Chapter 3-1 Basic Multi-Leg Strategies

Multi-leg strategies involve buying and selling options to construct a strategy that will meet your profit objective if the market behaves as you anticipate it will.  Multi-leg strategies are used for a number of reasons.  The most common reasons are to limit the downside risk of the options strategy, to protect an equity position, and to reduce the cost of buying options.  Multi-leg strategies can be as simple as buying two call options or as complex as buying and selling numerous puts and calls on the same underlying asset.  The following section will cover the risks and rewards associated with basic multi-leg options strategies and provide examples to aid your understanding. 

Covered Calls

Would you like to…

  • Generate income in neutral or rising markets?
  • Get paid to sell your long stock position?

Say you own a stock that is part of your long-term investment portfolio.  You like it over the long run, but do not see it going anywhere over the short term and you would consider selling it given the right terms.  You would also like to generate some income, but you are not interested in selling your stock only to buy a CD with a next to-nothing return.  Given these conditions, many self-directed (or “retail”) traders write covered calls to generate additional income in their accounts.  Writing covered calls is highly conservative and therefore widely popular.  In fact, many stock traders begin trading options this way.  The strategy can also be used to finance purchasing long stock positions.  This is known as a “buy-write”, which occurs when the investor buys the stock and writes (or sells) the call in conjunction.  A covered call is equivalent to a cash-secured put.

What is a Covered Call?

Implementing the covered call strategy involves buying (or owning) 100 shares of a stock and then selling a call that is “covered” by the stock (since 1 options contract controls 100 shares of stock).  The sale is a credit and therefore adds cash in the amount of the premium to your account.  But while selling the call brings income to the account, it also creates the obligation to sell the stock if the call is assigned.  Also, it is important to note that this can create tax issues for stocks with a low cost basis.  Covered calls are profitable within a defined range.  They profit if the stock price drops by less than the amount of the sold call, and remain profitable if the stock moves up to or beyond the strike price of the call sold.  The maximum gain is realized if the stock price is at the strike price.  At that point, the full value of the sold call is retained while the stock has achieved its maximum value without assignment.

Consider the following example:

  • With Wal-Mart (WMT) stock at $48, you sell a 50 call for $1.
  • If the stock goes to $49.50 you gain $1.50 per share and keep the $1 premium.
  • If the stock goes to $47.20 there is a $.20 profit.  Your stock position would have lost $0.80 but you gained $1 from selling the call option.
  • If the stock goes to $50.30 at expiration the call will be assigned and the stock will be sold.  You will realize a $2.00 gain in the stock price and $1 profit from the option premium which you received, but in this case you will have sold your stock.

If the sold call can be bought back for a small amount before expiration it is usually best to do so in order to lock in your profit and eliminate risk exposure.

WMT Stock

Stock Profits/Losses

Call Profits/Losses

Covered Call Profits/Losses

$40

-$8

$1

-$7

$47

-$1

$1

$0

$50

$2

$1

$3

$60

$12

-$9

$3

This can be shown graphically:

option-content-image-3-1-1

If you are purchasing stock at the same time that you are selling calls the strategy loses if the stock price drops significantly.  This occurs because to exit a position you will need to first buy back the call and then sell the stock.  In a falling market this can be quite problematic.  The credit from selling the call gives you small cushion, but no real downside protection.  (If you are content to own the stock for the longer term the options premium received offsets the stock loss.)

Alternately, if the stock takes off and moves beyond the strike price sold, the position will not partake in those gains.  You still make a profit, but there is the possibility of assignment before expiration.  If you are assigned, you will have to sell your stock, which can create tax issues (especially if you have held the stock for a long time).  You will be assigned if the stock price is above the strike price at expiration.  To reiterate, the covered call will profit from the stock’s moving up, staying flat, or falling by an amount no greater than the credit from the sold call.  The position will lose as the stock price moves down beyond the amount of the credit.  If implied volatility (the volatility expectation taken from the options price) goes down the covered call will profit because implied volatility is a significant part of the premium paid for an option.  Conversely, if implied volatility goes up the position will lose.  This is only the case before expiration because at expiration the profit and loss is fixed.  Time is on your side with a covered call because you have a position with positive Theta; every day you are profiting from time decay (all else held equal).

Example of a Winning Trade

  • Let’s say the stock price of INTC bounces off resistance at the same time that implied volatility spikes.  We want to sell calls on high implied volatility because that is more time decay in our favor.
  • Time decay is the greatest in the front month, so in this case with the stock at $23.50 and rising in mid-August we would sell one month out September 25 calls for $1.00.
  • If the underlying prices fall and/or implied volatility drops (as is the case), it is usually best to buy back the call at some pre-determined value (say $0.15).
  • As it happened, implied volatility fell quickly but the stock price rose above $25.  In this case it is usually best to wait for expiration and assignment because buying back the call can be very expensive.  If we had waited we would have had the $1 profit from the option and $1.50 from the rise in the stock price for a gain of more than 10% for the month (minus commissions and fees).

