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Duration: 15:24

Instructor:

Contributor: Interactive Brokers

Level: Intermediate

The final lesson brings the concepts together to illustrate the benefits of combining single option trades into complex
option strategies. Students will learn to easily identify potential profit and loss regions on the Performance Graph and understand how to configure the plot to view P&L and risk measures across different time horizons.

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Study Notes:

A call option buyer expects, or hopes, that the share price of a company will rise by a certain amount
within a specified time frame. For the right to lock in to a price agreed upon today, he pays the contract
seller a fixed amount known as a premium. If the call option expires in the money, through a process
known as exercise, the call buyer may exercise his right to purchase the shares of stock specified by the
contract. Alternatively the call buyer may sell the option contract at the prevailing market price.

Whether or not he makes a profit depends on the current market price of the underlying shares, the
amount of the premium paid, as well as any commissions or fees. As we did in the first video, in
calculating breakeven points, we’ll disregard the cost of commissions for simplicity, but please
remember that commissions are an added cost and should be considered when calculating breakeven points. Information on commissions and fees can be found on the IB website.

A call option provides the buyer with a fixed cost with potentially unlimited upside should the share
price increase.

Conversely, an investor may be bearish on a stock and could buy a put option giving him the right to sell a specified number of shares by expiration at a price agreed upon today. Once again, the current market price of the underlying shares, the amount of premium paid by buyer to seller and the cost of commissions and fees can have an impact on whether the tactic is profitable.

A put option provides the buyer with a fixed price at which to sell the underlying stock (the strike
price). The maximum risk is the cost of the put option (the premium) should it expire unexercised,
which would occur if the underlying share price increases beyond the strike price of the option.
Vertical spreads – In order to increase the likelihood of being profitable, some investors use spreads to
reduce the impact of premiums on P&L. Let’s walk through a theoretical example to make the point.

Let’s assume that shares in company XYZ Corp. are trading at $66.50, and that a 90-day call option with
a strike of $70.00 costs $1.00. And that a call option with a strike of $75.00 at the same expiration costs
50 cents. It is important to note that multiple leg strategies, including spreads, will incur multiple
commission charges.

Moderately bullish – An investor is moderately bullish on the short-term prospects of the stock and
expects it to rise by the time options expire by more than 10%. In order to reach the $70 strike, the
shares must rise by 5.2%. In order to reach the $75 strike, its shares must rise by almost 13%.
And so, if the investor paid $1.00 for the right to buy shares at $70 at or before expiration, because the
breakeven price is calculated by adding the cost of the premium to the strike price, the shares must rise
to $71 or 6.7%. Likewise, in order to reach breakeven at the $75 strike, its shares must rise by that
additional 50 cent premium or by 13.5%.

Compare the performance profile of the two options.

The investor is now faced with deciding which option is most likely to pay off in the event that he is
right. Of course, if the share price does not rise to at least the lower strike price plus the premium paid,
in either case he’d lose the premium paid. Alternatively, he could look at the trading opportunity
differently. Remember, he is looking for an upswing that would carry the stock above that $70 strike,
but he’s not assuming that the rally is without its limit.

The call spread or a vertical spread – He could buy the $70 strike, paying $1.00 and SELL the $75 strike
and receive the 50 cent premium. This leaves him bullish at prices between $70-75, but bearish at prices
above $75. Netting the two premiums means that he now pays just 50 cents in order to get bullish
above the $70 strike price and so his breakeven is now only $70.50 rather than $71.00. The pitfall here is
that his bullish rights above $70 are offset at any price above $75. However, if you recall, he’s
moderately bullish and has reasonable expectations.

This is known as a call spread or a vertical spread. Because there is a net cost, it is also known as a debit
spread and is a common trading strategy among option traders who are modestly bullish and want to
reduce the cost of upside exposure.

Moderately bearish – On the flip side of this strategy, a modestly bearish investor might buy a put
option with a strike below the prevailing trading price of a stock and sell another put option whose
strike price – and premium – is lower than that of the put option he bought. This exposes the investor to
profits in the event that the share price falls below the strike price of the purchased option by
expiration. Remember that the investor has selling rights at the higher put strike of the option that he
purchased, but has offsetting obligations at the lower strike price of the option that he sold.

