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Trading Strategies using Options on Derivatives

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TopicsIntroduction

Strategies for a single option and a stock Covered call

Spreads and spread trading Bull call spread

Combinations Long Straddle Strangle Short Straddle

Other strategies Box spread Calendar spread Diagonal spread Butterfly spread

Conclusion

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IntroductionFactors affecting the option price

Current stock price S0

Strike price K Time to expiration T Volatility of the stock σ Risk-free interest rate r Dividend expected before the option expiration

Options can be combined to create a range of payoffs - looking at holding a ‘portfolio’ vs. a single stock or option

For simplicity, we will ignore the time value of money – thus the profit for any strategy will be the final payoff – initial cost

Including transaction costs will not change the strategy being discussed. It is not included in the examples shown.

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Single Option and a Stock

Covered Call: Long in the stock S and short in the Call•The covered call strategy works for the stocks for

which one does not expect a lot of upside or downside

•This strategy decreases risk but also the profit potential

•It is considered a conservative strategyConsider the following example of ABC Company

Stock price S0 = 63 Strike price K = 67 Time to expiration T = 3 mo (Sep 09) Call premium c = 1 (currently out-of-the money)

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Single Option and a StockStock Price @ Expirati

on Long Stock Short Call Portfolio

55 -800 100 -700

56 -700 100 -600

57 -600 100 -500

58 -500 100 -400

59 -400 100 -300

60 -300 100 -200

61 -200 100 -100

62 -100 100 0

63 0 100 100

64 100 100 200

65 200 100 300

66 300 100 400

67 400 100 500

68 500 0 500

69 600 -100 500

70 700 -200 500

71 800 -300 500

72 900 -400 500

73 1000 -500 500

74 1100 -600 500

75 1200 -700 500

-1000

-500

0

500

1000

1500

55 57 59 61 63 65 67 69 71 73 75

Long S Short C Port

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Single Option and a StockStock Price @ Expirati

on Long Stock Short Call Portfolio

55 -800 100 -700

56 -700 100 -600

57 -600 100 -500

58 -500 100 -400

59 -400 100 -300

60 -300 100 -200

61 -200 100 -100

62 -100 100 0

63 0 100 100

64 100 100 200

65 200 100 300

66 300 100 400

67 400 100 500

68 500 0 500

69 600 -100 500

70 700 -200 500

71 800 -300 500

72 900 -400 500

73 1000 -500 500

74 1100 -600 500

75 1200 -700 500

Long Stock• Investor owns 100 share at Rs.63. So for any

change in price above Rs.63 there is a profit and for any change in price below Rs.63 there is a loss incurred

Short Call (investor has sold a call option)• Investor has received the premium of Rs.1 per

share for 100 shares • The option will be exercised by the holder only

if the ST is above K or else it will expire unused• When exercised the investor will lose the

difference in the ST and K but will always have the initial premium collected

• If ST = 70 then investor has to sell the shares at 67 and incur a loss: (67-70)*100 + 100 = -200

Portfolio• Sum of the two positions

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Spreads & Spread Trading

Spread trading involves taking a position in two or more options at the same time

Bull spread: When the investor expects the stock price to increase – buy a call option with a strike price and sell a call option on the same stock with a higher strike price. Both options have the same expiration date

Bear spread: When the investor expects the stock price to decrease – buy a put option with a strike price and sell a put option on the same stock with a lower strike price. Both options have the same expiration date.

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Spreads & Spread Trading

Consider the following example of ABC Company Stock price S0 = 63

Strike price K = 67 Call premium (K=67) c = 1 (currently out-of–the

money) Strike price K = 70 Call premium (K=70) c’ = 0.75(out-of-the money and lower

premium)

Time to expiration T = 3 mo (Sep 09)

For a bull call spread go long in the K=67 call option and short in the K=70 call option

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Spreads & Spread TradingStock

Price @ Expirati

onLong C

(lower K)Short C

(Higher K) Portfolio

55 -100 75 -2556 -100 75 -25

57 -100 75 -2558 -100 75 -25

59 -100 75 -25

60 -100 75 -2561 -100 75 -25

62 -100 75 -2563 -100 75 -25

64 -100 75 -2565 -100 75 -25

66 -100 75 -25

67 -100 75 -2568 0 75 75

69 100 75 17570 200 75 275

71 300 -25 275

72 400 -125 27573 500 -225 275

74 600 -325 27575 700 -425 275

-2000

-1500

-1000

-500

0

500

1000

1500

2000

Long C Short C Port

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Spreads & Spread TradingStock

