1

Trading Strategies Involving Options

• Strategies involving a single option and a stock

• Spread Strategies

• This involves taking position in two or more calls OR puts

[Except for Box Spread Strategy]

• Combination Strategies

• This involves taking position in both calls and puts

2

Trading Strategies Involving Options

Strategies involving a single option and a stock (Figure 11.1, page 262)

Profit

STK

Profit

ST

K

Profit

ST

K

Profit

STK

Synthetic Short Put Synthetic Long Put

Synthetic Long Call Synthetic Short Call

(a) (b)

(c) (d)

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Theory

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Profit

STK

So this strategy is named as ‘Writing a Covered Call’.

Long

Stock

Short

Call

1. You are shorting a call in the expectation that the market price of the underlying

(price) will fall, and the call will be out of money.

2. To cover the down side generating due to short call, you may simultaneously

go long on stock.

Though this does not eliminate loss in case of fall in price, loss is reduced by the

premium earned. It results into the pay offs pattern of ‘short put’, where the

potential loss due to increase in stock price gets covered.

(a) Synthetic Short Put Risk: Price may increase.

Profit

STK

Short

Stock

Short

Put

Thus, this strategy aims at covering short put.

1. You are shorting a put in the expectation that the price will increase, and the

put will be out of money.

2. To cover the down side generating due to short put, you may simultaneously

short on stock.

This results into the pay offs pattern of ‘short call’, where the potential loss due to

decrease in stock price gets covered.

(d) Synthetic Short Call Risk: Price may decrease.

Profit

ST

K

Long

Call

Short

Stock

Thus, this strategy aims at covering short position in stock.

1. You are shorting a stock in the expectation that the price will fall.

2. To cover the down side generating due to short stock, you may go long on call.

This results into the pay offs pattern of ‘’long put’, where the potential loss due to

increase in stock price gets covered.

(b) Synthetic Long Put Risk: Price may increase.

Profit

ST

K

Long

StockLong

Put

So this strategy is named as ‘Protective put’ that covers downside of stock.

1. You are going long on stock in the expectation that the price will increase.

2. To cover the down side generating due to long stock, you may go long on put.

This results into the pay offs pattern of ‘long call’, where the potential loss due to

decrease in stock price gets covered.

(c) Synthetic Long Call Risk: Price may decrease.

Spread Strategies

A ‘Spread Trading Strategy’ involves taking

positions in either two or more call options or

put options. For example _

• Bull Spread (created with calls)

• Bull Spread (created with puts)

• Bear Spread (created with calls)

• Bear Spread (created with puts)

• Butterfly Spread (created with calls)

• Butterfly Spread (created with puts)

• Calendar Spread (created with calls)

• Calendar Spread (created with puts)

• Box Spread (created with calls + puts)

Bull Spread Using Calls(Figure 11.2, page 263)

K1 K2

Profit

ST

This involves _

1. Going long on a call at a lower strike equal to K1.

2. Going short on a call at a higher strike equal to K2.

The resultant pay offs shield losses, of course along with profits, in the

events of extreme price movements. If the ‘bull expectation’ comes true,

there will be range bound profits.

Hope: Stock price will increase

Bull Spread Using PutsFigure 11.3, page 264

K1 K2

Profit

ST

This involves _

1. Going long on a put at a lower strike equal to K1.

2. Going short on a put at a higher strike equal to K2.

The resultant pay offs shield losses, of course along with profits, in the

events of extreme price movements. If the ‘bull expectation’ comes true,

there will be range bound profits.

Hope: Stock price will increase

Bear Spread Using PutsFigure 11.4, page 265

K1 K2

Profit

ST

This involves _

1. Going long on a put at a higher strike equal to K2.

2. Going short on a put at a lower strike equal to K1.

The resultant pay offs shield losses, of course along with profits, in the

events of extreme price movements. If the ‘bear expectation’ comes true,

there will be range bound profits.

Hope: Stock price will decrease

Bear Spread Using CallsFigure 12.5, page 266

K1 K2

Profit

ST

Hope: Stock price will decrease.

This involves _

1. Going long on a call at a higher strike equal to K2.

2. Going short on a call at a lower strike equal to K1.

The resultant pay offs shield losses, of course along with profits, in the

events f extreme price movements. If the ‘bear expectation’ comes true,

there will be range bound profits.

Butterfly Spread Using CallsFigure 11.6, page 267

K1 K3

Profit

STK2

Hope: Stock price will be range bound.

This involves _

1. Going long on a call at a lower strike equal to K1,

and also long on another call at a higher strike equal to K3.

The resultant pay offs assure profits when the movement in stock price remains

range bound. However, if the price moves more than that, it results into some loss.

