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FINA 4310 Lecture Notes 16(b): Option Strategies Basic Positions Buy Naked Call Write Naked Call Buy Naked Put Write Naked Put Stock and One Option Covered call Protective put Protective call Simple Spreads Bull Spread Bull Credit Spread Bear Spread Bear Credit Spread

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fina 4310 lecture notes

FINA 4310Lecture Notes

16(b): Option Strategies

overview
Basic Positions

Buy Naked Call

Write Naked Call

Buy Naked Put

Write Naked Put

Stock and One Option

Covered call

Protective put

Protective call

Simple Spreads

Bull Spread

Bull Credit Spread

Bear Spread

Bear Credit Spread

Simple Combinations

Straddle

StrangleStrapStrip

Butterfly Spread

Overview
basic positions
Basic Positions

Buy Call

Buy Put

K

S

K

S

Write Call

Write Put

K

S

K

S

basic positions buy naked call
Basic PositionsBuy Naked Call

Payoff

Profit

Premium{

K

S

K

S

basic positions buy naked call5
Basic PositionsBuy Naked Call

Low Premium

High Premium

Profit

Profit

50

50

S

S

basic positions buy naked call6
Basic PositionsBuy Naked Call
  • You pay the premium
  • You choose whether to exercise the contract
  • Potential profit is unlimited
  • Maximum loss = initial premium
  • Does not require a margin account
basic positions buy naked call7
Basic PositionsBuy Naked Call
  • The breakeven point is higher when the premium is higher.
  • The premium will tend to be higher when:
    • the option is further in the money

(the strike price is low compared to stock price)

    • the volatility of the stock is higher
    • the option has a longer time to expiration
basic positions write naked call
Basic PositionsWrite Naked Call
  • You receive the premium
  • You must honor the contract if exercised against you
  • Maximum profit = Initial option premium
  • Maximum loss is unlimited
  • This is a very dangerous position
  • Requires a margin account
basic positions write naked call9
Basic PositionsWrite Naked Call

Payoff and Profit/Loss Functions

  • Payoff for writing a call is just minus one times the payoff for buying a call
    • Payoff for buyer + payoff for writer = 0
  • Profit for writing a call is just minus one times the profit for buying a call
    • Profit for buyer + profit for writer = 0
basic positions write naked call11
Basic PositionsWrite Naked Call

Payoff

Profit

Premium{

K

S

K

S

basic positions write naked call12
Basic PositionsWrite Naked Call

On January 9, Pfizer is at 41.875

The February 45 PFE Call is at 1.125

You write naked calls on 1,000 shares.

Receive $1,125 today.

If PFE stays below 45, profit = $1,125

If PFE = 46, profit = 1,125-1,000 (46-45)=$125

If PFE = 55, 1,125 – 1,000 (55-45) = -$8,875

Breakeven point = 45 + 1.125 = 46.125

basic positions buy naked put
Basic PositionsBuy Naked Put

Payoff

Profit

K

Premium{

K

S

S

basic positions buy naked put14
Basic PositionsBuy Naked Put
  • Like Buying a Naked Call in that...
    • You pay the premium
    • You choose whether to exercise the contract
    • Maximum loss = initial premium
    • Does not require a margin account
  • Maximum payoff = Strike price (happens when stock goes to zero).
basic positions buy naked put15
Basic PositionsBuy Naked Put
  • The breakeven point is lower when the premium is higher.
  • The premium will tend to be higher when:
    • the option is further in the money

(strike price is high compared to stock price)

    • the volatility of the stock is higher
    • the option has a longer time to expiration
basic positions write naked put
Basic PositionsWrite Naked Put
  • Like writing a naked call in that...
    • You receive the premium
    • Must honor contract if exercised against you
    • Maximum profit = Initial option premium
    • Dangerous
    • Requires a margin account
  • Maximum loss if stock goes to zero.
basic positions write naked put17
Basic PositionsWrite Naked Put

Payoff and Profit/Loss Functions

  • Payoff for writing a put is just minus one times the payoff for buying a put
    • Payoff for buyer + payoff for writer = 0
  • Profit for writing a put is just minus one times the profit for buying a put
    • Profit for buyer + profit for writer = 0
basic positions write naked put19
Basic PositionsWrite Naked Put

Payoff

Profit

Premium{

K

S

K

S

basic positions write naked put20
Basic PositionsWrite Naked Put

On January 9, Delta Air is at 49

The February 45 DAL Put is at 1.50

You write naked puts on 10,000 shares.

