Trading Strategies Involving

Options

Lectures 13 & 14

1
Assumptions
In the analysis to follow:
1. While the underlying we talk about mostly is a single stock,
the principles apply to stock indices, foreign currencies, future
contracts, etc.
2. While we assume that we are dealing with European options,
the logic will apply most of the time to American options too.
American options may lead to slightly different outcomes,
however, because of the possibility of early exercise
3. TVM is being ignored in the present discussion. If the
endeavour is to be theoretically correct, we need to work out the
P&L on the basis of the PV of final payoff less the initial cost

2
Types of Strategies
Take a position in a single option and the underlying stock
- Writing a covered call: buying the stock and selling a call option
- Reverse of the above
- Buying a protective put: buying the stock and buying a put option
- Reverse of the above
SPREADS: Take a position in 2 or more options of the same type i.e. 2 or more
calls or 2 or more puts
- Bull Spreads using two calls OR bull spreads using two puts
- Bear Spreads using two puts OR bear spreads using two calls
- Box spreads: a combination of a bull call spread and a bear put spread
- Butterfly spreads: taking positions at 3 strike prices in 4 calls (or 4 puts)
- Calendar spreads using two calls (or two puts) with same strike price but
different expiration
- Diagonal spreads having both strike prices (of calls) and expiration dates as
different
COMBINATIONS: Take a position in a mixture of calls & puts
Straddles
Strips & Straps
Strangles
3
Graphical Representation of various possibilities of taking
up a position in an Option as well as in the Underlying Stock

Profit Profit

K
K ST ST
(a)
(b
Profit Profit )

K
ST K ST

(c (d
) )
4
Position in a single option and the underlying stock

• Figure (a): Writing a covered call: buying

the stock and selling a call option – the profit
pattern (see the solid line in the graph in the
previous slide) is like that of a short put
• Figure (b): Reverse of (a) - – the profit
pattern is like that of a long put
• Figure (c): Buying a protective put: buying
the stock and buying a put option – the profit
pattern is like that of a long call
• Figure (d): Reverse of (c) – the profit pattern
is like that of a short call

5
Spreads
A spread trading strategy involves taking a
position in 2 or more options of the same type
(i.e.2 or more calls or 2 or more puts)
One of the most popular types of spreads is a
bull spread
If you are creating a bull spread using calls, it
can be done 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

6
Bull Spread Using Calls

Profit

ST
K1 K2

7
 Bull Spread Using Calls continued
Three types of bull spreads
1) Both calls initially out of the money (current stock price
below both K2 as well as K1): most aggressive, costs little to
set up
2) One call (K1) initially in the money and the other call (K2)
initially out of the money i.e. current price between K1 and K2
3) Both calls initially in the money( current price beyond K2)

EXERCISE
• Investor buys a call for $ 3 with a strike price of $ 30 and
sells for $ 1 a call for $35. Thus the spread costs $ 2 to be set
up.
• What are the possible profits and losses

8
SOLUTION

If ST ≤ 30 -2
If 30 < ST < 35 ST – 32
If ST ≥ 35 +3

Is it not obvious from the above data that it

is a bull spread?

9
Now to a ‘Bull Spread Using Puts’:
See next slide for details

Profit

K1 K2 ST

10
Bull Spread Using Puts
Bull spreads can also be created by using puts
You buy a put with a low strike price and sell a put with a
high strike price, as illustrated in the last slide
Unlike the bull spread created from calls, this one
involves a positive upfront cash flow to the investor.
Why?
The subsequent pay off is either negative or zero. Please
see the previous slide:
• When ST < K1: Total of + (K1 – ST) and – (K2 – ST), hence
negative as K2 is higher than K1
• When ST between K1 and K2: - (K2 – ST), hence negative
• When ST > K2: Both expire worthless, hence zero

11
BEAR SPREADS: Using puts
Bear spreads can be created by buying a put with a
HIGHER strike price, and selling a put with a LOWER
strike price
See next slide: you buy the put option with strike
price of K2 and sell the put option with the strike price
of K1
This is in contrast to a bull spread, where the strike
price of the option purchased is less than the strike
price of the option sold
A bear spread created from puts involves an initial
cash outflow
Why?
A bear spread can also be created using call options
12
Bear Spread Using Puts

