Post on 16-Apr-2017
The Option Investment Strategies
Mayank BhatiaSandri SupardiGail Yambao
OptionsOptions: contract giving the buyer right, but not
obligation to buy or sell the underlying asset at a certain price on/before the certain date.
Two types of Options: Call Option: Gives the holder right to buy an assets at
certain price within the specific period of time. Put Option: Gives the holder right to sell an assets at
certain price within the specific period of time.
Options Trading Strategies Single Option & a Stock
Covered Call Protective Put
Spreads Bull Spread Bear Spread Butterfly Spread Calendar Spread
Combinations Strip Strap Straddle Strangle
Buy the stock of a listed company
Profit
Price (S)KST
Buy a call optionProfit
Price (S)KST
Call option price
Buy a Call Option
Stock Price Range Payoff Cost Profit
ST <= K 0 C0 Payoff - Cost
ST > K ST - K C0 Payoff - Cost
Call profit = max (0, ST - X) - C0
Buy a Call Option
Stock Price Range Payoff Cost Profit
ST <= K 0 3.5 -3.5
ST > K 5 3.5 1.5
When is this appropriate?Stock prices are expected to go up
Example: AT&T (July 1994)
ST <= K Stock Price 50ST > K Stock Price 60
K Strike Price 55
C0 Call Price 3.5
Sell a call optionProfit
Price (S)KST
Call option price
Sell a Call Option
Call writer's profit = C0 - max (0, ST - X)
Stock Price Range Payoff
Price of Call Profit
ST <= K 0 C0 Payoff + CostST > K K - ST C0 Payoff + Cost
Sell a Call OptionExample: AT&T (July 1994)ST <= K Stock Price 50ST > K Stock Price 60K Strike Price 55C0 Call Price 3.5
Stock Price Range Payoff
Price of Call Profit
ST <= K 0 3.5 3.5ST > K 55 3.5 -1.5
Buy a Put OptionProfit
Price (S)KST
Call option price
Buy a Put Option
Stock Price Range Payoff Cost ProfitST <= K K - ST C0 Payoff - CostST > K 0 C0 Payoff - Cost
Put Profit = max(0, X - ST) - P0
When is this appropriate?
When we expect prices to go down
Buy a Put OptionExample: AT&T (July 1994)ST <= K Stock Price 50ST > K Stock Price 60K Strike Price 55C0 Put Price 2.75
Stock Price Range Payoff Cost ProfitST <= K 5 2.75 2.25ST > K 0 2.75 -2.75
When is this appropriate?
When we expect prices to go down
Sell a Put optionProfit
Price (S)KST
Call option price
Sell a Put Option
Stock Price Range Payoff Price ProfitST <= K ST - K P0 Payoff + Price of PutST > K 0 P0 Payoff + Price of Put
Put Profit = P0 - max(0, X - ST)
Sell a Put OptionExample: AT&T (July 1994)ST <= K Stock Price 50ST > K Stock Price 60K Strike Price 55C0 Put Price 2.75
Stock Price Range Payoff Cost Profit
ST <= K -5 2.75 -2.25
ST > K 0 2.75 2.75
Covered Call Sell a call option and Buy Stock
Profit
Price (S)KST
Sell Call
Covered Call
Buy Stock
Covered Call Buy a Stock, Sell a Call Option
Stock Price
Range
Payoff from Stock
Payoff from Call Total Payoff
Price of Call Profit
ST <= K ST - SO 0Payoff from Stock +
Payoff from Call CCALL
Total Payoff + Price of
Call
ST >= K ST - SO K-ST
Payoff from Stock + Payoff from Call CCALL
Total Payoff + Price of
Call
Covered Call (Buy a Stock, Sell a Call Option) Example: January 1995 (AT&T)ST <= K stock price 50ST >= K stock price 60SO stock purchased 55CCALL price of call 5.25
K exercise price of call 55
Stock Price Range
Payoff from Stock
Payoff from Call Total Payoff Cost Profit
ST <= K -5 0 -5 5.25 0.25ST >= K 5 -5 0 5.25 5.25
Covered Call Buy a Stock, Sell a Call Option Advantage:
When there is a sharp rise in the stock price, purchased stock protects the seller of the call from pay-off
When is this appropriate?
A sharp rise in stock prices is expected
Covered Call Buy a Stock, Sell a Call Option Advantage:
When there is a sharp rise in the stock price, long stock position "covers" or protects the investor from the payoff on the short call
When is this appropriate?