Example of a Losing Trade

  • Some people like to use ETFs (exchange traded funds) for covered calls to minimize risk, but that does not mean risk free.  Here is an example using the QQQQ.
  • Consider that in late July, the price appears to be bottoming out with a spike in implied volatility.
  • The price breaks back above $48 as the implied volatility starts to fall so we sell the August 49 call for $1.20.
  • After a quick move in our direction the price dives down to below $46 as the implied volatility increases almost 50%.  Now we have two options- If we decide that we want to get out of the entire position then we will first need to buy back the call and then sell the stock.  Otherwise we can wait until expiration if we think that the QQQQ will be back up above $46.80 (our breakeven point) by expiration.
  • We hold the position and stock is down around $46 at expiration so we have a loss, but it is reduced by the amount of the credit of the sold call.

Protective Puts

Would you like to…

  • Have a limited-risk way of profiting from falling stock prices?
  • Be able to buy insurance on your stocks or overall portfolio?

You insure your house; you insure your car; why don’t you insure your portfolio?  Insurance for your portfolio – or any stock position – is available using put options.  While options have the reputation of being risky assets in some circles their original purpose was as insurance policies to protect positions, buying puts is a limited-risk way of doing just that.

What is a Protective Put?

Puts make money when the price of the underlying stock goes down.  Therefore, puts provide downside protection when owned in conjunction with the underlying stock.  As a put buyer you are able to limit the risk of stock ownership.  Just as with other insurance policies, the risk involved is represented by the premium you pay.  Also like your other insurance policies you put it in place with the intention of not having to use it.  Buying a protective put requires little more than for you to identify the strike price and the expiration date that you want.  This is as easy as picking a stop-loss point, usually involving an out-of-the- money put (a put strike that is below the stock price) which restricts the loss to an amount that you are comfortable with.  Your maximum loss to the downside is calculated by adding the cost of the option to the difference between the stock price and the strike price.  For those stock traders familiar with stop-losses, there is no slippage and no gapping down past your stop price.

As options are expiring assets they are also decaying assets.  There is a time value component to the premium price of an option and every day that amount decreases.  The decay rate also increases as expiration approaches.  Longer-term options decay at slower rates than short-term options and as a result most investors use longer term puts for protection and then sell them before the decay rate increases dramatically (usually in the last 30 to 45 days).

For example, if you own 100 shares of EBAY at $31.00 and want to protect your position, you could buy a four-month 30 strike put for $2.  You are protected dollar for dollar against stock declines below $28, the strike price minus the premium cost of the option.

Below is a profit and loss diagram of a long stock position with a protective put at expiration.  We have already discussed the fact that you do not want to hold this position until expiration, so let’s look at the position half way until expiration (with no change in implied volatility).  In this second P/L chart, we can see that the stock price of EBAY would have to drop all the way to $28 to produce the maximum loss of $300.  An increase in implied volatility would help the position and therefore would lower that price at which the maximum loss occurs.  If the stock moves up to $36, a gain of $300 is produced.  Again this will be impacted by a rise or fall in implied volatility.  Finally, if the stock remains unchanged, time decay will eat away at the options value and will produce a small loss (the cost of insurance).

EBAY Stock

Stock Profits/Losses

Put Profits/Losses

Total Profits/Losses

$36

$7

-$2

$5

$31

$0

-$2

-$2

$28

-$3

$0

-$3

$25

-$6

$3

-$3

This can be shown graphically:

option-content-image-3-1-2

Exiting Long Puts

When a put has been purchased, the position can be closed in one of three ways:

  • Selling the put – Once a put is bought it can be sold at any time, just like a stock.  This is the most common way of exiting a long position.  This is the most common way of exiting a long call position and the only way of exiting a long put position that captures any remaining time value.  Your profit or loss will be based on the difference between the premium paid and the premium received.
  • Letting it expire – If a put gets all the way to expiration and is out of the money (when the strike price is below the stock price) it will expire worthless.  If the stock price is below the strike price by $0.01 or more it will be automatically exercised and shares will be “taken” from your brokerage account.  Long puts are almost always sold before expiration because at expiration they will have no time value and thus carry the smallest premium possible.
  • Exercising the option – Utilizing the right to sell provided in the call contract is known as “exercising” the option.  This delivers shares of the stock from your account at the strike price.  Although this was their original intention, options are rarely bought with the intention of exercising the underlying right.  Similar to letting an option expire, taking this course of action also forfeits any remaining time value in the option.

