- CFA Exams
- June 2019 Level II > Study Session 14. Derivatives > Reading 41. Derivatives Strategies
- 5. Collars, Spreads and Combinations

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**Subject 5. Collars, Spreads and Combinations**

**Collar**

A

**collar**is an option trading strategy that works by holding shares of the underlying stock while simultaneously buying

*out-of-the-money*protective puts and selling call options against that holding.

It is a good strategy for investors who want to protect themselves from an unexpected sharp drop in the underlying without the significant initial outlay of writing a covered call.

- Limited profit potential. The maximum profit is achieved when the price of the underlying >= strike price of short call: max profit = strike price of short call - purchase price of underlying + net premium received
- Limited risk. The max loss occurs when the price of the underlying <= strike price of long put: max loss = purchase price of underlying - strike price of long put - net premium received

The collar dramatically narrows the distribution of possible investment outcomes. It reduces both risk and return potentials.

*Example*

You plan to purchase 100 shares of stock ABC, which is trading at $48 in June. You can establish a collar by writing a JUL 50 covered call for $2 per share while simultaneously purchasing a JUL 45 put for $1 per share. Your initial investment is -$4,800 + $200 - $100 = -$4,700.

Here is the profit and loss worksheet at expiration:

A collar is essentially holding an out-of-money covered call and protective put simultaneously. It is a "maintenance" or neutral strategy.

**Costless collars**can be established to fully protect existing long stock positions with little or no cost since the premium paid for the protective puts is offset by the premiums received for writing the covered calls.

What about a same-strike collar? The position will be worth the strike price at expiration, no matter what the stock price is at the time. It is essentially a risk-free investment.

**Bull Spread**

If you buy one call and write another call, or buy one put and write another put, you then create an

**option spread**. Spread is used to bet on direction; in the meantime, it gives up part of the profit potential in exchange for the lower cost of the position.

A spread can be a

**bull spread**, if it becomes more valuable when the underlying price rises, or a

**bear spread**, if it becomes more valuable when the underlying price declines. Spreads can be classified by the direction of the initial cash flows. A debit spread requires a cash payment and a credit spread results a cash inflow.

If a moderate rise in the price of the underlying is expected, a bull spread can be created: purchase call options at a specific strike price and sell the same number of calls of the same asset and expiration date but at a higher strike price.

- It is a debit spread.
- Limited upside profit. Maximum gain is reached when the underlying price moves above the higher strike price of the two calls.
- Limited downside risk. If the underlying price declines at expiration the strategy will result in a loss. Maximum loss cannot be more than the initial cost of the position.
- Breakeven Point = Strike Price of Long Call + Net Premium Paid

*Example*

Stock A is trading at $42. You enter a bull call spread by buying a JUL 40 call for $300 and writing a JUL 45 call for $100. The net cash outflow required is a debit of $200.

Here is the payoff diagram.

Note that the profit and loss diagram for a bull spread is similar to that for a collar.

**Bear Spread**

If the price of the underlying is expected to go down moderately, a bear spread can be created. For example, a bear put spread is buying a higher strike price put option and selling a lower strike price put option of the same underlying with the same expiration date.

- It is a debit spread.
- Limited downside profit. Maximum gain is reached when the underlying price moves below the lower strike price of the two calls. It is equal to the difference between the two strike prices minus the net cost of the options.
- Limited upside risk. If the underlying price rises above the higher strike price at expiration the strategy will suffer a maximum loss, which is equal to the net premium paid.
- Breakeven Point = Strike Price of Long Put - Net Premium Paid

*Example*

Stock A is trading at $38 in June. You enter a bear put spread by buying a JUL 40 put for $300 and writing a JUL 35 put for $100. The net cash outflow required is a debit of $200.

Here is the payoff diagram.

**Calendar Spread**

Investors can long or short a

**calendar spread**, which involves buying one option and selling another option of the same type and strike but with a different expiration. A long calendar spread would entail buying a long-dated option and selling a short-dated option of the same strike and type. In fact, the sale of the short-dated option reduces the price of the long-dated option, making the trade less expensive than buying the long-dated option outright.

This strategy is ideal for a trader whose short-term sentiment is neutral. The motivation is to take advantage of the option time decay and reduce the cost of purchasing a longer-term option (for a long position). Calendar spreads also profit from a rise in implied volatility, since the long option has a higher vega than the short option.

