COMBINATIONS OF OPTIONS

Options are of two types - call option and put option. Currency options can be used for
hedging foreign exchange risk as well as for speculating on the movement of exchange rates.
In the case of an appreciating currency, the basic strategy involves buying a call or selling a
put. Similarly, in the case of a depreciating currency, the basic strategy involves buying a put
option or selling a call option.

Several other trading strategies can, however, be evolved by combining the two basic types of
options, namely, calls and puts. Different combinations of options generate versatile
strategies to be used in different market situations. These combinations are designated by
different names such as tunnels, spreads, straddles, strangles and butterflies. These strategies
are complex in nature, their impact in different market situations has to be analysed carefully,
and the suitability of each strategy has to be determined before opting for any of these
strategies.

Tunnels
A tunnel involves simultaneous purchase and sale of options. It may be the purchase of a call
and sale of a put, or the purchase of a put and sale of a call. A dealer expecting a rise in the
value of a currency may buy a call and simultaneously sell a put on the currency. If the
currency value rises, the call may be exercised to generate profit; but the put will not be
exercised by the holder. The premium received on the put compensate for the premium paid
on the call. If, on the contrary, the value of the currency depreciates, the call would have no
value, but will be exercised and the dealer would be obliged to buy the currency at a rate
higher than the spot rate, resulting in a loss.

When a currency value is expected to fall, a dealer may buy a put and simultaneously sell a
call. The premium paid would be compensated by the premium received. If the currency
value declines, the put option may be exercised to generate profit, and the call option will not
be exercised. If on the contrary, the currency value appreciates the put option will be
worthless while the call option will be exercised, and the dealer will be obliged to sell the
currency at a lower prevailing exchange rate.

A tunnel helps reduce the cost of option trading by balancing the premium paid and the
premium received. But it involves higher loss in case of adverse movements in exchange
rates.

Spreads
A spread is a combination of either two calls or two puts on the underlying asset. For two
calls, one would be bought and another call on the same underlying asset would be sold. The
strategy is the same in the case of two puts. The spread strategy may, however, be of different
types such as vertical spread, horizontal spread and diagonal spread.
Vertical spread

Vertical spread, also known as money spread, involves the simultaneous buying and selling
of options on the same underlying asset for the same expiry month but with different strike
prices. Obviously, the options with different strike prices will have different option
premiums. For instance, when the dollar-rupee spot exchange rate is Rs. 40/USD a call option
with strike price Rs. 40.20 may have a premium Re. 0.35, while a call option with strike price
Rs. 41.00 may have a premium of Re. 0.20. The dealer may buy the call option with exercise
price Rs. 40.20/US $ and sell the call option with exercise price Rs. 41.00/US $, if he
anticipates the exchange rate to move up but doesnot expect it to move above Rs. 41.00/US $.
In such a case, option sold by him will not be exercised and the premium adds to his profit.
He can exercise the call option bought by generate profit from the transaction.

The vertical spread strategy may be either bullish or bearish. The bullish strategy is expected
to make a profit when the exchange rate moves up. The bearish vertical spread strategy is
used to make profit when the exchange rate moves down. For example, a dealer may buy a
call option with strike price below the spot exchange rate and sell another call option with a
still lower strike price. The premium received would be higher than the premium paid. If the
spot exchange moves down and remains below both the exercise prices, neither of the options
would be exercised. The excess of premium received over the premium paid would constitute
his profit.

Horizontal spread

Horizontal spread, also known as calendar spread, involves the simultaneous buying and
selling of the same type of options (either calls or puts) on the same underlying asset with
same strike price but with different expiry months. For instance, a dealer may buy a call
option on US dollars with strike price Rs. 40.35/US $ expiring in August and simultaneously
sell a call option on US dollars with the same exercise price of Rs. 40.35/US $ but expiring in
October. Here, even though the exercise price is the same, the spot rate may fluctuate in both
directions between the two expiry dates. The profitability of this strategy of horizontal spread
has to be analysed with respect to possible movements in the exchange rates between the two
expiry dates,

Diagonal spread

Diagonal spread is the combination of vertical and horizontal spreads. It involves the
simultaneous buying and selling of either calls or puts on the same underlying asset but with
different strike prices and different maturity dates. One typical combination is the purchase of
a long maturity call and simultaneous sale of a shorter maturity call with a higher strike price.
The shorter maturity call with higher strike price is not likely to be exercised. The premium
received from its sale would enhance the profit of the dealer. He would also profit by
exercising the long maturity call with lower strike price.

Spread strategies may be described as call and put spreads bull and bear spreads, credit and
debit spreads, ratio spreads and back spreads, and so on. A spread strategy that is created
using calls is referred to as a call spread, while a spread strategy created using put options is
referred to as a put spread. A spread that is designed to profit from a rise in the price of the
underlying asset is referred to as a bull spread, and a spread that is designed to profit from a
fall the price of the underlying asset is known as a bear spread. When the premium received
on the option sold is higher than the premium paid on the option bought, it is a credit spread.
When the premium paid on the option bought is higher than the premium received on the
option sold, it is a debit spread. Spread strategies may also involve unequal number of
options simultaneously purchased and sold. When more options are written than purchased, it
is a ratio spread, when more options are purchased than written or sold, it is a back spread

Volatility Trading Strategies

The extent of variation in prices of the underlying asset is an important factor in determining
the trading strategies. The price fluctuations may sometimes tend to be more volatile than at
other times. The main strategies for trading in situations of price volatility are straddles,
strangles, and butterflies.

