Section 4.

Complex strategies
This section will discuss the more complex option strategies and will
present examples of these strategies.
The previous section covered the simpler option trading strategies,
mainly the buying and selling of puts and calls. These simpler
strategies are usually thought of as very aggressive strategies, with
high profit potential on the long side and large risk on the short side.
This section will examine option positions which are structured by
combining options of different terms, put and call options, or options
and stock positions. Because they provide reduced risk, some of these
strategies are much more conservative than the simpler strategies. It
is of the utmost importance that the trader understand the risk/reward
characteristics of any strategy that he or she is considering.

A Note about Commissions

Because the more complex strategies involve multiple positions,
commission costs can be substantial. For this reason, it is
advantageous to keep commissions as low as possible through the use
of discount brokers, etc.

Margin
For covered positions, the user can elect to use margin for the
purchase of stock. When Use margin is selected, Cash Outlay will
Note only include the margin requirement for the stock and Cash ROI is
Margin rates can be viewed based on the margin requirement rather than the full value of the
and/or modified through the stock.
Margin Criteria page of Certain of the complex option strategies are credit positions. That is,
Broker/Margin Properties at the time the position is entered, a net credit is received. In this
respect, they are similar to the naked write option strategies discussed
in the previous section in that the option trader does not make a cash
investment. The investment is in the form of collateral, not cash.
However, for analysis purposes, OptionExpert assumes that the
investment in a credit position is the collateral requirement less
premiums received.
The computation of collateral for some of the complex strategies can
be rather involved. For instance, although the butterfly spread results
in a small net debit, the spread actually consists of a bull and a bear
spread. In this case, the collateral requirement is the sum of the two
spread requirements, which is much greater than the debit for the
position.

Working Guide 25
 Spread Strategies
Spread strategies are designed to take advantage of one of the more
basic tenets of option trading — sell time value and buy intrinsic
value. To become profitable, a spread must be held for some time
even if the stock price moves in favor of the position. If you want
maximum profit from a quick short-term move in the stock, calls are
a better choice. Spreading provides a hedge but, since profit is
limited, it is only advantageous when the stock moves slowly.
A spread position consists of two options of the same type (puts or
calls) on the same stock. The spreader buys one option and
simultaneously sells another with different terms. There are three
basic types of spreads:
• Vertical - Same expiration date, different strike price
• Horizontal - Same strike price, different expiration date
• Diagonal - Different expiration date, different strike price
The butterfly spread is a special type of spread which is a
combination of a bull and a bear spread. It involves the buying of two
options with different strike prices and the selling of two options with
the same strike price. The strike of the sold options is between the
strike prices of the two purchased options. This special spread
position has limited risk and requires small outlay. Maximum profit
occurs when the stock price at expiration is unchanged from the price
when the position was entered. Since it is most appropriate for the
trader who is neutral on the stock, it is termed a neutral position.

Straddles
A straddle consists of a put and a call with the same terms. Straddles
can be bought or sold and the short straddle can be covered or
uncovered.
The long straddle, a speculative strategy, has unlimited profit
potential in both directions. However, the more likely outcome, a
relatively small change in the stock price, results in a limited loss.
The uncovered short straddle, a neutral strategy, is the mirror image
of the long straddle. Loss is unlimited in either direction but, the
more likely outcome, a relatively small change in stock price, results
in a limited gain.
The covered short straddle is similar to the covered call write, a
conservative strategy. This is true because only the sale of the call is

26 AIQ OptionExpert
covered and an uncovered put is equivalent to a covered call.
Therefore, the strategy is the same as selling two covered calls.

