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This presentation covers several basic options strategies, including spreads, combinations, covered calls and protective puts.
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OPTION STRATEGIES
ALAN ANDERSON, Ph.D. ECI RISK TRAINING
www.ecirisktraining.com
(c) ECI Risk Training 2009 www.ecirisktraining.com 1
(c) ECI Risk Training 2009 www.ecirisktraining.com 2
Due to their unique payoff profiles, options may be used to create investment strategies that would be impossible with other financial assets
(c) ECI Risk Training 2009 www.ecirisktraining.com 3
SPREADS
A spread is created from two calls or two puts on the same underlying asset
(c) ECI Risk Training 2009 www.ecirisktraining.com 4
EXAMPLES
bull spread bear spread butterfly spread
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BULL SPREAD
A bull spread gains when the price of the underlying asset rises, but the potential profit is limited
(c) ECI Risk Training 2009 www.ecirisktraining.com 6
(c) ECI Risk Training 2009 www.ecirisktraining.com 7
A bull spread is created by:
buying an option with a LOW strike price
selling an option with a HIGH strike price
with the same asset and maturity
EXAMPLE
Assume that:
A European call option on IBM stock with a strike of 50 matures on September 1 and sells for $3
(c) ECI Risk Training 2009 www.ecirisktraining.com 8
(c) ECI Risk Training 2009 www.ecirisktraining.com 9
A European call option on IBM stock with a strike of 53 matures on September 1 and sells for $2
(c) ECI Risk Training 2009 www.ecirisktraining.com 10
This information is summarized as follows:
c1 = $3 X1 = $50
c2 = $2 X2 = $53
(c) ECI Risk Training 2009 www.ecirisktraining.com 11
where:
c1 = the price paid for the call with strike X1
c2 = the price paid for the call with strike X2
(c) ECI Risk Training 2009 www.ecirisktraining.com 12
The investor buys the first call and sells the second call
The payoffs are given in the following table:
(c) ECI Risk Training 2009 www.ecirisktraining.com 13
S MAX (S - X1, 0)
-MAX (S - X2, 0)
TOTAL PAYOFF
49.00 0.00 0.00 0.00 49.50 0.00 0.00 0.00 50.00 0.00 0.00 0.00 50.50 0.50 0.00 0.50 51.00 1.00 0.00 1.00 51.50 1.50 0.00 1.50 52.00 2.00 0.00 2.00 52.50 2.50 0.00 2.50 53.00 3.00 0.00 3.00 53.50 3.50 -0.50 3.00 54.00 4.00 -1.00 3.00
(c) ECI Risk Training 2009 www.ecirisktraining.com 14
The payoff to a call buyer is MAX (S – X, 0)
The payoff to a call seller is -MAX (S – X, 0)
The payoff to a put buyer is MAX (X – S, 0)
The payoff to a put seller is -MAX (X – S, 0)
(c) ECI Risk Training 2009 www.ecirisktraining.com 15
where:
S = underlying asset price
X = strike price
(c) ECI Risk Training 2009 www.ecirisktraining.com 16
The payoff to the bull spread is illustrated as follows:
(c) ECI Risk Training 2009 www.ecirisktraining.com 17
(c) ECI Risk Training 2009 www.ecirisktraining.com 18
The profits are given in the following table:
(c) ECI Risk Training 2009 www.ecirisktraining.com 19
