Trading Strategies Involving Options

Prof Mahesh Kumar

Amity Business School
profmaheshkumar@rediffmail.com
Payoffs from Options
What is the Option Position in Each Case?

K = Strike price, ST = Price of asset at maturity

Payoff Payoff
K
K ST ST
Long call Short Call

Payoff Payoff
K
K ST ST
Long Put Short Put
Profit from a Long Position

Profit

Price of Underlying
at Maturity
Profit from a Short Position

Profit

Price of Underlying
at Maturity
Strategies in Option Trading
 In option trading there are three alternative
strategies:
1. Taking position in the option and the
underlying
2. Taking position in two or more options of the
same type (A spread)
3. Taking position in a mixture of calls and puts
(A combination)
Strategies Involving A Single Option and A Stock
 There are number of different trading strategies
involving a single option on a stock and the stock itself.
 For the purpose of hedging, positions are taken in
conjunction with the underlying assets.
 Hedging represents a strategy by which an attempt is
made to limit the losses in one position by
simultaneously taking a offsetting position.
 The offsetting position may be in the same or different
security.
 In most cases, the hedges are not perfect because they
cannot eliminate all losses.
 Typically, a hedge strategy strives to prevent large
losses without significantly reducing the gains.
 Very often, options in equities are employed to hedge a
long or short position in the underlying common stock.
Hedging a Long Position in Stock
 An investor buying a common stock expects
that its price would increase. However, there is
a risk the price may in fact fall.
 In such a case, a hedge could be formed by
buying a put option, that is, buying the right to
sell.
 This strategy is also known as protective put
strategy.
Hedging a Long Position in Stock-Example
 Consider an investor who buys a share for
Rs.100. To hedge, he buys a put for Rs.16 for
an exercise price say Rs.110.
 Long put option will be exercised only if ST<110
 The conditional pay offs resulting from selected
prices of shares are as shown in the table
 Hedging a Long Position in Stock-Example
Profit/loss for Selected Share Value: Long Stock Long Put

Share Price Ex Price Profit on Ex. Profit/loss on Net Profit

(i) Shares (ii) (i)+ (ii)
70 110 24 -30 -6

80 110 14 -20 -6

90 110 4 -10 -6

100 110 -6 0 -6

110 110 -16 10 -6

120 110 -16 20 4

130 110 -16 30 14

140 110 -16 40 24

Pay Off Diagram

Long position in stock combined with a long

position in a put

Profit

K
ST
Hedging a Short Position in Stock
 Unlike an investor with a long position in stock, a
short seller of stock anticipates a decline in stock
price.
 By shorting the stock now and buying it at a lower
price in the future, the investor intends to make a
profit. Any price increase can bring losses because of
an obligation to purchase at a later date.
 To hedge, the investor can buy a call option with an
exercise price equal to or close to the selling price of
the stock.
 This investment strategy is the reverse of writing a
covered call.
Hedging a Short Position in Stock-Example
 Suppose an investor shorts a share at Rs.100
and buys a long call option for Rs.4 with a
strike price of Rs.105.
 Long call option will be exercised only if
ST>105
 The conditional pay offs resulting from selected
prices of shares are as shown in the table
 Hedging a Short Position in Stock-Example
Profit/loss for Selected Share Value: Short Stock Long Call

Share Price Ex Price Profit on Ex. Profit/loss on Net Profit

(i) Shares (ii) (i)+ (ii)
90 105 -4 15 11

95 105 -4 10 6

100 105 -4 5 1

105 105 -4 0 -4

110 105 1 -5 -4

115 105 6 -10 -4

120 105 11 -15 -4

 Pay Off Diagram
Profit
Short position in stock
combined with long position K
in a call ST
Hedging with Writing a Call Option
 If the common stock is not expected to experience
significant price variations in the short run, then the
strategies of writing calls and puts may be usefully
employed for the purpose.
 Suppose you hold a long position in a stock which
you expect will experience small changes in price in
the short term, then you can write a call on those
shares. This is known as writing a covered call.
 The writing of covered calls, that is, agreeing to sell
the stock you have, is a very conservative strategy.
Hedging with Writing a Call Option-Example
 An investor has bought a share for Rs.100 and who
writes a call with an exercise price of Rs.105, and
receives premium of Rs.3.
 The profit/loss occurring at some exercise price of
the underlying share indicated in the table depicts
the payoff function for the strategy of writing
covered calls.
 Hedging with Writing a Call Option-Example
Profit/loss for Selected Share Value: Long Stock Short Call