Strangles
The strangle or combination strategy is similar to the straddle in that
the position involves both puts and calls. However, with the strangle
the terms of the options are not the same. Usually, the strike prices
differ with the call one strike above the put, which is out-of-the-
money.
A long strangle is similar to a long straddle with large potential profit
in either direction but high probability of a limited loss. The
difference is that the strangle requires a smaller investment and,
therefore, the maximum loss, which occurs anywhere between the two
strike prices, is smaller. However, with a straddle the maximum loss
occurs only if the stock is at the exact strike at expiration.
A short uncovered strangle is also similar to the equivalent straddle
position. Both are neutral strategies with high probability of limited
profit. However, with the strangle, maximum profit occurs anywhere
between the two strike prices and the strangle writer makes maximum
profit over a wider range than the straddle writer. The straddle has
larger maximum profit but it occurs only if the stock is at the exact
strike at expiration.
Again, the covered strangle write is similar to and a variation of the
covered straddle write. The strangle differs in that the put is usually
out-of-the-money and a strike below the call. This increases the
profit potential of the position but also increases the potential loss
should the stock drop below the lower strike price.

Variable Ratio Call Write

In addition to the spreads, straddles, and strangles, OptionExpert’s
Strategy List includes two other positions, the covered call write and
the variable ratio call write. The covered call write is covered in
Section 3.
The ratio call write, which is a special type of covered call write, is a
sophisticated strategy that combines covered and uncovered call
writing. In a ratio call write, the writer sells calls against more
shares than are owned. The most common ratio, called the covered
call ratio, is 2:1, where two calls are sold against 100 shares of the
underlying stock.

Working Guide 27
 With a ratio call write, the trader usually attempts to establish a
neutral position with the strike of the calls close to the stock price. If
the stock remains relatively unchanged, this strategy will generally
result in higher profits than either the covered write or the uncovered
write. However, the ratio call write has both downside risk, as does a
covered write, and unlimited upside risk, as does a naked write. The
ratio call write position is similar to selling an uncovered straddle
which also involves selling large amounts of time premium. Both are
attractive to the more aggressive trader who is willing to risk that the
stock will remain fairly stable.
The variable ratio call write is a special form of the ratio write
strategy. In this variation, calls are written with two different strike
prices. Normally, it is used to obtain a neutral profit range when the
stock price is between two strikes. The 2:1 ratio is maintained by
writing one in-the-money call and one out-of-the-money call against
each 100 shares of stock. The variable ratio write position is similar
to selling an uncovered strangle. Since the strategy is profitable for
the most probable range of prices for the underlying stock, it has a
large probability of resulting in a limited profit. With this position,
follow-up action is mandatory to avoid large losses in both the upside
and downside directions.

28 AIQ OptionExpert
Examples of complex strategies

Examples of complex strategies include:

Bull Spread
Bear Spread
Bullish Time Spread
Neutral Time Spread
Bearish Time Spread
Diagonal Bull Spread
Diagonal Bear Spread
Butterfly Spread
Buy Straddle
Sell Straddle
Buy Strangle
Sell Strangle
Sell Covered Straddle
Sell Covered Strangle
Variable Ratio Call Write
Ratio Call Write

Working Guide 29
 Bull Spread Example

S&P 500 (SPX): October 1, 1999.

For the trader who is bullish but prefers a hedge, the bull spread is a
good alternative to buying calls. A bull spread using calls is
constructed by buying a call at one strike price and selling a second
call at a higher strike price. Normally the spread is vertical, meaning
that both options have the same expiration date.
In this example, our trader prefers to trade options on the S&P 500
index but is only moderately bullish on the market. This trader wants
the downside risk protection that a spread will provide. He realizes
that by spreading the position he is limiting his profit potential on the
upside but, if a moderately bullish outlook is correct, the profit he will
achieve can be as good or better than buying calls. However, his
primary goal in choosing a spread position is to reduce downside risk.
Looking at the Situation Data, the SPX is currently valued at 1282.80
and the Indicated Value for the Analysis Date of October 15, 1999 is
1322.00.

Position Analysis screen for SPX

on 10/01/99

To ask OptionExpert to select a Bull Spread, the strategy is first

selected from the list of strategies. With Bull Spread selected, the
Find Position command button is clicked and OptionExpert starts
looking for profitable bull spread positions.

