Professional Documents
Culture Documents
Option Strategies
Option Strategies
Purchasing calls has remained the most popular strategy with investors since
listedoptions were first introduced. Before moving into more complex bullish and
bearishstrategies, an investor should thoroughly understand the fundamentals about
buying andholding call options.
Market Opinion?
Bullish to Very Bullish
When to Use?
This strategy appeals to an investor who is generally more interested in the dollar
amountof his initial investment and the leveraged financial reward that long calls
can offer. The primary motivation of this investor is to realize financial reward
from an increase in priceof the underlying security. Experience and precision are
keys to selecting the right option(expiration and/or strike price) for the most
profitable result. In general, the more out-of-the-money the call is the more bullish
the strategy, as bigger increases in the underlyingstock price are required for the
option to reach the break-even point.7
As Stock Substitute
An investor who buys a call instead of purchasing the underlying stock considers
thelower dollar cost of purchasing a call contract versus an equivalent amount
of stock as aform of insurance. The uncommitted capital is "insured" against a
decline in the price of the call option's underlying stock, and can be invested
elsewhere. This investor isgenerally more interested in the number of shares of
stock underlying the call contracts purchased, than in the specific amount of the
initial investment - one call option contractfor each 100 shares he wants to own.
While holding the call option, the investor retainsthe right to purchase an
equivalent number of underlying shares at any time at the predetermined strike
price until the contract expires.
Note:
Equity option holders do not enjoy the rights due stockholders – e.g.,
voting rights,regular cash or special dividends, etc. A call holder must exercise the
option and takeownership of the underlying shares to be eligible for these rights.
Benefit
8
A long call option offers a leveraged alternative to a position in the stock. As the
contract becomes more profitable, increasing leverage can result in large
percentage profits because purchasing calls generally requires lower up-front
capital commitment than withan outright purchase of the underlying stock. Long
call contracts offer the investor a pre-determined risk.
Risk vs. Reward
Maximum Profit:
Unlimited
Maximum Loss:
Limited to the net premium paid
Upside Profit at Expiration:
Stock Price - Strike Price - Premium Paid(Assuming Stock Price above BEP)Your
maximum profit depends only on the potential price increase of the
underlyingsecurity; in theory it is unlimited. At expiration an in-the-money call
will generally beworth its intrinsic value. Though the potential loss is
predetermined and limited in dollar amount, it can be as much as 100% of
the premium initially paid for the call. Whatever your motivation for purchasing
the call, weigh the potential reward against the potentialloss of the entire premium
paid.
Break-Even-Point (BEP)?
BEP:
Strike Price + Premium PaidBefore expiration, however, if the contract's
market price has sufficient time valueremaining, the BEP can occur at a lower
stock price.
Volatility
If Volatility Increases:
Positive Effect
If Volatility Decreases:
Negative EffectAny effect of volatility on the option's total premium is on the time
value portion.
Time Decay?
Passage of Time:
Negative Effect9
The time value portion of an option's premium, which the option holder has
"purchased" by paying for the option, generally decreases, or decays, with the
passage of time. Thisdecrease accelerates as the option contract approaches
expiration.
Long Put
Long put can be an ideal tool for an investor who wishes to participate profitably
from adownward price move in the underlying stock. Before moving into more
complex bearishstrategies, an investor should thoroughly understand the
fundamentals about buying andholding put options.
Market Opinion?
Bearish
When to Use?
Purchasing puts without owning shares of the underlying stock is a purely
directionalstrategy used for bearish speculation. The primary motivation of this
investor is to realizefinancial reward from a decrease in price of the underlying
security. This investor isgenerally more interested in the dollar amount of his initial
investment and the leveragedfinancial reward that long puts can offer than in the
number of contracts purchased.Experience and precision are key in selecting the
right option (expiration and/or strike price) for the most profitable result. In
general, the more out-of-the-money the put10
purchased is the more bearish the strategy, as bigger decreases in the underlying
stock price are required for the option to reach the break-even point.
Benefit
A long put offers a leveraged alternative to a bearish, or "short sale" of
the underlyingstock, and offers less potential risk to the investor. As with a long
call, an investor who purchased and is holding a long put has predetermined,
limited financial risk versus theunlimited upside risk from a short stock sale.
Purchasing a put generally requires lower up-front capital commitment than the
margin required to establish a short stock position.Regardless of market conditions,
a long put will never require a margin call. As thecontract becomes more
profitable, increasing leverage can result in large percentage profits.
