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Orders for Strategies That Have More Than One Option
by Andy Chambers

Options Made Easy Many strategies involve the simultaneous purchase and sale of different options to establish a position with a specific risk-reward profile.

Vertical Debit Spread

A vertical spread results when simultaneously buying and selling puts or calls of the same option class and expiration date, but with different strike prices. Because it is a debit (net cash paid out), the option purchased is more expensive than the option sold. In other words, the option purchased is closer-to-the-money than the option sold, resulting in a bull call spread or bull put spread. The maximum amount that can be earned on a Vertical Debit Spread is the difference between the strikes less the amount of the premium paid out. The maximum risk is the amount of the premium paid out.

Call Debit Spread

As an example, assume that you are bullish the S&P market and decide to establish a bull call spread in OEX options. The December 570 call is trading at 18 ½ and the December 580 call is trading at 14. You decide to enter the spread but do not want to pay more than the current price spread 4 ½ (purchase the 570 @ 18 ½, sell the 580 @ 14).

Place a limit order at 4 ½ (per spread) and each spread will be filled at a net price of 4 ½ or better (less expensive). The order will tell the broker to spread the 570/580 strikes at a net price of 4 ½, and to do it 3 times. Since the order was placed as a spread it must be filled as a spread. That means that the broker can not buy all 3 of the 570 calls and sell only 1 or 2 of the 580 calls. When closing the position, the order can go in a spread or as individual options.

Put Debit Spread

For example, assume that you now are bearish and decide to establish a bull put spread by buying the October 515 OEX puts and selling the October 500 OEX puts. The 515 puts traded last at 14; the 500 puts at 10.

By placing a market order we can not be sure that the spread will be 4, but we do know that it will be filled as soon as possible at the best possible price for the spread. And we know it will be a debit because we are buying the more expensive, closer-to-the-money option.

Vertical Credit Spread

A vertical credit spread results when simultaneously buying and selling puts or calls of the same option class and expiration date, but with different strikes. Because it is a credit (net cash received), the option sold is closer-to-the-money than the option purchased, which results in a bear call spread or a bear put spread. The maximum amount that can be made on a Vertical Credit Spread is the amount of premium received. The maximum risk is the difference between the strikes less the amount of premium received.

Let’s assume that you are bearish the S&P market and decide to establish a bear call spread in OEX options. The December 570 call is trading at 18 ½ and the December 580 call is trading at 14. You decide to enter the spread but want to receive at least the current price spread, 4 ½. (Sell the 570 @ 18 ½, buy the 580 @ 14).

Place a limit order at 4 ½ (per spread) and it will be filled at a net price of 4 ½ or better (more premium received). The order tells the broker to spread the 580/570 strikes at a net price of 4 ½, and to do it 3 times. This is the flip side of the call debit spread mentioned above.

Put Credit Spread

An example of a put credit spread, assume that you are now bullish on the S&P market and decide to establish a bear put spread by selling October 515 OEX puts and buying October 500 OEX puts. The 515 puts traded last at 14; the 500 puts at 10, but you want to get 5 for the spread.

Place a limit order at 5 (per spread), it will be filled at a net price of 5 or better (higher), or not at all. The order will tell the broker to spread the 515/500 strikes at a net price of 5 credit (premium received).

Ratio Spreads

When the number of options that you buy in a spread differs from the number of options sold, you have a ratio spread.

Call Ratio Spread

In a call ratio spread you typically buy one call at a lower strike price and sell two calls at a lower strike, which will sharply reduce the net cost of the closer-to-the-money option or may even yield a net credit. These positions have unlimited risk if the underlying market explodes through the short strike price.

For example, assume that you are establishing a call ratio spread in December 520, 550 OEX options and want to receive credit of at least 6 per spread. The 520 call traded last at 41; the 550 call at 23.

The order, entered as a spread, must be filled as a spread, and generate a minimum credit of 6 because it was entered as a limit order. The spread was trading at 5 when the order was entered which means that it may or may not get filled on all or any at 6. When liquidating the position the orders can go in as spreads or as individual options.

Put Ratio Spread

In a put ratio spread you typically buy one put at a higher strike and sell two puts at a lower strike. The premium received from the sale of the two puts will sharply reduce the net cost of the closer-to-the-money option or may even yield a net credit. These positions have unlimited risk if the underlying market drops sharply through the short strike price.

Let’s assume that you are establishing a put ratio spread in November 480, 510 OEX options and want to receive a credit of at least 12 per spread. The 480 put traded last at 20; the 510 put at 29. The spread is trading at 11 but you are willing to let the order work for several days.

The order, entered as a spread, must be filled as a spread and generate a minimum credit of 12 because is it was entered as a limit order. The spread was trading at 11 when the order was entered which means that you may get filled on only one spread, or none, at 12. When liquidating the position the orders can go in as spreads or individual options.

Back Spread

A strategy in which you buy more options than you sell, the opposite of call and put ratio spreads, is a back spread. In a call back spread you typically sell one call with a lower strike price and buy two calls with a higher strike price, and buy two puts with a lower strike price. Maximum loss occurs if the underlying is exactly at the lower strike price at option expiration. These positions have limited risk and unlimited profit potential. And, if the position is established at a net credit, you have the opportunity to profit no matter which way the underlying market moves.

As an example of a call back spread, assume that you are spreading the December 84, December 86 DJX calls and are anxious to establish the position. The 84 calls traded last at 5; the 86 calls at 4.

This order is entered as a spread and must be filled as a spread. You know that the order was filled because it went in as a Market Order. We can not be sure of the price for the spread, but it was trading at 3 debit when the order was entered (sell 1 @ 5; buy 2 @ 4 each = 8). When liquidating the position the orders can go in as spreads or as individual options.

 
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