*Example*

With the stock trading at $135.13, the July 135 call is sold for $10.45 and the September 135 call is purchased for $15.45, for a net cost of $5, which is the maximum risk of this strategy.

**Straddle**

In an

**option combination**, both puts and calls are used. The most important option combination is the

**straddle**, which involves the simultaneous buying of a put and a call of the same underlying stock, striking price, and expiration date. It is used when the underlying is expected to experience significant volatility in the near term.

If someone writes both options, it is a short straddle. We discuss long straddle below.

- Unlimited profit potential. Large profits can be achieved no matter which way the underlying price heads, provided the move is strong enough. Profit = price of underlying - strike price of call - net premium paid, or strike price of put - price of underlying - net premium paid
- Limited risk. Maximum risk occurs when the underlying price on expiration date is trading at the strike price. Both options expire worthless at this price, and the entire premium is lost.
- There are 2 breakeven points: strike price + net premium paid and strike price - net premium paid.

*Example*

Suppose XYZ stock is trading at $40 in June. An options trader enters a long straddle by buying a JUL 40 put for $200 and a JUL 40 call for $200.

- If XYZ stock is trading at $50 on expiration in July, the JUL 40 put will expire worthless but the JUL 40 call expires in the money and has an intrinsic value of $1000. His profit will be $600.
- If XYZ stock is trading at $35 on expiration in July, the JUL 40 call will expire worthless but the JUL 40 put expires in the money and has an intrinsic value of $500. His profit will be $100.
- His maximum loss is therefore $400. This happens if, in July, the stock is still trading at $40.

#### Practice Question 1

What of the following is a collar position? An investor is long shares of stock, which are worth $16 right now, and buys an ______A. Oct 15 call and sells an Oct 17 put.

B. Oct 17 put and sells an Oct 15 call.

C. Oct 15 put and sells an Oct 17 call.Correct Answer: C

The current stock price should be higher than the exercise price of the put and lower than the exercise price of the call.

#### Practice Question 2

Debit spreads are effectively ______.A. long

B. shortCorrect Answer: A

A debit spread requires a net cash payment. The long option value exceeds the short option value.

#### Practice Question 3

In June a trader is expecting a decline in the price of the underlying stock in one month. It is currently trading at $15. She can buy a ______A. JUL 16 put and sell a JUL 14 put.

B. JUL 14 put and sell a JUL 16 put.

C. JUL 14 call and sell a JUL 16 call.Correct Answer: A

A is a bear put spread.

#### Practice Question 4

Which statement about calendar spread is false?A. In the early stages of a calendar spread, it is a neutral trading strategy.

B. If the stock price moves dramatically, the risk of a long calendar spread increases.

C. It generates profit as time decays.Correct Answer: B

Risk is limited to the net option premium.

#### Practice Question 5

Suppose XYZ stock is trading at $40 in June. An options trader enters a long straddle by buying a JUL 40 put for $200 and a JUL 40 call for $200. He will suffer a loss if the stock price is between ______ and ______ at expiration.Correct Answer: $36; $44#### Practice Question 6

A stock is priced at $80 per share. A call option with a strike price of $80 is priced at $5 and a put option with the same strike price is priced at $5. An investor enters into a straddle by purchasing one of each option. The maximum loss occurs if the stock price is ______ at expiration.
A. $77

B. $80

C. $85

Both options will be worthless at this price.

#### Practice Question 7

If an investor owns a stock and wants to lock in the profit but does not want to sell the stock yet, he should establish a ______ position.
A. collar

B. bull spread

C. straddle

#### Practice Question 8

A bull spread is created by buying a Sept 15 call, which costs $1.64, and selling a Sept 17 call, which costs $0.58. The breakeven price at expiration will be ______.
A. $15.58

B. $16.06

C. $16.64

X

_{L}+ (c

_{L}- c

_{H}) = 15 + (1.64 - 0.58) = 16.06

#### Practice Question 9

The maximum profit to be gained using a bear put spread is ______.A. the net option premium

B. X

_{H}- X

_{L}- net option premium

C. the spot stock price at expiration - net option premiumCorrect Answer: B

Max Profit = Strike Price of Long Put - Strike Price of Short Put - Net Premium Paid

#### Practice Question 10

A long straddle is a ______ strategy.A. bullish

B. bearish

C. neutralCorrect Answer: C

An options trader is indifferent to whether the underlying goes up or down; he expects it to move sharply either way.

