Trading Strategies With Options

Trading Strategies Involving Options
Chapter 10
Options, Futures, and Other Derivatives 6th Edition, Copyright John C. Hull 2005
10.1
Types of Strategies

Covered Strategies: Take a position in the option and the underlying Spread Strategies: Take a position in 2 or more options of the same type (A spread) Combination Strategies: Take a position in a mixture of calls & puts (A combination)
10.2
Types of Strategies

Note the following standard symbols

C = current call price, P = current put price S0 = current stock price, ST = stock price at expiration T = time to expiration X = exercise price 4 = profit from strategy
The following will represent the number of calls, puts and stock held

NC = number of calls NP = number of puts NS = number of shares of stock

10.3
Types of Strategies

These symbols imply the following:

NC or NP or NS > 0 implies buying (going long) NC or NP or NS < 0 implies selling (going short) Profit equation for calls held to expiration

The Profit Equations

4 = NC[Max(0,ST - X) - C]

For buyer of one call (NC = 1) this implies 4 = Max(0,ST - X) - C For seller of one call (NC = -1) this implies 4 = -Max(0,ST - X) + C
10.4
Types of Strategies

The Profit Equations (continued)

Profit equation for puts held to expiration

4 = NP[Max(0,X - ST) - P]

For buyer of one put (NP = 1) this implies - ST ) - P For seller of one put (NP = -1) this implies Max(0,X - ST) + P
4 = Max(0,X 4=-
10.5
Types of Strategies

The Profit Equations (continued)

Profit equation for stock

4 = NS[ST - S0]

For buyer of one share (NS = 1) this implies 4 = ST - S0 For short seller of one share (NS = -1) this implies 4 = -ST + S0
10.6
Positions in an Option & the Underlying (Figure 10.1, page 224)

Profit Profit
K K
(a) Profit Profit
ST
(b)
ST
K ST
(c)
K
(d)
ST
10.7
Bull Spread Using Calls

(Figure 10.2, page 225) Bull Spread Using Calls: Buying a call option on a stock with a particular strike price and selling a call option on the same stock with a higher strike price. Payoff from a Bull Spread: Stock price Range Payoff from Long Call Option ST - K1 ST - K1 0 Payoff from Short Call Option K2 - ST 0 0 Total Payoff
ST K2 K1 < ST < K2 ST K1
K2 - K1 ST K2 0
10.8

(Figure 10.2, page 225) Ex: An investor buys $3 a call with a strike price of $30 and sells for $1 a call with a strike price of $35. Payoff from a Bull Spread:
Stock price Range
Payoff from Long Call Option ST - $30 - $3 ST - $30 -$3 0 - $3
Payoff from Short Call Option $35 - ST +$1 0+$1 0+$1
Total Payoff
ST $35 $30 < ST < $35 ST $30
$3 ST - $32 -$2
10.9

(Figure 10.2, page 225)
Profit ST K1 K2
10.10
Bull Spread Using Puts

Figure 10.3, page 226
Profit K1 K2 ST
10.11
Bear Spread Using Puts

-buying one put with a strike price of K2 and selling one put with a strike price of K1
Profit
K1
K2
ST
10.12
Bear Spread Using Calls

Bear Spread: Buying a call option on a stock with a particular strike price and selling a call option on the same stock with a lower strike price.
Stock price Range
Payoff from Long Call Option ST - K2 0 0
Payoff from Short Call Option K1 - ST K1 - ST 0
Total Payoff
ST K2 K1 < ST < K2 ST K1
-(K2 - K1) -(ST K1) 0

10.13

Example: An investor buys a call for $1 with a strike price of $35 and sells for $3 a call with a strike price of $30.
Stock price Range
Payoff from Long Call Option ST - $35 0 0
Payoff from Short Call Option $30 - ST $30 - ST 0
Total Payoff
ST $35 $30 < ST < $35 ST $30
-($35 - $30) -(ST $30) 0

10.14

Profi t K1 K2 ST
10.15
Box Spread

A combination of a bull call spread and a bear put spread If all options are European a box spread is worth the present value of the difference between the strike prices If they are American this is not necessarily so. (See Business Snapshot 10.1)
10.16
Butterfly Spread Using Calls

