Advanced Option Strategies Derivatives and Risk Management BY SUMAT SINGHAL

Outline Principles of Money Spreads and combinations  Bull spread  Bear spread  Butterfly Spread Calendar spreads Combinations  Collars  Straddle  Strips and straps  strangles

Option Spreads What do we mean by a spread? Types of Spreads  Vertical/Money Spread  Horizontal Spread Buying the Spread Selling the Spread Why use spreads?

Money Spreads Bull Spreads Bear Spreads

Bull Spread Creating Bull spread with calls  Buy a call option on a stock with a certain exercise price and sell a call option on the same stock with a higher exercise price Example Creating Bull spread with puts  Buy a put with a low strike price and sell a put with a high strike price Example

Bear Spread Bearish on stock Creating bear spread with puts  Buy a put with a high exercise price and sell a put with a low exercise price Example Creating bear spread with calls  Buy a call with higher exercise price and sell a call with a lower exercise price Example

Butterfly Spread Involves two positions in options with three different exercise prices Buy a call with a relatively low exercise price, say E1 Buy a call with a relatively high exercise price, say E3, and Sell two calls with a strike price of E2 Usually, E2 is halfway between E1 and E3 E2 is usually close to the current stock price

A butterfly spread leads to a profit if the stock price stays close to E2, but Gives a small loss if there is a significant movement in either direction Good strategy if you feel significant stock price changes are unlikely Require small investment initially to setup the spread

Butterfly Spread

Breakeven Point  Upper Breakeven Point = Strike Price of Higher Strike Long Call - Net Premium Paid  Lower Breakeven Point = Strike Price of Lower Strike Long Call + Net Premium Paid

Calendar Spread Sell a call option with a certain exercise price and Buy a longer maturity call option with the same strike price Longer the maturity of the option bought, the more expensive it is due to speculative value of the option Requires initial investment to setup

Assuming that the long-maturity option is sold when the short-maturity option matures,  What will be the payoff diagram?  How to determine profit/loss? Types of Calendar Spreads  Neutral Calendar Spreads  Bullish Calendar Spread  Bearish Calendar Spread Calendar Spread with Put Options

Reverse Calendar Spread If you anticipate the stock price to move into in extremes, you can execute a reverse calendar spread Buy a call with a shorter maturity and Sell a call with a longer maturity with the same exercise price

Combinations Combination is an option trading strategy that involves taking a position in both calls and puts on the same stock  Straddle  Strips  Straps  Strangles  Collars

Straddle Buy a call and buy a put with the same strike price and expiration date When do you profit? When to use this strategy? Breakeven points Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid

Payoff diagram

Short a straddle Sale of a put and a call with the same exercise price and expiration date High risk strategy, especially if the stock price moves too much

Strips and Straps Strip  Long position in one call and two puts with the same strike price and expiration date

Upper Breakeven Point = Strike Price of Calls/Puts + Net Premium Paid Lower Breakeven Point = Strike Price of Calls/Puts - (Net Premium Paid/2)

Strap  A long position in two calls and one put with the same strike price and maturity  Upper Breakeven Point = Strike Price of Calls/Puts + (Net Premium Paid/2)  Lower Breakeven Point = Strike Price of Calls/Puts - Net Premium Paid

Payoff diagram of a Strap

Strangle Buy a put and a call with the same maturity date, but different strike prices

Breakeven Point Upper Breakeven Point = Strike Price of Long Call + Net Premium Paid Lower Breakeven Point = Strike Price of Long Put - Net Premium Paid

Collars Buy a stock Buy a put on the stock with an exercise price lower than the current stock price Sell a call on the stock with an exercise price higher than the current stock price Choose the call exercise price in such a manner that the call premium completely offsets the put premium

 = N s (S T – S) + N P [MAX(0, E 1 - S T ) – P 1 ] – Nc[max(0, S T – E 2 ) – C 2 ] If stock price at maturity is below both the exercise prices? If the stock price at maturity is between the two exercise prices If the stock price at maturity is higher than both the exercise prices

Payoff diagram of a Collar