Risk vs. Reward
Maximum Profit:
Limited Only by Stock Declining to Zero
Maximum Loss:
Limited to the premium paid
Upside Profit at Expiration:
Strike Price - Stock Price at Expiration - Premium Paid(Assuming Stock Price
Below BEP)11
The maximum profit amount can be limited by the stock's potential decrease to no
lessthan zero. At expiration an in-the-money put will generally be worth its
intrinsic value.Though the potential loss is predetermined and limited in dollar
amount, it can be asmuch as 100% of the premium initially paid for the put.
Whatever your motivation for purchasing the put, weigh the potential reward
against the potential loss of the entire premium paid.
Break-Even-Point (BEP)?
BEP:
Strike Price - Premium PaidBefore expiration, however, if the contract's
market price has sufficient time valueremaining, the BEP can occur at a higher
stock price.
Volatility
If Volatility Increases:
Positive Effect
If Volatility Decreases:
Negative EffectAny effect of volatility on the option's total premium is on the time
value portion.
Time Decay?
Passage of Time:
Negative EffectThe time value portion of an option's premium, which the option
holder has "purchased"when paying for the option, generally decreases, or decays,
with the passage of time. Thisdecrease accelerates as the option contract
approaches expiration. A market observer willnotice that time decay for puts
occurs at a slightly slower rate than with calls.
Married Put
An investor purchasing a put while at the same time purchasing an equivalent
number of shares of the underlying stock is establishing a "married put" position -
a hedging strategywith a name from an old IRS ruling.
Market Opinion?
Bullish to Very Bullish12
When to Use?
The investor employing the married put strategy wants the benefits of stock
ownership(dividends, voting rights, etc.), but has concerns about unknown, near-
term, downsidemarket risks. Purchasing puts with the purchase of shares of the
underlying stock is adirectional and bullish strategy. The primary motivation of
this investor is to protect hisshares of the underlying security from a decrease
in market price. He will generally purchase a number of put contracts equivalent to
the number of shares held.
Benefit
While the married put investor retains all benefits of stock ownership, he has
"insured"his shares against an unacceptable decrease in value during the lifetime of
the put, andhas a limited, predefined, downside market risk. The premium paid for
the put option isequivalent to the premium paid for an insurance policy. No matter
how much theunderlying stock decreases in value during the option's lifetime, the
investor has aguaranteed selling price for the shares at the put's strike price. If there
is a sudden,significant decrease in the market price of the underlying stock, a put
owner has theluxury of time to react. Alternatively, a previously entered stop loss
limit order on the purchased shares might be triggered at a time and at a price
unacceptable to the investor.The put contract has conveyed to him a guaranteed
selling price, and control over whenhe chooses to sell his stock.13
The investor employing the protective put strategy owns shares of underlying stock
froma previous purchase, and generally has unrealized profits accrued from an
increase invalue of those shares. He might have concerns about unknown,
downside market risks inthe near term and wants some protection for the gains in
share value. Purchasing putswhile holding shares of underlying stock is
a directional strategy, but a bullish one.
Benefit
Like the married put investor, the protective put investor retains all benefits of
continuingstock ownership (dividends, voting rights, etc.) during the lifetime of the
put contract,unless he sells his stock. At the same time, the protective put serves to
limit downsideloss in unrealized gains accrued since the underlying stock's
purchase. No matter howmuch the underlying stock decreases in value during the
option's lifetime, the putguarantees the investor the right to sell his shares at the
put's strike price until the optionexpires. If there is a sudden, significant decrease in
the market price of the underlyingstock, a put owner has the luxury of time to
react. Alternatively, a previously entered stoploss limit order on the purchased
shares might be triggered at both a time and a priceunacceptable to the investor.
The put contract has conveyed to him a guaranteed selling price at the strike price,
and control over when he chooses to sell his stock.15
Risk vs. Reward
Maximum Profit:
Unlimited
Maximum Loss:
LimitedStrike Price - (Stock Purchase Price + Premium Paid)
Upside Profit at Expiration:
Gains in Underlying Share Value since Purchase -Premium PaidPotential
maximum profit for this strategy depends only on the potential price increase of the
underlying security; in theory it is unlimited. If the put expires in-the-money,
anygains realized from in an increase in its value will offset any decline in the
unrealized profits from the underlying shares. On the other hand, if the put expires
at- or out-of-the-money the investor will lose the entire premium paid for the put.
