Trading Strategies Involving Options

Trading Strategies Involving Options

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

Strategies involving a single option and a stock

(Figure 10.1, page 240)
While some rationale can be assigned to each strategy, they can be better viewed as pricing propositions under Put-Call Parity Theory.

Profit

Profit

K K
Profit

ST
Profit

ST
(b) Synthetic Long Put

(a) Synthetic Short Put

K
ST
(c) Synthetic Long Call

ST

(d) Synthetic Short Call

(a) Synthetic Short Put

Profit

Risk: Price may increase.

Long Stock

K
Short Call

ST

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 simultaneously go 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.

So this strategy is named as Writing a Covered Call.

(d) Synthetic Short Call

Profit
Short Stock

Risk: Price may decrease.

Short Put

ST

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 simultaneously short on stock. This results into the pay offs pattern of short call, where the potential loss due to decrease in stock price gets covered.

Thus, this strategy aims at covering short put.

(b) Synthetic Long Put

Profit

Risk: Price may increase.

Long Call

K ST
Short 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.

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

(c) Synthetic Long Call

Profit
Long Put Long Stock

Risk: Price may decrease.

K ST

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.

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

Spread Strategies
A Spread Trading Strategy involves taking positions in either two or more 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)

Bull Spread Using Calls

(Figure 10.2, page 241)

Hope: Stock price will increase

Profit ST K1 K2

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.

Bull Spread Using Puts

Figure 10.3, page 242

Hope: Stock price will increase

Profit

K1

K2

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. 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.

Bear Spread Using Puts

Figure 10.4, page 243

Hope: Stock price will decrease

Profit

K1

K2

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. The resultant pay offs shield losses, of course along with profits, in the events of extreme price movements. If the bear expectation comes true, there will be range bound profits.

Bear Spread Using Calls

Figure 10.5, page 245

Hope: Stock price will decrease.

Profit

K1

K2

ST

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. The resultant pay offs shield losses, of course along with profits, in the events of extreme price movements. If the bear expectation comes true, there will be range bound profits.

Box Spread
Profit
Book does not provide graphic view of this strategy.

Purpose: Profiting from arbitrage

[At present, due to scaling differences, the gap does not seem to be equal to K2 K1. ]

This gap gives profit equal to K2 K1.

ST

K1

K2

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. 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. The resultant pay offs are always equal to K2 K1. So if the current values of call and put for the strikes of K2 and K1 are different than the present value of the box (k2 k1), then arbitrage profits can be earned by either buying or selling a box depending on the price differentials.

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 K2 K1.

However, if they are American options, the profit may not necessarily be so (see Business Snapshot 10.1).

Butterfly Spread Using Calls

Figure 10.6, page 247
Hope: Stock price will be range bound.

Profit

K1

K2

K3

ST

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

Butterfly Spread Using Puts

Figure 10.7, page 248
Hope: Stock price will be range bound.

Profit

K1

K2

K3

ST

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. 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.

Calendar Spread Using Calls

Figure 10.8, page 248
Hope: Stock price will be range bound.

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 K1 but with longer maturity period. 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.

Calendar Spread Using Puts

Figure 10.9, page 249
Hope: Stock price will be range bound.

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 K1 but with longer maturity period. 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.

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.

Combinations Strategies
A combination Strategy involves taking positions 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)

Straddle
Figure 10.10, page 250

Hope: Stock price will move sharply.

Profit

ST

This involves _ 1. Going long on a call at a certain strike, say equal to K1. 2. And going long on a put with the same strike K1 with same maturity period. 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.

Strip & Strap Figure

Profit

10.11, page 251

Hope: Stock price will move sharply, with upside more likely..

Hope: Stock price will move sharply, with downside more likely..

Profit

ST K Strip ST K Strap
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.

A 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.

Strangle
Figure 10.12, page 252

Hope: Stock price will move sharply.

Profit

K1

K2
ST

This involves _ 1. Going long on a call at a higher strike, say equal to K2. 2. And going long on a put with a lower strike K1 with same maturity period.

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.

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 from different butterfly spreads.