10_Trading_strategies - 10.1 Trading Strategies Invoiving...

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Unformatted text preview: 10.1 Trading Strategies Invoiving Options We discussed the profit pattern from an investment in a single stock option in Chapter 8. In this 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. Amer- ican 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 examine 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 payoff function 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 minus the initial cost.) 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 10.1(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 nan 224 CHAPTER 10 Figure 10.1 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; (0) long position in a put combined with long position in a stock; ((1) short position in a put combined with short position in a stock. Profit ll’Long ll Stock I (b) Profit \ Short (C) (d) a covered call. In Figure 10.1(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 10.1(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. Put—call parity provides a way of understanding why this is so. From Chapter 9, the Trading Strategies Involving Options 10.2 225 put—call parity relationship is p+S0=c+KeTrT + D (10.1) where p is the price of a European put, S0 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 risk-free 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’” + D) of ' cash. This explains why the profit pattern in Figure 10.1(c) is similar to the profit pattern from a long cali position. The position in Figure 10.1(d) is the reverse of that in Figure 10.1(0) and therefore leads to a profit pattern similar to that from a short call position. Equation (10.1) can be rearranged to become So-c=K6"'T+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 (2 Ke‘” + D) of cash. This equality explains why the profit pattern in Figure 10.1(a) is similar to the profit pattern from a short put position. The position in Figure 10.1(b) is the reverse of that in Figure 10.1(a) and therefore leads to a profit pattern similar to that from a long put position. 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 226 CHAPTER 10 Table 10.1 Payoff from a bull spread created using calls. Stock price Payofi’ from Payofl from Total range long, call option short call option payofl ST>K2 ST‘"K1 “(Sr—K2) Kz—Ki K1<ST<K2 ST~K1 0 ST—K1 ST g K1 0 0 0 ‘ 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 K1 is the strike price of the call option bought, K2 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 payofl‘ 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 K2 — K1. If the stock price on the expiration date lies between the two strike prices, the payoff is ST — K1. 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 K2 (K2 > K1). In return for giving up the upside potential, the investor gets the Figure 10.3 Profit from bull spread created using put options. T Profit Trading Strategies Involving Options 227 price of the option with strike price K2. 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 payofi" (= K2 — K1). 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 S 30 —2 30<ST<35 87—32 ST 2 35 3 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 up-front cash flow to the investor (ignoring margin requirements) and a payofi‘ 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 buyinga 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 1 0.4 Profit from bear spread created using put options. Profit 228 ' CHAPTER 10 Table 10.2 Payofi" from a bear spread created with put options. Stock price Payofl from Payoflfi‘om Total range long-put option short put option payofl ST 2 K2 0 0 0 K1<ST<K2 Rig-51" 0 Kg—ST Sr<K1 Kz-“Sr "(Kl"ST) K2"'K1 price of the option purchased is always less than the strike price of the option sold.) In Figure 10.4, 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 K1 and K2, with K; < 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 K2, the payoff is zero. If the stock price is less than K1, the payoff is K2 — K1. If the stock price is betWCen K I and K2, the payoff is K2 —- ST. 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 payoif 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 ST g 30 +3 30<ST<35 33—87' 57 2 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 K1 and K2 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 K3 — K1. The value of a box spread is therefore always the present value of this payoff or (K2 ~— K 1)e‘rT. 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 Trading Strategies Involving Options 229 Figure 1 0.5 Profit from bear spread created using call options. buy the box. This involves buying a call with strike price K1, buying a put with strike price K2, selling a call with strike price K2, and selling a put with strike price K ,. 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 K2, buying a put with strike price K1, selling a call with strike price K1, and selling a put with strike price K2. It is important to realize that a box—spread arbitrage only works with European options. Most of the options that trade on exchanges are American. As showu in Business Snapshot 10.1, inexperienced traders who treat American options as European are liable to lose money. Butterfly Spreads A buttelfiy 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, K1, buying a call option with a relatively high strike price, K3, and selling two call options with a strike price, K2, halfway between K1 and K3. Generally K2 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 K2, 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 1 0.3 Payoff from a box spread. Stock price Payofl from Payofi’ from Total range bull call spread bear put