Price @ Expirati

onLong C

(lower K)Short C

(Higher K) Portfolio

55 -100 75 -2556 -100 75 -25

57 -100 75 -2558 -100 75 -25

59 -100 75 -25

60 -100 75 -2561 -100 75 -25

62 -100 75 -2563 -100 75 -25

64 -100 75 -2565 -100 75 -25

66 -100 75 -25

67 -100 75 -2568 0 75 75

69 100 75 17570 200 75 275

71 300 -25 275

72 400 -125 27573 500 -225 275

74 600 -325 27575 700 -425 275

Long Call (Lower K)

• The call option will be exercised only if the ST is > K (67). However, a premium of Rs.100 has been paid for the option

• At ST = 68 the investor makes no profit or loss

Short Call (Higher K)• Investor has received the premium of Rs.0.75

per share for 100 shares = Rs.75 • The option will be exercised by the holder only

if the ST is above K (70) or else expire unused

• When exercised the investor will lose the difference in the ST and K but will always have the initial premium collected

Portfolio• Sum of the two positions This is a limited-risk limited-profit strategyThe portfolio profit is capped at the difference in

the strike price less the difference in the premium

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Combinations

Combination involves taking a position in both a call and put on the underlying stock at the same time. Traders and investors are ‘betting’ on the volatility of the stock price

Long Straddle: Buy a call and put option with the same strike price and expiration date. Close to at-the-money options work best. The premium on these options could be high.

Strangle: Buy an out-of the-money call and put option with different strike prices to reduce the cost. This is a low cost trade needing a high volatility to be profitable

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CombinationsShort Straddle: Short a call and a put on the same stock with the same strike price and expiration date. Investors and traders are expecting volatility and the stock to trade in a range. Unexpectedly if the stock declines rapidly, the risk is high. Barings Bank fiasco.

Consider the following example of ABC Company Stock price S0 = 63

Strike price K = 67 Call premium (K=67) c = 1 (currently out-of–the

money) Put premium (K=67)p = 4 (currently in-the money) Time to expiration T = 3 mo (Sep 09)

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Combinations – Long StraddleStock Price @ Expirati

on Long Call Long Put Portfoio

55 -100 800 700

56 -100 700 600

57 -100 600 500

58 -100 500 400

59 -100 400 300

60 -100 300 200

61 -100 200 100

62 -100 100 0

63 -100 0 -100

64 -100 -100 -200

65 -100 -200 -300

66 -100 -300 -400

67 -100 -400 -500

68 0 -400 -400

69 100 -400 -300

70 200 -400 -200

71 300 -400 -100

72 400 -400 0

73 500 -400 100

74 600 -400 200

75 700 -400 300

-1000

-500

0

500

1000

1500

2000

Long C Long P Port

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Combinations – Long StraddleStock Price @ Expirati

on Long Call Long Put Portfoio

55 -100 800 700

56 -100 700 600

57 -100 600 500

58 -100 500 400

59 -100 400 300

60 -100 300 200

61 -100 200 100

62 -100 100 0

63 -100 0 -100

64 -100 -100 -200

65 -100 -200 -300

66 -100 -300 -400

67 -100 -400 -500

68 0 -400 -400

69 100 -400 -300

70 200 -400 -200

71 300 -400 -100

72 400 -400 0

73 500 -400 100

74 600 -400 200

75 700 -400 300

Long Call

• The call option will be exercised only if the ST is > K (67). However a premium of Rs.100 has been paid for the option

• At ST = 68 investor make no profit or loss

Long Put• The put option will be exercised if the stock

price ST is < K (67). A premium of Rs.400 has been paid for the in-the money put

• When exercised the investor will gain the difference in the ST and K but reduced by the premium paid

• For ST between 63 and 67 the investor loses some portion of the premium paid and for ST > 67 the investor loses the entire premium

Portfolio• Sum of the two positions

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Combinations – Strangle

The idea in a Strangle is to profit on the volatility of the stock movement but also reduce the cost. As such the volatility has to be significant to realize a profit.