Receive $15,000 today.

If DAL stays above 45, profit = $15,000

DAL = 44: 15,000 -10,000 (45-44)=$5,000

DAL = 35: 15,000 - 10,000 (45-35) = -$85,000

Breakeven point = 45 - 1.50 = 43.50

stock and one option covered call
Stock and One OptionCovered Call
  • If you write a call option on a stock that you already own, this is called writing a covered call.
  • You keep the premium
  • If the call is exercised against you, you have to sell the stock at the strike price
  • Payoff = min(S,K)
stock and one option covered call23
Stock and One OptionCovered Call

Payoff Diagram

Buy Stock

Covered Call

S

S

Write Call

stock and one option covered call24
Stock and One OptionCovered Call

On January 9, Sun is at 29.50 February SUQ 35 Calls are at 1.75

A: Buy 100 shares for $2,950

B: Buy 100 shares for $2,950 AND write calls on 100 shares

Initial Investment = 2,950 – 175 = $2,775

stock and one option covered call25
SUNW goes to 25:

A: $2,500

B: $2,675

SUNW goes to 34:

A: $3,400

B: $3,575

SUNW goes to 35:

A: $3,500

B: $3,675

SUNW goes to 55:

A: $5,500

B: $3,675

Stock and One OptionCovered Call
stock and one option covered call26
Stock and One OptionCovered Call

If the option expires unexercised, you can then write another call.

Writing a covered call is selling off the upside potential of a stock in exchange for cash today.

stock and one option covered call27
Stock and One OptionCovered Call

Psychologically attractive to investors who fail to recognize a foregone gain as a loss.

This is one way to sell a stock if you have a “target price.”

stock and one option covered call28
Stock and One OptionCovered Call

You buy BankAmerica at $47

You want to sell if the stock reaches $70

One-year BAC 70 calls are at $2

Write the option. (Receive $2/share).

If BAC goes above 70 and option is exercised, you sell for 70.

If not, write another option next year.

stock and one option covered call29
Stock and One OptionCovered Call

Covered Call vs. Limit Sell Order

Limit order executed when price reaches limit

Possible price improvement beyond limit.

Call exercised at discretion of buyer. (Can drift in the money then out again).

With call, you get to keep the premium.

stock and one option protective put
Stock and One OptionProtective Put

Buying a put option on a stock you own is called buying a Protective Put

You pay the premium

If the stock crashes below the strike price, you are protected

The higher the strike price, the more protection.

Payoff = max(S,K)

stock and one option protective put32
Stock and One OptionProtective Put

Payoff Diagram

Buy Stock

Protective Put

Buy Put

S

S

stock and one option protective put33
Stock and One OptionProtective Put
  • A protective put is an insurance policy.
    • Pay a premium today
    • Policy covers losses above a certain amount
    • Option premium is the insurance premium
    • “Deductible” is current stock price minus strike
    • Have to renew the policy when option expires
stock and one option protective put34
Stock and One OptionProtective Put

Lucent is trading for 17.50

A one-year LU 10 Put is trading for 1.25

A:Buy 10,000 shares for $175,000

B: Buy 10,000 shares for $175,000 AND Buy puts on 10,000 shares for $12,500

(Initial investment $187,500)

stock and one option protective put35
LU goes to 25:

A: $250,000 (43%)

B: $250,000 (33%)

LU goes to 11:

A: $110,000 (-37%)

B: $110,000 (-41%)

LU goes to 10:

A: $100,000 (-43%)

B: $100,000 (-47%)

LU goes to 5:

A: $50,000 (-71%)

B: $100,000 (-47%)

Stock and One OptionProtective Put
stock and one option protective put36
Stock and One OptionProtective Put
  • You paid a premium of $12,500
  • The put protected you from any losses over $75,000
stock and one option protective call
Stock and One OptionProtective Call

If you have a short position in a stock, you lose money when the stock price increases.

You can limit your losses by buying a call option on the stock. This is called buying a Protective Call

stock and one option protective call38
Stock and One OptionProtective Call

Payoff Diagram

Buy Call

S

S

Protective Call

Short Stock

multiple option positions
Multiple Option Positions
  • Spreads
    • Calls only OR puts only
    • Buy some AND write some
  • Combinations
    • Calls AND puts together
simple spreads bull spread
Simple SpreadsBull Spread

BUY a call with a low strike

and WRITE a call with a high strike

  • Make money when stock goes up
  • Requires an initial investment
  • Loss limited to initial investment
  • Limited upside potential
simple spreads bull spread41
Simple SpreadsBull Spread

Buy Call

Bull Spread

K1

K2

K1

K2

Write Call

simple spreads bull spread43
Simple SpreadsBull Spread

FLY is trading at 70

March 65 FLY Call is trading for $7

March 75 FLY Call is trading for $2

Buy 65 calls * 500 shares: Pay $3,500

Write 75 calls * 500 shares: Get $1,000

Initial Investment = $2,500

simple spreads bull spread45
Simple SpreadsBull Spread

If FLY = 64:

Both Calls expire worthless.