A sharp rise in stock prices is expected
Protective PutBuy a put option and Buy a Stock option
Profit
Price (S)KST
Buy PutProtective PutBuy Stock
Protective Put Buy a Stock & Buy a Put
Stock Profit + Put Profit = ST - S0 + max (X - ST, 0) - P
Stock Price
Range
Payoff from Stock
Payoff from Put Total Payoff Cost Profit
ST <= K ST - SO K - ST ST - SO - K -ST CPUT
(Profit from Stock + Profit from Put) -
Price of Put
ST >= K ST - SO 0 ST - SO CPUT
(Profit from Stock + Profit from Put) -
Price of Put
Advantages:This combination of stock and put establishes a floor. It allows unlimited profits
while limiting the potential loss.* This is like purchasing insurance for your stock
Protective (Buy a Stock & Buy a Put)
Example: January 1995 (AT&T)ST <= K stock price 50ST >= K stock price 60SO stock purchased 55CPUT price of put 4.375K exercise price of put 55
Stock Price Range
Payoff from Stock
Payoff from Put
Total Payoff Cost Profit
ST <= K -5 5 0 4.375 -4.375
ST >= K 5 0 5 4.375 0.625
Protective PutBuy a Stock & Buy a Put
Advantages:This combination of stock and put establishes a floor. It allows unlimited profits
while limiting the potential loss.* This is like purchasing insurance for your stock
Protective (Buy a Stock & Buy a Put)
Advantages:
Potential gains or losses are created from the net effect of a long position in both the put and the stock. This establishes a floor, allowing unlimited profits while limiting the potential loss.
Should the stock price decline below the strike price before expiration of the
option, the investor would exercise the put option & sell his or her stock at the strike price
Should the stock price increase above the strike price, the option would not be
exercised & the investor could sell the stock at the higher price & recognize a profit if the stock price is above the overall cost of the position
* This is like purchasing insurance for your stock
Bull Spreads w/ Call Buy Call option and Sell Call on a higher strike price
Profit
Price (S)K1 ST
Sell Call @ Higher Price
Call Bull Spreads
Buy Call @ Lower Strike Price
K2
Bull SpreadBuy a Call at Low Strike Price, Sell Call at High Strike Price, Same Expiration Date
Stock Price Range
Payoff from Long Call Option
Payoff from Short Call Option Total Payoff
ST >= K2 ST - K1 K2 - ST K2 - K1
K1 <ST < K2 ST - K1 0 ST - K1
ST <= K1 0 0 0
Advantage:Limits the investor's upside & downside riskWhen is this appropriate?The investor expects stock prices to go up
Bull Spread(Buy a Call at Low Strike Price, Sell Call at High Strike Price, Same Expiration Date)
Example: January 1995 (AT&T)
AT&T (Jan 1995) Price of
OptionST >= K2 Stock Price 70
K1 <ST < K2 Stock Price 60 ST <= K1 Stock Price 50
K1 Call Option at Low Strike Price 55 5.25
K2 Call Option at High Strike Price 65 1.5
AT&T (January 1995) B
Stock Price Range
Payoff from Long Call Option
Payoff from Short Call Option
Total Payoff Cost Profit
ST >= K2 15 -5 10 -3.75 6.25
K1 <ST < K2 5 0 5 -3.75 61.25
ST <= K1 0 0 0 -3.75 -3.75
Bull SpreadBuy a Call at Low Strike Price, Sell Call at High Strike Price, Same Expiration Date
Advantage:Limits the investor's upside & downside riskWhen is this appropriate?The investor expects stock prices to go up
Bull Spreads w/ PutBuy Put option and Sell Put on a higher strike price
Profit
Price (S)K1
ST
Buy Put @ Lower Price
Put Bull Spreads
Sell Put @ Higher Strike Price
K2
Bear Spreads w/ Call Sell Call option and Buy Call on a higher strike price
Profit
Price (S)K1 ST
Buy Call @ Higher Price
Call Bear Spreads
Sell Call @ Lower Price
K2
Bear SpreadBuy Call at High Strike Price, Sell Call at Low Strike Price, Same Exercise Date
Stock Price Range
Payoff from Long Call Option
Payoff from Short Call Option
Total Payoff
ST >= K2 ST - K2 K1 - ST -(K2 - K1)
K1 <ST < K2 0 K1 - ST -(ST - K1)
ST <= K1 0 0 0
Advantage:Limits the investor's upside & downside riskWhen is this appropriate?The investor expects stock prices to go down
Bear Spread(Buy Call at High Strike Price, Sell Call at Low Strike Price, Same Exercise Date)Example: January 1995 (AT&T)
AT&T (Jan 1995) B Price of OptionST >= K2 Stock Price 70 K1 <ST <
K2 Stock Price 60 ST <= K1 Stock Price 50
K1 Call Option at Low Strike Price 55 5.25K2 Call Option at High Strike Price 65 1.5
AT&T (January 1995) B
Stock Price Range
Payoff from Long Call Option
Payoff from Short Call Option
Total Payoff Cost Profit
ST >= K2 15 -15 -10 3.75 -6.25
K1 <ST < K2 0 -5 -5 3.75 -1.25
ST <= K1 0 0 0 3.75 3.75
Bear SpreadBuy Call at High Strike Price, Sell Call at Low Strike Price, Same Exercise Date
Advantage:Limits the investor's upside & downside riskWhen is this appropriate?The investor expects stock prices to go down
