Financial Markets Book Financial Markets For The Rest Of Us
An Easy Guide To Money, Bonds, Futures, Stocks, Options, And Mutual Funds
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by Robert Hashemian

Page 317

Another type of combination is a spread. A spread involves the buying of one option and selling (writing) another same-style (call or put) option with the same underlying stock with the options having different expiration dates or different strike prices. If the options are call options, the spread is referred to as a call spread, otherwise it would be a put spread. Suppose Ford is trading at $50 and yes, it is early January again. You buy 1 FAJ contract (January 50 call) and write 1 FAK contract (January 55 call). You do that because you expect that Ford will be somewhere at or below $55 come expiration date but not below $50. Suppose that Ford is indeed at $55 at expiration. In that case you could sell FAJ at $5 ($3 above the $2 you paid for it) and the FAK options which you sold would expire worthless. With Ford at $55 you would make the maximum profit possible from your call spread position which would be:

$5 (sell FAJ)-$2 (paid for FAJ) + $1/2 (received for FAK) = $3 1/2 x 100 (shares per contract) = $350.

If Ford does however move beyond $55, you would still make a profit from the FAJ contract but you would be looking at a loss on the FAK contract. For example, with Ford at $60 your FAJ call option can be sold back at $10 while you would lose $5 on the FAK but you still would have a net profit. The point is that FAJ acts as insurance against FAK if Ford's stock continues to climb, while FAK acts as limited insurance against FAJ if Ford's stock does not rise or even falls. Suppose Ford does fall to $45. The FAK contract would expire worthless, which means you can keep the money you received, but the FAJ contract you had bought also expires worthless meaning that you would lose the amount invested in them. You would have a net loss in this case, but at least the sale of the FAK contract lessens the amount of loss.

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Table of Contents Copyright and Disclaimer Foreword Money
Bonds Futures Stocks Options
Mutual Funds Retirement Final Words Appendix A

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