S MAX (S - X1,0)-c1
-MAX (S - X2,0)+c2
TOTAL PROFIT
49.00 -3.00 2.00 -1.00 49.50 -3.00 2.00 -1.00 50.00 -3.00 2.00 -1.00 50.50 -2.50 2.00 -0.50 51.00 -2.00 2.00 0.00 51.50 -1.50 2.00 0.50 52.00 -1.00 2.00 1.00 52.50 -0.50 2.00 1.50 53.00 0.00 2.00 2.00 53.50 0.50 1.50 2.00 54.00 1.00 1.00 2.00
(c) ECI Risk Training 2009 www.ecirisktraining.com 20
The profit to a call buyer is MAX (S – X, 0) - C
The profit to a call seller is -MAX (S – X, 0) + C
The profit to a put buyer is MAX (X – S, 0) - P
The profit to a put seller is -MAX (X – S, 0) + P
(c) ECI Risk Training 2009 www.ecirisktraining.com 21
where:
C = call price
P = put price
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The profits to the bull spread are illustrated as follows:
(c) ECI Risk Training 2009 www.ecirisktraining.com 23
BEAR SPREAD
A bear spread gains when the price of the underlying asset falls, but the potential profit is limited
(c) ECI Risk Training 2009 www.ecirisktraining.com 24
(c) ECI Risk Training 2009 www.ecirisktraining.com 25
A bear spread is created by:
buying an option with a HIGH strike price
selling an option with a LOW strike price
with the same asset and maturity
EXAMPLE
Using the same two call options from the previous example:
c1 = $3 X1 = $50
c2 = $2 X2 = $53
(c) ECI Risk Training 2009 www.ecirisktraining.com 26
(c) ECI Risk Training 2009 www.ecirisktraining.com 27
The investor buys the first call and sells the second call
The payoffs are given in the following table and graph:
(c) ECI Risk Training 2009 www.ecirisktraining.com 28
S -MAX (S - X1, 0)
MAX (S - X2, 0)
TOTAL PAYOFF
49.00 0.00 0.00 0.00 49.50 0.00 0.00 0.00 50.00 0.00 0.00 0.00 50.50 -0.50 0.00 -0.50 51.00 -1.00 0.00 -1.00 51.50 -1.50 0.00 -1.50 52.00 -2.00 0.00 -2.00 52.50 -2.50 0.00 -2.50 53.00 -3.00 0.00 -3.00 53.50 -3.50 0.50 -3.00 54.00 -4.00 1.00 -3.00
(c) ECI Risk Training 2009 www.ecirisktraining.com 29
(c) ECI Risk Training 2009 www.ecirisktraining.com 30
The profits are given in the following table and graph:
(c) ECI Risk Training 2009 www.ecirisktraining.com 31
S -MAX (S -X1,0)+c1
MAX (S -X2,0)-c2
TOTAL PROFIT
49.00 3.00 -2.00 1.00 49.50 3.00 -2.00 1.00 50.00 3.00 -2.00 1.00 50.50 2.50 -2.00 0.50 51.00 2.00 -2.00 0.00 51.50 1.50 -2.00 -0.50 52.00 1.00 -2.00 -1.00 52.50 0.50 -2.00 -1.50 53.00 0.00 -2.00 -2.00 53.50 -0.50 -1.50 -2.00 54.00 -1.00 -1.00 -2.00
(c) ECI Risk Training 2009 www.ecirisktraining.com 32
BUTTERFLY SPREAD
A butterfly spread gains when the price of the underlying asset stays within a specific range of prices
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(c) ECI Risk Training 2009 www.ecirisktraining.com 34
A butterfly spread is created by:
buying an option with a LOW strike price
buying an option with a HIGH strike price
selling two options with an INTERMEDIATE strike price
all with the same asset and maturity
EXAMPLE
Assume that:
A European call option on IBM stock with a strike of 47 matures on September 1 and sells for $5
