Mcmillan on options pdf free download

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Throughout the book McMillan advises his readers toconstruct option positions that are insensitive or "delta-neutral"to changes in the price of the underlying stock e. Chapters 6,11, 12 and In his example of a neutral calendar spread page he buys 7 April 45 calls and sells 8 July 45 calls. The ratioof calls bought to calls sold was calculated from an unrealisticdelta ratio of. Actual delta values are expressed to at leastfour decimal places. A neutral position based on deltas rounded tothe nearest tenth would be far from neutral.

Chapter 40 explains howto create a position that is neutral with respect to both gamma anddelta and would profit at a specific rate vega if impliedvolatility increases or decreases pages - Theoretically,such a position would be insensitive to changes in the stock'sprice but would profit with changes in implied volatility IV. Theexample trade sells volatility; i. To construct such a position for thehypothetical "XYZ" stock, one must buy April 50 calls, sell April 60 calls and short 1, shares of XYZ stock.

In my opinion,this is an extremely large position just for the sake of making aprofit when implied volatility drops. The position vega in McMillan's example is Like McMillan's example, these were extraordinarily largepositions; so large that the , If anyone wants to see the specifics of thesesimulated trades, leave a comment or send me an email. Later page McMillan concedes that this is a "theoreticalexample", but in this book, McMillan appears to be advising hisreaders to actually make these large trades.

I wonder who he had inmind? Perhaps the London Whale made these types of trades untilJamie Dimon fired him. The book exaggerates the potential profitsand low cost of adding a collar to a long stock position. The text states, "Thus one should consider using 2. To break even, one wouldhave to sell at least two calls for every put purchased. As long as I can remember, tax rateson long-term capital gains has been lower than on short-term.

This long review focuses on a very smallportion of this very long book. Generally, this is a good book andit is reasonably-priced. Just keep in mind that the book is notperfect and contains information that was previously published. This bookwith the other snippets one can find, sans "advertising" stuff init freely around the Web, -- will get me where I need to be. As faras "writing style" as an evaluation :- , which I thought was ahistorical comment for this type of book to read, -- it's not anovel :- Moreover, I don't want a rambling, non-succinctexplanation sans example to work through.

I do like, and readeasily the more didactic with fond appreciation for that additionaleffort, and care when exists today. I have a Masters Degree MS ,and have been a "trader" not investor for a good long time,and have engaged many "PhD's" on their terms, "academically",etc.

Additionally, I in my frame of reference,do not prefer "advice" from a "trader" or trading platformwhich ultimately is pushing a "system" algorithm for their profit,--it's not what I want, at first instruction within a TradingEnvironment.

There seems to be to many folks out there stillengaging the opposite offered "advice" of what they may do; realknowledge and historic collated charts are still, everything to thesmart trader in my opinion and experience. It is very easy to followBy warren whiteThis is theabsolute bible of options trading strategies.

It is very easy tofollow, and is all laid out in logical fashion. The market in listed options and non-equity option productsprovides investors and traders with a wealth of new, strategicopportunities for managing their investments. This updated andrevised Fifth Edition of the bestselling Options as a StrategicInvestment gives you the latest market-tested tools for improvingthe earnings potential of your portfolio while reducing downsideriskmdash;no matter how the market is performing.

For example, an opening buy transaction creates or increases a long position in the customer's account. A closing transaction reduces the customer's position. Opening buys are often followed by closing sales; correspondingly, opening sells often precede closing buy trades. Open Interest. The option exchanges keep track of the number of opening and closing transactions in each option series. This is called the open interest.

Each opening transaction adds to the open interest and each closing transaction decreases the open interest. The open interest is expressed in number of option contracts, so that one order to buy 5 calls opening would increase the open interest by 5. Note that the open interest does not differentiate between buyers and sellers - there is no way to tell if there is a preponderance of either one.

While the magnitude of the open interest is not an extremely important piece of data for the investor, it is useful in determining the liquidity of the option in question. If there is a large open interest, then there should be little problem in making fairly large trades. However, if the open interest is small - only a few hundred contracts outstanding - then there might not be a reasonable secondary market in that option series. The Holder and Writer.

Anyone who buys an option as the initial transaction - that is, buys opening - is called the holder. On the other hand, the investor who sells an option as the initial transaction - an opening sale - is called the writer of the option. Commonly, the writer or seller of an option is referred to as being short the option contract. The term "writer" dates back to the overthe-counter days, when a direct link existed between buyers and sellers of options; at that time, the seller was the writer of a new contract to buy stock.

In the listed option market, however, the issuer of all options is the Options Clearing Corporation, and contracts are standardized. This important difference makes it possible to break the direct link between the buyer and seller, paving the way for the formation of the secondary markets that now exist. Exercise and Assignment. An option owner or holder who invokes the right to buy or sell is said to exercise the option.

Call option holders exercise to buy stock; put holders exercise to sell. The holder of most stock options may exercise the option at any time after taking possession of it, up until P.

