, $4. That way, if you are forced to
buy ABCD shares to cover your short position, you can exercise your call at $30,
resulting in a loss equal only to the premium you paid (which is $4 per share
here).
9. Investment Strategies
- Conservative vs. Speculative Investing
- Bear Market Strategies
- Bull Market Strategies
- Neutral Market Strategies
By now it should be fairly apparent that listed options satisfy
investment objectives ranging from a reasonably conservative approach to
outright speculation. Because of the complexity and volatile nature of option
markets, it is important for all investors to understand both the risks
associated with option trading, and the various strategies employed.
As was already shown, the best way to minimize risk when trading in
options is by adopting a conservative investment approach. This means you, as
the investor, should avoid uncovered writing and concentrate on writing covered
call options or holding protective puts, index puts, or protective calls to
simply manage the volatility of your existing portfolio.
However, for more experienced investors, more speculative investment
approaches can be considered. These approaches range from common tactics like
simply holding calls and puts, to moderately speculative tactics like spreading
and straddling, to outright risky tactics like uncovered writing.
For the purposes of this presentation, we've already examined the
conservative approaches to investing and will now spend some time looking over
some moderately speculative investment strategies.
A. Long Call (Very Bullish)
Call holding is the most popular bullish strategy. As we already
discussed, the holder of a Long Call has the right to take delivery of the
underlying security at the exercise price within a set period of time prior to
expiration.
This strategy is most often used when the investor anticipates
that the underlying security will increase in price. The risk to this strategy
is limited to the price paid for the contract, however the reward is
theoretically unlimited because the value of the underlying security could,
theoretically, rise indefinitely.
If call premiums are too high it generally means that the market believes
the price of the stock will continue to rise. At that point, it may be
worthwhile to consider buying the stock itself.
Because call holding is associated with short-term speculation, there is a
perception that it is a strategy in which most traders lose money. Some
statistics suggest that more than half of all options written expire worthless.
However, as with most statistical interpretations, this does not tell the whole
story. While it may be true that many call holders lose money, it does not mean
that all call holders are net losers over time. The most effective strategy is
to limit losses by closing out individual call purchases that are not working
out (even if this has to be done frequently) and to try to eventually offset
such losses with large, infrequent profits on profitable call purchases. The
successful call holder must take small losses in stride, and continue combing
the market place for a profitable underlying interest on which calls are
available.
B. Long Put (Very Bearish)
Just like call holding is the most popular bullish strategy, put
holding is the most popular bearish option strategy. It is simple to understand
and it offers an attractive risk/reward ratio. However, for a put holder to
profit, the market price of the underlying interest must decline sufficiently to recoup the put premium and commission.
A put holder must keep in mind that as time passes, any time
value in the put premium will waste away. Of course, the attraction of a put
purchase is that occasionally put holders make many times their original
investment in a very short period of time if the market price of the underlying
falls dramatically. And in the worst case scenario, the most the put holder can
lose is the premium paid.
There are generally two types of investors who hold puts. First, there are
speculators whose goal is to profit from a decline in the market price of the
underlying. Second, there are conservative investors who hold puts to hedge a
long position in an underlying interest. While both strategies have merit, they
address the needs of investors at different ends of the risk spectrum. The
strategy that fits the needs of a speculator will probably have no place in the
portfolio of a long term investor. Despite that, all put holders should look for
the best combination of time remaining to expiration and liquidity of the
selected put.
For investors trying to decide whether to hold puts or sell short, there
are certain advantages and disadvantages to each strategy. The advantages of put
holding is that margin deposits aren't needed, there is no need to make good any
dividends paid on the shorted shares, you can never be forced to exercise and
sell the underlying interest, and your loss is limited to the premium paid.
Disadvantages include the facts that puts have finite life, and they may not be
price sensitive to small declines in the underlying's market price (unless price
drops below premium paid, no profit is realized).
C. Short Call (Bearish/Neutral)
When an investor writes a call without owning the underlying
interest, he or she has sold a uncovered, or naked call.
If the market price of the underlying interest declines below
the call's strike price, the Naked Call writer will not be assigned and the
premium will be retained intact. This is why Naked Call writing is a bearish
strategy. As the expiration of the call approaches, the option's time value is
likely to decay. This works to the advantage of the Call writer because it
results in a profit even if the market price of the underlying remains unchanged
rather than declines.