Break-Even-Point (BEP)?
BEP:
Stock Purchase Price + Premium Paid
Volatility
If Volatility Increases:
Positive Effect
If Volatility Decreases:
Negative EffectAny effect of volatility on the option's total premium is on the time
value portion.
Time Decay?
Passage of Time:
Negative EffectThe time value portion of an option's premium, which the option
holder has "purchased"when paying for the option, generally decreases, or decays,
with the passage of time. Thisdecrease accelerates as the option contract
approaches expiration. A market observer willnotice that time decay for puts
occurs at a slightly slower rate than with calls.
Covered Call
The covered call is a strategy in which an investor writes a call option contract
while atthe same time owning an equivalent number of shares of the underlying
stock. If thisstock is purchased simultaneously with writing the call contract,
the strategy iscommonly referred to as a "buy-write." If the shares are already held
from a previous16
purchase, it is commonly referred to an "overwrite." In either case, the stock is
generallyheld in the same brokerage account from which the investor writes the
call, and fullycollateralizes, or "covers," the obligation conveyed by writing a call
option contract. Thisstrategy is the most basic and most widely used strategy
combining the flexibility of listed options with stock ownership.
Market Opinion?
Neutral to Bullish on the Underlying Stock
When to Use?
Though the covered call can be utilized in any market condition, it is most
oftenemployed when the investor, while bullish on the underlying stock, feels that
its marketvalue will experience little range over the lifetime of the call contract.
The investor desires to either generate additional income (over dividends) from
shares of theunderlying stock, and/or provide a limited amount of protection
against a decline inunderlying stock value.
Benefit
17
While this strategy can offer limited protection from a decline in price of the
underlyingstock and limited profit participation with an increase in stock price, it
generates income because the investor keeps the premium received from writing
the call. At the same time,the investor can appreciate all benefits of underlying
stock ownership, such as dividendsand voting rights, unless he is assigned an
exercise notice on the written call and isobligated to sell his shares. The
covered call is widely regarded as a conservative strategy because it decreases the
risk of stock ownership.
Risk vs. Reward
Maximum Profit:
Limited
Maximum Loss:
Substantial
Upside Profit at Expiration if Assigned:
Premium Received + Difference (if any)Between Strike Price and Stock Purchase
Price
Upside Profit at Expiration if Not Assigned:
Any Gains in Stock Value + PremiumReceivedMaximum profit will occur if the
price of the underlying stock you own is at or above thecall option's strike price,
either at its expiration or when you might be assigned anexercise notice for the call
before it expires. The risk of real financial loss with thisstrategy comes from the
shares of stock held by the investor. This loss can becomesubstantial if the stock
price continues to decline in price as the written call expires. Atthe call's
expiration, loss can be calculated as the original purchase price of the stock lessits
current market price, less the premium received from initial sale of the call. Any
lossaccrued from a decline in stock price is offset by the premium you received
from theinitial sale of the call option. As long as the underlying shares of stock are
not sold, thiswould be an unrealized loss. Assignment on a written call is always
possible. An investor holding shares with a low cost basis should consult his tax
advisor about the taxramifications of writing calls on such shares.
Break-Even-Point (BEP)?
BEP:
Stock Purchase Price - Premium Received
Volatility
If Volatility Increases:
Negative Effect
If Volatility Decreases:
Positive Effect18
Any effect of volatility on the option's price is on the time value portion of the
option's premium.
Time Decay?
Passage of Time:
Positive EffectWith the passage of time, the time value portion of the option's
premium generallydecreases - a positive effect for an investor with a short option
position.
Cash Secured Put
According to the terms of a put contract, a put writer is obligated to purchase
anequivalent number of underlying shares at the put's strike price if assigned an
exercisenotice on the written contract. Many investors write puts because they are
willing to beassigned and acquire shares of the underlying stock in exchange for
the premiumreceived from the put's sale. For this discussion, a put writer's position
will be consideredas "cash-secured" if he has on deposit with his brokerage firm a
cash amount (or equivalent) sufficient to cover such a purchase.
Market Opinion?
Neutral to Slightly Bullish
When to Use?