Note: Some options, called "European" exercise options, can be exercised only on their expiration date and not before - but they are generally not stock options. These exercise notices are irrevocable; once generated, they cannot be recalled. In practical terms, they are processed only once a day, after the market closes. Whenever a holder exercises an option, somewhere a writer is assigned the obligation to fulfill the terms of the option contract: Thus, if a call holder exercises the right to buy, a call writer is assigned the obligation to sell; conversely, if a put holder exercises the right to sell, a put writer is assigned the obligation to buy.

A more detailed description of the exercise and assignment of call options follows later in this chapter; put option exercise and assignment are discussed later in the book. Certain terms describe the relationship between the stock price and the option's striking price. A call option is said to be out-of-themoney if the stock is selling below the striking price of the option. A call option is inthe-money if the stock price is above the striking price of the option.

Put options work in a converse manner, which is described later. The intrinsic value of an in-the-money call is the amount by which the stock price exceeds the striking price. If the call is out-of-the-money, its intrinsic value is zero.

The price that an option sells for is commonly referred to as the premium. The premium is distinctly different from the time value premium called time premium, for short , which is the amount by which the option premium itself exceeds its intrinsic value. The premium - the total price - of the option is 4. With XYZ at 48 and the striking price of the option at 45, the in-the-money amount or intrinsic value is 3 points , and the time value isl Part I: Basic Properties ol Stoclc Options 8 If the call is out-of-the-money, then the premium and the time value premium are the same.

The call has no intrinsic value by itself with the stock price below the striking price. An option normally has the largest amount of time value premium when the stock price is equal to the striking price. As an option becomes deeply in- or out-ofthe-money, the time value premium shrinks substantially.

Table illustrates this effect. Note that the time value premium increases as the stock nears the striking price 50 and then decreases as it draws away from An option is said to be trading at parity with the underlying security if it is trading for its intrinsic value. Thus, if XYZ is 48 and the xyz July 45 call is selling for 3, the call is at parity. A common practice of particular interest to option writers as shall be seen later is to refer to the price of an option by relating how close it is to parity with the common stock.

Thus, the XY2 July 45 call is said to be a half-point over parity in any of the cases shown in Table TABLE Changes in time value premium. This phenomenon is discussed in more detail when arbitrage techniques are examined. Comparison of XYZ stock and call prices. The major quantifiable factors influencing the price of an option are the: The first four items are the major determinants of an option's price, while the latter two are generally less important, although the dividend rate can be influential in the case of high-yield stock.

Its dominance is obvious on the day that an option expires. On that day, only the stock price and the striking price of the option determine the option's value; the other four factors have no bearing at all. At this time, an option is worth only its intrinsic value. Example: On the expiration day in July, with no time remaining, an XYZ July 50 call has the value shown in Table ; each value depends on the stock price at the time.

XYZ option's values on the expiration day. The call option price curve is a curve that plots the prices of an option against various stock prices. Figure shows the axes needed to graph such a curve.

The vertical axis is called Option Price. The horizontal axis is for Stock Price. This figure is a graph of the intrinsic value. When the option is either out-of-the-money or equal to the stock price, the intrinsic value is zero. Once the stock price passes the striking price, it reflects the increase of intrinsic value as the stock price goes up. Since a call is usually worth at least its intrinsic value at any time, the graph thus represents the minimum price that a call may be worth.

The value of an option at expiration, its intrinsic value. The resultant call option price curve takes the form of an inverted arch that stretches along the stock price axis. If one plots the data from Table on the grid supplied in Figure , the curve assumes two characteristics: 1. The time value premium the shaded area is greatest when the stock price and the striking price are the same. When the stock price is far above or far below the striking price near the ends of the curve , the option sells for nearly its intrinsic value.

As a result, the curve nearly touches the intrinsic value line at either end. As the time to expiration grows shorter, the arched line drops lower and lower, until, on the final day in the life of the option, it merges completely with the intrinsic value line. In other words, the call is worth only its intrinsic value at expiration. Examine Figure , which depicts three separate XYZ calls. At any given stock price a fixed point on the stock price scale , the longest-term call sells for the highest price and the nearest-term call sells for the lowest price.

At the striking price, the actual differences in the three option prices are the greatest. Near either end of the scale, the three curves are much closer together, indicating that the actual price differences from one option to another are small. For a given stock price, therefore, option prices decrease as the expiration date approaches. The prices of a hypothetical July 50 call with 6 months of time remaining, plotted in Figure An XYZ July 50 call will sell for more than an April 50 call, which in turn will sell for more than a January 50 call.

The option price then equals its intrinsic value. The only reservation is that with the stock deeply in- or out-of-the-money, the actual difference between the January, April, and July calls will be smaller than with XYZ stock selling at the striking price of Time Value Premium Decay.

In Figure , notice that the price of the 9month call is not three times that of the 3-month call. Note next that the curve in Figure for the decay of time value premium is not straight; that is, the rate of decay of an option is not linear. An option's time value premium decays much more rapidly in the last few weeks of its life that is, in the weeks immediately preceding expiration than it does in the first few weeks of its existence. The rate of decay is actually related to the square root of the time remaining.

Thus, a 3month option decays loses time value premium at twice the rate of a 9-month option, since the square root of 9 is 3. Similarly, a 2-month option decays at twice the rate of a 4-month option This graphic simplification should not lead one to believe that a 9-month option necessarily sells for twice the price of a 3-month option, because the other factors also influence the actual price relationship between the two calls.

