WIXLIB

THE COMPLETEBOOKOF OPTIONSPREADSAND

COMBINATIONS

Strategies for IncomeGeneration,DirectionalMoves, and RiskReductionScott Nations

Cover images: iStock.com / TaylorHinton; iStock.com / Storman; iStock.com / joel-tCover design: WileyCopyright 2014 by Scott Nations. Allrights reserved.Published by John Wiley & Sons, Inc.,Hoboken, New Jersey.Published simultaneously in Canada.No part of this publication may bereproduced, stored in a retrieval system,or transmitted in any form or by anymeans,electronic,mechanical,photocopying, recording, scanning, orotherwise, except as permitted underSection 107 or 108 of the 1976 UnitedStates Copyright Act, without either the

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preparing this book, they make norepresentations or warranties withrespect to the accuracy or completenessof the contents of this book andspecifically disclaim any impliedwarranties of merchantability or fitnessfor a particular purpose. No warrantymay be created or extended by salesrepresentatives or written salesmaterials. The advice and strategiescontained herein may not be suitable foryour situation. You should consult witha professional where appropriate.Neither the publisher nor author shallbe liable for any loss of profit or anyother commercial damages, includingbut not limited to special, incidental,consequential, or other damages.

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www.wiley.com.Library of Congress Cataloging-inPublication Data:Nations, Scott.The complete book of option spreadsand combinations : strategies forincome generation, directional moves,and risk reduction / Scott Nations.pages cm. – (Wiley trading)Includes index.ISBN 978-1-118-80545-9 (paperback);ISBN 978-1-118-80639-5 (ebk); ISBN978-1-118-80620-3 (ebk)1. Options (Finance) 2. Options(Finance)–Mathematics. 3. Investmentanalysis. I. Title.HG6024.A3N347 2014332.64′53–dc23

2014016781

For my mother, who alwaysmade the time to answer aquestion from a curious kid.

CONTENTS1. Foreword2. Preface1. The Spreads andCombinations3. Chapter 1: Not JustMore or Less butDifferent

1. The “Flavors”:Calls and Puts2. The ExpirationDate3. The Strike Price4. An OptionCorresponds to 100Shares of Stock5. Defining an Option6. Moneyness7. What We Mean bySpread and

Combination8. A Final Thought4. Chapter 2: Just a LittleMath1. The Option Price2. Volatility and theVolatility Impliedby the Option Price3. Option Erosion4. Option PriceSensitivities5. Sensitivity to the

Passage of Time6. Sensitivity to thePrice of theUnderlying Stock7. Changes inVolatility8. Other Sensitivities5. Chapter 3: VerticalSpreads1. Buying and SellingVertical Spreads2. Vertical Spread

3.4.5.6.7.8.Maximum andMinimum ValuesNamingMoneyness andVertical SpreadsBullish and BearishVertical SpreadsSelling a CallVertical SpreadBreakeven PointsThe NecessaryPrice Action

9. Vertical Spreadsand Your MarketOutlook10. Asymmetry of Riskand Reward forVertical Spreads11. Option Delta andLikelihood12. Vertical SpreadValue Prior toExpiration13. The Other Greeks

14. The Best Measureof Vertical SpreadCost15. In-the-MoneyVertical Spreads6. Chapter 4: CoveredCalls1. Profitability2. Covered Calls andDownsideProtection—Not AsMuch As We’dLike

3. Using CoveredCalls to “Create”Dividends4. Having YourShares CalledAway5. Don’t FearAssignment6. Stock CoveredVertical CallSpread7. Chapter 5: Covered Puts

1. The Regret Point2. Market Outlook3. Out-of-the-MoneyCovered Puts4. In-the-MoneyCovered Puts5. At-the-Money orNearly At-theMoney6. Covered Put versusCovered Call8. Chapter 6: Calendar

Spreads1. Call CalendarSpreads2. Selling CalendarSpreads3. Directionality4. Catalysts5. The Super Calendar9. Chapter 7: Straddles1. The Short Straddle2. Likelihoods

3. Selling CoveredStraddles10. Chapter 8: Strangles1. Selling Strangles2. Selling CoveredStrangles11. Chapter 9: Collars1. Wider Collars2. In-the-MoneyCollars3. Potential Outcomes4. A Zero-Cost Collar

5. Skew6. How a Collar IsSimilar to OtherSpreads andCombinations7. Put Spread Collar8. Call Spread Collar12. Chapter 10: RiskReversal1. Likelihoods2. How Skew Helps aRisk Reversal

