What Are Ladder Options

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Ladder Option

What Is a Ladder Option?

A ladder option is an exotic option that locks in partial profits once the underlying asset reaches predetermined price levels or “rungs.” This guarantees at least some profit, even if the underlying asset retraces beyond these levels before the option expires. Ladder options come in put and call varieties.

Do not confuse ladder options, which are specific types of options contracts, with long call ladders, long put ladders, and their short counterparts, which are options strategies that involve buying and selling multiple options contracts simultaneously.

How a Ladder Option Works

Ladder options are similar to traditional option contracts that give the holder the right, but not the obligation to buy or sell the underlying asset at a predetermined price at or by a predetermined date. However, a ladder option adds a feature that allows the holder to lock in partial profits at predetermined intervals.

These intervals are fittingly called “rungs” and the more rungs the price of the underlying asset crosses, the more profit locks in. The holder keeps profits based on the highest rung achieved (for calls) or the lowest rung achieved (for puts) regardless if the price of the underlying crosses back below (for calls) or above (for puts) those rungs before expiration.

Because the holder earns non-returnable partial profits as the trade develops, total risk is much lower than for traditional vanilla options. The trade-off, of course, is that ladder options are more expensive than similar vanilla options.

Example of a Ladder Option

Consider a ladder call option where the underlying asset price is 50 and the strike price is 55. Rungs are set at 60, 65, and 70. If the underlying price reaches 62, the profit locks in at 5 (rung minus strike or 60 – 55). If the underlying reaches 71, then the locked in profit increases to 15 (new rung minus strike or 70 – 55), even if the underlying falls below these levels before the expiration date.

As with vanilla options, there is time value associated with ladder options. Therefore, the traded price for call options is usually above the locked in profit amount, and declining as the expiration date approaches.

If the price of the underlying falls below any of the triggered rungs, again for calls, it almost does not matter to the price of the option because the partial profit is guaranteed. Although, this is an oversimplification because the lower the underlying moves below the highest triggered rung, the less likely it will be to rally back to exceed that rung and reach the next rung.

Long Call Ladder

The long call ladder, or bull call ladder, is a limited profit, unlimited risk strategy in options trading that is employed when the options trader thinks that the underlying security will experience little volatility in the near term. To setup the long call ladder, the options trader purchases an in-the-money call, sells an at-the-money call and sells another higher strike out-of-the-money call of the same underlying security and expiration date.

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Long Call Ladder Construction
Buy 1 ITM Call
Sell 1 ATM Call
Sell 1 OTM Call

The long call ladder can also be thought of an extension to the bull call spread by selling another higher striking call. The purpose of shorting another call is to further finance the cost of establishing the spread position at the expense of being exposed to unlimited risk in the event that the underlying stock price rally explosively.

Limited Profit Potential

Maximum gain for the long call ladder strategy is limited and occurs when the underlying stock price on expiration date is trading between the strike prices of the call options sold. At this price, while both the long call and the lower strike short call expire in the money, the long call is worth more than the short call.

The formula for calculating maximum profit is given below:

  • Max Profit = Strike Price of Lower Strike Short Call – Strike Price of Long Call – Net Premium Paid – Commissions Paid
  • Max Profit Achieved When Price of Underlying is in between the Strike Prices of the 2 Short Calls

Limited Downside Risk, Unlimited Risk to the Upside

Losses is limited to the initial debit taken if the stock price drops below the lower breakeven point but large unlimited losses can be suffered should the stock price makes a dramatic move to the upside beyond the upper breakeven point.

The formula for calculating loss is given below:

  • Maximum Loss = Unlimited
  • Loss Occurs When Price of Underlying > Total Strike Prices of Short Calls – Strike Price of Long Call – Net Premium Paid
  • Loss = Price of Underlying – Upper Breakeven Price + Commissions Paid

Breakeven Point(s)

There are 2 break-even points for the long call ladder position. The breakeven points can be calculated using the following formulae.

  • Upper Breakeven Point = Total Strike Prices of Short Calls – Strike Price of Long Call – Net Premium Paid
  • Lower Breakeven Point = Strike Price of Long Call + Net Premium Paid

Example

Suppose XYZ stock is trading at $35 in June. An options trader executes a long call ladder strategy by buying a JUL 30 call for $600, selling a JUL 35 call for $200 and a JUL 40 call for $100. The net debit required for entering this trade is $300.

Let’s say XYZ stock remains at $35 on expiration date. At this price, only the long JUL 30 call will expire in the money with an intrinsic value of $500. Taking into account the initial debit of $300, selling this call to close the position will give the trader a $200 profit – which is also his maximum possible profit.

In the event that XYZ stock rallies and is trading at $50 on expiration in July, all the call options will expire in the money. The short JUL 35 call will expire with $1500 in intrinsic value while the short JUL 40 call will expire with $1000 in intrinsic value. Selling the long JUL 30 call will only give the options trader $2000 so he still have to top up another $500 to close the position. Together with the initial debit of $300, his total loss comes to $800. The loss could have been worse if the stock had rallied beyond $50.

However, if the stock price had dropped to $30 instead, all the calls will expire worthless and his loss will be the initial $300 debit taken to enter the trade.

Note: While we have covered the use of this strategy with reference to stock options, the long call ladder is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the long call ladder in that they are also low volatility strategies that have limited profit potential and unlimited risk.

Ladder Options

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Interested in learning more about each of our ladder safety attachments? O’Keefe’s has you covered. Knowledge is power, but knowledge also keeps you safe. That’s why we make sure you’re completely informed with in-depth product descriptions. For even more information or to request a free quote on our aluminum extension ladder parts accessory, contact us at 888-653-333 today.

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