Of those other factors, the volatility of the underlying stock is particularly influential. More volatile underlying stocks have higher option prices.

Time value premium decay, assuming the stock price remains constant. The interplay of the four major variables - stock price, striking price, time, and volatility can be quite complex. While a rising stock price for example is directing the price of a call upward, decreasing time may be simultaneously driving the price in the opposite direction.

Thus, the purchaser of an out-of-the-money call may wind up with a loss even after a rise in price by the underlying stock, because time has eroded the call value.

This rate is generally construed as the current rate of day Treasury bills. Higher interest rates imply slightly higher option premiums, while lower rates imply lower premiums. Although members of the financial community disagree as to the extent that interest rates actually affect option price, they remain a factor in most mathematical models used for pricing options.

These models are covered much later in this book. Though not classified as a major determinant in option prices, this rate can be especially important to the writer seller of an option. If the underlying stock pays no dividends at all, then a call option's worth is strictly a function of the other five items. Dividends, however, tend to lower call option premiums: The larger the dividend of the underlying common stock, the lower the price of its call options.

One of the most influential factors in keeping option premiums low on high-yielding stock is the yield itself. What is a fair price of an XYZ call with striking price 25?

A prospective buyer of XYZ options is determined to figure out a fair price. Moreover, since XYZ is a nonvolatile stock, it may not readily climb back to 25 after the ex-dividend reductions.

Therefore, the call buyer makes a low bid - even Chapter I: Definitions 15 for a 6-month call - because the underlying stock's price will be reduced by the exdividend reduction, and the call holder does not receive the cash dividends.

This particular call buyer calculated the value of the XYZ July 25 call in terms of what it was worth with the stock discounted to 24 - not at He knew for certain that the stock was going to lose 1 point of value over the next 6 months, provided the dividend rate of XYZ stock did not change. In actual practice, option buyers tend to discount the upcoming dividends of the stock when they bid for the calls. However, not all dividends are discounted fully; usually the nearest dividend is discounted more heavily than are dividends to be paid at a later date.

The less-volatile stocks with the higher dividend payout rates have lower call prices than volatile stocks with low payouts. In fact, in certain cases, an impending large dividend payment can substantially increase the probability of an exercise of the call in advance of expiration. This phenomenon is discussed more fully in the following section.

In any case, to one degree or another, dividends exert an important influence on the price of some calls. In practice, nonquantitative market dynamics - investor sentiment can play various roles as well. In a bullish market, call premiums often expand because of increased demand. In bearish markets, call premiums may shrink due to increased supply or diminished demand.

These influences, however, are normally short-lived and generally come into play only in dynamic market periods when emotions are running high. In the event that an option is exercised, the writer of an option with the same terms is assigned an obligation to fulfill the terms of the option contract. As the issuer of all listed option contracts, it controls all listed option exercises and assignments.

Its activities are best explained by an example. He instructs his broker to do so. The broker then notifies the administrative section of the brokerage firm that handles such matters. Now the OCC takes over the handling. OCC records indicate which member brokerage firms are short or which have written and not yet covered XYZ Jan 45 calls. The OCC selects, at random, a member firm that is short at least one XYZ Jan 45 call, and it notifies the short firm that it has been assigned.

The assigned firm, in tum, selects one of its customers who is short the XYZ January 45 call. This selection for the assignment may be either: 1. If one is an option writer, he should obviously determine exactly how his brokerage firm assigns its option contracts.

It is too late to try buying the option back in the option market. The assigned writer does, however, have a choice as to how to fulfill the assignment. If he happens to be already long shares of XYZ in his account, he merely delivers that shares as fulfillment of the assignment notice. A third alternative is merely to notify his brokerage firm that he wishes to go short XYZ stock and to ask them to deliver the shares of XYZ at 45 out of his short account.

At times, borrowing stock to go short may not be possible, so this third alternative is not always available on every stock. Margin Requirements. If the assigned writer purchases stock to fulfill a contract, reduced margin requirements generally apply to the transaction, so that he would not have to fully margin the purchased stock merely for the purpose of delivery. If he goes short to honor the assignment, then he has to fully margin the short sale at the current rate for stock sold short on a margin basis.

They want only to ensure that the shares of XYZ at 45 are, in fact, delivered. The holder who exercised the call can keep the stock in his account if he wants to, but he has to margin it fully or pay cash in a cash account. On the other hand, he may want to sell the stock immediately in the open market, presumably at a higher price than If he has an established margin account, he may sell right away without putting out any money.

If he exercises in a cash account, however, the stock must be paid for in full - even if it is subsequently sold on the same day. Alternatively, he may use the delivered stock to cover a short sale in his own account if he happens to be short XYZ stock. Generally, option holders incur higher commission costs through assignment than they do selling the option in the secondary market.

So the public customer who holds an option is better off selling the option in the secondary market than exercising the call. A public customer owns the XYZ January 45 call option. On the other hand, the XYZ January 45 call is worth and it would normally sell for at least 10 points in the listed options market. The customer therefore decides to sell his XYZ January 45 call in the option market. The benefit of his decision is obvious. Perhaps the stock is an attractive addition that will Part I: Basic Properties of Stock Options 18 bring greater potential to a portfolio.

