Trading Strategies Involving Options Week 7

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Trading Strategies Involving Options Week 7
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Introduction

• Various ways in which traders can form portfolios
  of calls and puts to get interesting payoffs
• Sometimes, you are just not able to say whether
  the price of a given stock will go up of down but
  you know that the price will move e.g. Official
  decision/Court decision/News conference
• Limit the loss if you are wrong
• Significant price change is unlikely

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Three Alternative Strategies

• Take a position in the option and the underlying
• Take a position in 2 or more options of the same
  type (spread)
• Take a position in a mixture of calls and puts
  (combination)

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Positions in an Option the Underlying

Profit
Profit
K
ST
ST
K
(a)
(b)
Profit
Profit
K
K
ST
ST
(c)
(d)
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Covered Call

• ASSET-CALL (option overwriting).
• Strategy Like selling insurance benefits from
  reversals.
• Commonly recommended since produces immediate
  cash flow for investor and less capital required.
• However
• Sacrifices upside potential.
• Be wary of commission costs!

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Protective Put

• ASSETCALL.
• Strategy Like buying insurance benefits from
  trends.
• Investor limits loss while benefits from upside
  potential.
• If market prices options correctly, this is a
  fair trade off for average investor!

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Why a position combining one long stock one
short call has a profit pattern similar to the
one of a short put?

• Use the put-call parity
• p S0 c Ke-rT
• S0 - c -p Ke-rT
• LONG SHORT SHORT AMOUNT OF
• STOCK CALL PUT CASH

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Forwards vs Options
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Synthetic ForwardsOTM CALL-ITM PUT
Synthetic Forward
Profit
Sell put
Future Asset Price
Buy call
Loss
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Bull Spread

• You believe the underlying asset price will rise
  but not very much.
• You are willing to sell off the extreme upside.
• Spread aggressiveness can be adjusted by choosing
  the strike prices.

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Bull Spread Using Calls

• ITM CALL-OTM CALL
• Long Call c(K1,T) Short Call c(K2,T)
• Payoff function

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Bull Spread Using Calls

Long call
Profit
c(K2,T)
ST
K1
K2
Short call
-c(K1,T)
Require initial investment?
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Bull Spread Using Puts
Short put
p(K2,T)
-p(K1,T)
Long put
Require initial investment?
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Bull Spread Using Puts

• OTM PUT-ITM PUT
• Long Put p(K1,T) Short Put p(K2,T)
• Payoff function

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Bear Spread Using Calls
Profit
Long call
K1
K2
ST
Short call
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Bear Spread Using Puts
Short put
Long put
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Calendar and Diagonal Spread

• Calendar constructed with calls with common
  strike price but different expiration dates.
• Depending on the strike price can be neutral,
  bullish or bearish.
• Diagonal constructed with calls with different
  strike prices and different expiration dates.

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Butterfly Spread Using Calls
Long call K1
Long call K3
Short 2 calls K2
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Butterfly Spread Using Puts
Short 2 puts K2
Long put K1
Long put K3
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Butterfly Spread1 ITM CALL-2 ATM CALLS 1 OTM
CALL

• Options can be used with surgical precision to
  take advantage of beliefs which differ sharply
  from most other investors.
• This position is very close to a state contingent
  claim. http//www.biz.uiowa.edu/iem/markets/

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A Straddle Combination
Long call K
Long put K
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Straddle ATM CALLATM PUT

• A bet on volatility.
• You believe that either very good or very bad
  news is about to be made public.
• Selling a straddle benefits from low realized
  volatility but loses after extreme moves up and
  down.

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Strip Strap

Profit
Profit
K
ST
K
ST
Strip
Strap
Long 2 puts K
Long 2 calls K
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A Strangle Combination
Profit
Long call K2
K1
K2
ST
Long put K1
Strangle or Straddle?
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Structured Products

• Positions in one or more underlying assets and in
  several derivatives on the assets
• Sold by banks as a package
• Attractive features
• Capital is guaranteed
• Upside participation
• No downside risk

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Structured Products Example

• Time 0, investor pays 5,000
• Time T, investor receives
• 5,000(10.75(Stock Index Return))
• if Stock Index Return gt 0
• or 5,000
• if Stock Index Return 0

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• Cash-flow at time T CFT
• If Stock index return is 10
• With structured product CFT 5,000 (1
  0.075) 5,375
• If direct investment in stocks CFT 5,000 (1
  0.1) 5,500
• If Stock index return is -10
• With structured product CFT 5,000
• If direct investment in stocks CFT 5,000 (1
  - 0.1) 4,500

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• Cash-flow at time T CFT Stock Index Value
  S
• CFT 5,000 5,000 0.75 Max( (ST S0) / S0
  0)
• CFT 5,000 5,000 0.75 (1/ S0) Max( ST
  S0 0)
• Suppose S0 10,000. Then
• CFT 5,000 5,000 0.75 (1 / 10,000) Max(
  ST 10,000 0)
• CFT 5,000 (3/8) Payoff ATM call
• Theoretical (Fair) Value of this structured
  product V0
• V0 PV(5,000) (3/8) ATM call price
• This security is fairly priced if and only if V0
  5,000
• Bank makes a profit if ATM call price lt (8/3)
  (5,000-PV(5,000))