Advanced Option Strategies

Derivatives and Risk Management

Outline
 Principles of Money Spreads and combinations
 Bull spread
 Bear spread
 Butterfly Spread
 Calendar spreads
 Combinations
 Collars
 Straddle
 Strips and straps
 strangles
Option Spreads

 What do we mean by a spread?

 Types of Spreads
 Vertical/Money Spread
 Horizontal Spread
 Buying the Spread
 Selling the Spread
 Why use spreads?
Money Spreads

 Bull Spreads
 Bear Spreads
Bull Spread

 Creating Bull spread with calls

 Buy a call option on a stock with a certain
exercise price and sell a call option on the same
stock with a higher exercise price
 Example
 Creating Bull spread with puts
 Buy a put with a low strike price and sell a put with
a high strike price
 Example
Bear Spread

 Bearish on stock
 Creating bear spread with puts
 Buy a put with a high exercise price and sell a put
with a low exercise price
 Example
 Creating bear spread with calls
 Buy a call with higher exercise price and sell a call
with a lower exercise price
 Example
Butterfly Spread
 Involves two positions in options with three different
exercise prices
 Buy a call with a relatively low exercise price, say E1
 Buy a call with a relatively high exercise price, say
E3, and
 Sell two calls with a strike price of E2
 Usually, E2 is halfway between E1 and E3
 E2 is usually close to the current stock price
 Payoff diagram for a butterfly spread
 A butterfly spread leads to a profit if the stock price
stays close to E2, but
 Gives a small loss if there is a significant movement
in either direction
 Good strategy if you feel significant stock price
changes are unlikely
 Require small investment initially to setup the
spread
 Examples
 Breakeven point
Calendar Spread

 Sell a call option with a certain exercise price

and
 Buy a longer maturity call option with the
same strike price
 Longer the maturity of the option bought, the
more expensive it is due to speculative value
of the option
 Requires initial investment to setup
 Assuming that the long-maturity option is sold
when the short-maturity option matures,
 What will be the payoff diagram?
 How to determine profit/loss?
 Types of Calendar Spreads
 Neutral Calendar Spreads
 Bullish Calendar Spread
 Bearish Calendar Spread
 Calendar Spread with Put Options
Reverse Calendar Spread

 If you anticipate the stock price to move into

in extremes, you can execute a reverse
calendar spread
 Buy a call with a shorter maturity and
 Sell a call with a longer maturity with the
same exercise price
Combinations

 Combination is an option trading strategy that

involves taking a position in both calls and
puts on the same stock
 Straddle
 Strips
 Straps
 Strangles
 Collars
Straddle

 Buy a call and buy a put with the same strike

price and expiration date
 Payoff diagram
 When do you profit?
 When to use this strategy?
 Examples
 Breakeven points
Short a straddle

 Sale of a put and a call with the same

exercise price and expiration date
 High risk strategy, especially if the stock price
moves too much
Strips and Straps

 Strip
 Long position in one call and two puts with the
same strike price and expiration date
 Strap
 A long position in two calls and one put with the
same strike price and maturity
Strangle

 Buy a put and a call with the same maturity

date, but different strike prices
Collars

 Buy a stock
 Buy a put on the stock with an exercise price
lower than the current stock price
 Sell a call on the stock with an exercise price
higher than the current stock price
 Choose the call exercise price in such a
manner that the call premium completely
offsets the put premium
  = Ns (ST – S) + NP[MAX(0, E1 - ST) – P1] –
Nc[max(0, ST – E2) – C2]

 If stock price at maturity is below both the

exercise prices?
 If the stock price at maturity is between the
two exercise prices
 If the stock price at maturity is higher than
both the exercise prices