30 AIQ OptionExpert
 OptionExpert always looks at Capital in the Situation Data window to
determine how many option contracts to write. In this case, $5,000 is
specified and the system selects positions requiring a Total
Investment as close to this amount as possible without exceeding it
(for this purpose, Commissions are not included in Cash Outlay).
Total investment for a bull spread is the difference between the price
of the two calls times the number of contracts — a bull spread is
always a debit transaction since the lower strike price call must trade
for more than the higher strike price call.
On October 1, five option expiration months are trading for the SPX:
Note October, November, December, January, and March.
For Bull Spreads,
OptionExpert selects only When the analysis is completed, the Position window displays the
positions in which both calls selected bull spread position. The spread consists of the Oct 1290
are out-of-the-money. If no call (buy 9 at 18) and the Oct 1300 call (sell 9 at 12-5/8). This is a
positions meeting this fairly conservative spread position as both options are not far out-of-
requirement are found, the the-money. The premium of the short Oct 1300 call contributes on
message “no appropriate the upside and also functions as downside protection.
positions” will appear in the
Position window.

Position Analysis screen for SPX

with graph of Bull Spread
position on 10/01/99

A graph of the bull spread position for SPX shows the computed
value of the position on the analysis date vs. the price of the stock.
The break-even index value, the value below which the position is
unprofitable, is around 1300. From the graph, it is evident that
maximum profit is limited to about $4,000 where the limitation on
profit due to the sale of the 1300 call takes effect.

Working Guide 31
 Bear Spread Example

IBM: October 4, 1999.

A put bear spread is constructed by selling one put with an out-of-the-
money strike price while buying a second put at a higher strike price.
Like the call bull spread, the put bear spread is a debit spread. This is
true because for any two puts with the same expiration the one with
the lower strike price will always sell at a higher price.
The put bear spread has a profit potential similar to the call bull
spread. Both maximum profit and maximum risk are limited. As the
stock declines, the price spread between the two puts widens and
reaches a maximum when the stock is below the lower strike price.
At this point, the spread equals the difference between the two strike
prices and profit is at a maximum.
The bear spread is an alternative to buying puts for the trader who is
bearish but wants to hedge upside risk. In this example, our trader is
bearish on IBM but wants the upside risk protection that a spread will
provide. He is aware that by spreading the position he is limiting
profit potential on the downside but, if a moderately bearish outlook
is correct, his profit may be as good or better than buying puts.
However, his primary goal in choosing a spread position is to limit
his loss if the position should move against him.
Looking at the Situation Data window, the Current Price for IBM is
118-5/8 and the Indicated Value for the Analysis Date of November
19 is 103.05. Volatility is 34.
To ask OptionExpert to select a bear spread, the Strategy list is first
displayed and the Bear Spread strategy is selected from the list of
strategies. When the Find Position button is selected, OptionExpert
Note starts looking for profitable bear spread positions.
For Bear Spreads,
OptionExpert always looks at Capital in the Situation Data window to
OptionExpert selects only
determine how many option contracts to write. In this case, $5,000 is
positions in which both puts
specified and the system selects positions with Cash Outlay not
are out-of-the-money. If no
exceeding this amount (for this purpose, Commissions are not
positions meeting this
included in Cash Outlay). Total Investment for a bear spread is the
requirement are found, the
difference between the price of the two puts times the number of
message “no appropriate
contracts.
positions” will appear in the
Position window. On October 4, 1999, the four option expiration months trading for
IBM are October, November, January, and April. Since the Analysis
Date is very close to the October expiration, the October options will
not be considered in the analysis process.

32 AIQ OptionExpert
Position Analysis screen for IBM
10/04/99

When the analysis is completed, the most profitable position found by

the system appears in the Position window. In this example, more
than one profitable position is found as is indicated by the row of
numbered buttons located along the top of the Position window.
The top position, the #1 position, sell the October 95 put and buy the
October 115 put, is displayed. This spread is classified as a
moderately aggressive position since the higher priced option is only
slightly out-of-the-money. From the position data, a return of 91% is
computed (ROI = 91%) but the price of the stock must move below
114 in order for the position to become profitable.
Looking at the Option List, both options are overpriced relative to
their fair values. The long side, the higher priced put, is priced at
120% of fair value, while the short side, the lower priced put, is
priced at 229% of fair value.
The Economic Analysis window shows an investment of $4,550.
Investment is computed by multiplying the number of contracts, 8,
times the position net debit, which is the difference between the two
option prices, 2 11/16, times 100. Cash Outlay of $4,614 is
investment plus entry Commissions.
Receipts and Profit are computed based on the computed values of the
options on the Analysis Date, November 19. Receipts are monies
received or paid out at the close of the position. In this case Receipts,
$8,763, is the net credit from the sale of the long puts less the outlay

