Options Strategies. BIGSKY INVESTMENTS.

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1 Options Strategies BIGSKY INVESTMENTS 1

2 Getting Started Before you buy or sell options, you need a strategy. Understanding how options work in your portfolio will help you choose an options strategy. Choose the Right Strategy A benefit of options is the flexibility they offer. They can complement portfolios in many different ways. It's worth taking the time to identify a goal that suits you and your financial plan. Once you've chosen a goal, you'll have narrowed the range of strategies to use. As with any type of investment, only some of the strategies will be appropriate for your objective. A particular strategy is successful only if it helps you meet your investment goals. For example, if you hope to increase the income you receive from your stocks, you'll choose a different strategy from an investor who wants to lock in a purchase price for a stock they'd like to own. Start Simple Some options strategies, such as writing covered calls, are relatively simple to understand and execute. Complicated strategies such as spreads and collars require two or more opening transactions. Investors often use these strategies to limit the risk associated with options, but they may also limit potential return. When you limit risk, there is usually a trade-off. Simple options strategies are usually the way to begin investing with options. By mastering simple strategies, you'll prepare yourself for advanced options trading. In general, more complicated options strategies are appropriate only for experienced investors. Stay Focused Once you've decided on an appropriate options strategy, it's important to stay focused. That might seem obvious, but the fast pace of the options market and the complicated nature of certain transactions make it difficult for some inexperienced investors to stick to their plan. If it seems the market or underlying security isn't moving in the predicted direction, it's possible to minimize your losses by exiting early. However, it's also possible to miss a future beneficial change in direction. That's why many experts recommend that you designate an exit strategy or cut-off point in advance, and hold firm. For example, if you plan to sell a covered call, you might decide that if the option moves 20% in-the-money before expiration, the loss you'd face if the option were exercised and assigned to you is unacceptable. If it moves only 10% in-the-money, you'd be confident that there remains enough chance of it moving out-of-the-money to make it worth the potential loss. 2

3 Bear Call Spread Produce Income Bearish Outlook Neutral Outlook Decrease Implied Volatility A bear call spread is a limited-risk-limited-reward strategy, consisting of one short call option and one long call option. This strategy generally profits if the stock price holds steady or declines. The most it can generate is the net premium received at the outset. If the forecast is wrong and the stock rallies instead, the losses grow only until long call caps the amount. Bear Put Spread Produce Income Bearish Outlook Sharp Move Increase Implied Volatility Bull Call Spread Bullish Outlook Sharp Move Increase Implied Volatility A bear put spread consists of buying one put and selling another put, at a lower strike, to offset part of the upfront cost. The spread generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly rally. This strategy consists of buying one call option and selling another at a higher strike price to help pay the cost. The spread generally profits if the stock price moves higher, just as a regular long call strategy would, up to the point where the short call caps further gains. Bull Put Spread Bullish Outlook Neutral Outlook Decrease Implied Volatility Cash-Backed Call Acquire Stock Bullish Outlook Increase Implied Volatility Cash-Secured Put Acquire Stock Produce Income Bullish Outlook Neutral Outlook Decrease Implied Volatility Collar Hedge Stock Bullish Outlook A bull put spread is a limited-risk-limited-reward strategy, consisting of a short put option and a long put option with a lower strike. This spread generally profits if the stock price holds steady or rises. This strategy allows an investor to purchase stock at the lower of strike price or market price during the life of the option. The cash-secured put involves writing a put option and simultaneously setting aside the cash to buy the stock if assigned. If things go as hoped, it allows an investor to buy the stock at a price below its current market value. The investor must be prepared for the possibility that the put won't be assigned. In that case, the investor simply keeps the interest on the T-Bill and the premium received for selling the put option. The investor adds a collar to an existing long stock position as a temporary, slightly less-than-complete hedge against the effects of a possible near-term decline. The long put strike provides a minimum selling price for the stock, and the short call strike sets a maximum price. Covered Call Hedge Stock Produce Income Bullish Outlook Neutral Outlook Decrease Implied Volatility Covered Put Produce Income Bearish Outlook Neutral Outlook This strategy consists of writing a call that is covered by an equivalent long stock position. It provides a small hedge on the stock and allows an investor to earn premium income, in return for temporarily forfeiting much of the stock's upside potential. This strategy is used to arbitrage a put that is overvalued because of its early-exercise feature. The investor simultaneously sells an in-the-money put at its intrinsic value and shorts the stock, and then invests the proceeds in an instrument earning the overnight interest rate. When the option is exercised, the position liquidates at breakeven, but the investor keeps the interest earned. 3

4 Covered Ratio Spread Hedge Stock Produce Income Bullish Outlook Neutral Outlook Decrease Implied Volatility This strategy profits if the underlying stock moves up to, but not above, the strike price of the short calls. Beyond that, the profit is eroded and then hits a plateau. Covered Strangle Acquire Stock Produce Income Bullish Outlook Neutral Outlook Decrease Implied Volatility Long Call Bullish Outlook Sharp Move Increase Implied Volatility Long Call Butterfly Neutral Outlook Long Call Calendar Spread Acquire Stock Neutral Outlook Increase Implied Volatility This strategy is appropriate for a stock considered to be fairly valued. The investor has a long stock position and is willing to sell the stock if it goes higher or buy more of the stock if it goes lower. This strategy consists of buying a call option. It is a candidate for investors who want a chance to participate in the underlying stock's expected appreciation during the term of the option. If things go as planned, the investor will be able to sell the call at a profit at some point before expiration. This strategy profits if the underlying stock is at the body of the butterfly at expiration. This strategy combines a longer-term bullish outlook with a near-term neutral/bearish outlook. If the underlying stock remains steady or declines during the life of the near-term option, that option will expire worthless and leave the investor owning the longer-term option free and clear. If both options have the same strike price, the strategy will always require paying a premium to initiate the position. Long Call Condor Neutral Outlook Decrease Implied Volatility This strategy profits if the underlying security is between the two short call strikes at expiration. Long Condor Sharp Move Increase Implied Volatility Long Iron Butterfly Sharp Move Increase Implied Volatility Long Put Bearish Outlook Sharp Move Increase Implied Volatility Long Put Butterfly Neutral Outlook This strategy profits if the underlying stock is outside the outer wings at expiration. This strategy profits if the underlying stock is outside the wings of the iron butterfly at expiration. This strategy consists of buying puts as a means to profit if the stock price moves lower. It is a candidate for bearish investors who want to participate in an anticipated downturn, but without the risk and inconveniences of selling the stock short. The time horizon is limited to the life of the option. This strategy profits if the underlying stock is at the body of the butterfly at expiration. 4

5 Long Put Calendar Spread Neutral Outlook Increase Implied Volatility This strategy combines a longer-term bearish outlook with a near-term neutral/bullish outlook. If the stock remains steady or rises during the life of the near-term option, it will expire worthless and leave the investor owning the longerterm option. If both options have the same strike price, the strategy will always require paying a premium to initiate the position. Long Put Condor Neutral Outlook Decrease Implied Volatility This strategy profits if the underlying security is between the two short put strikes at expiration. Long Ratio Call Spread Bullish Outlook Sharp Move Increase Implied Volatility The initial cost to initiate this strategy is rather low, and may even earn a credit, but the upside potential is unlimited. The basic concept is for the total delta of the two long calls to roughly equal the delta of the single short call. If the underlying stock only moves a little, the change in value of the option position will be limited. But if the stock rises enough to where the total delta of the two long calls approaches 200 the strategy acts like a long stock position. Long Ratio Put Spread Hedge Stock Bearish Outlook Sharp Move Increase Implied Volatility The initial cost to initiate this strategy is rather low, and may even earn a credit, but the downside potential is substantial. The basic concept is for the total delta of the two long puts to roughly equal the delta of the single short put. If the underlying stock only moves a little, the change in value of the option position will be limited. But if the stock declines enough to where the total delta of the two long puts approaches 200 the strategy acts like a short stock position. Long Stock Produce Income Bullish Outlook This strategy is simple. It consists of acquiring stock in anticipation of rising prices. The gains, if there are any, are realized only when the asset is sold. Until that time, the investor faces the possibility of partial or total loss of the investment, should the stock lose value. In some cases the stock may generate dividend income. In principle, this strategy imposes no fixed timeline. However, special circumstances could delay or accelerate an exit. For example, a margin purchase is subject to margin calls at any time, which could force a quick sale unexpectedly. Long Straddle Sharp Move Increase Implied Volatility This strategy consists of buying a call option and a put option with the same strike price and expiration. The combination generally profits if the stock price moves sharply in either direction during the life of the options. Long Strangle Sharp Move Increase Implied Volatility This strategy profits if the stock price moves sharply in either direction during the life of the option. 5

6 Naked Call Produce Income Bearish Outlook Neutral Outlook Decrease Implied Volatility Naked Put Produce Income Bullish Outlook Neutral Outlook Decrease Implied Volatility This strategy consists of writing an uncovered call option. It profits if the stock price holds steady or declines, and does best if the option expires worthless. A naked put involves writing a put option without the reserved cash on hand to purchase the underlying stock. This strategy entails a great deal of risk and relies on a steady or rising stock price. It does best if the option expires worthless. Protective Put Hedge Stock Bullish Outlook Sharp Move Increase Implied Volatility This strategy consists of adding a long put position to a long stock position. The protective put establishes a 'floor' price under which investor's stock value cannot fall. If the stock keeps rising, the investor benefits from the upside gains. Yet no matter how low the stock might fall, the investor can exercise the put to liquidate the stock at the strike price. Short Call Butterfly This strategy profits if the underlying stock is outside the wings of the butterfly at expiration. Short Call Calendar Spread Decrease Implied Volatility This strategy profits from the different characteristics of near and longer-term call options. If the stock holds steady, the strategy suffers from time decay. If the underlying stock moves sharply up or down, both options will move toward their intrinsic value or zero, thus narrowing the difference between their values. If both options have the same strike price, the strategy will always receive a premium when initiating the position. Short Condor Produce Income Neutral Outlook Decrease Implied Volatility Short Iron Butterfly Produce Income Neutral Outlook Short Put Butterfly Sharp Move This strategy profits if the underlying stock is inside the inner wings at expiration. This strategy profits if the underlying stock is inside the wings of the iron butterfly at expiration. This strategy profits if the underlying stock is outside the wings of the butterfly at expiration. Short Put Calendar Spread Sharp Move This strategy profits from the different characteristics of near and longer-term put options. If the underlying stock holds steady, the strategy suffers from time decay. If the stock moves sharply up or down, both options will move toward their intrinsic value or zero, thus narrowing the difference between their values. If both options have the same strike price, the strategy will always receive a premium when initiating the position. 6

7 Short Stock Bearish Outlook Short Straddle Produce Income Neutral Outlook Decrease Implied Volatility Short Strangle Produce Income Neutral Outlook Decrease Implied Volatility Short Ratio Call Spread Produce Income Bearish Outlook Neutral Outlook Decrease Implied Volatility Short Ratio Put Spread Produce Income Bullish Outlook Neutral Outlook Decrease Implied Volatility A candidate for bearish investors who wish to profit from a depreciation in the stock's price. The strategy involves borrowing stock through the brokerage firm and selling the shares in the marketplace at the prevailing price. The goal is to buy them back later at a lower price, thereby locking in a profit. This strategy involves selling a call option and a put option with the same expiration and strike price. It generally profits if the stock price and volatility remain steady. This strategy profits if the stock price and volatility remain steady during the life of the options. This strategy can profit from a steady stock price, or from a falling implied volatility. The actual behavior of the strategy depends largely on the delta, theta and Vega of the combined position as well as whether a debit is paid or a credit received when initiating the position. This strategy can profit from a slightly falling stock price, or from a rising stock price. The actual behavior of the strategy depends largely on the delta, theta and vega of the combined position as well as whether a debit is paid or a credit received when initiating the position. Synthetic Long Put Bearish Outlook Sharp Move Increase Implied Volatility Synthetic Long Stock Bullish Outlook Sharp Move This strategy combines a long call and a short stock position. Its payoff profile is equivalent to a long put's characteristics. The strategy profits if the stock price moves lower--the more dramatically, the better. The time horizon is limited to the life of the option. This strategy is essentially a long futures position on the underlying stock. The long call and the short put combined simulate a long stock position. The net result entails the same risk/reward profile, though only for the term of the option: unlimited potential for appreciation, and large (though limited) risk should the underlying stock fall in value. Synthetic Short Stock Bearish Outlook Sharp Move This strategy is essentially a short futures position on the underlying stock. The long put and the short call combined simulate a short stock position. The net result entails the same risk/reward profile, though only for the term of the options: limited but large potential for appreciation if the stock declines, and unlimited risk should the underlying stock rise in value. 7

8 Bear Call Spread (Credit Call Spread) Description A bear call spread is a type of vertical spread. It contains two calls with the same expiration but different strikes. The strike price of the short call is below the strike of the long call, which means this strategy will always generate a net cash inflow (net credit) at the outset. The short call's main purpose is to generate income, whereas the long call simply helps limit the upside risk. The profitability of the strategy depends on how much of the initial premium revenue is retained before the strategy is closed out or expires. As the strategy's name suggests, it does best if the stock stays below the lower strike price for the duration of the options. Still, an unexpected rally should not provoke a crisis: though the maximum gain of this strategy is very limited, so are potential losses. It is interesting to compare this strategy to the bear put spread. The profit/loss payoff profiles are exactly the same, once adjusted for the net cost to carry. Net Position (at expiration) EXAMPLE Short 1 XYZ 60 call Long 1 XYZ 65 call MAXIMUM GAIN Net premium received MAXIMUM LOSS High strike - low strike - net premium received The chief difference is the timing of the cash flows. The bear put spread requires a known initial outlay for an unknown eventual return; the bear call spread produces a known initial cash inflow in exchange for a possible outlay later on. Outlook Looking for a decline in the underlying stock's price during the life of the options. As with any limited-time strategy, the investor's long-term forecast for the underlying stock isn't as important, but this is probably not a suitable choice for those who have a bearish outlook past the immediate future. It would take an accurately timed forecast to pinpoint the turning point where a coming short-term rally would turn into a bearish long term. Summary A bear call spread is a limited-risk, limited-reward strategy, consisting of one short call option and one long call option. This strategy generally profits if the stock price holds steady or declines. The most it can generate is the net premium received at the outset. If the forecast is wrong and the stock rallies instead, the losses grow only until the long call caps the amount. Motivation 8

