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rading T Str"ategies
Involving Options
We discussed the profit pattern from an investment in a single stock option in
Chapter 8. In tllis chapter we cover more fully the range of profit patterns obtainable
using options. We assume that the underlying asset is a stock. Similar results can be
obtained for other underlying assets, such as foreign currencies, stock indices, and
futures contracts. The options used in the strategies we discuss are European. American options may lead to slightly different outcomes because of the possibility of early
exercise.
In the first section we consider what happens when a position in a stock option is
combined with a position in the stock itself. We then move on to exanline the profit
patterns obtained when an investment is made in two or more different options on the
same stock. One of the attractions of options is that they can be used to create a wide
range of different payoff functions. (A payofffunction is the payoff as a function of the
stock price.) If European options were available with every single possible strike price,
any payoff function could in theory be created.
For ease of exposition the figures and tables showing the profit from a trading
strategy will ignore the time value of money. The profit will be shown as the final
payoff minus the initial cost. (In theory, it should be calculated as the present value of
the final payoff nlinus the initial cost.)
10.1
STRATEGIES INVOLVING A SINGLE OPTION AND A STOCK
There are a number of different trading strategies involving a single option on a stock
and the stock itself. The profits from these are illustrated in Figure 10.1. In this figure
and in other figures throughout this chapter, the dashed line shows the relationship
between profit and the stock price for the individual securities constituting the
portfolio, whereas the solid line shows the relationship between profit and the stock
price for the whole portfolio.
In Figure 1O.1(a), the portfolio consists of a long position in a stock plus a short
position in a call option. This is known as writing a covered call. The long stock position
"covers" or protects the investor from the payoff on the short call that becomes
necessary if there is a sharp rise in the stock price. In Figure 10.1 (b), a short position
in a stock is combined with a long position in a call option. This is the reverse of writing
224
CHAPTER 10
Profit patterns (a) long position in a stock combined with short position
in a call; (b) short position in a stock combined with long position in a call; (c) long
position in a put combined with long position in a stock; (d) short position in a put
combined with short position in a stock.
Figure 10.1
Profit
Profit
;
;
;
;
;
;
;;Long
;; Stock
,,
,,
,,
,,
,,
....;
;; Long
,,
,
"
,,
,,
........
,,
K
;
;
,,
,
Long ;
Stock;;
Lana
',Put"
,
,
.,
,,
,
;
;
;
;
;
;
;
;
;
;
;;K
;
,
,
(c)
"
Short
',Stock
,,
(b)
Profit
,,
,,
'.
(a)
,,
Call
;
ST
Short "
Call
;
;
Profit
"
,
Short
',Stock
,
"
Short
Put
",
;
;
v
',K
,,
,
,,
,,
,,
,,
,,
,
(d)
a covered call. In Figure 10.I(c), the investment strategy involves buying a put option on
a stock and the stock itself. The approach is sometimes referred to as a protective put
strategy. In Figure 10.I(d), a short position in a put option is combined with a short
position in the stock. This is the reverse of a protective put.
The profit patterns in Figures 10.1 have the same general shape as the profit patterns
discussed in Chapter 8 for short put, long put, long call, and short call, respectively.
Putcall parity provides a way of understanding why this is so. From Chapter 9, the
225
Trading Strategies Involving Options
puteall parity relationship is
p + So = c + Ke rT + D
(10.1)
where p is the price of a European put, So is the stock price, c is the price of a European
call, K is the strike price of both call and put, r is the riskfree interest rate, T is the time
to maturity of both call and put, and D is the present value of the dividends anticipated
during the life of the options.
Equation (10.1) shows that a long position in a put combined with a long position in
the stock is equivalent to a long call position plus a certain amount (= Ke rT + D) of
cash. This explains why the profit pattern in Figure 1O.1(c) is similar to the profit
pattern from a long call position. The position in Figure 10.1 (d) is the reverse of that in
Figure 1O.1(c) and therefore leads to a profit pattern similar to that from a short call
position.
