Lec 11 Trading Strategies Lec 11: Options Trading Strategies (Hull, Ch. 11) Investment/Hedging Strategies (Hull, Ch. 11.1) Long Stock, Short Call {+ S, - C} = Covered Call Write Example: Suppose you bought the stock a while back at $40/share. Unfortunately, the stock price is still the same. To improve the return you Sell an “At the money call”: S0=$40, C0=$4, K = $40. Lec 11 Trading Strategies dfdf

Lec 11 Trading Strategies Cash Flow Analysis:(t = T). Possible scenarios. ST CT (Value) Value of {+ST , - CT} ROR for {+ST , - CT} $20 20 -44% 30 -17% 40 +11% 50 -10 60 -20 Lec 11 Trading Strategies dfdf

Lec 11 Trading Strategies Points to ponder: • The motivation for {-C} is the belief that the stock price will not go up in the short run. ➟ To improve the yield sell a call (positive). ➟ The Negative side is that by writing the call you are selling the upside potential of the stock Other Strategies: • Why not sell “Out of the money calls”? (High K) • Why not sell “Deep in the money calls”? (Low K) Lec 11 Trading Strategies dfdf

Lec 11 Trading Strategies Long Stock and Put {+S,+P}, “Portfolio Insurance” Example: Suppose you bought the stock at $40/share. The stock price is still $40 and you are concerned that it may go ↓. To protect the investment, Buy an “At the money Put”: S0=$40, P0=$3, K = $40. ➟ Pay $3 for insurance Lec 11 Trading Strategies dfdf

Lec 11 Trading Strategies Cash Flow Analysis: ST PT (Value) Value of {+ST , +PT} ROR for {+ST , + PT} $20 20 40 -7% 30 10 50 +16% 60 +40% Lec 11 Trading Strategies dfdf

Lec 11 Trading Strategies Points to ponder: • The motivation for {+S, +P} is the belief that the stock price may ↓ • The put works like an insurance contract: Losses on the stock are covered by gains on the put. • Cost of insurance = $3/share. Lec 11 Trading Strategies dfdf

Lec 11 Trading Strategies Buy T-Bills, + Call Suppose S0 = $40, C0(K=40, T=1yr) =$4. and interest rate = 10%/year Consider two alternative strategies: ▸ Buy 100 shares of stock for $4,000 total, or ▸ Buy 1 call for $400 and invest $3,600 in T-Bills. Lec 11 Trading Strategies dfdf

Lec 11 Trading Strategies Buy T-Bills, + Call. Assume S0 = $40, C0(K=40, T=1yr) =$4, i =10%/year. Consider two alternative strategies: ▸ Buy 100 shares of stock for $4,000 total, or ▸ Buy 1 call for $400 and invest $3,600 in T-Bills. Cash Flow Analysis: Why is this a good idea? • Downside protection, and upside reward (though not as much as with stock). • Some banks used to sell CDs with a call option imbedded in it. ST CT (Value) T-Bills {+CT , + T-Bills} {100% ST } $20 3,960 2,000 30 3,000 40 4,000 50 1,000 4,960 5,000 60 5,960 6,000 Lec 11 Trading Strategies dfdf

Lec 11 Trading Strategies SPREADS (11.2) Bullish Call Spreads (Bullish Vertical Spread, Bullish Money Call Spread) {+C(KL), -C(KH)} Example: Suppose S0=$42. C0(K=40) = $3, C0(K=45) = $1 Buy 40 call @ $3, Sell 45 call @ $1. Net CF0 = -3+1 = -$2. ST +CT (K=40) -CT (K=45) Total ROR $35 -100% 40 42 2 0% 45 5 150% 50 10 -5 55 15 -10 Lec 11 Trading Strategies dfdf

