76 Part 2
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Options spreads
Table 8.2 Long SPY June 117–119 call spread
SPDR
115 116 117 117.90 118 119 120 121
Spread
debit
–0.90
Value of
spread at
expiration
0 0 0.00 0.90 1.00 2.00 2.00 2.00
Profit/loss
–0.90 –0.90 –0.90 0.00 0.10 1.10 1.10 1.10
*Short call spread
Neutral to bearish strategy
Suppose you are neutral to bearish on the S&P 500. With 45 days till
expiration, June time decay is beginning to accelerate. You would like to
collect premium if the index stays in its current range or if it declines, but
you don’t want to risk the unlimited loss from a short call. You may then
sell the June 117 call at 2.60, and in the same transaction pay 1.70 for the
June 119 call, for a net credit of 0.90 Your position is known as the short
call spread because it is similar to a short call.
4
The advantage of your spread is that it has a built-in stop-loss cover at the
higher strike, or 119. You may think of this spread as a potential sale of
the stock at 117, and a potential buy of the stock at 119. For this risk, you
collect a premium.
4

Maximum profit: credit from spread: 0.90
Maximum loss: (difference between strikes) – credit from spread:
(119 – 117) – 0.90 = 1.10
Break-even level: lower strike + credit from spread: 117 + 0.90 = 117.90
The risk/return potential from this spread is also opposite to the long call
spread, or maximum loss divided by maximum return at 1.10/0.90. Here, a
risk of each $110 offers a potential return of $90.
Table 8.3 shows the expiration profit/loss for this short call spread.
Table 8.3 Short SPY June 117–119 call spread
SPDR
115 116 117 117.90 118 119 120 121
Spread
credit
0.90
Value of
spread at
expiration
0 0 0.00 0.90 1.00 2.00 2.00 2.00
Profit/loss
0.90 0.90 0.90 0.00 –0.10 –1.10 –1.10 –1.10
The expiration profit/loss for this spread is graphed in Figure 8.2.

78 Part 2
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Options spreads
*Long put spread
Bearish strategy
The SPDR is currently trading at 115.22, and you are bearish, short term,
on the S&P 500 index. You may wish to purchase the June 113 put to
profit from a downside move. With 45 days till expiration, time decay is

This spread is also known as the bear put spread and the long vertical put spread.

8

Call spreads and put spreads, or one by one directional spreads 79
At expiration, the maximum profit is gained if the stock is at or below
the lower strike, or 111. This is calculated as the difference between strike
prices minus the cost of the spread, or (113 – 111) – 0.50 = 1.50.
The maximum loss is taken if the stock is at or above the higher strike, or
113, at expiration. This is calculated simply as the cost of the spread, or 0.50
.
The break-even level is the level at which a decline in the stock pays for
the cost of the spread. This is calculated as the higher strike minus the cost
of the spread, or 113 – 0.50 = 112.50. The expiration profit/loss is summa-
rised as follows:
Debit from long June 113 put: –3.10
Credit from short June 111 put: 2.60
–––––
Total debit: –0.50
Maximum profit: difference between strikes – cost of spread:
(113 – 111) – 0.50 = 1.50
Maximum loss: cost of spread: 0.50
Break-even level: higher strike – cost of spread: 113 – 0.50 = 112.50
The risk/return potential of this spread is maximum loss divided by maxi-
mum profit, or 0.50/1.50. In other words you are risking $0.33 for each
potential profit of $1.00, or a risk/return ratio of 1/3.
6
In tabular form the expiration profit/loss is as in Table 8.4.
Table 8.4 Long SPY June 113–111 put spread
Microsoft

7
The
advantage of this spread is that if the stock declines, a possible loss is cut
at the lower strike, or 111. You may think of this spread as a potential buy
of the stock at the higher strike, or 113, and a potential sale of the stock at
the lower strike, or 111. For this potential risk you collect a premium.
The expiration profit/loss of this short put spread is exactly opposite to the
former long put spread. The maximum profit is earned if the stock is at or
above the higher strike, or 113. This amount is simply the premium col-
lected for the spread, or 0.50.
The maximum loss occurs if the stock is at or below the lower strike, or
111. This is calculated as the difference between the strike prices minus
the income from the spread: (113 – 111) – 0.50 = 1.50.
1.5
2
1
0.5
0
–0.5
–1
109
110 111 112 113 114 115
Figure 8.3
Expiration profit/loss relating to Table 8.4
7
This spread is also known as the bull put spread and the short vertical put spread.