Example of a Winning Trade

  • Let’s say the QQQQ price hits resistance at the same time that implied volatility bottoms.  Ideally we want to buy puts on low implied volatility because that provides for more time decay, which is in our favor.
  • Time decay is the greatest in the front month and for strikes near the money, so in this case, with the stock hitting resistance at $52.50 and implied volatility at 21% we would buy three months out:  March 50 puts for $0.95.
  • If the underlying price falls and implied volatility rises (as was the case) the put protection kicks in.
  • In this case, the stock hit $43 within a month and implied volatility went to 34%.  The option went from $0.95 to $7.25 even with a month of time decay, providing exactly the protection we desired.
  • Using disciplined position management we would have exited this position before the full gain, taking half of the position off after a 100% gain and selling most of the rest at a 200% gain.  The reason to do so is to avoid letting a winner become a loser since we could not have known the future trajectory of the option.

Example of a Losing Trade

  • The worst thing that can happen with protective puts is a sideways market, especially if implied volatility falls.
  • Using the same underlying as on the previous example we can determine that the trade might not have worked out as well if we had bought puts three weeks earlier.  Let’s say at this time the QQQQ is making a lower high and implied volatility is off of its highest levels.  Most options traders ignore implied volatility and buy out-of-the-money calls only in the near months.
  • With the stock at $52 and the implied volatility at 27% we could have bought the January 51 put for $1.30.
  • This position showed a small profit after two weeks as the price dropped and implied volatility went up.  But then both reversed.  The price went up to $52.50 and the implied volatility dropped to 21% (our entry in this example).  The price is basically at the same point and implied volatility has dropped.  We have made no money on the price direction and we have lost money on the protective put.

Calendar Spreads

Would you like to…

  • Be able to profit from range-bound markets?
  • Take advantage of the different time decay rates in different expiration months?

Anyone who has traded options for a while has a feel for how time decay can eat away at an option’s value, especially as expiration approaches.  However, options positions can in fact profit from time decay but this normally entails selling options and significant risk.  Long calendar spreads provide a limited-risk way to take advantage of time decay inherent in different expiration dates.  Long calendar spreads are profitable when the underlying asset remains within a given range.  They also profit from a rise in implied volatility and therefore are a low-cost way of taking advantage of options with a low implied volatility.  Although calendar spreads are considered a more advanced options strategy, they usually have lower risk and a higher probability of profit than outright call or put buying.  As with other spreads, the maximum risk is known from the outset of the trade.  This is equal to the debit paid for the spread up until the near-term option that you sell expires, at which point exposure becomes the risk inherent to the option that you have purchased.

What is a Calendar Spread?

Calendar spreads can be constructed with calls or puts and, if made using the same strikes, are virtually equivalent.  Implementing the strategy involves buying one option and selling another option of the same type and strike, but with a different expiration.  A long calendar spread would entail buying an option (not a “front month” contract) and selling an earlier expiration option of the same strike and type.  Long calendar spreads are traded for a debit which means you pay to establish the overall position.

This strategy profits in a limited range around the strike used.  The trade can be set up with a bullish, bearish, or neutral bias.  The greatest profit will come when the underlying asset is at the strike used at expiration.  Calendar spreads also profit from a rise in implied volatility since the long option has a higher Vega (a metric for the amount an option’s price changes when volatility changes) than the short option.  Calendar spreads lose if the underlying asset moves too far in either direction.  The maximum loss is the debit paid, up until the option you sold expires.  After the near-term option expires you are simply long an option, and your further risk is the entire value of that option.

Options in nearer-month expirations have more time decay than later months, as they have a higher Theta.  The calendar spread profits from this difference in decay rates.  This trade is best used when implied volatility is low and when there is implied volatility “skew” between the months used, specifically when the near-month sold has a higher implied volatility than the later-month bought.

Consider the following example:

  • With Salesforce.com (CRM) stock at $135.13, the September 135 call is purchased for $15.45 and the July 135 call is sold for $10.45, for a net debit of $5.
  • The cost of the spread, $5, is the maximum risk.
  • If the implied volatility does not change, the position profits from roughly 121 to 154.
  • Rises in implied volatility will increase the profit and the range.
  • Time decay is on your side with this trade.

The profit and loss from a call calendar spread can be shown graphically:

option-content-image-3-1-3

Example of a Winning Trade

  • Let’s say Research in Motion (RIMM) moved up to $108 in late February while implied volatility moved fell below 50.
  • With the stock at $108, we would buy the April 110 calls for $7.50 and sell the March 110 calls for $4.45 for a net debit of $3.05.
  • The maximum risk is the $305 we paid (remembering that options contacts come in lots of 100).  This loss would be realized if the stock moves too far in either direction.
  • Say RIMM fell to $101 at March expiration and implied volatility increased to 65.
  • The March 110 call expired worthless while the April 110 call is worth $4.30, for a 41% return.