9 The chance to earn income with limited risk, and/or profit from a decline in the underlying stock's price. Variations A vertical call spread can be a bullish or bearish strategy, depending on how the strike prices are selected for the long and short positions. See bull call spread for the bullish counterpart. Max Loss The maximum loss is limited. The worst that can happen at expiration is for the stock price to be above the higher strike. In that case, the investor will be assigned on the short call, now deep-in-the-money, and will exercise the long call. The simultaneous exercise and assignment will mean selling the stock at the lower strike and buying the stock at the higher strike. The maximum loss is the difference between the two strikes, but it is reduced by the net credit received at the outset. Max Gain The maximum gain is limited. The best that can happen at expiration is for the stock to be below both strike prices. In that case, both the short and long call options expire worthless, and the investor pockets the credit received when putting on the position. Profit/Loss Both the potential profit and loss for this strategy are very limited and very well-defined. The initial net credit is the most the investor can hope to make with the strategy. Profits at expiration start to erode if the stock is above the lower strike price, and losses reach their maximum if the stock hits the higher strike price. Above the higher strike price, profits from exercising the long call completely offset further losses on the short call. The way in which the investor selects the two strike prices determines the maximum income potential and maximum risk. By selecting a lower short call strike and/or a higher long call strike, the investor can increase the initial net premium income. However, it may be interesting to experiment with the Position Simulator to see how such decisions would affect the likelihood of short call assignment and the level of protection in the event of a big rally. Breakeven This strategy breaks even at expiration if the stock price is above the lower strike by the amount of the initial credit received. In that case the long call would expire worthless, and the short call's intrinsic value would equal the net credit. Breakeven = short call strike + net credit received Volatility Slight, all other things being equal. Since the strategy involves being short one call and long another with the same expiration, the effects of volatility shifts on the two contracts may offset each other to a large degree. Note, however, that the stock price can move in such a way that a volatility change would affect one price more than the other. Time Decay The passage of time helps the position, though not quite as much as it does a plain short call position. Since the strategy involves being short one call and long another with the same expiration, the effects of time decay on the two contracts may offset each 9

10 other to a large degree. Regardless of the theoretical impact of time erosion on the two contracts, it makes sense to think the passage of time would be a positive. This strategy generates net upfront premium income, which represents the most the investor can make on the strategy. If there are to be any claims against it, they must be occur by expiration. As expiration nears, so does the date after which the investor is free of those obligations. Assignment Risk Yes. Early assignment, while possible at any time, generally occurs when the stock goes ex-dividend. Be warned, however, that using the long call to cover the short call assignment will require establishing a short stock position for one business day, due to the delay in receiving assignment notification. And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as for example a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock. Expiration Risk Yes. The investor cannot know for sure whether or not they were assigned on the short call until the Monday after expiration. That creates risk. The problem is most acute if the stock is trading just below, at or just above the short call strike. Say the short call ends up slightly in-the-money, and the investor buys the stock in the market in anticipation of being assigned. If assignment fails to occur, the investor won't discover the unintended net long stock position until the following Monday and is subject to an adverse move in the stock over the weekend. There is risk in guessing wrong in the other direction, too. This time, assume the investor bets against being assigned. Come Monday, if assignment occurred after all, the investor is unexpectedly short the stock, and its value may have risen over the weekend. Two ways to prepare: close the spread out early, or be prepared for either outcome on Monday. Either way, it's important to monitor the stock, especially over the last day of trading. Comments N/A Related Position Comparable Position: Bear Put Spread Opposite Position: Bull Call Spread 10

11 Bear Put Spread in Description A bear put spread is a type of vertical spread. It consists of buying one put in hopes of profiting from a decline in the underlying stock, and writing another put with the same expiration, but with a lower strike price, as a way to offset some of the cost. Because of the way the strike prices are selected, this strategy requires a net cash outlay (net debit) at the outset. Assuming the stock moves down toward the lower strike price, the bear put spread works a lot like its long put component would as a standalone strategy. However, in contrast to a plain long put, the possibility of greater profits stops there. This is part of the tradeoff; the short put premium mitigates the cost of the strategy but also sets a ceiling on the profits. A different pair of strike price choices might work, provided that the short put strike is below the long put strike. The choice is a matter of balancing tradeoffs and keeping to a realistic forecast. Net Position (at expiration) EXAMPLE Long 1 XYZ 60 put Short 1 XYZ 55 put MAXIMUM GAIN High strike - low strike - net premium paid MAXIMUM LOSS Net premium paid The lower the short put strike, the higher the potential maximum profit; but that benefit has to be weighed against the disadvantage: a smaller amount of premium received. It is interesting to compare this strategy to the bear call spread. The profit/loss payoff profiles are exactly the same, once adjusted for the net cost to carry. The chief difference is the timing of the cash flows. The bear put spread requires a known initial outlay for an unknown eventual return; the bear call spread produces a known initial cash inflow in exchange for a possible outlay later on. Outlook Looking for a steady or declining stock price during the term of the options. While the longer-term outlook is secondary, there is an argument for considering another alternative if the investor is bearish on the stock's future. It would take careful pinpointing to forecast when an expected rally would end and the eventual decline would start. Summary A bear put spread consists of buying one put and selling another put, at a lower strike, to offset part of the upfront cost. The spread generally profits if the stock price moves lower. The potential profit is limited, but so is the risk should the stock unexpectedly 11

12 rally. Motivation Profit from a near-term decline in the underlying stock. Variations A vertical put spread can be a bullish or bearish strategy, depending on how the strike prices are selected for the long and short positions. See bull put spread for the bullish counterpart. Max Loss The maximum loss is limited. The worst that can happen at expiration is for the stock to be above the higher (long put) strike price. In that case, both put options expire worthless, and the loss incurred is simply the initial outlay for the position (the debit). Max Gain The maximum gain is limited. The best that can happen is for the stock price to be below the lower strike at expiration. The upper limit of profitability is reached at that point, even if the stock were to decline further. Assuming the stock price is below both strike prices at expiration, the investor would exercise the long put component and presumably be assigned on the short put. So, the stock is sold at the higher (long put strike) price and simultaneously bought at the lower (short put strike) price. The maximum profit then is the difference between the two strike prices, less the initial outlay (the debit) paid to establish the spread. Profit/Loss Both the potential profit and loss for this strategy are very limited and very well defined. The net premium paid at the outset establishes the maximum risk, and the short put strike price sets the upper boundary, beyond which further stock price erosion won't improve the profitability. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position. The investor can alter the profit/loss boundaries by selecting different strike prices. However, each choice represents the classic risk/reward tradeoff: greater opportunities and risk, versus more limited opportunities and risk. Breakeven This strategy breaks even if, at expiration, the stock price is below the upper strike by the amount of the initial outlay (the debit). In that case, the short put would expire worthless, and the long put's intrinsic value would equal the debit. Breakeven = long put strike - net debit paid Volatility Slight, all other things being equal. Since the strategy involves being short one put and long another with the same expiration, the effects of volatility shifts on the two contracts may offset each other to a large degree. Note, however, that the stock price can move in such a way that a volatility change would affect one price more than the other. Time Decay The passage of time hurts the position, though not quite as much as it does an plain long put position. Since the strategy involves being long one put and short another with the same expiration, the effects of time decay on the two contracts may offset each 12

13 other to a large degree. Regardless of the theoretical impact of time erosion on the two contracts, it makes sense to think the passage of time would be somewhat of a negative. This strategy requires a non-refundable initial investment. If there are to be any returns on the investment, they must be realized by expiration. As expiration nears, so does the deadline for achieving any profits. Assignment Risk Yes. Early assignment, while possible at any time, generally occurs only when a put option goes deep into-the-money. Be warned, however, that using the long put to cover the short put assignment will require financing a long stock position for one business day. And be aware, any situation where a stock is involved in a restructuring or capitalization event, such as for example a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock. Expiration Risk Yes. If held into expiration, this strategy entails added risk. The investor cannot know for sure until the following Monday whether or not the short put was assigned. The problem is most acute if the stock is trading just below, at or just above the short put strike. Guessing wrong either way could be costly. Assume that on Friday afternoon the long put is deep-in-the-money, and that the short put is roughly at-the-money. Exercise (stock sale) is certain, but assignment (stock purchase) isn't. If the investor guesses wrong, the new position next week will be wrong, too. Say, assignment is anticipated but fails to occur; the investor won't discover the unintended net short stock position until the following Monday, and is subject to an adverse rise in the stock over the weekend. Now assume the investor bet against assignment and bought the stock in the market to liquidate the position. Come Monday, if assignment occurred after all, the investor has bought the same shares twice, for a net long stock position and exposure to a decline in the stock price. Two ways to prepare: close the spread out early or be prepared for either outcome on Monday. Either way, it's important to monitor the stock, especially over the last day of trading. Comments N/A Related Position Comparable Position: Bear Call Spread Opposite Position: Bull Put Spread 13

14 Bear Spread Spread (Double Bear Spread, Combination Bear Spread) Description This strategy consists of being short one call and long another call with a higher strike; also long one put and short another put with a lower strike. Typically, the call strikes are above and the put strikes below the current level of underlying stock, and the distance between the call strikes equals the distance between the put strikes. All options must be the same expiration. This strategy is the combination of a bear call spread and a bear put spread. Outlook Looking for falling stock price. Summary This strategy is the combination of a bear call spread and a bear put spread. A key part of the strategy is to initiate the position at even money, so the cost of the put spread should be offset by the proceeds from the call spread. Motivation Profit from a declining stock price. Net Position (at expiration) EXAMPLE Long 1 XYZ 70 call Short 1 XYZ 65 call Long 1 XYZ 55 put Short 1 XYZ 50 put MAXIMUM GAIN High put strike - low put strike - net premium paid MAXIMUM LOSS High call strike - low call strike - net premium paid Variations N/A Max Loss The maximum loss would occur should the underlying stock be above the upper call strike at expiration. In that case both calls would be in-the-money, and the loss would be the difference between the call strike prices, plus or minus any premium paid or received from initiating the position. Max Gain The maximum gain would occur should the underlying stock be below the lower put strike at expiration. In that case both puts would be in-the-money, and the gain would be the difference between the put strike prices, plus or minus any premium received or paid from initiating the position. 14

15 Profit/Loss The potential profit and loss are both limited. This strategy is the combination of a bear call spread and a bear put spread. The maximum profit occurs when the underlying stock goes below the lower put strike at expiration. The maximum loss occurs when the underlying stock goes above the upper call strike at expiration. Breakeven If this strategy is initiated at even money, then breakeven is anywhere that all the options expire worthless, or between the lower call strike and upper put strike. If a premium was paid or received, then breakeven would occur where the underlying stock at expiration is above the lower call strike price by the premium received or below the upper put by premium paid. Volatility An increase in implied volatility will, all other things equal, generally have only a slight impact on this strategy. Whether the impact is positive or negative, however, depends on which options are in-the-money or out-of-the-money, the time to expiration and level of interest rates. Time Decay The passage of time will, all other things equal, generally have only a slight impact on this strategy. Whether the impact is positive or negative, however, depends on which options are in-the-money or out-of-the-money, the time to expiration and level of interest rates. Assignment Risk Yes. Early assignment, while possible at any time, generally occurs for a call when the stock goes ex-dividend and for a put when it goes deep in-the-money. And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as for example a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock. Expiration Risk Yes. The investor cannot know for sure whether or not they will be assigned on a short option until the Monday after expiration. If unexpected exercise activity occurs, they could find themselves with a stock position on the Monday following expiration and subject to an adverse move in the stock over the weekend. Comments N/A Related Position Comparable Position: N/A Opposite Position: Bull Spread Spread 15

16 Bull Call Spread (Debit Call Spread) Description A bull call spread is a type of vertical spread. It contains two calls with the same expiration but different strikes. The strike price of the short call is higher than the strike of the long call, which means this strategy will always require an initial outlay (debit). The short call's main purpose is to help pay for the long call's upfront cost. Up to a certain stock price, the bull call spread works a lot like its long call component would as a standalone strategy. However, unlike with a plain long call, the upside potential is capped. That is part of the tradeoff; the short call premium mitigates the overall cost of the strategy but also sets a ceiling on the profits. A different pair of strike prices might work, provided that the short call strike is above the long call's. The choice is a matter of balancing risk/reward tradeoffs and a realistic forecast. Net Position (at expiration) EXAMPLE Long 1 XYZ 60 call Short 1 XYZ 65 call MAXIMUM GAIN High strike - low strike - net premium paid MAXIMUM LOSS Net premium paid The benefit of a higher short call strike is a higher maximum to the strategy's potential profit. The disadvantage is that the premium received is smaller, the higher the short call's strike price. It is interesting to compare this strategy to the bull put spread. The profit/loss payoff profiles are exactly the same, once adjusted for the net cost to carry. The chief difference is the timing of the cash flows. The bull call spread requires a known initial outlay for an unknown eventual return; the bull put spread produces a known initial cash inflow in exchange for a possible outlay later on. Outlook Looking for a steady or rising stock price during the life of the options. As with any limited-time strategy, the investor's long-term forecast for the underlying stock isn't as important, but this is probably not a suitable choice for those who have a bullish outlook past the immediate future. It would require an accurately timed forecast to pinpoint the turning point where a coming short-term dip will turn around and a long-term rally will start. Summary This strategy consists of buying one call option and selling another at a higher strike price to help pay the cost. The spread generally profits if the stock price moves higher, just as a regular long call strategy would, up to the point where the short call caps 16

