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The Option Investment Strategies Mayank Bhatia Sandri Supardi Gail Yambao

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Options Options: contract giving the buyer right, but not obligation to buy or sell the underlying asset at a certain price on/before the certain date. Two types of Options: Call Option: Gives the holder right to buy an assets at certain price within the specific period of time. Put Option: Gives the holder right to sell an assets at certain price within the specific period of time.

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Options Trading Strategies Single Option & a Stock Covered Call Protective Put Spreads Bull Spread Bear Spread Butterfly Spread Calendar Spread Combinations Strip Strap Straddle Strangle

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Buy the stock of a listed company Profit Price (S) K STST

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Buy a call option Profit Price (S) K STST Call option price

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Buy a Call Option Stock Price RangePayoffCostProfit S T <= K0C0C0 Payoff - Cost S T > KS T - KC0C0 Payoff - Cost Call profit = max (0, S T - X) - C 0

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Buy a Call Option Stock Price RangePayoffCostProfit S T <= K03.5-3.5 S T > K53.51.5 When is this appropriate? Stock prices are expected to go up Example: AT&T (July 1994) S T <= KStock Price50 S T > KStock Price60 KStrike Price55 C0C0 Call Price3.5

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Sell a call option Profit Price (S) K STST Call option price

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Sell a Call Option Call writer's profit = C 0 - max (0, S T - X) Stock Price RangePayoff Price of CallProfit S T <= K0C0C0 Payoff + Cost S T > KK - S T C0C0 Payoff + Cost

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Sell a Call Option Example: AT&T (July 1994) S T <= KStock Price50 S T > KStock Price60 KStrike Price55 C0C0 Call Price3.5 Stock Price RangePayoff Price of CallProfit S T <= K03.5 S T > K553.5-1.5

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Buy a Put Option Profit Price (S) K STST Call option price

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Buy a Put Option Stock Price RangePayoffCostProfit S T <= KK - S T C0C0 Payoff - Cost S T > K0C0C0 Payoff - Cost Put Profit = max(0, X - S T ) - P 0 When is this appropriate? When we expect prices to go down

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Buy a Put Option Example: AT&T (July 1994) S T <= KStock Price 50 S T > KStock Price 60 KStrike Price 55 C0C0 Put Price 2.75 Stock Price Range Payoff CostProfit S T <= K52.752.25 S T > K02.75-2.75 When is this appropriate? When we expect prices to go down

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Sell a Put option Profit Price (S) K STST Call option price

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Sell a Put Option Stock Price RangePayoffPriceProfit S T <= KST - KP0P0 Payoff + Price of Put S T > K0P0P0 Payoff + Price of Put Put Profit = P 0 - max(0, X - S T )

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Sell a Put Option Example: AT&T (July 1994) S T <= KStock Price 50 S T > KStock Price 60 KStrike Price 55 C0C0 Put Price 2.75 Stock Price RangePayoffCostProfit S T <= K-52.75-2.25 S T > K02.75

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Covered Call Sell a call option and Buy Stock Profit Price (S) K STST Sell Call Covered Call Buy Stock

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Covered Call Buy a Stock, Sell a Call Option Stock Price Range Payoff from Stock Payoff from CallTotal Payoff Price of CallProfit S T <= KS T - S O 0 Payoff from Stock + Payoff from CallC CALL Total Payoff + Price of Call S T >= KS T - S O K-S T Payoff from Stock + Payoff from CallC CALL Total Payoff + Price of Call

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Covered Call (Buy a Stock, Sell a Call Option) Example: January 1995 (AT&T) S T <= Kstock price50 S T >= Kstock price60 SOSO stock purchased55 C CALL price of call5.25 Kexercise price of call55 Stock Price Range Payoff from Stock Payoff from CallTotal PayoffCostProfit S T <= K-50 5.250.25 S T >= K5-505.25

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Covered Call Buy a Stock, Sell a Call Option Advantage: When there is a sharp rise in the stock price, purchased stock protects the seller of the call from pay-off When is this appropriate? A sharp rise in stock prices is expected

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Covered Call Buy a Stock, Sell a Call Option Advantage: When there is a sharp rise in the stock price, long stock position "covers" or protects the investor from the payoff on the short call When is this appropriate? A sharp rise in stock prices is expected