Equation (l0.1) can be rearranged to become
So  c = Ke rT
+D
P
In other words, a long position in a stock combined with a short position in a call is
equivalent to a short put position plus a certain amount (= Ke rT + D) of cash. This
equality explains why the profit pattern in Figure 1O.1(a) is similar to the profit
pattern from a short put position. The position in Figure 1O.1(b) is the reverse of
that in Figure 1O.1(a) and therefore leads to a profit pattern similar to that from a
long put position.
10.2 SPREADS
A spread trading strategy involves taking a position in two or more options of the same
type (i.e., two or more calls or two or more puts).
Bull Spreads
One of the most popular types of spreads is a bull spread. This can be created by buying
a call option on a stock with a certain strike price and selling a call option on the same
Figure 10.2
Profit from bull spread crea.ted using call options.
Profit
K1
,/
/
/
/
/
/
______________ J
/
/
,,
,,
,,
,,
'.
226
CHAPTER 10
Table 10.1
Stock price
range
Payoff from a bull spread created using calls.
Payoff ji'OI11
long call option
Payoff ji'OI11
short call option
Total
payoff
ST ~ K2
KI < ST < K2
ST:::;; K\
stock with a higher strike price. Both options have the same expiration date. The
strategy is illustrated in Figure 10.2. The profits from the two option positions taken
separately are shown by the dashed lines. The profit from the whole strategy is the sum
of the profits given by the dashed lines and is indicated by the solid line. Because a call
 price always decreases as the strike price increases, the value of the option sold is always
less than the value of the option bought. A bull spread, when created from calls,
therefore requires an initial investment.
Suppose that K\ is the strike price of the call option bought, K 2 is the strike price of
the call option sold, and ST is the stock price on the expiration date of the options.
Table 10.1 shows the total payoff that will be realized from a bull spread in different
circumstances. If the stock price does well and is greater than the higher strike price,
the payoff is the difference between the two strike prices, or K 2  K\. If the stock price
on the expiration date lies between the two strike priCes, the payoff is ST  K \. If the
stock price on the expiration date is below the lower strike price, the payoff is zero.
The profit in Figure 10.2 is calculated by subtracting the initial investment from the
payoff.
A bull spread strategy limits the investor's upside as well as downside risk. The strategy
can be described by saying that the investor has a call option with a strike price equal to
K\ and has chosen to give up some upside potential by selling a call option with strike
price K 2 (K2 > K\). In return for giving up the upside potential, the investor gets the
Figure 10.3
Profit from bull spread created using put options.
Profit
""
"
""
""
""
""
, "" "
.,.""
""
""
""
""
""
227
Trading Strategies Involving Options
price of the option with strike price
~2'
Three types of bull spreads can be distinguished:
1. Both calls are initially out of the money.
2. One call is initially in the money; the other call is initially out of the money.
3. Both calls are initially in the money.
The most aggressive bull spreads are those of type 1. They cost very little to set up and
have a small probability of giving a relatively high payoff (= K 2  K 1). As we move
from type 1 to type 2 and from type 2 to type 3, the spreads become more conservative.
Example 10.1
An investor buys for $3 a call with a strike price of $30 and sells for $1 a call with
a strike price of $35. The payoff from this bull spread strategy is $5 if the stock
price is above $35, and zero if it is below $30. If the stock price is between $30 and
$35, the payoff is the amount by which the stock price exceeds $30. The cost of the
strategy is $3  $1 = $2. The profit is therefore as follows:
Stock price range
Profit
ST ~ 30
30 < ST < 35
ST ~ 35
ST 32
3
2
Bull spreads can also be created by buying a put with a low strike price and selling a put
with a high strike price, as illustrated in Figure 10.3. Unlike the bull spread created from
calls, bull spreads created from puts involve a positive upfront cash flow to the investor
(ignoring margin requirements) and a payoff that is either negative or zero.