17 further gains. Motivation Profit from a gain in the underlying stock's price without the up-front capital outlay and downside risk of outright stock ownership. Variations A vertical call spread can be a bullish or bearish strategy, depending on how the strike prices are selected for the long and short positions. See bear call spread for the bearish counterpart. Max Loss The maximum loss is very limited. The worst that can happen is for the stock to be below the lower strike price at expiration. In that case, both call options expire worthless, and the loss incurred is simply the initial outlay for the position (the net debit). Max Gain The maximum gain is capped at expiration, should the stock price do even better than hoped and exceed the higher strike price. If the stock price is at or above the higher (short call) strike at expiration, in theory, the investor would exercise the long call component and presumably would be assigned on the short call. As a result, the stock is bought at the lower (long call strike) price and simultaneously sold at the higher (short call strike) price. The maximum profit then is the difference between the two strike prices, less the initial outlay (the debit) paid to establish the spread. Profit/Loss Both the potential profit and loss for this strategy are very limited and very well-defined: the net premium paid at the outset establishes the maximum risk, and the short call strike price sets the upper boundary beyond which further stock gains won't improve the profitability. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position. Breakeven This strategy breaks even at expiration if the stock price is above the lower strike by the amount of the initial outlay (the debit). In that case, the short call would expire worthless and the long call's intrinsic value would equal the debit. Breakeven = long call strike + net debit paid Volatility Slight, all other things being equal. Since the strategy involves being long one call and short another with the same expiration, the effects of volatility shifts on the two contracts may offset each other to a large degree. Note, however, that the stock price can move in such a way that a volatility change would affect one price more than the other. Time Decay The passage of time hurts the position, though not as much as it does a plain long call position. Since the strategy involves being long one call and short another with the same expiration, the effects of time decay on the two contracts may offset each other to a large degree. Regardless of the theoretical price impact of time erosion on the two contracts, it makes sense to think the passage of time would be somewhat of a negative. This strategy 17

18 requires a non-refundable initial investment. If there are to be any returns on the investment, they must be realized by expiration. As expiration nears, so does the deadline for achieving any profits. Assignment Risk Early assignment, while possible at any time, generally occurs only when the stock goes ex-dividend. Be warned, however, that using the long call to cover the short call assignment will require establishing a short stock position for one business day, due to the delay in assignment notification. And be aware, any situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock. Expiration Risk Yes. If held into expiration this strategy entails added risk. The investor cannot know for sure until the following Monday whether or not the short call was assigned. The problem is most acute if the stock is trading just below, at or just above the short call strike. Assume that the long call is in-the-money and that the short call is roughly at-themoney. Exercise (stock purchase) is certain, but assignment (stock sale) isn't. If the investor guesses wrong, the new position on Monday will be wrong, too. Say, assignment is expected but fails to occur; the investor will unexpectedly be long the stock on the following Monday, subject to an adverse move in the stock over the weekend. Now assume the investor bet against assignment and sold the stock in the market instead; come Monday, if assignment occurred, the investor has sold the same shares twice for a net short stock position, and is exposed to a rally in the stock price. Two ways to prepare: close the spread out early or be prepared for either outcome on Monday. Either way, it's important to monitor the stock, especially over the last day of trading. Comments N/A Related Position Comparable Position: Bull Put Spread Opposite Position: Bear Call Spread 18

19 Bull Put Spread (Credit Put Spread) Description A bull put spread involves being short a put option and long another put option with the same expiration but with a lower strike. The short put generates income, whereas the long put's main purpose is to offset assignment risk and protect the investor in case of a sharp move downward. Because of the relationship between the two strike prices, the investor will always receive a premium (credit) when initiating this position. This strategy entails precisely limited risk and reward potential. The most this spread can earn is the net premium received at the outset, which is likeliest if the stock price stays steady or rises. If the forecast is wrong and the stock declines instead, the strategy leaves the investor with either a lower profit or a loss. The maximum loss is capped by the long put. It is interesting to compare this strategy to the bull call spread. The profit/loss payoff profiles are exactly the same, once adjusted for the net cost to carry. The chief difference is the timing of the cash flows and the potential for early assignment. Net Position (at expiration) EXAMPLE Short 1 XYZ 60 put Long 1 XYZ 55 put MAXIMUM GAIN Net premium received MAXIMUM LOSS High strike - low strike - net premium received The bull call spread requires a known initial outlay for an unknown eventual return; the bull put spread produces a known initial cash inflow in exchange for a possible outlay later on. Outlook Looking for a rise in the underlying stock's price during the options' term. While the longer-term outlook is secondary, there is an argument for considering another alternative if the investor is bullish on the stock's future. It would take careful pinpointing to forecast when an expected decline would end and the eventual rally would start. Summary A bull put spread is a limited-risk, limited-reward strategy, consisting of a short put option and a long put option with a lower strike. This spread generally profits if the stock price holds steady or rises. Motivation Investors initiate this spread either as a way to earn income with limited risk, or to profit from a rise in the underlying stock's price, or both. Variations 19

20 A vertical put spread can be a bullish or bearish strategy, depending on how the strike prices are selected for the long and short positions. See bear put spread for the bearish counterpart. Max Loss The maximum loss is limited. The worst that can happen is for the stock price to be below the lower strike at expiration. In that case, the investor will be assigned on the short put, now deep-in-the-money, and will exercise their long put. The simultaneous exercise and assignment will mean buying the stock at the higher strike and selling it at the lower strike. The maximum loss is the difference between the strikes, less the credit received when putting on the position. Max Gain The maximum gain is limited. The best that can happen is for the stock to be above the higher strike price at expiration. In that case, both put options expire worthless, and the investor pockets the credit received when putting on the position. Profit/Loss Both the potential profit and loss for this strategy are very limited and very well-defined. The initial net credit is the most the investor can hope to make with the strategy. Profits at expiration start to erode if the stock is below the higher (short put) strike, and losses reach their maximum if the stock falls to, or beyond, the lower (long put) strike. Below the lower strike price, profits from exercising the long put completely offset further losses on the short put. The way in which the investor selects the two strike prices determines the maximum income potential and maximum risk. By selecting a higher short put strike and/or a lower long put strike, the investor can increase the initial net premium income. However, it may be interesting to experiment with the Position Simulator to see how such decisions would affect the likelihood of short put assignment and the level of protection in the event of a downturn in the underlying stock. Breakeven This strategy breaks even if, at expiration, the stock price is below the upper strike (short put strike) by the amount of the initial credit received. In that case, the long put would expire worthless, and the short put's intrinsic value would equal the net credit. Breakeven = short put strike - net credit received Volatility Slight, all other things being equal. Since the strategy involves being short one put and long another with the same expiration, the effects of volatility shifts on the two contracts may offset each other to a large degree. Note, however, that the stock price can move in such a way that a volatility change would affect one price more than the other. Time Decay The passage of time helps the position, though not quite as much as it does a plain short put position. Since the strategy involves being short one put and long another with the same expiration, the effects of time decay on the two contracts may offset each other to a large degree. Regardless of the theoretical impact of time erosion on the two contracts, it makes 20

21 sense to think the passage of time would be a positive. This strategy generates net upfront premium income, which represents the most the investor can make on the strategy. If there are to be any claims against it, they must occur by expiration. As expiration nears, so does the date after which the investor is free of those obligations. Assignment Risk Yes. Early assignment, while possible at any time, generally occurs only when a put option goes deep into-the-money. Be warned, however, that using the long put to cover the short put assignment will require financing a long stock position for one business day. And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as for example a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock. Expiration Risk Yes. If held into expiration, this strategy entails added risk. The investor cannot know for sure whether or not they will be assigned on the short put until the Monday after expiration. The problem is most acute if the stock is trading just below, at or just above the short put strike. Say, the short put ends up slightly in-the-money, and the investor sells the stock short in anticipation of being assigned. If assignment fails to occur, the investor won't discover the unintended net short stock position until the following Monday and is subject to an adverse rise in the stock over the weekend. There is risk in guessing wrong in the other direction, too. This time, assume the investor bets against being assigned. Come Monday, if assignment occurs after all, the investor has a net long position in a stock that may have lost value over the weekend. Two ways to prepare: close the spread out early, or be prepared for either outcome on Monday. Either way, it's important to monitor the stock, especially over the last day of trading. Comments N/A Related Position Comparable Position: Bull Call Spread Opposite Position: Bear Put Spread 21

22 Bull Spread Spread (Double Bull Spread, Combination Bull Spread) Description This strategy consists of being long one call and short another call with a higher strike, and short one put with a long put on a lower strike. Typically, the call strikes are above and the put strikes below the current level of underlying stock, and the distance between the call strikes equals the distance between the put strikes. All options must have the same expiration date. Outlook Looking for rising stock price. Summary This strategy is the combination of a bull call spread and a bull put spread. A key part of the strategy is to initiate the position at even money, so the cost of the call spread should be offset by the proceeds from the put spread. Motivation Profit from a rising stock price. Variations N/A Net Position (at expiration) EXAMPLE Short 1 XYZ 70 call Long 1 XYZ 65 call Short 1 XYZ 55 put Long 1 XYZ 50 put MAXIMUM GAIN High call strike - low call strike - net premium paid MAXIMUM LOSS High put strike - low put strike - net premium paid Max Loss The maximum loss would occur should the underlying stock be below the lower put strike at expiration. In that case, both puts would be in-the-money, and the loss would be the difference between the put strike prices plus or minus any premium paid or received from initiating the position. Max Gain The maximum gain would occur should the underlying stock be above the upper call strike at expiration. In that scenario, both calls would be in-the-money, and the gain would be the difference between the call strike prices plus or minus any premium received or paid from initiating the position. 22

23 Profit/Loss The potential profit and loss are both limited. The maximum profit occurs when the underlying stock goes above the upper call strike. The maximum loss occurs when the underlying stock goes below the lower put strike. Breakeven If this strategy is initiated at even money, then breakeven is anywhere that all the options expire worthless, i.e., between the lower call strike and upper put strike. If a premium was paid or received, then breakeven would occur where the underlying stock at expiration is above the lower call strike price by the premium paid or below the upper put by the premium paid. Volatility An increase in implied volatility will, all other things equal, generally have only a slight impact on this strategy. Whether the impact is positive or negative depends on which options are in-the-money or out-of-the-money, the time to expiration and level of interest rates. Time Decay The passage of time will, all other things equal, generally have only a slight impact on this strategy. Whether the impact is positive or negative depends on which the options are in-the-money or out-of-the-money, the time to expiration and level of interest rates. Assignment Risk Yes. Early assignment, while possible at any time, generally occurs for a call when the stock goes ex-dividend and for a put when it goes deep in-the-money. And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock. Expiration Risk Yes. The investor cannot know for sure whether or not they will be assigned on a short option until the Monday after expiration. If unexpected exercise activity occurs, they could find themselves with a stock position on the Monday following expiration and subject to an adverse move in the stock over the weekend. Comments N/A Related Position Comparable Position: N/A Opposite Position: Bear Spread Spread 23

24 Cash-Backed Call (Cash-Secured Call) Description The investor buys a call option, and sets aside in a risk-free interest-bearing instrument enough cash to exercise it. This strategy is the equivalent of a rain check for the underlying stock, because it allows an investor to postpone the purchase decision. The call guarantees a maximum purchase price during the life of the option, while leaving the investor free to take advantage of any downturn that might occur in the stock price. If the stock rallies above the strike price, a call owner can consider exercising or selling to close, hopefully at a higher price. If, on the other hand, the stock is below the strike at expiration, the call expires worthless. However, by purchasing the call option, the investor locked in an opportunity to reconsider the stock purchase. Assuming that the long-term outlook for the stock still looks good, it might be a great time to buy the stock at the new, lower market price. Net Position (at expiration) EXAMPLE Long 1 XYZ 60 call Long $6,000 T-Bill MAXIMUM GAIN Unlimited MAXIMUM LOSS Premium paid If the stock's prospects now seem fundamentally worse, the investor 'dodged a bullet' by only risking the call premium. The remaining capital is still available for other investments. Outlook Looking for a sharp move in underlying stock, either up or down, during life of option. The longer-term outlook for stock is bullish. Summary This strategy allows an investor to purchase stock at the lower of strike price or market price during the life of the option. Motivation Acquire stock. This is a classic option strategy whereby an investor locks in a future purchase price without giving up the ability to purchase the stock at a lower price should the market decline during the life of the option. Variations This strategy differs from a long call only in the motivation of the investor and their ability to actually exercise the option and pay for the underlying stock. A long call strategy is usually liquidated for a profit or loss before its expiration, whereas an 24

