Trading Strategies Involving Options Chapter 10

Positions in an Option & the Underlying Buy or sell call Buy or sell put buy or short sell stock buy (lend at) or sell (borrow at) risk-free bond (rate)

Trading Strategies Involving Options Take a position in the option & the underlying Spread: Position in 2 or more options of the same type Combination: Position in a mixture of calls & puts

Payoff for Put Option x Cost = p buy ST X sell -X Cost = -p

Payoff for Call Option x Cost = c buy ST X sell Cost = -c

Payoff for Stock buy Cost = S ST sell Cost = -S

Payoff for Investing or Borrowing PV(X) in Risk-Free Bond Cost = Xe-rT X buy ST Cost = -Xe-rT -X sell

Method Draw payoff pattern for each position Add patterns together to obtain payout pattern Determine cost of portfolio Subtract cost of portfolio to obtain profit pattern

Write a Covered Call buy stock X Cost = S - c ST X sell call

Profit Pattern for Covered Call Cost = S - c X X-S+c ST X -S+c X-S+c

Payoff for Protective Put Cost = S + p x ST X

Profit Pattern Protective Put Cost = S + p x X ST X-S-p S+p

Bull Spread Buy 1 call and sell 1 call at higher strike buy ST sell X2-X1 buy Cost = c1 - c2 > 0 ST X1 X2 sell

Profit Pattern for Bull Spread X2-X1 -c1+c2 ST -c1+c2

Bear Spread Sell 1 call and buy 1 call at higher strike buy ST sell Cost = c1 - c2 < 0 ST X2 X1 sell X2-X1

Profit Pattern for Bear Spread Cost = c1 - c2 < 0 ST X2 X1

Buy a Straddle Buy 1 call and 1 put at same strike X X Cost = c + p payout profit X -p-c X-p-c X+p+c

Butterfly Spread Buy 1 call at X1, sell 2 calls at X2, buy 1 call at X3 m = +1 m = -1 X2 m = 0 X1 X3 m = - 2 Cost = c1 - 2c2 + c3

Butterfly Spread Buy 1 call, sell 2 calls, buy 1 call X2-X1 payoff cost profit Cost = c1 - 2c2 + c3

Bull Spread Using Calls Figure 10.2 Profit X1 X2 ST

Bull Spread Using Puts Figure 10.3 X1 X2 Profit ST

Bear Spread Using Calls Figure 10.4 X1 X2 Profit ST

Bear Spread Using Puts Figure 10.5 X1 X2 Profit ST

Butterfly Spread Using Calls Figure 10.6 X1 X3 Profit ST X2

Butterfly Spread Using Puts Figure 10.7 X1 X3 Profit ST X2

A Straddle Combination Figure 10.10 Profit ST X

Strip & Strap Figure 10.11 Profit Profit X ST X ST Strip Strap

A Strangle Combination Figure 10.12 X1 X2 Profit ST

Summary Write covered call: buy stock sell call Protective put: buy stock and buy put Bull spread: buy X1 call and sell X2 call Bear spread: opposite of bull Buy Straddle: buy X call and buy X put Sell Straddle: opposite of buy straddle Strangle: buy X1 put and buy X2 call Butterfly spread: buy 1 X1 call, sell 2 X2 calls, and buy 1 X3 call