There are two key motivations for employing this strategy: either as an attempt
to purchase underlying shares below current market price, or to collect and
keep premiumfrom the sale of puts which expire out-of-the-money and with no
value. An investor should write a cash secured put only when he would be
comfortable owning underlyingshares, because assignment is always possible at
any time before the put expires. Inaddition, he should be satisfied that the net cost
for the shares will be at a satisfactory19
net cost than the cost of the put alone. In some cases, depending on the strike
prices andthe expiration month chosen, the premium received from writing the call
will be morethan the cost of the put. In other words, the combination can
sometimes be established for a net credit - the investor receives cash for
establishing the position. The investor keepsthe cash credit, regardless of the
price of the underlying stock when the options expire.Until the investor either
exercises his put and sells the underlying stock, or is assigned anexercise notice on
the written call and is obligated to sell his stock, all rights of stock ownership are
retained.
Risk vs. Reward
This example assumes an accrued profit from the investor's underlying shares at
the timethe call and put positions are established, and that this unrealized profit is
being protectedon the downside by the long put. Therefore, discussion of
maximum loss does not apply.Rather, in evaluating profit and/or loss below, bear
in mind the underlying stock's purchase price (or cost basis). Compare that to the
net price received at expiration on thedownside from exercising the put and selling
the underlying shares, or the net sale priceof the stock on the upside if assigned on
the written call option. This example alsoassumes that when the combined position
is established, both the written call and purchased put are out-of-the-money.
Net Upside Stock Sale Price if Assigned on the Written Call:
Call's Strike Price + Net Credit Received for Combination
or
Call's Strike Price - Net Debit Paid for Combination
Net Downside Stock Sale Priceif Exercising the Long Put:
Put's Strike Price + Net Credit Received for Combination
or
Put's Strike Price - Net Debit Paid for Combination23
If the underlying stock price is between the strike prices of the call and put when
theoptions expire, both options will generally expire with no value. In this case, the
investor will lose the entire net premium paid when establishing the combination,
or keep theentire net cash credit received when establishing the combination.
Balance either resultwith the underlying stock profits accrued when the spread was
established.
Break-Even-Point (BEP)?
In this example, the investor is protecting his accrued profits from the underlying
stock with a sale price for the shares guaranteed at the long put's strike price.
In this case,consideration of BEP does not apply.
Volatility
If Volatility Increases:
Effect Varies
If Volatility Decreases:
Effect VariesThe effect of an increase or decrease in the volatility of the
underlying stock may benoticed in the time value portion of the options' premiums.
The net effect on the strategywill depend on whether the long and/or short options
are in-the-money or out-of-the-money, and the time remaining until expiration.
Time Decay?
Passage of Time:
Effect VariesThe effect of time decay on this strategy varies with the underlying
stock's price level inrelation to the strike prices of the long and short options. If the
stock price is midway between the strike prices, the effect can be minimal. If the
stock price is closer to thelower strike price of the long put, losses generally
increase at a faster rate as time passes.Alternatively, if the underlying stock price is
closer to the higher strike price of thewritten call, profits generally increase at a
faster rate as time passes.24
Long Straddle
A strategy of trading options whereby the trader will purchase a long call and
a long putwith the same underlying asset, expiration date and strike price. The
strike price willusually be at the money or near the current market price of
the underlying security.The strategy is a bet on increased volatility in the future as
profits from this strategy aremaximized if the underlying security moves up or
down from present levels. Should theunderlying security's price move a small
amount, (or not at all), the options will beworthless at expiration.
V i e w C o m
m e n t
P r o f i t U n l
i m i t e d L o s s L
i m i t e d t o t h e n e
t p r e m i u m p a i d B r
e a k e v e n L o w B E P = S t r i k e
p r i c e – n e t p r e m i u m High BEP =
Strike price + net
premiumT i m e D e c a y
H u r t s U s e E x p e c t i n g
a l a r g e b r e a k o u t , U n c e r t
a i n a b o u t t h e d i r e c t i o n 25
V o l a t i l i t y V o l a t i l i t y i n c r e a
s e i m p r o v e s t h e p o s i t i o n M
a r g i n
N o
Profits and losses
At expiry, the investor will make profits if the share price has moved strongly
enough ineither direction. Profits can be taken early in the life of the straddle, but
only if theexpected movement occurs quickly. As the market moves strongly in
one direction, thegain made on one leg exceeds the loss incurred on the other, and
the straddle increases invalue.
Other considerations
Time decay
:The bought straddle consists of two long positions. As a result, time decay works
stronglyagainst the bought straddle. The longer the straddle is left in place,
the greater the lossdue to time decay. The position must therefore be closely
monitored and may need to beclosed out well before expiry.