Straddle

A straddle involves the simultaneous purchase of a call and a put or the simultaneous sale of
a call and a put. The simultaneous purchase of a call option and a put option on the same
underlying asset, with the same exercise price and for the same expiry month, is described as
a long straddle. The simultaneous sale of two such options (a call and a put with the same
exercise price and expiry dates) is described as a short straddle. A forex dealer buying a
straddle is taking the view that there would be high volatility in exchange rates of the
underlying currency, whereas the seller of a straddle takes the view that volatility in exchange
rate would be low. Thus, the holder of a long straddle expects high volatility, while the holder
of a short straddle expects low volatility. A long straddle generates profit in a situation of
alternating movements in exchange rates. A short straddle is profitable only when exchange
rate moves within a narrow band. A long straddle is the appropriate strategy when substantial
movement is expected in exchange rates, but there is uncertainty as to the direction of
movement.

Strangle

A strangle is similar to a straddle. It also involves the simultaneous purchase of a call and a
put (a long strangle) or the simultaneous sale of a call and a put (a short strangle). However,
in a strangle, the call and put used in the combination will have different exercise prices. Here
again, the buyer of the strangle takes the view that exchange rate volatility would be high,
while the seller of the strangle expects low volatility. The profit potential of this trading
strategy depends on the actual volatility of the exchange rates before expiry. The long
strangle holder will benefit from substantial movements in exchange rates in either direction,
while the short strangle holder will benefit when exchange rates move within a narrow range.
Butterflies

A butterfly trading strategy involves taking positions in calls and puts simultaneously with
different strike prices. For example, a butterfly can be created by taking the following
positions simultaneously:

 Buying a call option with a low strike price (K1)

 buying a call option with a high strike price (K3)
 Selling two call options with the strike price (K 2), halfway between K1 and K2.
Generally, K2 would be close to the spot exchange rate.

In other words, this involves buying an in-the-money call, buying another out-of-the-money
call and selling (or writing) two at-the-money calls. A butterfly strategy generates profit when
exchange rates do not deviate much from the current exchange rate. This will result in a small
loss when exchange rates deviate substantially, in either direction, from the current exchange
rate. Hence, the strategy is appropriate when much fluctuation is not expected in exchange
rates in the short-term.

Other long butterfly positions can also be created. For example, a long butterfly position can
be created by buying an in-the-money put, buying another out-of-the-money put and selling
(or writing) two at the-money puts.

A short butterfly position can be created by taking the following positions:

 Writing a call option with low exercise price (K1)

 Writing a call option with high exercise price (K3)
 Buying two call options with exercise price (K 2), halfway between K1 and K3 and
close to the spot exchange rate.

In other words, it involves writing an in-the-money call and an out-of-the-money call and
buying two at-the-money calls. Another short butterfly could be created by writing an in-the-
money put and an out-of-the-money put and buying two at-the-money puts. A short butterfly
strategy produces modest profit only if there is a significant movement in exchange a rate;
otherwise, there would be a loss.

Straddles, strangles and butterflies are characterized as volatility trading Strategies. A

comparison of these three trading strategies reveals following position. "Straddles tend to
provide the highest potential profits, but also the greatest potential losses. Strangles involves
a low minimum loss but a greater likelihood of it occurring. Butterflies have small potential
losses, but at the cost of limited profit possibilities.
Combination of options

Tunnel Simultaneous purchase and sale of options (Buying a call and selling a
put, or buying a put and selling a call)

Spread Combination of two calls or two puts (Buying one call and selling
another call, or buying one put and selling another put)

Vertical spread: Simultaneous buying and selling of call option for the same expiry month
call : with different strike prices

Vertical spread: Simultaneous buying and selling of put options for the same expiry
put : month with different strike prices

Horizontal Simultaneous buying and selling of call options with same strike price
spread: call but different expiry dates

Horizontal Simultaneous buying and selling of put options with same strike price but
spread: put : different expiry dates

Diagonal Simultaneous buying and selling of call options with varying expiry dates
spread: call and different strike prices

Diagonal Simultaneous buying and selling of put options with varying expiry dates
spread: put and different strike prices

Long straddle Simultaneous buying of a call and a put with same expiry and same strike
price

Short straddle Simultaneous selling of a call and a put with same expiry and same strike
price

Long strangle Simultaneous buying of a call and a put with different strike prices

Short strangle Simultaneous selling of a call and a put with different strike prices

Long butterfly Buying a call option with a low strike price, buying a call option with a
high strike price, and selling two call options with the strike price
halfway between the low strike price and the high strike price

Short butterfly Writing a call option with a low exercise price, writing a call option with
a high exercise price, and buying two call options with exercise price
halfway between the low exercise price and the high exercise price