APTER Tradting Sitrategies

fnvolving Options
We discussed the profit patLcnr f'ronL un rnvestmenI in a single stock qption
in
Chapter 8. In this chapter \'r'e cL)\'er nrore fullv the range of profiipattcrns
obtainable
using options. We assutne tliat thc uncler-lying asset is;r stock Similar
results can be
obtained for other underlying iisseis, such as fbrei-en currencies. stock indices.
and
[utures contracts. The options LLsecl in the sLrertegies r.ve discr-rss rLre European.
Amer-
ican options rnay lend to slightl-v dift'erent out.o,.,.r., bccar,rse of the possibility
ot'early
exerclse.
In the first section rve consicler vvhat happens when a position in a stock crption
is
combined with a position in the stock itself. We then rnoue on to examine
the profit
patterns obtained when zrn investment il; made in t'uvo or
morc differenioptions on the
same stock. One of the attractions ot' options is that they can
be used to create a wide
range of different payoff functions. (A payoff fr.rnction ls the payoff
as a function of the
stock price.) [f European options
',vere available with ever1,
' single possible strike pnce,
any payoff function could in theorl, be created. .
For ease of exposition the figr-rrcs and tables shorving the profit from a tradi'g
stral€rqv
"\^'ill ignore the time valLre of loney. The profit rvill be sh1;wn as the final
"payoff minus the inirial cost. (ln theory. it snoula be calculated as the present value
of
the final payoff minus the initial cost.)

10.1 STRATECIES INVOTVING A SINCLE OPTION AND A STOCK

There are a number oI different trading strategies involving a single eption
on a stock
and the stock itself. The profits from'th:se are illustratecl in Figure.fO.t.
tn this figure
and ino iFis chlpter, the dashed line shorvs the relatronship
between orice lrrr the individual securities constituting the
portfolio shows the relationship between profit and the stock
price for
In Figure 10. l(a), the portfolio consir;ts of a long por;ition in a stock plus a short
position in a call ontion. This is known a; w,riting a coler€d call. The
long sttck position
"covers" or protects the investor from the payoff on the short cali
that bec'mes
necessary if there is a sharp rise in the stock price. In Figure I 0. I (b),
a short osition
in a stock is combined with a long positic,n in a call optior:1. This is the reverse
oi writing

245
216
c'tJ.\P.t.Ett l0
Figure 10.r profit patterns
(a) rong position in a sroc.k c.mbined
rn a cail; 1b; short position in a srock r.r,rth short position
combined *irt Iong'fu;;;;, ,,
a cail: (cr rons
ff;i;UT,i'fiT':[:lJ':i'n'1;1,!1"''"n in a stockl(dj;;;., p,,siric,n in p,,i
"

(a)
(b)

Profit
Profit
Long-
Long
\. - Stock 7
Put .. Short
r.Stock

(c)
(d)

a covered call. In Figure l0.l(c),

the investrnent buying a put
a stock and the stock itself. The approach
is s iio u oro
strategy. In Figure 10. l(d), a short position
position in the stock. This is the reverse
in ^, wi
combined
of a protective put.
The profit patt,erns in Figures 10. I have
t
discussed i" a;;;i;; 8 fo,-rhort pr,, rr"ri ffiit"''fii:1,'ll,l'l*
Put--call parity provides a way of understir this is so. From Chap
 'fradiil.g Strotegr.t's Itri r,lt rrtg ( )ptiotrs
217
put rall parit-\ rcli.rtiorrship is
/)rS,,-tlKt" ll, il(f .l )