Consider the following example of ABC Company Stock price S0 = 63Strike price (call) Kc = 67Call premium (K=67) c = 1 (currently out-of-money)Strike price (put) Kp = 61Put premium (K=61)p = 0.25 (currently out-of-money)Time to expiration T = 3 mo (Sep 09)

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Combinations – StrangleStock Price @ Expirati

on Long C Long Put Portfolio

55 -100 575 47556 -100 475 375

57 -100 375 27558 -100 275 175

59 -100 175 75

60 -100 75 -2561 -100 -25 -125

62 -100 -25 -12563 -100 -25 -125

64 -100 -25 -12565 -100 -25 -125

66 -100 -25 -125

67 -100 -25 -12568 0 -25 -25

69 100 -25 7570 200 -25 175

71 300 -25 275

72 400 -25 37573 500 -25 475

74 600 -25 57575 700 -25 675

-500

0

500

1000

1500

2000

Long C Long P Port

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Combinations – StrangleStock

Price @ Expirati

on Long C Long Put Portfolio

55 -100 575 47556 -100 475 375

57 -100 375 27558 -100 275 175

59 -100 175 75

60 -100 75 -2561 -100 -25 -125

62 -100 -25 -12563 -100 -25 -125

64 -100 -25 -12565 -100 -25 -125

66 -100 -25 -125

67 -100 -25 -12568 0 -25 -25

69 100 -25 7570 200 -25 175

71 300 -25 275

72 400 -25 37573 500 -25 475

74 600 -25 57575 700 -25 675

Long Call

• The call option will be exercised only if the ST is > K (67). However a premium of Rs.100 has been paid for the option

• At ST = 68 investor make no profit or loss

Long Put• The put option will be exercised if the stock

price ST is < K (61). A premium of Rs.25 has been paid for the out-of-the money put

• When exercised the investor will gain the difference in the ST and K but reduced by the premium paid

• For ST > 61 the entire premium is lost

Portfolio• Sum of the two positions Note that the cost of this strategy was lesser than

the Straddle since the premiums were lower

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Combinations – Short StraddleThe investor writes an uncovered call and an uncovered put on the same stock, same expiration and same strike price. Together the strategy is expected to be ‘neutral’ if the stock trades within a range. However, large potential loss exists should the stock movement be unexpected. The profit potential is limited to the premiums of the put and call. It is a highly risky strategy.

Consider the following example of ABC Company Stock price S0 = 63Strike price (call) K = 67Call premium (K=67) c = 1 (currently out-of-money)Put premium (K=61)p = 4 (currently in-the money)Time to expiration T = 3 mo (Sep 09)

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Combinations – Short StraddleStock Price @ Expirati

on Short C Short P Portfolio

55 100 -800 -70056 100 -700 -600

57 100 -600 -50058 100 -500 -400

59 100 -400 -300

60 100 -300 -20061 100 -200 -100

62 100 -100 063 100 0 100

64 100 100 20065 100 200 300

66 100 300 400

67 100 400 50068 0 400 400

69 -100 400 30070 -200 400 200

71 -300 400 100

72 -400 400 073 -500 400 -100

74 -600 400 -20075 -700 400 -300

-2000

-1500

-1000

-500

0

500

1000

Short C Short P Port

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Combinations – Short StraddleStock Price @ Expirati

on Short C Short P Portfolio

55 100 -800 -70056 100 -700 -600

57 100 -600 -50058 100 -500 -400

59 100 -400 -300

60 100 -300 -20061 100 -200 -100

62 100 -100 063 100 0 100

64 100 100 20065 100 200 300

66 100 300 400

67 100 400 50068 0 400 400

69 -100 400 30070 -200 400 200

71 -300 400 100

72 -400 400 073 -500 400 -100

74 -600 400 -20075 -700 400 -300

Short Call • The call option will be exercised by the holder only

if the ST is > K (67). However a premium of Rs.100 has been received

• At ST = 68 investor makes no profit or loss

• Being uncovered the loss potential is highShort Put• The put option will be exercised by the holder if the

stock price ST is < K (67). A premium of Rs.400 has been received by the investor

• When exercised the investor will lose the difference in the ST and K but compensated for by the premium received

• For ST > 67 the investor only receives the premium

Portfolio• Sum of the two positions As the stock price increases the loss on the short call

is much greater than the premium received for the short put. Thus the loss potential is high

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Combinations – Short StraddleNick Leeson Story

• Invested in Nikkei 225 stock index futures – made losses when the Nikkei dropped due to the Kobe earthquake (unexpected event)

• To recoup the losses created a short straddle (uncovered and highly risky) on the Nikkei expecting it to stabilize and trade within a range(19000)

• His straddle positions ranged from 18,500 – 20,000• Nikkei dropped way below and Nick Leeson incurred 1.4b

losses and Barings filed for bankruptcy.