Working Guide 33
 to close the short side of the position. The value of these puts on the
Analysis Date is calculated based on the projected value of the stock
(Indicated Value). The profit, $4,150, is derived from receipts less
selling commissions. The Position ROI (return on investment) of
91% is computed based on the total investment. Maximum Loss is
roughly equivalent to the Cash Outlay.

Position Analysis screen for IBM

with graph of Bear Spread
position on 10/04/99

The above screen shows a graph of the bear spread position for IBM
on the Analysis Date of November 19, 1999. For the conditions
specified, the graph reflects the computed value of the position on the
Analysis Date vs. the price of the stock. The break-even stock price,
the price below which the position is profitable, is around 114.
From the graph, it is evident that maximum loss is limited to about
$4,500 while maximum profit is about $11,200. Maximum profit
occurs at stock prices below 95 where the limitation on profit due to
the sale of the 95 put takes effect.

34 AIQ OptionExpert
 Bullish Time Spread Example

S&P 100 Index (OEX): October 1, 1999.

Time spreads are horizontal, meaning that both options have the
same strike price. A bullish time spread is constructed by selling one
near-term call while buying a second longer-term call, both with the
same out-of-the-money strike price. Since the two calls have the
same strike price, the longer term call will always sell at a higher
price. The bullish time spread is, therefore, a debit spread.
In a bullish time spread, the sale of the near-term call reduces the net
cost of the longer-term call. Maximum profit is achieved when the
near-term call expires out-of-the-money and, when the stock
subsequently rises, substantial profit is achieved from the longer-term
call. The profit potential of the spread is relatively large and risk is
moderate due to the low dollar investment which keeps losses small.
The strategy is considered speculative, however, since the probability
of making a profit is low.
In this example, our trader is bullish on the OEX index and has
selected a time spread because of the strategy’s high profit potential.
He recognizes the risk inherent in this type of spread and, therefore,
is committing only a small share of his trading capital to the position.

Position Analysis screen for OEX

10/01/99

Working Guide 35
 Looking at the Situation Data, the OEX is currently priced at 670.32.
Volatility is 19 and the Indicated Value for the Analysis Date of
October 15 is 700.00. The system generated value was replaced by
the analyst to reflect a bullish outlook for the index.
Before requesting OptionExpert to find positions, Bullish Time
Spread was selected from the list of strategies available on the
strategy menu. With this selection made, the Find Positions
command was executed and OptionExpert began to look for profitable
positions.
OptionExpert always looks at Capital in the Situation Data window to
determine how many option contracts to write. In this case, $5,000 is
specified and the system selects positions requiring a Total
Investment as close to this amount as possible without exceeding it
(for this purpose, Commissions are not included in Cash Outlay). A
bullish time spread is a debit position. Total investment is the
difference between the price of the long calls and the price of the
short calls multiplied by the number of contracts times 100.
On October 1, the option expiration months trading for OEX index
options are October, November, December, January, and March.
In this example, only one profitable position is found, a bullish time
spread consisting of the Oct 690 call (sell 4 at 4) and the Nov 690 call
(buy 4 at 15-1/2). This spread has a net debit of 11-1/2, and requires
an investment of $1,150 per spread contract, or $4,600 for 4
Note contracts. Note that the near-term (Oct) call is only two weeks from
For time spreads, expiration and the long-term (Nov) call is six weeks from expiration.
OptionExpert selects only
those positions where the Looking at the Economic Analysis window, the Cash Outlay of
strike price is approximately $4,650 is the Total Investment plus entry Commissions. Receipts and
one strike from the current Profit are computed based on the computed values of the options on
stock price. the Analysis Date, October 15, after exit Commissions. The Position
ROI of 10.7% is computed based on the Total Investment. Maximum
Loss is $862.
The screen on the next page displays a graph of this bullish time
spread position for the OEX. For the conditions specified, the graph
reflects the computed value of the position on the Analysis Date for a
range of stock prices. The graph clearly shows that maximum profit
occurs at a value of about 690, the strike price of the options. The
range of profitability for the position is about 677 to 707. Therefore,
the index must rise at least seven points above the current level in
order for the position to become profitable.