where p is tire plice ot'u F_unrpean put tr is thc stock pricc. (.is thc
call' K is the strike price of both call antl rt. r is thc risk-ri'ct-- irriee 9i.u l:.urtrpcap
1r irrtcr-est r-atc- r r\ rhc tir)c
t0 naturitr' of both call and put. and l) is the prcsent
raluc.r'thc crrrrtlcrrtis u.rieiprLtccl
during the lit'e ol- the opt-ions.
Equation (10' l) shoivs that a iortg p.sititru nr a put conrbinecl
rvith rr long positio' irl
a certlLi. l']r()trlt (: Ae ,' + D) ot
the stock is ecluii'alcut to a rong call posiricln prus
cash' This e.rplains u'hy the protit prttern in Figurc
l0.ltc) is silrilar to rhc protit
pattern fr-ont a long call pttsition. The position in Figure
10. t(cll is rhe r.crcrsc gf.rhirr ip
Figure l0'l(c) and therefore leads to u prolit prrrtenl
similar-to thlrt t.ro.r a shorr call
position.
Equation ( 10. l) can be rearranged t,r Secsm(l

Se-c=- Ke-'r+D-1,
In other words' a long position in a stock conrbined w,ith
l short posirion in a call is
equivalent to a short put position plus a certain amount
(_ yr-,:r'*;i;r;. il,
equality explains why the profit pattilrn in Figure li).
l(a) is sirlilar ro rhe pro{ir
pattern from a short put position. Ttre position
in Figuie ro.riul is the reverse of
that in Figure 10. l(a) and therefore leadi to ir profit partern
sirnilar to that from a
long put position.

1O.2 SPREADS

A spread trading strategy involves takinl; a position in tu,o

or more optio's of the same
type (i.e., two or more_ealls or two or Inore pu$).

Bull Spreadr
one of the most popular types of spreads is a bult spreacl. This
can be creared by uu[,r-q
acall option on a stock with acertain strik: price and selling
a call optron on the same
.tt).r).,!tt;tr:t:t))..t',,..6-:ta,*??:a! ,*tri-r€._ .jrr::,,:i!, , ,: tr I

Figure 10.2 Profit from bull spread created using call options.

a,{ &a&a*-e,&,r}
u8 C}IIPTER 10
%k1:.nn.

Table 10..1 Paroff tionr rL bLrll spread created usinc calls

Stock prict Ptno// f rLtnt Paro.lJ.front 'fotul
range long cull ()prion s'horl cull option 1tu.vo.lJ
Sr) Kt Sr-Kr -(Sr - K:) K:-Kr
K1 <51 <K1 Sz'- KL U 57 K1
Sr(Kr U 0 0
3ra:rr;*..t,.tiat&. 9,;r\2.*: r.e?,:r;str:::rrr:,;2.a-,:,i.;.a../

stock with a higher strike price. Borh options have fhe same
expiration date. The
strategy is illustrated in Figure 10.2. llhe profits from the t,,vo option positions taken
separately are sho'uvn by the dashed lines The profit lrom
the r.vhole strategy rs the sum
of the profits given by the dashed lines and is indicated by the
soLid line. Beca.use acall
price always decreases as the strike price increases,
the value of the optron sold is always
less than the varue of the option bought. A bulr
spread, when created tiom calls,
therefore requires an initial investmenl.
Suppose that K1 is the strike price of the call option
bought, K2 is the strike price of
the call option sord, and s1 is the stcck price on the ,:xpilation'date
of the options:
Table l0't shows the total payoff that will be realized f.om
a bull spread in different
clrcumstances' If the stock price does well and is greatr:r
than the higher strike price,
the payoff is the difference between the two strike prices,
- or K2 Kr. If the stobk price
on the expiration date lies between ther two strike prices, the payoff
is s1 _ r,. Ii the
stock price on the expiration date is trelow the lower
srtrike i.i.e, tr,. payoff is zero.
The profit in Figure 10.2 is calculated by subtracting the
initial invesrment from the
payon.
A bull spread strategy limits the inveslor's upside as well as downside
risk. The strategy
can be described by saying that the investor has a call
option with a strike price
K1 and has chosen to give up some upside potential by "q.rutio
selling a call option with strike
price K2 (K2 > K)-rn return for gwing uf the upsidl jpoten-rial,
the investor sets the

f igurel0.3 Profit from bull spread ;reated using put options.