Lec 11 Trading Strategies Bullish Put Spreads (Bullish Vertical Put Spread) {+P(KL), -P(KH)} Example: Suppose S0=$42. P0(K=40) = $1, P0(K=45) = $4 Buy 40 Put @ $1, Sell 45 Put @ $4. Net CF0 = +4-1 = +$3. Cash Flow Analysis: ST +PT (K=40) -PT (K=45) Total $35 5 -10 -5 40 42 -3 45 50 55 Lec 11 Trading Strategies dfdf

Lec 11 Trading Strategies Bearish Call Spreads: {-C(KL), +C(KH)} Example: Suppose S0=$42. C0(K=40) = $3, C0(K=45) = $1 {Sell 40 Call @ $3, Buy 45 Call @ $1}. Net CF0 = +3-1 = +$2 Cash Flow Analysis: ST - CT (K=40) + CT (K=45) Total $35 40 42 -2 45 -5 50 -10 5 55 -15 10 Lec 11 Trading Strategies dfdf

Lec 11 Trading Strategies Time Spreads with Calls (Horizontal Spread, Time or Calendar Spread) Example: Suppose S0=$50. C0(T1 = April ) = $2 C0(T2 = Dec) = $12, K=50 for both. ➀ April 1: Sell April call @ $2, Buy the Dec call @ $12 ➟ Net CF0 = +2-12 = -$10 ➁ April 29 (right before April call expiration) Buy back the April call and sell the May Call. ➂ May 29 (right before May call expiration) Buy back the May call and sell the June Call. And so on until Dec. The goal is to take advantage of “Time Decay”. Lec 11 Trading Strategies dfdf

Lec 11 Trading Strategies Long Butterfly Call Spreads: {+C(KL), -2C(KM), +C(KH)} Example: Suppose S0=$50, C0(K=40)=$12, C0(K=50)=$6, C0(K=60)=$3. {Buy one 40 Call, Sell two 50 calls, Buy one 60 Call}. Net CF0 = -12+12-3 = -$3 Cash Flow Analysis: ST + CT (K=40) -2 CT (K=50) + CT (K=60) Total ROR $40 -100% 45 5 67% 50 10 233% 55 15 -10 60 20 -20 70 30 -40 Lec 11 Trading Strategies dfdf

Lec 11 Trading Strategies Short Butterfly Call Spreads: {-C(KL), +2C(KM), -C(KH)} Example: Suppose S0=$50, C0(K=40)=$12, C0(K=50)=$6, C0(K=60)=$3. {Sell one 40 Call, Buy two 50 calls, Sell one 60 call}. Net CF0 = +$3 Cash Flow Analysis: ST - CT (K=40) +2 CT (K=50) - CT (K=60) Total $40 45 -5 50 -10 55 -15 10 60 -20 20 70 -30 40 Lec 11 Trading Strategies dfdf

Lec 11 Trading Strategies Combinations: Straddles, Strangles, Strips and Straps Bottom Straddle: {+C, +P} same K, same T Example: Suppose S0=$40, C0(K=40)=$4, P0(K=40)=$3. Net CF0 = -4-3 = -$7 Cash Flow Analysis: Top Straddle: {-C, -P} same K, same T ST + CT (K=40) + PT (K=40) Total RORl $30 10 +43% 35 5 -29% 40 -100% 45 50 Lec 11 Trading Strategies dfdf

Lec 11 Trading Strategies Bottom Strangle: { +C(KH), +P(KL) } same T, KL < S0 < KH Example: Suppose S0=$50, C0(KH = 55)=$2, P0(KL=45)=$1. Buy 55 call @ $2, Buy 45 Put @ $1. Net CF0 = -2-1 = -$3 Cash Flow Analysis: NOTE: a Strangle is similar to a Straddle, but it is cheaper since both options are out-of-the-money. ST + CT (K=55) + PT (K=45) Total RORl $40 5 +66% 45 -100% 50 55 60 Lec 11 Trading Strategies dfdf

Lec 11 Trading Strategies Thank You (A Favara) Lec 11 Trading Strategies dfdf