(c) ECI Risk Training 2009 www.ecirisktraining.com 35
(c) ECI Risk Training 2009 www.ecirisktraining.com 36
A European call option on IBM stock with a strike of 50 matures on September 1 and sells for $3
A European call option on IBM stock with a strike of 53 matures on September 1 and sells for $2
(c) ECI Risk Training 2009 www.ecirisktraining.com 37
This is summarized as follows:
c1 = $5 X1 = $47
c2 = $3 X2 = $50
c3 = $2 X3 = $53
(c) ECI Risk Training 2009 www.ecirisktraining.com 38
The investor buys the first and third calls, and sells two of the second call
The payoffs are given in the following table and graph:
(c) ECI Risk Training 2009 www.ecirisktraining.com 39
S MAX (S - X1, 0)
-2*MAX (S - X2, 0)
MAX (S - X3, 0)
TOTAL PAYOFF
45 0.00 0.00 0.00 0.00 46 0.00 0.00 0.00 0.00 47 0.00 0.00 0.00 0.00 48 1.00 0.00 0.00 1.00 49 2.00 0.00 0.00 2.00 50 3.00 0.00 0.00 3.00 51 4.00 -2.00 0.00 2.00 52 5.00 -4.00 0.00 1.00 53 6.00 -6.00 0.00 0.00 54 7.00 -8.00 1.00 0.00 55 8.00 -10.00 2.00 0.00
(c) ECI Risk Training 2009 www.ecirisktraining.com 40
Payoff to Butterfly Spread
0.00
0.50
1.00
1.50
2.00
2.50
3.00
3.50
45.00 46.00 47.00 48.00 49.00 50.00 51.00 52.00 53.00 54.00 55.00
Stock Price ($)
Payo
ff (
$)
(c) ECI Risk Training 2009 www.ecirisktraining.com 41
The profits are given in the following table and graph:
(c) ECI Risk Training 2009 www.ecirisktraining.com 42
S MAX (S - X1, 0)
-2*MAX (S - X2, 0)
MAX (S - X3, 0)
TOTAL PROFIT
45 0.00 0.00 0.00 -1.00 46 0.00 0.00 0.00 -1.00 47 0.00 0.00 0.00 -1.00 48 1.00 0.00 0.00 0.00 49 2.00 0.00 0.00 1.00 50 3.00 0.00 0.00 2.00 51 4.00 -2.00 0.00 1.00 52 5.00 -4.00 0.00 0.00 53 6.00 -6.00 0.00 -1.00 54 7.00 -8.00 1.00 -1.00 55 8.00 -10.00 2.00 -1.00
(c) ECI Risk Training 2009 www.ecirisktraining.com 43
Profit/Loss to Butterfly Spread
-1.50
-1.00
-0.50
0.00
0.50
1.00
1.50
2.00
2.50
45.00 46.00 47.00 48.00 49.00 50.00 51.00 52.00 53.00 54.00 55.00
Stock Price ($)
Pro
fit/
Lo
ss (
$)
COMBINATIONS
A combination consists of one call and one put with the same underlying asset
(c) ECI Risk Training 2009 www.ecirisktraining.com 44
EXAMPLE
Assume that:
A European call on IBM stock with a strike of 50 matures on September 1 and sells for $3
(c) ECI Risk Training 2009 www.ecirisktraining.com 45
(c) ECI Risk Training 2009 www.ecirisktraining.com 46
A European put on IBM stock with a strike of 50 matures on September 1 and sells for $2
(c) ECI Risk Training 2009 www.ecirisktraining.com 47
c = $3 p = $2 X = $50
An investor buys the call and the put; this position is known as a straddle
The payoffs are given in the following table and graph:
(c) ECI Risk Training 2009 www.ecirisktraining.com 48
S MAX (S - X, 0)
MAX (X - S , 0)
TOTAL PAYOFF
40 0 10 10 42 0 8 8 44 0 6 6 46 0 4 4 48 0 2 2 50 0 0 0 52 2 0 2 54 4 0 4 56 6 0 6 58 8 0 8 60 10 0 10
(c) ECI Risk Training 2009 www.ecirisktraining.com 49
Payoff to Straddle
0
1
2
3
4
5
6
7
8
9
10
40 42 44 46 48 50 52 54 56 58 60
Stock Price ($)
Pa
yo
ff (
$)
(c) ECI Risk Training 2009 www.ecirisktraining.com 50
