Plan for Today

RSM 6310, Class 2, Kevin Wang

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B Pairs Trading

B Option Strategies

B Selling Options

B Technical Analysis I

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Pairs Trading

• Prediction or bet: A pair of stocks with price paths that have

historically moved together will converge if they ever diverge.

Pairs trading may profit from temporary relative mispricing of

close substitutes.

An optional article on pairs trading - by Gatev, Goetzmann, and

Rouwenhorst, Review of Financial Studies (2006).

• Select a pair and use the normalized price - computed as the

cumulative return, with dividends reinvested.

• Trading: Open a long-short pair when the prices diverge.

Unwind the position at the next crossing of the prices.

Imperial Bank of Commerce (CM) 4:06PM EST: 75.71 0.73 (0.96%)

DIG DEEP

ON CM

An illustration: CIBC vs. RBC

RY GET CHART COMPARE EVENTS TECHNICAL INDICATORS CHART SETTINGS RESET

lysis

Normalize
s

the prices 6 6
s

6
EW!

⇠
w Long CIBC Yes!

⇢⇡ Short RBC ) Exit

3
ERAGE

Long CIBC 98 -
P

Short RBC 138 -

P

Payo↵: (138 P ) + (P 98) = 138 98

Long CIBC 98 -
P1

Short RBC 138 -

P2

Payo↵: (138 P2) + (P1 98)

= (138 98) (P2 P1 )

Option Trading Strategies

• We first discuss options trading with the underlying asset.

• Let the underlying asset be a stock - referred to as “ABC stock.”

• A trader holds a long position in the stock in the following cases:

————————–

Covered calls

Protective puts

Collars

————————–

Covered calls

• A covered call is an option strategy in which a trader holds a

position on a stock and sells a call option on the same stock in

order to produce supplementary earnings from the asset.

• Example

You own 100 shares of ABC stock valued at $45. In the short

term (less than 30 days), you expect the stock price to rise

slightly (likely below $50).

You sell a $50 call contract on ABC stock that expires in 30

days, which earns you an option premium valued at $100 (i.e.,

$1.00 option premium x 100 = $100 per contract).

An option
Positions in analong with
Option &the
theunderlying
Underlying

(Figure 11.1, page 237)

Profit Profit

K ST ST

(a)
(b)

Profit Profit

ST K ST

(c) (d)

Covered Call

+S

u
@

@
@

@
@

@
@

@
@

@
@

@
@

@
@

Covered Call

S C

Profit diagram of a covered call

Protective puts

• A protective put, or married put, is a strategy in which a trader

purchases a put option while buying an equivalent number of

shares of the underlying stock. This protects the trader against

the potential depreciation of the share price.

• Example

You purchase 100 shares of ABC stock valued at $26 per share.

To protect yourself against the potential depreciation of the

shares, you simultaneously purchase a $24 put contract for $75

($0.75 ⇥ 100) with a 30-day expiration.

Although your initial loss is $75, this caps your total potential

loss at $275 (($26 - $24) x 100 + $75).

Profit diagram of a protective put

Collars

• In a collar, a trader is long the stock and buys a protective put

while selling a call option against the same stock.

• Example

You buy 100 shares of ABC stock currently valued at $20 per

share in February.

To protect yourself against a sharp decline of the share price, you

purchase a $18 out-of-the-money (OTM) put contract for $100

($1.00 x 100) that expires in January of next year.

To complete the collar, you simultaneously sell a $30 OTM call

contract of the same expiration date for $250 ($2.50 x 100).

10

 Profit diagram of a collar

Payo↵ Diagram of Collar

11
34
 Spreads

• Spread trading - two or more options of the same type

——————————
Vertical spreads
Calendar spreads
Diagonal spreads
Butterfly spreads
Condor spreads
——————————

12
 Bullish call vertical spreads

• In a call vertical spread, a trader buys one call option and sells
another call option of the same underlying simultaneously.
The call options have identical expiration dates but di↵erent
strike prices. In the bullish case, the strick price of the long call
is lower than that of the short call. This strategy may be used to
reduce the cost.

• Example

You believe ABC shares, now trading at $50, will rise moderately.

Buy a $45 call contract for $500 and sell a $55 contract for $100.

Your initial investment would be a debit of $400.

13
Bullish Call Vertical

+ C1

K1 K2
u u
@
@
@
@
@
@
@
@
@
@
@
@
@
C2
Bullish Call Vertical

u + C1 C2

K1 K2
u u
 Payo↵ from a bull call vertical spread

Stock price Payo↵ from Payo↵ from Total

range long call short call payo↵

ST  K 1 0 0 0

K1 < ST < K2 ST K1 0 ST K1

ST K2 ST K1 (ST K2 ) K2 K1

14
 Profit diagram of a bull call vertical spread
Payo↵ Diagram of Vertical Bull Call Spread

37
15
 Bearish call vertical spreads

• A vertical call spread can be either a debit bull call spread or a

credit bear call spread.
In the bear call case, it is used to reduce the overall risk by
having the higher strike call long position as protection rather
than selling a naked call on its own.

