10-Trading Strategies Involving Options

8/13/2019 10-Trading Strategies Involving Options

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Trading Strategies I nvolving Options


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Strategies involving a single option and a stock

Spread Strategies This involves taking position in two or more calls OR puts

[Except for Box Spread Strategy]

Combination Strategies This involves taking position in both calls and puts

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Trading Strategies I nvolving Options


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Strategies involving a single option and a stock(F igure 10.1, page 240)

Profit

STK

Profit

ST

K

Profit

ST

K

Profit

ST

K

Synthetic Short Put Synthetic Long Put

Synthetic Long Call Synthetic

Short Call

(a) (b)

(c) (d)

Whilesom

erationalecanbeassigned

toeachstrategy,theycan

bebetter

viewedas

pricingpropositionsunder

Put-CallParityTheory.


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Profit

STK

So this strategy is named as Writing a Covered Call.

LongStock

Short

Call

1. You are shorting a call in the expectation that the market price of the underlying

(price) will fall, and the call will be out of money.

2. To cover the down side generating due to short call, you may simultaneouslygo long on stock.

Though this does not eliminate loss in case of fall in price, loss is reduced by the

premium earned. It results into the pay offs pattern of short put, where the

potential loss due to increase in stock price gets covered.

(a) Synthetic Short Put Risk: Price may increase.


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Profit

ST

K

ShortStock

Short

Put

Thus, this strategy aims at covering short put.

1. You are shorting a put in the expectation that the price will increase, and the

put will be out of money.

2. To cover the down side generating due to short put, you may simultaneouslyshort on stock.

This results into the pay offs pattern of short call, where the potential loss due to

decrease in stock price gets covered.

(d) Synthetic Short Call Risk: Price may decrease.


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Profit

ST

K

Long

Call

Short

Stock

Thus, this strategy aims at covering short position in stock.

1. You are shorting a stock in the expectation that the price will fall.

2. To cover the down side generating due to short stock, you may go long on call.This results into the pay offs pattern of long put, where the potential loss due to

increase in stock price gets covered.

(b) Synthetic Long Put Risk: Price may increase.


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Profit

ST

K

Long

StockLongPut

So this strategy is named as Protective put that covers downside of stock.

1. You are going long on stock in the expectation that the price will increase.

2. To cover the down side generating due to long stock, you may go long on put.This results into the pay offs pattern of long call, where the potential loss due to

decrease in stock price gets covered.

(c) Synthetic Long Call Risk: Price may decrease.


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Spread Strategies

A Spread Trading Strategy involves taking

positions in either two ormore call options or

put options. For example _

Bull Spread (created with calls)

Bull Spread (created with puts) Bear Spread (created with calls)

Bear Spread (created with puts)

Box Spread (created with calls + puts)

Butterfly Spread (created with calls)

Butterfly Spread (created with puts)

Calendar Spread (created with calls)

Calendar Spread (created with puts)


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Bull Spread Using Calls(F igure 10.2, page 241)

K1 K2

Profit

ST

This involves _

1. Going long on a call at a lower strike equal to K1.

2. Going short on a call at a higher strike equal to K2.

The resultant pay offs shield losses, of course along with profits, in the

events of extreme price movements. If the bull expectation comes true,there will be range bound profits.

Hope: Stock price will increase


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Bull Spread Using PutsF igure 10.3, page 242

K1

K2

Profit

ST

This involves _

1. Going long on a put at a lower strike equal to K1.

2. Going short on a put at a higher strike equal to K2.


events of extreme price movements. If the bull expectation comes true,there will be range bound profits.

Hope: Stock price will increase


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Bear Spread Using PutsF igure 10.4, page 243

K1

K2

Profit

ST

This involves _

1. Going long on a put at a higher strike equal to K2.

2. Going short on a put at a lower strike equal to K1.


events of extreme price movements. If the bear expectation comes true,there will be range bound profits.

Hope: Stock price will decrease


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Bear Spread Using CallsFigure 10.5, page 245

K1

K2

Profit

ST

Hope: Stock price will decrease.

This involves _

1. Going long on a call at a higher strike equal to K2.

2. Going short on a call at a lower strike equal to K1.


events of extreme price movements. If the bear expectation comes true,there will be range bound profits.


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Box Spread

K1

K2

Profit

ST

This involves _

1. Creating Bull Spread by going long on a call at a lower strike equal to K1,

and short on a call at a higher strike equal to K2.