Loss = $2,500

If FLY = 72:

Written Call expires worthless

Purchased call pays (72-65)*500 = $3,500

Profit = 0

simple spreads bull spread46
Simple SpreadsBull Spread

If FLY = 76:

Both Calls are exercised

Payoff = (75-65) * 500 = $5,000

Profit = $2,500 Return = 100%

If FLY = 150:

Both Calls are exercised

Profit = $2,500 Return = 100%

simple spreads bull credit spread
Simple SpreadsBull Credit Spread

BUY a put with a low strike

and WRITE a put with a high strike

  • Generates Initial Credit
  • Liability at expiration
  • Payoff pattern same as bull spread
simple spreads bull credit spread48
Simple SpreadsBull Credit Spread

Buy Put

K1

K2

K1

K2

Credit Bull Spread

Write Put

simple spreads bull credit spread50
Simple SpreadsBull Credit Spread

Triton is trading at 30.125

Feb 27.50 OIL Put is trading for $1.50

Feb 32.50 OIL Put is trading for $4.00

Buy 27.50 puts * 2,000 shares: Pay $3000

Write 32.50 puts * 2,000 shares: Get $8000

Initial Credit = $5,000

simple spreads bull credit spread52
Simple SpreadsBull Credit Spread

If OIL = 33:

Both puts expire worthless

Payoff = 0 Profit = $5,000

If OIL = 30:

Purchased put expires worthless

Loss on written put:

(30-32.50) 2,000 = -$5,000 Profit = 0

simple spreads bull credit spread53
Simple SpreadsBull Credit Spread

If OIL = 26:

Both puts are exercised

Liability at exercise:

(27.50 – 32.50)*2,000 = -$10,000

Loss: - $5,000

If OIL = 15: Loss: -$5,000

simple spreads bull credit spread54
Simple SpreadsBull Credit Spread

PROBLEM: If you enter a Credit Spread with American-style options, your written option may be exercised early.

This leaves you with a naked put.

simple spreads bull credit spread55
Simple SpreadsBull Credit Spread

Example: Triton goes to 20 and there are still 6 weeks left on the options.

  • Written option is exercised against you
  • Payoff on written put = -$25,000
  • If you exercise purchased put, its payoff is $15,000, limiting your loss to $5,000
  • Had they been European, you would have had six more weeks to recover
  • If you don’t exercise, you become a bear.
simple spreads bear spread
Simple SpreadsBear Spread

BUY a put with a high strike

and WRITE a put with a low strike

  • Make money when stock goes down
  • Requires an initial investment
  • Loss limited to initial investment
  • Limited upside potential
simple spreads bear spread57
Simple SpreadsBear Spread

Buy Put

Bear Spread

K2

K1

K1

K2

Write Put

simple spreads bear spread59
Simple SpreadsBear Spread

EK is trading at 42

March 40 EK Put is trading for $2.75

March 45 EK Put is trading for $5.75

Buy 45 puts * 1,000 shares: Pay $5,750

Write 40 puts * 1,000 shares: Get $2,750

Initial Investment = $3,000

simple spreads bear spread61
Simple SpreadsBear Spread

If EK = 46:

Both Puts expire worthless.

Loss = $3,000

If EK = 42:

Written put expires worthless

Purchased put pays (45-42)*1000 = $3,000

Profit = 0

simple spreads bear spread62
Simple SpreadsBear Spread

If EK = 39:

Both Puts are exercised.

Payoff = (45-40) * 1,000 = $5,000

Profit = $2,000

If EK = 20:

Both puts are exercised

Profit = $2,000

simple spreads bear credit spread
Simple SpreadsBear Credit Spread

BUY a call with a high strike

and WRITE a call with a low strike

  • Generates Initial Credit
  • Liability at expiration
  • Payoff pattern same as bear spread
simple spreads bear credit spread64
Simple SpreadsBear Credit Spread

Buy Call

K1

K2

K2

K1

Credit Bear Spread

Write Call

simple spreads bear credit spread65
Simple SpreadsBear Credit Spread

Like a bull credit spread, if you use American-style options, you can run into trouble if the written option is exercised early against you.