The profits are given in the following table and graph:
(c) ECI Risk Training 2009 www.ecirisktraining.com 51
S MAX (S - X,0) - c
MAX (X - S ,0) - p
TOTAL PROFIT
40 -3 8 5 42 -3 6 3 44 -3 4 1 46 -3 2 -1 48 -3 0 -3 50 -3 -2 -5 52 -1 -2 -3 54 1 -2 -1 56 3 -2 1 58 5 -2 3 60 7 -2 5
(c) ECI Risk Training 2009 www.ecirisktraining.com 52
Profit/Loss to Straddle
-6
-4
-2
0
2
4
6
40 42 44 46 48 50 52 54 56 58 60
Stock Price ($)
Pro
fit/
Lo
ss (
$)
(c) ECI Risk Training 2009 www.ecirisktraining.com 53
An investor who buys a straddle will profit if the underlying asset is highly volatile
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An investor who expects the underlying asset to be highly stable can sell a call and a put; this position is known as a short straddle
STRANGLE
With a strangle, a call with a high strike and a put with a low strike are purchased
(c) ECI Risk Training 2009 www.ecirisktraining.com 55
EXAMPLE
Assume that:
A European call on IBM stock with a strike of 53 matures on September 1 and sells for $2
(c) ECI Risk Training 2009 www.ecirisktraining.com 56
(c) ECI Risk Training 2009 www.ecirisktraining.com 57
A European put on IBM stock with a strike of 50 matures on September 1 and sells for $2
(c) ECI Risk Training 2009 www.ecirisktraining.com 58
c = $2 p = $2
An investor buys the call with strike of 53 and the put with strike of 50
(c) ECI Risk Training 2009 www.ecirisktraining.com 59
The payoff and profit diagrams show that the position resembles a straddle, but with a “flat bottom”
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This position requires a larger movement in the stock price to produce a profit, but produces smaller losses if the stock price remains within the two strike prices
(c) ECI Risk Training 2009 www.ecirisktraining.com 61
The payoffs and profits to the strangle are shown in the following tables and graphs:
(c) ECI Risk Training 2009 www.ecirisktraining.com 62
S MAX (S - X, 0)
MAX (X - S , 0)
TOTAL PAYOFF
45 0 5 5 46 0 4 4 47 0 3 3 48 0 2 2 49 0 1 1 50 0 0 0 51 0 0 0 52 0 0 0 53 0 0 0 54 1 0 1 55 2 0 2 56 3 0 3
(c) ECI Risk Training 2009 www.ecirisktraining.com 63
Payoff to Strangle
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
44.00 45.00 46.00 47.00 48.00 49.00 50.00 51.00 52.00 53.00 54.00 55.00 56.00 57.00 58.00 59.00
Stock Price ($)
Payo
ff (
$)
(c) ECI Risk Training 2009 www.ecirisktraining.com 64
S MAX (S - X,0) - c
MAX (X - S ,0) - p
TOTAL PROFIT
45 -2 3 1 46 -2 2 0 47 -2 1 -1 48 -2 0 -2 49 -2 -1 -3 50 -2 -2 -4 51 -2 -2 -4 52 -2 -2 -4 53 -2 -2 -4 54 -1 -2 -3 55 0 -2 -2 56 1 -2 -1
(c) ECI Risk Training 2009 www.ecirisktraining.com 65
Profit/Loss to Strangle
-5.00
-4.00
-3.00
-2.00
-1.00
0.00
1.00
2.00
3.00
44.00 45.00 46.00 47.00 48.00 49.00 50.00 51.00 52.00 53.00 54.00 55.00 56.00 57.00 58.00 59.00
Stock Price ($)
Pro
fit/
Lo
ss (
$)
STRIPS
A strip is similar to a straddle except that one call and two puts are purchased with the same strike price