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Protective Put Buy a put option and Buy a Stock option Profit Price (S) K STST Buy Put Protective Put Buy Stock

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Protective Put Buy a Stock & Buy a Put Stock Profit + Put Profit = S T - S 0 + max (X - S T, 0) - P Stock Price Range Payoff from Stock Payoff from PutTotal PayoffCostProfit S T <= KS T - S O K - S T S T - S O - K -S T C PUT (Profit from Stock + Profit from Put) - Price of Put S T >= KS T - S O 0 C PUT (Profit from Stock + Profit from Put) - Price of Put Advantages: This combination of stock and put establishes a floor. It allows unlimited profits while limiting the potential loss. * This is like purchasing insurance for your stock

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Protective (Buy a Stock & Buy a Put) Example: January 1995 (AT&T) S T <= Kstock price50 S T >= Kstock price60 SOSO stock purchased55 C PUT price of put4.375 Kexercise price of put55 Stock Price Range Payoff from Stock Payoff from Put Total PayoffCostProfit S T <= K-5504.375-4.375 S T >= K5054.3750.625

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Protective Put Buy a Stock & Buy a Put Advantages: This combination of stock and put establishes a floor. It allows unlimited profits while limiting the potential loss. * This is like purchasing insurance for your stock

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Protective (Buy a Stock & Buy a Put) Advantages: Potential gains or losses are created from the net effect of a long position in both the put and the stock. This establishes a floor, allowing unlimited profits while limiting the potential loss. Should the stock price decline below the strike price before expiration of the option, the investor would exercise the put option & sell his or her stock at the strike price Should the stock price increase above the strike price, the option would not be exercised & the investor could sell the stock at the higher price & recognize a profit if the stock price is above the overall cost of the position * This is like purchasing insurance for your stock

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Bull Spreads w/ Call Buy Call option and Sell Call on a higher strike price Profit Price (S) K1K1 STST Sell Call @ Higher Price Call Bull Spreads Buy Call @ Lower Strike Price K2K2

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Bull Spread Buy a Call at Low Strike Price, Sell Call at High Strike Price, Same Expiration Date Stock Price Range Payoff from Long Call Option Payoff from Short Call OptionTotal Payoff S T >= K 2 S T - K 1 K 2 - S T K 2 - K 1 K 1 ~~
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Bull Spread (Buy a Call at Low Strike Price, Sell Call at High Strike Price, Same Expiration Date) Example: January 1995 (AT&T) AT&T (Jan 1995) Price of Option S T >= K 2 Stock Price70 K 1 ~~= K 2 15-510-3.756.25 K 1 ~~~~
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Bull Spread Buy a Call at Low Strike Price, Sell Call at High Strike Price, Same Expiration Date Advantage: Limits the investor's upside & downside risk When is this appropriate? The investor expects stock prices to go up

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Bull Spreads w/ Put Buy Put option and Sell Put on a higher strike price Profit Price (S) K1K1 STST Buy Put @ Lower Price Put Bull Spreads Sell Put @ Higher Strike Price K2K2

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Bear Spreads w/ Call Sell Call option and Buy Call on a higher strike price Profit Price (S) K1K1 STST Buy Call @ Higher Price Call Bear Spreads Sell Call @ Lower Price K2K2

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Bear Spread Buy Call at High Strike Price, Sell Call at Low Strike Price, Same Exercise Date Stock Price Range Payoff from Long Call Option Payoff from Short Call Option Total Payoff S T >= K 2 S T - K 2 K 1 - S T -(K 2 - K 1 ) K 1 ~~
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Bear Spread (Buy Call at High Strike Price, Sell Call at Low Strike Price, Same Exercise Date) Example: January 1995 (AT&T) AT&T (Jan 1995) BPrice of Option S T >= K 2 Stock Price70 K 1 ~~= K 2 15-15-103.75-6.25 K 1 ~~~~
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Bear Spread Buy Call at High Strike Price, Sell Call at Low Strike Price, Same Exercise Date Advantage: Limits the investor's upside & downside risk When is this appropriate? The investor expects stock prices to go down

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11. Bear Spreads w/ Put : Sell Put option and Buy Put on a higher strike price Profit Price (S) K1K1 STST Buy Put @ Higher Price Put Bear Spreads Sell Put @ Lower Strike Price K2K2