If, however, the market price of the underlying rises above the call's
strike price, the call writer may lose money if the call is exercised. On being
assigned, the Naked Call writer will have to buy the underlying at the higher
market price and deliver it for the lower strike price. If the market price
continues to rise, the calls will require more margin from the writer and the
eventual loss can be substantial.
In fact, theoretically the value of the underlying security can
rise indefinitely, so Naked Call writers are exposed to a theoretically
unlimited risk. Of course, in reality, built-in practical constraints to the
trading system make unlimited loss very unlikely. If the market price of an
underlying interest started rising without interruption, the Naked Call writer
would ultimately be unable to meet margin calls, which would force the position
to be closed out and the calls bought back. Furthermore, most Naked Call writers
adopt a mental "stop loss" point to contain exposure. An appropriate
point is when the market price rises to an amount equal to the strike price plus
the premium received.
Because the risks assumed by Naked Call writers are enormous, and the
potential reward is limited to the premium received, you would generally only
write a Naked Call when premiums are very high.
D. Short Put (Bullish/Neutral)
An investor who writes an Uncovered or Naked Put is obligated to
buy the underlying interest at the put's strike price if the put is exercised.
Using the above example, an investor would write this type of
ABCD put if he or she believed that it is unlikely for the ABCD stock price to
decline, and that it is worth the risk of being obligated to buy the stock at
$20 in view of the $0.25 premium received.
Because of the limited nature of the reward, this strategy should only be
used when you do not expect the price of the underlying security to fall below
the strike price during the term of the contract. Like any type of short
selling, this strategy has a high degree of risk since the writer will have to
pay $20 for the ABCD shares even if they fall to zero. For this reason, a mental
"stop loss" point should be used to contain exposure. An appropriate
point to cover your short position would be when the market value of the stock
falls to the strike price minus the premium received.
As with writing naked calls, the writer of a Naked Put should generally
only consider this strategy if premiums are very high. In fact, many investors
are uncomfortable with the concept of Naked Put writing, especially after the
strategy gained unfavourable notoriety following the October, 1987 stock market
crash. At that time, many Naked Put writers incurred huge losses, causing some
to conclude that naked put writing is not a suitable strategy for conservative
investors. However, if naked put writing is done on a cash-secured basis, the
strategy has similar risk/reward characteristics to covered call writing. The
1987 stock index put losses were caused by a combination of extreme volatility
in market indices, poorly executed strategies, and overextended margin
positions, not by the strategy of writing Naked Puts.
E. Covered Call Write (Neutral)
For investors who are neither bearish nor bullish about various
underlying interests, there are still a good number of neutral option investment strategies you may want to consider.
A Covered Call Write is achieved by either simultaneously buying
the underlying interest and writing equivalent calls against it, or by writing
calls against an underlying interest that you already own.
This strategy has the identical risk profile to uncovered put writing, and
Covered Call Writing is the only way to write calls in an RSP.
Certain situations make this strategy very attractive. Writing a covered
call against a long stock position is a good way to partially hedge against an
expected short term decline. It is not, however, an alternative to selling the
stock outright should the company's prospects sour dramatically. Covered calls
are also used for additional income when the investor does not anticipate a
decline in the underlying share price.
You shouldn't write covered calls simply because the premium is
attractive. You also shouldn't implement a Covered Call Write on an underlying
interest that you don't want to own if the option expires, or if you would be
disappointed if the call is exercised and the underlying is called away.
Because a Covered Call Writer owns the underlying interest, the
maximum risk occurs if the market price of the underlying falls to zero. In such
a case, the Covered Call Writer will have lost the value of the stock minus the
premium received. The reward is similarly limited to the difference between the
call's strike price and your net debit. To calculate your debit, subtract the
premium you paid from the price of the stock ($22.75 here).
F. Bear Call Spread (Bearish/Neutral)
As mentioned earlier, Spreads are moderately speculative option
trading strategies. Basically, a spread is the purchase and sale of an equal
number of either puts or calls on the same underlying interest.