Tradt n! Strattgirs Itri ttltittg Options
249
price ol thc option n ith strike rice K.. 1'hree rvpes of bull spreads can be distinguished:
l. Both calls are initiallv t of the nlone\,.
2. One call is initialli in t mone).: r.['re othcr call is initially out of the moner.
3. Both calls are initially i the moncy.
The most aggressive bull s are those of type l. The:y cost very little to set up and
have a small probability' of ing a relatively high payoff (: Kz_ K1). As we move
from type I to type 2 and fron type 2 to type 3, the spreads become more conservative.
Example l0.l
An rnvestor buys for call with a strike price of $10 and sells for $l a call rvith
53
a strike price of S35. T payoff from rhis bull spread srraregy is $5 if rhe stock
price is above $35, and o if it is b,elow $30. If the stock price is between $30 and
$35, the payoffis the unt by which the stock price exceeds $30. The cost of the
strategy is $3 - Sl : $2 profit is therefore as lbllows:
Stock price range Prof t
Sr(30 -2
30<sr<35 {'- - 'l?
Sr)35 .J

Bull spreads can also be by buyinl3 a put with a low strike price and selling a put
with a high strike price, as 'ated in Fr gure 10.3. Unlike the
ill bull spread created from
calls, bull spreads created from uts involve a positive up-front cash flow
to the investor
(ignoring margin requirements and a payoff that is either negative or
zero.

Bear Spreads
An investor who enters into a b[.rll spread is hoping that the stock price willlncrease.
By
ear spread is hoping that the ll
rying a pur with one strike pri a
price of the option purchased n
; in contrast to a bull spread, where the strike

Figure 10.4 Profit from bear spread created using put options.
250 CHAPTER IO

Table 10.2 Payoff from a bear sprr:ad created with put options.
Stock pric'e Payoff front Pavof from Total
range long put option short put option pa),of
Sr2 Kt 0 0 0
K1 <S7<K2 Kz-Sr 0 Kz-Sr
Sr(Kr Kz-Sr -(Kr - Sr) Kz- Kr

price of the option purchased is alwal's less than the strike price of the option sold.) In
Figure 10.4, the profit from the spread is shown by the solid line. A bear spread crcated
from puts involves an initial cash out]low because the price of the put sold is less than
the price of the put purchased. In esst:nce, the investor has bought a put with a certain
strike price and chosen to give up sorne of the profit potential by selling a put with a
lower strike price. In return for the ;rrofit given up, the investor gets the price of the
option sold.
Assume that the strike prices are ,l(1 and K2, with K1 < K2. Table 10.2 shows the
payoff that will be realized from a bear spread in different circumstances. [f the stock
price is greater than K2, the payoff is zero. If the stock price is less than K1 , the payoff is
Kz- Kr. If the stock price is betweerr K1 and K2, the payoffis K2 - S1. The profit is
calculated by subtracting the initial crlst from the payoff.

Example lO.2
An investor buys for $3 a put with a strike price of $35 and sells for $ I a put with
a strike price of $30. The payoff from this bear spread strategy is zero if the stock
price is above $35, and $5 if it is below $30. If the stock price is between $30 and
$35, the payoff is 35 - 57. The options cost $3 - $l = $2 up front. The profit is
therefore as follows:

Stock price range Proft

sr<30 +3
30<51<35 33-Sr
sr )- 35 -2
Like bull spreads, bear spreads limit troth the upside profit potential and the downside
risk. Bear spreads can be created usirrg calls instead of puts. The investor buys a call
with a high strike price an{ sells a call with a low strike price, as illustrated in
Figure 10.5. Bear spreads created with calls involve an initial cash inflow (ignoring:
margin requirements).