8

Call spreads and put spreads, or one by one directional spreads 81

Long versus short call and put spreads
So far we have seen that both a long call spread and a short put spread
profit from an upside move. Likewise both a long put spread and a short
8
I wouldn’t, but many do because supposedly ‘It’ll never happen’.

82 Part 2
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Options spreads
call spread profit from a downside move. The question may arise as to
which one is preferable. The basic difference is that of buying or selling
premium, and the trade-offs are similar to straight long or short positions
in calls or puts.
If a long and a short spread are both out-of-the-money and equidistant
from the underlying, the maximum profit of the long spread is greater
than the maximum profit of the short spread, but the short spread has the
greater probability to profit.
The probability of either spread expiring in the money can be approxi-
mated by the delta of the strike that is nearest the underlying. In the above
examples, both the 117 call and the 113 put have a delta that is approxi-
mately 0.40. If the index has a 40 per cent probability of moving to a strike
in either direction, then the direction which is short has a 60 per cent
probability of collecting its premium. The maximum loss, however, is
greater with the short spread. The maximum profit, of course, favours the
long spread, and this is a fair return for an outcome that is less probable.
Premium sellers often short out-of-the-money spreads that are at a safe
distance from the underlying because these spreads have limited risk.
Premium buyers, however, can afford to place their position closer to the
underlying because the cost of the spread is less than the cost of a straight
call or put.

put is 2.60 while the 119 call is 1.70. This is a function of what are known
as volatility skews, which are discussed in Part 3.
In commodities, however, the call spreads are often cheaper than the equi-
distant put spreads because there is a positive call skew.
But don’t be bewildered at this point. If you spread
1×1s then you minimise your exposure to the
skews. Long call spreads and long put spreads are
the safest way to trade options.
A final note
The difference between a spread and a straight call or put is that the
spread’s maximum profit/loss can be quantified at the outset. For the
longs, the cost of the spread is the maximum loss, and if the trader is good
with technicals, he can pick his levels. For the shorts, these spreads allow
for premium selling with a built-in stop-loss order. On a risk/return basis
they can be recommended to everyone, especially beginners.
Long call spreads
and long put spreads
are the safest way to
trade options9
One by two directional spreads
There are other ways of financing the purchase of a directional position.
Those that we will discuss in this chapter are variations of the long call
and put spreads. Again, they involve buying an option to take advantage
of a chosen market direction. But instead of selling one, they sell two
options at the strike price that is more distant from the underlying.
The spreads in this chapter are suitable for slowly trending markets, and
they are unsuitable for markets that are trending rapidly higher or lower,

at 0.34 for a net debit of 0.77. At expiration, the maximum profit occurs if
the stock closes at the higher strike; this is the same level as with a long call
spread at the same strike. This profit is calculated as the difference between
the strike prices less the cost of the spread, or 60 – 55 – 0.77 = 4.23.
Because of the extra short call there are two break-even levels. The lower
break-even level is, like the long call spread, the lower strike price plus the
cost of the spread, or 55 + 0.77 = 55.77.
The upper break-even level is the maximum profit plus the higher strike
price, or 60 + 4.23 = 64.23.
Above the upper break-even level this spread takes a loss equivalent to the
amount that the stock increases. A summary of the profit/loss at expira-
tion is as follows.
Debit from August 55 call: 1.45
Credit from two August 60 calls: 2 × 0.34 = –0.68
–––––
Total debit: –0.77
Maximum profit: (difference between strikes) minus cost of spread:
(60 – 55) – 0.77 = 4.23
Lower break-even level: lower strike plus cost of spread: 55 + 0.77 = 55.77

Upper break-even level: maximum profit plus higher strike:
60 + 4.23 = 64.23
Maximum loss: unlimited upside
In order to evaluate the risk/return potential of this spread, you must con-
sider the upside potential of the stock or underlying. Remember that the
maximum loss is potentially unlimited.
1
Data courtesy of the Chicago Board Options Exchange, CBOE.