spread payofl ST>K2 Kg—Kl 0 Kg-Kl K1<ST<K2 ST—Kl Kg—ST K2—K1 ST<K1 0 Kz—Ki KZ—Kl «:55; 174.23 230 CHAPTER 10 Business SnapshotJOJgym-Losing MbncyzwithBoxSpreads _ Suppose that a stockhas a‘price of $50 and a volatility of, 30%. No dividends are expected and the risk—free rate is 8%. A traderroffers you the chanceto sell on the CBOE a 2~rnonth box“ spread where the Strike ‘pricesai'e $55 fi'and' $60'for $5.10. Should you do the trade? , " ' r _ '_ ff ,' My ‘ 4‘ ‘ V' V ,, The trade certainly. sounds attractive. In this case K1 55,’ K: t“ 60, and the payoff is certain to be $5 1112 months. By selling the box [spread forr$5L10jand inveSting the funds for 2 months-you would h’avemore than enough funds torneet the $5 payoff in 2 months. The theoretical value of the box spreadltoday is SVXfef-Q-‘VVGS’F-Z/‘z:$4.93. ' Unfortunately there is a snag. CBOE‘stook optiOns are American and the $5payolf from the box-spread is Calculated on" the'rassumptimi that'the options CompriSingthe- ‘box are European. Option prices for this example'(calculated using DerivaGem) are; shown in Table [10.4.24 bull call spread where‘the strike prices are $55'and $60'COS’ES 0.96— 0.26: $0.70. (This is the SSame, fOr both 'VEuropean'andgAinerican“ options because, as we saw in Chapter 9, the price Of a‘EurOPean callis the same as theiprice-of ' an American'cgill Whent'there are'no 'dividye‘_nds.)‘A bearVp'utlspreadgwiththe Same strike prices c'osts9.46~‘ 5.23 $34.23 ifthe Options atesur'opeananaiooo 51447: $4.56 if they are American. ‘iThe'combined value of Eboth‘spreads Vifi’theytare‘created with European Options is 017044.23 This‘iiis:IthejtheoretiCal :bonilspread priced calculated abOve. The combined valueOf buyingboth spreads if theyar'e' American is 0704—456”: $5.26. Selling a hex spread'i‘creatediiwith‘ American’omions‘ for $5.10 would not be a goodtrade; You Would realiize this'alnios‘t immediately, as the trade involves selling a $60 strike put-and this would'beexercised“ against “you almost as 80011 as Yousold’it! ' ' * V ' ‘ ' V' 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 6~rnonth calls are as follows: Strike price (3 ) c511 price (S) 55 10 60 7 65 5 Table 1 0.4 Values of 2-month European and American options on a non~dividend~paying stock. Stock price = $50; interest rate = 8% per annum; and volatility 2 30% per annum. Option Strike European American type price option price ' option price Call 60 0.26 0.26 Call 55 0.96 0.96 Put 60 9.46 10.00 5.23 5.44 PM 55 Trading Strategies Involving Options 231 Figure 10.6 Profit from butterfly‘spread using call options. 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) 2 $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. Put—call 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 strike prices of K1 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 Payofi’ from Payofl from Payofi” from Total range first long call second long call slzort calls payoff * ST < K1 0 0 0 O K1<ST<K2 ST—K1 0 0 ST—Kl K3 <ST< K3 ST—K1 0 -—2(ST~K2) K3~ST S7- > K3 ST—Kl ST—K3 ~2(ST~K2) 0 * These payoffs are calculated using the relationship K; = 0.5(K1 + K3). W _, _, ._ __ ,. ., _, , .. _. .,. ._ __ , ,, , . _ , _ r, “*MNM,. 232 CHAPTER 10 Figure 1 0.7 Profit from butterfly spread using put options. 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 selling a call option with a certain strike price and buying a longer-maturity 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 short—maturity option expires on the assumption that the long—maturity 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 1 0.8 Profit from calendar spread created using two calls. Trading Strategies Involving Options 233 Figure 10.9 Profit from a calendar spread created using two puts. Profit \ 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 short—maturity option is close to the strike price of the short-maturity 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 short-maturity option expires. The short-maturity option is worthless and the value of the long-maturity 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 short-maturity option expires. The short—maturity option costs the investor ST —— K, and the long— maturity 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 short-maturity option costs the investor either a small amount or nothing at all. However, the long~maturity 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 long-maturity put option and sells a short-maturity 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 short-maturity option and sells a long-maturity option. A small profit arises if the stock price at the expiration of the short-maturity option is well above or well below the strike price of the short-maturity 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 10.3 CHAPTER 10 Figure 1 0.10 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. COMBINATIONS A cmnbination 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 aaMmefla-WMMMWWLemu/NW;r ““mw" "‘"7 "" * "V ' “V” “'V-‘i‘fw‘y "hermetic #9.“:vgmxg WA fling.» Newman», Jams/M WW.” chwa/«MJ: u mambo.” We“ Table 10.6 Payoff from a straddle. Range of Payoff Payofl Total stock price from call from put payofl ST s K I 0 K — ST K - ST $7 > K ST-K 0 ST—K Trading Strategies Itmol-vitzg Options 235 Business Snapshot 10.2 How .to Make Money‘fromt Trading straddles Suppose that a big move is expected in a company’s stock pricebecausekthere isia takeover bid for the company or the outcome of a major lawsuit involying' the company is about to be announced. Should you trade a straddle? ’ 'V‘ , j ’ A straddle seems a natural trading strategy in this case. However; if your View of the company’s situation is muchthe same as that, of ,othermarketparticipants, thisView will be reflected in the priCes of options. Options on the stock-will be significantly more, expensive than options on a similarstock for? which nojumpis expected The V4shaped profit pattern'from the straddle in Figure 10.10 will have mOVed downward, so'that a bigger move in thestock price is necessarnyr you to make a prom.)