36 AIQ OptionExpert
 Position Analysis screen for OEX
with graph of Bullish Time Spread
position on 10/01/99

Working Guide 37
 Neutral Time Spread Example

General Motors: October 15, 1999

Time spreads are horizontal, meaning that both options have the
same strike price. They are constructed by selling one near-term
option while buying a second longer-term option and are designed to
take advantage of the characteristics of the decay of time value
premium. The near-term option is sold to obtain maximum rate of
decay on the short side, and the longer-term option is bought to lessen
the effect of time decay on the long side.
In a neutral time spread, the strike price of the options is at or near
the price of the underlying stock. Since both options have the same
strike price, the longer-term option will always sell at a higher price.
The neutral time spread is, therefore, a debit spread.
The neutral time spread is based on the principal that time erodes the
value of the near-term option faster than the value of the more distant
option. As long as the stock remains in a fairly narrow range, the
spread will widen with time and a profit will result at the expiration
of the near-term option. With a neutral time spread, the initial intent
should be to close the position when the near-term option expires.
Maximum profit is achieved when the stock price equals the strike
price of the options at expiration. When this occurs, the near-term
call expires out-of-the-money and the more distant option still has
significant time value premium.
The neutral time spread is profitable over a wide range of stock
prices. The risk is that the stock will make a big move in either
direction. Risk is, therefore, relatively low. Maximum Loss is
limited to the amount of the initial debit plus Commissions.
However, the profit potential of this spread is limited.
In this hypothetical example, our trader is neutral on General Motors
stock for the short term. He wants a low risk strategy for generating
trading profits, and has selected a neutral time spread.
Looking at the Situation Data, the current price for GM is 61-7/8.
Volatility is 40 and the Indicated Value has been changed to 64 to
reflect a neutral outlook on the stock.
In evaluating this type of spread, the Analysis Date is critical. This is
because profitability depends entirely on the decay of the time value
premium of the near-term option with respect to the longer-term
option. For maximum rate of decay, it is best that the spread be
established 8 to 12 weeks before the expiration of the near-term

38 AIQ OptionExpert
 option. To eliminate options that expire too early and allow adequate
time for decay of premiums, the Analysis Date can be moved ahead.

Position Analysis screen for GM

10/15/99

In this example, the Neutral Time Spread strategy is selected and the
Find Positions command is executed to ask OptionExpert to find
profitable positions.
OptionExpert always looks at Capital in the Situation Data window to
determine how many option contracts to write. In this case, $5,000 is
specified and the system selects positions requiring a Total
Investment as close to this amount as possible without exceeding it
(for this purpose, Commissions are not included in Cash Outlay). A
neutral time spread is a debit position and Total Investment is the
difference between the price of the long options and the price of the
short options multiplied by the number of contracts (times 100).
On October 15, the option expiration months trading for GM are
Note
November, December, January, and March.
For neutral time spreads,
OptionExpert selects only On this date, three profitable positions were found. The #1 (most
those positions where the profitable) neutral time spread position consists of the Dec 65 call
strike price is less than one (sell 21 at 2) and the Mar 65 call (buy 21 at 4-3/8). This spread has a
strike from the current stock net debit of 2-3/8 point, and requires an investment of $237.50 per
price. spread contract, or $4,987.50 for 21 contracts. Note that the near-
term (Dec) call is more than two months from expiration and the
long-term (Mar) call is more than five months from expiration.