25 investor using the cash-backed call strategy actually intends to purchase the stock and hold it for the longer term. A common variation of this strategy is to liquidate a long position in the stock and replace it with the cash-backed call, thus preserving the investor's exposure to the stock while limiting the risk. There could, however, be tax consequences for using this replacement strategy. And for any variation of this strategy, ownership of a call option does not give the investor any voting rights in the company, nor will they receive any dividends. Max Loss The maximum loss from the option itself would be the premium paid. Since this strategy is designed to acquire stock, the ultimate gain or loss depends on the longer-term performance of the stock. From this perspective, the option expiring worthless would be a positive event since it would allow the investor to purchase stock at an even lower price. Max Gain The maximum gain from the option is unlimited since there is no upper bound on the price of the underlying stock. Profit/Loss The potential profit is unlimited, whether measured by the option's near-term or stock's long-term performance. Losses during the life of the option are limited. The worst situation would be if at expiration the stock were exactly at the strike price of the call option; in this case the premium paid would have been lost without the benefit of being able to purchase the stock at a reduced price. Assuming the investor's outlook for the stock remains bullish, they would benefit from a move in either direction. If the stock goes down it can be purchased at the lower price; however high it might rise, the stock can be purchased at the strike price of the option. Breakeven Breakeven at expiration can be defined here in two ways. The standard definition for an option breakeven is the point where the benefits of exercising the option are equal to the premium paid: Breakeven = strike price + premium. But to really understand this strategy, it should be compared to the alternative of simply buying the stock today. If the stock moves higher, the investor using the cash-backed call strategy is worse off by a fixed amount: the premium paid, plus (minus) the original out-of-the-money (in-the-money) amount. But if the stock drops by more than the premium amount, the investor will be better off for having delayed the purchase, i.e., the downside 'breakeven' point could be seen as: Breakeven = starting stock price premium Volatility An increase in implied volatility, all other things equal, would have a positive impact on this strategy. However, since the investor's motivation is to purchase the stock, this is not the driving factor. Time Decay The passage of time, all other things equal, will have a negative impact on this strategy. 25

26 As expiration approaches the insurance value of the strategy is eroded because there is less likelihood of a significant move in the underlying stock. Assignment Risk None. Expiration Risk None. It is presumed that the investor will want to exercise the option if it's in-themoney. If in-the-money at expiration, the option will most likely be exercised on the holder's behalf unless contrary instructions are submitted to their brokerage firm, so it's always a good idea to be familiar with all your broker's procedures and deadlines for option expirations. Comments This strategy is especially suitable for investors who have a large amount of cash to invest in the market. It allows them to immediately lock in some upside potential without giving up the ability to dollar-cost average their stock purchases. Should the stock rise and the option go in-the-money, the investor should pay particular attention to any dividend payments as it may be optimal to exercise the call early to reap the dividend. Unlike a shareholder, the owner of a call has no voting rights, receives no dividends and, in the event of a merger or spinoff, is not entitled to take advantage of any election that might be offered. Related Position Comparable Position: Protective Put Opposite Position: N/A 26

27 Cash-Secured Put Description The cash-secured put involves writing an at-the-money or out-of-the-money put option and simultaneously setting aside enough cash to buy the stock. The goal is to be assigned and acquire the stock below today's market price. Whether or not the put is assigned, all outcomes are presumably acceptable. The premium income will help the net results in any event. The investor is bullish on the underlying stock and hopes for a temporary downturn in its price. If the stock drops below the strike, the put may be assigned. That would allow the put writer to buy the stock at the strike price. The effective purchase would be even lower: strike price less the premium received. There are two principal risks. First, the stock might not only dip but plummet well below the strike price. The investor must be comfortable with the strike price as an acceptable long-term acquisition price, no matter how low the market goes. Net Position (at expiration) EXAMPLE Short 1 XYZ 60 put Long $6,000 T-Bill MAXIMUM GAIN Premium received MAXIMUM LOSS Strike price - premium received (substantial) Second, by waiting for a price dip, the investor risks missing out on a stock that keeps climbing upward. The choices then include repeating the short put strategy (possibly at a higher strike price), or closing out and buying the stock outright, or simply accepting that this winner 'got away.' Outlook Looking for a short-term dip in stock price, followed by a longer-term appreciation. Summary The cash-secured put involves writing a put option and simultaneously setting aside the cash to buy the stock if assigned. If things go as hoped, it allows an investor to buy the stock at a price below its current market value. The investor must be prepared for the possibility that the put won't be assigned. In that case, the investor simply keeps the premium received for selling the put option. Motivation This is primarily a stock acquisition strategy for a price-sensitive investor. Unlike a naked put writer whose only goal is to collect premium income, a cash-secured put writer actually wants to acquire the underlying stock via assignment. The strike price, less the premium received, represents a desirable purchase price. However, the put assignment is not guaranteed. Should the stock price remain above 27

28 the strike during the life of the option, the investor will miss out on the stock purchase. The consolation would be pocketing the premium received for the put. If the investor is intent on acquiring the stock and is less concerned about price, there are other strategy choices worth considering. Variations A cash-secured put is a variation on the naked put strategy. The main difference is that the cash-secured put writer has set aside the funds for buying the stock in the event it is assigned and views assignment as a positive outcome. In contrast, the naked put writer hopes that the put will keep losing value so the position won't be assigned and can be closed out early at a profit. This investor would have to liquidate other assets quickly, or borrow cash, to be able to honor an assignment notice. Max Loss The maximum loss is limited but substantial. The worst that can happen is for the stock to become worthless. In that case, the investor would be obligated to buy stock at the strike price. The loss would be reduced by the premium received for selling the put option. Notice, however, that the maximum loss is lower than would have occurred, had the investor simply purchased the stock outright rather than via selling a put option. Max Gain The maximum gain from the put option itself is limited. However, the optimal outcome is not readily apparent in the expiration profit/loss payoff diagram, because it does not address developments after expiration. The best scenario would be for the stock to dip slightly below the strike price at the put option's expiration, trigger assignment and then rally immediately afterwards to record heights. The put assignment would have allowed our investor to buy the stock at the strike price just in time to participate in the following rally. From a strictly short-term perspective, the maximum possible gain occurs if the stock stays above the strike, causing the put option to expire worthless. The investor would keep the T-Bill cash originally set aside in case of assignment and simply pocket the premium from the sale of the option. While that is a benign outcome, it obviously doesn't reflect the fact that the investor would rather be participating in the stock's upward movement. Profit/Loss In a short-term sense, the potential profit (from the put option itself) is very limited, while the potential losses are substantial. The premium earned is comparatively small compensation for accepting the large downside risk of a stock owner. If the stock falls to zero, the put writer is obligated to buy a worthless stock at the strike price. Still, this short-term view gives an incomplete picture of the risks and rewards. It is perhaps more appropriate to compare this strategy to buying the stock outright, since the goal of stock ownership is the same. The cash-secured put does somewhat better if assignment occurs. The put writer gets a better purchase price than the original stock price. The 'discount' consists of the original out-of-the-money amount, if any, plus the premium received. Both investors face the risk of the stock's falling to zero, but the put writer's premium income reduces the loss at every level. And if the stock rallies back, the put writer's gains are better by the amount 28

29 of the premium. The outright stock buyer is better off than the put writer if the put is not assigned and the stock keeps rallying. Granted, the put writer keeps the T-Bill interest and the put premium. However, the stock has gotten even further away from the original target price and would now cost more to get into the portfolio. Breakeven Since the object of this strategy is to acquire stock, the investor would break even if it is possible to sell the stock at the same effective price they paid for it. Breakeven = strike price premium Volatility Whereas an increase in implied volatility would be considered an unqualified negative for a naked put writer, the effect could be described as neutral to slightly negative for the cash-secured put writer, all other things being equal. If it now appears likelier that the put will be assigned, greater volatility is a neutral or perhaps even encouraging development. However, greater implied volatility is clearly a negative in the sense that it can raise the put's market value and thereby the cost of closing out the position. Remember, implied volatility is a measure of anticipated movement in either direction, up or down. Say, the investor is now convinced the stock will rally instead, and decides to purchase the stock outright before it goes any higher. Unless the investor is prepared to buy even more stock if assigned, the short put must be closed out, and its cost is now higher. Time Decay The passage of time will have a positive impact on this strategy, all other things being equal. As expiration approaches, the option tends to move toward its intrinsic value, which for out-of-money puts is zero. If the original forecast and goals still apply, the investor keeps the premium and is free to either buy the stock outright or write a new put. Assignment Risk Slight. Since the goal of this strategy is to acquire stock, assignment is not a problem. However, early exercise would require the investor to convert the interest-bearing asset to cash in order to pay for the stock. Also, if assignment happened during a particularly severe downturn and the put writer has second thoughts about owning the stock at the strike price, the delay between assignment and notification means that the stock could fall further before the investor can act to limit losses. This is one reason why all option writers have reason to monitor the underlying stock very closely. And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock. Expiration Risk None. Since the goal of this strategy is to acquire stock, the investor should welcome an assignment at the option's expiration. Comments Investors are told repeatedly to be wary of short option strategies, and quite rightly so. 29

30 Without question, they entail tremendous risk, far greater than the limited premium income. They are definitely not suitable for all investors and situations. However, here is a short option strategy with a risk profile that is identical to the covered call. Though far from risk-free, covered call writing is considered a perfectly legitimate strategy for many equity investors. The key here is the cash-secured put investor's intent to acquire the underlying stock regardless of the near-term lows it might hit. So as long as the put writer is comfortable with assignment and the downside risks of the stock, this strategy isn't inherently more dangerous than a covered call. Of course the risk is large if the stock is falls to zero. However, that risk applies to all stock owners and covered call writers, too. Related Position Comparable Position: Covered Call Opposite Position: N/A 30

31 Collar (Protective Collar) Description An investor writes a call option and buys a put option with the same expiration as a means to hedge a long position in the underlying stock. This strategy combines two other hedging strategies: protective puts and covered call writing. Usually, the investor will select a call strike above and a long put strike below the starting stock price. There is latitude, but the strike choices will affect the cost of the hedge as well as the protection it provides. These strikes are referred to as the 'floor' and the 'ceiling' of the position, and the stock is 'collared' between the two strikes. The put strike establishes a minimum exit price, should the investor need to liquidate in a downturn. The call strike sets an upper limit on stock gains. The investor should be prepared to relinquish the shares if the stock rallies above the call strike. In return for accepting a cap on the stock's upside potential, the investor receives a minimum price where the stock can be sold during the life of the collar. Outlook For the term of the option strategy, the investor is looking for a slight rise in the stock price, but is worried about a decline. Net Position (at expiration) EXAMPLE Long 100 shares XYZ stock Short 1 XYZ 65 call Long 1 XYZ 55 put MAXIMUM GAIN Call strike - stock purchase price - net premium paid OR Call strike - stock purchase price + net credit received MAXIMUM LOSS Stock purchase price - put strike - net premium paid OR Stock purchase - put strike + net credit received Summary The investor adds a collar to an existing long stock position as a temporary, slightly less-than-complete hedge against the effects of a possible near-term decline. The long put strike provides a minimum selling price for the stock, and the short call strike sets a maximum profit price. To protect or collar a short stock position, an investor could combine a long call with a short put. Motivation This strategy is for holders or buyers of a stock who are concerned about a correction and wish to hedge the long stock position. 31

32 Variations N/A Max Loss The maximum loss is limited for the term of the collar hedge. The worst that can happen is for the stock price to fall below the put strike, which prompts the investor to exercise the put and sell the stock at the 'floor' price: the put strike. If the stock had originally been bought at a much lower price (which is often the case for a long-term holding), this exit price might actually result in a profit. The short call would expire worthless. The actual loss (profit) would be the difference between the floor price and the stock purchase price, plus (minus) the debit (credit) from establishing the collar hedge. Max Gain The maximum gain is limited for the term of the strategy. The short-term maximum gains are reached just as the stock price rises to the call strike. The net profit remains the same no matter how much higher the stock might close; only the position outcome might differ. If the stock is above the call strike at expiration, the investor will likely be assigned on the call and liquidate the stock at the 'ceiling': the call strike. The profit would be the ceiling price, less the stock purchase price, plus (minus) the credit (debit) from establishing the collar hedge. If the stock were to close exactly at the call strike, it would expire worthless, and the stock would probably remain in the account. The profit/loss leading up to that point would be identical, but from that day forward the investor would still continue to face a stockowner's risks and rewards. Profit/Loss This strategy establishes a fixed amount of price exposure for the term of the strategy. The long put provides an acceptable exit price at which the investor can liquidate if the stock suffers losses. The premium income from the short call helps pay for the put, but simultaneously sets a limit to the upside profit potential. Both the potential profit and loss are very limited, depending on the difference between the strikes. Profit potential is not paramount here. This is, after all, a hedging strategy. The issues for the protective collar investor concern mainly how to balance the level of protection against the cost of protection for a worrisome period. Breakeven In principle, the strategy breaks even if, at expiration, the stock is above (below) its initial level by the amount of the debit (credit). If the stock is a long-term holding purchased at a much lower price, the concept of breakeven isn't relevant. Volatility Volatility is usually not a major consideration in this strategy, all things being equal. Since the strategy involves being long one option and short another with the same expiration (and generally equidistant from the stock value), the effects of implied volatility shifts may offset each other to a large degree. Time Decay Usually not a major consideration. Since the strategy involves being long one option and short another with the same expiration (and generally equidistant from the stock 32

33 value), the effects of time decay should roughly offset each other. Assignment Risk Yes. Early assignment of the short call option, while possible at any time, generally occurs only just before the stock goes ex-dividend. And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as for example a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock. Expiration Risk The option writer cannot know for sure whether or not assignment actually occurred on the short call until the following Monday. However, this is generally not an issue since the investor has stock to deliver if assigned on the call. Comments This strategy lends itself to use as a LEAPS hedge, where time value tends to make premiums higher and the period of protection is longer. The collar offers more protection than a covered call, but at a lower up-front cost than a protective put. See both of these alternatives for additional details. Related Position Comparable Position: N/A Opposite Position: N/A 33