Butterfly Spread: buying a call option with a relative low strike price, K1,, buying a call option with a relative high strike price. K3, and selling two call options with a strike price halfway in between, K2.
Stock price Range Payoff from First Long Call Option ST - K1 ST - K1 ST - K1 0 Payoff from Second Long Call Option ST - K3 0 0 0 Payoff from Short Calls Total Payoff
ST K3 K2 < ST < K3 K2 < ST < K3 ST K1
-2(ST - K2) -2(ST - K2) 0 0
0 K3 - ST ST - K1 0
10.17

Example: Call option prices on a $61 stock are: $10 for a $55 strike, $7 for a $60 strike, and $5 for a $65 strike. The investor could create a butterfly spread by buying one call with $55 strike price, buying a call with a $65 strike price, and selling two calls with a $60 strike price.
Stock price Range
Payoff from First Long Call Option ST - $55 ST - $55 ST - $55 0
Payoff from Second Long Call Option ST - $65 0 0 0
Payoff from Short Calls
Total Payoff
ST $65 $60 < ST <$65 $55 < ST <$60 ST $55
-2(ST - $60) -2(ST - $60) 0 0
0 $65 - ST ST -$55 0
10.18

Profit K1 K2 K3 ST
10.19
Butterfly Spread Using Puts

Profit K1 K2 K3 ST
10.20
Calendar Spread Using Calls

Profit ST K
10.21
Calendar Spread Using Puts

Profit ST K
10.22
A Straddle Combination
Straddle: Buying a call and a put with the same strike price and expiration Date.
Stock price Range ST K ST < K
Payoff from Call
Payoff from Put
Total Payoff
ST K 0
0 K - ST
ST - K K - ST
10.23
Example: An investor buying a call and a put with a strike price of $70 and an expiration date in 3 months. Suppose the call costs $4 and the put $3.
Stock price Range ST $70 ST < $70
Payoff from Call
Payoff from Put
Total Payoff
ST $70 -$4 0 - $4
0 -$3 $70 - ST - $3
ST - $77 $63 - ST
10.24
Profit
ST
10.25
Strip & Strap

Strip: combining one long call with two long puts Strap: combining two long calls with one long put
Profit
Profit
ST
ST
Strip
Strap
10.26
A Strangle Combination
buying one call with a strike price of K2 and buying one put with a strike price of K1
Profit K1 K2 ST
10.27

Trading Strategies With Options

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Trading Strategies With Options

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Trading Strategies Involving Options

Note the following standard symbols

NC = number of calls NP = number of puts NS = number of shares of stock

These symbols imply the following:

The Profit Equations

The Profit Equations (continued)

Profit equation for puts held to expiration

The Profit Equations (continued)

Profit equation for stock

Positions in an Option & the Underlying (Figure 10.1, page 224)

Bull Spread Using Calls

Bull Spread Using Calls

Stock price Range

Payoff from Long Call Option ST - $30 - $3 ST - $30 -$3 0 - $3

Payoff from Short Call Option $35 - ST +$1 0+$1 0+$1

ST $35 $30 < ST < $35 ST $30

Bull Spread Using Calls

Bull Spread Using Puts

Bear Spread Using Puts

Bear Spread Using Calls

Stock price Range

Payoff from Long Call Option ST - K2 0 0

Payoff from Short Call Option K1 - ST K1 - ST 0

-(K2 - K1) -(ST K1) 0

Bear Spread Using Calls

Stock price Range

Payoff from Long Call Option ST - $35 0 0

Payoff from Short Call Option $30 - ST $30 - ST 0

ST $35 $30 < ST < $35 ST $30

-($35 - $30) -(ST $30) 0

Bear Spread Using Calls

Butterfly Spread Using Calls

ST K3 K2 < ST < K3 K2 < ST < K3 ST K1

-2(ST - K2) -2(ST - K2) 0 0

Butterfly Spread Using Calls

Stock price Range

Payoff from First Long Call Option ST - $55 ST - $55 ST - $55 0

Payoff from Second Long Call Option ST - $65 0 0 0

Payoff from Short Calls

ST $65 $60 < ST <$65 $55 < ST <$60 ST $55

-2(ST - $60) -2(ST - $60) 0 0

Butterfly Spread Using Calls

Butterfly Spread Using Puts

Calendar Spread Using Calls

Calendar Spread Using Puts

Stock price Range ST K ST < K

Payoff from Call

Payoff from Put

Stock price Range ST $70 ST < $70

Payoff from Call

Payoff from Put

Strip & Strap

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