Share Price Ex Price Profit on Ex. Profit/loss on Net Profit

(i) Shares (ii) (i)+ (ii)
90 105 3 -10 -7

95 105 3 -5 -2

100 105 3 0 3

105 105 3 5 8

110 105 -2 10 8

115 105 -7 15 8

120 105 -12 20 8

 Pay Off Diagram

Profit

K ST

Long Position in stock combined with short

position in call option
Hedging with Writing a Put Option
 Similar to writing a call option, an investor who
shorts a stock can hedge by writing a put option.
 By undertaking to ‘be the buyer’, the investor hopes
to reduce the magnitude of loss that would be
occurring from an increase in the stock price, by
limiting the profit that could be made when the
stock price declines.
Hedging with Writing a Put Option- Example
 You short a share at Rs.100 and write a put
option for Rs.3, having an exercise price of
Rs.100.
 The put option will be exercised by the buyer of
the put option if ST<X.
 The conditional trade offs resulting from some
selected values of share prices can be depicted
as per the following table
 Hedging with Writing a Put Option-Example
Profit/loss for Selected Share Value: Short Stock Short Put

Share Price Ex Price Profit on Ex. Profit/loss on Net Profit

(i) Shares (ii) (i)+ (ii)
90 100 -7 10 3

95 100 -2 5 3

100 100 3 0 3

105 100 3 -5 -2

110 100 3 -10 -7

115 100 3 -15 -12

120 100 3 -20 -17

Pay Off Diagram
Short Position in a stock combined with
short position in put

Profit

K ST
Gist
To summarize there are four profit patterns:
a) Long position in a stock plus a short position in a call
option. This is known as writing a covered call. The long
stock option ‘covers’ or protects the investor from the
pay off on the short call that become necessary if there
is a sharp rise in the stock price.
b) A short position in a stock is combined with a long
position in call option. This is the reverse of writing a
covered call.
c) The investment strategy that involves buying a put
option on a stock and the stock itself. This strategy is
also known as protective put strategy.
d) A short position in a put option combined with a short
position in the stock. This is the reverse of protective
put.
 Profit Patterns
Short position
Long position Profit Profit In stock +
In stock + Long position
Short position K In call
In call
K ST ST
(a)
(b
Profit ) Short position
Long position Profit
In stock +
In stock + Short position
Long position In put
In put
K
ST K ST

(c (d
) )
Gist
According to put call parity relationship
p + S0 =c + D + Xe-r T
a) According to above equation long position in put
option and long position in stock is equivalent to
a long call position plus a certain amount (D +
Xe-r T ) of cash. This explains why the profit
pattern is similar to the profit pattern from a
long call position.
b) The position mentioned in (d) is the reverse of
that mentioned in (c) and therefore leads to
position similar to that from a short call position.
Gist
The put call parity relationship can also be
rearranged as
S0- c=D + Xe-r T- p
c) In other words, a long position in a stock combined
with a short position in a call is equivalent to short
position in put plus a certain amount (D + Xe -r T ) of
cash. This equality explains why the profit pattern
for (a) is similar to profit pattern from a short put
position.
d) The position mentioned in (b) is the reverse of that
mentioned in (a) and therefore leads to a profit
pattern similar to that from a long put position.
Spread
 A spread trading strategy involves taking a
position in two or more options of the same
type (i.e. two or more calls or two or more
puts)
Spread- Bull Spread
 It is one of the most popular strategies of spreads
 A bull spread represents a bullish sentiment of a
trader.
 It can be created by buying a call option on a stock
with a certain strike price and selling a call option on
the same stock with a higher strike price. Both
options have the same expiration dates.
 Because a call option price always decreases as the
strike price increases, the value of the option sold is
always less than the value of option bought. A bull
spread, when created from calls, therefore requires
an initial investment.
Spread- Bull Spread
Stock Price Pay off from Pay off from Total Payoff
Long Call Short Call
ST>=X2 ST-X1 X2-ST X2-X1
X1<ST<X2 ST-X1 0 ST-X1
ST<=X1 0 0 0
Suppose that X1 is the strike price of the call option bought, X 2 is
the strike price of the call option sold and ST is the strike price on
the expiration date of the options.
If the stock price does well and is greater than the higher strike
price, the pay off is the difference between two strike prices X 2- X1.
If the stock price on the expiration date lies between the two
strike prices, the pay off is ST-X1
If the strike price on expiration date is below the lower strike
price, the payoff is zero.
Spread- Bull Spread
 A bull spread strategy limits the investors upside as
well as downside risk.
 The strategy can be described by saying that the
investor has a call option with a strike price equal
to X1 and has chosen to give up some upside
potential by selling a call option with strike price X2
(X2>X1)
Bull Spread Using Calls