Expiry month:
The investor must balance the cost of the strategy against the time needed to give it
the best chance of success. The more distant expiry months will provide the
strategy with26
more time, however longer dated options will be more expensive than those with
shorter dates.Where the investor expects a sharp movement in the share price, but
is unsure of thedirection it will take, the long straddle may be appropriate.
Follow up action
The taker of a long straddle expects volatility in the market to increase. Only rarely
willthis strategy be held to expiry. If the investor’s market view proves correct, the
straddleshould be unwound to crystallize the profits. The position can be liquidated
on bothsides simultaneously or, if the out-of-the-money option has little value, it
could be leftopen in case the markets were to reverse.
Short Straddle
An options strategy carried out by holding a short position in both a call and a put
thathave the same strike price and expiration date. The maximum profit is the
amount of premium collected by writing the options.If a trader writes a straddle
with a strike price of Rs.100 and the price of the stock jumpsup to Rs. 175, the
trader would be obligated to sell the stock for Rs. 100. If the investor did not hold
the underlying stock, he or she would be forced to buy it on the market for Rs.175
and sell it for Rs.100.The short straddle is a very risky strategy an investor uses
when he or she believes that astock's price will not move up or down significantly.
Because of its riskiness, the short27
straddle should be employed only by advanced traders due to the unlimited amount
of risk associated with a very large move up or down.
Construction
Short call X, short put X
Point of entry
Market near strike price X
Maximum profit (at expiry)
Limited to premium
Maximum loss (at expiry)
Unlimited
Time decay
Helps the short straddle
Margins to be paid
Yes28
Other considerations
Time decay
:The sold straddle consists of two short positions. As a result, time decay assists
thecombination. In order to get the greatest benefit from time decay, it may be best
to tradeoptions with near-month expiries, where time decay is starting to
accelerate.
Risk of exercise:
Unless the share price is exactly at the strike price of the two options sold, one of
thelegs will be in-the-money. Therefore, there is always a risk of early exercise on
one legor the other.
Taking protection:
The trader who is unhappy about being exposed to possibly unlimited losses
mayconsider limiting their potential loss. This can be achieved by taking a put and
a calloption with out-of-the-money strike prices.
Volatility:
An increase in volatility will be damaging to the short straddle. The twowritten
options may rise in value, making them more expensive to buy back. Thehigher
volatility also signals that the market may be about to move strongly. The
optiontrader must monitor volatility closely and be prepared to take action should
it increaseunexpectedly.For the investor who believes the share price is stagnating,
the short straddle may be an appropriate way of earning income.
When to use the short straddle?
29
Market outlook aggressively neutralVolatility outlook falling
Follow-up action
If the share price remains stable around the strike price, the maximum profit will
occur.However, because of the risk of exercise, few short straddles are held until
expiryIn the event of an adverse market movement, the investor may decide to
close out one or both legs of the straddle. Alternatively, as mentioned above, an
out-of-the-money optioncould be taken as protection. The costs of adjusting the
existing straddle position should be weighed against the risks of leaving it in place.
Long Strangle
The long strangle is a neutral-outlook options trading strategy that involve
thesimultaneous buying of a slightly out-of-the-money put and a slightly out-of-
the-moneycall of the same underlying security and expiration date. It is an
unlimited profit, limitedrisk strategy that is taken when the options trader thinks
that the price of the underlyingsecurity will experience high volatility in the near
term. The long strangle is a debitspread as a net debit is taken to enter the trade.30
Risk:
Limited
Reward:
Unlimited
The Trade:
Buying out-of-the-money calls and puts
WHEN TO USE:
You believe the stock/index will have an explosive move either up or down. This
strategy is similar to the buy straddle but the premium paid is less but then alarger
move is needed to show a profit.
VOLATILITY EXPECTATION:
Very bullish, increases in volatility work marvels for the position
PROFIT:
The profit potential is unlimited although a substantial directional movementis
necessary to yield a profit for both a rise or fall in the underlying.
LOSS:
Occurs if the market is static; limited to the premium paid in establishing
the position
BREAKEVEN:
Occurs if the market rises above the higher strike price at B by anamount equal to
the cost of establishing the position, or if the market falls below thelower strike
price at A by the amount equal to the cost of establishing the position.