34 Covered Call (Buy/Write) Description An investor who buys or owns stock and writes call options in the equivalent amount can earn premium income without taking on additional risk. The premium received adds to the investor's bottom line regardless of outcome. It offers a small downside 'cushion' in the event the stock slides downward and can boost returns on the upside. Predictably, this benefit comes at a cost. For as long as the short call position is open, the investor forfeits much of the stock's profit potential. If the stock price rallies above the call's strike price, the stock is increasingly likely to be called away. Since the possibility of assignment is central to this strategy, it makes more sense for investors who view assignment as a positive outcome. Because covered call writers can select their own exit price (i.e., strike plus premium received), assignment can be seen as success; after all, the target price was realized. This strategy becomes a convenient tool in equity allocation management. The investor doesn't have to sell an at-the-money call. Choosing between strike prices simply involves a trade off between priorities. Net Position (at expiration) EXAMPLE Long 100 shares XYZ stock Short 1 XYZ 60 call MAXIMUM GAIN Strike price - stock purchase price + premium received MAXIMUM LOSS Stock purchase price - premium received (substantial) The covered call writer could select a higher, out-of-the-money strike price and preserve more of the stock's upside potential for the duration of the strategy. However, the further out-of-the-money call would generate less premium income, which means there would be a smaller downside cushion in case of a stock decline. But whatever the choice, the strike price (plus the premium) should represent an acceptable liquidation price. A stock owner who would regret losing the stock during a nice rally should think carefully before writing a covered call. The only sure way to avoid assignment is to close out the position. It requires vigilance, quick action, and might cost extra to buy the call back especially if the stock is climbing fast. Outlook The covered call writer is looking for a steady or slightly rising stock price for at least the term of the option. This strategy not appropriate for a very bearish or a very bullish investor. Summary This strategy consists of writing a call that is covered by an equivalent long stock 34

35 position. It provides a small hedge on the stock and allows an investor to earn premium income, in return for temporarily forfeiting much of the stock's upside potential. Motivation The primary motive is to earn premium income, which has the effect of boosting overall returns on the stock and providing a measure of downside protection. The best candidates for covered calls are the stock owners who are perfectly willing to sell the shares if the stock rises and the calls are assigned. Stock owners that would be reluctant to part with the shares, especially mid-rally, are not usually candidates for this strategy. Covered calls require close monitoring and a readiness to take quick action if assignment is to be avoided during a sharp rally; even then, there are no guarantees. Variations Covered calls are being written against stock that is already in the portfolio. In contrast, 'Buy/Write' refers to establishing both the long stock and short call positions simultaneously. The analysis is the same, except that the investor must adjust the results for any prior unrealized stock profits or losses. Max Loss The maximum loss is limited but substantial. The worst that can happen is for the stock to become worthless. In that case, the investor will have lost the entire value of the stock. However, that loss will be reduced somewhat by the premium income from selling the call option. It is also worth noting that the risk of losing the stock's entire value is inherent in any form of stock ownership. In fact, the premium received leaves the covered call writer slightly better off than other stock owners. Max Gain The maximum gains on the strategy are limited. The total net gains depend in part on the call's intrinsic value when sold and on prior unrealized stock gains or losses. The maximum gains at expiration are limited by the strike price. If the stock is at the strike price, the covered call strategy itself reaches its peak profitability, and would not do better no matter how much higher the stock price might be. The strategy's net profit would be the premium received, plus any stock gains (or minus stock losses) as measured against the strike price. That maximum is very desirable to investors who were happy to liquidate at the strike price, whereas it could seem suboptimal to investors who were assigned but would rather still be holding the stock and participating in future gains. The prime motive determines whether the investor would consider post-assignment stock gains as irrelevant or as a lost economic opportunity. Profit/Loss This strategy may be best viewed as one of two things: a partial stock hedge that does not require additional up-front payments, or a good exit strategy for a particular stock. An investor whose main interest is substantial profit potential might not find covered calls very useful. The potential profit is limited during the life of the option, because the call caps the stock's upside potential. The main benefit is the effect of the premium income. It lowers 35

36 the stock's break even cost on the downside and boosts gains on the upside. The best-case scenario depends in part on the investor's motives. First, consider the investor who prefers to keep the stock. If at expiration the stock is exactly at the strike price, then the stock theoretically will have reached the highest value it can without triggering call assignment. The strategy nets the maximum gains and leaves the investor free to participate in the stock's future growth. By comparison, the covered call writer who is glad to liquidate the stock at the strike price does best if the call is assigned -- the earlier, the better. Unfortunately, in general it is not optimal to exercise a call option until the last day before expiration. An exception to that general rule occurs the day before a stock goes ex-dividend, in which case an early assignment would deprive the covered call writer of the stock dividend. While the profit from the option is limited to the premium received, it's possible the investor might be holding a significant unrealized gain on the stock. You could view the strategy as having protected some of those gains against slippage. As stated earlier, the hedge is limited; potential losses remain substantial. If the stock goes to zero the investor would have lost the entire amount of their investment in the stock; that loss, however, would be reduced by the premium received from selling the call, which would of course expire worthless if the stock were at zero. Note however, that the risk of loss is directly related to holding the stock, and the investor took that risk when the stock was first acquired. The short call option does not increase that downside risk. Break even Whether this strategy results in a profit or loss is largely determined by the purchase price of the stock, which may have occurred well in the past at a different price. Assume the stock and option positions were acquired simultaneously. If at expiration the position is still open and the investor wants to sell the stock, the strategy loses money only if the stock price has fallen by more than the amount of the call premium. Break even = starting stock price premium received Volatility An increase in implied volatility would have a neutral to slightly negative impact on this strategy, all other things being equal. It would tend to increase the cost of buying the short call back to close the position. In that sense, greater volatility hurts this strategy as it does all short option positions. However, considering that the long stock position covers the short call position, assignment would not trigger losses, so a greater chance of assignment should not matter. As for the downside, the premium received buffers the risk from a stock decline to some extent. Increased implied volatility is a negative, but not as risky as it would be for an uncovered short option position. Time Decay The passage of time has a positive impact on this strategy, all other things being equal. It tends to reduce the time value (and therefore overall price) of the short call, which would make it less expensive to close out if desired. As expiration approaches, an option tends to converge on its intrinsic value, which for out-of-money calls is zero. The covered call writer who would rather keep the stock definitely benefits from time erosion. In contrast, for the investor who is anxious to be assigned as soon as possible, 36

37 the passage of time may not seem like much of a benefit. However, let's say the call has not been assigned by expiration. That's OK. The investor keeps the premium and is free to earn more premium income by writing another covered call, if it still seems reasonable. Assignment Risk If the strategy was selected appropriately, there should be no problem here. A covered call strategy implicitly assumes the investor is willing and able to sell stock at the strike price (premium, in effect). Therefore, assignment simply allows the investor to liquidate the stock at the pre-set price and put the cash to work somewhere else. Investors who have any reluctance about selling the stock would have to monitor the market very closely and stay ready to act (i.e., close out) on short notice, possibly having to pay a higher price to buy the call back. Until the position is closed out, there are no guarantees against assignment. And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock. Expiration Risk For reasons described in 'Assignment Risk', there should be no issue with expiration risk, either. The appropriate use of this strategy implicitly assumes the investor is willing and able to sell stock at the strike price. It should not matter whether the option is exercised at expiration. If it is not, the investor is free to sell the stock or redo the covered call strategy. If the call is assigned, it means the stock surpassed its target price (i.e., strike) and the investor was pleased to liquidate it. There is some risk that a call that expired slightly out-of-the-money may have been assigned, yet notification won't go out until the following Monday. The investor should take care to confirm the status of the option after expiration before taking further steps involving that stock. Comments As long as the short call position remains open, the investor isn't free to sell the stock. It would leave the calls uncovered and expose the investor to unlimited risk. To understand why, see the naked call strategy discussion. Unless they are completely indifferent to being assigned and to the cost of closing out the short position, all investors with short positions must monitor the stock for possible early assignment. Related Position Comparable Position: Cash Secured Put Opposite Position: Synthetic Long Put 37

38 Covered Put Description The idea is to sell the stock short and sell a deep-in-the-money put that is trading for close to its intrinsic value. This will generate cash equal to the option's strike price, which can be invested in an interest bearing asset. Assignment on the put option, when and if it occurs, will cause complete liquidation of the position. The profit would then be the interest earned on what is essentially a zero outlay. The danger is that the stock rallies above the strike price of the put, in which case the risk is open-ended. Outlook Looking for a steady to slightly falling stock price during the life of the option. A neutral longer-term outlook isn't necessarily incompatible with this strategy, but a bullish longterm outlook is incompatible. Summary This strategy is used to arbitrage a put that is overvalued because of its early-exercise feature. The investor simultaneously sells an in-the-money put near its intrinsic value, sells the stock and then invests the proceeds in an instrument earning the overnight interest rate. When the option is exercised, the position liquidates at breakeven, but the investor keeps the interest earned. Net Position (at expiration) EXAMPLE Short 100 shares XYZ stock Short 1 XYZ 60 put MAXIMUM GAIN Short sale price - strike price + premium received (interest) MAXIMUM LOSS Unlimited Motivation Earn interest income on zero initial outlay. Variations This strategy discussion focuses only on a variation that is an arbitrage strategy involving deep-in-money puts. A covered put strategy could also be used with an out-ofmoney or at-themoney put where the motivation is simply to earn premium. But since a covered put strategy has the same payoff profile as a naked call, why not just use the naked call strategy and avoid the additional problems of a short stock position? Max Loss The maximum loss is unlimited. The worst that can happen at expiration is that the stock price rises sharply above the put strike price. At that point, the put option drops out of the equation and the investor is left with a short stock position in a rising market. Since there is no absolute limit to how high the stock can rise, the potential loss is also 38

39 unlimited. An important detail to note: as the stock rises, the strategy actually begins to incur losses when the Delta of the option starts declining (in absolute terms). Max Gain Since the put is deep in-the-money, the maximum gain is limited to interest on initial cash received plus any time value in the option when sold. The best that can happen is for the stock price to remain well below the strike price, which means the option will be exercised before it expires and the position will liquidate. The profit/loss from the stock is the sale price less the purchase price, i.e., where the stock was sold short minus the strike price of the option. Add to that the premium received for selling the option and any interest earned. Keep in mind that a put's intrinsic value is equal to the strike price minus the current stock price. So if the option was sold for its intrinsic value with regard to where the stock was sold short, exercise of the option results in zero profit/loss (excluding any interest earned). Profit/Loss The potential profit is limited to the interest earned on the proceeds of the short sales. Potential losses are unlimited and occur when the stock rises sharply. Just as in the case of the naked call, which has a comparable payoff profile, this strategy entails enormous risk and limited income potential, and therefore is not recommended for most investors. Breakeven The investor breaks even if the option is sold for intrinsic value and assignment occurs immediately. In that case, the option ceases to exist and the short stock position will also be closed out. Should the investor be assigned the same day, cash received from the short sales would be paid out right away, so there would be no time to earn any interest. The assigned stock will be transferred directly to cover the short. Breakeven = price stock shorted at + premium received Volatility An increase in volatility, all other things equal, would have a negative impact on this strategy. Time Decay The passage of time will have a positive impact on this strategy, all other things equal. Assignment Risk Yes. Since assignment liquidates the investor's position, early exercise simply means that no further interest is earned from the strategy. And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock. Expiration Risk Yes. However, the risk is that late news causes the option to not be exercised and the stock is sharply higher the following Monday. A sharp rise in the stock is always a threat to this strategy, and not just at expiration. Comments Due to its very limited rewards, unlimited risk potential and the standard complications of selling stock short, this risky strategy is not recommended for most investors. As a 39

40 practical matter, it is challenging to sell a deep-in-the-money put at its intrinsic value. This strategy is included more as an academic exercise to understand the effects of cost of carry than as an appropriate strategy for the typical investor. Related Position Comparable Position: Naked Call Opposite Position: Protective Put 40

41 Covered Ratio Spread Description This strategy consists of being long stock, short two calls at one strike and long a call at a higher strike. All the options must have the same expiration date. Outlook Looking for a slight rise in the stock price. Summary This strategy profits if the underlying stock moves up to, but not above, the strike price of the short calls. Beyond that, the profit erodes and then hits a plateau. Motivation Earn additional income while holding a long stock position. This is a classic option strategy for lowering the breakeven level of a long stock position that is underwater. Variations N/A Net Position (at expiration) EXAMPLE Long 100 shares XYZ stock Short 2 XYZ 65 calls Long 1 XYZ 70 call MAXIMUM GAIN Lower call strike - stock purchase price + net premium received MAXIMUM LOSS Stock purchase price - net premium received (substantial) Max Loss The maximum loss would occur should the stock become worthless. In that case, the investor would have lost the entire value of their stock. That loss, however, would be reduced by the premium received from initiating the option strategy. Max Gain The maximum gain would occur should the underlying stock be at the strike price of the short calls. In that case, all the options would expire worthless, and the investor could pocket the premium received for initiating the option strategy in addition to the profit from the stock's appreciation. Profit/Loss The potential profit (from the options) is limited. Potential losses are substantial. However, the maximum loss results from the investor's stockholding, not the options. Any loss resulting from this strategy would always be less than a loss resulting from simply purchasing the same amount of stock at the initial position entry date. 41