Profit

ST
X1 X2
Spread- Bull Spread
 Three type of bull spreads can be distinguished:
1. Both calls are initially out of the money.
2. One call is initially in the money; the other call is
initially out of the money.
3. Both calls are initially in the money.
The most aggressive bull spreads are those of type
1. They cost very little to set up and have a small
probability of giving a relatively high payoff (=X2-
X1). As we move from Type 1 to Type 2 and from
Type 2 to Type 3, the spreads become more
conservative.
Spread- Bull Spread-Example
 An investor buys for Rs.8 a call with a strike price of
Rs.50 and sells a call for Rs.5 with a strike price of
Rs.60.
 The payoff from this bull strategy is Rs.10 if the price is
above Rs.60 and zero if it is below Rs.50. If the stock
price is below Rs.50 and Rs.60, the payoff is the
amount by which the stock exceeds Rs.50. The cost of
the strategy is Rs.8- Rs.5=Rs.3. The profit is therefore
as follows:
Stock Price Range Profit
ST=<50 -3
50<ST<60 ST-53
ST>=60 7
Spread- Bull Spread
 A bull spread can also be created using puts.
 One put is purchased at low strike price and another one is sold
which is on the same stock, with the same expiry date but with
a higher exercise price.
 Pay off from Bull Spreads (with Puts) can be depicted as follows

Stock Price Pay off from Pay off from Total Payoff
Long Put Short Put
ST<=X2 X1-ST ST-X2 X 1 - X2
X1<ST<X2 0 ST-X2 ST-X2
ST>=X2 0 0 0
Bull Spread Using Puts

Profit

X1 X2 ST
Spread- Bull Spread-Example
 An investor buys a put option with an exercise price equal to
Rs.40 for Rs.6 and writes an option identical in all respects
except the exercise price that is equal to Rs.50 for a price of
Rs.9
 The strategy involves a initial credit of Rs.9-Rs.6= Rs.3
 If the stock price is less than Rs.40, then both the options are
in-the-money and can be exercised. A commitment to buy at
Rs.50 and to sell at Rs.40 implies an outward payoff of Rs.10
and a net loss equal to Rs.10-Rs.3=Rs.7
 If the stock prices is between the two exercise prices, say
Rs.44 the investor has to buy the stock at Rs.50 and thus
lose Rs.6 on the option. In this case the net loss will be Rs.6-
Rs.3=Rs.3
 Similarly, when the stock price would be more than Rs.50,
none of the options will be exercised and a net profit of Rs.3
will be made.
Spread- Bear Spread
 An investor who enters into bear spread is hoping that the stock
price will decline.
 Similar to bull run, bear spread is created by buying two calls with
different strike price.
 In the case of a bear spread, the strike price of the option
purchased is greater than the strike price of the option sold.
 A bear spread created from calls involves an initial cash flow,
because the price of the call sold is greater than the price of the
call purchased.

Stock Price Pay off from Pay off from Total Payoff
Long Put Short Call
ST>=X2 ST-X2 X1 - S T - (X2 - X1)
X1<ST<X2 0 X1 - S T -(ST-X1)
ST<=X2 0 0 0
Bear Spread Using Calls

Profit

X1 X2 ST
Spread- Bear Spread-Example
 An investor buys for Re.1 a call with a strike price of
Rs.35 and sells for Rs.3 a call with a strike price of
Rs.30.
 The payoff from this bear spread strategy is Rs.5 if the
stock price is above Rs.35 and zero if it is below Rs.30.
If the stock price is between Rs.30 and Rs.35, the pay
off is -(ST-30).The investment generates a cash flow of
Rs.3 – Re1 = Rs.2 upfront. The profit is therefore as
follows:
Stock Price Range Profit
ST=<30 +2
30<ST<35 32-ST
ST>=35 -3
 Like in bull spreads, bear spreads limit both upside
profit potential and the downward risk.
Spread- Bear Spread
 The investor buys a put option with a high strike price and sells a
put with a low strike price.
 Bear spreads created with puts require an initial investment.
 The investor has bought a put with a certain strike price and
chosen to give up some of the profit potential by selling a put with
a lower strike price. In return for the profit given up, the investor
gets the price of option sold.
 The payoffs from a bear spread using puts can be depicted as
follows:

Stock Price Pay off from Pay off from Total Payoff
Long Put Short Put
ST>=X2 0 0 0
X1<ST<X2 X2-ST 0 X2-ST
ST<=X1 X2-ST ST-X1 X2 – X 1
Bear Spread Using Puts

Profit

X1 X2 ST
Spread-Example
 For each of the following cases, name the strategy
adopted and calculate the profit/loss for different price
ranges of the stock taking ST>=X2, X1<ST<X2 and ST<=X1.
Also determine the break even stock price in each case.

Type of Exercise Price of Option Premium of an Option

Option
Purchase Sold Purchase Sold

Call 60 75 10 4
Call 80 70 5 11
Put 70 60 9 5
Put 50 65 4 11
Spread- Example
 Case I: Buying a call with a lower exercise price and
selling a call with greater exercise price results in bull
spread. Initial cash flow is -10+4=-6
 The payoff can be depicted as follows:
Stock Price Pay off from Pay off from Total Payoff Net Profit
Long Call Short Call Payoff- Cost
ST>=X2 ST-60 75-ST 15 15-6=9
X1<ST<X2 ST-60 0 ST-60 ST-60-6= ST-
66
ST<=X1 0 0 O 0-6=-6

To determine the breakeven stock price the net profit is equal to

zero. Therefore ST-66=0, and ST=66
Spread- Example
 Case II: Buying a call with higher exercise price and
selling a call with lower exercise price is a bear spread
strategy. Initial cash flow is Rs.-5+Rs.11=Rs.6
 The payoff can be depicted as follows:
Stock Price Pay off from Pay off from Total Payoff Net Profit
Long Call Short Call Payoff+ Net
Premium
ST>=X2 ST-80 70-ST -10 -10+6=-4
X1<ST<X2 0 70-ST 70-ST 70-ST+6=
76+ST
ST<=X1 0 0 O 0+6=6

To determine the breakeven stock price the net profit is equal to

zero. Therefore 76+ST=0, and ST=76
Spread- Example
 Case III: The sale of a lower exercise put option and purchase
of a higher value put option is also a bear spread strategy. The
initial cash flow of the investor is -9 + 5= -Rs.4
 The payoff can be depicted as follows:

Stock Price Pay off from Pay off from Total Payoff Net Profit
Long Call Short Call Payoff+ Net
Premium
ST>=X2 0 0 0 -9+5=-4
X1<ST<X2 0 60-ST 60-ST 60-ST-4=
56-ST
ST<=X1 70-ST ST-60 10 10-4=6
To determine the breakeven stock price the net profit is equal to
zero. Therefore 56-ST=0, and ST=56. With stock prices below Rs.56,
profit will result, while loss will result with prices greater than this.
 Spread- Example
 Case IV: Buying a put option with exercise price equal to Rs.50 and selling a
put option with a greater price of Rs.65 represents a bull spread. This would
result in a positive cash flow of Rs.11-Rs.4= Rs.7 to the investor upfront.
 The payoff can be depicted as follows:

Stock Price Pay off from Pay off from Total Payoff Net
Long Put Short Put Profit/Loss

ST>=X2 0 0 0 0+7=7
X1<ST<X2 0 ST-65 ST-65 ST-65+7=
ST-58
ST<=X1 50-ST ST-65 -15 -15+7=-8

To determine the breakeven stock price the net profit is equal to zero.
Therefore ST-58=0, and ST=58. This implies that a profit would result when
the stock price exceeded Rs. 58 and loss would incur if it falls short of Rs.58
Butterfly Spreads Using Calls
 A butterfly spread involves positions in options with
three different strike prices.
 It can be created by buying a call option with a
relatively low strike price X1; buying a call option
with a relatively high strike price X3; and selling two
call options with a strike price, X2, halfway between
X1 and X3. Generally X2 is close to current stock
price.
Butterfly Spread Using Calls

Profit

X1 X2 X3 ST
Butterfly Spreads Using Calls
 A butterfly spread leads to a profit if the stock price
stays close to X2, but gives rise to a small loss if
there is a significant stock price movement in either
direction.
 It is an appropriate strategy for an investor who
feels that large stock moves are unlikely.
 The strategy requires a small investment initially.
Butterfly Spreads Using Calls
 The payoff from butterfly spread can be shown as
follows:
Stock Price Pay off from Pay off from Pay off from Total Payoff
Range ST first long call X1 second long call short calls X2
X3

