Investments, tenth edition

Example 20.4 

Covered Call

eXcel APPLICATIONS: Spreads and Straddles

U

sing spreadsheets to analyze combinations of options is 

very helpful. Once the basic models are built, it is easy 

to extend the analysis to different bundles of options. The 

Excel model “Spreads and Straddles” shown below can be 

used to evaluate the profitability of different strategies. You 

can find a link to this spreadsheet at www.mhhe.com/bkm.

Excel Question

 1.  Use the data in this spreadsheet to plot the profit on 

a  bullish spread (see Figure 20.10) with X

1

 5 120 

and X

2

 5 130.

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

Stock Prices

Buying Options:

Call Options Strike

Put Options Strike

Straddle

 Spreads and Straddles

Payoff

Payoff

Payoff

Profit

Profit

Profit

Return %

Return %

Return %

Ending

Ending

X 120  Straddle

X 110  Straddle

A

B

C

D

E

F

G

H

I

J

K

L

Beginning Market Price

Ending Market Price

116.5

130

120

110

130

120

110

140

170

160

150

180

210

200

190

100

90

80

70

60

50

130

120

110

140

170

160

150

180

210

200

190

100

90

80

70

60

50

130

120

110

140

130

140

130

120

110

140

22.80

0.00

0.00

0.00

10.00

20.00

10.00

0.00

10.00

16.80

13.60

10.30

12.60

17.20

23.60

30.50

35.40

34.00

37.20

40.80

−12.60

−17.20

−23.60

−20.50

−15.40

−24.00

−15.40

24.60

24.60

34.60

44.60

54.60

64.60

14.60

14.60

4.60

4.60

−5.40

−15.40

−25.40

−35.40

−25.40

−15.40

−5.40

−24.00

36.00

16.00

26.00

36.00

46.00

56.00

26.00

6.00

16.00

−4.00

6.00

−4.00

−14.00

−24.00

−34.00

−24.00

−14.00

−37.20

−30.80

−100.00%

−100.00%

−100.00%

−67.21%

−43.50%

−70.59%

−100.00%

−75.49%

Price

Price

Price

Stock Price

Profit

Stock Price

Profit

20.00

10.00

0.00

0.00

−2.80

−6.80

−13.60

−10.30

−12.28%

−40.48%

−100.00%

−100.00%

bod61671_ch20_678-721.indd   694

bod61671_ch20_678-721.indd   694

7/25/13   2:50 AM

7/25/13   2:50 AM

Final PDF to printer

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  C H A P T E R  

2 0

  Options Markets: Introduction 

695

establishes a straddle must view the stock as more volatile than the market does. Con-

versely, investors who  write  straddles—selling both a call and a put—must believe the 

stock is less volatile. They accept the option premiums now, hoping the stock price will not 

change much before option expiration. 

 The payoff to a straddle is presented in  Table  20.3 . The solid line of  Figure  20.9, 

panel C  illustrates this payoff. Notice the portfolio payoff is always positive, except 

at the one point where the portfolio has zero value,  S  

 T 

      5     X.  You might wonder why 

all investors don’t pursue such a seemingly “no-lose” strategy. The reason is that the 

straddle requires that both the put and call be purchased. The value of the portfolio at 

expiration, while never negative, still must exceed the initial cash outlay for a straddle 

investor to clear a profit.   

 The dashed line of  Figure 20.9, panel C  is the profit diagram. The profit line lies below 

the payoff line by the cost of purchasing the straddle,  P     1     C.  It is clear from the dia-

gram that the straddle generates a loss unless the stock price deviates substantially from  X.  

The stock price must depart from  X  by the total amount 

expended to purchase the call and the put for the straddle 

to clear a profit.  

  Strips  and  straps  are variations of straddles. A strip is 

two puts and one call on a security with the same exercise 

price and expiration date. A strap is two calls and one put.  

  Spreads 

 A     spread    is a combination of two or more call options (or two or more puts) on the same 

stock with differing exercise prices or times to maturity. Some options are bought, whereas 

others are sold, or written. A  money spread  involves the purchase of one option and the 

simultaneous sale of another with a different exercise price. A  time spread  refers to the sale 

and purchase of options with differing expiration dates. 

 Consider a money spread in which one call option is bought at an exercise price  X  

1

 , 

whereas another call with identical expiration date, but higher exercise price,  X  

2

 ,  is  writ-

ten. The payoff will be the difference in the value of the call held and the value of the call 

written,  as  in   Table 20.4 .  

 There are now three instead of two outcomes to distinguish: the lowest-price region 

where  S  

 T 

  is below both exercise prices, a middle region where  S  

 T 

  is between the two exer-

cise prices, and a high-price region where  S  

 T 

  exceeds both exercise prices.  Figure 20.10  

illustrates the payoff and profit to this strategy, which is called a  bullish spread  because the 

payoff either increases or is unaffected by stock price increases. Holders of bullish spreads 

benefit from stock price increases.  

 One motivation for a bullish spread might be that the investor thinks one option is over-

priced relative to another. For example, an investor who believes an  X   5  $100 call is cheap 

compared to an  X   5  $110 call might establish the spread, even without a strong desire to 

take a bullish position in the stock.