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Advanced Option Strategies
Derivatives and Risk Management
BY SUMAT SINGHAL
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Outline
Principles of Money Spreads and combinations Bull spread Bear spread Butterfly Spread
Calendar spreads Combinations
Collars Straddle Strips and straps strangles
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Option Spreads
What do we mean by a spread? Types of Spreads
Vertical/Money Spread Horizontal Spread
Buying the Spread Selling the Spread Why use spreads?
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Money Spreads
Bull Spreads Bear Spreads
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Bull Spread
Creating Bull spread with calls Buy a call option on a stock with a certain
exercise price and sell a call option on the same stock with a higher exercise price
Example Creating Bull spread with puts
Buy a put with a low strike price and sell a put with a high strike price
Example
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Bear Spread
Bearish on stock Creating bear spread with puts
Buy a put with a high exercise price and sell a put with a low exercise price
Example Creating bear spread with calls
Buy a call with higher exercise price and sell a call with a lower exercise price
Example
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Butterfly Spread
Involves two positions in options with three different exercise prices
Buy a call with a relatively low exercise price, say E1
Buy a call with a relatively high exercise price, say E3, and
Sell two calls with a strike price of E2 Usually, E2 is halfway between E1 and E3 E2 is usually close to the current stock price
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A butterfly spread leads to a profit if the stock price stays close to E2, but
Gives a small loss if there is a significant movement in either direction
Good strategy if you feel significant stock price changes are unlikely
Require small investment initially to setup the spread
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Butterfly Spread
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Breakeven Point Upper Breakeven Point = Strike Price of Higher
Strike Long Call - Net Premium Paid Lower Breakeven Point = Strike Price of Lower
Strike Long Call + Net Premium Paid
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Calendar Spread
Sell a call option with a certain exercise price and
Buy a longer maturity call option with the same strike price
Longer the maturity of the option bought, the more expensive it is due to speculative value of the option
Requires initial investment to setup
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Assuming that the long-maturity option is sold when the short-maturity option matures, What will be the payoff diagram? How to determine profit/loss?
Types of Calendar Spreads Neutral Calendar Spreads Bullish Calendar Spread Bearish Calendar Spread
Calendar Spread with Put Options
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Reverse Calendar Spread
If you anticipate the stock price to move into in extremes, you can execute a reverse calendar spread
Buy a call with a shorter maturity and Sell a call with a longer maturity with the
same exercise price
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Combinations
Combination is an option trading strategy that involves taking a position in both calls and puts on the same stock Straddle Strips Straps Strangles Collars
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Straddle
Buy a call and buy a put with the same strike price and expiration date
When do you profit? When to use this strategy? Breakeven points
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
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Payoff diagram
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Short a straddle
Sale of a put and a call with the same exercise price and expiration date
High risk strategy, especially if the stock price moves too much
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Strips and Straps
Strip Long position in one call and two puts with the
same strike price and expiration date
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Upper Breakeven Point = Strike Price of Calls/Puts + Net Premium Paid
Lower Breakeven Point = Strike Price of Calls/Puts - (Net Premium Paid/2)
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Strap A long position in two calls and one put with the
same strike price and maturity Upper Breakeven Point = Strike Price of
Calls/Puts + (Net Premium Paid/2) Lower Breakeven Point = Strike Price of
Calls/Puts - Net Premium Paid
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Payoff diagram of a Strap
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Strangle
Buy a put and a call with the same maturity date, but different strike prices
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Breakeven Point
Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid
Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid
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Collars
Buy a stock Buy a put on the stock with an exercise price
lower than the current stock price Sell a call on the stock with an exercise price
higher than the current stock price Choose the call exercise price in such a
manner that the call premium completely offsets the put premium
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= Ns (ST – S) + NP[MAX(0, E1 - ST) – P1] – Nc[max(0, ST – E2) – C2]
If stock price at maturity is below both the exercise prices?
If the stock price at maturity is between the two exercise prices
If the stock price at maturity is higher than both the exercise prices
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Payoff diagram of a Collar