# Part 2: How Vertical Spreads Can Affect Expensing Stock Options

Provided By Options University

#### Construction of a Vertical Spread For Expensing Stock Options

Again we set time forward to Friday, July expiration. We set the expensing stock options closing price at \$60.00. At \$60.00, both the July 45 puts and the July 60 puts will be out of the money and thus worthless. With both the July 45 puts and July 60 puts worthless, the spread is also worthless (July 60 put \$0  July 45 put \$0). If the expensing stock options finish at \$52.50, then the July 60 puts will be worth \$7.50 while the July 45 puts will still be worthless. In this scenario the July 45  60 put spread will be worth \$7.50 (July 60 puts \$7.50  July 45 puts \$0). If the expensing stock options finish at \$45.00, then the July 60 puts will be worth \$15.00 while the July 45 puts will be worth \$0.

At this level, the spread will be worth \$15.00 (July 60 puts \$15.00  July 45 puts \$0). This is the maximum value of the spread. As you can see it is identical to the \$15.00 difference between the strikes. As the expensing stock options go lower, the July 45 puts become in-the-money and gain intrinsic value. Now, for every penny that the expensing stock options decrease in value, the July 60 puts and the July 45 puts will gain value equally, keeping the \$15.00 spread between the two strikes constant. To see this, refer to the table below.

As stated, the maximum value of a vertical spread is the difference between the two strikes while the minimum value of the spread is, of course, \$0. This means that in this expensing stock options strategy, both the buyer and the seller have a limited, fixed maximum loss. The buyer can only lose what he spent. So, if the buyer spent \$2.20 to purchase the August 35  40 call spread, the most he can lose is the \$2.20 he spent.

For the seller, the maximum loss is the difference between the maximum value of the expensing stock options spread (difference between the strikes) and the amount of money received for the sale of the spread. For example, if you were to sell the August 35  40 call spread for \$2.20 then your maximum loss will be \$2.80. Remember, the maximum value of the spread is the difference between the two strikes or \$5.00 (40  35).

 Stock Price June 60 put value July 45 put value Spread 65 0 0 0 62 0 0 0 60 0 0 0 57 3 0 3 55 5 0 5 50 10 0 10 47 13 0 13 45 15 0 15 42 17 2 15 40 20 5 15

The difference between the maximum value of the expensing stock options spread (\$5.00) and the amount the seller received for the sale (\$2.20) leaves a \$2.80 maximum loss. Below, the chart shows the potential amount of money, both profit and loss, that can be made or lost by both the buyer and the seller.

 Closing Stock Price August 35-40 Call Spread Price August 35-40 Call Closing Price Buyer P&L Seller P&L 30 2.20 0 -2.20 +2.20 32 2.20 0 -2.20 +2.20 34 2.20 0 -2.20 +2.20 35 2.20 0 -1.20 +2.20 36 2.20 \$1.00 - .20 +1.20 37 2.20 \$3.00 + .80 + .20 38 2.20 \$4.00 +1.80 - .80 39 2.20 \$5.00 +2.80 -1.80 40 2.20 \$5.00 +2.80 -2.80 42 2.20 \$5.00 +2.80 -2.80 44 2.20 \$5.00 +2.80 -2.80 46 2.20 \$5.00 +2.80 -2.80 48 2.20 \$5.00 +2.80 -2.80 50 2.20 \$5.00 +2.80 -2.80

In conclusion, it is important to understand and remember that vertical expensing stock options spreads have both a limited profit and a limited loss scenario for both the buyer and the seller.

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