Bear Spreads
An investor who enters into a bull spread is hoping that the stock price will increase. By
contrast, an investor who enters into a bear spread is hoping that the stock price will
decline. Bear spreads can be created by buying a put with one strike price and selling a
put with another strike price. The strike price of the option purchased is greater than
the strike price of the option sold. (This is in contrast to a bull spread, where the strike
Figure 10.4
Profit from bear spread created using put options.
Profit
""
""
""
"
...
... ...
... ...
... ...
... ...
...
... ...
...
... ...
... ...
"""
"
""
""
""
"",
228
CHAPTER 10
Table 10.2
Payoff from a bear spread created with put options.
Stock price
range
Payofffrom
long put option
Payoff}i'om
short put option
Sr ~ K2
K j < Sr < K2
Sr ~ K j
o
K2 Sr
K2 Sr
o
o
Total
payoff
(Kj  Sr)
price of the option purchased is always less than the strike price of the option sold.) In
Figure IDA, the profit from the spread is shown by the solid line. A bear spread created
from puts involves an initial cash outflow because the price of the put sold is less than
the price of the put purchased. In essence, the investor has bought a put with a certain
 strike price and chosen to give up some of the profit potential by selling a put with a
lower strike price. In return for the profit given up, the investor gets the price of the
option sold.
Assume that the strike prices are K j and K 2 , with K j < K2 Table 10.2 shows the
payoff that will be realized from a bear spread in different circumstances. If the stock
price is greater than K 2 , the payoff is zero. If the stock price is less than Kj, the payoff is
K 2  K 1 If the stock price is between K 1 and K 2, the payoff is K 2  Sr. The profit is
calculated by subtracting the initial cost from the payoff.
Example 10.2
An investor buys for $3 a put with a strike price of $35 and sells for $1 a put with
a strike price of $30. The payoff from this bear spread strategy is zero if the stock
price is above $35, and $5 if it is below $30. If the stock price is between $30 and
$35, the payoff is 35  ST. The options cost $3  $1 = $2 up front. The profit is
therefore as follows:
Stock price range
Profit
Sr ~ 30
30 < Sr < 35
+3
33  Sr
Sr~35
2
Like bull spreads, bear spreads limit both the upside profit potential and the downside
risk. Bear spreads can be created using calls instead of puts. The investor buys a call
with a high strike price and sells a call with a low strike price, as illustrated in
Figure 10.5. Bear spreads created with calls involve an initial cash inflow (ignoring
margin requirements).
Box Spreads
A box spread is a combination of a bull call spread with strike prices K j and K 2 and a
bear put spread with the same two strike prices. As shown in Table 10.3 the payoff from
a box spread is always K 2  K j The value of a box spread is therefore always the
present value of this payoff or (K2  K1)e rr . If it has a different value there is an
arbitrage opportunity. If the market price of the box spread is too low, it is profitable to
229
Trading Strategies Involving Options
Figure 10.5
Profit from bear spread created using call options.
Profit
,,
",
,,
,,
,,
,,
,,
""
,,
,,
"
""
"
"
""
""
"
""
'.
buy the box. This involves buying a call with strike price K(, buying a put with strike
price K 1, selling a call with strike price K 1, and selling a put with strike price K 1 If the
market price of the box spread is too high, it is profitable to sell the box. This involves
buying a call with strike price K 1 , buying a put with strike price K(, selling a call with
strike price K(, and selling a put with strike price K 1 .
It is important to realize that a boxspread arbitrage only works with European
options. Most of the options that trade on exchanges are American. As shown in
Business Snapshot 10.1, inexperienced traders who treat American options as European
are liable to lose money.
Butterfly Spreads
A butterfly spread involves positions in options with three different strike prices. It can
be created by buying.a call option with a relatively low strike price, K(, buying a call
option with a relatively high strike price, K 3 , and selling two call options with a strike
price, K 1, halfway between K 1 and K 3 Generally K 1 is close to the current stock price.