Or if the customer is already short the XYZ stock, he is going to have to buy shares and pay the commissions sooner or later in any case; so exercising the call at the lower stock price of 45 may be more desirable than buying at the current price of It should be strJssed again that once the writer receives an assignment notice, it is too late to attempt to buy back cover the call.

The writer must buy before assignment, or live up to the terms upon assignment. The writer who is aware of the circumstances that generally cause the holders to exercise can anticipate assignment with a fair amount of certainty. In anticipation of the assignment, the writer can then close the contract in the secondary market. As long as the writer covers the position at any time during a trading day, he cannot be assigned on that option. Assignment notices are determined on open positions as of the close of trading each day.

The crucial question then becomes, "How can the writer anticipate assignment? Automatic Exercise. Assignment is all but certain if the option is in-themoney at expiration. Should the stock close even a half-point above the striking price on the last day of trading, the holder will exercise to take advantage of the half-point rather than let the option expire.

Assignment is nearly inevitable even if a call is only a few cents in-the-money at expiration. In fact, even if the call trades in-the-money at any time during the last trading day, assignment may be forthcoming. This automatic exercise mechanism ensures that no investor throws away money through carelessness.

Since options don't expire until Saturday, the next day, the OCC and all brokerage firms have the opportunity to review their records to issue assignments and exercises and to see if any options could have been profitably exer- Gapter 1: Definitions 19 cised but were not.

If XYZ closed at 51 and a customer who owned a January 45 call option failed to either sell or exercise it, it is automatically exercised. In the case of an XYZ January 50 call option, the automatic exercise procedure is not as clear-cut with the stock at Though the OCC wants to exercise the call automatically, it cannot identify a specific owner.

It knows only that one or more XYZ January calls are still open on the long side. When the OCC checks with the brokerage firm, it may find that the firm does not wish to have the XYZ January 50 call exercised automatically, because the customer would lose money on the exercise after incurring stock commissions.

Yet the OCC must attempt to automatically exercise any in-the-money calls, because the holder may have overlooked a long position. When the public customer sells a call in the secondary market on the last day of trading, the buyer on the other side of the trade is very likely a market-maker.

Thus, when trading stops, much of the open interest in in-the-money calls held long belongs to market-makers. Since they can profitably exercise even for an eighth of a point, they do so. Hence, the writer may receive an assignment notice even if the stock has been only slightly above the strike price on the last trading day before expiration. Any writer who wishes to avoid an assignment notice should always buy back or cover the option if it appears the stock will be above the strike at expiration.

The probabilities of assignment are extremely high if the option expires in-the-money. Early Exercise Due to Discount. When options are exercised prior to expiration, this is called early, or premature, exercise. The writer can usually expect an early exercise when the call is trading at or below parity. A parity or discount situation in advance of expiration may mean that an early exercise is forthcoming, even if the discount is slight. A writer who does not want to deliver stock should buy back the option prior to expiration if the option is apparently going to trade at a discount to parity.

The reason is that arbitrageurs floor traders or member firm traders who pay only minimal commissions can take advantage of discount situations. Arbitrage is discussed in more detail later in the text; it is mentioned here to show why early exercise often occurs in a discount situation. The call is actually "worth" 10 points.

The arbitrageur can take advantage of this situation through the following actions, all on the same day: Part I: Basic Properties ol Stoclc Options 20 1. Buy the January 40 call at 9. Sell short XYZ common stock at Exercise the call to buy XYZ at The arbitrageur makes 10 points from the short sale of XYZ steps 2 and 3 , from which he deducts the 9.

Thus, his total gain is 20 cents - the amount of the discount. Since he pays only a minimal commission, this transaction results in a net profit. The call is not necessarily in imminent danger of being called, since it still has half a point of time premium left.

Sometimes the market conditions create a discount situation, and sometimes a large dividend gives rise to a discount. Since the stock price is almost invariably reduced by the amount of the dividend, the option price is also most likely reduced after the ex-dividend. Since the holder of a listed option does not receive the dividend, he may decide to sell the option in the secondary market before the ex-date in anticipation of the drop in price.

If enough calls are sold because of the impending ex-dividend reduction, the option may come to parity or even to a discount. Once again, the arbitrageurs may move in to take advantage of the situation by buying these calls and exercising them.

If assigned prior to the ex-date, the writer does not receive the dividend for he no longer owns the stock on the ex-date. Furthermore, if he receives an assignment notice on the ex-date, he must deliver the stock with the dividend. It is therefore very important for the writer to watch for discount situations on the day prior to the exdate.

It won't. An example will show why. The arbitrageur's transactions thus consist of: 1. Exercise the call the same day to buy XYZ at He makes 9 points on the stock steps 2 and 3 , and he receives a 1-point dividend, for a total cash inflow of 10 points. The overall transaction is a loser and the arbitrageur would thus not attempt it.