Working Guide 39
 Looking at the Economic Analysis section, the Cash Outlay of $5,097
is the Total Investment plus entry Commissions. Receipts and Profit
are computed based on the values of the options computed for the
Analysis Date, November 19, after exit Commissions. The position
ROI (return on investment) of 24% is computed based on the Total
Investment. Maximum Loss is only $1204.
The screen below displays a graph of the neutral time spread position
for GM on the Analysis Date of November 19, 1999. For the
conditions specified, the graph reflects the computed value of the
position on the Analysis Date for a range of stock prices. Maximum
profit is at 65, the strike price of the options. The break-even stock
price on the low side, the price that defines the low end of the
profitability range, is around 59. The high end break-even price, the
price above which the position is unprofitable, is about 74.
Therefore, the range of profitability for the spread is 59 to 74.

Position Analysis screen for GM

with graph of Neutral Time Spread
position on 10/15/99

40 AIQ OptionExpert
 Bearish Time Spread Example

Pfizer: October 13, 1999.

Time spreads are horizontal spreads, meaning that both options have
the same strike price. A bearish time spread is constructed of two
puts — selling one near-term and buying a second longer-term, both
with the same out-of-the-money strike price. Since the two puts have
the same strike price, the longer-term put will always sell at a higher
price. The bearish time spread is, therefore, a debit spread.
In a bearish time spread, the sale of the near-term put reduces the net
cost of the longer-term put. Maximum profit is achieved when the
near-term put expires out-of-the-money and the longer-term put
expires in-the-money. If this occurs, the return from the spread is
substantially greater than from buying only the longer-term put. The
profit potential of the spread is relatively large and, due to the low
dollar investment which keeps losses small, risk is moderate. This
spread strategy is considered speculative, however, since the
probability of making a profit is low.
In this example, our trader is bearish on Pfizer and has selected a
time spread because of the strategy’s high profit potential. He
recognizes the risk inherent in this type of spread and, therefore, is
committing only a small share of his trading capital to the position.
Looking at the Situation Data, the Current Price for PFE is 38.

Position Analysis screen for PFE

10/13/99

Working Guide 41
 Volatility is 37, and the Indicated Value for the Analysis Date of
November 19 is 33.17. No changes were made to the data generated
by the system on this date.
Before asking OptionExpert to select a position, the strategy shown in
the Strategy box was first changed to Bearish Time Spread. Bearish
time spread is one of the strategies provided on the list of strategies.
The Find Positions command was then selected and OptionExpert
started looking for profitable bearish time spread positions.
OptionExpert always looks at Capital in the Situation Data window to
determine how many option contracts to write. In this case, $5,000 is
specified and the system selects positions requiring a Total
Investment as close to this amount as possible without exceeding it
(for this purpose, Commissions are not included in Cash Outlay). A
bearish time spread is a debit position. Total Investment is obtained
by multiplying the net debit, the difference between the price of the
long puts and the price of the short puts, by the number of contracts
times 100.
On October 13, the option expiration months trading for Pfizer are
November, December, January, and April.
In this example, three profitable position were found which is
indicated by the buttons (labeled Pos 1, Pos 2, and Pos 3) located at
the top of the Position window.
Note The #1 spread position is the December 31-5/8 put (sell 160 at 3/8)
For time spreads, and the January 31-5/8 put (buy 160 at 11/16). This spread has a net
OptionExpert selects only debit of 5/16, and requires an investment of 31.25 per spread
those positions where the contract, or $5,000 for 160 contracts. Note that the near-term
strike price is approximately (December) put is two months from expiration and the long-term
one strike from the current (January) put is three months from expiration.
stock price. Looking at the Economic Analysis section, the Cash Outlay of $5,596
is the Total Investment plus entry Commissions. Receipts and Profit
are computed based on the expected values of the options on the
Analysis Date, November 19, after exit Commissions. The position
ROI (return on investment) of 51% is computed based on the Total
Investment. Maximum Loss is only $2,561.
A graph of the bearish time spread position for PFE is shown on the
next page. For the conditions specified, the graph reflects the
computed value of the position on the Analysis Date (11/19/99) for a
range of stock prices. The break-even stock price, the price below
which the position is profitable, is around 35-3/4. From the graph, it
is evident that maximum profit occurs at a stock price of about 32 on
the Analysis Date.
42 AIQ OptionExpert
 Position Analysis screen for PFE
with graph of Bearish Time Spread
position on 10/13/99

Working Guide 43
 Diagonal Bull Spread Example

Sun Microsystems: October 15, 1999.