The pattern of profits from the strategy is shown in Figure 10.6. A butterfly spread
leads to a profit if the stock price stays close to K1 , but gives rise to a small loss if there
is a significant stock price move in either direction. It is therefore an appropriate
strategy for an investor who feels that large stock price moves are unlikely. The strategy
requires a small investment initially. The payoff from a butterfly spread is shown in
Table 10.5.
Table 10.3
Stock price
range
ST ~ K1
Kl < ST < K1
ST ::( Kl
Payoff from a box spread.
Payofffrom
bull call spread
Payoff from
bear put spread
Total
payoff
K1 K l
K1 K l
K1 K l
230
CHAPTER 10
Business Snapshot 10.1 . Losing Money with Box Spreads
Suppose that a stock has a price of $50 and a volatility of 30%. No dividends are
expected and the riskfree rate is 8%. A trader offers you the chance to sell on the
CBOE a 2month box spread where the strike prices are $55 and $60 for $5.10.
Should you do the trade?
The trade certainly sounds attractive. In this case K} = 55, K 2 = 60, and the payoff
is certain to be $5 in 2 months. By selling the box spread for $5.10 and investing the
funds (or 2 months you would have more than enough funds to meet the $5 payoff in
2 months. The theoretical value of the box spread today is 5 x eO.08x2/12 = $4.93.
Unfortunately there is a snag. CBOE stock options are American and the $5 payoff
from the box spread is calculated on the assumption that the options comprising the
box are European. Option prices for this example (calculated using DerivaGem) are
_ shown in Table lOA. A bull call spread where the strike prices are $55 and $60 costs
0.96  0.26 = $0.70. (This is the same for both European and American options
because, as we saw in Chapter 9, the price of a European call is the same as the price of
an American call when there are no dividends.) A bear put spread with the same strike
prices costs9A6  5.23 = $4.23 if the options al:e European and 10.00  5.44 = $4.56
if they are American. The combined value of both spreads if they are created with
European options is 0.70 + 4.23 = $4.93. This is the theoretical box spread price
calculated above. The combined value of buying both spreads if they are American is
0.70 + 4.56 = $5.26. Selling a box spread created \vith American options for $5.10
would not be a good trade. You would realize this almost immediately as the trade
involves selling a $60 strike put and this \vould be exercised against you almost as soon
as you sold it!
Suppose that a certain stock is currently worth $61. Consider an investor who feels
that a significant price move in the next 6 months is unlikely. Suppose that the market
prices of 6month calls are as follows:
Strike price ($ )
Call price ($)
55
60
65
10
7
5
Values of 2month European and American options
on a nondividendpaying stock. Stock price = $50; interest rate
= 8% per annum; and volatility = 30% per annum.
Table 10.4
Option
type
Strike
price
European
option price
American
option price
Call
Call
Put
Put
60
55
60
55
0.26
0.96
9046
5.23
0.26
0.96
10.00
5.44
Tl~adilli Strategies Involving Options
Figure 10.6
231
Profit from butterfly' spread using call options.
Profit
\
\
\
\
\
Kj
"
"
,,"
\~"~7(
"
_/,,"
\
\
\\
\
\
\
\
The investor could create a butterfly spread by buying one call with a $55 strike price,
buying one call with a $65 strike price, and selling two calls with a $60 strike price. It
costs $10 + $5  (2 x $7) = $1 to create the spread. If the stock price in 6 months is
greater than $65 or less than $55, the total payoff is zero, and the investor incurs a net
loss of $1. If the stock price is between $56 and $64, a profit is made. The maximum
profit, $4, occurs when the stock price in 6 months is $60.
Butterfly spreads can be created using put options. The investor buys a put with a low
strike price, buys a put with a high strike price, and sells two puts with an intermediate
strike price, as illustrated in Figure 10.7. The butterfly spread in the example just
considered would be created by buying a put with a strike price of $55, buying a put
with a strike price of $65, and selling two puts with a strike price of $60. If all options
are European, the use of put options results in exactly the same spread as the use of call
options. Puteall parity can be used to show that the initial investment is the same in
both cases.