A dividend payment that exceeds the time premium in the call, therefore, does not imply that the writer will be assigned. More of a possibility, but a much less certain one, is that the arbitrageur may attempt a "risk arbitrage" in such a situation. Risk arbitrage is arbitrage in which the arbitrageur runs the risk of a loss in order to try for a profit. The arbitrageur may suspect that the stock will not be discounted the full ex-dividend amount or that the call's time premium will increase after the ex-date.

In either case or both , he might make a profit: If the stock opens down only 60 cents or if the option premium expands by 40 cents, the arbitrageur could profit on the opening. In general, however, arbitrageurs do not like to take risks and therefore avoid this type of situation.

So the probability of assignment as the result of a dividend payment on the underlying stock is small, unless the call trades at parity or at a discount. Of course, the anticipation of an early exercise assumes rational behavior on the part of the call holder.

If time premium is left in the call, the holder is always better off financially to sell that call in the secondary market rather than to exercise it. However, the terms of the call contract give a call holder the right to go ahead and exercise it anyway - even if exercise is not the profitable thing to do. In such a case, a writer would receive an assignment notice quite unexpectedly.

Financially unsound early exercises do happen, though not often, and an option writer must realize that, 22 Part I: Basic Properties of Stock Options in a very small percentage of cases, he could be assigned under very illogical circumstances. However, the option trader is required to do more homework regarding the operation of the option markets. In fact, the option strategist who does not know the details of the working of the option markets will likely find that he or she eventually loses some money due to ignorance.

Stock markets use specialists to do two things: First, they are required to make a market in a stock by buying and selling from their own inventory, when public orders to buy or sell the stock are absent.

Second, they keep the public book of orders, consisting of limit orders to buy and sell, as well as stop orders placed by the public.

When listed option trading began, the Chicago Board Options Exchange CBOE introduced a similar method of trading, the market-maker and the board broker system. The CBOE assigns several market-makers to each optionable stock to provide bids and offers to buy and sell options in the absence of public orders. Market-makers cannot handle public orders; they buy and sell for their own accounts only. A separate person, the board broker, keeps the book of limit orders. The board broker, who cannot do any trading, opens the book for traders to see how many orders to buy and sell are placed nearest to the current market consisting of the highest bid and lowest offer.

The specialist on the stock exchange keeps a more closed book; he is not required to formally disclose the sizes and prices of the public orders.

In theory, the CBOE system is more efficient than the stock exchange system. With several market-makers competing to create the market in a particular security, the market should be a more efficient one than a single specialist can provide. Also, the somewhat open book of public orders should provide a more orderly market. In practice, whether the CBOE has a more efficient market is usually a subject for heated discussion.

The strategist need not be concerned with the question. The American Stock Exchange uses specialists for its option trading, but it also has floor traders who function similarly to market-makers. The regional option exchanges use combinations of the two systems; some use market-makers, while others use specialists. If one has a sophisticated option quoting and pricing system, the quote vendor will usually provide the translation between option symbols and their meanings.

Even with those aids, it is important that an option trader understand the concepts surrounding option symbology. In its simplest form, the base symbol is the same as the stock symbol. However, that is not always the case. The symbology that has been created actually uses the expiration month code for two purposes: 1 to identify the expiration month of the option, and 2 to designate whether the option is a call or a put. The concept is generally rather simple. The letters Y and Z are not used for expiration month codes.

Things can get ve:iy complicated where striking price codes are concerned, but simplistically the designations are that the letter A stands for 5, B stands for 10, on up to S for 95 and T for It should be noted that the exchanges - who designate the striking price codes and their numerical meaning - do not have to adhere to any of the generalized conventions described here.

They usually adhere to as many of them as they can, in order to keep things somewhat standardized, but they can use the letters in any way they want.

Typically, they would only use any striking price code letter outside of its conventional designation after a stock has split or perhaps paid a special dividend of some sort.

Preceding them is the option base symbol. For the IBM July , the option symbol is quite straightforward. IBM is the option base symbol as well as the stock symbol , G stands for July, and E for , in this case. For the Cisco April 75 put, the option base symbol is CYQ this was given in the previous table, but if one didn't know what the base symbol was, you would have to look it up on the Internet or call a broker.

The expiration month code in this case is P, because P stands for an April put option. Finally, the striking price code is 0, which stands for The Ford March 40 call and the GM December 65 put are similar to the others, except that the stock symbols only require one and two characters, respectively, so the option symbol is thus a shorter symbol as well - first using the stock symbol, then the standard character for the expiration month, followed by the standard character for the striking price.

In those cases, a special letter designation is usually used for the striking price codes: Striking Price Code u V w X y z Possible Meanings 7. The higher-priced ones only occur after a very expensive stock splits 2-for-l say, a stock that had a strike price of and split 2-for-l, creating a strike. Something else must be done.

In the early years of option trading, there was no need for wrap symbols, but in recent - more volatile - times, stocks have risen points during the life of an option. If, in the course of the next few months, XYZ traded up to nearly while the December 10 call was still in existence, the exchange would want to trade an XYZ December call. But a new letter would have to be designated for any new strikes A already stands for 5, so it cannot stand for ; B already stands for 10, so it cannot stand for , etc.