9

–2
–4
–6
–8
50
52.5 55
57.5 60 62.5
65
67.5 70
Figure 9.1
Expiration profit/loss relating to Table 9.1

88 Part 2
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Options spreads
Long one by two call spread for a credit
Bearish to slightly bullish strategy
With adjacent strikes, or strikes that are close to each other, the long one
by two call spread can often be done for a credit. Effectively, then, there
is no lower break-even level, and the spread will profit from a downside
market move. The upper break-even level, however, becomes much closer
to the underlying. But there is a hidden danger in this spread.
For example, using the above strikes, you could pay 1.45 for one Auggie
55 call and sell two Auggie 57.50 calls at 0.79 for a net credit of 0.13 on
the spread.
The upper break-even level is calculated as the higher strike plus the maxi-
mum profit, or 57.50 + 0.13 = 57.63.
Remember that above the upper break-even level this spread has the
potential for unlimited loss.
This spread may look like easy money, but don’t be misled. If the one

the Greeks. This spread is less costly than the long put spread because it is
financed by the extra short put.
With Coca-Cola at 52.67, examine the August options on offer
2
(60 days
until expiration):
Strike
40 42.50 45 47.50 50 52.50 55 57.50 60
August
calls
4.04 2.52 1.45 0.79 0.34
August
puts
0.34 0.47 0.82 1.30 2.05 2.90
With Coca-Cola at 52.67, in the August options, you could pay 2.05 for
the 50.00 put and sell two 45.00 puts at 0.82 for a net debit of 0.41 ($41).
At expiration, the maximum profit occurs if the stock closes at 45.00. This
profit is calculated as the difference between strikes minus the cost of the
spread, or (50.00 – 45.0 ) – 0.41 = 4.59.
Like the long one by two call spread, there are two break-even levels. The
upper break-even level is calculated as the higher strike minus the cost of
the spread, or 50.00 – 0.41 = 49.59 The lower break-even level is calculated
as the lower strike minus the maximum profit, or 45.00 – 4.59 = 40.41.
Below the lower break-even level the spread loses point for point with the
decline of the stock.
A summary of the expiration profit/loss is as follows:
Debit from long August 50.00 put: –2.05
Credit from two short August 45.00 puts: 2 × 0.82 = 1.64
–––––
Total debit: –0.41

Value
of extra
short
put at
expiration
– full amt –10.00 –7.50 –4.59 –2.50 0.00 0.00 0.00 0.00
Profit/loss
– full amt –5.41 –2.91 0.00 2.09 4.59 2.09 0.00 –0.41
In graphic form, the expiration profit/loss of this spread is shown in
Figure 9.2.
2
4
6
0
–2
–4
–6
–8
–10
32.5
35 37.5 40 42.5 45 47.5 50 52.5 55
Figure 9.2
Expiration profit/loss relating to Table 9.2

9

One by two directional spreads 9 1
How to manage the risk of the long one by
two spreads
The return scenario for these spreads is a gradual underlying move from the

strikes. The long call ladder is a long call spread
with an extra short call at a third strike that is
above the lower two strikes. If XYZ is at 100,
then you can buy one 105 call, sell one 110 call,
Long call ladder is a
long call spread with an
extra short call at a third
strike that is above the
lower two strikes

92 Part 2
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Options spreads
and sell one 115 call in the same transaction. This spread is also known
as the long Christmas tree, or simply, the ‘tree’.
3
In practice, it is placed
out-of-the-money.
In August, with the Coca-Cola stock at 52.67, you could pay 1.45 for one
55.00 call, sell one 57.50 call at 0.79, and sell one 60.00 call at 0.34 for a
net debit of 0.32.
At expiration, the maximum profit for the ladder is earned when the stock
closes at the two upper strikes, 57.50 and 60. This profit is calculated as
the difference between the two lower strikes minus the debit, or 57.50 –
55.00 – 0.32 = 2.18. The lower break-even level is calculated as the lowest
strike plus the spread debit, or 55.00 + 0.32 = 55.32.
The upper break-even level is the highest strike plus the maximum profit.
In this case, the calculation is 60.00 + 2.18 = 62.18. Above the upper break-
even level the spread loses point for point with the stock, and faces the
possibility of unlimited loss. The expiration profit/loss is as follows:

Value
of one
by one
spread at
expiration
0.00 0.00 0.32 2.50 2.50 2.50 2.50 2.50
Value
of extra
short
call at
expiration
0.00 0.00 0.00 0.00 0.00 –2.18 –5.00 (– unlimited)
Profit/loss
–0.32 –0.32 0.00 2.18 2.18 0.00 –2.82 (– unlimited)
Figure 9.3 is a graph of this spread at expiration.
0
1
2
3
–1
–2
–3
–4
–5
–6
52.5
55
57.5 60 62.5 65 67.5
Figure 9.3
Expiration profit/loss relating to Table 9.3

Debit from long August 50 put: –2.05
Credit from short August 45 put: 0.82
Credit from short August 40 put: 0.34
–––––
Total debit: –0.89
Maximum profit/loss: (highest strike minus middle strike) minus cost
of spread: (50 – 45) – 0.89 = 4.11
Upper break-even level: highest strike – cost of spread: 50 – 0.89 = 49.11
Lower break-even level: lowest strike minus maximum profit:
40 – 4.11 = 35.89
Maximum loss: amount of stock decline below lower break-even level
The long put ladder is a
long put spread with an
extra short put at a
third strike below
the put spread

9

One by two directional spreads 9 5
The risk/return potential of this spread should account for a decline in the
stock below the lower break-even level. The expiration profit/loss in tabu-
lar form is shown in Table 9.4.
Table 9.4 Coca-Cola long August 50–45–40 put ladder
Coca-
Cola
30.00 35.00 35.89 40.00 45.00 49.11 50.00 55.00
Spread
debit
–0.89

Expiration profit/loss relating to Table 9.4

96 Part 2

Options spreads
You might compare this put ladder to the Coca-Cola call ladder. Here, we
have split strikes, while the call ladder has adjacent strikes. For the put
ladder we paid 0.82, while for the call ladder we paid 0.30. With the put
ladder, however, we have doubled our profit range from 2.50 points to
5.00 points. We have also placed our break-even point further from the
underlying.
How to manage the risk of the long ladder
The risk of the long ladder is managed similarly to that of the long one by
two. If the underlying suddenly moves to the short strike that was formerly
furthest out-of-the-money, the first solution is to buy back that strike.
The second solution is to buy the out-of-the-money option that is as far
from the ladder as the three options in the ladder are from each other.
For example, if the ladder is long one 105 call, short one 110 call and
short one 115 call, and if XYZ quickly rallies to 115, then the solution is
to buy one 120 call. Likewise, if the ladder is long one 95 put, short one
90 put and short one 85 put, and if XYZ suddenly breaks to 85, then the
solution is to buy one 80 put. In the first case, the resulting position is a
long call condor, and in the second case, the resulting position is a long
put condor. Both of these spreads have limited risk; they are discussed in
Chapter 13.
Ladders at different strike prices
With the ladder the consecutive strike prices are usually equidistant from
each other. The equidistance
4
may vary, however, from adjacent to any

Comparing call spreads, 1×2s and ladders
At this point, it will be constructive to compare the data from the spreads
already discussed. We want to examine costs, profit potentials, risks and
break-even levels. If we examine the call spreads, then we can apply the con-
clusions to the put spreads. Refer to the table of Coca-Cola options above.
Coca-Cola at 52.67
August options, 100 days until expiration
Try to develop your options awareness by taking a few minutes to analyse
the data in Table 9.5. Compare the costs or incomes to the potential prof-
its, and compare the potential profits to the upper break-even levels, etc.
The most risk averse spreads are obviously the two one by one call spreads.
Concerning the others, if the market moves in the direction of your short
strike you may have to cover simply out of worry. It is much easier to
make trading decisions when your judgement is not impaired by proxi-
mate risk.
An analysis procedure such as the above should always be used when
deciding which spread to trade.

98 Part 2

Options spreads
Table 9.5 Comparing call spreads, 1×2s and ladders
Coca-
Cola call
spreads
Cost/
income
Max.
profit
Max.

devised trade recommendations which the brokers passed on to their
clients.
The clients did well. One of them took one of our recommendations and
bought a Bund put ladder at just the right time. The Greeks and the levels
worked in her favour. Another did well in the Euribor for the same reasons.
But later, one of the brokers falsely assumed that he had mastered what I
had taught him, and he began to recommend 1×2s and ladders without
consulting me. It led to disaster.