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Other Strategies

Theoretically if European options with expiration at time T exist for every single strike price then it is possible to construct any payoff with a combination of these

Box Spread: This is a combination of a bull call spread with strike price K1 and K2 and a bear put spread at the same two strike prices. When K2 > K1, buy a call option at K1 and sell a call option at K2 & buy a put option at K2 and sell a put option at K1

This combination does not work with American options

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Other StrategiesCalendar spread or Horizontal spread: The combination is developed using options with different expiration dates but with the same strike price

Diagonal spread: The strike price and the expiration dates of the options are different

Butterfly spread: involves options with three different strike prices and same expiration date. Either all puts or all calls can be used for this strategy. The idea is to buy a call (long) with at strike price K1 and another at strike price K2 and short two calls with a strike price K3 midway between K1 and K2. Usually potential gain and loss is limited

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Other Strategies - Butterfly

Consider the following example of XYZ Co.

Stock price S0 = 75.28Strike price (Low call) K1 = 72Call premium c1 = 6.10 (in-the-money)Strike price (High call) K2 = 78Call premium c2 = 2.60 (currently out-of-money)Strike price (Mid call) K3 = 75Call premium c3 = 4.10 (almost at-the money)Time to expiration T = 3 mo (Sep 09)

Investor: one long c1, one long c2, two short c3

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Other Strategies - ButterflyStock

Price @ Expirati

on L C(Hi K) LC (Lo K) Sh C (2 ) Portfolio65 -260 -610 820 -5066 -260 -610 820 -5067 -260 -610 820 -5068 -260 -610 820 -5069 -260 -610 820 -5070 -260 -610 820 -5071 -260 -610 820 -5072 -260 -610 820 -5073 -260 -510 820 5074 -260 -410 820 15075 -260 -310 820 25076 -260 -210 620 15077 -260 -110 420 5078 -260 -10 220 -5079 -160 90 20 -5080 -60 190 -180 -5081 40 290 -380 -5082 140 390 -580 -5083 240 490 -780 -5084 340 590 -980 -5085 440 690 -1180 -50

-1500

-1000

-500

0

500

1000

65 67 69 71 73 75 77 79 81 83 85

L C(Hi K) LC (Lo K) Sh C (2 ) Portfolio

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Other Strategies - ButterflyStock

Price @ Expirati

on L C(Hi K) LC (Lo K) Sh C (2 ) Portfolio65 -260 -610 820 -5066 -260 -610 820 -5067 -260 -610 820 -5068 -260 -610 820 -5069 -260 -610 820 -5070 -260 -610 820 -5071 -260 -610 820 -5072 -260 -610 820 -5073 -260 -510 820 5074 -260 -410 820 15075 -260 -310 820 25076 -260 -210 620 15077 -260 -110 420 5078 -260 -10 220 -5079 -160 90 20 -5080 -60 190 -180 -5081 40 290 -380 -5082 140 390 -580 -5083 240 490 -780 -5084 340 590 -980 -5085 440 690 -1180 -50

Long Call (high)

• The call option will be exercised only if the ST is > K1 (78). However a premium of Rs.260 has been paid upfront

• For ST > 78 the upward profit potential is high

Long Call (low)

• The call option will be exercised only if the ST is > K2 (72). However a premium of Rs.610 has been paid upfront

• For ST > 72 the ‘loss’ initially decreases and then the profit potential set in

• Short Call (midway)• The call option will be exercised by the holder only if

the ST is > K3 (75). However a premium of Rs. 820 (for 2 trades) has been received by the investor

Portfolio

• For ST below 73 or above 77 the loss of the portfolio is the maximum initial outlay = (-260 –610 + 820 = 50)

• Maximum profit is at the midway strike price of Rs.75 This is used when the trading range is expected to be

narrow and investor does not want to use an uncovered straddle.

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Other Strategies - Butterfly

Forbes.com OptionsFlash by Andrew Wilkinson 06.23.09 1:35 PM ET

Betting On A Big Downside For Apple

Apple Inc.: In the July contract and with shares in Apple easing 2.6% to $133.74, one option investor is betting on a 17.5% price decline in shares of the iPhone-maker to $110 within the next three weeks. A put butterfly combination was bought at the 100/110 and 120 strikes for a net premium of 64 cents. In this combination the investor sells twice as many put options at the central strike price against the purchase of puts at the two outer strikes. With this combination involving strike prices exactly $10 wide, the maximum profit of that strike distance less the premium amounts to$9.34 per contract in the event that the share price arrives at expiration at $110. Options implied volatilities are higher by almost 9% on the share price decline. The bearish activity comes shortly after the company released news that founder Steve Jobs underwent a liver transplant during personal leave two months ago.

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Conclusions

• Any payoff strategy can be developed using a combination of options – very exciting and challenging!

• Many strategies are risky and have a significant downside potential

• Prudent financial risk management is critical to success in trading

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Thank You!