TIME DECAY:
This position is a big wasting asset. As time passes, value of positionerodes toward
expiration value. If volatility increases, erosion slows, if volatilitydecreases,
erosion speeds up.
Short Strangle
31
The
short strangle
is a neutral-outlook options trading strategy that involves thesimultaneous selling
of a slightly out-of-the-money put and a slightly out-of-the-moneycall of the same
underlying security and expiration date. It is a limited profit, unlimitedrisk strategy
that is taken when the options trader thinks that the underlying stock
willexperience little volatility in the near term. The short strangle is a credit spread
as a netcredit is taken to enter the trade.
WHEN TO USE:
You believe the stock/index will move in a range or sideways type price action.
This strategy is similar to the sell straddle but the premium received issmaller but
then a larger move either way is needed to show a loss. Which options to sell(or
how far away from the underlying price) depends on what type of range you
expect.Expecting a tight range, nearer the money; expecting a wide range then
further out-of-the-money.
VOLATILITY EXPECTATION:
Very bearish, a decrease in volatility will work marvels for the position32
PROFIT:
The profit potential is limited but a substantial and sudden move can turn thistrade
into a big loser especially if one of the sold options goes ‘into the
money’. Butgenerally considered as a more cautious trade than a ‘short straddle’.
LOSS:
Unlimited for a sharp move in the underlying in either direction
BREAKEVEN:
Occurs if the underlying expires below strike A or above strike B by thesame
amount as the premium received in establishing the position.
TIME DECAY:
This position is a big wasting asset therefore time decay helpsenormously. But if
volatility increases, erosion slows, if volatility decreases, erosionspeeds up.
Strap
An options strategy created by being long in one put and two call options, all with
theexact same strike price, maturity and underlying asset. It is also referred to as a
"tripleoption".A strap option is used when a trader believes that the future price
movement of theunderlying security will be large and more likely up than down.
By adding two calloptions the trader has a large gain if he or she is right about the
large upward movement.But if the forecast is wrong and the price has a large
reversal, the trader is protected bythe put option.
Strip
An options strategy created by being long in two calls and one put with the same
strike price and expiration date.In a strip, the investor is betting that there will be a
big price move and considers adecrease in the stock price to be more likely than an
increase.
Profit from a Strip and a Strap
33
StripStrap
Benefit
The bull call spread can be considered a doubly hedged strategy. The price paid for
thecall with the lower strike price is partially offset by the premium received from
writingthe call with a higher strike price. Thus, the investor's investment in the
long call, and therisk of losing the entire premium paid for it, is reduced or
hedged.On the other hand, the long call with the lower strike price caps or hedges
the financialrisk of the written call with the higher strike price. If the investor is
assigned an exercisenotice on the written call and must sell an equivalent number
of underlying shares at thestrike price, those shares can be purchased at a
predetermined price by exercising the purchased call with the lower strike price.
As a trade-off for the hedge it offers, thiswritten call limits the potential maximum
profit for the strategy.
Risk vs. Reward
36
between the strike prices, the effect can be minimal. If the stock price is closer to
thelower strike price of the long call, losses generally increase at a faster rate as
time passes.Alternatively, if the underlying stock price is closer to the higher strike
price of thewritten call, profits generally increase at a faster rate as time passes.
Bear Put Spread
Establishing a bear put spread involves the purchase of a put option on a
particular underlying stock, while simultaneously writing a put option on the same
underlying stock with the same expiration month, but with a lower strike price.
Both the buy and the sellsides of this spread are opening transactions, and are
always the same number of contracts.This spread is sometimes more broadly
categorized as a "vertical spread": a family of spreads involving options of the
same stock, same expiration month, but different strike prices. They can be
created with either all calls or all puts, and be bullish or bearish. The bear put
spread, as any spread, can be executed as a "package" in one single transaction,not
as separate buy and sell transactions. For this bearish vertical spread, a bid and
offer for the whole package can be requested through your brokerage firm from an
exchangewhere the options are listed and traded.
Market Opinion?
Moderately Bearish to Bearish
When to Use?
Moderately Bearish
An investor often employs the bear put spread in moderately bearish
marketenvironments, and wants to capitalize on a modest decrease in price of the
underlyingstock. If the investor's opinion is very bearish on a stock it will generally
prove more profitable to make a simple put purchase.
Risk Reduction
An investor will also turn to this spread when there is discomfort with either the
cost of 38
purchasing and holding the long put alone, or with the conviction of his bearish
marketopinion.
