The Spread Is Less Expensive Than A Straddle Option And This Is Why




Provided By optiontradingstrategies.org

Most option business is done in stocks listed on the New York Stock Exchange, some in stocks listed on the American Stock Exchange, and a small part in securities traded in the "over-the-counter" market. While options cannot always be negotiated on every stock on the exchange, the number of stocks on which options are written includes most of the leading stocks and also enough additional issues to satisfy a large demand.

Straddle Option
A Straddle is a combination of a Put and a Call option sold for a single price. The premium is paid by the buyer at the time the contract is made. The Straddle gives the holder the right, at his option, to sell the maker of the contract the stated number of shares of the specified stock at the stated price before the specified date and also the right to receive and buy from the maker the stated number of shares of the specified stock at the same price before the same date.

Example: A Put contract at 60 and a Call contract at 60. The exercise of one contract before expiration does not void the remaining option.

A "Spread" is similar to a Straddle—a combination of a Put and a Call contract—except that where a Straddle is a combination of a Put and a Call at the same price, the Spread is a Put at a price below the current stock-market price, and the Call is a price above the current stock-market price.

Example: Stock selling at 60 in the market. A Spread is a Put possibly at 58 and a Call possibly at 62. A Spread can be made at various distances from the market price, and the dollar cost price of the Spread contract varies with the Spread of the option prices.

The Spread is less expensive than a Straddle on the same stock for the same length of time by approximately half the difference of the spread between the Put and Call. For example, if a Straddle at 60 were to cost $600, a Spread of two points up and two points down would cost $400. The difference of $200 would represent half of the spread between 58 and 62.

Straddle at 60 - Cost $600
Spread 58-62 - Cost $400

Options are dealt with in units of 100 shares—never in odd lots. Nevertheless, orders for 500- or 1,000-share options are common and orders for 10,000-share options occasionally come into the market. However, to buy options on such a quantity of shares is a job which the option-dealer must handle with care. To go to a seller of options and let him know that you have an order of that size would immediately arouse his suspicions and he would be reluctant to sell any options. So, in handling such an order, the option-dealer must try to fill his order 500 or 1,000 shares at a time, without disclosing the size of the full order. The same technique would probably be used on the floor of the stock exchange by a broker who had a large quantity of a stock to buy or sell. To disclose the size of his order would enable other brokers to "take the market away from him," and he would then be able to complete his order only by bidding the stock up in the case of a "buy" order or marking it down considerably in the case of a "sell" order.

Most option business is done in stocks listed on the New York Stock Exchange, some in stocks listed on the American Stock Exchange, and a small part in securities traded in the "over-the-counter" market. While options cannot always be negotiated on every stock on the exchange, the number of stocks on which options are written includes most of the leading stocks and also enough additional issues to satisfy a large demand.

All option contracts expire at 3:15 P.M. (New York time) on the date stated in the contract, and they cannot be exercised by telephone but must be presented to the cashier of the stock-exchange firm that endorses the contract before the expiration time of 3:15 P.M. (New York time). A number of stock-exchange firms who have bought contracts for their customers, to avoid loss, insist on having instructions for the exercise of options well in advance of expiration time on the day that the option expires. In order to eliminate the chance of loss in late presentation of an option and to avoid delay when a contract is to be exercised, contracts should never be kept outside of New York City but should remain with your stockbroker or your option-dealer for safekeeping. The maker of an option contract will not accept it if it is presented after it expires. When he sells the option, he agrees to live up to the terms of the contract but not beyond them. If the maker of a contract agreed to accept one presented two minutes after it had expired, he might be asked to accept one twenty minutes or thirty minutes after it had expired, or even on the next day. He is not willing to go beyond the terms or time of his contracted agreement. Thus, holders of contracts that are to be exercised should take extra care to see that ample notice is given to exercise options before expiration time. The holder of a contract should acquaint himself with the rules of his stock-exchange house and the latest time he may give instructions to exercise an option.

To exercise an option, the stock-exchange firm that holds the contract for its customer presents the actual Put or Call contract to the stock-exchange firm that endorsed it, together with a comparison ticket. A comparison ticket is written notice to the endorsing house that "We have sold you 100 shares of X at 70 according to the Put contract presented herewith," or, in the case of a Call, "We are buying 100 shares of X at 70, according to the Call contract presented herewith." Delivery of and payment for the actual stock is usually made four days after the trade. In exercising such an option contract, the stock-exchange broker will charge the client a commission for exercising the contract just as if he had sold stock for him on the exchange, in the case of a Put, or had bought stock, in the case of a Call. If the customer supplies his own stock for the Put or retains the stock that he Called, there is no other commission. But if he buys the stock that he Put or sells the stock that he Called, he will pay regular commissions in those transactions, also. To give the uninitiated an idea of the amount of stock-exchange commissions charged by your stockbroker for buying or selling stock either in the market or through the exercise of an option, the following established rate will guide:

For buying or selling 100 shares of a stock at $50 per share, the commission is $44; for buying or selling 100 shares of a stock at $75 per share, the commission is $46.50; for buying or selling 100 shares of a stock at $100, the commission is $49.

