Trading Strategies

Involving Options
Chapter 10

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.1
 Types of Strategies

 Covered Strategies: Take a position in

the option and the underlying
 Spread Strategies: Take a position in 2
or more options of the same type (A
spread)
 Combination Strategies: Take a position
in a mixture of calls & puts (A
combination)

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.2
 Types of Strategies
 Note the following standard symbols
 C = current call price, P = current put price
 S0 = current stock price, ST = stock price at
expiration
 T = time to expiration
 X = exercise price
  = profit from strategy
 The following will represent the number of
calls, puts and stock held
 NC = number of calls
 NP = number of puts
 NS = number of shares of stock
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.3
 Types of Strategies
 These symbols imply the following:
 NC or NP or NS > 0 implies buying (going long)
 NC or NP or NS < 0 implies selling (going short)
 The Profit Equations
 Profit equation for calls held to expiration
  = NC[Max(0,ST - X) - C]
 For buyer of one call (NC = 1) this implies
  = Max(0,ST - X) - C
 For seller of one call (NC = -1) this implies
  = -Max(0,ST - X) + C

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.4
 Types of Strategies
 The Profit Equations (continued)
 Profit equation for puts held to expiration
  = NP[Max(0,X - ST) - P]
 For buyer of one put (NP = 1) this implies  = Max(0,X
- S T) - P
 For seller of one put (NP = -1) this implies =
-Max(0,X - ST) + P

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.5
 Types of Strategies
 The Profit Equations (continued)
 Profit equation for stock
  = NS[ST - S0]
 For buyer of one share (NS = 1) this implies  = ST - S0
 For short seller of one share (NS = -1) this implies  = -ST
+ S0

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.6
 Positions in an Option & the
Underlying (Figure 10.1, page 224)

Profit Profit

K
K ST ST
(a)
(b
Profit Profit )

K
ST K ST

(c (d
)
Options, Futures, and Other Derivatives ) 2005
6th Edition, Copyright © John C. Hull 10.7
 Bull Spread Using Calls
(Figure 10.2, page 225)

Bull Spread Using Calls: Buying a call option on a stock with a particular
strike price and selling a call option on the same stock with a higher
strike price.

Payoff from a Bull Spread:

Stock price Payoff from Payoff from Total Payoff

Range Long Call Short Call
Option Option

ST ≥ K2 ST - K1 K2 - ST K2 - K1
K1 < ST < K2 ST - K1 0 ST ≥ K2
ST ≤ K1 0 0 0
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.8
 Bull Spread Using Calls
(Figure 10.2, page 225)

Ex: An investor buys $3 a call with a strike price of $30 and sells
for $1 a call with a strike price of $35.

Payoff from a Bull Spread:

Stock price Payoff from Payoff from Total Payoff

Range Long Call Short Call
Option Option

ST ≥ $35 ST - $30 - $3 $35 - ST +$1 $3

$30 < ST < $35 ST - $30 -$3 0+$1 ST - $32
ST ≤ $30 0 - $3 0+$1 -$2

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.9
 Bull Spread Using Calls
(Figure 10.2, page 225)

Profit

ST
K1 K2

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.10
 Bull Spread Using Puts
Figure 10.3, page 226

Profit

K1 K2 ST

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.11
 Bear Spread Using Puts
-buying one put with a strike price of K2 and selling one put with a strike
price of K1

Profit

K1 K2 ST

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.12
 Bear Spread Using Calls
Figure 10.5, page 229

Bear Spread: Buying a call option on a stock with a particular strike price
and selling a call option on the same stock with a lower strike price.

Stock price Payoff from Payoff from Total Payoff

Range Long Call Short Call
Option Option

ST ≥ K2 ST - K2 K1 - ST -(K2 - K1)
K1 < ST < K2 0 K1 - ST -(ST ≥ K1)
ST ≤ K1 0 0 0

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.13
 Bear Spread Using Calls
Figure 10.5, page 229

Example: An investor buys a call for $1 with a strike price of $35 and sells
for $3 a call with a strike price of $30.

Stock price Payoff from Payoff from Total Payoff

Range Long Call Short Call
Option Option

ST ≥ $35 ST - $35 $30 - ST -($35 - $30)

$30 < ST < $35 0 $30 - ST -(ST ≥ $30)
ST ≤ $30 0 0 0

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.14
 Bear Spread Using Calls
Figure 10.5, page 229

Profi
t

K1 K2 ST

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.15
 Box Spread
 A combination of a bull call spread and a
bear put spread
 If all options are European a box spread is
worth the present value of the difference
between the strike prices
 If they are American this is not necessarily
so. (See Business Snapshot 10.1)

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.16
 Butterfly Spread Using Calls
 Butterfly Spread: buying a call option with a relative low
strike price, K1,, buying a call option with a relative high
strike price. K3, and selling two call options with a strike
price halfway in between, K2.
Stock price Payoff Payoff from Payoff from Total Payoff
Range from First Second Short Calls
Long Call Long Call
Option Option
ST ≥ K3 ST - K1 ST - K3 -2(ST - K2) 0
K2 < ST < K3 ST - K1 0 -2(ST - K2) K3 - ST
K2 < ST < K3 ST - K1 0 0 ST - K1
0 0 0 0
ST ≤ K1
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.17
 Butterfly Spread Using Calls
 Example: Call option prices on a $61 stock are: $10 for a $55 strike, $7
for a $60 strike, and $5 for a $65 strike. The investor could create a
butterfly spread by buying one call with $55 strike price, buying a call with
a $65 strike price, and selling two calls with a $60 strike price.

Stock price Payoff Payoff from Payoff from Total Payoff

Range from First Second Short Calls
Long Call Long Call
Option Option
ST ≥ $65 ST - $55 ST - $65 -2(ST - $60) 0
$60 < ST <$65 ST - $55 0 -2(ST - $60) $65 - ST
$55 < ST <$60 ST - $55 0 0 ST -$55
ST ≤ $55 0 0 0 0

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.18
 Butterfly Spread Using Calls
Figure 10.6, page 231

Profit

K1 K2 K3 ST

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.19
 Butterfly Spread Using Puts
Figure 10.7, page 232

Profit

K1 K2 K3 ST

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.20
 Calendar Spread Using Calls
Figure 10.8, page 232

Profit

ST
K

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.21
 Calendar Spread Using Puts
Figure 10.9, page 233

Profit

ST
K

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.22
 A Straddle Combination
Figure 10.10, page 234

Straddle: Buying a call and a put with the same strike price and expiration
Date.

Stock price Payoff from Call Payoff from Put Total Payoff
Range

ST ≥ K ST – K 0 ST - K
ST < K 0 K - ST K - ST

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.23
 A Straddle Combination
Figure 10.10, page 234

Example: An investor buying a call and a put with a strike price of $70
and an expiration date in 3 months. Suppose the call costs $4 and the
put $3.

Stock price Payoff from Call Payoff from Put Total Payoff
Range

ST ≥ $70 ST – $70 -$4 0 -$3 ST - $77

ST < $70 0 - $4 $70 - ST - $3 $63 - ST

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.24
 A Straddle Combination
Figure 10.10, page 234

Profit

K ST

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.25
 Strip & Strap
Strip: combining one long call with two long puts
Strap: combining two long calls with one long put

Profit Profit

K ST K ST

Strip Strap
Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.26
 A Strangle Combination
buying one call with a strike price of K2 and buying one put with a
strike price of K1

Profit

K1 K2
ST

Options, Futures, and Other Derivatives 6th Edition, Copyright © John C. Hull 2005 10.27