Chapter 15 Option Strategies and Profit Diagrams

‡ In the diagrams that follow, it is important to remember that the diagrams that follow are based on option intrinsic value, at expiration. ‡ Helpful Hint: In the diagrams that follow, the µKINKS¶ are at strike prices. ‡ Throughout this chapter, bid-ask spreads and brokerage fees are assumed to be zero. ‡ CT = max(0, ST-K) and PT = max(0, K-ST)
©David Dubofsky and 15-1 Thomas W. Miller, Jr.

Quick Quiz: Identify These Six Basic Derivative Positions:
Profit

ST
[A] [B] [C]

[D]

[E]

[F]

©David Dubofsky and 15-2 Thomas W. Miller, Jr.

To These Six Basic Positions, add These Two Riskless Positions
profit

ST

[A

[B]

‡ Why are these positions riskless? ‡ What do they represent?
± Riskless Borrowing, [A], Receive money today, always pay money at µexpiration¶ of the loan. (AKA: Short (sell) T-bills) ± Lending, [B], Pay money today, always receive money at µexpiration¶ of the loan. (AKA: Long (buy) T-bills)
©David Dubofsky and 15-3 Thomas W. Miller, Jr.

. ‡ Take a position in 2 or more options of the same type (This is called a spread) ± Same type means: ‡ Use only calls ±or‡ Use only puts ‡ Take a position in a mixture of calls and puts (This is called a combination. Jr. Miller.) ©David Dubofsky and 15-4 Thomas W.There are Three Basic Option Trading Strategies ‡ Take a position in an option and the underlying.

Miller.Positions in an Option and the Underlying ‡ ‡ Try to identify the positions in the option. [A] Covered Call [B] [C] Protective Put [D] ©David Dubofsky and 15-5 Thomas W. and the net position. Jr. the underlying. NB: The µKINKS¶ occur at strike prices. .

CF0.How to construct a profit table ‡ Begin by computing the initial outlay. Jr. and you will have computed the strategy profit for each relevant value of ST. . Miller. this gives you CFT. ‡ Choose a range of day T prices for the underlying asset (begin at ~$2 below the lowest strike price and end at ~$2 above the highest strike price) ‡ Compute the expiration day payoffs for each position if they are offset on day T ‡ Add up the expiration day payoffs from offsetting each position. ©David Dubofsky and 15-6 Thomas W. CF0. ‡ Add CFT to the initial outlay.

Miller. You fear it may fall in value in the short run. ‡ ‡ ‡ Suppose you current own 100 shares of a stock. ©David Dubofsky and 15-7 Thomas W. . I. but do not want to sell now. You see the following option data: St 75 8 85 9 95 11 5 7 4 25 2 25 81 Put 75 1 38 3 25 6 13 8 88 ‡ ‡ You decide to purchase an 85 put. with a value of $86.Example: Protective Put. The protective put strategy is long stock + long put.38/share. Jr.

00 0.38) 0.00 4.Example: Protective Put.00 3.63 -89.00 85.63 CF(0)+CF(T) Portfolio CF(0) Profit -89.00 5.00 81.38 87.00 86.63 -89.63 90.00 91.00 2.00 81.00 7.00 88.00 92.00 86.00 85.00 85.63) (4.00 81.00 85.63 90.00 1. .00 88.00 89.63 -89.00 0.00 83.63 -89.00 85.38 .63) (0.00 89.63 -89.00 81.63 -89.00 92. II ‡ That is: At time 0 Buy stock Buy put CF(0) Stock Price at P(T) Sell Expiration 85 Put stock 78.25) (2.75 82.63) (4.63 -89.63 -89.00 -86.00 0.37 CF(T) 85.00 88.63 -89.63 -89.38 87.00 85.00 85.63) (4.25 -89.00 79.00 78.00 0.00 6.00 0.00 89.63 -89.63) (4. Jr. Miller.63 -89.00 85.63) (3.00 86.63 -89.63) (4.00 86.00 84.63) (4.63 -89.25 3.63 -89.00 0.00 0.63) (4.00 92.00 0.25 89.00 0.00 80.00 79.00 86.00 91.38 87.25 89.37 2.63) (4.63) (3.00 This is the range of S(T) that you really need { ©David Dubofsky and 15-8 Thomas W.75 82.00 83.63 -89.00 85.00 84.00 86.25 89.63 (4.00 85.63) (1.3.00 80.63 -89.63 90.37 1.00 91.00 0.00 0.

Jr.Then. Miller. . One Can Plot the Constituent Profits and the Portfolio Profits Example: Pr ective Put 1 on on 5 Put to k Portfolio Profit Portfolio Profit -1 9 1 5 9 91 tock Price at Expiration 9 95 ©David Dubofsky and 15-9 Thomas W.

