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Trading Strategies using Options

on Derivatives

PUT CALL RATIO


Put trading volume/Call trading volume over a day
or week
When this ratio is higher, market expects to
decline
Investors buy put when they feel that price of
asset will fall by expiration date
It also determines market sentiments
Low ratio indicates bullish trend in the market

OPEN INTEREST
This indicates the outstanding position of
contracts on a particular asset
An investor who purchased an option can close
the position by selling the same
A writer of option can close the position by buying
the same option
When an option contract is traded and if neither
investor close the position, open interest
increases by one contract
If one investor is closing existing position and
other do not, the open interest remains same

Contd.
If both investors close existing position, the open
interest goes down
It indicates expected market trend either bullish or
bearish
Higher price but decline in trade volume and open
interest indicates bullish trend
Decline in Price together with rise in trading
volume and open interest, market may go bearish
Decline in price and declining in trading volume
and open interest, maeket is likely to reverse.

Topics

Introduction
Strategies for a single option and a stock
Covered call

Spreads and spread trading


Bull call spread

Combinations
Long Straddle
Strangle
Short Straddle

Other strategies

Box spread
Calendar spread
Diagonal spread
Butterfly spread

Conclusion
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Introduction
Factors affecting the option price

Current stock price

S0

(Positive)

Strike price
K ( Inverse)
Time to expiration
T (positive)
Volatility of the stock
(positive)
Risk-free interest rate
r (Positive)
Dividend expected before the option expiration (Inverse)

Options can be combined to create a range of payoffs looking at holding a portfolio vs. a single stock or option
For simplicity, we will ignore the time value of money thus
the profit for any strategy will be the final payoff initial cost
Including transaction costs will not change the strategy being
discussed. It is not included in the examples shown.
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Single Option and a Stock


Covered Call: Long in the stock S and short in the Call
The covered call strategy works for the stocks for
which one does not expect a lot of upside or
downside
This strategy decreases risk but also the profit
potential
It is considered a conservative strategy
Consider the following example of ABC Company

Stock price
Strike price
Time to expiration
Call premium

S0 = 63
K = 67
T = 3 mo (Sep 15)
c = 1 (currently out-of-the money)
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Single Option and a Stock

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Single Option and a Stock

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Long Stock
Investor owns 100 share at Rs.63. So for any
change in price above Rs.63 there is a profit
and for any change in price below Rs.63 there
is a loss incurred
Short Call (investor has sold a call option)
Investor has received the premium of Rs.1 per
share for 100 shares
The option will be exercised by the holder only if
the ST is above K or else it will expire unused
When exercised the investor will lose the
difference in the ST and K but will always have
the initial premium collected
If ST = 70 then investor has to sell the shares at
67 and incur a loss: (67-70)*100 + 100 = -200
Portfolio
Sum of the two positions

Spreads & Spread Trading


Spread trading involves taking a position in two or
more options at the same time
Bull spread: When the investor expects the stock price
to increase buy a call option with a strike price and
sell a call option on the same stock with a higher strike
price. Both options have the same expiration date
Bear spread: When the investor expects the stock price
to decrease buy a put option with a strike price and
sell a put option on the same stock with a lower strike
price. Both options have the same expiration date.
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Spreads & Spread Trading


Consider the following example of ABC Company
Stock price

Strike price
Call premium (K=67)
Strike price
Call premium (K=70)
Time to expiration

S0 = 63
K = 67
c = 1 (currently out-ofthe money)
K = 70
c = 0.75(out-of-the money and lower premium)
T = 3 mo (Sep 15)

For a bull call spread go long in the K=67 call option


and short in the K=70 call option
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Spreads & Spread Trading

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Spreads & Spread Trading


Long Call (Lower K)
The call option will be exercised only if the ST is
> K (67). However, a premium of Rs.100 has
been paid for the option
At ST = 68 the investor makes no profit or loss
Short Call (Higher K)
Investor has received the premium of Rs.0.75
per share for 100 shares = Rs.75
The option will be exercised by the holder only if
the ST is above K (70) or else expire unused
When exercised the investor will lose the
difference in the ST and K but will always have
the initial premium collected
Portfolio
Sum of the two positions
This is a limited-risk limited-profit strategy
The portfolio profit is capped at the difference in
the strike price less the difference in the
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premium