The resultant pay offs are always equal to K2K1. So if the current values of call

and put for the strikes of K2and K1 are different than the present value of the box

(k2k1), then arbitrage profits can be earned by either buying or selling a boxdepending on the price differentials.

Purpose: Profiting from arbitrage

2. Creating Bear Spread by going long on a put at a higher strike

equal to K2, and short on a put at a lower strike equal to K1.

This gap gives profit equal to K2

K1.

[At present, due to scaling differences, the gap does

not seem to be equal to K2 K1. ]

Boo

kdoesnot

providegraphicview

ofthisstrategy.


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Box Spread Elaborated

It is a combination of a bull call spread and a bear put spread.

If the options with which the box spread is created are

European, the resultant box spread is worth the present value

of the difference between the strike prices K2K1.

However, if they are American options, the profit may not

necessarily be so (see Business Snapshot 10.1).


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Butter f ly Spread Using CallsF igure 10.6, page 247

K1

K3

Profit

ST

K2

Hope: Stock price will be range bound.

This involves _

1. Going long on a call at a lower strike equal to K1,and also long on another call at a higher strike equal to K3.

The resultant pay offs assure profits when the movement in stock price remains

range bound. However, if the price moves more than that, it results into some loss.

2. Going short on two calls at a strike equal to K2, which should be near to So.


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Butterf ly Spread Using PutsF igure 10.7, page 248

K1

K3

Profit

ST

K2


This involves _

1. Going long on a put at a lower strike equal to K1,and also long on another put at a higher strike equal to K3.



2. Going short on two puts at a strike equal to K2, which should be near to So.


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Calendar Spread Using CallsF igure 10.8, page 248

Profit

ST

K

This involves _

1. Going short on a call at a certain strike, say equal to K1.



2. And going long on another call with the same strike K1but with longer

maturity period.



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Calendar Spread Using PutsF igure 10.9, page 249

Profit

ST

K

This involves _1. Going short on a put at a certain strike, say equal to K1.



2. And going long on another put with the same strike K1but with longer

maturity period.



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Diagonal Spreads

As seen earlier, a Calendar Spread is based on same

strike but different maturities.

However, along with different maturities, if the strikes

are also different, than the range of profit can be

increased. Such a strategy is called Diagonal Spread.


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Combinations Strategies

A combination Strategy involves takingpositions in both call options and put options.

For example _

Straddle (created with long call and put with same

strike price and maturity)

Strips (created with long one call and two puts

with same strike price and maturity)

Straps (created with long two calls and one put

with same strike price and maturity)

Strangles (created with long one call and one put

with different strike prices but same maturity)


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StraddleF igure 10.10, page 250

Profit

ST

K

This involves _

1. Going long on a call at a certain strike, say equal to K1.

The resultant pay offs, which are opposite to butterfly spreads, assure profits when the

stock price witnesses large movements. However, if the price remains range bound,than it results into some loss.

2. And going long on a put with the same strike K1with same maturity period.

Hope: Stock price will move sharply.

S & S


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Strip & StrapF igure 10.11, page 251

Profit

K ST

Profit

KST

Strip StrapA Strip involves _Going long on one call and two puts with

same strike and maturity. This is very

similar to Straddle except that here two

puts are bought. So Strap gives more

profit than Straddle if the price decreases.

A Strap involves _

Going long on two calls and one put with

same strike and maturity. This is very

similar to Straddle except that here two

calls are bought. So Strap gives more

profit than Straddle if the price increases.

Hope: Stock price will move sharply,

with downside more likely..

Hope: Stock price will move sharply,

with upside more likely..


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StrangleF igure 10.12, page 252

K1

K2

Profit

ST

This involves _

1. Going long on a call at a higher strike, say equal to K2.

The resultant pay offs assure profits when the stock price witnesses large movements.

However, if the price remains range bound, than it results into some loss. It is very

similar to Straddle with the following differences.

Differences: Favourable:- Loss bottom is reduced.

Unfavourable:- Loss zone is expanded.

2. And going long on a put with a lower strike K1with same maturity period.

Hope: Stock price will move sharply.


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Other Payoff Patterns

When the strike prices are close together a butterfly

spread provides a payoff consisting of a small

spike.

If options with all strike prices were available any

payoff pattern could (at least approximately) be

created by combining the spikes obtained fromdifferent butterfly spreads.

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10-Trading Strategies Involving Options