Box Spreads
A box spread is a combination of a btill call spr€ad with strike prices K1 and K2 and a
bear put spread with the same two strike prices. As shown in Table 10.3 the payofffrom
a box spread is always' Kz - Kr. Thr: value of a box spread is therefore always the
pr€sent value of this payoff or (K2-'Kr)e-'r.If it has a different value there is an
arbitrage opportunity. If the market price of the box spread is too low, it is profitable to
 Trudt ng Siralr,grc.s I nutlt'ing () ptiotts
25r
,wlAiixe.?]:r .., t,r.--:.rr:.,1r
1i?.,':rig3?,:7 - ,, ":ie;;e,::i_!:.;":.-,, 1i!::.,r/|j@,*

Figure 10.5 Profit frorn be[rr spread created using call optlons.

\r- sr
I
--\<
I
I

t
'.

buy the box. This involves buying a call with strike price
K1, buying a put with strike
price K2, selling a call with srrike price A12, and selling put;ith:t1ke
a price Kr. If the
market price of the box spread is too hi61h, it is profiLble
to sell the box. This involves
s buying ac4ll with srrike price K2, buying a put with strike price
K1, seiling a cail with
s strike price K1, and selling a put with strike price K2.
It is important to realize that a box-spread arbitrage only works with European
options. Most of the options that trade on exchanges
are American. As shown in
Business Snapshot 10. l, inexperienced trrLders who
treat American options as European
I are liable to lose money.
t-
f,

c
B.utterfly Spreads
s
A butterfy spread involves positions in options with three different
strike prices. It can
be created by buying a call option with a rera"tively
row strikg price, K1 ,-buying a cal
op.tisn+izith a.relatively high strike price,.K3, and ' o
price, K2, halfway between K1 and K3. Generally "ult
o the
The pattern of profits from the strategy is show
10.6.
leads to a profit if the stock price stays close
is a significant stock price move in either
le strategy for an investor who feels that larte st
ll requires,a small investment initially. Th; p
.n Table 10.5.
rg

Table 10.3 Payoffiomz-box spread.

Stock price Payofffrom I'ayof from Total
a range bull call spread beur put spread payof
m Sr)-Kz Kz- Kt 0 Kz- Kt
le
K1 <57<K2 Sr-Kr Kz-Sr K2
1n
Sr(Kr - I<-T

to
0 Kz- Kr Kz- Kr
252
CHAPTER IO

Business Snapshot 10.1 Losing lrloney wiih Bcx Spreads

Suppose that a stock has a price of $50 and
a volatility of 30%. No
#::"0 ral1is.8%. A t,ua", ., t;";h;;;;;; to ^^,, )n
cBoE a 1{:T,n:\-1,:e
2-month box spread where rhe "n
Should you do the trade? "rtk ori;JL'tir??*il: , '.::r,

spreac where the strikr: prices are

, sanlr: for both European and
becausO, as- we,s4qr o ean 6aU is tl

Suppose that a certain stock is currenr.ly worth

$6 l. Clonsider an investor who feels
that a significant price move ia the next ti months
is unliikely. suppose that the market
prices of 6-month calls are as follows:

Strike price (S ) --ollprice ($)

55 l0
60 7
65 5

Table 10.4 Values of 2-month Europeirn and American

options
ojra non-dividend-payingstock. Stock price : $50; inrterest
rate
:8o/o per annum; and volatility :30|6 Wr annum.
Option Strike Europetn llmerican
type price option price option price
Call 60 0.26 0.26
Call 55 0.96 0.96
Put 60 9AL 10.00
Put 55 5.23 5.44
7'ratlttrt! .\!rrrtc,gtts Itri olt r.tr4 ( )f tt,rt,
253
Figure 10.6 prof ir ll.orrr hrrtrcrll,r \pl_eild using call
options

