3 - introduction to trading strategies

7/31/2019 3 - Introduction to Trading Strategies

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TRADING STRATEGIES FOREQUITY OPTIONS


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Recall the standard long and short positions

Long Call

Lon Put

Short Call

Short Put


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Payoff of Basic StrategiesStrategy Payoff Profit Outlook Diagram

Long Call Max (0 , ST X) Max (0 , ST X) - c Bullish

- , T - , T

Long Put Max (0, X ST) Max (0, X ST) - p Bearish

Short Put - Max (0, X ST) - Max (0, X ST) + p Bullish


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Covered Call(Short Call + Long Underlying)

Composed of a long position on

an asset and a short call

The long position covers or

protects an investor from the

payoff on the short call for a

V0 = S0 c0

VT = ST max (0, ST X) Profit ( ) = VT V0

= ST max (0, ST X) - S0

.

Generate cash upfront but

removes upside potential

+ c0 If ST X: ST - S0 + c0

If ST > X: = X - S0 + c0

BEV and Maximum Loss :

ST = S0 c0

Maximum Profit: X - S0 + c0


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Protective Put(Long Put + Long Underlying)

Composed of a long put

and a long position on theunderlying

The long position is

V0 = S0 + p0

VT = max(0, X ST) + ST If ST X: X

If ST > X: ST=

any drastic decline inprices

= max(0, X ST) + ST - S0 -p0 If ST X: = X S0 - p0

If ST > X:

= ST S0 - p0 BEV: ST = S0 + p0 Max Profit:

Max loss: S0 + P0 - X


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Reverse of a Covered Call(Long call + Short Underlying)

Composed of a long call

and short underlying asset The short position is

protected by the long call

V0 = c0 S0

VT = max (0, ST X) - ST

Profit ( ) = VT V0

= max (0, STX) - ST- c0+S0

the price If ST X: = S0 ST - c0 If ST > X: = S0 - X - c0

BEV : ST = S0 c0

Max loss: S0 - X - c0 Max Profit: S0 C0


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Reverse of a Protective Put(Short put + Short Underlying)

Short put and short

underlying The short put is

covered b the short

V0 = - p0 - S0 V

T

= -max(0, X ST

) - ST

If ST X: -X

If ST > X: -ST Profit: VT V0

in the underlyingasset

= -max(0, X ST) - ST +S0 + p0 If ST X: = S0 -X + p0 If ST > X: = S0 - ST + p0

BEV: ST = s0 + p0 Max Profit: S0 -X + p0 Max loss: S0 - ST + p0


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Option Combination Strategies

Bull spread using calls

Bull spread using puts

Bear spread using calls

Bear s read usin uts

DirectionalSpread

Straddle

Strangle Strip

Strap

Butterfly spread

VolatilityTrades


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Directional Spread Strategies


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Bull Spread using call options(Long call at X1, short call at X2)

Created by buying a call option on an asset and

selling a call option for a higher strike. Buy call at X1, sell call at X2 , where X2 > X1

The premium of a call option decreases as the

exercise price increases (c1 > c2 ). Has an initial

investment: - c1 + c2

ST Long call

payoff

Short call

payoff

Total

Payoff

Total Payoff

ST X2 ST X1 X2 ST X2 X1 X2 X1 - c1 + c2

X1 < ST < X2 ST X1 0 ST X1 ST X1- c1 + c2

ST X1 0 0 0 - c1 + c2


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Concept Check An investor bought a call option with a strike price

of $30 for $3 and writes another call option for $1with a strike price of $35. Construct the payoff

table for a bull spread using call options.


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Bull spread using put options(Long put at X1, short put at X2)

Created by buying a put option on an asset and then

selling a put option with the same variables except

for a higher strike price.

Buy puy at X1, sell put at X2, where X2 > X1

The premium of a put option increases as the

exerc se pr ce ncreases p2

> p1

. as n t a cas

inflow ofp2 p1.

ST Long put

payoff

Short put

payoff

Total

Payoff

Total Profit

ST X2 0 0 0 p2 p1

X1 < ST < X2 0 ST X2 ST X2 ST - X2 + p2 p1

ST X1 X1 ST ST X2 X1 X2 X1 X2 + p2 p1


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Concept Check An investor bought a put option with a strike price

of $30 for $1 and writes another put option for $3with a strike price of $35. Make the payoff table for

a bull spread using put options.


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Bear spread using call options(Long call at X2, short call at X1)

Created by buying a call option on an asset and

then selling a call option with the same variables

except for a lower strike price.

Buy call at X2, sell call at X1, where X2 > X1

The premium of a call option increases as the

exerc se pr ce ecreases c1 > c2 . as n t a cas

inflow of - c2 + c1.

ST Long call

payoff

Short call

payoff

Total

Payoff

Total Profit

ST X2 ST X2 X1 ST X1 X2 X1 X2 - c2 + c1

X1 < ST < X2 0 X1 ST X1 ST X1 ST - c2 + c1

ST X1 0 0 0 c1 c2


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Concept Check An investor bought a call option with a strike price


diagram for a bear spread using call options.


