Options Trading

Ratio Spreads

Expect a stock price to remain relatively stable? Consider taking in a little premium by writing Calls or Puts to profit, while limiting your risk by hedging yourself with a few long contracts.

Ratio Call Spread

This is also referred to as the Call Back Spread

• Sell call with lower strike price
• Buy 2 or more calls with higher strike price

Ratio Put Spread

This is also refer to as a Put Back Spread

Ratio spreads should be done with either all Calls or all Puts. The expiration months should be the same, and should reflect how long you expect the price of the underlying stock to be stable. These spreads are like long vertical spreads with extra short options to increase profits. Relative profits can be greater, but these extra short contracts are uncovered. If the stock moves against you, you're exposed to increased risk on the upside (for a Call spread) and downside (for a Put spread). Depending on the expiration month you choose, and the strike prices relationship (i.e., above or below) to the current stock price, these spreads may be put on for either a net debit or a net credit for the transaction.

• Sell 1 put with higher strike price
• Buy 2 or more puts with lower strike price

Maximum Profit Potential - Limited

You should see your maximum profit if the underlying stock closes exactly at the written options strike price at expiration.

Loss Potential

Call Spread

Upside unlimited; downside limited to net debit paid for the spread As the underlying stock price goes above the short calls strike price, your extra short contract(s) expose you to unlimited potential loss. If the stock closes below both strike prices, all contracts will expire out-of-the-money, should be worthless, and your loss is limited to the net debit paid for the spread. Under the same circumstances, if you put the spread on for a net credit and all options expire worthless, you keep this credit and the position makes a profit.

Put Spread

Downside substantial; upside limited to net debit paid for the spread As the underlying stock drops below the short puts strike price, your extra short contract(s) expose you to potentially substantial losses. If the stock closes above both strike prices, all contracts will expire out-of-the-money, should be worthless, and your loss is limited to the net debit paid for the spread. Under the same circumstances, if you put the spread on for a net credit and all options expire worthless, you keep this credit and the position makes a profit.

Break-Even Point (B.E.P.) at Expiration

Call Spread

Upside B.E.P. = underlying stock price = short strike + (maximum profit number of naked calls)

If debit paid for spread: Downside B.E.P. = underlying stock price = long strike price + debit paid

Your primary risk comes from the upside, and a rising stock price. Remember, you're short at least one naked call contract a risky situation.

Put Spread

Downside B.E.P. = underlying stock price = short strike (maximum profit number of naked puts)

If debit paid for spread: Upside B.E.P. = underlying stock price = long strike price debit paid

Calendar Spread

A calendar spread involves buying and selling options with different expirations, but the same strike price with the intention of capitalizing on the differing rates of time decay on the two legs of the spread, which can consist of either Calls or Puts. Construction of a simple long calendar spread calls for buying an option with a longer expiration and selling an option with the same strike price but a shorter expiration. For this strategy to be successful, the shorter expiration Call must lose its time premium faster than its further-out companion, allowing the spread between them to increase. Also known as a time or horizontal spread, this is considered a neutral strategy because any substantial swing in the price of the underlying stock will cause the spread to lose value in other words, volatility is no friend of the long calendar spread

• For example, imagine that Dell Computer (DELL) is trading for $10 per share. To initiate a calendar spread, you might sell the Dell June 10 Calls and buy the July 10 Calls.
• DELL trading @ $10 June July
• Dell 10 Calls 4.50 6.50
• Time to Expiration 2 months 3 months
• Spread value: $2 (6.50 - 4.50)

Like most long positions, there is a cost to put on this trade. In this case, the cost is $2. For the time spread to work, the June option must lose its time premium faster than the July option. If the stock price remains relatively stable as the June expiration approaches, the value of the spread should increase. With only one month remaining before the June expiration, the option prices might look like this.

• DELL trading @ $10 June July
• Dell 10 Calls 1.50 4.50
• Time to Expiration 1 months 2 months
• Spread value: $3 (4.50 - 1.50)

In this case, the position could be closed for a one-point profit by selling the July Calls and buying back the June Calls.

For long calendar spreads to work, the underlying stock price must remain relatively stable. Any swings in either direction will negatively impact the time value of both options causing the spread to lose value.

A short calendar spread would simply reverse the setup in the above scenario, selling the option with a longer expiration and buying one with the same strike price and a shorter expiration. The short variation of this strategy also holds the opposing view of volatility – the more the underlying stock price moves, the greater the likelihood of success for a short calendar spread.

Time Diagonal Put Spread

This strategy is very similar to the Bull Put Spread. The major difference is that in a Time Diagonal Spread, you don't use Put contracts within the same expiration month.