42 Breakeven This strategy breaks even if at expiration the underlying stock has fallen by the amount of premium received for initiating the strategy. Volatility An increase in implied volatility, all other things equal, would have a negative impact on this strategy. Time Decay The passage of time, all other things equal, will have a positive effect on this strategy. Assignment Risk Yes. However, the investor is already covered on one of the short calls. And while the call options can be exercised at any time, it is usually not optimal to exercise a call early unless there is a dividend payment. Should the investor be assigned on both short calls, exercising the long call to cover one of the assignments would require being short the underlying stock for one business day. And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock. Expiration Risk Yes. Should an assignment at expiration occur or not occur unexpectedly, the investor could find themselves with a position on the Monday following expiration and subject to an adverse move over the weekend. Comments This strategy is often used by an investor to lower their breakeven point on a long stock position. To the extent that a credit is received for initiating the position, it can also serve as a hedge. Related Position Comparable Position: N/A Opposite Position: N/A 42

43 in Covered Strangle (Covered Combination) Description This strategy consists of two parts: (1) short a call and long the underlying stock, and (2) short a put with sufficient cash to purchase the stock if assigned. This is a combination of the covered call and cash-secured put strategies. If the stock rises above the call strike at expiration, the investor is most likely assigned on the call, which means selling their stock at the call strike. If the stock falls below the put strike at expiration, the investor is more than likely assigned on the put and obligated to buy more stock at the put strike. Outlook Looking for underlying stock to trade in a narrow range during the life of options. Summary This strategy is appropriate for a stock considered to be fairly valued. The investor has a long stock position and is willing to sell the stock if it goes higher or buy more of the stock if it goes lower. Net Position (at expiration) EXAMPLE Long 100 shares XYZ stock Short 1 XYZ 65 call Long $5,500 T-Bill Short 1 XYZ 55 put MAXIMUM GAIN Call strike - stock purchase price + net premium received MAXIMUM LOSS Stock purchase price + put strike - net premium received (substantial) Motivation Profit from a sideways to slightly-higher appreciation in the underlying. This is a classic option strategy for an investor who wants to increase their holding in the underlying stock should the market decline or decrease their holding should the market rise. Variations A variation of this strategy is a covered straddle. The only difference is that both the call and put options have the same strike price, but the underlying concepts would still apply. Max Loss The maximum loss would occur should the stock become worthless. In that case, the investor would have lost the entire value of their stock; half purchased initially when putting on the strategy and half as a result of assignment on their put option. The loss would be reduced by the premium received for selling the options. The risk is only on 43

44 the downside, since a move by the stock above the call strike results in assignment and consequently liquidation of the position at a profit. Max Gain The maximum gain would occur if the stock were above the call strike price at expiration. In that case the investor would be assigned on the call and sell their stock at the call strike price, consequently closing out their position. In addition to the profit from buying and selling the stock, the investor would pocket the premium received from selling both options. Profit/Loss During the life of the options, the potential profit is limited, while the potential loss is substantial. However, since the loss scenario involves acquiring additional stock, it is entirely possible that should the investor simply hold on to their stock, the short-term unrealized loss could eventually become a long-term gain. The riskiness of this strategy is to a large extent a function of the investor's motivation. If the investor is long-term bullish, a slight initial loss might actually be the desired scenario since it increases their stockholding at a much lower cost, and the maximum gain might be somewhat undesirable since it liquidates the stockholding and the investor was never assigned on the put. Breakeven The concept of breakeven for this strategy is somewhat nebulous, since if the investor is assigned on their short put the profit/loss will fluctuate for as long as the stock is held. Technically speaking, the strategy breaks even if the stock price at expiration is below the original stock price by the amount of premium received for selling the options (or below the average of the initial stock price and the put strike price if the put was exercised). Notice again, however, that if the original stock was purchased at a significantly lower price than the put strike (quite possible if the purchase took place long ago) this breakeven may lack any relevance. Volatility An increase in implied volatility, all other things equal, would have a negative impact on this strategy. Some investors use this strategy as a way to play volatility. If the stock price held steady and implied volatility quickly dropped, the investor might conceivably be able to close out the position for a profit well before expiration. Time Decay The passage of time, all other things equal, will have a positive impact on this strategy. Every day that passes without a move in the stock price brings both options one day closer to expiring worthless. Assignment Risk Slight. This strategy is explicitly based on the investor being willing and able to take the assignment on either option. At worst, an early assignment would only cause the investor to lose some interest or dividend income. Early assignment, while possible at any time, generally occurs for a call when the stock goes ex-dividend or for a put when it goes deep in-the-money. And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset 44

45 typical expectations regarding early exercise of options on the stock. Expiration Risk None. The strategy explicitly assumes a willingness to buy more stock if the price declines and to sell stock if the price rises, thus implying that the investor is indifferent to whether or not they are assigned on either option. Comments N/A Related Position Comparable Position: N/A Opposite Position: N/A 45

46 Long Call Description A long call strategy typically doesn't appreciate in a 1-to-1 ratio with the stock, but pricing models often give us a reasonable estimate about how a $1 stock price change might affect the call's value, assuming other factors remain the same. What's more, the percentage gains relative to the premium can be significant if the forecast is on target. The call buyer who plans to resell the option at a profit is looking for suitable opportunities to close the position out early: usually a rally and/or a sharp increase in volatility. Some investors set price targets or re-evaluation dates; others 'play it by ear.' Either way, timing is everything for this strategy, because all value must be realized before the option expires. Being right about an anticipated rally does no good if it occurs after expiration. If the gains fail to materialize, and expiration is approaching, a careful investor is ready to re-evaluate. One choice is to wait and see if the stock rallies before expiration. If it does, the strategy might generate a nice profit after all. Net Position (at expiration) EXAMPLE Long 1 XYZ 60 call MAXIMUM GAIN Unlimited MAXIMUM LOSS Premium paid On the other hand, if a quick turnaround starts looking unlikely, it might make sense to sell the call while it still has some time value. A timely decision might allow the investor to recoup some or even all of the investment. Outlook A call buyer is definitely bullish in the near term, anticipating gains in the underlying stock during the life of the option. An investor's long-term outlook could range from very bullish to somewhat bullish or even neutral. If the long-term outlook is solidly bearish, another strategy alternative might be more appropriate. Summary This strategy consists of buying a call option. Buying a call is for investors who want a chance to participate in the underlying stock's expected appreciation during the term of the option. If things go as planned, the investor will be able to sell the call at a profit at some point before expiration. Motivation The investor buys calls as a way to profit from growth in the underlying stock's price, without the risk and up-front capital outlay of outright stock ownership. The smaller initial 46

47 outlay also gives the buyer a chance to achieve greater percentage gains (i.e., greater leverage). Variations This discussion targets the long call investor who buys the call option primarily with the idea of reselling it later at a profit. If acquiring the underlying stock is a key motive, see cash-backed call, a variation of the long call strategy. In that case, the investor buys the call but also sets aside enough capital to buy the stock. Then the call acts as a sort of 'rain check': a limited-time guarantee on the stock price for investors who intend to buy the stock, but hesitate to do so right away. This approach is especially relevant if a substantial near-term price move is expected. Max Loss The maximum loss is limited and occurs if the investor still holds the call at expiration and the stock is below the strike price. The option would expire worthless, and the loss would be the price paid for the call option. Max Gain The profit potential is theoretically unlimited. The best that can happen is for the stock price to rise to infinity. In that case, the investor could either sell the option at a virtually infinite profit, or exercise it and purchase stock at the strike price and sell it for 'infinity'. Profit/Loss The potential profit is unlimited, while the potential losses are limited to the premium paid for the call. Although a call option is unlikely to appreciate a full dollar for every dollar that the stock rises during most of the option's life, there is in theory no limit to how high either could go. Considering the limited size of the investment (i.e., premium), the potential percentage gains can be substantial. The caveat is that all gains must be realized by the time the call expires. Generally speaking, the earlier and sharper the increase in the stock's value, the better for the long call strategy. All other things being equal, an option typically loses time value premium with every passing day, and the rate of time value erosion tends to accelerate. That means the long call holder may not be able to re-sell the call at a profit, unless at least one major pricing factor changes favorably. The most obvious is an increase in the underlying stock's price. A rise in implied volatility could also help significantly by boosting the call's time value. An option holder cannot lose more than the initial price paid for the option. Breakeven At expiration, the strategy breaks even if the stock price is equal to the strike price plus the initial cost of the call option. Any stock price above that point produces a net profit. In other words: Breakeven = strike + premium Volatility An increase in implied volatility would have a positive impact on this strategy, all other things being equal. Volatility tends to boost the value of any long option strategy, because it indicates a greater mathematical probability that the stock will move enough 47

48 to give the option intrinsic value (or add to its current intrinsic value) by expiration day. By the same logic, a decline in volatility has a tendency to lower the long call strategy's value, regardless of the overall stock price trend. Time Decay As with most long option strategies, the passage of time has a negative impact here, all other things being equal. As time remaining to expiration disappears, the statistical chances of achieving further gains in intrinsic value shrink. Furthermore, the cost-tocarry savings offered by a long call strategy, versus an outright long stock position, diminish over time. Once time value disappears, all that remains is intrinsic value. For in-the-money options, that is the difference between the stock price and the strike price. For at-themoney and out-of-the-money options, intrinsic value is zero. Assignment Risk None. The investor is in control. Expiration Risk Slight. If the option expires in-the-money it may be exercised for you by your brokerage firm. Since this investor did not originally set aside the cash to buy the stock, an unexpected exercise could be a major inconvenience and require urgent measures to come up with the cash for settlement. Every investor carrying a long option position into expiration is urged to verify all related procedures with their brokerage firm: automatic exercise minimums, exercise notification deadlines, etc. Comments All option investors have reason to monitor the underlying stock and keep track of dividends. This applies to long call holders too, regardless of whether they intend to acquire the stock. On an ex-dividend date, the amount of the dividend is deducted from the value of the underlying stock. That in turn puts downward pressure on the call option's value. Although the effect is foreseeable and usually gets factored more gradually, dividend dates are still a consideration in deciding when it might be optimal to close out the call position. If the holder of an in-the-money call decides to exercise the option, and a dividend has been announced, it may be optimal to exercise the call before the ex-dividend date to capture the dividend payment. Related Position Comparable Position: Protective Put Opposite Position: Naked Call 48

49 Long Call Butterfly Description Combining two short calls at a middle strike, and one long call each at a lower and upper strike creates a long call butterfly. The upper and lower strikes (wings) must both be equidistant from the middle strike (body), and all the options must have the same expiration date. Outlook Looking for the underlying stock to achieve a specific price target at the expiration of the options. Summary This strategy generally profits if the underlying stock is at the body of the butterfly at expiration. Motivation Profit by correctly predicting the stock price at expiration. Variations The long call butterfly and long put butterfly, assuming the same strikes and expiration, will have the same payoff at expiration. Net Position (at expiration) EXAMPLE Long 1 XYZ 65 call Short 2 XYZ 60 calls Long 1 XYZ 55 call MAXIMUM GAIN High strike - middle strike - net premium paid MAXIMUM LOSS Net premium paid However, they may vary in their likelihood of early exercise should the options go intothe-money or the stock pay a dividend. While they have similar risk/reward profiles, this strategy differs from the short iron butterfly in that it usually requires a debit to enter all four legs of the spread. Max Loss The maximum loss would occur should the underlying stock be outside the wings at expiration. If the stock were below the lower strike all the options would expire worthless; if above the upper strike all the options would be exercised and offset each other for a zero profit. In either case the premium paid to initiate the position would be lost. Max Gain The maximum profit would occur should the underlying stock be at the middle strike at expiration. In that case, the long call with the lower strike would be in-the-money and all the other options would expire worthless. The profit would be the difference between the 49

50 lower and middle strike (the wing and the body), less the premium paid for initiating the position, if any. Profit/Loss The potential profit and loss are both very limited. In essence, a butterfly at expiration has a minimum value of zero and a maximum value equal to the distance between either wing and the body. An investor who buys a butterfly pays a premium somewhere between the minimum and maximum value, and profits if the butterfly's value moves toward the maximum as expiration approaches. Breakeven The strategy breaks even if at expiration the underlying stock is above the lower strike or below the upper strike by the amount of premium paid to initiate the position. Volatility An increase in implied volatility, all other things equal, will usually have a slightly negative impact on this strategy. Time Decay The passage of time, all other things equal, will usually have a positive impact on this strategy if the body of the butterfly is at-the-money, and a negative impact if the body is away from the money. Assignment Risk Yes. The short calls that form the body of the butterfly are subject to exercise at any time, while the investor decides if and when to exercise the wings. The components of this position form an integral unit, and any early exercise could be disruptive to the strategy. In general, since the cost of carry makes it optimal to exercise a call option on the last day before expiration, this usually does not pose a problem. But the investor should be wary of using this strategy where dividend situations or tax complications have the potential to intrude. And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock. Expiration Risk Yes. This strategy has an extremely high expiration risk. Consider that the maximum profit occurs when at expiration if the stock is trading right at the body of the butterfly. Presumably the investor will choose to exercise their in-the-money wing, but there is no way of knowing for sure whether none, one or both of the calls in the body will be exercised. If the investor guesses wrong, they face the risk of the stock opening sharply higher or lower when trading resumes after the expiration weekend. Comments N/A Related Position Comparable Position: Long Put Butterfly Opposite Position: Short Call Butterfly 50