Combinations
Combination involves taking a position in both a call
and put on the underlying stock at the same time.
Traders and investors are betting on the volatility of
the stock price
Long Straddle: Buy a call and put option with the
same strike price and expiration date. Close to atthe-money options work best. The premium on these
options could be high.
Strangle: Buy an out-of the-money call and put option
with different strike prices to reduce the cost. This is
a low cost trade needing a high volatility to be
profitable
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Combinations
Short Straddle: Short a call and a put on the same
stock with the same strike price and expiration date.
Investors and traders are expecting volatility and the
stock to trade in a range. Unexpectedly if the stock
declines rapidly, the risk is high. Barings Bank fiasco.
Consider the following example of ABC Company
Stock price

Strike price
Call premium (K=67)
Put premium (K=67)
Time to expiration

S0 = 63
K = 67
c = 1 (currently out-ofthe money)
p = 4 (currently in-the money)
T = 3 mo (Sep 15)
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Combinations Long Straddle

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Combinations Long Straddle


Long Call
The call option will be exercised only if the ST is
> K (67). However a premium of Rs.100 has
been paid for the option
At ST = 68 investor make no profit or loss
Long Put
The put option will be exercised if the stock
price ST is < K (67). A premium of Rs.400 has
been paid for the in-the money put
When exercised the investor will gain the
difference in the ST and K but reduced by the
premium paid
For ST between 63 and 67 the investor loses
some portion of the premium paid and for ST >
67 the investor loses the entire premium
Portfolio
Sum of the two positions
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Combinations Strangle
The idea in a Strangle is to profit on the volatility of the stock
movement but also reduce the cost. As such the volatility has
to be significant to realize a profit.
Consider the following example of ABC Company
Stock price
S0 = 63
Strike price (call)
Kc = 67
Call premium (K=67) c = 1 (currently out-of-money)
Strike price (put)
Kp = 61
Put premium (K=61)
p = 0.25 (currently out-of-money)
Time to expiration
T = 3 mo (Sep 15)

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Combinations Strangle

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Combinations Strangle
Long Call
The call option will be exercised only if the ST is
> K (67). However a premium of Rs.100 has
been paid for the option
At ST = 68 investor make no profit or loss
Long Put
The put option will be exercised if the stock
price ST is < K (61). A premium of Rs.25 has
been paid for the out-of-the money put
When exercised the investor will gain the
difference in the ST and K but reduced by the
premium paid
For ST > 61 the entire premium is lost
Portfolio
Sum of the two positions
Note that the cost of this strategy was lesser than
the Straddle since the premiums were lower20

Combinations Short Straddle


The investor writes an uncovered call and an uncovered put
on the same stock, same expiration and same strike price.
Together the strategy is expected to be neutral if the stock
trades within a range. However, large potential loss exists
should the stock movement be unexpected. The profit
potential is limited to the premiums of the put and call. It is a
highly risky strategy.
Consider the following example of ABC Company
Stock price
S0 = 63
Strike price (call)
K = 67
Call premium (K=67) c = 1 (currently out-of-money)
Put premium (K=61)
p = 4 (currently in-the money)
Time to expiration
T = 3 mo (Sep 15)
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Combinations Short Straddle

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Combinations Short Straddle


Short Call
The call option will be exercised by the holder only
if the ST is > K (67). However a premium of Rs.100
has been received
At ST = 68 investor makes no profit or loss
Being uncovered the loss potential is high
Short Put
The put option will be exercised by the holder if the
stock price ST is < K (67). A premium of Rs.400
has been received by the investor
When exercised the investor will lose the difference
in the ST and K but compensated for by the
premium received
For ST > 67 the investor only receives the premium
Portfolio
Sum of the two positions
As the stock price increases the loss on the short call
is much greater than the premium received for the
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short put. Thus the loss potential is high