Example of a Losing Trade

  • Using the same RIMM example as above, let’s say that in August we saw the price heading up through $220 and implied volatility at 62 percent.
  • The October 220 call was purchased for $22.60 and the September 220 call sold for $15.90 for a net debit of $6.70.
  • After terrible earnings the stock price plummeted down into the $80 range and implied volatility dropped below 50.
  • The implied volatility recovered by the September and October expirations, but the price did not.
  • As a result the maximum loss of $670 was realized. This is calculated by taking the difference of the $2260 cost for purchasing the October call by the $1590 payment received for writing the September call.

Vertical Spreads

Would you like to…

  • Be able to increase your probability of profit?
  • Reduce your exposure to high premiums and implied volatility?

One of the issues with buying “naked” calls and puts is that by the time you purchase them, the premiums are already very high.  As options trading is a probability game, the higher the premiums are the lower the probability of profit for buyers.  So to lower your exposure to those high premiums you should know when to spread them.  Vertical spreads are used to offset premium costs when buying options, or to hedge risks when selling options.  The maximum gain and risk are known from the outset of the trade and therefore allow for very specific risk management.  Verticals are usually used when implied volatility, and therefore option premiums, is high.

What is a Vertical Spread?

Vertical spreads are strategies that can be constructed using either calls or puts.  They involve buying one option and selling another of the same type at the same expiration date but with a different strike price.  A “bull call” spread, for example, entails buying one call and selling a higher-strike (and thus lower-priced call) to offset some of the premium cost.  This type of spread is constructed for a debit, but is cheaper than buying an option outright.  A “bear call” spread would entail selling the lower-strike call and buying a higher-strike call to hedge the risk.  This would produce a credit in your account, cash will be held as a margin for the position.

Debit vertical spreads (bull call and bear put spreads) profit from a directional move.  Debit vertical spreads are used to offset the premium cost of the purchased option, especially when implied volatilities are high.  This increases the probability of profit for the trade, but does limit the potential gains.  The position will succeed if the stock has moved past the bought strike plus the debit paid.  For a full profit, the underlying needs to move beyond the sold strike by expiration.  For example, consider an XYZ call spread that is purchased by buying the 25 call and selling the 30 call for a debit of $2.   The position will profit anywhere above $27 and the maximum profit occurs if the underlying asset moves anywhere above $30.

Credit spreads are used when one wants to be a net seller of options, but wants to hedge the risk.  Option selling can have a very high probability of profit but also the potential of large losses.  Using a credit spread limits that exposure.  Credit vertical spreads involving calls will make a full profit if the underlying asset is below the sold strike at expiration.  The breakeven price is the strike plus the credit.  Credit spreads using puts will profit if the underlying stays above the strike sold minus the credit.  For example, sell the XYZ 30 put and buy the 25 put to hedge the risk for a net credit of $2.50.  The position will profit anywhere above $27.50, and will get reach maximum profit if XYZ is anywhere above $30 at expiration.

Vertical spreads lose if the underlying asset moves in the wrong direction.  The maximum loss for debit spreads is the debit paid.  The maximum loss for credit spreads is the difference between the two strikes used minus the credit received.  Consequently, this is also the amount of margin held by your broker.

For example, with the stock at $149, the 150 call is purchased for $10 and the 160 call is sold for $6 (to offset some of that cost) for a net debit of $4.  This is a directional trade- the bull call spread will profit from the stock moving up and lose if the stock moves down.  The maximum gain and risk are known from the outset of the trade and therefore allow for very specific risk management.  The spread is used to limit exposure to implied volatility; as a result changes in implied volatility will have little effect.  Time is working against you with both credit and debit spreads.

Example of a Winning Trade

  • Let’s say Intel’s (INTC) price bounces off resistance at the same time that implied volatility spikes.  We usually buy call spreads on high implied volatility to offset the premium cost.
  • With the stock at $23.50, and rising in mid-August, we would buy the September 22.50 calls for $2.00 and sell the 25 calls for $0.85 resulting in a net debit of $1.15.
  • The maximum risk is the $115 we paid (remember: shares in option lots come in 100s), realized if the stock is below $22.50.  The maximum gain is $135.
  • In this case, INTC went up to $26 so the trade worked out perfectly resulting in a 117% return.  The stock went higher than $25, but we were still better off with the spread.

This can be shown graphically:

option-content-image-3-1-4

Example of a Losing Trade

  • Now consider what would occur if the price of the underlying asset moved against our position.
  • In late July the price seems to have the bottomed out and implied volatility seems to have spiked.
  • We bought the August 49 call for $0.80 and sold the 50 call for $0.50, for a net debit of $0.30, when the price broke back above $48 and implied volatility started to fall.
  • After a quick move in our direction the price dove down to below $46.
  • We held the position to expiration at which point we realized a loss of $30, equal to the debit we paid.

This can be shown graphically:

option-content-image-3-1-5

Questions