A butterfly spread can be sold or shorted by following the reverse strategy. Options
are sold with prices strike of K 1 and K 3, and two options with the middle strike price K 2
are purchased. This strategy produces a modest profit if there is a significant movement
in the stock price.
Table 10.5
Payoff from a butterfly spread.
Stock price
range
Payoff from
first long call
Payoff from
second long call
Payofffrom
short calls
ST < K,
K, < ST < K2
K 2 < ST < K3
ST> K3
0
STK,
STK,
STKI
0
0
0
0
0
ST K 3
2(ST  K2)
2(ST  K 2)
* These payoffs are calculated using the relationship K2 = O.5(K]
+ K3).
Total
payoff*
0
STK,
K3 ST
0
232
CHAPTER 10
Figure 10.7
Profit from butterfly spread using put options.
Profit
\
\
\
\
\
"
,,""
\:'>""7(
\
,,""
\
"
\\
\
\
\
\
Calendar Spreads
up to now we have assumed that the options used to create a spread all expire at the
same time. We now move on to calendar spreads in which the options have the same
strike price and different expiration dates.
,A calendar spread can be created by s~lling a call option with a certain strike price
and buying a longermaturity call option with the same strike, price. The longer the
maturity of an option, the more expensive it usually is. A calendar spread therefore
usually requires an initial investment. Profit diagrams for calendar spreads are usually
produced so that they show the profit when the shortmaturity option expires on the
assumption that the longmaturity option is sold at that time. The profit pattern for a
calendar spread produced from call options is shown in Figure 10.8. The pattern is
Figure 10.8
Profit from calendar spread created using two calls.
,
Profit
,
,,
/
/
/
,,
,,
""
""
"
...
//
,,
""
,,
/
""
,,
,,
,,
,,
,
"
233
Trading Strategies Involving Options
Profit from a calendar spread created using two puts.
Figure 10.9
Profit
""
"
""
""
""
"
"" "
", ,
/
/
/~
ST
/
/
/
/
/
/
/
/
/
/
/
/
/
/
similar to the profit from the butterfly spread in Figure 10.6. The investor makes a profit
if the stock price at the expiration of the shortmaturity option is close to the strike
price of the shortmaturity option. However, a loss is incurred when the stock price is
significantly above or significantly below this strike price.
To understand the profit pattern from a calendar spread, first consider what happens
if the stock price is very low when the shortmaturity option expires. The shortmaturity
option is worthless and the value of the longmaturity option is close to zero. The
investor therefore incurs a loss that is close to the cost of setting up the spread initially.
Consider next what happens if the stock price, ST, is very high when the shortmaturity
option expires. The shortmaturity option costs the investor ST  K, and the longmaturity option is worth close to ST  K, where K is the strike price of the options.
Again, the investor makes a net loss that is close to the cost of setting up the spread
initially. If ST is close to K, the shortmaturity option costs the investor either a small
amount or nothing at all. However, the longmaturity option is still quite valuable. In
this case a significant net profit is made.
In a neutral calendar spread, a strike price close to the current stock price is chosen.
A bullish calendar spread involves a higher strike price, whereas a bearish calendar
spread involves a lower strike price.
Calendar spreads can be created with put options as well as call options. The investor
buys a longmaturity put option and sells a shortmaturity put option. As shown in
Figure 10.9, the profit pattern is similar to that obtained from using calls.
A reverse calendar spread is the opposite to that in Figures 10.8 and 10.9. The investor
buys a shortmaturity option and sells a longmaturity option. A small profit arises if
the stock price at the expiration of the shortmaturity option is well above or well below
the strike price of the shortmaturity option. However, a significant loss results if it is
close to the strike price.
Diagonal Spreads
Bull, bear, and calendar spreads can all be created from a long position in one call and
a short position in another call. In the case of bull and bear spreads, the calls have
234
CHAPTER 10
Figure 10.10
Profit from a straddle.
