Option Spreads





Kerry Back

Overview

  • Bull and bear spreads
  • Straddles and strangles
  • Butterfly spreads and condors

Review of collars

  • A collar is a hedge in which you pay for some or all of the hedge by selling another option.
    • Sell an out-of the money call to buy a protective put.
    • Sell an out-of-the-money put to buy a protective call for a short position.
  • When people speculate by buying a call or put, they often sell an option to pay for part of the speculative bet.

Bull spread

Buy a call and sell a call with a higher strike

Bear spread

Buy a put and sell a put with a lower strike

Straddle

Buy a put and buy a call with the same strike

Strangle

Buy a put and buy a call with call strike > put strike

Short Straddle

Sell a put and sell a call with the same strike

Butterfly spread

  • Sell a call and put with the same strike (short straddle)
  • Buy a put with a lower strike and buy a call with a higher strike to hedge

Condor

  • Sell a strangle
  • Buy a put with a lower strike and buy a call with a higher strike to hedge

Multiple ways to create positions

Because of put-call parity, for European options on a stock that does not pay dividends prior to option maturity,

  • puts can be replaced by calls
  • and/or calls can be replaced by puts
  • timing of cash (upfront or at maturity) may change

Example: bull spread with puts

Buy a call put and sell a call put with a higher strike

Example: butterfly spread with only calls

  • Sell a call and put call with the same strike (i.e., sell 2 calls)
  • Buy a put call with a lower strike and buy a call with a higher strike