3. Call Spread RiskReversal13. Chapter 11: Butterflies1. Buying and SellingButterflies—TheTerminology2. Put Butterflies3. Butterflies Prior toExpiration4. Butterflies andYour MarketExpectations

5. Broken Butterflies14. Chapter 12: Condors andIron Condors1. Selling a Condor2. The Bid/AskSpread and CondorSpreads3. Iron Condor4. DirectionalCondors15. Chapter 13:Conversion/Reversal

1. Reversal2. Dividends3. Pin Risk16. Chapter 14: RatioSpreads and BackSpreads1. Vertical Spreads,Butterflies, andRatio Spreads2. Call Ratio Spreads3. Call Ratio Spreadsfor Stock Repair

4. Back Spreads5. Super Back Spreads17. Chapter 15: OtherSpreads andCombinations1. Married Put2. Diagonal Spread3. Iron Butterfly4. Christmas Tree5. Box Spread6. Jelly Roll

18.19.20.21.7. Stupid8. Guts9. Other PotentialSpreads andCombinationsAbout the WebsiteAbout the AuthorIndexEnd User LicenseAgreement

List of Tables1. Table 1.12. Table 1.23. Table 1.34. Table 1.45. Table 2.16. Table 3.17. Table 3.28. Table 3.3

9. Table 3.410. Table 3.511. Table 3.612. Table 3.713. Table 3.814. Table 3.915. Table 3.1016. Table 3.1117. Table 3.1218. Table 3.13

19. Table 3.1420. Table 3.1521. Table 3.1622. Table 4.123. Table 4.224. Table 4.325. Table 4.426. Table 4.527. Table 4.628. Table 5.1

29. Table 5.230. Table 5.331. Table 5.432. Table 5.533. Table 6.134. Table 6.235. Table 6.336. Table 6.437. Table 6.538. Table 6.6

39. Table 6.740. Table 6.841. Table 6.942. Table 6.1043. Table 7.144. Table 7.245. Table 8.146. Table 8.247. Table 8.348. Table 9.1

49. Table 10.150. Table 10.251. Table 10.352. Table 11.153. Table 11.254. Table 11.355. Table 11.456. Table 12.157. Table 12.258. Table 12.3

59. Table 12.460. Table 12.561. Table 12.662. Table 12.7

List of Illustrations1. Figure 1.1 Some Optionsin GM2. Figure 1.2 Profit or Lossfor Our Long 37 StrikeCall In GM3. Figure 1.3 Profit or Lossfor Our Short 37 StrikeCall in GM4. Figure 1.4 Profit or Lossfor Our Long 33 Strike

Put in GM5. Figure 1.5 Profit or Lossfor Our Short 33 StrikePut in GM6. Figure 1.6 MoneynessExamples7. Figure 2.1 Option Valueby Time to Expiration8. Figure 2.2 OptionErosion by Time toExpiration9. Figure 2.3 Option

Erosion by UnderlyingStock Price10. Figure 2.4 Sensitivity tothe Price of theUnderlying Stock11. Figure 2.5 Delta byStock Price12. Figure 2.6 How OptionValue Changes withChanges in VolatilityAssumption13. Figure 2.7 Gamma

14. Figure 3.1 Some CallOptions15. Figure 3.2 Call Optionsand Vertical Spread16. Figure 3.3 Put Optionsand Vertical Spreads17. Figure 3.4 Payoff forBuying a Long VerticalCall Spread18. Figure 3.5 Stock MustRally for Long CallVertical Spread to Be

Profitable19. Figure 3.6 Payoff forSelling a Call Vertical20. Figure 3.7 Payoff forBuying a Vertical PutSpread21. Figure 3.8 Payoff forSelling a Vertical PutSpread22. Figure 3.9 Short PutVertical and the Marginof Error

23. Figure 3.10 Payoffs andLikelihoods for Buying aVertical Call Spread24. Figure 3.11 Payoff for aLong Vertical CallSpread and Value BeforeExpiration25. Figure 3.12 Payoff for aLong Vertical CallSpread and Value beforeExpiration26. Figure 3.13 Put SpreadTheta

27. Figure 4.1 Would YouMake This Trade?28. Figure 4.2 The 60 StrikeJPM Covered Call29. Figure 4.3 JPM 60 StrikeCovered Call Price byTime to Expiration30. Figure 4.4 Our CoveredCall over a Longer TimePeriod31. Figure 4.5 Covered CallPrice by Time to