Benefit
The bear put spread can be considered a doubly hedged strategy. The price paid for
the put with the higher strike price is partially offset by the premium received from
writingthe put with a lower strike price. Thus, the investor's investment in the long
put and therisk of losing the entire premium paid for it, is reduced or hedged.On
the other hand, the long put with the higher strike price caps or hedges the
financialrisk of the written put with the lower strike price. If the investor is
assigned an exercisenotice on the written put, and must purchase an equivalent
number of underlying sharesat its strike price, he can sell the purchased put with
the higher strike price in themarketplace. The premium received from the put's sale
can partially offset the cost of purchasing the shares from the assignment. The net
cost to the investor will generally bea price less than current market prices. As a
trade-off for the hedge it offers, this written put limits the potential maximum
profit for the strategy.
Risk vs. Reward
Downside Maximum Profit:
LimitedDifference Between Strike Prices - Net Debit Paid
Maximum Loss:
Limited Net Debit Paid39
A bear put spread tends to be profitable if the underlying stock decreases in price.
It can be established in one transaction, but always at a debit (net cash outflow).
The put withthe higher strike price will always be purchased at a price greater than
the offsetting premium received from writing the put with the lower strike
price.Maximum loss for this spread will generally occur as underlying stock
price rises abovethe higher strike price. If both options expire out-of-the-money
with no value, the entirenet debit paid for the spread will be lost.The maximum
profit for this spread will generally occur as the underlying stock pricedeclines
below the lower strike price, and both options expire in-the-money. This will bethe
case no matter how low the underlying stock has declined in price. If the
underlyingstock is in between the strike prices when the puts expire, the
purchased put will be in-the-money, and be worth its intrinsic value. The written
put will be out-of-the-money,and have no value.
Break-Even-Point (BEP)?
BEP:
Strike Price of Purchased Put - Net Debit Paid
Volatility
If Volatility Increases:
Effect Varies
If Volatility Decreases:
Effect VariesThe effect of an increase or decrease in either the volatility of the
underlying stock may be noticed in the time value portion of the options'
premiums. The net effect on thestrategy will depend on whether the long and/or
short options are in-the-money or out-of-the-money, and the time remaining until
expiration.
Time Decay?
Passage of Time:
Effect VariesThe effect of time decay on this strategy varies with the underlying
stock's price level inrelation to the strike prices of the long and short options. If the
stock price is midway between the strike prices, the effect can be minimal. If the
stock price is closer to thehigher strike price of the purchased put, losses generally
increase at a faster rate as time passes. Alternatively, if the underlying stock price
is closer to the lower strike price of thewritten put, profits generally increase at a
faster rate as time passes.40
Butterfly Spreads
A butterfly spread involves positions in options with 3 different strike prices. It
can becreated by buying a call (put) option with a relatively low strike price, K1,
buying a call(put) option with a relatively high strike price, K3, and selling 2 call
(put) options with astrike price, K2 , halfway between K1 and K3. Generally K2 is
close to the current stock price.A butterfly spread leads to a profit if the
stock price stays close to K2 but gives rise to asmall loss if there is a significant
stock price move in either direction. It is therefore aninappropriate strategy for an
investor who feels that large stock price moves are unlikely.The strategy requires
a small investment initially.
Construction,
Long call (Put) K1, short 2 calls (Put) K2,Long call (put) K3
Point of entry
Market around central strike price
Break-even points(at expiry)
Lower strike plus cost of spreadUpper strike less cost of spread
Maximum profit(at expiry)
Central strike less lower strike lesscost of spread
Maximum loss(at expiry)
Cost of spread
Time decay market:around upper or lower strikearound central strike
HurtsHelps
Margins to be paid
Yes41
While the use of the long butterfly implies a neutral view of the market’s direction,
anyleaning towards bullishness or bearishness will influence the choice of
componentoptions. Since the strategy always involves the sale of options around-
the-money, thereis always the risk of exercise as the market price moves away
from the central strike price. Whether this risk is present in the case of a market
rise or a market fall, willdepend on whether calls, or puts, or a combination of the
two, have been sold. If thetrader has built the long butterfly using only calls, a rise
in the market introduces the risk of exercise. If only puts have been used, a fall in
the market exposes the trader to thesame risk. Therefore, any directional view of
the market the trader holds may suggestone way of structuring the long butterfly in
preference to another.A butterfly can be sold or shorted by following the reverse
strategy. Options are sold withstrike prices K1 and K3, and two options with the
middle strike price K2 are purchased.This strategy produces a modest profit if
there is a significant movement in the stock price.
