1. 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
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2. 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
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3. 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
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4. 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
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5. 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
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6. 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
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7. 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
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8. 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
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9. 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 $3, Sell 45 $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
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10. 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 $1, Sell 45 $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
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11. 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 $3, Buy 45 $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
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12. 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 $2, Buy the Dec $12
➟ Net CF0 = = -$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
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13. 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 = = -$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
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14. 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
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15. 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
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16. 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 $2, Buy 45 $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
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17. Lec 11 Trading Strategies
Thank You
(A Favara)
Lec 11 Trading Strategies
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