Background:

As with the Bull Put Spread, a Time Diagonal Spread requires that you consider a stock trading in a general sideways pattern. The advantage to the Time Diagonal Spread is the additional time it allows for your intended play to work to your advantage.

Case Study:

Here's how it works: let's say you've identified a stock currently trading for $26 per share, and that the current option expiration month is August. You're slightly bullish to neutral on the forecast for the movement of the stock. For this example, once again, assume you have Level 3 trading authority, which means you aren't authorized to trade naked Puts, so you must first cover your position with a Put purchase.

The first step is to buy the Put option at least one strike price out-of-the-money for the September expiration. With the stock trading at $26 per share, purchase the $22.50 Put for expiration next month. Suppose the ask price for the Put is $1.50 per share. As the option buyer, you will pay the ask price for the option contract.

If the current stock price is $26 per share and you sell the $25 at-the-money Put, you can expect to make a reasonable premium for the contract. If the bid price for this option is $2.25 per share, you will generate $225 per contract on the sale.

The next step is to take the $225 in revenue from selling the option and purchase a Put option one strike price further out-of-the-money for the next month's expiration. This is where the Time Diagonal Put Spread differs from the Bull Put Spread. Using the $225 revenue generated from the sale of the Put, purchase the $22.50 Put for next month out with an ask price of $1.50, which leaves you with $0.75 per share in revenue ($2.25 - $1.50 = $.75 or $75 per contract).

To this point, you've assumed the obligation to buy the stock for $25 per share, and you've purchased the right to sell the stock for $22.50 per share.

Potential Profit:

Your maximum profit from this transaction is the $75 surplus you retain after buying the Put. As long as the stock plays along with your neutral to slightly up-trending forecast, you're able to keep that surplus.

Potential Risk:

In the event the stock falls below the $25 strike price, you'll be assigned the stock or forced to buy it for $25 per share. However, you could buy the Put back, thereby removing your obligation. It's likely you will have to pay more to buy it back than you received in revenue from the transactions you've made to this point ($75). But remember, you still hold the Put contract you purchased at the $22.50 strike price. This gives you the right to sell the stock for $22.50 per share, should the stock fall below this strike price. The worst-case scenario is buying the stock at $25 per share and exercising the $22.50 Put to sell the stock at $22.50 per share.

Now you are required to buy the stock at $25, while selling the stock at $22.50. This represents a loss of $250 ($25 x 100 shares = $250). Now, take the $75 surplus from the original sale of the $25 Put and use it to offset the $250 loss, reducing the maximum loss to $175 or $1.75 per share ($250 - $25 = $175). To calculate the return on risked capital for this transaction, divide the return revenue ($100) and divide it by the maximum potential loss ($150): $75 / $175 = 42% return on risked capital.

Let's examine another trade, using an example from the Web site tools.

Suppose you've found the stock Charles River Laboratories (ticker symbol CRL), in a neutral trend, with little expectation of a large movement in either direction. CRL has a strong Phase 2 score with prospects for an uptrend in the stock price, as influenced by the industry group. The news looks good, with compelling evidence the stock shouldn't fall before expiration Friday. The stock is currently trading for $37.13 per share.

To establish a Time Diagonal Put Spread trade, first sell a Put option contract with a strike price just below the current price of the stock for the current month's expiration. In the example of CRL, this would be the Put contract with the $35 strike price. As the Put option seller, you are assuming the obligation to purchase the stock at a price of $25 per share in the event the stock falls below $35 per share anytime between now and options expiration. The bid price for the $35 Put is $1.55 per share or $155 per contract, which gives you a profit of $155.

Consider using the $155 in revenue to purchase a Put contract the next month out and one strike price out-of-the-money. In this example, that is the $30 Put for September. As the option buyer, you need to pay the ask price for the option, which is $0.45 per share, or $45 per contract. Using the $155 revenue from the sale of the $35, spend $45 to purchase the $30 Put for September, leaving you with $110 net credit to your account.

Maximum Potential Return:

The maximum potential return for this trade is the $110 from the sale of the August $35 Put and the purchase of the September $30 Put.

Maximum Potential Loss:

The maximum potential loss for the trade is $3.90 per share or $390 per contract. This represents the difference between the price of the stock you may be obligated to purchase ($35) and the $30 per-share price you may receive if you exercise the $30 Put you purchased, less the $110 in initial profit from the original transactions.

Maximum return on risked capital:

To find the maximum return on risked capital for this transaction, take the maximum potential profit ($110) and divide it by the maximum potential loss ($390): $110 / $390 = 28.2% return on risked capital.

At this point, the stock will move one of three ways: up, down, or sideways. As we did with the Bull Put Spread, following are examples of how to handle each scenario in a Time Diagonal Put Spread.