_. .-i .if\?r:{iz,&?{?r-,il
,.r . i :,,1 ;:'

r could create a butterfly spn:

call with a $65 strike price, €r
$5 - (2 x $7): $l ro creare

opttons. Put-call parity can be used

to sho
both cases.
be sol<l or shorted
he rever Options
of Kl aLnd K3, and th the m
gy pro<tuces a mrd re is a si ffff"fi
* j/|* fl{*:r&t *f
Table10.5 payoff from a burterfly
spread.
Stock-price payofffrom Payojrfrom Payof from Total
_Jlnge frst long call second long call short calls payof :
Sr<Kr 0 c 0 0
Kt<Sr<Kz Sr-Kr
Kz<Sr<Kt Sr-Kr
0 0 Sr-Kr
Sr>K: Sr-Kr
0
-2(Sr - Kz) K:-Se
Sr-K: -2(Sr - Kz) 0
* These payoffs
are calculated using the relatiorLship
Kz = 0.5(Kr * Kt)
254
l0
:ir&#i-,*.?7.:?d2,,&*@
)k*r!:@e*@*,*,,rr"_r*,r*:HAPTtER
Figure 10.7 protir frorn butterlly:;pread using put options.

Calendar Spreads

used to create a spread all expire

at the
ads in which the options hau" the
sam.

Figure -t0.8 piofit lrom

calendar spread created using two calls.
Truding S trategies Intulz i.ug ()ptions
@ 255
Fig ':'''i-'4*;&')&se'[&
::rd creatcd usin_{ trvo puts.
Protir \

J-r

--_________

Figure 10.6.
t-maturiry
loss is incur " : i,:",fj
Pnce ls
rike price.

e to the current stock price is chosen.

ke price, whereas a bearish calendar

wever, a sigrrificant loss results if it is

Diagonal Spreads
Bull, bear, and calendar spreads can all
be created from a long position
a short position in another call. In the case in one call and
of bull and bear spreads, the calls have
 256
,||''l|'''|'|!|'6ry..''''.',|,4
CH \P'f ER 10
,@Weg@@4.w.e*i&&*.4p.*ri,
. t* t a.. r.-t b4 e. rk,.e,
Figure 10.10 profit l'rorn a straddle.

different strike prices and the same expiration

date. In the case ot-calendar spreads,
ca,s have the same strike price and drfferent the
.*pi.uiron-aut"r.
ln a diagonal spread both the expiration date and
che-strike price of the calls are
different' This increases the range oi
lrrofit patterns that a.. possible.

10.3 COMBINATIONS
A combination is an option trading strirtegy
that involves taking a position in both
and puts on the same stock-fA&'-rvill calls
r;oniider straddles, ;i;ipr, straps, and
stransles.
Straddle
one popular combination is a straddle,,which^involves
buyrng a call and put with the
same strike price and expiration date.'fhe pattein ir'rtrorun in Figure 10.10.
strike price is denoted by (. If the stock
irofit The
. the options' the straddle leads.to
price is
"ror.
,o ,ni, strike price at expiration of
aJoss, However, irtn",= i, u sufficiently large move in ,
a significant profit wiii"."'urt. rt'diuv.;;.;,"
fitihijfiTn, a straddle i,?i""r;i"J
A straddle is appropriate when an investor
is expecting a large move in a stock price
but does not know in w rich direction the
move *ilr u". L""rider an investor who
that the price of a certain stock, currently feels
valued at $69 by the market, wi1
significantly in the next 3 months. The investor.outa move
a straddle by buying both a
put and a cail wirh a strike price of "..*i" late in 3 months.
$tll*un suppose
that the cail costs $4 and the put costs
$3. rr,t uo"n".p,;;r."
p;; ;"r, at $69, it is easy to see
"

Table 10.6 Payofffrom a straddle.