00 45.00 42.00 -42.00 41.Writing a covered call ‡ Buy a stock for S(0) = 43 ‡ Sell a call with K = 45 for C(0) = 1 ‡ Initial outlay is -42 profit Stock offset Price t C(T) Expir tion 45 call 40.00 45.00 43. .00 44. Jr.00 -42.00 47.00 43.00 42.00 45.00 -2.00 45. Miller.00 -42.00 (2.00 0.00 -3.00 2.00) 0.00 46.00 CF(T) 40.00 43.00 1.00 41.00 -42.00 42.00 -42.00 3.00 0.00 45.00 44.00 41.00 46.00 3.00 -42.00 48.00 0.00 45.00 -42.00 0.00 Sell stock 40.00 47.00 -42.00 -1.00 3.00 0.00 CF(0)+CF(T) Portfolio CF(0) Profit -42.00 44.00 0.00 48.00 +3 42 45 ST ©David Dubofsky and 15-10 Thomas W.00 3.00) (1.

Miller. St Note that there is an initial outlay with this strategy. ‡ A ullish Vertical Spread with Calls (AKA: A or a bullish call money spread). . Jr. Profit ull Call Spread.Vertical Spreads. ± Sell Call with higher strike. the purchased call has a higher price than the written call A ull Call Spread Identify the Strike Prices Using the µkinks¶ ©David Dubofsky and 15-11 Thomas W. I. ± uy Call with lower strike.

‡ ullish Vertical Spread with Puts (AKA: A ± uy Put with lower strike.Vertical Spreads. . Profit ull Put Spread. Do they make sense? ©David Dubofsky and 15-12 Thomas W.) St There is an initial cash inflow with this strategy. ull Put Spread Again: Identify the Strikes by the µKinks¶. II. ± Sell Put with higher strike. Miller. Jr.

Profit St Is there an initial cash inflow or outflow? C ear Call Spread ©David Dubofsky and 15-13 Thomas W. Jr. ‡ C earish Vertical Spread with Calls (AKA: A ear Call Spread.) ± uy call with higher strike. . III.Vertical Spreads. ± Sell call with lower strike. Miller.

) ± uy put with higher strike. ± Sell put with lower strike. Profit St Is there an initial cash inflow or cash outflow? D ear Put Spread ©David Dubofsky and 15-14 Thomas W. . ‡ D earish Vertical Spread with Puts (AKA: A ear Put Spread. IV.Vertical Spreads. Miller. Jr.

00.00. Miller.75 ($375 per contract) ± Price of Jan 75 Call: $5. I.75. your payoff is $2. ‡ Suppose you observe the following data from the CBOE: ± Price of Jan 80 Call: $3.00. your payoff is $0 and your loss is $1. and your loss (CF0 + CFT) is $0. . your outlay is $1.25. ± If the underlying price is $76 at expiration. ± At any price equal to or above $80. ± If the underlying price is $77 at expiration. and your profit is 3. your payoff is $1. your payoff is $4.00 ($500 per contract) ‡ ‡ ‡ You decide to buy the Jan 75 call and sell the Jan 80 Call. At expiration: ± At any price lower than $75.25 (your initial outlay). ©David Dubofsky and 15-15 Thomas W. Today. Jr.75.Example: ullish Vertical Spread with Calls.25.75. or $500. and your profit is $0.00. ± If the underlying price is $79 at expiration. or $125 per contract. your payoff is $5. and your profit is $2.

. . . . CF . II. C set Call .75 CF(0) -1. . . . . .25 C O set Call . . . . . . . . . . . . . . . Miller. . . . . . . . . .   S ©David Dubofsky and 15-16 Thomas W. . . . ‡ Today: Buy Jan 75 call -5 Sell Jan 80 call +3. tal r it CF +CF . . . . Jr.Example: ullish Vertical Spread with Calls. . . . . . . . . . . .

) ©David Dubofsky and 15-17 Thomas W. III. . Miller. Jr.75 -0. 5 -1. one can plot the underlying price at expiration against the position profit or loss (note that the kinks are at the strike prices.Example: ullish Vertical Spread with Calls. Then. 5 7 7 75 7 77 78 7 80 81 8 8 8 85 derl i rice at Expirati as well.75 r it/ ss 1. e c uld pl t each eleme tar p siti ullish Vertical Spread with Calls . 75 and 80): ( bvi usl .75 .75 0.

Jr.Butterfly Spread Using Calls ‡ This is a Long Call Butterfly: With equally spaced strikes: Profit ST Long with lowest strike. Short with middle strike. Long with highest strike Long Butterfly Using Calls ©David Dubofsky and 15-18 Thomas W. . Miller.

. Long with highest strike Long Butterfly Using Puts What do you think a written butterfly would look like? ©David Dubofsky and 15-19 Thomas W.Butterfly Spread Using Puts ‡ This is a Long Put Butterfly: With equally spaced strikes: Long with lowest strike. Miller. Jr. Short with middle strike.