CRL Moves Up:

If the stock price moves up, close the September $30 Put while it still has value. The $35 Put for August you sold expires worthless, allowing you to keep the initial $110 in revenue. Also, you keep any remaining revenue from the original sale of the $30 Put. You make 28.2% return on your risked capital, possibly more depending on how much you are able to recover from the $30 Put you sell.

CRL Moves Sideways:

In this case, again the $35 Put you sold will expire worthless, as the stock price has never fallen below the $35 strike price you sold. Sell the $30 Put for any remaining value. Keep the $110 in profit for a return on your risked capital of at least 28.2%, plus whatever additional revenue you are able to make from the sale of the $30 Put.

CRL Drops Slightly to $34.50, Though You're Still Bullish:

If CRL falls to $34.50 on expiration Friday, buy-to-close the $35 Put you originally sold in order to avoid being assigned the stock. Since the stock is now trading at $34.50 and the options are due to expire that same day, there is no time value remaining. The only component still influencing the price of the option is the loss in intrinsic value of $0.50 per share. You can expect to pay $50 per contract to buy back the Put. Since you originally held $110 in profit from the first set of transactions, your net profit from the trade is now $60 ($100 - $50 = $60). Since you're still bullish on the stock and you own the $40 Put for September, consider "rolling" into a Bull Put Spread by placing a new sell-to-open trade for the September $35 Put.

CRL Drops Slightly, Your Forecast Is Now Neutral:

CRL falls to $34.50 on expiration Friday. As with the previous scenario, you need to buy back the $35 Put to avoid being assigned the stock. Since the options expire the same day, once again, time value has eroded to nothing. However, since the stock is now $.50 below the strike price, you need to pay $50 per contract to buy the option back. Subtract this cost from the initial revenue received from the original sale of the options ($110), for a net profit of $60 per contract on the trade. Next, sell the September $30 Put for whatever remaining value you can get.

Looking at this example, if the stock falls below your strike price, the sooner you buy back the Put, the better.

CRL Falls Heavily To $32, Your Forecast Is Bearish:

CRL falls to $32 on bad news and continues to look bearish. Buy back the $35 Put to avoid being assigned the stock. With the stock price now at $32 per share, a total of $3 per share of intrinsic value has been lost on the Put, requiring that you pay $300 per contract to remove your obligation to purchase the stock for $35 per share.

Now remember, you still own the $30 strike price Put. However, even though the stock has fallen, the $30 Put you sold doesn't have any intrinsic value. This won't happen until the stock price falls below $30 per share. Since there isn't any intrinsic value, the only value is time value. Depending on how close you are to expiration for the $30 Put, there may or may not be enough profit to cover your commissions, let alone make you a profit. If your forecast continues to be bearish, consider keeping the $30 Put, as it should increase in value, especially if the stock price falls below the $30 strike price.

Your total profit or loss for the transaction will be determined once all of the positions have been sold.

Summary:

The advantage to a Diagonal Put Spread is much the same as that of the Bull Put Spread. Specifically, you are assuming that a given stock will move in a direction consistent with your forecast. The difference between the Time Diagonal Put Spread versus the Bull Put Spread is whether or not you wish to buy more time for your protection. The time diagonal aspect of the trade refers to the fact that you use option strike prices spread over two subsequent expiration months.

To execute a Diagonal Spread, simply buy a Put option contract one strike price further out-of-the-money than the current stock price for the next expiration month. Then, sell an at-the-money Put option for the current expiration month. Once you've purchased the out-of-the-money Put for next month, sell the at-the-money Put for the current expiration month. The difference should result in a net profit - hold on to this profit.

In the event the stock stays neutral in price, the Put you sold expires worthless (just remember, you were paid up-front for this). The Put you bought also expires worthless. Thus, the net effect is your maximum profit.

In the event the stock price falls below the strike price you sold, you may want to act quickly to back out of the trade by placing a buy-to-close order with your broker to remove your obligation on the Put you sold and avoid being assigned the stock.

If the stock falls below the strike price of both the contract you sold and the contract you bought, first identify how much time remains until expiration. If you have several days before options expiration Friday, consider a buy-to-close order for the Put you sold and let the Put you bought run until expiration or for as long as the stock price continues to drop. The Put you bought may increase in value enough to offset the loss incurred in buying back the Puts you sold. If you have enough time remaining until expiration, consider rolling out by selling an at-the-money Put once again, only this time, sell the contract for the same month as the contract you purchased (you should still have the one you purchased). Selling another contract for the same month as the Put you purchased makes the trade a Bull Put Spread.

If you don't have enough time until expiration, buy-to-close the Put you sold and then sell the Put you originally purchased for whatever you can get for it. This results in the maximum loss for this trade.