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Bear spread using put options(Long put at X2, short put at X1)

Created by buying a put option on an

asset and then selling a put option with

the same variables except for a lowerstrike price.

Buy put at X2, sell put at X1, where X2 > X1

e prem um o a put opt on ec nes as

the exercise price decreases (p2 > p1). Has

an initial investment of -p2 +p1.

ST Long put

payoff

Short put

payoff

Total

Payoff

Total Profit

ST X2 0 0 0 -p2 +p1

X1 < ST < X2 X2 ST 0 X2 ST X2 ST - p2 +p1

ST X1 X2 ST ST X1 X2 X1 X2 X1- p2 +p1


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Concept Check An investor bought a put option with a strike price


diagram for a bear spread using put options.


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Volatility Strategies


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Volatility Trades

Options combinations whose profit are

based on substantial increases and/ordecreases in the volatility of the

un er y ng asset.Straddles and Strangles

Strips and Straps

Butterfly Spreads and Calendar Spreads


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Long Straddle

(Long call at X1, long put at X1)

Involves buying a call and a put option with the

same exercise price and maturity date.

Buy call at X1, buy put at X1

Appropriate when an investor is expecting a large

move in the underlying asset but does not know

w c rect on t e pr ce s go ng.

Requires an initial investment of the two

premiums c1 +p1.

ST Long Call

payoff

Long Put

payoff

Total

Payoff

Total Profit

ST X 0 X ST X ST X ST - c1 p1

ST > X ST X 0 ST X ST X c1 p1


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Short Straddle

(Short call at X1, short put at X1)

Involves writing a call and a put option with the same

exercise price and maturity date.

Sell call at X1, sell put at X1

A very risky strategy since it results to a loss on a

significant move on either direction of the underlying

.

The profit is limited to the sum of the premiums

received if the underlying asset does not change

significantly.

Has initial inflow of the two premiums ct+pt.

ST Short Call

payoff

Short Put

payoff

Total

Payoff

Total Profit

ST X 0 ST X ST X ST X+ ct+pt

ST > X X - ST 0 X ST X ST + ct+pt


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Long Strangle

(Long put at X1, long call at X2)

Involves buying a put option and another call

option with the same maturity date but higher

strike price. Buy put at X1, buy call at X2

Similar to straddle wherein the investor is uncertain

which direction the price will move. Difference is

the cost of the investment and the payoff dependson the distance of the two strike prices

Requires initial investment c1 +p1

ST Long Call

payoff

Long Put

payoff

Total Payoff Total Profit

ST X1 0 X1 ST X1 ST X1 ST c1 p1

X1 < ST < X2 0 0 0 0

ST

X2

ST

X2

0 ST

X2

ST

X2

-c1

p1


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Short Strangle

(Short put at X1, short call at X2)

Involves writing a put option and

another call option with the samematurity date but higher strike price.

Sell put at X1, sell call at X2

w w 1 1.

ST Short Call

payoff

Short Put

payoff

Total

Payoff

Total Profit

ST X1 0 ST - X1 ST - X1 ST - X1 + c1 +p1

X1 < ST < X2 0 0 0 0

ST X2 X2 ST 0 X2 ST X2 ST +c1 +p1


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Butterfly spread using call options

(Long call at X1, long call at X3, 2 short calls at X2)

Created by buying two call options with

different strike prices and writing two calls

whose exercise prices are exactly betweenthe previous strike prices.

A butterfly spread can either be at a cost or

the strategy. This cash flow must beincluded in the net profit of the strategy

ST 1st Long Call

payoff

2nd Long Call

payoff

Short Calls

payoff

Total

Payoff

ST < X1 0 0 0 0

X1 < ST < X2 ST X1 0 0 ST X1

X2 < ST < X3 ST X1 0 -2(ST X2) X3 ST

ST > X3 ST X1 ST X3 -2(ST X2) 0


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Concept Check Suppose that a certain commodity is currently

worth $61 and an investor expects that the pricewill not move significantly. The market of different

calls are shown below. Construct a payoff diagram

for a butterfly spread using call options.

X 55 60 65

ct

10 7 5


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Butterfly Spread

Created by buying two put

options with different

Created by selling two call

options with different

Butterfly spread using put options Reverse Butterfly spread

two puts whose exerciseprices are exactly between

the previous strike prices.

two calls whose exerciseprices are exactly between

the previous strike prices.


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Other volatility trade strategies

involve buying a longer-dated option and

selling a nearer-dated option, takingadvantage of the fact that options expirefaster as they approach expiration.

Calendarspreads

consists of a long call position and two ormore puts with the same strike price andexpiration date.

Strip

consists of a consists of a two or more longcalls and a long put.Strap

3 - introduction to trading strategies

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