There aren't enough letters in the alphabet to handle this, so the exchange creates an additional option base symbol, called a wrap symbol. In this case, the exchange might say that the option base symbol XYA is now going to be used to designate strike prices of and higher up to for the common stock whose symbol is XYZ. Having done that, the letter A can be used for , B for , etc.

However, because puts are more oriented toward downward stock movement than calls are, some bearish put spread strategies are superior to their equivalent bearish call spread strategies. The same types of spreads that were constructed with calls can be established with puts, but there are some differences. Similarly, a put bear spread is established by selling a put at a lower strike while buying a put at a higher strike. The put bear spread is a debit spread. This is true because a put with a higher striking price will sell for more than a put with a lower striking price.

There is a limited maximum potential profit, and this profit would be realized if XYZ were below the lower striking price at expiration. The put spread would widen, in this case, to equal the difference between the striking prices. The maximum risk is also limited, and would be realized if XYZ were anywhere above the higher striking price at expiration. Buying the January 60 put and selling the January 50 would establish a bear spread for a 5-point debit. Table will help verify that this is indeed a bearish position.

The reader will note that Figure has the same shape as the call bear spread's graph Figure The investment required for this spread is the net debit, and it must be paid in full.

Notice that the maximum profit potential is realized anywhere below 50 at expiration, and the maximum risk potential is realized anywhere above 60 at expiration. The maximum risk is always equal to the initial debit required to establish the spread plus commissions. The break-even point is 55 in this example.

The following formulae allow one to quickly compute the meaningful statistics regarding a put bear spread. With puts, one is selling an out-of-the-money option when setting up the spread. Thus, one is not risking early exercise of his written option before the spread becomes profitable. For the written put to be in-the-money, and thus in danger of being exercised, the spread would have to be profitable, because the stock would have to be below the lower striking price.

Such is not the case with call bear spreads. In the call spread, one sells an in-the-money call as part of the bear spread, and thus could be at risk of early exercise before the spread has a chance to become profitable.

Put bear spread. Stock Price at Expiration Beside this difference in the probability of early exercise, the put bear spread holds another advantage over the call bear spread. In the put spread, if the underlying stock drops quickly, thereby making both options in-the-rrwney, the spread will normally widen quickly as well.

This is because, as has been mentioned previously, put options tend to lose time value premium rather quickly when they go into-themoney. In the example above, if XYZ rapidly dropped to 48, the January 60 put would be near 12, retaining very little time premium.

However, the January 50 put that is short would also not retain much time value premium, perhaps selling at 4 points or Part Ill: Put Option Strategies so. Thus, the spread would have widened to 8 points.

Call bear spreads often do not produce a similar result on a short-term downward movement. Since the call spread involves being short a call with a lower striking price, this call may actually pick up time value premium as the stock falls close to the lower strike.

Thus, even though the call spread might have a similar profit at expiration, it often will not perform as well on a quick downward movement. For these two reasons - less chance of early exercise and better profits on a short-term movement - the put bear spread is superior to the call bear spread.

Some investors still prefer to use the call spread, since it is established for a credit and thus does not require a cash investment. This is a rather weak reason to avoid the superior put spread and should not be an overriding consideration. Note that the margin requirement for a call bear spread will result in a reduction of one's buying power by an amount approximately equal to the debit required for a similar put bear spread.

The margin required for a call bear spread is the difference between the striking prices less the credit received from the spread. Thus, the only accounts that gain any substantial advantage from a credit spread are those that are near the minimum equity requirement to begin with. This, again, is the same way a bull spread was constructed with calls: selling the higher strike and buying the lower strike. The bull spread is constructed by buying the January 50 put and selling the January 60 put.

This is a credit spread. The credit is 5 points in this example. If the underlying stock advances by January expiration and is anywhere above 60 at that time, the maximum profit potential of the spread will be realized.

In that case, with XYZ anywhere above 60, both puts would expire worthless and the spreader would make a profit of the entire credit - 5 points in this example. Thus, the maximum profit potential is limited, and the maximum profit occurs if the underlying stock rises in price Chapter Basic Put Spreads above the higher strike.

These are the same qualities that were displayed by a call bull spread Chapter 7. The name "bull spread" is derived from the fact that this is a bullish position: The strategist wants the underlying stock to rise in price. The risk is limited in this spread. If the underlying stock should decline by expiration, the maximum loss will be realized with XYZ anywhere below 50 at that time.

The risk is 5 points in this example. To see this, note that if XYZ were anywhere below 50 at expiration, the differential between the two puts would widen to 10 points, since that is the difference between their striking prices.

Thus, the spreader would have to pay 10 points to buy the spread back, or to close out the position. Since he initially took in a 5-point credit, this means his loss is equal to 5 points - the point cost of closing out less the 5 points he received initially.

The investment required for a bullish put spread is actually a collateral requirement, since the spread is a credit spread. The amount of collateral required is equal r.. V l,,J VoJ,J I.. Note that the maximum possible loss is always equal to the collateral requirement in a bullish put spread. It is not difficult to calculate the break-even point in a bullish spread. With XYZ at 55 in January, the January 50 put would expire worthless and the January 60 put would have to be bought back for 5 points.