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12. Butterfly Spreads w/ Call : Sell 2 calls at K2 Buy Call option at K1 and K3. Profit Price (S) K1K1 STST Sell 2 Call @ K2, close to current Stock Price. Butterfly Spreads w/ call Buy Call @ Higher Strike Price K3K3 K2K2 Buy Call @ Lower Strike Price

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13. Butterfly Spreads w/ Put: Sell 2 Puts at K2 and buy Put option at the price of K1 and K3 Profit Price (S) K1K1 STST Sell 2 Put @ K2, close to current Stock Price. Butterfly Spreads w/ Put Buy Put @ Lower Strike Price K3K3 K2K2 Buy Put @ Higher Strike Price

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Straddle Buy Call and Put at the same Strike Price and Expiration Profit Price (S)STST Buy Call @ K Straddle Buy Put @ K K

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Straddle Buy Call & Put, Same Strike Price, Expiration Date Stock Price Range Payoff from Call Payoff from Put Total PayoffCostProfit S T <= K0K - S T C call + C put Payoff - Cost S T > KS T - K0 C call + C put Payoff - Cost

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Straddle (Buy Call & Put, Same Strike Price, Expiration Date) Example: July 1994 (AT&T) - when stock price is close to strike price S T <= Kstock price50 S T > Kstock price60 Kstrike price55 C call price of call3.5 C put price of put2.75 Stock Price RangePayoff from Call Payoff from Put Total PayoffCostProfit S T <= K0556.25-1.25 S T > K5056.25-1.25

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Straddle (Buy Call & Put, Same Strike Price, Expiration Date) Stock Price Range Payoff from Call Payoff from Put Total PayoffCostProfit S T <= K0K - S T C call + C put Payoff - Cost S T > KS T - K0 C call + C put Payoff - Cost Example: July 1994 (AT&T) - when stock price is far from strike price S T <= Kstock price45 S T > Kstock price65 Kstrike price55 C call price of call3.5 C put price of put2.75

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Example: July 1994 (AT&T) - when stock price is far from strike price S T <= Kstock price45 S T > Kstock price65 Kstrike price55 C call price of call3.5 C put price of put2.75 Straddle (Buy Call & Put, Same Strike Price, Expiration Date) Stock Price RangePayoff from Call Payoff from Put Total PayoffCostProfit S T <= K010 6.253.75 S T > K100 6.253.75

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Straddle Buy Call & Put, Same Strike Price, Expiration Date Advantage If there is a sufficiently large move in either direction, a significant PROFIT will result Disadvantage If stock price is close to strike price at expiration of options --> LOSS When is this appropriate to use? Investor is expecting a large move in a stock price but does not know in which direction the move will be; a big jump in the price of a companys stock is expected; a takeover bid for the company or outcome of a major lawsuit is expected to be announced soon

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Strips Buy 1 Call and 2 Puts at the same Strike Price and Expiration Profit Price (S)STST Buy Call @ Kt Strips Buy 2 Put @ Kt K

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Strips (Buy One Call & 2 Puts, Same Strike Price, Same Exercise Date) Stock Price Range Payoff from Call Payoff from Puts Total PayoffCostProfit S T <= K02 x (K-S T ) C call + C put1 + C put2 Total Payoff - Cost S T > KS T - K0 C call + C put1 + C put2 Total Payoff - Cost When is this appropriate to use? When the investor expects a decrease in price

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STRIP (Buy One Call & 2 Puts, Same Strike Price, Same Exercise Date) Example: July 1994 (AT&T) S T <= Kstock price50 S T > Kstock price60 Kstrike price55 C call price of call3.5 C put1 price of put 12.75 C put2 price of put 22.75 Stock Price Range Payoff from Call Payoff from PutsTotal PayoffCostProfit S T <= K010 91 S T > K5059-4

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Strips Buy One Call & 2 Puts, Same Strike Price, Same Exercise Date When is this appropriate to use? When the investor is expecting the prices to decrease

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Straps Buy 2 Call and 1 Puts at the same Strike Price and Expiration Profit Price (S)STST Buy 2 Call @ Kt Straps Buy 1 Put @ Kt K

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Straps (Buy 2 Calls & 1 Put, Same Strike Price, Same Expiration Date) Strock Price Range Payoff from Calls Payoff from PutTotal PayoffCostProfit S T <= K0K - S T C call1 + Ccall 2 + C put Total Payoff - Cost S T > K2 x (S T - K)0 C call1 + Ccall 2 + C put Total Payoff - Cost When is this appropriate? When the investor is expecting the prices to go up