Profit and loss – For debit spreads, the P&L calculations are straight forward. For buying call positions we
added the premium to the strike price to show the breakeven point. For buying puts, we subtract the
premium from the strike price to calculate the breakeven price. We still follow that process with the net
cost for spreads, but we need to make another calculation. For the call spread, the distance between the
strikes is $5.00 – that’s the 75 strike less the 70 strike.

One way to visualize the profile for a vertical spread is to split the distance between the strikes between
a cost and potential profit. If the spread is $5.00 between the two strike prices and the net premium is
50 cents, the breakeven is the lower strike of $70 plus the premium to give a breakeven of $70.50. If the
trade has a maximum 50 cent loss, the remaining $4.50 is potential profit. And the maximum potential
profit occurs at the upper strike price of $75, which is also where the long position is entirely offset by
the obligations of the short position. That’s why the performance profile displays two horizontal lines.
The first to the left of the lower $70 strike represents the fixed cost or loss of the trade of 50 cents. The
upward sloping line joins the other horizontal at the upper strike of $75 where the initial call purchase is
offset by obligations from the sale of the higher strike option. Because there is a $5 distance between
the two, this is the most the investor could make from this trade MINUS the cost of getting the position
on – that was, of course, 50 cents.

Adding vertical spreads to Mosaic – So let’s learn how to create some vertical spreads in Mosaic and
add them to the order tab or a watch list. It is also easy to analyze scenarios using the Performance
Profile.

For the purpose of illustrating a vertical spread, let’s use this watch list in Mosaic, which already
monitors shares in Apple – ticker AAPL. Let’s add the options combination to a new line in order to view
its current status, historic movement and have it accessible should we wish to trade it at some point.
Input the ticker symbol in the watch list and select Combinations from the dropdown menu and follow
Option Combinations (SMART). This opens the Combo Selection tool, prepopulated with option data for
the underlying. Stay on the first tab, named Multiple, and use the Strategy selection menu to locate the
Vertical Spread. In this case we are going to create a $10-wide spread using call options with a January
2018 expiration. As those filters are applied using the boxes on the left of the Combo Selection tool,
more data is eliminated from the search. Click on the month, the Call selection and click on 10 for point
spread and then select the lower buy strike you wish to use. This automatically isolates the only possible
combination in the box on the right. Highlight the line and click Add from below. In order to also add
quotes for both legs to the watch list, check the box in the lower left of the tool. The default input shows
a buy/sell ratio of 1:1. However, ratio spreads involving the sale of multiple higher strike call options is
also common amongst option traders. By taking in multiple premiums at the farther strike further a
trader can reduce the overall cost of the trade. However, it increases the associated risk of the trade and
you should examine the Performance Profile to see how this might impact your trading. Click OK and
you will see the legs of the trade beneath the quote for the combination. Typically, if part of the bid/ask
display is missing for either leg of the combination, TWS is unable to display a quote.

Let’s run through the same exercise for this ticker for a vertical put spread. Once again we will
demonstrate a January expiration using a 10-point wide spread. Input the ticker in the watch list, follow
the Combination line and select Option Combinations. Make the selections from the Strategy menu and
create the spread from the boxes to the left, remembering this time to select Put. When you have
narrowed down the choice to the single vertical spread desired, highlight the line and click Apply and
OK. The spread now appears in the watch list.

Because Mosaic is color-linked, clicking on either spread will enable us to populate the chart. For best
viewing of a combination spread, select Max Line from the time period selection in the chart toolbar.
This displays the dynamic price of the spread, which you can relate to the price of the underlying ticker
over time.

