Basic Option Strategies

1
FINA 6220Professor Andrew Chen

• Basic Option Strategies
• Lecture Note 2

2
Outline

• Some Preliminary Issues
• Strategies involving a single type of option
• Strategies involving combinations of options

AC 22
3
Preliminary Issues

• Discussion over the following option prices
• S(t) 100
• r 5
• s 25
• Standstill return
• Margin requirements and trading costs of
  strategies
• Profit vs. Payoff

AC 23
4
Buying a Call Option

• Buying a call (Long position in 1 month 100
  strike price call option)
• Initial Cost
• Maximum Profit
• Maximum Loss
• Breakeven Price
• Standstill Return
• Market Outlook
• Risk Posture

C 3.085
Unlimited if price rises
-C -3.085, if price at expiration is below K
K C 103.085
Loss of the options time value, -C max(S-K,0)
-3.085 max(100-100,0) -3.085
Bullish
Defensive
AC 24
5
Buying a Call Option
AC 25
6
Buying a Put Option

• Buying a put (Long position in 1 month 100 strike
  price put option)
• Initial Cost
• Maximum Profit
• Maximum Loss
• Breakeven Price
• Standstill Return
• Market Outlook
• Risk Posture

P 2.669
K P 97.331, if the underlying asset falls to
zero
-P -2.669. if the price at expiration is above K
K P 97.331
Loss of the options time value, -P max(K-S,0)
-2.669 max(100-100,0) -2.669
Bearish
Defensive
AC 26
7
Buying a Put Option
AC 27
8
Married/Protective Puts

• Married Puts
• Protective Puts
• Profit at expiration

Profit max(K,S(T)) (SP)
AC 28
9
Married/Protective Puts

• Long Position in the stock and a long position in
  the 1 month 100 strike price of put option.
• Initial Cost
• Maximum Profit
• Maximum Loss
• Breakeven Price
• Standstill Return
• Market Outlook
• Risk Posture

S P 102.669
Unlimited, if the stock price rises
K (SP) -2.669, if the underlying asset falls
below K
S P 102.669
Loss of the options initial time value
-P-max(K-S,0) -2.669
Bullish
Defensive
AC 29
10
Married/Protective Puts
AC 210
11
Covered Call

• Buy Write Strategy
• Profit at expiration

Profit max(K,S(T)) (S-C)
AC 211
12
Covered Call

• Long Position in the stock and a short position
  in the 1 month 100 strike price of call option.
• Initial Cost
• Maximum Profit
• Maximum Loss
• Breakeven Price
• Standstill Return
• Market Outlook
• Risk Posture

S C 96.915
K (SC) 3.085, if the call finishes
in-the-money
-(S-C) -96.915, if the asset price falls below
zero
S C 96.915
Gain of the options options initial time value
C-max(S-K,0) 3.085
Neutral to mildly bullish
Defensive
AC 212
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Covered Call (Buy-Write)
AC 213
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More on Call Writing Strategies

• Naked Call Writing
• Covered Call Writing (1/1) Long 1S and short 1C
• Ratio Call Writing (2/1) Long 1S and short 2C
• Variable Ratio Write Long 1S and short CL and CH

AC 214
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Covered Call Writing (1/1 Ratio)
(Long 1S and short 1C)
S0 70
C70 4
C75 2
AC 215
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Covered Call Writing (1/1 Ratio)
AC 216
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Ratio Covered Call Writing (2/1 Ratio)
1 Stock
- 1 Put
(Short Straddle)
- 2 Calls
- 1 Call
AC 217
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Ratio Covered Call Writing (2/1 Ratio)
S0 70
C70 4
C75 2
AC 218
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Ratio Covered Call Writing (2/1 Ratio)
AC 219
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Variable Ratio Covered Call (C70/C75)
S0 70
C70 4
C75 2
1 Stock
- 1C70
- 1C75
AC 220
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Variable Ratio Covered Call (C70/C75)
AC 221
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Follow-Up Actions In Option Strategies

• Roll Down (Writing Covered Call)

t 0
t 1
S0 51
S1 45
C50 6
C45 4
C50 1
(No Action)
(Roll-Down)
AC 222
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Roll Down (Writing Covered Call)
AC 223
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Roll-Up (Ratio Covered Write)

• Long One stock Short two calls

t 0
t 1
S0 70
S1 75
C70 3.5
C70 6
C75 3.5
(No Action)
(Roll-Up)
AC 224
25
Roll-Up (Ratio Covered Write)
AC 225
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Strategies Involving Combinations of Options