Diagonal spreads use different striking prices and different expiration
dates. In a diagonal spread, the long side of the spread expires later
than the short side. Therefore, a horizontal spread is diagonalized by
buying an option with a longer expiration than the short side of the
spread.
A diagonal bull spread differs from a normal bull spread in that the
long call, the call with the lower strike price, has a later expiration
than the short call, the call with the higher strike price. The profit
potential of the diagonal bull spread is similar to the normal bull
spread. However, by diagonalizing a bull spread, the downside hedge
of the position is increased somewhat. Consequently, if the stock
remains unchanged or falls, the diagonal spread can do better than
the normal bull spread. The negative aspect is that because it is more
expensive to establish, the upside profit potential of the diagonal
spread is somewhat lower.
Another advantage of the diagonal spread is that the spread can be
reestablished if the short call expires worthless. In this case, the long
call is written against twice, and the diagonal spread may turn out to
be more than worth its higher cost.
Since the long call has both a lower strike price and a longer term, it
will always sell at a higher price. The diagonal bull spread is,
therefore, a debit spread.
In this example, our trader is bullish on Sun Microsystems but wants
the downside risk protection that a spread position will provide. He
realizes that by diagonalizing the spread he is limiting further his
profit potential on the upside. However, his primary goal in choosing
a spread position is to reduce downside risk, and for this reason he
has selected a diagonal bull spread.
The Situation Data for October 15, 1999 shows that the current stock
price for SUNW is 92-9/16. The stock has a volatility of 23 and the
indicated value for the analysis date of November 17 is 106.76.
To ask OptionExpert to select a Diagonal Bull Spread, the strategy is
first selected from the list of strategies. With this strategy shown in
the Strategy box, Find Positions is executed and OptionExpert starts
looking for profitable positions.
OptionExpert always looks at Capital in the Situation Data window to
determine how many option contracts to write. In this case, $5,000 is

44 AIQ OptionExpert
Position Analysis screen for SUNW
10/15/99

specified and the system selects positions requiring a Total

Investment as close to this amount as possible without exceeding it
(for this purpose, Commissions are not included in Cash Outlay).
Total Investment for a diagonal bull spread is the difference between
the price of the two calls times the number of contracts.
On October 15, 1999, the option expiration months trading for
SUNW are October, November, December, January, and April.
Since more than one profitable position is found, numbered tabs
appear along the top of the Position window. These tabs are used to
display individual positions in the Position and Economic Analysis
sections of the screen.
In this example, the #1 position is selected. This diagonal bull spread
consists of the January 100 call (sell 3 at 6-5/8) and the April 80 call
(buy 3 at 21-1/8). The position net debit is 14-1/2, and each spread
contract requires an investment of $1,450, or $4,350 for 3 contracts.
Looking at the Economic Analysis section, the Cash Outlay of $4,400
is the Total Investment plus entry Commissions. Receipts and Profit
are computed based on the values computed for the options on the
Analysis Date, November 19, after exit Commissions. The position
ROI (return on investment) of 24% is computed based on the Total
Investment. Maximum Loss for the position is only $1,049.

Working Guide 45
 Below is a graph of the diagonal bull spread position for Sun
Microsystems on the analysis date of November 19, 1999. For the
conditions specified, the graph reflects the computed value of the
position on the Analysis Date for a range of stock prices. The break-
even stock price, the price above which the position is profitable, is
around 94-1/4. From the graph, it is evident that profit is limited to
about $1,500 regardless of the price on the Analysis Date.
Should the January 100 calls expire out-of-the-money, the trader has
the option of closing the position or re-establishing a spread by
writing another call, such as the April 90 call, against the long April
call. In this case, the new spread would, of course, be a normal bull
spread.

Position Analysis screen for SUNW

with graph of Diagonal Bull Spread
position on 10/15/99

46 AIQ OptionExpert
Diagonal Bear Spread Example

Bank of America: October 13, 1999.