51 Long Call Calendar Spread (Call Horizontal) Description Short one call option and long a second call option with a more distant expiration is an example of a long call calendar spread. The strategy most commonly involves calls with the same strike (horizontal spread), but can also be done with different strikes (diagonal spread). Outlook Looking for either a steady to slightly declining stock price during the life of the nearterm option and then a move higher during the life of the far-term option, or a sharp move upward in implied volatility. Summary This strategy combines a longer-term bullish outlook with a near-term neutral/bearish outlook. If the underlying stock remains steady or declines during the life of the nearterm option, that option will expire worthless and leave the investor owning the longerterm option free and clear. If both options have the same strike price, the strategy will always require paying a premium to initiate the position. Net Position (at expiration) EXAMPLE Short 1 XYZ near 60 call Long 1 XYZ far 60 call MAXIMUM GAIN Unlimited MAXIMUM LOSS Net premium paid Motivation The investor hopes to reduce the cost of purchasing a longer-term call option. Variations The strategy described here involves two calls with the same strike but at different expirations. A diagonal spread, involving two calls with different strikes as well as expirations, would have a slightly different profit/loss profile. The basic concepts, however, would continue to apply. Max Loss The maximum loss would occur should the two options reach parity. This could happen if the underlying stock declined enough that both options became worthless, or if the stock rose enough that both options went deep in-the-money and traded at their intrinsic value. In either case, the loss would be the premium paid to put on the position. Max Gain At the expiration of the near-term option, the maximum gain would occur should the underlying stock be at the strike price of the expiring option. If the stock were any higher, the expiring option would have intrinsic value, and if the stock were any lower, 51

52 the longer-term option would have less value. Once the near-term option has expired worthless, the investor is left with simply a long call position, which has no upper limit on its potential profit. Profit/Loss During the life of the near-term option, the potential profit is limited to the extent the near-term option declines in value more quickly than the longer-term option. Once the near-term option has expired, the strategy becomes simply a long call whose potential profit is unlimited. The potential loss is limited to the premium paid to initiate the position. Breakeven Since the options differ in their time to expiration, the level where the strategy breaks even is a function of the underlying stock price, implied volatility and rates of time decay. Should the near-term option expire worthless, breakeven at the longer-term option's expiration would occur if the stock were above the strike price by the amount of the premium paid. But of course it could occur at any time should the position be closed out for a credit equal to the debit paid when the position was initiated. Volatility An increase in implied volatility, all other things equal, would have an extremely positive impact on this strategy. In general, longer-term options have a greater sensitivity to changes in market volatility, i.e., a higher Vega. Be aware, that the near-term and farterm options could and probably will trade at different implied volatilities. Time Decay The passage of time, all other things equal, would have a positive impact on this strategy in the beginning. That changes, however, once the near-term option has expired and the strategy becomes simply a long call whose value will be eroded by the passage of time. In general, an option's rate of time decay increases as its expiration draws nearer. Assignment Risk Yes. Early assignment, while possible at any time, generally occurs for a call only when the stock goes ex-dividend. Should early exercise occur, using the the longer-term option to cover the assignment would require establishing a short stock position for one business day. And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock. Expiration Risk Slight. Should the near-term call (the short side of the spread) be exercised when it expires, the longer-term call option would remain to provide a hedge. If the longer-term option were held into expiration, it may be exercised on the investor's behalf by their brokerage firm if it's in-the-money. Comments The difference in time to expiration of these two call options results in their having a different Theta, Delta and Gamma. Obviously, the near-term call suffers more from time decay, i.e., has a greater Theta. Less intuitively, the near-term call has a lower Delta but 52

53 a higher Gamma (if the strike is at-the-money). This means that if the stock moves sharply higher, the near-term call becomes much more sensitive to the stock price and its value approaches that of the more expensive longer-term call. A common variation of this strategy is to write another short-term option each time the previous one expires, until such time as the underlying stock moves significantly or the longer-term call approaches expiration. Related Position Comparable Position: N/A Opposite Position: Short Call Calendar Spread 53

54 Long Call Condor Description A long call condor consists of four different call options of the same expiration. The strategy is constructed of 1 long in-the-money call, 1 short higher middle strike in-themoney call, 1 short middle out-of-money call, 1 long highest strike out-of-money call. An alternative way to think about this strategy is an in-the-money bull call spread (debit spread) coupled with an out-of-the money bear call spread (credit spread) with the bear call spread at higher strikes than the bull call spread. Outlook The long call condor investor is normally looking for little or no movement in the underlying. Summary This strategy profits if the underlying security is between the two short call strikes at expiration. Net Position (at expiration) EXAMPLE Long 1 XYZ 55 Call Short 1 XYZ 60 Call Short 1 XYZ 65 Call Long 1 XYZ 70 Call MAXIMUM GAIN (Lowest, short call strike lowest, long call strike) Net premium paid MAXIMUM LOSS Net premium paid Motivation Anticipating minimal price movement in the underlying during the lifetime of the options. Variations This strategy is a variation of the long call butterfly. Instead of a body and two wings, the body has been split into two different (short call) strikes so that there are two shoulders in the middle and two wingtips outside the shoulders. Maximum Loss In all circumstances the maximum loss is limited to the net debit paid (assuming the distances between all four strikes prices are equal). The maximum loss would occur should the underlying be below the lowest long call strike at expiration or at or above the highest long call strike. At the lowest strike all the options would expire worthless, and the debit paid to initiate the position would be lost. At expiration, all the options above the highest strike would be in-the-money and the resulting profits and losses would offset. Maximum Gain 54

55 The maximum gain would occur if the underlying security is between the two short call strikes at expiration. In that case, the lower strike long call is worth its maximum value. The profit would be the difference between the strikes less the premium paid to initiate the position. Profit/Loss The potential profit and loss are both limited. In essence, a long call condor at expiration has a minimum value of zero and a maximum value equal to the distance between the strike prices. An investor who buys a long call condor pays a premium somewhere between the minimum and maximum value and profits if the condor's value moves toward the maximum payoff as expiration approaches. Breakeven There are two breakeven points. This strategy breaks even if at expiration the underlying security is above the lower long call strike plus the amount of premium paid to initiate the position or if the underlying is below the highest long call strike less the premium paid. Downside breakeven = lowest long call strike + premium paid Upside breakeven = highest long call strike - premium paid Volatility All other things being equal, an increase in implied volatility if the underlying is between the two short strikes when established would have a negative impact on this strategy. As with most strategies however, the impact of implied volatility changes will depend on strike selection relative to the stock price when the position is established. Time Decay All other things being equal, the passage of time will have a positive impact on this strategy. Assignment Risk In the case of American style options, the short options that form the body of the long call condor are subject to assignment at any time. Should early assignment occur on the short call options, the investor can exercise the appropriate long option but may be required to borrow or finance stock for one business day. The resulting position from an assignment on both short calls may still result in a net short stock position. Investors can avoid an assignment by closing out their position if the short calls appear to be candidates for an early exercise. Be aware of situations where the underlying is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, as that could completely upset typical expectations regarding early exercise of options on the security. Expiration Risk Investors face an uncertainty when the underlying trades above both short call strikes but below the highest long call strike. In this case, the investor is likely to be assigned on both short calls resulting in a short position that is unhedged following expiration. Investors in this case would be subject to an adverse move the next business day. Comments One important consideration of the long call condor is assignment risk. If the underlying 55

56 is above both short call strikes yet below the highest long call strike, an assignment would result in both short calls delivering stock yet only one of the long calls being exercised. Thus, the investor would end up net short the underlying. Another consideration for the long call condor is commission charges. As there are four different contracts traded, that may entail four separate commission charges to establish the position and four additional commission charges if the trade is closed prior to expiration. Investors should understand their commission costs before entering into this transaction. Related Position Comparable Position: Short Condor (Iron Condor) 56

57 Long Condor Description A long condor consists of being long one call and short another call with a higher strike, and long one put and short another put with a lower strike. Typically, the call strikes are above and the put strikes below the current level of underlying stock, and the distance between the call strikes equals the distance between the put strikes. All the options must be of the same expiration. An alternative way to think about this strategy is as a long strangle with a short strangle outside of it. It could also be considered as a bull call spread and a bear put spread. Outlook The long condor investor is looking for a sharp move either up or down in the underlying stock during the life of the options. Summary This strategy profits if the underlying stock is outside the outer wings at expiration. Net Position (at expiration) EXAMPLE Short 1 XYZ 70 call Long 1 XYZ 65 call Long 1 XYZ 55 put Short 1 XYZ 50 put MAXIMUM GAIN (High call strike - low call strike) OR (High put strike - low put strike) - net premium paid MAXIMUM LOSS Net premium paid Motivation Profit from a large move in underlying stock in either direction. Variations This strategy is a variation of the long iron butterfly. Instead of a body and two wings, the body has been split into two different strikes so that there are two shoulders in the middle and two wingtips outside the shoulders. Max Loss The maximum loss would occur should the underlying stock be between the lower call strike and upper put strike at expiration. In that case all the options would expire worthless, and the premium paid to initiate the position would have been lost. Max Gain The maximum gain would occur should the underlying stock be above the upper call strike or below the lower put strike at expiration. In that case, either both calls or both puts would be in-the-money. The profit would be the difference between either the call 57

58 strikes or the put strikes (whichever are in-the-money), less the premium paid to initiate the position. Profit/Loss The potential profit and loss are both very limited. In essence, a condor at expiration has a minimum value of zero and a maximum value equal to the span of either wing. An investor who buys a condor pays a premium somewhere between the minimum and maximum value, and profits if the condor's value moves toward the maximum as expiration approaches. Breakeven This strategy breaks even if at expiration the underlying stock is either above the lower call strike or below the upper put strike by the amount of the premium paid to initiate the position. Upside breakeven = long call strike + premiums paid Downside breakeven = long put strike - premiums paid Volatility An increase in implied volatility, all other things equal, would have a positive impact on this strategy. Time Decay The passage of time, all other things equal, will have a negative effect on this strategy. Assignment Risk Yes. The short options that form the wingtips of the condor are subject to exercise at any time, while the investor decides if and when to exercise the shoulders of the wings. If an early exercise occurs at a wingtip, the investor can exercise their option from the appropriate shoulder to lock in the maximum gain and continue to hold the other half of the position, which might still have value. So early exercise might be a good thing, although it may require borrowing stock or financing stock for one business day. And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock. Expiration Risk Yes. If at expiration the stock is trading right at either wingtip, the investor would face uncertainty as to whether or not they would be assigned on that wingtip. Should the investor not be assigned on the wingtip, they could be unexpectedly long or short the stock on the Monday following expiration and hence subject to an adverse move over the weekend. Comments N/A Related Position Comparable Position: N/A Opposite Position: Short Condor 58

59 Long Iron Butterfly Description This strategy combines a short call at an upper strike, a long call and long put at a middle strike, and short a put at lower strike. The upper and lower strikes (wings) must both be equidistant from the middle strike (body), and all the options must be the same expiration. An alternative way to think about this strategy is a long straddle with a short strangle. It could also be considered as a bull call spread and a bear put spread. Outlook The investor is looking for a sharp move either up or down in the underlying stock during the life of the options. Summary This strategy profits if the underlying stock is outside the wings of the iron butterfly at expiration. Motivation Profit from a move in the underlying stock in either direction. Net Position (at expiration) EXAMPLE Short 1 XYZ 65 call Long 1 XYZ 60 call Long 1 XYZ 60 put Short 1 XYZ 55 put MAXIMUM GAIN High strike - middle strike - net premium paid MAXIMUM LOSS Net premium paid Variations While this strategy has a similar risk/reward profile to the short call butterfly and short put butterfly, the long iron butterfly differs in that a negative cash flow occurs up front, and any positive cash flow is uncertain and would occur somewhere in the future. Max Loss The maximum loss would occur should the underlying stock be at the body of the butterfly at expiration. In that case all the options would expire worthless, and the premium paid to initiate the position would have been lost. Max Gain The maximum gain would occur should the underlying stock be outside the wings at expiration. In that case, either both calls or both puts would be in-the-money. The profit would be the difference between the body and either wing, less the premium paid to initiate the position. 59

60 Profit/Loss The potential profit and loss are both very limited. In essence, an iron butterfly at expiration has a minimum value of zero and a maximum value equal to the distance between either wing and the body. An investor who buys an iron butterfly pays a premium somewhere between the minimum and maximum value, and profits if the butterfly's value moves toward the maximum as expiration approaches. Breakeven The strategy breaks even if at expiration the underlying stock is either above or below the body of the butterfly by the amount of premium paid to initiate the position. Volatility An increase in implied volatility, all other things equal, would have a positive impact on this strategy. Time Decay As with most strategies where the investor is a net buyer of option premium, passage of time, all other things equal, will have a negative effect on this strategy. Assignment Risk Yes. The short options that form the wings of the butterfly are subject to exercise at any time, while the investor decides if and when to exercise the body. If an early exercise occurs at the wing, the investor can exercise an option at the body (put or call, whichever is appropriate) to lock in the maximum gain and continue to hold the other half of the position, which might still have value. So early exercise might be a good thing, although it may require borrowing stock or financing stock for one business day. And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock. Expiration Risk Yes. This strategy has expiration risk. If at expiration the stock is trading right at either wing the investor faces uncertainty as to whether or not they will be assigned on that wing. Should the investor not be assigned on the wing, they could be unexpectedly long or short the stock on the Monday following expiration and hence subject to an adverse move over the weekend. Comments N/A Related Position Comparable Position: Short Call Butterfly Opposite Position: Short Iron Butterfly 60