It would be 5 points in-the-money with XYZ at Thus, the spreader would break even, since he originally received 5 points credit for the spread and would then pay out 5 points to close the spread. This definition applies to either a put or a call calendar spread. In Chapter 9, it was shown that there were two philosophies available for call calendar spreads, either neutral or bullish. Similarly, there are two philosophies available for put calendar spreads: neutral or bearish.

In this type of spread, the maximum profit will be realized if the stock is exactly at the striking price at expiration. The spreader is merely attempting to capitalize on the fact that the time value premium disappears more rapidly from a near-term option than it does from a longer-term one.

Example: XYZ is at 50 and a January 50 put is selling for 2 points while an April 50 put is selling for 3 points. A neutral calendar spread can be established for a 1-point debit by selling the January 50 put and buying the April 50 put. The investment required for this position is the amount of the net debit, and it must be paid for in full.

If XYZ is exactly at 50 at January expiration, the January 50 put will expire worthless and the April 50 put will be worth about 2 points, assuming other factors are the same.

The neutral spreader would then sell the April 50 put for 2 points and take his profit. The spreader's profit in this case would be one point before commissions, because he originally paid a 1-point debit to set up the spread and then liquidates the position by selling the April 50 put for 2 points. Since commission costs can cut into available profits substantially, spreads should be established in a large enough quantity to minimize the percentage cost of commissions.

This means that at least 10 spreads should be set up initially. In any type of calendar spread, the risk is limited to the amount of the net debit. This maximum loss would be realized if the underlying stock moved substantially far away from the striking price by the time the near-term option expired. If this happened, both options would trade at nearly the same price and the differential would shrink to practically nothing, the worst case for the calendar spreader.

For example, if the underlying stock drops substantially, say to 20, both the near-term and the longterm put would trade at nearly 30 points. Neutral call calendar spreads are generally superior to neutral put calendar spreads. Since the amount of time value premium is usually greater in a call option unless the underlying stock pays a large dividend , the spreader who is interested in selling time value would be better off utilizing call options.

The second philosophy of calendar spreading is a more aggressive one. With put options, a bearish strategy can be constructed using a calendar spread. In this case, one would establish the spread with out-of-the-money puts. He would then like the underlying stock to remain above the striking price until the near-term January put expires. Then, he would become bearish, hoping for the underlying stock to decline in price substantially before April expiration in order that he might be able to generate large profits on the April 50 put he holds.

Just as the bullish calendar spread with calls can be a relatively attractive strategy, so can the bearish calendar spread with puts. Granted, two criteria have to be fulfilled in order for the position to work to the optimum: The near-term put must expire worthless, and then the underlying stock must drop in order to generate profits on the long side. Although these conditions may not occur frequently, one profitable situation can more than make up for several losing ones.

Thus, the losses will be small and the potential profits could be very large if things work out right. The aggressive spreader must be careful not to "leg out" of his spread, since he could generate a large loss by doing so. The object of the strategy is to accept a rather large number of small losses, with the idea that the infrequent large profits will more than offset the sum of the losses.

If one generates a large loss somewhere along the way, this may ruin the overall strategy. Also, if the underlying stock should fall to the striking price before the near-term put expires, the spread will normally have widened enough to produce a small profit; that profit should be taken by closing the spread at that time.

Spreads Cotnbining Calls and Puts Certain types of spreads can be constructed that utilize both puts and calls. One of these strategies has been discussed before: the butterfly spread. However, other strategies exist that offer potentially large profits to the spreader.

Recall that the butterfly spread is a neutral position that has limited risk as well as limited profits. The position involves three striking prices, utilizing a bull spread between the lower two strikes and a bear spread between the higher two strikes. The maximum profit is realized at the middle strike at expiration, and the maximum loss is realized if the stock is above the higher strike or below the lower strike at expiration. Since either a bull spread or a bear spread can be constructed with puts or calls, it should be obvious that a butterfly spread consisting of both a bull spread and a bear spread can be constructed in a number of ways.

In fact, there are four ways in which the spread can be established. If option prices are fairly balanced - that is, the arbitrageurs are keeping prices in line - any of the four ways will have the same potential profits and losses at expiration of the options. However, because of the ways in which puts and calls behave prior to their expiration, certain advantages or disad- Chapter Spreads Combining Calls and Puts vantages are connected with some of the methods of establishing the butterfly spread.

Example: The following prices exist: XYZ common: 60 Strike: 50 Call: Put: 12 60 6 70 5 11 2 The method using only the calls indicates that one would buy the 50 call, sell two 60 calls, and buy the 70 call. Thus, there would be a bull spread in the calls between the 50 and 60 strikes, and a bear spread in the calls between the 60 and 70 strikes. In a similar manner, one could establish a butterfly spread by combining either type of bull spread between the 50 and 60 strikes with any type of bear spread between the 60 and 70 strikes.

Some of these spreads would be credit spreads, while others would be debit spreads. In fact, one's personal choice between two rather equivalent makeups of the butterfly spread might be decided by whether there were a credit or a debit involved. Table summarizes the four ways in which the butterfly spread might be constructed.