Profit

K1 K2 ST

13
Example of a bear spread using puts
An investor buys a put with a strike price of $ 35 for
$3
He sells a put with a strike price of $ 30 for $1
Therefore the upfront cost of setting up the spread is
$2
The terminal payoff is zero if the stock price > $35.
Why?
The terminal payoff is $5 if the stock price < $30.
Why?
Terminal payoff is $35–ST , if stock price is between $
30 & $ 35. Why?
Computation of P&L in various situations is given in
the next slide
A bear spread can also be created using call options:
presented after the following slide

14
Example continued
Computation of P & L
Stock Price Range Profit
ST ≤ 30 +3
30 < ST < 35 33 – ST
ST ≥ 35 -2

Is it not obvious from the above data

that this is a bear spread

15
Bear Spread Using Calls:
Buy a call with higher strike price and sell a call with lower price

Profit

K1 K2 ST

16
 Box Spread
A combination of a bull call spread and a bear put spread, with the
same 2 strike prices, say K1 and K2, the latter being higher than the
former
The above means that you:
• Buy a call with lower strike price and sell a call with higher strike price
• Buy a put with higher strike price and sell a put with lower strike price
Presuming that all options are European, a box spread is worth the
present value of the difference between the strike prices, i.e. it is equal
to K2 – K1, regardless of the value of ST.
See Table 10.3 of the textbook for the working
The value of the box spread is therefore always the PV of this payoff:
(K2 – K1) e-rT
If it has a different value, there is an arbitrage opportunity
However, it needs reiteration that the above works only with European
options
17
 Butterfly spreads using calls
A butterfly spread involves 4 positions in options with 3 different strike
prices
Can be created
- by buying a call option with a relatively low strike price, K1 ,
- by buying a call option with a relatively high price, K3 , and
- by selling two call options with a strike price, K2 , half way between K1 and
K3
Generally, K2 is close to the current stock price
The pattern of profits is shown on the next slide.
The butterfly spread leads to a profit if the stock price stays close
to K2
The spread leads to a small loss if there is a significant deviation in either
side
Thus, it is a proper strategy for an investor who feels that large price moves
are unlikely
An exercise follows after the next slide

18
Butterfly Spread Using Calls
Profit

K1 K2 K3 ST

19
Butterfly Spread Using Calls - Exercise
Current stock price $ 61
Investor feels that significant price move is unlikely in the next 6
months
Market prices of 6 month calls are given in the following table
Investor creates a butterfly spread. Work out various
possibilities, when price on maturity is
1. Greater than 65
2. Less than 55
3. Between 56 & 64
At which price is the profit maximum?

Strike Price ($) Call Price ($)

55 10
60 07
65 05

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Butterfly Spread Using European Calls – Solution

Cost of creating spread: 10 + 5 – (7*2) = 1

Price in 6 months Terminal Payoff Profit incl. cost

Greater than $ 65 0 -1
Less than $ 55 0 -1
Between $56 & $64 Varying Profit
Max Profit at $ 60 5 +4

21
Butterfly spread using put options
Buy a put with a low strike price, buy another with a high strike
price, and sell two puts, with an intermediate strike price
It is illustrated in the next slide
In the exercise just completed, buy one put option with a strike
price of 55, buy another with a strike price of 65, and sell two
puts with a strike price of 60
All options being European, the use of the put options results in
the same spread (as seen in the next slide) as the use of the
call options (as seen earlier). See the red lines in both the
graphs.