However, if the stock pays no dividends, the call is not very likely to be exercised early.

(Theory says you should never exercise a call option early if the stock pays no dividends)

combinations straddle
CombinationsStraddle

Buy a call and a put with the same strike price and same maturity.

You pay the premium on both options.

Stock goes down: make money on put

Stock goes up: make money on call

combinations straddle68
CombinationsStraddle

Payoff Function

Profit Function

K

S

K

S

combinations straddle69
CombinationsStraddle

You lose money if the stock finishes near the strike price.

Breakeven points:

S = K + C + P S = K – C – P

combinations straddle70
CombinationsStraddle

On January 10, Microsoft is at 52.875

Feb 55 MSFT Call is at 3.25

Feb 55 MSFT Put is at 5.125

Buy straddle on 1,000 shares for (3.25+5.125)*1,000 = $8,375

combinations straddle71
CombinationsStraddle

IF MSFT = 75

Call pays 1,000 (75-55) = $20,000

Put expires worthless Return = 0

IF MSFT = 55

Call expires worthless

Put expires worthless

Return = -100%

combinations straddle72
CombinationsStraddle

IF MSFT = 60

Call pays 1,000 (60-55) = $5,000

Put expires worthless

IF MSFT = 50

Call expires worthless

Put pays 1,000 (55-50) = $5,000

Return = -40%

combinations straddle73
CombinationsStraddle

IF MSFT = 63.375

Call pays 1,000 (63.375-55) = $8,375

Put expires worthless

IF MSFT = 50

Call expires worthless

Put pays 1,000 (55-50) = $5,000

Return = -40%

combinations straddle74
CombinationsStraddle
  • The straddle is a volatility play
  • The price of the straddle reflects the market’s assessment of the volatility of the underlying asset.
  • You might buy a straddle if you believe volatility will be higher than the market believes it will be
combinations straddle75
CombinationsStraddle
  • If you think volatility will be low, you might be tempted to write a straddle
    • Write a call option
    • Write a put option
  • This can be a dangerous position
combinations straddle76
CombinationsStraddle

Writing a Straddle

Payoff Function

Profit Function

K

S

S

K

combinations strangle
CombinationsStrangle

Buy a call with a higher strike price and buy a put with a lower strike price (with the same expiration date)

Like a straddle, this is a long volatility position.

combinations strangle79
CombinationsStrangle

Payoff Function

Profit Function

K1

K2

K1

K2

S

S

combinations strangle80
CombinationsStrangle

Breakeven points:

K1 – C – P K2 + C + P

A strangle tends to be cheaper than a straddle.

combinations strangle81
CombinationsStrangle

Chevron is at 80.50

February 80 call is at 3.375

February 80 put is at 3.00

Straddle Price = 6.375

February 85 call is at 1.25

February 75 put is at 1.125

Strangle Price = 2.375

combinations strangle82
CombinationsStrangle

Strangle vs. Straddle

Profit

S

-2.375

75

85

-6.375

80

combinations strap
CombinationsStrap

Buy two calls and one put with the same strike price and same maturity.

(Straddle plus one more call).

This is a long volatility position and a bullish position

combinations strap84
CombinationsStrap

Payoff Function

K

S

combinations strap85
CombinationsStrap

Strap vs. Straddle

Profit

S

-6.675

-9.75

combinations strip
CombinationsStrip

Buy one call and two puts with the same strike price and same maturity.

(Straddle plus one more put).

This is a long volatility position and a bearish position

butterfly spread
Butterfly Spread

Butterfly Spread with Call Options

Three strike prices, evenly spaced:

(K1, K2, K3)

Buy one call with strike price K1

Writetwo calls with strike price K2

Buy one call with strike price K3

butterfly spread88
Butterfly Spread

Buy Call

Buy Call

K1

K3

Butterfly Spread

K2

K1

K2

K3

Write Two Calls

butterfly spread89
Butterfly Spread

Butterfly Spread with Put Options

Three strike prices, evenly spaced:

(K1, K2, K3)

Buy one put with strike price K1

Writetwo put with strike price K2

Buy one put with strike price K3

butterfly spread90
Butterfly Spread

Buy Put

Buy Put

K1

K3

Butterfly Spread

K2

K1

K2

K3

Write Two Puts