Beginner: Chapter 1

Intermediate Level : Chapter 2

Agenda

Spreads (cont)
Calendar spreads
Market-neutral call calendar spreads
Bullish call calendar spreads
Market-neutral put calendar spreads
Bearish put calendar spreads
Market-neutral butterfly call spread
Market-neutral butterfly put spread
Bullish butterfly call spread
Bearish butterfly put spread

Calendar spreads

A calendar spread is a horizontal spread:

The trader buys one option and sells another with the same strike price but a different time to expiration.

A trader can design calendar spreads to implement market-neutral, bullish or bearish market views.

Key Terms: CALENDAR SPREADS

Market-neutral call calendar spreads

To implement a market-neutral call calendar spread, a trader sells a near-the-money or an at-the-money call that has a short time to expiration and buys a call that has the same strike price and a longer time to expiration.

If the price of the underlying changes not at all or little during the near-expiry call’s time to expiration, then the near-expiry call will lose value more quickly than will the far-expiry call.

The spread in value between the short and long calls will increase. If the trader closes the spread when the near-expiry call expires, he or she will profit.

Bullish call calendar spreads

To implement a bullish call calendar spread, a trader sells an out-of-the-money call that has a short time to expiration and buys a call that has the same strike price and a longer time to expiration.

Because out-of-the-money options are cheaper than near-, at- or in-the-money options, it is cheaper to set up a bullish call calendar spread than it is to set up a market-neutral one.

If, during the near-expiry (short) call’s time to expiration, the price of the underlying rises at least near to but not above the short call’s strike price, then the short call will expire worthless. The long call will gain in value.

If the envisioned price rise occurs and the trader closes the spread when the near-expiry call expires, he or she will profit.

If the currency price fails to rise or rises little, then the long call as well as the short call will lose value. If that happens, the bullish call calendar spread is likely to produce a loss.

Market-neutral put calendar spreads

Market-neutral put calendar spreads are very similar to market-neutral call calendar spreads.

To implement a market-neutral put calendar spread, a trader sells a near-the-money or an at-the-money put that has a short time to expiration and buys a put that has the same strike price and a longer time to expiration.

If the price of the underlying changes not at all or little during the near-expiry (short) put’s time to expiration, then the near-expiry put will lose value more quickly than will the far-expiry put. The spread in value between the short and long puts will increase. If, when the near-expiry put expires, the trader closes the spread, he or she will profit.

Bearish put calendar spreads

To implement a bearish put calendar spread, a trader sells an out-of-the-money put that has a short time to expiration and buys a put that has the same strike price and a longer time to expiration.

If, during the near-expiry (short) put’s time to expiration, the price of the underlying falls at least near to but not below the short put’s strike price, then the short put will expire worthless. The long put will gain in value.

If the envisioned drop in price occurs and the trader closes the spread when the near-expiry put expires, he or she will profit.

If the currency price fails to fall or falls little, then the long put as well as the short put will lose value. If that happens, the bearish put calendar spread is likely to produce a loss.

Market-neutral butterfly call spread

A market-neutral butterfly call spread has its maximum profit if the market price of the underlying currency changes not at all.

To implement a market-neutral butterfly call spread, a trader buys one call that has an in-the-money strike price, buys one call that has an out-of-the-money strike price and sells two calls that have an at-the-money strike price. At implementation, the purchases and sales will produce a net debit to the trader’s account.

If, at expiration, the price of the underlying is unchanged, then the two short calls expire worthless and the trader benefits by the amount for which he or she sold them. The call the trader purchased in the money has a positive payoff. The out-of-the-money call the trader purchased expires worthless. This outcome produces the maximum possible profit from a market-neutral butterfly call spread.

If, at expiration, the price of the underlying is higher than at implementation, then the trader’s net proceeds will be less than the maximum possible because the payoffs of the two short calls will be positive.

If, at expiration, the price of the underlying is lower than at implementation, then the trader’s net proceeds will be less because the payoff of his or her long, in-the-money call will be less.

On a price rise, the strategy’s long, out-of-the-money call limits losses.

The strategy’s maximum possible loss is equal to the net debit required to establish the spread.

Market-neutral butterfly put spread

A market-neutral butterfly spread achieves its maximum profit if the market price of the underlying currency changes not at all. In the case of large, unforeseen price moves in the underlying currency, the long out-of-the-money option and the long in-the-money option limit potential losses.

Given these relationships, a trader can establish a market-neutral butterfly spread with calls or with puts.

Bullish butterfly call spread

If a trader expects the price of the underlying currency to rise and wishes to establish a butterfly spread, he or she would follow the same steps as for a market-neutral butterfly call spread but adjust the three strike prices upward by the amount that he or she expects the price of the underlying to rise over the options’ time to expiration.

Maximum profit will occur if the price of the underlying rises to but does not go above the strike prices of the short calls.

Bearish butterfly put spread

If a trader expects the price of the underlying currency to fall and wishes to establish a bearish butterfly spread, he or she would sell two puts that have a strike price equal to the lowest level to which he or she thinks the underlying currency is likely to go over the options’ time to expiration, buy one put that has a strike price higher than that of the two short puts, and buy one put that has a strike price lower than that of the two short puts.

The trader will achieve maximum profit if, at expiration, the price of the underlying has reached but not gone below the strike price of the two short puts.

Should the price of the underlying fall by more than expected, the trader’s long, lower-strike-price put limits his or her losses.

Should the price of the underlying not fall at all or even rise, the trader’s potential loss is limited to the net debit of establishing the spread.

Summary

Next: Chapter Three