# Part 1: How Vertical Spreads Can Affect Expensing Stock Options

Provided By Options University

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

A vertical spread for expensing stock options is constructed by the purchase of a call (or put) and the sale of a call (or put) in the same stock and in the same month. The only difference between the two expensing stock options is the strike price. For instance, a vertical spread can be constructed by purchasing the IBM June 55 call while selling the June IBM 60 call. This trade would be called the IBM June 55 - 60 call spread. Similarly, a purchase of the IBM July 45 put and sale of the IBM July 60 put would be called the IBM July 45  60 put spread.

The key to the construction of vertical spreads is that you choose the expensing stock options that are in the same stock, same month, but different strikes and in a 1 to 1 ratio. That is, you must purchase expensing stock options for every one you sell or sell one option for every one you buy.

Value and the Vertical Spread For Expensing Stock Options

A vertical spreads maximum value for expensing stock options is the difference between the two strikes. For example, the maximum value of the June 55  60 call spread is \$5.00. [60  55] = \$5.

Using the June 55  60 call spread example, we will set the date to June expiration on Friday. On that day, all the June options will expire and the expensing stock options will be worth parity, as all of the extrinsic value will have eroded away.

Where does the spread get its value? Basically, from its two components - the call (or put) you buy or the call (or put) you sell. Lets look at the spreads value with a couple of different closing expensing stock options prices. If the expensing stock options close at \$55, then both the 55 strike and the 60 strike will be out of the money and thus worthless. The value of the spread will be zero as both expensing stock options are worth \$0. If the expensing stock options close at \$57.50, the June 55 calls will be worth \$2.50. The June 60 calls will be out of the money and thus worthless, therefore the spread will be worth \$2.50 (June 55 call \$ 2.50  June 60 call \$0).

 Spread Difference between strikes Spreads maximum value August 35-40 call 5 \$5.00 April 70-85 put 15 \$15.00 Nov. 20-22.5 call 2.5 \$2.50 Dec. 40-50 put 10 \$10.00 Jan 60-80 call 20 \$20.00

If the expensing stock options close at \$60.00, then the June 55 calls will be worth \$5.00. Meanwhile, the June 60 calls will be worth \$0. This means that the spread will be worth \$5.00 (June 55 call \$ 5.00 - June 60 call \$0). This is the maximum value of the spread. Note that the maximum value is identical to the difference between the strikes.

As the expensing stock options go higher, the June 60 call becomes in-the-money and gains intrinsic value. Now, for every penny that the expensing stock options increases in value, the June 55 calls and June 60 calls gain value equally, keeping the \$5.00 spread between the two strikes constant. To see this, refer to the Table below.

 Stock Price June 55 call Value June 60 call value Spread 55 0 0 0 56 1 0 1 57 2 0 2 58 3 0 3 59 4 0 4 60 5 0 5 61 6 1 5 62 7 2 5 65 10 5 5 70 15 10 5 100 45 40 5

The difference between the strikes is the maximum value of all vertical spreads regardless of the distance between the two strikes. It does not matter whether the spread is \$5.00 wide, \$10.00 wide, \$20.00 wide, or even \$50.00 wide; its maximum value is the difference between the two strikes. Further, the vertical spreads maximum value (the difference between the two strikes) holds true for vertical put spreads as well as vertical call spreads. Look at our other example, the July 45  60 put spread.

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