Different Strategies involving two or more options of same type (Spread)

1. Different Strategies involving two or more options of same type (Spread) • Bull Spread: It can created 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. • This strategy limits the investor’s upside and downside potential. It has chosen to give up upside potential by selling a call option with higher strike price. • Three different types of bull spread: Both calls are initially out of the money, one call is initially in the money, the other call is initially out of the money, and Both calls are initially in the money.

2. Bull Spread Using Calls • Figure 9.2 (p.219) Profit X1 X2 ST

3. Bull Spread Using Put Options • Bull spread can also be created by buying a put option with a low strike price and selling a put with a high strike price. • Unlike bull spread created from call, bull spread created from puts involve a positive cash flow to the investor up front. • Investor has chosen to give up upside potential by getting the price of the put option with higher strike price.

4. Figure 9.3 (p.221) Profit X1 X2 ST Bull Spread Using Puts

5. Problem • An investor buys for $3 a call with a strike price of $30 and sells for $1 a call with a strike price of $35. Calculate the payoff from this bull strategy under the following scenarios: • Stock price (S)  $ 30 • $ 30 < Stock price (S) < $ 35 • Stock price  $ 35

6. Bear Spread • In bear spread, strike price of the option purchased is greater than the strike price of option sold. • Bear spread can be created using either call or put option. • Like bull spread, bear spread also limits both the upside profit potential and downside risk.

7. Figure 9.4 (p.221) Profit X1 X2 ST Bear Spread Using Calls

8. Figure 9.5 (p. 223) Profit X1 X2 ST Bear Spread Using Puts

9. Butterfly Spread • A butterfly spread involves positions in options with three different strike prices. It can be created by buying two options with low and high strike prices and selling two options with a strike price halfway between low and high strike prices. • It leads to a small profit if futures price stay close to selling strike price but makes small loss if there is a significant futures price move in either direction.

10. Figure 9.7 (p.225) Profit X1 X2 X3 ST Butterfly Spread Using Puts

11. Figure 9.6 (p.223) Profit X1 X2 X3 ST Butterfly Spread Using Calls

12. Butterfly Spread Example • An investor feels that futures prices will not move significantly in next three months and decides to set up a butterfly spread. • Call options on May soybean are quoted as: • Strike price = $ 4.55/bu, premium: $ 0.45/bu • Strike price = $ 4.8/bu, premium: $ 0.28/bu • Strike price = $ 5.05/bu, premium: $ 0.18/bu • The investor buys one call with a $ 4.55/bu strike price, buys one call with $ 5.05/bu strike price and sells two call with $ 4.80/bu strike price.

13. Example • Soybean price (P)  $ 5.05 • payoff (low buy) : P- $4.55-$0.45, payoff (high buy): P - $ 5.05 - $ 0.18, payoff (sell): 2*($ 4.80-P+ $ 0.28) • $ 4.55<Soybean price (P)< $ 5.05 • payoff (low buy) : P- $4.55-$0.45, payoff (high buy): - $ 0.18, payoff (sell): 2* $0.28 or 2*($4.80-P+ $ 0.28) • Soybean price (P)  4.55 • payoff (low buy) : -$0.45, payoff (high buy): - $ 0.18, payoff (sell): 2*($ 0.28)

14. Calendar Spread • A calendar spread can be created by selling a call option with a certain strike price and buying a longer maturity call option with the same strike price.

15. Figure 9.8 (p. 225) Profit ST X Calendar Spread Using Calls

16. Calendar Spread Using Puts • Figure 9.9 (p.226) Profit ST X

17. Combinations • A combination is a strategy that involves taking a position in both calls and puts on the same stock. • There are different types of combinations • Straddle: Can be created by buying both a put and a call with a strike price close to current selling price. A straddle is appropriate strategy if the investor is expecting a large move in a stock price in either direction. This is also called as a bottom straddle or straddle purchase.

18. Figure 9.10 (p.227) Profit X ST A Straddle Combination

19. Combinations • Similarly, a top straddle or straddle write can be created by selling a call and a put with the same exercise price and expiration date. • This strategy results in profit If the stock price on the expiration date is close to the strike price. • A large move in either direction results in significant loss.

20. Combinations • Strip: A strip strategy includes a long position in one call and two puts with the same strike price and expiration date. • In a strip, investor believes that there is more likelihood of price to decrease than increase. • Strap: A strap includes a long position in two calls and one put with same strike price and expiration date. • Investor is betting a increase in the stock price more likely than a decrease.

21. Strip & Strap • Figure 9.11 (p. 229) Profit Profit X ST X ST Strip Strap

22. Combinations • Strangles: Includes a long in call and put with the same expiration date and different strike price. • This is similar to strangle strategy. The use of two different strike price reduces the downward risks.

23. Figure 9.12 (p. 229) Profit X1 X2 ST A Strangle Combination

24. USDA Publication Calendar • Web Address: http://www.usda.gov/nass/pubs/rptscal.htm • March 7, 2000: Weekly Weather and Crop Bulletin • March 10, 2000: Crop Production