Combinations Short Straddle


Nick Leeson Story
Invested in Nikkei 225 stock index futures made losses
when the Nikkei dropped due to the Kobe earthquake
(unexpected event)
To recoup the losses created a short straddle (uncovered
and highly risky) on the Nikkei expecting it to stabilize and
trade within a range(19000)
His straddle positions ranged from 18,500 20,000
Nikkei dropped way below and Nick Leeson incurred 1.4b
losses and Barings filed for bankruptcy.

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Other Strategies
Theoretically if European options with expiration at
time T exist for every single strike price then it is
possible to construct any payoff with a combination of
these
Box Spread: This is a combination of a bull call
spread with strike price K1 and K2 and a bear put
spread at the same two strike prices. When K 2 > K1,
buy a call option at K1 and sell a call option at K2 &
buy a put option at K2 and sell a put option at K1
This combination does not work with American
options
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Other Strategies
Calendar spread or Horizontal spread: The
combination is developed using options with different
expiration dates but with the same strike price
Diagonal spread: The strike price and the expiration
dates of the options are different
Butterfly spread: involves options with three different
strike prices and same expiration date. Either all
puts or all calls can be used for this strategy. The
idea is to buy a call (long) with at strike price K 1 and
another at strike price K2 and short two calls with a
strike price K3 midway between K1 and K2. Usually
potential gain and loss is limited
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Other Strategies - Butterfly


Consider the following example of XYZ Co.
Stock price
Strike price (Low call)
Call premium
Strike price (High call)
Call premium
Strike price (Mid call)
Call premium
Time to expiration

S0 = 75.28
K1 = 72
c1 = 6.10 (in-the-money)
K2 = 78
c2 = 2.60 (currently out-of-money)
K3 = 75
c3 = 4.10 (almost at-the money)
T = 3 mo (Sep 15)

Investor: one long c1, one long c2, two short c3


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Other Strategies - Butterfly

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Other Strategies - Butterfly


Long Call (high)
The call option will be exercised only if the S T is > K1
(78). However a premium of Rs.260 has been paid
upfront
For ST > 78 the upward profit potential is high
Long Call (low)
The call option will be exercised only if the S T is > K2
(72). However a premium of Rs.610 has been paid
upfront
For ST > 72 the loss initially decreases and then the
profit potential set in
Short Call (midway)
The call option will be exercised by the holder only if
the ST is > K3 (75). However a premium of Rs. 820 (for
2 trades) has been received by the investor
Portfolio
For ST below 73 or above 77 the loss of the portfolio is
the maximum initial outlay = (-260 610 + 820 = 50)
Maximum profit is at the midway strike price of Rs.75
This is used when the trading range is expected to be
narrow and investor does not want to use an
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uncovered straddle.

Other Strategies - Butterfly


Forbes.com OptionsFlash by Andrew Wilkinson 06.23.09 1:35 PM ET
Betting On A Big Downside For Apple
Apple Inc.: In the July contract and with shares in Apple easing 2.6% to
$133.74, one option investor is betting on a 17.5% price decline in shares
of the iPhone-maker to $110 within the next three weeks. A put butterfly
combination was bought at the 100/110 and 120 strikes for a net
premium of 64 cents. In this combination the investor sells twice as many
put options at the central strike price against the purchase of puts at the
two outer strikes. With this combination involving strike prices exactly $10
wide, the maximum profit of that strike distance less the premium amounts
to$9.34 per contract in the event that the share price arrives at expiration
at $110. Options implied volatilities are higher by almost 9% on the share
price decline. The bearish activity comes shortly after the company
released news that founder Steve Jobs underwent a liver transplant during
personal leave two months ago.
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Conclusions
Any payoff strategy can be developed using a combination
of options very exciting and challenging!
Many strategies are risky and have a significant downside
potential
Prudent financial risk management is critical to success in
trading

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Thank You!

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