• Options Spreads
• Bull and Bear Spreads with Calls
• Bull and Bear Spreads with Puts
• Ratio Spreads
• Call Ratio Spread
• Put Ratio Spread
• Ratio Backspreads
• Straddle
• Strangle
• Butterfly Spread
• Zero-Cost Collar Strategy

AC 226
27
Bull Call Spread

• Buy a Call CL(KL95) and write another call
  CH(KH105) with the same expiration date but a
  higher strike price.
• CL 6.286 CH 1.208
• Strategy Profit

-(CL CH) -5.078
for S(T)95
S(T) 95 (CL-CH) S(T) 100.078
for 95S(T)lt105
105 95 (CL CH) 4.922
for S(T)105
AC 227
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Bull Call Spread
AC 228
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Bull Put Spread

• Write a High Strike Put PH(KH105) and buy a
  lower strike price put PL(KL95) with the same
  expiration date.
• PL 0.891 PH 5.771
• Strategy Profit

95 105 - (PL PH) -5.12
for S(T)95
S(T) 105 (PL-PH) S(T) 100.12
for 95S(T)lt105
(PL PH) 4.88
for S(T)105
AC 229
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Bull Put Spread
AC 230
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Bull Put Spread
AC 231
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Call Ratio Spread

• Call Bull Spread Call Ratio Spread

AC 232
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Put Ratio Spread

• Bear Put Spread Put Ratio Spread

AC 233
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Buying a Straddle

• Combination of a call and a put having the same
  expiration date and written on the same stock
• C 3.085 P 2.669
• Strategy Profit

100 S(T) (C P) 94.246 S(T)
for S(T)lt100
-(C P) -5.754
for S(T)100
S(T) 100 (C P) S(T) 105.754
for S(T)gt100
AC 234
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Buying a Straddle
AC 235
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Buying a Straddle

• Buy a Strapt 1P 2C
• Buy a Stript 2P 1C

AC 236
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Selling a Straddle

• Write a 1 month 100 strike price call and put
• Strategy Profit

for S(T)lt100
S(T) - 100 (C P) S(T) - 94.246
for S(T)100
(C P) 5.754
100 - S(T) (C P) 105.754 - S(T)
for S(T)gt100
AC 237
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Selling a Straddle
AC 238
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Buying a Strangle

• Like a straddle, but KC is above KP, and both
  options are out-of-the-money at the outset.
• C105 1.208 P95 0.891
• Strategy Profit

95 S(T) (C P) 92.901 S(T)
for S(T)lt95
-(C P) -2.099
for 95S(T)lt105
S(T) 105 (CP) S(T) 107.099
for S(T)105
AC 239
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Buying a Strangle
AC 240
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Selling a Strangle

• Similar to selling a straddle, but the KC is
  above the KP, and both options are
  out-of-the-money at the outset.
• Strategy Profit

S(T) 95 (C P) S(T) - 92.901
for S(T)lt95
(C P) 2.099
for 95S(T)lt105
105 - S(T) (CP) 107.099 S(T)
for S(T)105
AC 241
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Selling a Strangle
AC 242
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Butterfly Spreads with calls or puts

• Three calls or three puts with different strike
  prices and the same expiration.
• Call-butterfly-spread position
• Long CL and CH
• Short 2CM
• Put-butterfly-spread position
• Long PL and PH
• Short 2PM

AC 243
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Call Butterfly Spread

• Example of call butterfly spread
• CL(KL95)6.286, CM(KM100)3.085, and
  CH(KH105)1.208

AC 244
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Call Butterfly Spread

• Strategy Profit

2CM - (CL CH) -1.324
for S(T)lt95
S(T)952CM(CLCH)S(T) 96.324
for 95S(T)lt100
105-S(T)2CM-(CLCH)103.676-S(T)
for 100S(T)lt105
2CM (CL CH) -1.324
for S(T)105
AC 245
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Call Butterfly Spread
AC 246
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Zero-Cost Collar Strategy

• Goal
• Strategy

To protect profits on 100 shares of IBM stock
bought earlier at 60, and currently at 84.
Sell one April call with strike price of 90 for
200, and buy one April put with strike price of
75 at a cost of 100.
AC 247
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Zero-Cost Collar Strategy
AC 248
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Zero-Cost Collar Strategy
AC 249
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Box Spread Risk Free Lending or Borrowing

• 1. Rf 5 semi-annual Rf 2.5
• 2. 6-month options
• 3. Long Box Spread

Call July
Put July
AMC
K
50.625
45
7.75
1.875
50.625
55
2.875
6.875
10
4.875
5.00
9.875

t0
tT
-9.875
10.0
10
RRR (Rate of Return)
-1
1.27
9.875
Therefore, Short Box-Spread
AC 250