11. Bear Spreads w/ Put : Sell Put option and Buy Put on a higher strike price
Profit
Price (S)K1
ST
Buy Put @ Higher Price
Put Bear Spreads
Sell Put @ Lower Strike Price
K2
12. Butterfly Spreads w/ Call : Sell 2 calls at K2 Buy Call option at K1 and K3.
Profit
Price (S)K1
ST
Sell 2 Call @ K2, close to current Stock Price.
ButterflySpreads w/ call
Buy Call @ Higher Strike Price
K3K2
Buy Call @ Lower Strike Price
13. Butterfly Spreads w/ Put: Sell 2 Puts at K2 and buy Put option at the price of K1 and K3
Profit
Price (S)
K1
ST
Sell 2 Put @ K2, close to current Stock Price.
ButterflySpreads w/ PutBuy Put@ Lower Strike Price
K3K2
Buy Put@ Higher Strike Price
StraddleBuy Call and Put at the same Strike Price and Expiration
Profit
Price (S)ST
Buy Call @ K
Straddle
Buy Put@ K
K
StraddleBuy Call & Put, Same Strike Price, Expiration Date
Stock Price Range
Payoff from Call
Payoff from Put
Total Payoff Cost Profit
ST <= K 0 K - ST K - ST Ccall + Cput
Payoff - Cost
ST > K ST - K 0 ST - K Ccall + Cput
Payoff - Cost
Straddle(Buy Call & Put, Same Strike Price, Expiration Date)
Example: July 1994 (AT&T) - when stock price is close to strike price
ST <= K stock price 50ST > K stock price 60
K strike price 55
Ccall price of call 3.5
Cput price of put 2.75
Stock Price Range Payoff from Call
Payoff from Put
Total Payoff Cost Profit
ST <= K 0 5 5 6.25 -1.25
ST > K 5 0 5 6.25 -1.25
Straddle(Buy Call & Put, Same Strike Price, Expiration Date)
Stock Price Range
Payoff from Call
Payoff from Put
Total Payoff Cost Profit
ST <= K 0 K - ST K - ST Ccall + Cput
Payoff - Cost
ST > K ST - K 0 ST - K Ccall + Cput
Payoff - Cost
Example: July 1994 (AT&T) - when stock price is far from strike priceST <= K stock price 45ST > K stock price 65K strike price 55Ccall price of call 3.5Cput price of put 2.75
Example: July 1994 (AT&T) - when stock price is far from strike price
ST <= K stock price 45
ST > K stock price 65
K strike price 55
Ccall price of call 3.5
Cput price of put 2.75
Straddle(Buy Call & Put, Same Strike Price, Expiration Date)
Stock Price Range Payoff from Call
Payoff from Put
Total Payoff Cost Profit
ST <= K 0 10 10 6.25 3.75
ST > K 10 0 10 6.25 3.75
StraddleBuy Call & Put, Same Strike Price, Expiration Date
Advantage
If there is a sufficiently large move in either direction, a significant PROFIT will result
Disadvantage
If stock price is close to strike price at expiration of options --> LOSS
When is this appropriate to use?Investor is expecting a large move in a stock price but does not know in which direction
the move will be; a big jump in the price of a company’s stock is expected; a takeover bid for the company or outcome of a major lawsuit is expected to be announced soon
StripsBuy 1 Call and 2 Puts at the same Strike Price and Expiration
Profit
Price (S)ST
Buy Call @ Kt
Strips
Buy 2 Put@ Kt
K
Strips(Buy One Call & 2 Puts, Same Strike Price, Same Exercise Date)
Stock Price Range
Payoff from Call
Payoff from Puts
Total Payoff Cost Profit
ST <= K 0 2 x (K-ST) 2 x (K-ST) Ccall + Cput1 + Cput2
Total Payoff - Cost
ST > K ST - K 0 ST - K Ccall + Cput1 + Cput2
Total Payoff - Cost
When is this appropriate to use?
When the investor expects a decrease in price
STRIP(Buy One Call & 2 Puts, Same Strike Price, Same Exercise Date)
Example: July 1994 (AT&T)ST <= K stock price 50ST > K stock price 60K strike price 55Ccall price of call 3.5Cput1 price of put 1 2.75Cput2 price of put 2 2.75
Stock Price Range
Payoff from Call
Payoff from Puts Total Payoff Cost Profit
ST <= K 0 10 10 9 1
ST > K 5 0 5 9 -4
StripsBuy One Call & 2 Puts, Same Strike Price, Same Exercise Date
When is this appropriate to use?
