Fin4328 (Moore)
Trading Strategies with Options
Summer 2006
Trading Strategies Involving Options
Four Basic Option Positions (Basis of Chapters)
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Fin4328 (Moore)
Trading Strategies with Options
Summer 2006
Payoff Streams we will be working with to create other payoff
profiles (trading strategies)
Long Call
Long Put
Long Straddle
Short Call
Short Put
Short Straddle
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Fin4328 (Moore)
Trading Strategies with Options
Summer 2006
Trading Strategies Involving Options
A.
Review of Profit Diagrams
1. Assumptions
 Profit is defines as: ending value – beginning value
 Time value is not considered (although it is simple to
modify the diagrams for time value)
 Transaction costs not included (although they can be)
 Profit diagrams generally assume European options
held to maturity
 A pricing model is needed to construct profit diagrams
for positions closed prior to maturity
2. Adding Functions Using Graphs (Basic Technique)
EXAMPLE 1
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Fin4328 (Moore)
Trading Strategies with Options
Summer 2006
Example 2 (fixed negative payoff)
Example 3: Fixed payouts and Increasing Function
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Fin4328 (Moore)
Trading Strategies with Options
Summer 2006
B. Combining A Single Option With the Underlying Stock
Long Stock and Short Call
(Writing Covered Call)
minimizes downside risk
on stock
Long Call and Short Stock
(Reversed Covered call)
Long Stock and Short Put
(Protective Put)
Short Stock and Short Put
(Reversed Protective Put)
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Fin4328 (Moore)
Trading Strategies with Options
Summer 2006
Example: Rio Tinto – Current Stock Price = $32.40 per share
Call or Put
Call Options
Put Options
Price (C or P)
C = 3.20
C = 0.99
C = 0.61
Strike Price
X = 30.00
X = 34.00
X = 35.50
Maturity
29 Nov
29 Nov
29 Nov
C = 3.52
C = 1.48
C = 1.04
X = 30.00
X = 34.00
X = 35.50
20 Dec
20 Dec
20 Dec
P = 0.63
P = 2.50
P = 3.60
X = 30.00
X = 34.00
X = 35.50
29 Nov
29 Nov
29 Nov
P = 0.87
P = 2.80
P = 3.83
X = 30.00
X = 34.00
X = 35.50
20 Dec
20 Dec
20 Dec
Covered Call Using the 20 Dec. Call option with Strike = $34
(Long Stock and Short Call)
Stock Price
Range
ST  X
S T  $34
Profit
Payoff From
Long Stock
ST
ST - S0
S T – $32.40
Payoff From
Short Call
X - ST
$34 - S T
X + C0 - ST
34 + 1.48 - S T
ST  X
S T  $34
Profit
ST
$0
ST - S0
S T – $32.40
<0
C0
$1.48
Breakeven Price is $30.92
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Total Payoff
X
$34
X + C0 - S0
35.48 - 32.40
= 3.08
ST
ST - S0 + C0
S T - 30.92
Fin4328 (Moore)
Trading Strategies with Options
Summer 2006
C. Spreads – Options of same type with different X (Strike) or T
(Assume 2 calls with same maturity, X1 < X2 )
1. Bull Call Spread - Buy C(X1) , Sell C(X2) where X1 < X2
 Has initial Cash Flow (CF), profits from increase in price
 Calls may initially be: 1) in-the-money; 2) out-of-themoney; or 3) 1 in and 1 out (both out is riskiest, highest
potential returns)
 Can also be constructed with puts (Buy P(X2) , Sell P(X1))
 Put Spreads have + initial CF, But lower payoffs
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Fin4328 (Moore)
Trading Strategies with Options
Summer 2006
2. Bear Call Spread - Buy C(X2) , Sell C(X1)
 Opposite of Bull Spread (mirror image)
 Can be constructed with puts (Sell P(X2) , Buy P(X1))
Bear call Spread
Bear Put Spread
3. Butterfly Spreads
 3 Different Strike Calls (or Puts): X1 < X2 < X3
 Buy C(X1), Buy C(X3), Sell 2 C(X2)
 Butterfly spreads can also be reversed
 Transaction costs can be large (4 Options total)
 For European Options, exactly the same profits will be
obtained by using puts instead of calls
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Fin4328 (Moore)
Trading Strategies with Options
Summer 2006
4. Calendar (Time) Spreads
 Use two different maturities (Same Strike): T1 < T2
 Buy Long Maturity, Sell Short Maturity
 Profit is defined at maturity of short maturity option
 Diagram is not linear since the profit depends on the
market value of the long maturity call
 Profit at maturity of short maturity option (T1) is positive
if the stock price is near the strike price
 A Loss results if the stock price is substantially above or
below the strike at time T1
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Fin4328 (Moore)
D.
Trading Strategies with Options
Summer 2006
COMBINATIONS of CALLS AND PUTS
1. Bottom Straddle – Buy Call, Buy Put (Same Strike, T)
 Profits from a large increase or decrease
 Note: High Volatility means cost of both options will be
high, and large price changes may be needed for profits
Bottom Straddle
2. Top Straddle – Sell Call, Sell Put (Same Strike, T)
 Opposite (Reverse) of Bottom Straddle
3. Strip – Buy 1 Call, Buy 2 Puts (Same Strike, T)
 Greater profit from a large decline than a large increase
(Strip)
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Fin4328 (Moore)
Trading Strategies with Options
Summer 2006
4. Strap - Buy 2 Calls, Buy 1 Put (Same Strike, T)
 Greater Profit from a large increase than a large decline
5. Strangle – Buy Call with lower X1 , Buy Put with Higher X2
 Similar to a Bottom Straddle (with a flat bottom)
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