• Example

You believe that ABC shares currently trading at $50 will fall in
the near future.

Buy a $54 call contract for $100 and sell a $45 contract for $500.

Your initial credit would be $400.

16
Bearish Call Vertical

+ C2

K1 K2
u u
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
@
C1
Bearish Call Vertical

K1 K2
u u
@
@
@
@
@
@
@
@
@
@u
C1 + C2
 Profit diagram of a bear call vertical spread
Payo↵ Diagram of Vertical Bear Call Spread

39
17
 Bullish put vertical spreads

• A put vertical spread is an options strategy in which a trader

buys one put option and sells another put option of the same
underlying simultaneously. The put options have identical
expiration dates but di↵erent strike prices.

• There are two types of put vertical spreads (bullish and bearish).

• Example
You believe that ABC shares currently trading at $23 will rise
moderately. You buy a $20 put contract for $125 and sell a $27
put contract for $300.
You would receive an initial credit of $175.
18
 Profit diagram of a bull put vertical spread
Payo↵ Diagram of Vertical Bull Put Spread

19
41
 Bearish put vertical spreads

• In a bearish put vertical spread, a trader buys one put option

(higher strike) and sells another put option (lower strike) of the
same underlying simultaneously. This strategy may be used to
reduce the cost of purchasing one put option by selling another
put option.

• Example

Suppose that ABC shares are trading at $28 in August. You

believe that the price will fall in the near future so you purchase
a September $30 put contract for $400 and sell a September $25
put contract for $100.

The initial investment would be a debit of $300.

20
 Profit diagram of a bear put vertical spread
Payo↵ Diagram of Vertical Bear Put Spread

21
43
 T1 T2 T3 ···

K1 p11 p12 p13 ···

K2 p21 p22 p23 ···

K3 p31 p32 p33 ···

.. .. .. ..
 T1 T2 T3 ···

K1 p11 p12 p13 ···

K2 p21 p22 p23 ···

K3 p31 p32 p33 ···

.. .. .. ..
 T1 T2 T3 ···

K1 p11 p12 p13 ···

K2 p21 p22 p23 ···

K3 p31 p32 p33 ···

.. .. .. ..
 Calendar spreads

• A call (put) calendar spread is an options strategy in which a

trader sells a call (put) option with a near-term expiration, and
simultaneously buys a longer-term call (put) option that expires
after the near-term option, each with identical strike prices.

• Example

ABC shares are currently trading at $28 in February, and you

believe that they will rise moderately over the next five months.

– You sell a March $32 call option contract for $10.

– You buy a July $32 call option contract for $190.

To set up this calendar strategy, you will be debited $180.

22
Di↵erence between the two calls (long positions)

Payo↵
6

CJuly
@ @
I
R
@ @
CMar

t - S
32

CJuly CMar
 Profit diagram of a call calendar spread

Profit 6

v -

K ST
($32)

23
 Diagonal spreads

• A call (put) diagonal spread is an option strategy in which a

trader simultaneously buys one long-term call (put) option while
selling a near-term call (put) option of the same stock.
The strike prices of the two options are di↵erent.

• Example

ABC shares are currently trading at $13 in February, and you

believe the stock will rise slowly over the next seven months.
– You buy a September $13 call option contract for $300.
– You sell a March $17 call option contract for $11.

You enter into this strategy with an initial debit of $289.

24
Di↵erence between the two calls (long positions)
Let’s start with the calendar case:

Payo↵
6

CSept
@ @
I
@
R
@
CMar(K = 13)

t - S
13

Next change the strike of the March Call.

Di↵erence between the two calls (long positions)

Payo↵
6

CSept
@ @
I
R
@ @
CMar

t t - S
13 17

CSept CMar
 Profit diagram of a call diagonal spread

Profit 6

v -

K ST
($17)

25
 Butterfly spreads

• In a call (put) butterfly, a trader sells two call (put) options at a

strike price, while buying one call (put) below the strike price,
and buying one call (put) above the strike price.