of
Range payof Payolf Total
price
slock from catt from put payof
Sr(K 0 K-Sr K-Sr
Sr>K Sr-K 0 Sr-K
T'radtng .9tratt,!!it,: I tR rtlz,ittg
Optiatts

rha.r a big move ii

,1i.0.1"t. expecrerJ iu r.r co
takeover bid for t"h. .orpuny
compa[y is about or rhe ,",.*Tl"'fi':,'T:::'j:1,$:"y'. rhere is a
o[ a ntajor lawsuit inuoruog
t
u. oti"o,in;;. ;;ffi"me iiJ
::fu y:*,Tff ";*l*i;:l*:ji::l1i*"iJ.:iiT:"i::i,.urview.r,he
will be reflectedin thepnces rnzrrket participants,
of on1in." this view
ons ^rr,""3t"1'ler
;.":' in'anttY'o"
fi: . ififfwil
t0.10
ificantlv mo."
Th.ev-shaped.
ard;'sb that a
i':: 'rot
Yu

you must take a view

that is d
must be right!

a bottom straddle or
stqddle
selling a
strategy.
nt profit

Figure 10.'t l Profit from a strip and a stre,p.

Strip
Sqrap
258
CI I.\P'f ER IO
t)i!rn?3,r'*ai za. ., r ,:
;:.:, 4,-44ta*@,
Figure 10.12 Profit fl-onr a st rtt n !rle

:::!'./.:<-3rr'ax:-rtlu??:-:?)41r'q1r.:r.-:._.,-;42a'*
|

Strips and Straps

A strip consists of a long position in one
and expiration date. A stntp consists
of a lo
same strike price and expiration date.
T
shown in Figure l0.ll. In a strip the inv
price move and considers a decrease in
increase. In a strap the investor. is also
bett
However, in this case. an increase in the
sto
a decrease.

Strangles
,tical combin
Put and
fferent strike
srrike price, l,ffi:
;le is calcula
lle. The investor iS betting that
comparing Figures 10.12 and 10.10, ,fln'i,
in a strangle than in a straddle for the investor
*. ,i:J'rril:TX'r.,; ili
to make a profit. However, the downside
risk if the stock price ends up at a central value
is less wittL a strangle.
The profit patte with a stranl ds on how close together the strike
prices are. The fa re apart, the downsicle risk and the farther the
stock price has to p.ofiLto b" ,

Table 10.7 Payoff from a strangle.

Range of payofl Payof fron Total
slock price from call put payofl
Sr(Kr 0 Kr-Sr Kr
K; <57<K2 0
-Sr
0 0
Sr)Kz Sr-Kz 0 Sr-Kz
 Tnt,tiuq Strate.qies I tn rtft.inn ( )pt ilrt-t
259
Figure 10.13 pavolf tnrrn
l but tcrtl_r spt-clcl

ve&rxl*ar-- i!ri.> !r,:x;:. 1,-,I :'j r _

The sale of a strangle is sometimes

ref'erred to as a !op verticql
tonnbination.lt can be
,:,.1: rn.-e. ,to.k
,irx'J:iJ:"x:i:rT,iT,J",1,.,1:lll
loss to the investor.
,L 15 .1 rrsK!.str.ategy involving Ij;
are un,ike,y
unlimited pot.ntinl
;;;.';o,,.,

1O.4 OTHER PAYOFFS

This chapter has demonstrated just

a f.ew of the rva,ys
produce an int
tlationship between profit arLd
expiring ,iniJtil'lrl
", time Z coul
function at

the spike becomes smal

very small spikes, any payoff
function can be approriimated.

SUMMARY

A number
stock. For involve a r;ingle option ancl
th
option on t tnvolves buying the stock aLnrl
es buying a put option
The former and buyi
Spreads invorve either taki ,:;Tj'::flo?lJ:lini?j",,o",ffi
r cali (

prrce and selling u

ou, ft""o
ng calls (puts) with a low
rmediate strike price. A r:ale
expiration anrJ buying a

rn another option,".L,:."i,::Ti!:ilft:tll'J,"'f,"il.
combinations involve taking
a positron in'uoth cal^; and
llrrl,fJffi:lTl
straddte combinarion invorveslakins; puts on the s:rme stock. A
b;;'p"sition irr rong posirion in a
" ""fi;;i;