Trading Strategies Involving Options

1. Trading Strategies Involving Options

2. 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.

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

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

5. Call options on a stock are available with strike prices of $15, $17.5, and $20 and expiration dates in three months. Their prices are $4, $2, and $0.5, respectively. Explain how the options can be used to create a butterfly spread. Construct a table showing how profit varies with stock price for the butterfly spread.

6. 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.

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

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

9. 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.

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

11. Problem • Consider an investor who feels that the price of a certain stock, currently, valued at $69 by the market, will move significantly in the next three months. The investor could create a straddle by buying a put and a call with a strike price of $70 and an expiration date in three months. Suppose that the call costs $4 and the put costs $3. What is the pattern of profit from the straddle?

12. Combinations • Similarly, a top straddle 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.

13. 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.

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

15. 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.

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

17. Payoff from a straddle • A call with a strike price of $60 costs $6. A put with the same strike price and expiration date costs $4. Construct a table that shows the profit from a straddle. For what range of stock prices would the straddle lead to a loss?

18. Three put options on a stock have the same expiration date and strike prices of $55, $60, and $65. The market prices are $3, $5, and $8, respectively. Explain how a butterfly spread can be created. Construct a table showing the profit from the strategy. For what range of stock prices would the butterfly spread lead to a loss?