Diagonal spreads use different striking prices and different expiration
dates. In a diagonal spread, the long side of the spread expires later
than the short side. Therefore, a horizontal spread is diagonalized by
buying an option with a longer expiration than the short side of the
spread.
Diagonal spreads attempt to take advantage of the characteristics of
the decay of time value premium. A near-term option is sold to
obtain maximum rate of decay on the short side and a longer term
option is bought to lessen the effect of time decay on the long side.
A diagonal bear spread differs from a normal bear spread in that the
long put, the put with the higher strike price, has a later expiration
than the short put, the put with the lower strike price. The profit
potential of the diagonal bear spread is similar to the normal bear
spread. However, by diagonalizing a bear spread, the upside hedge of
the position is increased somewhat. Consequently, if the stock
remains unchanged or rises, the diagonal spread can do better than
the normal bear spread. The negative aspect is that because it is more
expensive to establish, the downside profit potential of the diagonal
spread is somewhat lower.
Another advantage of the diagonal spread is that the spread can be re-
established if the short put expires worthless. In this case, the long
put is written against twice, and the diagonal spread may turn out to
be more than worth its higher cost.
Since the long put has both a higher strike price and a longer term, it
will always sell at a higher price. The diagonal bear spread is,
therefore, a debit spread.
In this example, our trader is moderately bearish on Bank of America
and wants the upside risk protection that a spread position will
provide. He realizes that by diagonalizing the spread he is limiting
further his profit potential on the downside. However, his primary
goal in choosing a spread position is to reduce upside risk and for this
reason he has selected a diagonal bear spread.
Looking at the Situation Data, the Current Price for BAC on October
13, 1999 is 51-7/8. The system-generated Indicated Value for the
Analysis Date of November 19 is 44.68 and the stock's Volatility is
40.

Working Guide 47
 Position Analysis screen for BAC
10/13/99

Before asking OptionExpert to find positions, Diagonal Bear Spread

was selected from the list of strategies. With this selection made, the
Find Positions command button is clicked and OptionExpert starts
looking for profitable positions.
OptionExpert always looks at Capital in the Situation Data window to
determine how many option contracts to write. In this case, $5,000 is
specified and the system selects positions requiring a Total
Investment as close to this amount as possible without exceeding it
(for this purpose, Commissions are not included in Cash Outlay).
Total Investment for a diagonal bear spread is the difference between
the price of the two calls times the number of contracts.
On October 13, the option expiration months trading for BAC are
November, January, February, and May.
When the selection process is complete, the most profitable position
appears in the Position window and tabs are displayed at the top of
the window indicating the number of profitable positions found. In
this example, three profitable positions were found as is shown by the
three tabs (tabs labeled Pos 1, Pos 2, and Pos 3). When a position is
selected by clicking its tab, the position is displayed in the Position
window and an analysis of the position appears in the Economic
Analysis section.
In this example, the most profitable position (Pos 1) is selected. This
position is a diagonal bear spread consisting of the January 45 put

48 AIQ OptionExpert
 (sell 14 at 1-3/4) and the May 50 put (buy 14 at 5-1/8). This position
has a net debit of 4-3/8, and requires an investment of $337.50 per
spread contract, or $4,725 for 14 contracts.
Looking at the Economic Analysis data, the Cash Outlay of $4,810 is
the Total Investment plus entry Commissions. Receipts and Profit are
computed based on the computed values of the options on the
Analysis Date, November 19, after exit Commissions. The Position
ROI (return on investment) computed based on the Total Investment
is 42% and Maximum Loss is $2,046.
The screen below displays a graph of the diagonal bear spread
position for BAC on the Analysis Date, November 19, 1999. For the
conditions specified, the graph depicts the computed value of the
position on the Analysis Date over a range of stock prices. The
break-even stock price, the price below which the position is
profitable, is about 53. From the graph, it is evident that maximum
profit occurs at a stock price of about 40 on the Analysis Date.

Position Analysis screen for BAC

with graph of Diagonal Bear Spread
position on 10/13/99

Working Guide 49