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STRAP (Buy 2 Calls & 1 Put, Same Strike Price, Same Expiration Date) Example: July 1994 (AT&T) S T <= Kstock price50 S T > Kstock price60 Kstrike price55 C call1 price of call3.5 C call2 price of put 13.5 C put price of put 22.75 Strock Price Range Payoff from Calls Payoff from Put Total Pay offCostProfit S T <= K0559.75-4.75 S T > K100 6.253.75

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When is this appropriate? The investor is betting that there will be a big stock price move; however, an increase in the stock price is considered to be more likely than a decrease Straps (Buy 2 Calls & 1 Put, Same Strike Price, Same Expiration Date)

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Strangle Buy 1 Call and 1 Puts at the same Expiration date but with different Strike Price Profit Price (S)STST Buy 1 Call @ K2 Strangle Buy 1 Put @ K1 K1K1 K2K2

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Strangle (Buy Put & Call, Same Expiration Dates, Different Strike Prices; K2 > K1) Range of Stock Price Payoff From Call Payoff from Put Total Payof fCostProfit S T <= K 1 0K 1 - S T C K1 + C K2 Total Payoff - Cost K 1 < S T < K 2 000C K1 + C K2 Total Payoff - Cost S T >= K 2 S T - K 2 0 C K1 + C K2 Total Payoff - Cost

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STRANGLE (Buy Put & Call, Same Expiration Dates, Different Strike Prices; K2 > K1) Example: AT&T (January 1995) - stock price close to strike price S T <= K 1 Stock Price50 K 1 < S T < K 2 Stock Price60 S T >= K 2 Stock Price70 K1K1 Put Strike Price55 K2K2 Call Strike Price65 C K1 Price of Put1.5 C K2 Price of Call4.375 Range of Stock Price Payoff From Call Payoff from Put Total PayoffCostProfit S T <= K 1 0555.875-0.875 K 1 < S T < K 2 0005.875-5.875 S T >= K 2 5055.875-0.875

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STRANGLE (Buy Put & Call, Same Expiration Dates, Different Strike Prices; K2 > K1) Range of Stock Price Payoff From Call Payoff from Put Total Payof fCostProfit S T <= K 1 0K 1 - S T C K1 + C K2 Total Payoff - Cost K 1 < S T < K 2 000C K1 + C K2 Total Payoff - Cost S T >= K 2 S T - K 2 0 C K1 + C K2 Total Payoff - Cost Example: AT&T (January 1995) - stock price far from strike price S T <= K 1 Stock Price45 K 1 < S T < K 2 Stock Price60 S T >= K 2 Stock Price75 K1K1 Put Strike Price55 K2K2 Call Strike Price65 C K1 Price of Put1.5 C K2 Price of Call4.375

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STRANGLE (Buy Put & Call, Same Expiration Dates, Different Strike Prices; K2 > K1) Example: AT&T (January 1995) - stock price far from strike price S T <= K 1 Stock Price45 K 1 < S T < K 2 Stock Price60 S T >= K 2 Stock Price75 K1K1 Put Strike Price55 K2K2 Call Strike Price65 C K1 Price of Put1.5 C K2 Price of Call4.375 Range of Stock Price Payoff From Call Payoff from Put Total PayoffCostProfit S T <= K 1 010 5.8754.125 K 1 < S T < K 2 0005.875-5.875 S T >= K 2 100 5.8754.125

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Strangle (Buy Put & Call, Same Expiration Dates, Different Strike Prices; K2 > K1) When is this appropriate? The investor is betting that there will be a large price move, but is uncertain whether it will be an increase or decrease. The stock price has to move farther in a strangle than in a straddle for the investor to make a profit Disadvantage The downside risk if the stock price ends up at a central value is less with a strangle Advantage The farther strike prices are apart, the less the downside risk and the farther the stock price has to move for a profit to be realized

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Copyright © 2002 by John Stansfield All rights reserved. 9-0 Finance 457 9 Chapter Nine Trading Strategies Involving Options.

Copyright © 2002 by John Stansfield All rights reserved. 9-0 Finance 457 9 Chapter Nine Trading Strategies Involving Options.

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