• Example
ABC shares are currently trading at $32 in February, and you
believe the stock will remain stagnant for the next 30 days.
– You buy one March $27 call contract for $570.
– You sell two March $32 call contracts for $394.
– You buy one March $37 call contract for $14.
To carry out this butterfly trade, you will be debited $190.
26
 Butterfly

K1 K2 K3
u u u
@
@
@
@
@
@
@
@
@u
@
 Butterfly

u
@
@
@
@
@
@
@
@
K1 K2 K 3
u u @u
@
Profit diagram of a call butterfly

27
An example from CNBC Options Action

28
 Yahoo’s share price was at $41.

Profit 6

@
@
@
@
@
@
@
@
@
@
@
@
40 45 @@
@
50 ST
u w u @w u
@
-
@
@
6 6@@
@ -

41 49
 Condor spreads

• In a call (put) condor spread, a trader enters two call (put)

vertical spreads. For the four options involved, if the two middle
strikes are the same, a condor reduces to a butterfly.

• Example
ABC shares are currently trading at $54 in March, and you
believe the stock will remain stagnant for the next 30 days.
– You buy one April $44 call contract for $1,105.
– You sell one April $49 call contract for $604.
– You sell one April $59 call contract for $53.
– You buy one April $64 call contract for $8.
To carry out this strategy, you will be initially debited $456.
29
Picture of a condor
 Condor

K1 K2 K3 K4
u u u u
@
@
@
@
@
@
@
@

@u
@
 Condor

u u
@
@
@
@
@
@
@
K1 K2 K3 @ K4
u u u @u
@
Profit diagram of a call condor spread

30
Sideways Bull vertical Bear vertical
strategies (debit) (credit)

Butterfly C1 C2 plus C2 + C3

Condor C1 C2 plus C3 + C4
 Combinations

• A combination has two or more positions of both types.

(That is, it is built with both call and put options.)

—————————
Straddles
Strangles
Iron butterflies
Iron condors
—————————

31
 Straddles

• A straddle is an options strategy in which a trader buys a put

and call option of the same stock simultaneously. Both options
have identical expiration dates and strike prices.

• Example
ABC shares are currently trading at $70 in September. You think
the stock will experience major volatility in the short term. You
decide to employ a straddle strategy.
You simultaneously purchase a $70 October put contract for
$250 and buy a $70 October call contract for the same price.
To enter into this position, you will be debited $500.
32
 Profit diagram of a straddle
Payo↵ Diagram of Straddle

52
33
 Profit diagram of a short straddle
Payo↵ Diagram of Short Straddle

34
53
 Strangles

• A strangle is an options strategy in which a trader buys one

out-of-the money put and one out-of-the money call of the same
symbol simultaneously, each with di↵erent strike prices, but
identical expiration dates.

• Example
ABC shares are currently trading at $70 in September. You think
it will experience considerable, short-term volatility.
To employ a strangle, you buy a $60 October put contract for
$75 and buy a $80 October call contract, also for $75.
To enter into this position, you will be debited $150.
35
 Profit diagram of a strangle
Payo↵ Diagram of Strangle

55
36
 Profit diagram of a short strangle
Payo↵ Diagram of Short Strangle

37
56
 Iron butterflies

• An iron butterfly consists of a bull put vertical and a bear call

vertical. The two verticals share one (usually the ATM) strike.

• Example
ABC shares are currently trading at $28 in March, and you
believe the stock will remain within a tight trading range.
– You buy one $23 April put contract for $61.
– You sell one $28 April put contract for $141.
– You sell one $28 April call contract for $140.
– You buy one $33 April call contract for $58.
After initiating the iron butterfly, you will receive a $162 credit.
38
 Profit diagram of an iron butterfly
Payo↵ Diagram of Iron Butterfly

39
58
 Iron condors

• In an iron condor, a trader simultaneously enters a vertical bull

put credit spread and a vertical bearish call credit spread.

• Example
ABC shares are currently trading at $154 in March, and you
believe the stock will remain within a tight trading range.
– You buy one $144 April put contract for $61.
– You sell one $149 April put contract for $124.
– You sell one $159 April call contract for $37.
– You buy one $164 April call contract for $5.
After initiating the iron condor, you will receive a $95 credit.
40
Profit diagram of an iron condor

41
 Sideways Bull vertical Bear vertical
strategies (credit) (credit)

Iron Butterfly P1 P2 plus C2 + C3

Iron Condor P1 P2 plus C3 + C4

 Sum-up

There is a lot that one can do with options!

———————————————————————
With the stock - covered call, protective put, collar

Direction - vertical, calendar, and diagonal spreads

Volatility - straddle, strangle

Sideways - (iron) butterfly, (iron) condor

———————————————————————

42
Selling options

——————————
Covered calls
Vertical spreads
Calendar spreads
Iron butterflies
Iron condors
——————————

43
 Is there an edge in selling options?

“... I’m going to let you in on a closely guarded secret

of many successful option traders.