2. Going short on two calls at a strike equal to K2, which should be near to So.

Butterfly Spread Using PutsFigure 11.7, page 268

K1 K3

Profit

STK2

Hope: Stock price will be range bound.

This involves _

1. Going long on a put at a lower strike equal to K1,

and also long on another put at a higher strike equal to K3.

The resultant pay offs assure profits when the movement in stock price remains

range bound. However, if the price moves more than that, it results into some loss.

2. Going short on two puts at a strike equal to K2, which should be near to So.

Calendar Spread Using CallsFigure 11.8, page 270

Profit

ST

K

This involves _

1. Going short on a call at a certain strike, say equal to K.

The resultant pay offs assure profits when the movement in stock price remains

range bound. However, if the price moves more than that, it results into some loss.

2. And going long on another call with the same strike K but with longer

maturity period.

Hope: Stock price will be range bound.

Calendar Spread Using PutsFigure 11.9, page 271

Profit

ST

K

This involves _

1. Going short on a put at a certain strike, say equal to K.

The resultant pay offs assure profits when the movement in stock price remains

range bound. However, if the price moves more than that, it results into some loss.

2. And going long on another put with the same strike K but with longer

maturity period.

Hope: Stock price will be range bound.

Diagonal Spreads

As seen earlier, a Calendar Spread is based on same

strike but different maturities.

However, along with different maturities, if the strikes

are also different, than the range of profit can be

increased. Such a strategy is called Diagonal Spread.

Box Spread

K1 K2

Position Value

ST

This involves _

1. Creating Bull Spread by going long on a call at a lower strike equal to K1,

and short on a call at a higher strike equal to K2.

The resultant position pay offs (NOT NET PAYOFFS) are always equal to

K2 – K1. So if the current values of call and put for the strikes of K2 and K1 are

different than the present value of the box (k2 – k1), then arbitrage profits can be

earned by either buying or selling a box depending on the price differentials.

Purpose: Profiting from arbitrage

2. Creating Bear Spread by going long on a put at a higher strike

equal to K2, and short on a put at a lower strike equal to K1.

This gap gives profit equal to K2 – K1.

[At present, due to scaling differences, the gap

does not seem to be equal to K2 – K1. ]

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Box Spread Elaborated

• It is a combination of a ‘bull call spread’ and a ‘bear put spread’.

• If the options with which the box spread is created are

European, the resultant box spread is worth the present value

of the difference between the strike prices K2 – K1. If it is not so,

then it may be interpreted as ‘arbitrage opportunity’.

• However, if they are American options, the profit may not

necessarily be so (see Business Snapshot 11.1).

Combinations Strategies

A ‘combination Strategy’ involves taking

positions in both call options and put options.

For example _

• Straddle (created with long call and put with same

strike price and maturity)

• Strips (created with long one call and two puts

with same strike price and maturity)

• Straps (created with long two calls and one put

with same strike price and maturity)

• Strangles (created with long one call and one put

with different strike prices but same maturity)

Straddle Figure 11.10, page 271

Profit

STK

This involves _

1. Going long on a call at a certain strike, say equal to K1.

The resultant pay offs, which are opposite to butterfly spreads, assure profits when the

stock price witnesses large movements. However, if the price remains range bound,

than it results into some loss.

2. And going long on a put with the same strike K1 with same maturity period.

Hope: Stock price will move sharply.

Strip & Strap Figure 11.11, page 273

Profit

K ST

Profit

K

ST

Strip StrapA Strip involves _

Going long on one call and two puts with

same strike and maturity. This is very

similar to Straddle except that here two

puts are bought. So Strap gives more

profit than Straddle if the price decreases.

A Strap involves _

Going long on two calls and one put with

same strike and maturity. This is very

similar to Straddle except that here two

calls are bought. So Strap gives more

profit than Straddle if the price increases.

Hope: Stock price will move sharply,

with downside more likely..

Hope: Stock price will move sharply,

with upside more likely..

Strangle Figure 11.12, page 274

K1 K2

Profit

ST

This involves _

1. Going long on a call at a higher strike, say equal to K2.

The resultant pay offs assure profits when the stock price witnesses large movements.

However, if the price remains range bound, than it results into some loss. It is very

similar to Straddle with the following differences.

Differences: Favourable:- Loss bottom is reduced.

Unfavourable:- Loss zone is expanded.

2. And going long on a put with a lower strike K1 with same maturity period.

Hope: Stock price will move sharply.

Other Payoff Patterns

• When the strike prices are close together a butterfly

spread provides a payoff consisting of a small

“spike”.

• If options with all strike prices were available any

payoff pattern could (at least approximately) be

created by combining the spikes obtained from

different butterfly spreads.