- 3 7 .V , if . : I For a- straddle to be an‘effective strategy, you milst believe that thereareli , rely togbe' big movements in the ,stockryprice [and thesebeliefs must, be difi‘erent- _from'thOSeg_of' most iother investOrs. Market prices incorporate the beliefs of market participants. To make money from any investment strategy, you must takea :view that isdifiierentyfrom' most of the rest of the market—and you must be right! L i L V ' ‘ ‘ that the strategy costs the investor $6. (An up—front 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, theloss arising from a large move is unlimited. Figure 10.1 1 Profit 236 CHAPTER 10 Figure 10.12 Profit from a strangle. Profit 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 stockvprice 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, K2, is higher than the put strike price, K1. 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. ,_ a, , _,. , L, _, film, ,M _,, W... v ., MN, W, VNWMVHW ,,_/, r, *1 Table 10.7 Payofi“ from a strangle. Range of Payofl Payofl from T 0m! stock price from call put payofl ST<K1 0 Kl—ST K1~ST K; < ST < K; 0 0 0 ST - K2 5:72K2 Srer 0 1w . MW we MM... WWW, “WNW r "Mr WWW ,; WWW,“ Trading Strategies Involving Options 10.4- 237 Figure 10.1 3 Payofl‘ from a butterfly spread. Payoff K1 K2 K3 S r ,,,,,_~,,,,mzw,s 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. 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 K1 and K3 and selling two options with strike price K3, Where K1 < K2 < K3 and K3 -— K2 2 K2 — K]. Figure 10.13 shows the payoff from a butterfly spread. The pattern could be described as a spike. As K \ and K3 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 238 CHAPTER 10 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 Put—Call Parity Tests for the S&P Index LEAPS Markets,” Journal of Derivatives, 8, 4 (Summer 2001): 62—71. Chaput, J. S., and L. H. Ederington, “Option Spread and Combination Trading,” Journal of Derivatives, 10, 4 (Summer 2003): 70~88. V McMillan, L. G. Options as a Strategic Investment. 4th edn., Upper Saddle River: Prentice-Hall, 2001. Rendleman, RJ. “Covered Call Writing from an Expected Utility Perspective,” Journal of Derivatives, 8, 3 (Spring 2001): 63—75. Ronn, A. G. and El. Ronn. “The Box—Spread Arbitrage Conditions,” Review of Financial Studies, 2, l (1989): 91-108. Questions And Problems (Answers in solutions Manual) 10.1. 10.2. 10.3. 10.4. 10.5. 10.6. 10.7. 10.8. 10.9. 10.10. 10.11. What is meant by a protective put? What position in call options is equivalent to a protective put? Explain two ways in which a bear spread can be created. I When is it appropriate for an investor to purchase a butterfly spread? 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. What trading strategy creates a reverse calendar spread? What is the difference between a strangle and a straddle? 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? Use put—call parity to relate the initial investment for a bull spread created using calls to the initial investment for a bull spread created using puts. Explain how an aggressive bear spread can be created using put options. 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 payoiT for both spreads. Use put-call 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. Trading Strategies Involving Options 10.12. 10.13. 10.14. 10.15. 10.16. 10.17. 10.18. 239 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? .5 Construct a table showing the payoff from a bull spread when puts with strike prices K1 and K2, with K2 > K1, are used. 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. How can a forward contract on a stock with a particular delivery price and delivery date be created from options? “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. What is the result if the strike price of the put is higher than the strike price of the call in a strangle? One Australian dollar is currently worth $0.64. A l—year butterfly spread is set up using European call options with strike prices of $0.60, $0.65, and $0.70. The risk—free 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. 10.20. 10.21. 10.22. 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? A diagonal spread is created by buying a call with strike price K2 and exercise date T2 and selling a call with strike price KI and exercise date T1, where T2 > T1. Draw a diagram showing the profit when (a) K2 > K1 and (b) K2 < K1. 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. Suppose that the price of‘a non-dividend-paying stock is $32, its volatility is 30%, and the risk-free rate for all maturities is 5% per annum. Use DerivaGern to calculate the costof 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 240 CHAPTER 10 (b) A bear spread using European put options with strike prices of $25 and $30 and a maturity of 6 months (0) A butterfly Spread using European call options with strike prices of $25, $30, and $35 and a maturity of 1 year ((1) A butterfly spread using European put options with strike prices of $25, $30, and $35 and a maturity of 1 year A (e) A straddle using options with a strike price of $30 and a 6—month maturity (f) A strangle using options with strike prices of $25 and $35 and a 6~month maturity In each case provide a table showing the relationship between profit and final stock price. Ignore the impact of discounting. “ ...
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