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10-Trading Strategies Involving Options
10-Trading Strategies Involving Options
This involves taking position in two or more calls OR puts [Except for Box Spread Strategy]
Combination Strategies
Profit
Profit
K K
Profit
ST
Profit
ST
(b) Synthetic Long Put
K
ST
(c) Synthetic Long Call
ST
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.
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.
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.
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.
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)
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.
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.
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.
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.
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.
However, if they are American options, the profit may not necessarily be so (see Business Snapshot 10.1).
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.
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.
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.
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
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.
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
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.