Options Professor Brooks BA /14/08

Chapter 4 – Combinations of Options Buying/Selling a more than one option (put or call or puts and calls) – Combinations Usually requires a belief about what way prices will move Tends to have less up-side and less down- side than a naked position These are not risk-management strategies…these are speculative strategies with some reduction in risk

Straddles Simultaneous positions in a put and call such that The options have the same Strike price Same underlying asset Same maturity date Buying a straddle Long call and long put Make $ with extreme price change up or down Lock in a loss with little price movement Sell a straddle Short call and short put Make small $ with no price movement Loss money with large price change up or down. Remember…Zero Sum Game Construct payoffs from table or diagrams Payoffs are a mirror image around X-axis for buying and selling

Strangles Buying and Selling a put and a call option with different strike prices Long Strangle – buy put with lower strike price, sell (write) call with higher strike Same underlying asset Same expiration date Minimum down-side Potential high upside with significant price movements Write a Strangle (Short Strangle) -- Sell Put with lower strike price and buy call with higher strike price Minimum up-side Significant down-side with large price movements Draw these positions Logic?

Condors Less risky strangle Requires for different strike prices Strike Prices; A < B < C < D Calls only – Long A and D, Short B and C Puts only – Long A and D, Short B and C Both  Long Call A, Short Call B, Short Put C, Long Put D  Long Put A, Short Put B, Short Call C, Long Call D Draw positions Logic?

Spreads Matching of call or puts with different Strike prices (vertical) Buy the low strike, sell the high strike Sell the low strike, buy the high strike Maturity dates (horizontal) Also known as calendar spreads Buy early maturity, sell late maturity Sell early maturity, buy late maturity Strike and maturity dates (diagonal spreads) Buy early maturity with low strike, sell late maturity with high strike Sell early maturity with low strike, buy late maturity with high strike

Spreads Continued How to remember types of spreads? Based on how prices were originally displayed Look at Prices at ISE Strike prices listed in ascending order in each column Maturity dates listed in ascending dates in each row Debit spread (cash inflow at construction) Credit spread (cash outflow at construction)

Butterfly Spread Spread constructed with puts and calls Usually low cost to construct with strike prices A < B < C Construction: Long Call A, Short 2 Calls B, Long Call C Long Put A, Short 2 Calls B, Long Call C Long Put A, Short Put B, Short Call B, Long Call C Long Call A, Short Call B, Short Put B, Long Put C Diagram Logic?

Margins The OCC steps between every trade to guarantee execution should the option holder choose to exercise If exercised, writers are always in a loss position OCC does not want to cover defaults from the writers of options Margin is required for anyone with a down-side (after the initial transaction… No down-side to buyer, no margin required Down-side potential for seller, margin require If you are writing a call, you can put up the stock (what you are required to deliver if the call holder exercises) Otherwise  Premium + 20% of current stock price – out-of-money amount or  Premium + 10% of current stock price Spread deposits – debit spread (cash in flow at construction), debit amount or credit spread (cash out flow at construction), difference in strike prices.

Rules for Speculating in Options Leave it to the professionals… If you must trade, Know your risks, payoff profile, and monitor If you can’t fully explain your position…probably should not take the position Don’t rely on someone else’s logic Remember the debacles…things can go bad quickly

Your Very Own Options Calculator On page 74 of text CBOE Options Toolbox Download the free interactive software for options pricing p p Other helpful information tips on options at this site.

Option Trades Four Basic Positions Call option buy and sell Put option buy and sell Four combinations A straddle A strangle A vertical, horizontal or diagonal spread A condor or a butterfly Complete with ISE data and for at least one use an index as the underlying Determine the margin required if any Give your logic (tell why you think this position will make money before March 14 th ).