Selling options, when done correctly, can give you an

overwhelming advantage in the market place.”

from Chapter 5: Option Selling Is Your Key to Success,

in “Get Rich with Options,” by Lee Lowell (2009)

44
 Long Call Short Call

@
@
@
@
@
@
@

Long Put Short Put

@
@
@
@
@
@
@
What’s that got to do with an insurance company?

“... how to create a business of trading options successfully

by using the framework of an insurance company.”

“... selling options is very much like running an insurance

company.”

from “The Option Trader’s Hedge Fund - A Business

Framework for Trading Equity and Index Options,”
by Dennis A. Chen and Mark Sebastian (2012)

45
Benjamin Graham said, in perhaps his most famous words:

“In the short run, the stock market is a voting machine,

but in the long run it is a weighing machine.”

 Technical Analysis

• Technical Analysis (TA) forecasts future price trends by studying

market action (price movement and trading volume).

– Basic assumptions:
Market action provides sufficient information to forecast the
future. Prices move in trends. History repeats itself.

– Technical analysts’ tools and objective:

technical indicators and trading rules.

– TA is up against Efficient Market Hypothesis (EMH).

46
Eugene E. Fama John W. Henry
(EMH, Chicago) (Boston Red Sox)
 Dow Theory

• Charles Dow

Dow Jones Industrial Average, Wall Street Journal

• It is a classic in technical analysis.

• Trends in stock prices:

Primary trends; intermediate trends; minor trends.

• Two frequently used concepts

Support level and resistance level

47
 Technical trading rules

• Trading range breakout

– A buy or sell signal is generated when the price penetrates the

resistance level (local max) or support level (local min).

⇥ ⌅C
Aw Cw⇥⇥ @ A ⌅ C Sell signal
B ⌅⌅JwJ⇥⇥
⇥ A ⌅ C
A A @ A ⌅ C B

F Bw
A I
@ A A⌅ B A
Price A
A
A ⌅
@
@
A
Aw
A
Aw
A @ A ⌅ @ A
A C
C ⌅
⌅
Buy signal E G A
A
C ⌅ A
C ⌅
C ⌅
C⌅

– This trading rule is a modified version of the Dow theory.

48
 Trading range breakout - continued

• The local maximum or minimum prices are picked over an interval of past
L days, where L is often set to be 50, 150, or 200.

• Test results of Brock, Lakonishok, and LeBaron (Journal of Finance, 1992),

using DJIA data from 1897 to 1986:
Reported are 10-day returns (in percent) after signals. The trading rules are
applied to DJIA, from 1897 to 1986.

L Days Buy Sell Buy Sell

50 0.82 0.08 0.90

150 0.86 0.35 1.21

200 0.72 0.47 1.19

49
The next trading rule is based on moving averages.
Moving average - an example: a 5-week moving average of TSE

50
• Moving average oscillator

– Buy and sell signals are generated by two moving averages of the price:
a long-period average (LMA) versus a short-period average (SMA).

Price Price
6 6

y
LMA
SMA
y LMA
A
K
A
A KA
A
Buy signal A

SMA Sell signal

- -
Time Time

Buy when SMA crosses over (rises above) LMA.

Sell when SMA crosses down (falls below) LMA.
51
 Moving average oscillator - continued

• The most popular is the 1-200 rule (i.e., SMA = 1-day MA, LMA = 200-day
MA). Other variations include 1-50, 1-150, 5-150, 2-200, etc.

• Brock, Lakonishok, and LeBaron (Journal of Finance, 1992):

Reported are 10-day returns (in percent) after signals. The trading rules are
applied to DJIA. The data are from 1897 to 1986.

SMA-LMA Buy Sell Buy Sell

1-50 0.52 0.46 0.98

1-150 0.71 0.39 1.10
5-150 0.62 0.33 0.95
1-200 0.58 0.77 1.35
2-200 0.18 0.88 1.06

52
• The trading range breakout and the moving average
oscillator are so simple and well-known.

How could they possibly work?

• Without using fundamentals, how could Technical

Analysis possibly work?
 How could TA work? - Quote from John W. Henry

“I don’t believe that I am the only person who cannot predict

future prices. No one can consistently predict anything, especially
investors. Prices, not investors, predict the future.

Despite this, investors hope or believe that they can predict

the future, or someone else can.

We rely on the fact that other investors are convinced that they can
predict the future, and I believe that’s where our profits come from.
I believe it’s that simple.”
53
 Concluding Remarks

———————————————————————–
B Textbook Chapter 12 and the class slides

B Option trading strategies - impressively flexible

B Technical Analysis - used by option traders

———————————————————————–
 Quiz for Class 2

———————————————————————

B Is pairs trading related to option strategies?

B What is an option-based income strategy?

B What is the intuition for sideways strategies?

B Why selling options may have some advantage?

———————————————————————