Visitmbafin.blogspot.comfor more projectreports, presentations, notes etc.
Box Spreads
A box spread is a combination of a bull spread with strike prices K1 and K2 & a
bear putspread with the same two strike prices.43
The value of a box spread is always the present value of the payoff or (K2 – K1). If
it hasa different value, there is an arbitrage opportunity. If the market price of the
box spread istoo low, it is profitable to buy the box.This involves buying a call
with strike price K1, buying a put with K2, selling a call withK2 and selling a put
with K1.If the market price of the box spread is too high, it is profitable to sell the
box.This involves buying a call with strike price K2,buying a put with K1, selling a
call withK1 and selling a put with K2.
Calendar Spreads
A calendar spread can be created by selling a call (put) option with a certain strike
priceand buying a longer-maturity call (put) option with the same strike price.The
longer the maturity of an option, the more expensive it usually is. A
calendar spreadtherefore requires an initial investment.The investor makes a profit
if the stock price at the expiration of the short-maturityoption is close to the strike
price of the short-maturity option. However, a loss is incurredwhen the stock price
is significantly above or below the strike price.In a
neutral calendar spread
, a strike price close to the current stock price is chosen.A
bullish calendar spread
involves a higher strike price, whereas a
bearish calendarspread
involves a lower strike price.A
reverse calendar spread
can be created by buying a short-maturity option and sellinga long-maturity option.
A small profit arises if the stock price at the expiration of the44
short-maturity option is well above or well below the strike price of the short-
maturityoption.However, a significant loss results if it is close to the strike price.
Diagonal Spreads
In a diagonal spread, both the expiration date and the strike price of the options
aredifferent. This increases the range off profit patterns that are possible.
Ratio Call Spread
A very bullish investment strategy that combines options to create a spread with
limitedloss potential and mixed profit potential. It is generally created by selling
one call optionand then using the collected premium to purchase a greater number
of call options at ahigher strike price. This strategy has potentially unlimited upside
profit because the trader is holding more long call options than short ones.An
investor using this strategy would sell fewer calls at a low strike price and buy
morecalls at a high strike price. The most common ratios used in this strategy are
one shortcall combined with two long calls, or two short calls combined with three
long calls. If this strategy is established at a credit, the trader stands to make a
small gain if the price of the underlying decreases dramatically
Risk:
Limited
Reward:
Unlimited
The Trade:
The trade itself involves selling a call (normally at the money or near to themoney)
at a lower strike and buying a greater number of calls at a higher strike
price.Depending on the strikes chosen, the position could also be established at
break-even or at a small premium cost.
WHEN TO USE:
For bullish investors who expect big moves in already volatilestocks/indexes, call
back spreads are a great limited risk, unlimited reward strategy45
VOLATILITY EXPECTATION:
Bullish, you want to see volatility levels keep at leaststable, but preferably rise.
PROFIT:
Unlimited if underlying rallies.
LOSS:
Greatest loss occurs at higher strike which is the difference between strikes
minus(plus) net credit (debit).
BREAKEVEN:
Lower break-even point is reached when the underlying exceeds thelower strike
option by the same amount as the net credit received (if initial positionestablished
at a net cost, there is no lower break-even point). Higher break-even pointreached
when intrinsic value of the lower strike is equal to the intrinsic value of
the twohigher strike options plus (minus) the net credit (debit).
TIME DECAY:
Hurts but not too much
Construction
Long call X, Short Calls Y
Point of entry
Market around X
Break-even points(at expiry)
Lower strike plus cost of the spreadUpper strike plus maximum profit
Maximum profit(at expiry)
Difference between strike prices lesscost of spread
Maximum loss(at expiry
)Unlimited if shares riseCost of spread if shares fall
Time decay - market around lowerstrike
Hurts
Margins to be paid
Yes, on naked calls46
Synthetic Long
Here the arbitrageur buys one call, sells one put and sells one futures+
Synthetic Short
Here the arbitrageur sells one call, buys one put and buys one futures
Market neutral strategy
This involves:Selling two deeply out-of-the-money options (one call and one put)
&Buying 2 at-the-money options (one call and one put)The investor will lose his
initial investment if the market stays close to the strike price of the at-the-money
options but will gain if market moves in either direction.