When the investor is expecting the prices to decrease
Straps Buy 2 Call and 1 Puts at the same Strike Price and Expiration
Profit
Price (S)ST
Buy 2 Call @ Kt
Straps
Buy 1 Put@ Kt
K
Straps(Buy 2 Calls & 1 Put, Same Strike Price, Same Expiration Date)
Strock Price Range
Payoff from Calls
Payoff from Put Total Payoff Cost Profit
ST <= K 0 K - ST K - ST Ccall1 + Ccall2 + Cput
Total Payoff - Cost
ST > K 2 x (ST - K) 0 2 x (ST - K) Ccall1 + Ccall2 + Cput
Total Payoff - Cost
When is this appropriate?
When the investor is expecting the prices to go up
STRAP(Buy 2 Calls & 1 Put, Same Strike Price, Same Expiration Date)
Example: July 1994 (AT&T)ST <= K stock price 50ST > K stock price 60K strike price 55Ccall1 price of call 3.5Ccall2 price of put 1 3.5Cput price of put 2 2.75
Strock Price Range
Payoff from Calls
Payoff from Put
Total Payoff Cost Profit
ST <= K 0 5 5 9.75 -4.75
ST > K 10 0 10 6.25 3.75
When is this appropriate?
The investor is betting that there will be a big stock price move; however, an increase in the stock price is considered to be more likely than a decrease
Straps(Buy 2 Calls & 1 Put, Same Strike Price, Same Expiration Date)
StrangleBuy 1 Call and 1 Puts at the same Expiration date but with different Strike Price
Profit
Price (S)ST
Buy 1 Call @ K2
Strangle
Buy 1 Put@ K1
K1 K2
Strangle (Buy Put & Call, Same Expiration Dates, Different Strike Prices; K2 > K1)
Range of Stock Price
Payoff From Call
Payoff from Put
Total Payoff Cost Profit
ST <= K1 0 K1 - ST K1 - ST CK1 + CK2
Total Payoff - Cost
K1 < ST < K2 0 0 0 CK1 + CK2
Total Payoff - Cost
ST >= K2 ST - K2 0 ST - K2 CK1 + CK2
Total Payoff - Cost
STRANGLE (Buy Put & Call, Same Expiration Dates, Different Strike Prices; K2 > K1)Example: AT&T (January 1995) - stock price close to strike priceST <= K1 Stock Price 50K1 < ST < K2 Stock Price 60ST >= K2 Stock Price 70K1 Put Strike Price 55
K2 Call Strike Price 65
CK1 Price of Put 1.5
CK2 Price of Call 4.375
Range of Stock Price
Payoff From Call
Payoff from Put
Total Payoff Cost Profit
ST <= K1 0 5 5 5.875 -0.875
K1 < ST < K2 0 0 0 5.875 -5.875
ST >= K2 5 0 5 5.875 -0.875
STRANGLE (Buy Put & Call, Same Expiration Dates, Different Strike Prices; K2 > K1)
Range of Stock Price
Payoff From Call
Payoff from Put
Total Payoff Cost Profit
ST <= K1 0 K1 - ST K1 - ST CK1 + CK2
Total Payoff - Cost
K1 < ST < K2 0 0 0 CK1 + CK2
Total Payoff - Cost
ST >= K2 ST - K2 0 ST - K2 CK1 + CK2
Total Payoff - Cost
Example: AT&T (January 1995) - stock price far from strike priceST <= K1 Stock Price 45K1 < ST < K2 Stock Price 60ST >= K2 Stock Price 75K1 Put Strike Price 55K2 Call Strike Price 65CK1 Price of Put 1.5CK2 Price of Call 4.375
STRANGLE (Buy Put & Call, Same Expiration Dates, Different Strike Prices; K2 > K1)
Example: AT&T (January 1995) - stock price far from strike priceST <= K1 Stock Price 45K1 < ST < K2 Stock Price 60ST >= K2 Stock Price 75K1 Put Strike Price 55K2 Call Strike Price 65CK1 Price of Put 1.5CK2 Price of Call 4.375
Range of Stock Price
Payoff From Call
Payoff from Put
Total Payoff Cost Profit
ST <= K1 0 10 10 5.875 4.125
K1 < ST < K2 0 0 0 5.875 -5.875
ST >= K2 10 0 10 5.875 4.125
Strangle (Buy Put & Call, Same Expiration Dates, Different Strike Prices; K2 > K1)
When is this appropriate?The investor is betting that there will be a large price move, but is uncertain
whether it will be an increase or decrease.The stock price has to move farther in a strangle than in a straddle for the
investor to make a profit DisadvantageThe downside risk if the stock price ends up at a central value is less with a
strangle AdvantageThe farther strike prices are apart, the less the downside risk and the farther
the stock price has to move for a profit to be realized