Strategy Builder – Here is another way of adding a combination to your page. Input the underlying ticker
in the Order Entry panel. To the right, use the dropdown menu to select the Strategy Builder. This leaves
the quote for the underlying intact in the order entry panel but also displays a quote panel and option
chain. Use the option chain to select the desired expiration. And then click on the bid and ask prices for
the options you want to combine. Remember, for vertical call option spreads we are buying the lower
and more expensive strike, and selling the higher less costly strike. Input the number of contracts to
trade and modify the price if necessary. To add this to your Orders panel in the Activity window, click on
the Advanced ‘+’ sign and click Save. You can add more spread orders to this tab by repeating the
process. If not displayed, access the order panel by clicking on the ‘+’ button to the right of the Activity
panel. Orders can be transmitted from this panel by clicking on the blue submit button to the right. You
can now click on any saved spread to tailor an order in the Order panel or by entering a new trade from
the Order Entry window in the top left of Mosaic. Open orders can be modified or cancellation
requested for existing orders using the right-click menu, or clicking the grey Cancel button to the right of
the order line.

If you add multiple spreads or have other orders, this window can become quite busy. When an open
order is cancelled, the display turns grey rather than deleting the item. That way you can come back to it
if necessary. Use the filter to the right on the toolbar to filter the display for just Live orders for fast
access, or you can review Cancelled or Completed by selecting from the menu. One final note –
remember that these are Orders, and may be day orders. Day orders will expire and disappear from the
Activity panel if unfilled by the end of trading and will not appear upon reopening TWS. You may want to
consider adding your favorite or commonly-traded combinations to a watch list to track and save these
items.

Chart entry – Saved combinations also appear in the Orders panel beneath the chart. This can be
displayed using the increase/decrease arrows beneath the chart and again, orders can be created and
modified from here.

Performance profile – the Performance profile window can be accessed from the blue new window
button and locating the Option Analysis directory beneath Option Analytics. You could also embed the
profile window in Mosaic or you can build and save a whole page devoted to options, if you wish.
Clicking on any of the spreads in either a Watch list or from the Order panel, will display the spread. Any
of the equal ratio combinations we have so far referred to in this video will have the same profile. The
difference will be determined by the spread between strike prices, the premium paid for the
combination, the remaining time value and the implied volatility. Remember that the distance between
the strike prices will always be either fixed cost or potential profit. For call spreads, the maximum gain is
at the upper strike price and is the spread distance minus the net premium paid. For put spreads, the
maximum gain is at the lower strike price and is the spread distance minus the net premium paid.

Once you get used to the basic concept behind equal ratio debit spreads and can quickly identify the at
expiration profile associated with them, try manipulating the ratio to see how the risk profile changes.
But remember that selling more options than you are buying might reduce the outlay of the trade, but
imposes greater obligations and potential losses if the trade plan doesn’t turn out as you had planned.
Use the Performance profile to analyze your trading risks in advance and take full advantage of IB’s
range of free trading tools.

Disclosure: Interactive Brokers

The analysis in this material is provided for information only and is not and should not be construed as an offer to sell or the solicitation of an offer to buy any security. To the extent that this material discusses general market activity, industry or sector trends or other broad-based economic or political conditions, it should not be construed as research or investment advice. To the extent that it includes references to specific securities, commodities, currencies, or other instruments, those references do not constitute a recommendation by IBKR to buy, sell or hold such investments. This material does not and is not intended to take into account the particular financial conditions, investment objectives or requirements of individual customers. Before acting on this material, you should consider whether it is suitable for your particular circumstances and, as necessary, seek professional advice.

Supporting documentation for any claims and statistical information will be provided upon request.

Any stock, options or futures symbols displayed are for illustrative purposes only and are not intended to portray recommendations.

Disclosure: Margin Trading

Trading on margin is only for sophisticated investors with high risk tolerance. You may lose more than your initial investment.

For additional information regarding margin loan rates, see ibkr.com/interest

Disclosure: Options Trading

Options involve risk and are not suitable for all investors. For more information read the “Characteristics and Risks of Standardized Options” also known as the options disclosure document (ODD). To receive a copy of the ODD call 312-542-6901 or click here. Multiple leg strategies, including spreads, will incur multiple commission charges.

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