The example you see on this slide is considered a "Price
Spread" (also a Money or Vertical Spread), which shows the purchase and
sale of an equal number of ABCD calls with the same expiration but with
different strike prices. If the market bias on the underlying security is
bearish, you would hold a call with a higher strike price than the call you
wrote.
This strategy is useful as a limited risk alternative to uncovered call
writing. It should be used when you expect the price of the underlying security
to remain below the lower strike price through the life of each contract.
The maximum risk on a Bear Call Spread is the difference between the two
strike prices (which is $5 in this example), less the credit received. To
calculate the credit received, you look at the premium you received on the call
you sold (which is $1.25 here), and you reduce that amount by the premium you
paid on the call you bought (which is 25 cents), totalling $1. Consequently,
your maximum loss on this Bear Call Spread would be $4 per share ($5 difference
in strike price - $1 credit).
On the other hand, the maximum reward you can receive is your net credit,
or $1 per share. One note of caution is to be aware of an early assignment on
the short side.
G. Bear Put Spread (Bearish)
Another strategy you may want to consider adopting in a bear
market is a Bear Put Spread. Like other price spreads, in this example you would
hold and write an equal number of ABCD puts with the same expiration but with
different strike prices.
If the market bias on the underlying security is bearish, you
would hold a put with a higher strike price than the put you wrote. This
strategy is especially useful if premiums are too expensive to justify an
outright purchase.
With a Bear Put Spread, the maximum loss you can risk is limited to the
cost of the spread. In this example, the spread is equal to the premium cost of
the put you bought ($1.95) minus the premium you made on the put your sold (30
cents), for a total debit of $1.65 per share.
Conversely, your reward would be limited to the difference between the two
strike prices ($5) less the cost of the spread ($1.65), totalling a maximum
profit of $3.35 per share.
H. Bull Call Spread (Bullish)
The third bullish strategy that we're going to consider is a
Bull Call Spread. This investment strategy essentially works in the opposite
direction of a Bear Call Spread. When the market bias on the underlying security
is bullish, you would hold a call with a lower strike price than the one you
wrote.
This strategy is useful when you are bullish on the underlying
security but call premiums are too expensive to justify an outright purchase. As
with similar strategies, your risk would be limited to the cost of the spread,
which in this case is $1 per share ($1.25 - 0.25).
Unfortunately, the reward of Bull Call Spreads is also capped at the
difference between the two strike prices ($5) less the cost of the spread ($1),
which in this case is $4 per share. You must also be wary of an early assignment
on the short side of the spread.
I. Bull Put Spread (Bullish/Neutral)
Finally, the last bullish option investment strategy we will be
considering is the Bull Put Spread. When the market bias on the underlying
security is bullish to neutral, you can hold a put with a lower strike price
than the put you wrote.
This strategy is useful as a limited risk alternative to
uncovered put writing. It should be used when you expect the price of the
underlying security to remain above the upper strike price throughout the life
of each contract.
Like similar strategies, the maximum risk of investing in Bull Put Spreads
is the difference between the two strike prices ($5) minus the credit received
($1.65), making the maximum loss in this example $3.35 per share.
Conversely, the maximum reward is limited to the net credit you receive on
the spread, which here is equal to $1.65 per share ($1.95 - $0.30).
J. Long Combination/Straddle (Neutral-Expecting High Volatility)
A Long Combination is when you hold both calls and puts on the
same underlying interest with different expiry dates and/or different strike
prices. A Long Straddle is when you hold both calls and puts on the same
underlying interest, but they have the same expiry dates and strike prices.
You would hold Long Combinations or Straddles if you expected
dramatic price movement but were unsure of the direction. This uncertainty could
arise from a pending earnings announcement, litigation, etc. By holding both
calls and puts on the same underlying interest, you are effectively limiting
your loss to the premiums you pay for each contract. The reward is theoretically
unlimited on the upside (the underlying security value could rise indefinitely),
and limited to the puts strike price less the premiums paid on the downside (the
underlying security value can only fall to zero).
With these strategies, your loss is limited to the cost of the position,
which in this example would be $1.50. Theoretically, however, you can benefit
from unlimited profit if the market price of the underlying rises or falls
dramatically before the long call expires.