(c) ECI Risk Training 2009 www.ecirisktraining.com 66
EXAMPLE
Assume that:
A European call on IBM stock with a strike of 50 matures on September 1 and sells for $3
(c) ECI Risk Training 2009 www.ecirisktraining.com 67
(c) ECI Risk Training 2009 www.ecirisktraining.com 68
A European put on IBM stock with a strike of 50 matures on September 1 and sells for $2
(c) ECI Risk Training 2009 www.ecirisktraining.com 69
c = $3 p = $2 X = $50
An investor buys the call and two puts; this position is known as a strip
The payoffs and profits are given in the following tables and graphs:
(c) ECI Risk Training 2009 www.ecirisktraining.com 70
S MAX (S - X, 0)
MAX (X - S , 0)
TOTAL PAYOFF
40 0 20 20 42 0 16 16 44 0 12 12 46 0 8 8 48 0 4 4 50 0 0 0 52 2 0 2 54 4 0 4 56 6 0 6 58 8 0 8 60 10 0 10
(c) ECI Risk Training 2009 www.ecirisktraining.com 71
Payoff to Strip
0.00
5.00
10.00
15.00
20.00
25.00
40.00 42.00 44.00 46.00 48.00 50.00 52.00 54.00 56.00 58.00 60.00
Stock Price ($)
Payo
ff (
$)
(c) ECI Risk Training 2009 www.ecirisktraining.com 72
S MAX (S - X, 0)
MAX (X - S , 0)
TOTAL PROFIT
40 0 20 13 42 0 16 9 44 0 12 5 46 0 8 1 48 0 4 -3 50 0 0 -7 52 2 0 -5 54 4 0 -3 56 6 0 -1 58 8 0 1 60 10 0 3
(c) ECI Risk Training 2009 www.ecirisktraining.com 73
Profit/Loss to Strip
-10.00
-5.00
0.00
5.00
10.00
15.00
40.00 42.00 44.00 46.00 48.00 50.00 52.00 54.00 56.00 58.00 60.00
Stock Price ($)
Pro
fit/
Lo
ss (
$)
STRAPS
A strap is similar to a straddle except that two calls and one put are purchased with the same strike price
(c) ECI Risk Training 2009 www.ecirisktraining.com 74
EXAMPLE
Assume that:
A European call on IBM stock with a strike of 50 matures on September 1 and sells for $3
(c) ECI Risk Training 2009 www.ecirisktraining.com 75
(c) ECI Risk Training 2009 www.ecirisktraining.com 76
A European put on IBM stock with a strike of 50 matures on September 1 and sells for $2
(c) ECI Risk Training 2009 www.ecirisktraining.com 77
c = $3 p = $2 X = $50
An investor buys two calls and one put; this position is known as a strap
The payoffs and profits are given in the following tables and graphs:
(c) ECI Risk Training 2009 www.ecirisktraining.com 78
S MAX (S - X, 0)
MAX (X - S , 0)
TOTAL PAYOFF
40 0 10 10 42 0 8 8 44 0 6 6 46 0 4 4 48 0 2 2 50 0 0 0 52 4 0 4 54 8 0 8 56 12 0 12 58 16 0 16 60 20 0 20
(c) ECI Risk Training 2009 www.ecirisktraining.com 79
Payoff to Strap
0.00
5.00
10.00
15.00
20.00
25.00
40.00 42.00 44.00 46.00 48.00 50.00 52.00 54.00 56.00 58.00 60.00
Stock Price ($)
Payo
ff (
$)
(c) ECI Risk Training 2009 www.ecirisktraining.com 80
S MAX (S - X, 0)
MAX (X - S , 0)
TOTAL PROFIT
40 0 10 2 42 0 8 0 44 0 6 -2 46 0 4 -4 48 0 2 -6 50 0 0 -8 52 4 0 -4 54 8 0 0 56 12 0 4 58 16 0 8 60 20 0 12
(c) ECI Risk Training 2009 www.ecirisktraining.com 81
Profit/Loss to Strap
-10.00
-5.00
0.00
5.00
10.00
15.00
40.00 42.00 44.00 46.00 48.00 50.00 52.00 54.00 56.00 58.00 60.00
Stock Price ($)
Pro
fit/
Lo
ss (
$)
OTHER OPTIONS STRATEGIES
Options can also be combined with the underlying asset to create more patterns of payoffs and profits