Expiration for SeveralStrike Prices32. Figure 4.6 One LongDated Covered Call or aSeries of 30-DayCovered Calls?33. Figure 4.7 DownsideProtection from aCovered Call—Not asMuch as We’d Like34. Figure 4.8 Covered CallYield and Likelihood ofGetting Stock Called

Away35. Figure 4.9 Covered CallTime Value for SeveralStrike Prices36. Figure 4.10 ThreePotential GLD CoveredCalls37. Figure 4.11 A StockCovered Vertical CallSpread in GLD38. Figure 4.12 A StockCovered vertical Call

Spread versus aTraditional Covered Call39. Figure 5.1 A CoveredPut in MSFT40. Figure 5.2 MSFTCovered Put PayoffChart41. Figure 5.3 MSFT 36Strike Covered Putversus MSFT Stock42. Figure 5.4 MSFT 36Strike Covered Put by

Time to Expiration43. Figure 5.5 36 Strikeversus 34 Strike44. Figure 5.6 An At-theMoney Put versus aDeep Out-of-the-MoneyPut45. Figure 5.7 WFC DeepIn-the-Money CoveredPut versus At-theMoney Covered Put46. Figure 5.8 A WFC Deep

In-the-Money CoveredPut versus Owning theStock47. Figure 5.9 Deep In-theMoney Covered Puts inGM and the Bid/AskSpread48. Figure 5.10 MSFT Atthe-Money Covered Putand the ImportantLikelihoods49. Figure 5.11 ThreeCovered Puts in GLD

50. Figure 5.12 In-theMoney, Out-of-theMoney, and At-theMoney Options in GLD51. Figure 6.1 Two PutCalendar Spreads inORCL52. Figure 6.2 Two CallCalendar Spreads inOracle (ORCL)53. Figure 6.3 TheMay/June 34 Strike Call

Calendar Payoff54. Figure 6.4 TheMay/June 33 Strike CallCalendar Payoff55. Figure 6.5 Daily NetErosion Collected for 33Strike Call Calendar56. Figure 6.6 The ShortJune/July 30 Strike PutCalendar Payoff57. Figure 6.7 Call CalendarSpreads and

Directionality58. Figure 7.1 A Straddle59. Figure 7.2 The Payofffor Our Long 21 StrikeStraddle60. Figure 7.3 Where OurStraddle Breaks Even61. Figure 7.4 Buying a SPYStraddle before a FedMeeting62. Figure 7.5 Buying aStraddle In SPY

63. Figure 7.6 Our LongStraddle in SPY versusthe Constituent Options64. Figure 7.7 Selling aStraddle in DeutscheBank (DB)65. Figure 7.8 A ShortStraddle in DeutscheBank (DB)66. Figure 7.9 Our ShortStraddle in DeutscheBank (DB)

67. Figure 7.10 DoublingOur Money with aStraddle in SPY68. Figure 7.11 Stock Chartof Ford for Our CoveredStraddle69. Figure 7.12 Selling aCovered Straddle inFord70. Figure 7.13 Payoff for aCovered Straddle inFord

71. Figure 8.1 Buying aStrangle in Blackberry(BBRY)72. Figure 8.2 Buying aBullish Strangle inBlackberry (BBRY)73. Figure 8.3 Buying aBearish Strangle inBlackberry (BBRY)74. Figure 8.4 The Payofffor Our Long 9.50/11.50Strangle in Blackberry(BBRY)

75. Figure 8.5 The Cost ofOur Google Strangleversus the Likelihood ofBreaking Even76. Figure 8.6 Options for aStrangle in EEM, theEmerging-Markets ETF77. Figure 8.7 Selling aStrangle in Facebook(FB)78. Figure 8.8 The Payofffor Our Short Strangle in

Facebook (FB)79. Figure 8.9 Selling ACovered Strangle in ford80. Figure 8.10 The Payofffor Our CoveredStrangle in Ford81. Figure 8.11 The StockChart of Ford and OurEffective Prices82. Figure 9.1 An OptionCollar on MGM83. Figure 9.2 Payoff for the

23/24 Collar in MGM84. Figure 9.3 Payoff or the22/24 Collar in MGM85. Figure 9.4 A WiderCollar in MGM That’sAlso a Zero-Cost Collar86. Figure 9.5 An In-theMoney Collar on MGM87. Figure 9.6 An In-theMoney Collar on MGM88. Figure 9.7 A Zero-CostCollar in IWM