"Federal Reserve fixes margin requirements which are changeable.

In the closing or exercising of an option contract, by buying or selling stock in the market and exercising the option on the same day, the customer will be required to deposit with his stockbroker 25 per cent margin (instead of 70° per cent) or $1,000—whichever is higher—because such a trade is a complete and virtually riskless transaction. Some individuals who are far from an office of a stock-exchange firm or who have no account with one often do business directly with an option-dealer. The option-dealer will hold options for the account of a customer and will exercise the options upon instructions from the customer.
In lieu of closing a contract for a client, the Put and Call Dealer may buy the contract from the client. The price which he will pay will be computed after the Dealer has exercised the contract for his own account and has sold the corresponding stock in the market (in the case of a Call), or has bought the stock in the market (in the case of a Put); the price will be equal to the net proceeds of the Dealer's transactions less two regular stock exchange commissions and any applicable tax. No margin has been required because the customer will have sold the contract itself to the Put and Call Dealer.

The customer who expects to buy options directly from an option-dealer should make a deposit with his option-dealer to open an account and thereby avoid any delay in the execution of orders when he desires to buy an option. Any options bought by the client will be debited against his account, and any profit arising from the sale of a contract by a client to an option-dealer will be credited to the client's account. Most dealers ask their clients to send their orders by wire, collect, because if a client gets an idea that a stock is going to move and wants to buy an option, the delay in sending an order through the mail could make him miss the move.

While option-dealers carry accounts for clients who want to purchase options, the making or selling of original Put and Call contracts must be arranged with a stock-exchange firm so that the contracts sold will carry that firm's endorsement. The option-dealer will be glad to help make such arrangements for those who do not already have an account with a stock-exchange firm but the option-dealer does not carry customers' securities and members of our association are not members of the New York Stock Exchange and cannot endorse options.

In the purchase of options, timing is most important. Many times, the customer has good information but buys 90-day options or 6-month options, only to have the stock move just after his option expires. For that reason it might be well to consider the purchase of option contracts on the stagger system so that the expiration dates occur a week or so apart. Buy some of your options this week, some next week, etc., as far as you want to go, so that if the first set of options is bought too early, it is possible that those bought subsequently can prove profitable. It is also good policy to buy an option of longer duration than you think you need. If you think that a move may take place in 60 days, it is smart to buy an option for 90 days. The cost of the longer option will ordinarily be very little more.

For many years prior to 1935, options were dealt in for periods of 2 days, 7 days, 15 days, and 30 days—rarely longer. The short-term contract is now quite obsolete-most of our current business is in contracts for 60 days, 90 days, and 6 months. The 6-month option is usually made for 6 months and 10 days to take advantage of the long-term gains provision of the tax law.

The option business is a little different from the stock-exchange business. In the latter, if you want to buy 100 shares of U.S. Steel, you place your order with a broker who, through his man on the floor of the exchange, can buy or sell the stock in a matter of minutes. A ready market will be quoted, e.g., 691/2 bid offered at 70. That means that there is a ready market where you can sell stock at 691/2 or buy stock at 70. In the over-the-counter market, if you want to buy or sell an unlisted stock such as an insurance or a bank stock, a dealer in those issues will quote you a firm market and will trade immediately. Not so in the option business—here almost all quotes are nominal and subject to being filled, and every trade must be consummated individually and by phone. It may be that when an order is placed to buy or sell an option, as many as fifty phone calls will have to be made by the option-dealer before a trade is completed. He may have to make phone calls to Detroit or Chicago or anywhere in the country. Only through an option-dealer's knowledge of the business can he quote with any accuracy the market on any issue for an option, and only through this knowledge and his contacts can he fill his orders for options with the least delay. Contracts are sometimes offered "firm" for a few minutes and, occasionally, a contract will be offered overnight. The option-dealer usually keeps a file system listing clients who have signified that they have an interest in selling options on various issues, and it is this list of possible sellers of options that the dealer contacts when he has orders to buy either Puts or Calls.

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