Profit
different strike prices and the same expiration date. In the case of calendar spreads, the
calls have the same strike price and different expiration dates.
In a diagonal spread both the expiration date and the strike price of the calls are
different. This increases the range of profit patterns that are possible.
10.3 COMBINATIONS
A combination is an option trading strategy that involves taking a position in both calls
and puts on the same stock. We will consider straddles, strips, straps, and strangles.
Straddle
One popular combination is a straddle, which involves buying a call and put with the
same strike price and expiration date. The profit pattern is shown in Figure 10.10. The
strike price is denoted by K. If the stock price is close to this strike price at expiration of
the options, the straddle leads to a loss. However, if there is a sufficiently large move in
either direction, a significant profit will result. The payoff from a straddle is calculated
in Table 10.6.
A straddle is appropriate when an investor is expecting a large move in a stock price
but does not know in which direction the move will be. Consider an investor who feels
that the price of a certain stock, currently valued at $69 by the market, will move
significantly in the next 3 months. The investor could create a straddle by buying both a
put and a call with a strike price of $70 and an expiration date in 3 months. Suppose
that the call costs $4 and the put costs $3. If the stock price stays at $69, it is easy to see
Table 10.6
Payoff from a straddle.
Range of
stock price
Payoff
from call
Payoff
ji'om put
Total
payoff
ST ~ K
ST> K
0
STK
KST
0
KS T
STK
235
Tl'ading Strategies Involving Options
that the strategy costs the investor $6. (An upfront investment of $7 is required, the call
expires worthless, and the put expires worth $1.) If the stock price moves to $70, a loss
of $7 is experienced. (This is the worst that can happen.) However, if the stock price
jumps up to $90, a profit of $13 is made; if the stock moves down to $55, a profit of $8
is made; and so on. As discussed in Business Snapshot 10.2 an investor should carefully
consider whether the jump that he or she anticipates is already reflected in option prices
before putting on a straddle trade.
The straddle in Figure 10.10 is sometimes referred to as a bottom straddle or straddle
purchase. A top straddle or straddle write is the reverse position. It is created by selling a
call and a put with the same exercise price and expiration date. It is a highly risky strategy.
If the stock price on the expiration date is close to the strike price, a significant profit
results. However, the .loss arising from a large move is unlimited.
Figure 10.11
Profit from a strip and a strap.
Profit
Profit
Strip
Strap
236
CHAPTER 10
Figure 10.12
Profit from a strangle.
Profit
,,

~T~_
_
 :_
/
/
Strips and Straps
A strip consists of a long position in one call and two puts with the same strike price
and expiration date. A strap consists of a long position in two calls and one put with the
same strike price and expiration date. The profit patterns from strips and straps are
shown in Figure 10 .11. In a strip the investor is betting that there will be a big stock
price move and considers a decrease in the stock price to. be more likely than an
increase. In a strap the investor is also betting that there will be a big stockprice move.
However, in this case, an increase in the stock price is considered to be more likely than
a decrease.
Strangles
In a strangle, sometimes called a bottom vertical combination, an investor buys a put and
a call with the same expiration date and different strike prices. The profit pattern that is
obtained is shown in Figure 10.12. The call strike price, K 2 , is higher than the put strike
price, K j The payoff function for a strangle is calculated in Table 10.7.
A strangle is a similar strategy to a straddle. The investor is betting that there will be a
large price move, but is uncertain whether it will be an increase or a decrease.
Comparing Figures 10.12 and 10.10, we see that the stock price has to move farther
in a strangle than in a straddle for the investor to make a profit. However, the downside
risk if the stock price ends up at a central value is less with a strangle.
The profit pattern obtained with a strangle depends on how close together the strike
prices are. The farther they are apart, the less the downside risk and the farther the
stock price has to move for a profit to be realized.
Table 10.7
Payoff from a strangle.