61 Long Put Description The investor buys a put contract that is compatible with the expected timing and size of a downturn. Although a put usually doesn t appreciate $1 for every $1 that the stock declines, the percentage gains can be significant. Exercising a put would result in the sale of the underlying stock. These comments focus on long puts as a standalone strategy, so exercising the option would result in a short stock position, something not all individuals would choose as a goal. The plan here is to resell the put at a profit before expiration. The investor is hoping for a dramatic downturn; the sooner, the better. Timing is of the essence. Some put holders set price targets or re-evaluation dates; others 'play it by ear.' Either way, all value must be realized before the put expires. If the expected results have not materialized as expiration draws near, a careful investor is ready to re-evaluate. Net Position (at expiration) EXAMPLE Long 1 XYZ 60 put MAXIMUM GAIN Strike price - premium paid MAXIMUM LOSS Premium paid If the put holder is willing to forfeit 100% of the premium paid and is convinced a decline is imminent, one choice is to wait until the last trading day. If the stock falls, the put might generate a nice profit after all. However, if a quick correction looks unlikely, it might make sense to sell the put while it still has some time value. A timely decision might recover part or even all of the investment. Outlook The investor is looking for a sharp decline in the stock's price during the life of the option. This strategy is compatible with a variety of long-term forecasts for the underlying stock, from very bearish to neutral. However, if the investor is firmly bullish on the underlying stock in the long run, other strategy alternatives might be more suitable. Summary This strategy consists of buying puts as a means to profit if the stock price moves lower. It is a candidate for bearish investors who want to participate in an anticipated downturn, but without the risk and inconveniences of selling the stock short. The time horizon is limited to the life of the option. Motivation A put buyer has the opportunity to profit from a fall in the stock's price, without risking an unlimited amount of capital, as a short stock seller does. What's more, the leverage 61

62 involved in a long put strategy can generate attractive percentage returns if the forecast is right. Another common use for puts is hedging a long stock position. It is described separately under protective put. Variations These remarks are targeted toward the investor who buys puts as a standalone strategy. See the discussion on protective puts for a discussion on using long puts as a way to hedge or exit a long stock position. Max Loss The maximum loss is limited. The worst that can happen is for the stock price to be above the strike price at expiration with the put owner still holding the position. The put option expires worthless and the loss is the price paid for the put. Max Gain The profit potential is limited but substantial. The best that can happen is for the stock to become worthless. In that case, the investor can theoretically do one of two things: sell the put for its intrinsic value or exercise the put to sell the underlying stock at the strike price and simultaneously buy the equivalent amount of shares in the market at, theoretically, zero cost. The investor's profit would be the difference between the strike price and zero, less the premium paid, commissions and fees. Profit/Loss The profit potential is significant, and the losses are limited to the premium paid. Although a put option is unlikely to appreciate $1 for every $1 that the stock declines during most of the option's life, the gains could be substantial if the stock falls sharply. Generally speaking, the earlier and more dramatic the drop in the stock's value, the better for the long put strategy. Given that the premium investment can be small relative to the stock value it represents, the potential percentage gains and losses can be large, with the caveat that they must be realized by the time the option expires. All other things being equal, an option typically loses time value premium with every passing day, and the rate of time value erosion tends to accelerate. That means the long put holder may not be able to re-sell the option at a profit unless at least one major pricing factor changes favorably. The most obvious would be an decline in the underlying stock's price. A rise in volatility could also help significantly by boosting the put's time value. An option holder cannot lose more than the initial price paid for the option. Breakeven At expiration, the strategy breaks even if the stock price equals the strike price minus the cost of the option. Any stock price below that level produces a net profit. In other words: Breakeven = strike premium Volatility An increase in implied volatility would have a positive impact on this strategy, all other things being equal. Volatility tends to boost the value of any long option strategy, because it indicates a greater mathematical probability that the stock will move enough to give the option intrinsic value (or add to its current intrinsic value) by expiration day. 62

63 By the same logic, a decline in volatility has a tendency to lower the long put strategy's value, regardless of the overall stock price trend. Time Decay As with most long option strategies, the passage of time has a negative impact, all other things being equal. As time remaining until expiration disappears, the statistical chances of achieving further gains shrink. That tends to be reflected in eroding time premiums, which put downward pressure on the put's market value. Once time value disappears, all that remains is intrinsic value. For in-the-money options, that is the difference between the going stock price and the strike price. For atthe-money and out-of-the-money options, intrinsic value is zero. Assignment Risk None. The investor is in control. Expiration Risk Slight. If the option is in-the-money at expiration, it may be exercised on your behalf by your brokerage firm. Since this investor did not own the underlying stock, an unexpected exercise could require urgent measures to find the stock for delivery at settlement. A short stock position might be a problematic outcome for an individual investor. Every investor carrying a long option position into expiration is urged to verify all related procedures with their brokerage firm: automatic exercise minimums, exercise notification deadlines, etc. Comments All option investors have reason to monitor the underlying stock and keep track of dividends. This applies to long put investors, too. On an ex-dividend date, the amount of the dividend is deducted from the value of the underlying stock. Assuming nothing else has changed, a lower stock value typically boosts the put option's value. The effect is foreseeable and usually gets factored more gradually, but dividend dates could nevertheless be one consideration in deciding when it might be optimal to close out the put position. Related Position Comparable Position: Synthetic Long Put Opposite Position: Naked Put 63

64 Long Put Butterfly Description A long put butterfly is composed of two short puts at a middle strike, and long one put each at a lower and a higher strike. The upper and lower strikes (wings) must both be equidistant from the middle strike (body), and all the options must be the same expiration. Outlook The investor is looking for the underlying stock to achieve a specific price target at expiration. Summary This strategy profits if the underlying stock is at the body of the butterfly at expiration. Motivation Profit by correctly predicting the stock price at expiration. Variations The long call butterfly and long put butterfly, assuming the same strikes and expiration, will have the same payoff at expiration. Net Position (at expiration) EXAMPLE Long 1 XYZ 65 put Short 2 XYZ 60 puts Long 1 XYZ 55 put MAXIMUM GAIN High strike - middle strike - net premium paid MAXIMUM LOSS Net premium paid They may, however, vary in their likelihood of early exercise should the options go intothe-money or the stock pay a dividend. While they have similar risk/reward profiles, this strategy differs from the short iron butterfly in that a negative cash flow occurs up front, and any positive cash flow is uncertain and would occur somewhere in the future. Max Loss The maximum loss would occur should the underlying stock be outside the wings at expiration. If the stock were above the upper strike all the options would expire worthless; if below the lower strike all the options would be exercised and offset each other for a zero profit. In either case the premium paid to initiate the position would be lost. Max Gain The maximum gain would occur should the underlying stock be at the middle strike at expiration. In that case, the long put with the upper strike would be in-the-money and all the other options would expire worthless. The profit would be the difference between the 64

65 upper and middle strike (the wing and the body), less the premium paid for initiating the position. Profit/Loss The potential profit and loss are both very limited. In essence, a butterfly at expiration has a minimum value of zero and a maximum value equal to the distance between either wing and the body. An investor who buys a butterfly pays a premium somewhere between the minimum and maximum value, and profits if the butterfly's value moves toward the maximum as expiration approaches. Breakeven The strategy breaks even if at expiration the underlying stock is above the lower strike or below the upper strike by the amount of the premium paid to initiate the position. Volatility An increase in implied volatility, all other things equal, will usually have a slightly negative impact on this strategy. Time Decay The passage of time, all other things equal, will usually have a positive impact on this strategy if the body of the butterfly is at-the-money and a negative impact if the body is away from the money. Assignment Risk The short puts that form the body of the butterfly are subject to exercise at any time, while the investor decides if and when to exercise the wings. The components of this position form an integral unit, and any early exercise could be disruptive to the strategy. Since the cost of carry sometimes makes it optimal to exercise a put option early, investors using this strategy should be extremely wary if the butterfly moves into-themoney. And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock. Expiration Risk This strategy has an extremely high expiration risk. Consider that the maximum profit occurs when at expiration the stock is trading right at the body of the butterfly. Presumably the investor will choose to exercise their in-the-money wing, but there is no way of knowing for sure whether none, one or both of the puts in the body will be exercised. If the investor guesses wrong, they face the risk of the stock opening sharply higher or lower when trading resumes after the expiration weekend. Comments N/A Related Position Comparable Position: Long Call Butterfly Opposite Position: Short Put Butterfly 65

66 Long Put Calendar Spread (Put Horizontal) Description To enter into a long put calendar spread, an investor sells one near-term put option and buys a second put option with a more distant expiration.the strategy most commonly involves puts with the same strike (horizontal spread), but can also be done with different strikes (diagonal spread). Outlook The investor is looking for either a steady to slightly rising stock price during the life of the near-term option and then a move lower during the life of the far-term option, or a sharp rise in implied volatility levels. Summary This strategy combines a longer-term bearish outlook with a near-term neutral/bullish outlook. If the stock remains steady or rises during the life of the near-term option, it will expire worthless and leave the investor owning the longer-term option. If both options have the same strike price, the strategy will always require paying a premium to initiate the position. Net Position (at expiration) EXAMPLE Short 1 XYZ near 60 put Long 1 XYZ far 60 put MAXIMUM GAIN Strike price - net premium paid MAXIMUM LOSS Net premium paid Motivation The investor is hoping the sale of the near-term put offsets the cost of purchasing a longer-term put. Variations The strategy described here involves two puts with the same strike but a different expiration, i.e., a horizontal spread. A diagonal spread, involving two puts with different strikes as well as expirations, would have a slightly different profit/loss profile. The basic concepts, however, would continue to apply. Max Loss The maximum loss would occur should the two options reach parity. This could happen if the underlying stock rose enough that both options became worthless, or if the stock declined enough that both options went deep in-the-money and traded at their intrinsic value. In either case, the loss would be the premium paid to establish the position. Max Gain 66

67 At the expiration of the near-term option, the maximum gain would occur should the underlying stock be at the strike price of the expiring option. If the stock were any lower the expiring option would have intrinsic value, and if the stock were any higher the longer-term option would have less value. Once the near-term option has expired worthless, the investor is left with simply a long put, whose potential profit is limited only because the stock cannot go below zero. Profit/Loss During the life of the near-term option, the potential profit is limited to the extent the near-term option declines in value more quickly than the longer-term option. Once the near-term option has expired, however, the strategy becomes simply a long put whose potential profit is substantial. The potential loss is limited to the premium paid to initiate the position. Breakeven Since the options differ in their time to expiration, the level where the strategy breaks even is a function of the underlying stock price, implied volatility and rates of time decay. Should the near-term option expire worthless, breakeven at the longer-term option's expiration would occur if the stock were below the strike price by the amount of the premium paid. But of course it could occur at any time should the position be closed out for a credit equal to the debit paid when the position was initiated. Volatility An increase in implied volatility, all other things equal, would have an extremely positive impact on this strategy. In general, longer-term options have a greater sensitivity to changes in market volatility, i.e., a higher Vega. Be aware, however, that the near and far-term options could and probably will trade at different implied volatility levels. Time Decay The passage of time, all other things equal, would have a positive impact on this strategy in the beginning. That changes, however, once the near-term option has expired and the strategy becomes simply a long put whose value will be eroded by the passage of time. In general, an option's rate of time decay increases as its expiration draws nearer. Assignment Risk Early assignment, while possible at any time, generally occurs for a put only when it goes deep-in-the-money. Should early exercise occur, using the longer-term option to cover the assignment would require financing a long stock position for one business day. And be aware, a situation where a stock is involved in a restructuring or capitalization event, such as a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock. Expiration Risk Should the near-term put (the short side of the spread) be exercised when it expires, the longer-term put option would remain to provide a hedge. However, assignment on the near-term put would result in the investor entering into a long stock position. If the longer-term put were held into expiration, it could be subject to auto-exercise if inthe-money. 67

68 Comments The difference in time to expiration of these two put options results in their having a different Theta, Delta and Gamma. Obviously, the near-term put suffers more from time decay, i.e., has a higher Theta. While the near-term put may often have a lower Delta, its Gamma may be higher (if the strike is at-the-money). This means that if the stock moves sharply lower, the near-term put becomes much more sensitive to the stock price and its value approaches that of the more expensive longer-term put. A common variation of this strategy is to write another short-term option each time the previous one expires, until such time as the underlying stock moves significantly or the longer-term put approaches expiration. Related Position Comparable Position: N/A Opposite Position: Short Put Calendar Spread 68

69 Long Put Condor Description A long put condor consists of four different put options of the same expiration. The strategy is constructed of 1 long out-of-money put at the lowest strike, 1 short out-ofmoney put at the middle strike, 1 short put at a higher in-the-money strike and 1 long deeper in-the-money put at the highest strike. An alternative way to think about this strategy is as an out-of-the-money bull put spread (credit spread) coupled with an in-the-money bear put spread (debit spread) with the bear put spread at the higher strikes and the bull put spread is at the lower strikes. Outlook The long put condor investor is normally looking for little or no movement in the underlying. Summary This strategy profits if the underlying security is between the two short put strikes at expiration. Net Position (at expiration) EXAMPLE Long 1 XYZ 55 Put Short 1 XYZ 60 Put Short 1 XYZ 65 Put Long 1 XYZ 70 Put MAXIMUM GAIN (Highest long put strike highest short put strike) - Net premium paid MAXIMUM LOSS Net premium paid Motivation Anticipating minimal price movement in the underlying during the lifetime of the options. Variations This strategy is a variation of the long put butterfly. Instead of a body and two wings, the body has been split into two different (short put) strikes so that there are two shoulders in the middle and two wingtips outside the shoulders. Max Loss In all circumstances the maximum loss is limited to the net debit paid (assuming the distances between all four strikes prices are equal). The maximum loss would occur should the underlying be above the highest long put strike at expiration or at or below the lowest long put strike. At the highest strike all the options would expire worthless, and the debit paid to initiate the position would be lost. At expiration, all the options below the lowest strike would be in-the-money and the resulting profits and losses 69