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(c) ECI Risk Training 2009 www.ecirisktraining.com 83
Two of these strategies are known as:
covered call protective put
COVERED CALL
A covered call is created by buying the underlying asset and selling a call on the asset
(c) ECI Risk Training 2009 www.ecirisktraining.com 84
(c) ECI Risk Training 2009 www.ecirisktraining.com 85
In this case, the owner of the underlying asset collects the option price while placing a limit on the position’s potential profits
EXAMPLE
Assume that:
A European call on IBM stock with a strike of 50 matures on September 1 and sells for $3
An investor buys one share of the IBM stock at $50 and sells this call
(c) ECI Risk Training 2009 www.ecirisktraining.com 86
(c) ECI Risk Training 2009 www.ecirisktraining.com 87
c = $3 X = $50
The payoffs and profits are given in the following tables and graphs:
(c) ECI Risk Training 2009 www.ecirisktraining.com 88
S -MAX (S - X, 0)
TOTAL PAYOFF
46 0 -4 47 0 -3 48 0 -2 49 0 -1 50 0 0 51 -1 0 52 -2 0 53 -3 0 54 -4 0 55 -5 0
(c) ECI Risk Training 2009 www.ecirisktraining.com 89
COVERED CALL
-4.5
-4
-3.5
-3
-2.5
-2
-1.5
-1
-0.5
0
46 47 48 49 50 51 52 53 54 55
Stock Price ($)
Payo
ff (
$)
(c) ECI Risk Training 2009 www.ecirisktraining.com 90
S -MAX (S - X, 0)+c
TOTAL PROFIT
46 3 -1 47 3 0 48 3 1 49 3 2 50 3 3 51 2 3 52 1 3 53 0 3 54 -1 3 55 -2 3
(c) ECI Risk Training 2009 www.ecirisktraining.com 91
COVERED CALL
-1.5
-1
-0.5
0
0.5
1
1.5
2
2.5
3
3.5
46 47 48 49 50 51 52 53 54 55
Stock Price ($)
Pro
fit/
Lo
ss (
$)
PROTECTIVE PUT
A protective put is created by buying the underlying asset and buying a put on the asset
(c) ECI Risk Training 2009 www.ecirisktraining.com 92
(c) ECI Risk Training 2009 www.ecirisktraining.com 93
In this case, the owner of the asset:
earns a smaller profit if the asset price rises above the strike price
does not suffer any further losses if the asset price falls below the strike price
EXAMPLE
Assume that:
A European put on IBM stock with a strike of 50 matures on September 1 and sells for $2
An investor buys one share of the IBM stock and buys this put
(c) ECI Risk Training 2009 www.ecirisktraining.com 94
(c) ECI Risk Training 2009 www.ecirisktraining.com 95
p = $2 X = $50
The payoffs and profits are given in the following tables and graphs:
(c) ECI Risk Training 2009 www.ecirisktraining.com 96
S MAX (X - S, 0)
TOTAL PAYOFF
46 4 0 47 3 0 48 2 0 49 1 0 50 0 0 51 0 1 52 0 2 53 0 3 54 0 4 55 0 5
(c) ECI Risk Training 2009 www.ecirisktraining.com 97
PROTECTIVE PUT
0
1
2
3
4
5
6
46 47 48 49 50 51 52 53 54 55
Stock Price ($)
Payo
ff (
$)
(c) ECI Risk Training 2009 www.ecirisktraining.com 98
S MAX (X - S , 0) - p
TOTAL PROFIT
46 2 -2 47 1 -2 48 0 -2 49 -1 -2 50 -2 -2 51 -2 -1 52 -2 0 53 -2 1 54 -2 2 55 -2 3
(c) ECI Risk Training 2009 www.ecirisktraining.com 99
PROTECTIVE PUT
-3
-2
-1
0
1
2
3
4
46 47 48 49 50 51 52 53 54 55
Stock Price ($)
Pro
fit/
Lo
ss (
$)