Range of
stock price
Payoff
from call
Payoffjrom
put
Total
payoff
ST ~ K j
Kl < ST < K2
0
0
ST K2
KI ST
0
0
KIST
0
ST K 2
ST
~
K2
Trading Strategies Involving Options
Figure 10.13
237
Payoff from a butterfly spread.
The sale of a strangle is sometimes referred to as a top vertical combination. It can be
appropriate for an investor who feels that large stock price moves are unlikely.
However, as with sale of a straddle, it is a risky strategy involving unlimited potential
loss to the investor.
10.4 OTHER PAYOFFS
This chapter has demonstrated just a few of the ways in which options can be used to
produce an interesting relationship between profit and stock price. If European options
expiring at time T were available with every single possible strike price, any payoff
function at time T could in theory be obtained. The easiest illustration of this involves a
series of butterfly spreads. Recall that a butterfly spread is created by buying options
with strike prices K 1 and K 3 and selling two options with strike price K 2 , where
K 1 < K 2 < K 3 and K 3  K 2 = K 2  K 1 Figure 10.13 shows the payoff from a butterfly
spread. The pattern could be described as a spike. As K 1 and K 3 move closer together,
the spike becomes smaller. Through the judicious combination of a large number of
very small spikes, any payoff function can be .approximated.
SUMMARY
A number of common trading strategies involve a single option and the underlying
stock. For example, writing a covered call involves buying the stock and selling a call
option on the stock; a protective put involves buying a put option and buying the stock.
The former is similar to selling a put option; the latter is similar to buying a call option.
Spreads involve either taking a position in two or more calls or taking a position in two
or more puts. A bull spread can be created by buying a call (put) with a low strike price
and selling a put (call) with a high strike price. A bear spread can be created by buying a
put (call) with a high strike price and selling a put (call) with a low strike price. A
butterfly spread involves buying calls (puts) with a low and high strike price and selling
two calls (puts) with some intermediate strike price. A calendar spread involves selling a
call (put) with a short time to expiration and buying a call (put) with a longer time to
expiration. A diagonal spread involves a long position in one option and a short position
in another option such that both the strike price and the expiration date are different.
Combinations involve taking a position in both calls and puts on the same stock. A
straddle combination involves taking a long position in a call and a long position in a
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238
put with the same strike price and expiration date. A strip consists of a long position in
one call and two puts with the same strike price and expiration date. A strap consists of
a long position in two calls and one put with the same strike price and expiration date.
A strangle consists of a long position in a call and a put with different strike prices and
the same expiration date. There are many other ways in which options can be used to
produce interesting payoffs. It is not surprising that option trading has steadily
.
increased in popularity and continues to fascinate investors.
FURTHER READING
Bharadwaj, A. and J. B. Wiggins. "Box Spread and Puteall Parity Tests for the S&P Index
LEAPS Markets," Journal of Derivatives, 8, 4 (Summer 2001): 627l.
Chaput, J. S., and L. H. Ederington, "Option Spread and Combination Trading," Journal of
Derivatives, 10, 4 (Summer 2003): 7088.
.
McMillan, L. G. Options as a Strategic Investmelll. 4th edn., Upper Saddle River: PrenticeHall,
200l.
Rendleman, R. J. "Covered Call Writing from an Expected Utility Perspective," Journal of
Derivatives, 8, 3 (Spring 2001): 6375.
Ronn, A. G. and E.1. Ronn. "The BoxSpread Arbitrage Conditions," Review of Financial
Studies, 2, 1 (1989): 91108.
Questions And Problems (Answers in Solutions Manual)
:.zt'
10.1. What is meant by a protective put? What position in call options is equivalent to a
protective put?
10.2. Explain two ways in which a bear spread can be created.
10.3. When is it appropriate for an investor to purchase a butterfly spread?
IDA. Call options on a stock are available with strike prices of $15, $17~, and $20, and
expiration dates in 3 months. Their prices are $4, $2, and $~, respectively. Explain how
the options can be used to create a butterfly spread. Construct a table showing how
profit varies with stock price for the butterfly spread.