#### Practice Question 11

If a trader believes the price of a stock will rise but that the price movement is not imminent, he may consider a ______ option strategy.A. collar

B. bull spread

C. calendar spreadCorrect Answer: C

In the early stages of a calendar spread, it is essentially a neutral trading strategy.

#### Practice Question 12

Suppose stock XYZ is trading at $50 in June 2016. An options trader holding on to 100 shares of XYZ wishes to protect his shares should the stock price take a dive. At the same time, he wants to hang on to the shares, as he feels that they will appreciate in the next 6 to 12 months. He sets up a costless collar by writing a one-year JUL '17 60 call for $5 while simultaneously using the proceeds from the call sale to buy a one-year JUL '17 50 put for $5. The maximum profit at expiration is ______.Correct Answer: $1,000If the stock price rallies to above $60 at the expiration date, his maximum profit is capped, as he is obliged to sell his shares at the strike price of $60. At 100 shares, his profit is $1000.

#### Practice Question 13

A bull spread is created with a Sept 15 call, which costs $1.64, and a Sept 17 call, which costs $0.58. The current underlying price is $15. The maximum profit for the position is ______.A. $0.94

B. $1.06

C. $1.42Correct Answer: A

(17 - 15) - (1.64 - 0.58) = 0.94

#### Practice Question 14

If a trader expects a substantial movement in the underlying asset, he should establish a ______ position.A. collar

B. bull spread

C. straddleCorrect Answer: C

#### Practice Question 15

Which statement about calendar spread is false?A. If you want to use calendar spread for a bearish strategy, you have to use put options instead of call options.

B. It has limited upside potential when both legs are in play.

C. It can be traded as either a bullish or bearish strategy.Correct Answer: A

Both types of options can be used to construct bullish or bearish strategies.

#### Practice Question 16

Suppose XYZ stock is trading at $40 in June. An options trader wants to enter a straddle position. Which combination should he choose, in general?A. JUL 40 call and JUL 40 put

B. JUL 42 call and JUL 42 put

C. JUL 38 call and JUL 38 putCorrect Answer: A

In general, the strike price that is close to the current underlying price is chosen, otherwise there will be a directional bias.

#### Practice Question 17

Consider three bull spread positions: Sept 14/17, Sept 15/17, and Sept 16/17. The underlying stock is currently trading at $14. Which position will be the first to become profitable with a small price rise in the underlying stock?A. Sept 14/17

B. Sept 15/17

C. Sept 16/17Correct Answer: A

For example, if the stock price rises to $14.5, the Sept 14 call will be exercised, resulting in a $0.50 gain.

#### Practice Question 18

A stock is trading at $30. An options trader can use a bear put spread by purchasing one put option contract with a strike price of $35 for a cost of $475 ($4.75 * 100 shares/contract) and selling one put option contract with a strike price of $30 for $175 ($1.75 * 100 shares/contract). In this case, the investor will need to pay a total of $300 to set up this strategy ($475 - $175). What is the breakeven price of the position?A. $31.75

B. $32

C. $33.35Correct Answer: B

Breakeven Point = Strike Price of Long Put - Net Premium Paid

#### Practice Question 19

When the near-term option expires, the maximum gain for a long calendar spread position would occur if the underlying stock price is ______ the strike price of the expiring option.A. lower than

B. equal to

C. higher thanCorrect Answer: B

If the stock price was any higher, the expiring option would have intrinsic value, and if the stock price was any lower, the longer-term option would have less value. Once the near-term option has expired worthless, the investor is left with simply a long call position, which has no upper limit on its potential profit.

#### Practice Question 20

Suppose XYZ stock is trading at $40 in June. If you expect that the XYZ stock price will remain at $40 in July, you can ______ based on your expectations.A. sell a collar

B. sell a straddle

C. buy a calendar spreadCorrect Answer: B

A straddle is a bet on underlying volatility. If you believe there is no underlying volatility, you may sell a straddle to try to make a profit.

#### Practice Question 21

Suppose stock XYZ is trading at $50 in June '16. An options trader holding on to 100 shares of XYZ wishes to protect his shares should the stock price take a dive. At the same time, he wants to hang on to the shares as he feels that they will appreciate in the next 6 to 12 months. He sets up a costless collar by writing a one-year JUL '17 60 call for $5 while simultaneously using the proceeds from the call sale to buy a one-year JUL '17 48 put for $5. The maximum loss he can possibly suffer at expiration is ______.A. $0

B. $200

C. $500Correct Answer: B

Should the stock price plunge to $48 or lower, his loss is $200, since the protective put allows him to still sell his shares at $48.

