INSURANCE, COLLARS, AND OTHER STRATEGIES

Chapter 11

Trading Strategies

Take a position in
The

option and the underlying asset Two or more options of the same type
Spread

mixture of calls and puts

Combinations

Floors (Protective puts)

Recall that options can provide insurance against price declines (puts) and increases (calls)
Floor:
Long

guarantee of minimum sales price

put option coupled with underlying asset Also called a protective put
The

long position in the put protects the investor from a sharp decline in stock prices
Insurance

on stock prices since downside risk is limited, but can take advantage of upside potential when stock prices increase

Payoff/profit

looks like a long call option

Payoff and Profit Diagrams of Protective Put

Payoff and Profit Diagrams of Protective Put

Protective Put
20 15

10
5 0 40 -5 -10 -15 -20 45 50 55 60 65 70

Stock

Put

Payoff

Profit

Covered Calls

A covered call is a combination of an option and the underlying

Combines

a long stock position with a short call

Potential losses from the shorted calls are offset by the long positions in the stock
Similar
The

to insurance against a sharp rise in stock prices

combined profit from the equity position is greater than the loss on the option Aggregate payoff looks like a short put

Payoff and Profit for Covered Calls

Payoff and Profit for Covered Calls

Covered Call
15 10

5
0 40 -5 -10 -15 -20 -25 45 50 55 60 65 70

Stock

Call

Payoff

Profit

Other Strategies

Cap
Short

Covered put
Short

stock, long call

against

stock, short

Protects

put
Price

higher repurchase/purchase price

Looks

like a long put

declines lead to losses on put, but gains on short underlying Price increases incur premium retention, but offset by losses on short underlying
Looks

like a short

call

Spreads

Combinations of two or more options of the same variety (calls or puts) Make small bets on movement of prices
Limited

upside potential and downside risk But, low cost strategy

Bull Spreads

Investors expect stock prices to increase Two methods:

Buy

a call with a low strike price, sell a call with a high strike price (same T) or Buy a put with a low strike price, sell a put with a high strike price (same T)
Limits

upside potential and downside loss

Also

called vertical spreads

Bull Spreads

Bull Spreads
Call Bull Spread Payoff Diagram
20 15

10

0 Profit

-5

-10

-15

-20

Stock Price
C1 C2 Spread

Bull Spreads (cont)

Bull Spreads (cont)

Put Bull Spread
15 10

5
Payoff

0 15 -5 -10 -15 20 25 30 35 40 45 50

-20
P1 P2 Spread

Bear Spreads

Investors expects stock price to decrease Two methods:

Buy

a call with a high strike price and sell a call with a low strike price or Buy a put with a high strike price and sell a put with a low strike price
Both

options must have the same expiration

Bear Spreads

Bear Spreads
Call Bear Spread
15 10 5 0 15 -5 -10 20 25 30 35 40 45 50

Payoff

-15
-20 C1 C2 Spread

Bear Spreads (cont)

Bear Spreads (cont)

Put Bear Spread
20

15
10 5 0 15 -5 -10 -15 P1 P2 Spread 20 25 30 35 40 45 50

Payoff

Variations on Bull and Bear Spreads

Box spreads
Use

combinations of puts and calls to create a synthetic long forward at one strike and a synthetic short forward at a different strike
Costly,

but no stock price risk

Ratio spreads
Instead

of one-to-one ratio between bought and sold calls (or puts), buy m options at one strike and sell n options at a different strike
Possible

to have a zero premium

Collars

Holder of a stock buys a put with a low x and sells a call with a high X
Collar

width
between call and put Xs

Difference

Call

premium should reduce the cost of the put

Payoff

is similar to a short forward If own the underlying, payoff looks like a bull spread

Collared stock

Normally

used with index options

Collar Payoff Diagram

Collar Payoff Diagram

Collar
20 15 10 5 0 -5 -10 -15 -20 15 20 25 30 35 40 45 50

Spread

Directional vs. Volatility Plays

Bull spreads, bear spreads, floors, caps are all directional plays
Anticipate

prices to move in one direction

What happens when we expect large (or small) price movements, but we dont know in which direction the movement will occur?
News

driven events

Lawsuit

outcomes, product launches, earnings announcements, macroeconomic reports, etc.

Butterfly Spreads

Low cost option strategy Appropriate for investors who feel that large price moves are unlikely Can be made with either puts or calls

Buy (sell) lo & hi calls (or puts) and sell (buy) 2 middle calls (or puts) Expect stock price to move a lot, but dont know which direction

Reverse butterflies

Still low cost strategy

Practice put butterflies and reverse call or put butterflies on your own

Butterfly Spreads

Butterfly Spreads
Call Butterfly Spread
30

20

10

0 Profit

-10

-20

-30

-40

-50 Stock
C1 C2 C3 Spread

Straddles, Strangles, Strips, and Straps

With any of the above strategies, the investor expects extremely large price movements (high volatility), but doesnt know in which direction the price will move
Shorts

of these strategies expect small price movement

These strategies are much costlier than spreads

Straddles, Strangles, Strips, and Straps

Straddle: buy a call and a put with the same strike, same T Straps: buy one put and more than one call with same X, T

More bullish strategy

Strips: buy one call and more than one put with same X, T

More bearish strategy

Strangle: buy one put with low strike, one call with high strike, same T

Lower cost than others, but requires larger movement in price

Practice strips, straps, and strangles on your own

Straddle Payoffs

Straddle Payoffs
Straddle
30

25

20

15

Profit

10

-5

-10
Stock
C1 P1

Calendar Spreads

Time or horizontal spread involves the purchase of one option at a strike = X1 and T = T1 and the sale of another with a strike = X1 and T = T2, where T1 T2
Cannot

hold both until expiration

Longest

holding period possible is T1 Cost is proportional to maturity, and usually requires an initial investment More complicated than other spreads

Calendar Spreads

Since both have the same X, both have the same intrinsic value
Profitability

is determined solely by the difference in time values This does not mean that you should always purchase the long-term option and short the short-term option
Depends

on investors outlook for the stock

Neutral: strike price close to current S is chosen Bullish: X > S Bearish: X < S

Calendar Spreads

Much like butterfly and combinations, volatility is a major factor in the performance of a calendar spread
Profits

are highest if low volatility If prices move too far away from the exercise price, the time value becomes low for both options and profits are eroded
If

volatility expectations are high, then enact a reverse calendar spread