In order to verify the debits and credits listed, the reader should recall that a bull spread consists of buying a lower strike and selling a higher strike, whether puts or calls are used. Similarly, bear spreads with either puts or calls consist of buying a higher strike and selling a lower strike. Note that the third choice - bull spread with puts and bear spread with calls - is a short straddle protected by buying the outof-the-money put and call.

In each of the four spreads, the maximum potential profit at expiration is 8 points if the underlying stock is exactly at 60 at that time.

The maximum possible loss in any of the four spreads is 2 points, if the stock is at or above 70 at expiration or is at or below 50 at expiration. For example, either the top line in the table, where the spread is set up only with calls; or the bottom line, where the spread is set up only with puts, has a risk equal to the debit involved - 2 points. The large-debit spread second line of table will be able to be liquidated for a minimum of 10 points at expiration no matter where the stock is, so the risk is also 2 points.

It cost 12 points to begin with. Finally, the credit combination third line has a maximum buy-back of 10 points, so it also has risk of 2 points.

Butterfly spread. Bull Spread Buy Option at 50, Sell at 60 Bear Spread Buy Option at 70, Sell at 60 Total Money Calls 6 debit Calls 4 credit 2 debit Calls 6 debit Puts 6 debit Puts 4 credit Calls 4 credit 12 debit 8 credit Puts 4 credit Puts 6 debit 2 debit The factor that causes all these combinations to be equal in risk and reward is the arbitrageur.

If put and call prices get too far out of line, the arbitrageur can take riskless action to force them back. This particular form of arbitrage, known as the box spread, is described later, in Chapter 27, Arbitrage. Even though all four ways of constructing the butterfly spread are equal at expiration, some are superior to others for certain price movements prior to expiration. Recall that it was previously stated that bull spreads are best constructed with calls, and bear spreads are best constructed with puts.

Since the butterfly spread is merely the combination of a bull spread and a bear spread, the best way to set up the butterfly spread is to use calls for the bull spread and puts for the bear spread. This combination is the one listed on the second line of Table This strategy involves the largest debit of the four combinations and, as a result, many investors shun this approach.

However, all the other combinations involve selling an in-the-money put or call at the outset, a situation that could lead to early exercise. The reader may also recall that the credit combination, listed on the third line of Table , was previously described as a protected straddle position. That is, one sells a straddle and simultaneously buys both an out-of-the-money put and an out-of-the-money call with the same expiration month, as protection for the straddle.

Thus, a butterfly spread is actually the equivalent of a completely protected straddle wiite. A butterfly spread is not an overly attractive strategy, although it may be useful from time to time. The commissions required are extremely high, and there is no chance of making a large profit on the position. The limited risk feature is good to have in a position, but it alone cannot compensate for the less attractive features of the strategy.

Essentially, the strategist is looking for the stock to remain in a neutral pattern until the options expire. If the potential profit is at least three times the maximum 1isk and preferably four times and the underlying stock appears to be in trading range, the strategy is feasible.

Othe:nvise, it is not. This strategy is often used when one has a quite bullish opinion regarding the underlying security, yet the call one wishes to purchase is "overpriced. Both approaches are described in this section. In fact, they may be so expensive as to preclude thoughts of making an outright call purchase. This might happen, for example, if the stock has suddenly plummeted in price perhaps during an ongoing, rapid bearish move by the overall stock market.

To buy calls at this time would be overly risky. If the underlying began to rally, it would often be the case that the implied volatility of the calls would shrink, thus harming one's long call position.

As a counter to this, it might make sense to buy the call, but at the same time to sell a put credit spread. Recall that a put credit spread is a bullish strategy. Moreover, since it is presumed that the options are expensive on this particular stock, the puts being used in the spread would be expensive as well. Thus, the credit received from the spread would be slightly larger than "normal" because the options are expensive. Example: XYZ is selling at One wishes to purchase the December call as an outright bullish speculation.

That call is selling for However, one determines that the December call is overpriced at these levels. In order to make this determination, one would use an option model whose techniques are described in Chapter 28 on mathematical applications. Hence, he decides to use the following put spread in addition to buying the December call: Sell December 90 put, 6 Buy December 80 put, 3 The sale of the put spread brings in a 3-point credit. Thus, his total expenditure for the entire position is 7 points 10 for the December call, less 3 credit from the sale of the put spread.

If one is correct about his bullish outlook for the stock i. Another way Part Ill: Put Option Strategies to look at it is this: The sale of the put spread reduces the call price down to a more moderate level, one that might be in line with its "theoretical value. The sale of the put spread can be considered a way to reduce the overall cost of the call.

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Thinkorswim desktop download	Thus, the spread would have widened to 8 points. Chapter Spreads Combining Calls and Puts Example: If the stock were to undergo a very bullish move and rise continue reading before April expiration, the April 70 call could downlload sold for 30 points. However, the option trader is required to do more homework regarding the operation of the odf markets. The rate of decay is actually related to the square root of the time remaining. Even with those aids, it is important that an option trader understand the concepts surrounding option symbology. The strategist may also be able to rely upon technical input. As the issuer of all listed option contracts, it controls all listed option exercises and assignments.

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