Trading Strategies Involving Options

Thota Nagaraju
Dept of Econ & Fin
BITS-Pilani Hyd Campus
Derivatives and Risk Management
Trading Strategies Involving Options
Source: Chapter-11: 8th edition Hull Book

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Why should we discuss about the Trading Strategies Involving Options?
Through this chapter, we will learn as what can be achieved when an option is traded in
conjunction with other assets. In particular, we examine the properties of portfolios
consisting of positions in (a) an option and a zero-coupon bond, (b) an option and the asset
underlying the option, and (c) two or more options on the same underlying asset.

Learning Outcomes of this chapter

Principal-Protected Notes
Trading an Option and the Underlying Asset: Covered Call & Protective Puts
Spreads: Bull, Bear, Box, Butterfly, and Calendar Spreads
Combinations: Straddle; Strips and Straps and Strangles

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Strategies to be Considered
Bond plus option to create principal protected note
Stock plus option
Two or more options of the same type (a spread)
Only calls or
Only puts
Two or more options of different types (a combination)
Mix of both (Calls and Puts)

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Principal Protected Note
Allows investor to take a risky position without risking any principal
Example: $1000 instrument consisting of
3-year zero-coupon bond with principal of $1000
3-year at-the-money call option on a stock portfolio currently worth $1000
Viability depends on
Level of dividends
Level of interest rates
Volatility of the portfolio
Variations on standard product
Out of the money strike price
Caps on investor return
Knock outs, averaging features, etc.

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Positions in an Option & the Underlying
When is it appropriate?: If you own an underlying stock and you think that its price
is going to stay flat, but you don't want to sell it, then you can write a call.

This is called a covered call strategy and it's a nice way to profit from one of your equity holdings that would otherwise
be static.
Keep in mind that you are still exposed to downside risk and you have sold off your upside potential, but you are
rewarded with a premium from selling the call.

Covered Call (CC): One long stock and one short call.
Kinks occurs at strike prices.

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Positions in an Option & the Underlying
Protective Put: Involves one long stock and one long put.
It is the classical insurance use of options case.
When to go for Protective Put?
1. the stock has increased in value and protection for unrealized profits is purchased
2. a put is bought at the same time the stock is purchased
3. the stock has decreased in value and protection from further loss is desired

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Bull Spread Using Calls
Bullish Vertical Spread with Calls (AKA: A Bull Call Spread, or a bullish call money spread).
Buy Call with lower strike.
Sell Call with higher strike.

Since the purchased call has a higher price than the written call there is a initial cash outflow in
this strategy

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Bull Spread Using Puts
Bullish Vertical Spread with Puts (AKA: A Bull Put Spread.)
Buy Put with lower strike.
Sell Put with higher strike.
Since the written (sell) put has a higher price than the purchased (long) put there is a initial cash inflow
in this strategy

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Bear Spread Using Calls
Bearish Vertical Spread with Calls (AKA: A Bear Call Spread.)
Buy call with higher strike.
Sell call with lower strike.
Since the written call with lower strike price is higher than the long call with higher strike price so there
is an initial cash inflow in this strategy.

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Bear Spread Using Puts
Bearish Vertical Spread with Puts (AKA: A Bear Put Spread.)
Buy put with higher strike.
Sell put with lower strike.
Since the purchased (long) put with higher strike price is higher than the short (sell) put with
lower strike price so there is an initial cash outflow in this strategy.

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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

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Butterfly Spread Using Calls
This is a Long Call Butterfly: With equally spaced strikes:
Long 1 with lowest strike (K1);
Short 2 with middle strike (K2); where K2=(K1+K3/2)
Long 1 with highest strike (K3)

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Butterfly Spread Using Puts
This is a Long Put Butterfly: With equally spaced strikes:
Long 1 with lowest strike (k1);
Short 2 with middle strike(K2); where K2=(K1+K3/2)
Long 1 with highest strike(K3)

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Calendar Spread Using Calls
.

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Calendar Spread Using Puts
.

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A Straddle Combination
A Long Straddle is formed by a long call and a long put:
Both have the same strike and expiration date.
In a Short Straddle, one sells the call and sells the put.

Long Straddle: buying a European call and put with the same strike price and expiration date.

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Strip & Strap
Strips and straps are formed by using a different number of calls and puts. However, all the options share
The same strike price.
The same expiration date.
A strip consists of a long position in one European call and two European puts with the same strike price and
expiration date.
A strap consists of a long position in two European calls and one European put with the same strike price and
expiration date.

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A Strangle Combination
A Long Strangle is formed by a long call and a long put:
Both have the same expiration date.
But, the call and put have different strike prices.
In a Short Strangle, one sells the call and sells the put. (How does it look like?)

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Zero Collar Strategy
Long a put with K1 and shirt a call with K2 (where K1 < K2)
The puts and calls are both out of money options having the same expiration
date and must be equal in the number of contracts.

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Condor Strategy
Uses four, equally spaced strikes.
For a long condor spread: Long 1 at the lowest and 1 at the highest strike; short 1 at both
intervening strikes.
The resulting payoff resembles a butterfly spread, but with a flat spot between the
middle two strikes. (The payoff for a long butterfly resembles a witches hat; the payoff for
a long condor resembles a stovepipe hat.)

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Other Payoff Patterns
When the strike prices are close together a butterfly spread provides a payoff
consisting of a small spike
If options with all strike prices were available any payoff pattern could (at least
approximately) be created by combining the spikes obtained from different
butterfly spreads

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