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

X2=0.5(X1+X3)
Butterfly Spreads Using Calls-Example
 An investor decides to go long in two calls- one
each with exercise price Rs.65 and Rs.75 and writes
to call option with strike price of Rs.70. Determine
his payoffs for different levels of stock prices. Also
find his profit/loss when the stock price at maturity
is (i) Rs.63 (ii) Rs.68 (iii) Rs.73 and (iv) Rs.80
Butterfly Spreads Using Calls-Example
 This decision of investor leads to a butterfly spread. Buying two calls
involves a payment of Rs.11+Rs.6 = Rs.17 and writing two calls yield
Rs.8*2=Rs.16. Thus the cost involved with the package of options= Rs.17-
Rs.16= Re.1. Payoff can be depicted as follows:
Stock Price Pay off from first Pay off from 2nd Pay off two sht. Total Payoff
long call X1-65 long call X3-75 calls (X2=70)
ST<65 0 0 0 0
65<ST<70 ST-65 0 0 ST-65
70<ST<75 ST-65 0 2(70-ST) 75-ST
ST>75 ST-65 ST-75 2(70-ST) 0
Profit and loss for various given prices is
No. Price Tot. Payoff call Cost of strategy Net profit/Loss
1 63 0 (1) (1)
2 68 3 (1) 2
3 73 2 (1) 1
4 80 0 (1) (1)
Butterfly Spreads Using Puts
 A butterfly spread can also be created using put
options. The investor buys a put with low strike
price, buys a put with a high strike price and sells
two puts with an intermediate strike price.
Butterfly Spread Using Puts

Profit

X1 X2 X3 ST
Butterfly Spreads Using Puts
 The butterfly spread considered would be created by
buying a put with a strike price of Rs.65, buying a put
with strike price of Rs.75 and selling two puts with a
strike price of Rs.60
 If all options are European, the use of put option results
in exactly the same spread as the use of call options. Put
call parity can be used to show that the initial
investment is same in both the cases.
 A butterfly spread can be sold or shorted by following
the reverse strategy. Options are sold with strike prices
X1 and X3 and two options with the middle price X2 are
purchased. The strategy produces modest profit if there
is significant movement in the stock price.
Calendar Spreads
 Calendar spreads use options having same
strike price but different expiration dates.
 A calendar spread can be created by selling a
call option with a certain strike price and
buying a longer maturity call option with the
same strike price.
 The longer the maturity of an option, the more
expensive it usually is. A calendar option
therefore requires some initial investment.
 The profit pattern is similar to the profit from
the butterfly spread.
Calendar Spread Using Calls

Profit

ST
X
Calendar Spreads
 The investor makes a profit if the stock price at
the expiration of the short maturity option is
close to the strike price of the short maturity
option. However, a loss is incurred when the
stock price is significantly above or significantly
below this strike price.
Calendar Spreads
 If the strike price ST is very low when the short maturity
option expires, the short maturity option is worthless and
the value of long maturity option is close to zero. The
investor therefore incurs a loss that is close to the cost of
setting up the spread initially.
 If the stock price ST is very high when the short maturity
option expires, then the short maturity option costs the
investor ST-X and the long maturity option (assuming early
exercise is not optimal) is worth little more than ST-X. Again
the investor makes a net loss that is close to the cost of
setting up the spread initially.
 If ST is close to X, the short maturity option costs the
investor either a small amount or nothing at all. However
the long maturity option is quite valuable. In this case
significant profit is made.
Calendar Spreads
 In a neutral calendar spread, a strike price
close to the current stock price is chosen. A
bullish calendar spread involves a higher strike
price, whereas bearish calendar spread
involves a lower strike price
Calendar Spreads- Using Puts
 A calendar spread can be created with put
options. The investor buys a long maturity put
option and sells a short maturity put option.
 The pay off can be diagrammatically
represented as follows:
Calendar Spread Using Puts