The risk/reward characteristics of a long out-of-the-money
combination are similar to a long at-the-money straddle. The advantage of the
combination is the lower cost. Two out-of-the-money options are less expensive
to hold than a neutral straddle's two at-the-money options. Additionally, this
type of combination offers more leverage than a long at-the-money straddle. A
sharp move, up or down, in the underlying's market price will result in a sharp
price change in both the call and the put. The main disadvantage of such a long
combination, however, is that the options' time value component erodes quickly
as expiration approaches.
K. Short Combination/Straddle (Neutral - Expecting
Low Volatility)
A Short Combination is when an investor writes both calls and
puts on the same underlying interest with different expiry dates and/or
different strike prices, while a Short Straddle is when you write both calls and
puts with the same expiry dates and strike prices.
You would use these strategies if you expect the underlying
security to trade within a tight range during the life of the contracts. The
objective is to keep the entire premium received when both the put and the call
expire worthless.
This strategy can be extremely risky since the risk is theoretically
unlimited on the upside (the underlying security value could rise indefinitely),
and limited to the puts strike price less the premiums received on the downside
(the underlying security value can only fall to zero). The reward is limited to
the premium received for both contracts or the total credit. Mental stop loss
points should be used to contain exposure. Appropriate points are the call
strike price plus both premiums (on the upside) and the put strike price minus
both premiums (on the downside). If the underlying security rises above or falls
below your stop loss points you should always close out both sides
simultaneously to avoid being whipsawed. Also, beware of early assignments.
While straddles or combinations are bought with the hope that
the market price of the underlying interest will move significantly up or down,
a Short Straddle or Short Combination writer wants the exact opposite -- very
little market price movement in the underlying interest during the options'
lives. As long as the market price of the underlying keeps within a determined
range of the exercise price, the investor profits.
However, just like long combinations and straddles, it is generally easier
to break even on Short Combinations than it is to break even on Short Straddles.
10. Other Spreading Strategies
- Calendar Spreads (Time or Horizontal Spreads)
- Exotic Spreads (Diagonal or Butterfly Spreads)
- The Risks of Spreading
In addition to price spreads, there are also Calendar Spreads
and Exotic Spreads.
A Calendar Spread (Time or Horizontal Spread) is the purchase
and sale of an equal number of either puts or calls on the same underlying
interest with different expirations and the same strike price. To be eligible
for spread margining, the option you hold must expire at the same time or after
the option you write.
Exotic Spreads include both Diagonal and Butterfly Spreads. A Diagonal
Spread is the purchase and sale of an equal number of either puts or calls on
the same underlying interest with different expirations and different strike
prices. To be eligible for spread margining, the option you hold must expire at
the same time or after the option you write.
Butterfly Spreads, on the other hand, involve putting on a call or put
spread with three series of calls or puts at three different strike prices on
the same underlying interest. For example, two options bought in the middle of a
Butterfly Spread at a middle strike price could be flanked by written options
having strike prices above and below the middle strike price.
Before engaging in any spreading strategies, you should
understand the risks of spreading. Because spread orders require the execution
of both a purchase and sale transaction at or about the same time, there is no
guarantee that they will be executed. Similarly, you should recall that the
short side of the spread can be assigned at any time prior to the option's
expiry. Finally, the advantages of the spread are eliminated if the investor
liquidates the long side of the spread but remains at risk on the short side.
11. Criticisms of Bullish and Bearish Combinations and Straddles
- Used as Non-Neutral Strategies
- Require Experience, Sophistication and Sufficient Funds
While this guide discussed the uses of combinations and
straddles as neutral strategies, there are some investors who have attempted to
put these devices into use as bearish or bullish strategies.
The acceptance of non-neutral combinations and straddles is by
no means universal. Critics are adamant that straddles and combinations are
neutral by definition, so attempting to skew them to a bearish or bullish bias
is of dubious value.
Investors generally use combinations and straddles for technical reasons.
For example, if premiums are very expensive, writing options becomes more
attractive. However, novice investors may not be able to determine when premiums
are expensive. That is why straddle and combination writing strategies usually
require experience, sophistication, and sufficient funds to carry the position.
Options may be held in a TD Waterhouse Discount Brokerage margin account or Discount Brokerage Self-Directed RSP account. Get more information on the types of accounts available to you through TD Waterhouse Discount Brokerage.
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