22
Butterfly Spread Using Puts
Profit

K1 K2 K3 ST

23
Reverse strategy
You can also sell or short a butterfly spread
One option each is sold with strike prices of
K1 and K3, and 2 options with the middle
strike price K2 are purchased
This strategy produces a modest profit if
there is a significant movement in the stock
price (recollect that the butterfly spread leads
to a profit if the strike price stays close to K2
but gives rise to a small loss if there is a
significant price move in either direction)

24
Calendar Spreads
So far we have been dealing with options
having the same expiration dates but
different strike prices
In case of calendar spreads, the options have
the same strike price but different expiration
dates

25
 Calendar Spreads
USE EITHER CALL OR PUT OPTIONS FOR CALENDAR SPREADS
Either
Sell a shorter maturity call option with a certain strike price
and buy a longer maturity call option, with the same strike
price
Or
Sell a shorter maturity put option and buy a longer maturity
put option, with the same strike price
• The profit pattern when you use puts is similar to the one
using calls. See the next two slides.
• The investor makes a profit if the stock price at expiration of
the short maturity option is close to the strike price of the
short maturity option.
• It is being assumed here that the long maturity option is
being sold at the time when the short maturity option expires
• A reverse calendar spread is the opposite to what is
described above. The investor buys a short maturity option
and sells a long maturity option, at the same strike price

26
Calendar Spread Using Calls
You buy the longer maturity option and sell the shorter maturity one

Profit

ST
K

27
Calendar Spread Using Puts
You buy the longer maturity option and sell the shorter maturity one

Profit

ST
K

28
Diagonal Spreads
In a diagonal spread both the expiration
dates and the strike price of the calls are
different
This increases the range of profit patterns
which are possible

29
 Combinations
Combinations include:
Straddles
Strips
Straps
Strangles
A combination is an option trading strategy
which involves taking a position in both calls
and puts in the same stock

30
A Straddle Combination
This involves buying a call and a put with the same
strike price and same expiration date

Profit

K ST

31
 A Straddle
A popular combination
Buying a call as well as a put with the same strike price and
the same expiration date
Thus, you pay premium for both
If the stock price is close to this strike price at maturity, both
options are not exercised and the straddle leads to a loss
If the price moves significantly one way or the other, a
significant profit results
A straddle is appropriate when the investor is expecting a
large move in the stock price but does not know the direction
However, we must remember that market prices (of options,
as everything else) reflect the views of the participants. So,
the investor needs to consider whether or not the jump in
price that he anticipates is already reflected in the option
prices

32
A tall order?
To make money from any strategy, you
must take a view which is different from
the rest of the market, and you must be
right

33
Straddle – an example
The price of a stock is currently valued at $ 69
The investor anticipates a significant move in 3 months
He creates a straddle by buying both a call and a put at $
70, with expiration date of 3 months
The call costs $ 4 and the put $ 3
Thus, the upfront requirement is $ 7
If the stock moves to $ 70, the investor has a loss of $ 7
If the price moves to 90, the investor makes $ 13. How?
If the price moves to $ 60, the investor makes $ 3. How?
What happens if the price stays at 69?

34
The reverse position – risky indeed!
The graph that we saw 3 slides earlier is representation
of a bottom straddle or a straddle purchase
The reverse position is the top straddle or the straddle
write
The top straddle is created by selling both a call and a
put with the same exercise price and expiration date

If the strike price on expiration date is close to the

strike price, you make money

If a large move happens either way, the loss could be

big!

35
Strips and Straps
A strip consists of a long position in 1 call and 2 puts
with the same strike price and expiration date
Here, the investor is expecting a big stock price move
and thinks that a decrease is more likely
Thus the investor is bearish

A strap consists of a long position in 2 calls and 1 put

with the same strike price and expiration date
Here the investor thinks that an increase in price is
more likely
Here, the investor is bullish

Profit patterns are shown in the next slide

36
Strip & Strap
Profit Profit

K ST K ST

Strip Strap

37
Strangles: See Graphical Representation in the next slide

A similar strategy to a straddle

The investor here too is betting that there will be a
large price move and is uncertain as to the direction
The investor buys a put and a call with the same
expiration date but different strike prices, the call strike
price K2 , being higher than the put strike price, K1
Profit pattern is shown in the next slide.
As we see from there, the price has to move farther in
a strangle, than in a straddle, for the investor to make
a profit. However, the downside risk, if the stock price
ends up at a central value, is less with a strangle
The sale of a strangle, which is again a risky strategy, is
appropriate for an investor who is convinced that large
price moves are unlikely

38
A Strangle Combination
You buy a put and a call with the same expiration date but
different strike prices, the call strike price K2 , being higher than
the put strike price, K1

Profit

K1 K2
ST

39