10.5. What trading strategy creates a reverse calendar spread?
10.6. What is the difference between a strangle and a straddle?
10.7. A call option with a strike price of $50 costs $2. A put option with a strike price of $45
costs $3. Explain how a strangle can be created from these two options. What is the.
pattern of profits from the strangle?
10.8. Use puteall parity to relate the initial investment for a bull spread created using calls to
the initial investment for a bull spread created using puts.
10.9. Explain how an aggressive bear spread can be created using put options.
10.10. Suppose that put options on a stock with strike prices $30 and $35 cost $4 and $7,
respectively. How can the options be used to create (a) a bull spread and (b) a bear
spread? Construct a table that shows the profit and payoff for both spreads.
10.11. Use puteall parity to show that the cost of a butterfly spread created from European
puts is identical to the cost of a butterfly spread created from European calls.
Tradiizg Strategies Involving Options
239
10.12. A call with a strike price of $60 costs $6. A put with the same strike price and expiration
date costs $4. Construct a table that shows the profit from a straddle. For what range of
stock prices would the straddle lead to a loss?
A
10.13. Construct a table showing the payoff from a bull spread when puts with strike prices K I
and K 2 , with K 2 > K b are used.
10.14. An investor believes that there will be a big jump in a stock price, but is uncertain as to
the direction. Identify six different strategies the investor can follow and explain the
differences among them.
10.15. How can a forward contract on a stock with a particular delivery price and delivery date
be created from options?
10.16. "A box spread comprises four options. Two can be combined to create a long forward
position and two can be combined to create a short forward position." Explain this
statement.
.
10.17. What is the result if the strike price of the put is higher than the strike price of the call in
a strangle?
10.18. One Australian dollar is currently worth $0.64. A Iyear butterfly spread is set up using
European call options with strike prices of $0.60, $0.65, and $0.70. The riskfree interest
rates in the United States and Australia are 5% and 4% respectively, and the volatility of
the exchange rate is 15%. Use the DerivaGem software to calculate the cost of setting up
the butterfly spread position. Show that the cost is the same if European put options are
used instead of European call options.
Assignment Questions
10.19. Three put options on a stock have the same expiration date and strike prices of $55, $60,
and $65. The market prices are $3, $5, and $8, respectively. Explain how a butterfly
spread can be created. Construct a table showing the profit from the strategy. For what
range of stock prices would the butterfly spread lead to a loss?
10.20. A diagonal spread is created by buying a call with strike price K 2 and exercise date T2
and selling a call with strike price K I and exercise date TI , where T2 > TI Draw a
diagram showing the profit when (a) K 2 > K I and (b) K 2 < K I .
10.21. Draw a diagram showing the variation of an investor's profit and loss with the terminal
stock price for a portfolio consisting of:
(a) One share and a short position in one call option
(b) Two shares and a short position in one call option
(c) One share and a short posItion in two call options
(d) One share and a short position in four call options
In each case, assume that the call option has an exercise price equal to the current
stock price.
10.22. Suppose that the price of a nondividendpaying stock is $32, its volatility is 30%, and
the riskfree rate for all maturities is 5% per annum. Use DerivaGem to calculate the
cost of setting up the following positions:
(a) A bull spread using European call options with strike prices of $25 and $30 and a
maturity of 6 months
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CHAPTER 10
(b) A bear spread using European put options with strike prices of $25 and $30 and a
maturity of 6 months
(c) A butterfly spread using European call options with strike prices of $25, $30, and
$35 and a maturity of 1 year
(d) A butterfly spread using European put options with strike prices of $25, $30, and
$35 and a maturity of 1 year
(e) A straddle using options with a strike price of $30 and a 6month maturity
(f) A strangle using options with strike prices of $25 and $35 and a 6month maturity
In each case provide a table showing the relationship between profit and final stock price.
Ignore the impact of discounting.