Miller.Other Spreads. the number of options held in each position is not the same. Jr. 430) ± Can use either calls or puts. ± However. I. ± The resulting payoff is curved. . ‡ Ratio Spreads (pg. but with two different strikes. and sell one put with a strike of 35. For example. ©David Dubofsky and 15-20 Thomas W. ± Can use either calls or puts. but with two different expiration dates. This is because one option is still µalive¶ at the expiration date of the other. ± Same expiration. a one could buy 3 puts with a strike of 30. unlike other spreads. ‡ Calendar Spreads: ± Use the same strike.

Jr. short 1 at both intervening strikes.) ©David Dubofsky and 15-21 Thomas W. but with a µflat spot¶ between the middle two strikes. II.Other Spreads. Miller. (The payoff for a long butterfly resembles a µwitches¶ hat. ‡ Condor Spread. equally spaced strikes. the payoff for a long condor resembles a µstovepipe¶ hat. ± For a long condor spread: Long 1 at the lowest and 1 at the highest strike. ± The resulting payoff resembles a butterfly spread. ± Uses four. .

Therefore.Other Spreads. a short box resembles riskless borrowing. Long a put with strike K ... K1 and K2. . Short a call with strike K . these are combinations) ± Use two equally spaced strikes. ‡ Box µSpread¶ (Really. III. I. ± A Long Box costs money today. ©David Dubofsky and 15-22 Thomas W.e. ± A Short Box is formed by reversing all the positions in a long box. a short box generates a cash inflow today. Therefore. Short a put with strike K . Jr. but has a value of ±(K2 ± K1) at expiration. short T-bill. As a result. but always has a value of K2 ± K1 at expiration. I. Miller. long T-bill. ± Long Box: Long a call with strike K .e. a long box resembles riskless lending. where K1 < K2.

. Profit ST on Straddle Usin a Call and a t ©David Dubofsky and 15-23 Thomas W. ‡ A Long Straddle is formed by a long call and a long put: ± Both have the same strike and expiration date. one sells the call and sells the put.Combinations. ± What is the worst possible value for the underlying at expiration? ± In a Short Straddle. Jr. I. Miller.

(what does it look like?) Profit ST ong Strangle sing a Call an a t ©David Dubofsky and 15-24 Thomas W. the call and put have different strike prices.Combinations. ‡ A Long Strangle is formed by a long call and a long put: ± Both have the same expiration date. . Jr. ± But. Miller. one sells the call and sells the put. II. ± In a Short Strangle.

However.Combinations. Miller. ± The same expiration date. Strips and Straps ‡ Strips and straps are formed by using a different number of calls and puts. on Puts on Put. III. . all the options share ± The same strike price. on [B] on Strap Calls [A] on Strip What are the slopes of these lines? ©David Dubofsky and 15-25 Thomas W. on Call. Jr.

Str ke 7 all 11 7 42 22 1 Put 7 13 32 6 13 9 9 ‡ Using the steps to build a profit table. ©David Dubofsky and 15-26 Thomas W. you construct the following table. . Miller.Example: Long Straddle ‡ You see the following option data and decide to purchase an 85 call and an 85 put. Jr.

. . . . . . . . . ©David Dubofsky and 15-27 Thomas W. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Miller. . . . II. . . . . . .25 -3. . . . . . . . . . . . . . . . . . . . . . . . . . . .Long Sto ri e at E iration Straddle. ort olio ro it .25 -7. . . . . . et all . . . . . .50 . . . Jr. . . et t . . . . . . . . . . Time 0 Buy C (K=85) Buy P (K=85) CF(0) -4. . . . . . . . . . . . . . . . . . . . . . . . . .

one can plot the profit data: Example: Long 1 . .5 . Jr.Long Straddle. Miller. . 5 8 85 5 1 Stock rice at Expiration ©David Dubofsky and 15-28 Thomas W.5 -1 . III.. -2. .5 5. Straddle on 85 u on 85 all osi ion rofi rofit 2. Then.5 -5.

Miller. ‡ To prepare a profit diagram (as a function of the price of the underlying asset on a given day prior to T). you must estimate the value of the options. You also have to guess what implied volatility ( ) will exist in the option prices on that day. For this. . you need an option pricing model. Jr. ©David Dubofsky and 15-29 Thomas W. ‡ See pg. 434 for diagrams depicting how a bullish money spread and a long straddle evolve over time.Profit Diagrams for Positions Offset Prior to the Expiration Day ‡ Any strategy can be offset prior to expiration.

©David Dubofsky and 15-30 Thomas W. See. problem 15. and what their profit diagrams look like: ± ± ± ± ± Long stock.Expectations of Students ‡ You should know what the following strategies are. short call. short put Covered call. Jr. protective put Bullish money spread and bearish money spread Long and short straddle and strangle ‡ BUT«I can give you any melange of elementary positions. short stock Long call. long put. and you should be able to prepare a profit table.10. for example. . Miller.

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