#### Practice Question 22

Assume an investor is long 1,000 shares of stock ABC, which is currently trading at $50 per share. The investor wants to temporarily hedge the position due to the increase in the overall market's volatility. Therefore, the investor purchases 10 put options with a strike price of $50 and writes 10 call options with a strike price of $50. The option premiums cancel each other out. The maximum profit of this position is ______.A. $0

B. $1,000

C. $50,000Correct Answer: A

This is a same-strike collar, and the risk is completely neutralized.

#### Practice Question 23

A bull spread is created with a Sept 15 call which costs $1.64, and a Sept 17 call, which costs $0.58. The current underlying price is $15. The maximum loss for the position is ______.A. $0.94

B. $1.06

C. $1.64Correct Answer: B

It is the net premium paid, if the underlying price drops below $15.

#### Practice Question 24

A stock is trading at $30. An options trader can use a bear put spread by purchasing one put option contract with a strike price of $35 for a cost of $475 ($4.75 * 100 shares/contract) and selling one put option contract with a strike price of $30 for $175 ($1.75 * 100 shares/contract). In this case, the investor will need to pay a total of $300 to set up this strategy ($475 - $175). If the price of the underlying asset closes at $29 upon expiration, how much profit can the investor realize?A. $0

B. $100

C. $200Correct Answer: C

(($35 - $30 )* 100 shares/contract) - ($475 - $175) = $200

#### Practice Question 25

The maximum loss of a long calendar spread position is ______.A. stock price at expiration - strike price + net option premium paid

B. strike price - stock price at expiration + net option premium paid

C. net option premium paidCorrect Answer: C

The maximum loss would occur should the two options reach parity. This could happen if the underlying stock declined enough that both options became worthless or if the stock rose enough that both options went deep-in-the-money and traded at their intrinsic value. In either case, the loss would be the premium paid to put on the position.

#### Practice Question 26

Which factor has a positive impact on a long calendar spread position in the beginning?
I. Volatility

II. Time decay

A. I only

B. II only

C. I and IICorrect Answer: C

An increase in implied volatility, all other things remaining equal, would have an extremely positive impact on this strategy. In general, longer-term options have a greater sensitivity to changes in market volatility (i.e., a higher vega). Be aware that the near-term and far-term options could and probably will trade at different implied volatilities.

The passage of time, all other things remaining equal, would have a positive impact on this strategy in the beginning. That changes, however, once the near-term option has expired and the strategy becomes simply a long call whose value will be eroded by the passage of time. In general, an option's rate of time decay increases as its expiration draws nearer.

#### Practice Question 27

Suppose XYZ stock is trading at $40 in June. An options trader enters a long straddle by buying a JUL 40 put for $2 and a JUL 40 call for $2. Which stock price is his breakeven point?A. $40

B. $42

C. $44Correct Answer: C

Note that there are 2 breakeven points in a straddle. The other one is $36.

#### Practice Question 28

Suppose XYZ stock is trading at $40 in June. An options trader enters a long straddle by buying a JUL 40 put for $2 and a JUL 40 call for $2. The maximum loss would occur if the stock price is ______ at expiration.A. $36

B. $40

C. $44Correct Answer: B

The maximum loss occurs when the price of the underlying asset equals the strike price of the options at expiration.

#### Practice Question 29

Which statement about calendar spread is false?A. The idea behind the calendar spread is to sell time.

B. Losses can be dramatic if the stock price moves dramatically.

C. A long calendar spread is a long volatility position.Correct Answer: B

Risk is limited to the net option premium.

A: This is why calendar spreads are also known as time spreads. The options trader hopes that the price of the underlying remains unchanged at the expiration of the near-month options so that they expire worthless. As the time decay of near-month options is at a faster rate than longer-term options, his long-term options still retain much of their value. The options trader can then either own the longer-term calls for less or write more calls and repeat the process.

C: This means it benefits from an increase in implied volatility.

### Study notes from a previous year's CFA exam:

g. describe the investment objective(s), structure, payoffs, and risks of the follow- ing option strategies: bull spread, bear spread, collar, and straddle;

h. calculate and interpret the value at expiration, profit, maximum profit, maximum loss, and breakeven underlying price at expiration of the following option strategies: bull spread, bear spread, collar, and straddle;

i. describe uses of calendar spreads;