Profit

ST
X
Reverse Calendar Spreads
 A reverse calendar spread is the opposite. The
investor buys a short-maturity option and sells
a long-maturity option. A small profit arises if
the stock price at the expiration is well above
or well below the strike price of the short
maturity option. However, significant loss
results if it is close to the strike price.
Diagonal Spreads
 In a diagonal spread both the expiration date
and the strike price of the calls are different.
This increases the range of profit pattern that
are possible.
Combination
 A combination is an option strategy that
involves taking a position in both calls and puts
on the same stock.
 Important combination strategies include
straddles, strips, straps and strangles.
Straddle
 This strategy involves buying a call and put
with the same strike price and expiration date.
 The profit pattern can be depicted as follows:
A Straddle Combination

Profit

X ST
Straddle
 The strike price is denoted by X. If the strike price is close
to this strike price at the expiration of the options, the
straddle leads to a loss. However, if there is a sufficiently
large move in either direction, a significant profit will
result. The pay off from straddle is represented as:

Range of Pay off from Pay off from Total Payout

stock price call put
ST<=X 0 X-ST X-ST
ST>X ST-X 0 ST-X

A straddle is appropriate strategy when an investor is

expecting a large move in a stock price but does not
know in which direction the move will be.
Straddle- Example
 A stock is currently trading at Rs.85. A three month call
with a strike price of Rs.85 costs Rs.4 whereas a three
month put with the same strike price costs Rs.2. An
investor feels that the stock price is likely to experience a
significant jump (either up or down) in the next three
months.
 The Strategy: The trader buys both the put and the call.
The worst that can happen is that the stock price is Rs.85 in
three months. In this case the strategy costs Rs.6.
 The farther away from Rs.85 the stock price is, the more
profitable strategy becomes.
 If the stock price jumps to Rs.100, then the call will be
exercised resulting in a net profit of Rs.100-Rs.85-Rs.6=
Rs.9.
 If the stock price falls to say Rs.57 then put option will be
exercised and net profit of Rs.85-Rs.57-Rs.6= Rs.22 will
result.
Straddle
 The straddle seems to be a natural strategy to use when
a big jump in the price of a company’s stock is expected,
for example, when there is a takeover bid for the
company or when the outcome of a major lawsuit is
expected to be announced soon.
 If the general view of the market is that there will be a
big jump in the stock prices soon, that view will be
reflected in the prices of the options. An investor will
find the options on the stocks to be significantly more
expensive than the options on a similar stock for which
no jump is expected.
 For a straddle to be an effective strategy, the investor
must believe that there are likely to be big movements
in the stock price and these beliefs must be different
from those of most other market participants.
Straddle
 The mentioned straddle strategy is also known
as a bottom straddle or straddle purchase.
 A top straddle or straddle write is the reverse
position. It is created by selling a call and a put
with the same exercise price and expiration
date. It is a highly risky strategy. If the stock
price on the expiration date is close to the
strike price, a significant profit results.
However, the loss arising from a large move in
a either direction is unlimited.
Strips and Straps
 A strip consists of a long position in one call
and two puts with the same strike price and
expiration date.
 A strap consists of a long position in two calls
and one put with the same strike price and
expiration date.
 The profit patterns from strips and straps are
depicted below:
Strip & Strap

Profit Profit

X ST X ST

Strip Strap
Strips and Straps
 In a strip the investor is betting that there will
be a big stock price move and considers a
decrease in the stock price to be more likely
than an increase.
 In a strap the investor is also betting that there
will be a big stock price move. However in this
case, an increase in the stock price is
considered more likely than a decrease.
Strangles
 In a strangle also referred as bottom vertical
combination or strangle bought or long
strangle, an investor buys a put and a call
option with the same expiration date and
different strike prices.
 The profit pattern of strangle strategy is
depicted below:
A Strangle Combination

Profit

X1 X2
ST
Strangle
 The call strike price, X2 is higher than the put strike price
X1. The pay off is as follows:

Range of Pay off from Pay off from Total Payout

stock price call put
ST<=X1 0 X1-ST X1-ST
X1<ST<X2 0 0 0
ST>X2 ST-X2 0 ST-X2
Strangles
 A strangle is similar strategy to a straddle. The
investor is betting that there will be a large
price move, but is uncertain whether it will
increase or decrease.
 On comparing strangle with straddle, we see
that the stock price has to move farther in a
strangle than in a straddle for the investor to
make profit. However the downside risk if the
stock price ends up at a central value is less
with a strangle.
Strangles
 The sale of strangle is sometimes referred to as
a top vertical combination or short strangle.
This strategy is appropriate for an investor who
feels that large stock prices moves are unlikely.
However, as with the sale of a straddle, it is a
risky strategy involving unlimited loss to the
investor.