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

= Ns (ST – S) + NP[MAX(0, E1 - ST) – P1] – Nc[max(0, ST – E2) – C2]

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