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