Lecture 4

Bullish StrategiesRiskReward Call purchaselimitedunlimited Synthetic long stockunlimitedunlimited Bull spreadlimitedlimited Protective Putlimitedunlimited Bullish calendar spreadlimitedunlimited Covered callunlimitedlimited Naked put writeunlimitedlimited

Bearish StrategiesRiskReward Put purchaselimitedunlimited Synthetic Putlimitedunlimited Synthetic short saleunlimitedunlimited Bear spreadlimitedlimited Covered put writeunlimitedlimited Bearish calendar spreadlimitedunlimited Naked call writeunlimitedlimited

Long Stock, Short Call

Profit = S + call - P BE = P - call

Long Stock, Long Put

Profit = P - put - S

 Short Stock, Long Call

 Short Stock, Short Put

 Short Put, Long Call

 Long s1 s1 < s2  Short s2  Max Profit = s2 - s1 - c1 + c2  Break Even = s2 - MP = s1 - c2 + c1

Example Price = 32Oct35C = 1t=60days/365 Oct30C = 3v =.24 Buy Oct30C = -3 Sell Oct35C = +1 Max Profit = = 3 BE = = 32 Net Debit = = -2

 Profit / Loss Diagram Table

 Compute probability of bull spread Example V t =.24 (60/365).5 =.097 Prob (<32) = N[ln(32/32) /.097] =.5000 Prob (>32) = =.5000 Max Profit = $300 Max Loss = -$200 at 50% odds, makes good sense

 s1 < P << s2  Good probability, good profit potential

 P < s1 < s2  Small Cost, high profit, low prob

 S1 < s2 < P  Low profit, high prob

Long s1 s1 < s2 Short s2 example (Credit Spread) Price = 55 Jan50P = 2 Jan60P = 7 Net Credit = p2 - p1 = = + 5 Break Even = S2 - credit = = 55

Short s1 s1 < s2 Long s2credit spread

Short s1 s1 < s2 Long s2credit spread Example P = 55Jan60C = 2Jan50C = 7 Net Credit = = 5BE = = 55

Short s1 s1 < s2 Long s2credit spread Example P = 55Jan60C = 2Jan50C = 7 Net Credit = = 5BE = = 55

Long s1 s1 > s2 Short s2debit spread

Long s1 s1 > s2 Short s2debit spread Example P = 55Jan50P = 2Jan60P = 7 Net Debit = = 5BE = = 55

Long s1 s1 > s2 Short s2debit spread Example P = 55Jan50P = 2Jan60P = 7 Net Debit = = 5BE = = 55

+Credit spread - assignment risk ? What causes assignment -Large Credit = P well above lower strike Example: p = 59, Jan60C=1, Jan50C=9

Long Stock, Long Call, Short 2 Calls Example Own $48 Price = 42 Oct40Call = 4 (buy) Oct45Call = 2 (sell 2) Net Credit = 0 BE = 44

PriceP/LStP/L Sh CP/L Lg CNet P/L

If call is deep in the money and has no time to exp, a bull spread can be used to simulate a covered call. Example Price = 49 Sell Apr50C = 3 Buy Apr35C = 14

A neutral position that combines both a bear spread and a bull spread Long s1s1 < s2 < s3 Short 2 s2 Long s3 Example Price = 60 buy July50C = debit short2 July60C = credit buy July70C = debit 300 Net Debit

Multiple ways to create the butterfly spread example Strike Call1262 Put1511 Butterfly PositionsNet Position Buy 50C / sell 2 60C / buy 70C2 debit Buy50C/sell 60C/buy70P/sell60P12 debit Buy50P/sell60P/Buy70C/sell60C8 credit Buy50P / sell 2 60P / buy 70P2 debit

Long stock, short multiple calls example 2:1 ratio call write Price = 49 Oct50C = 6 sell 2 calls and long 100 stock

example 2:1 ratio call write Price = 49 Oct50C = 6 sell 2 calls and long 100 stock Price drops to 40 Oct50C = 1 Oct40C = 4 Buy 2 Oct50C = profit = = 10 Sell 2 Oct40C apply to stock price & pretend we own stock at $39

Max Profit = m(S-P) + nCm = # stock lots Upside BE = S + MP/(n-m)n = # of Call ks Downside BE = S - MP / m Example Max Profit = 1 (50-49) + 2 (6) = 13 Upside BE = / (2-1) = 63 Downside BE = /1 = 37

Example 3:1 Buy 1 lot 49 sell 3 Max Profit = 1 (50-49) + 3 (6) = 19 Upside BE = / (3-1) = 59.5 Downside BE = /1 = 31

Example 3:1 Buy 1 lot 49 sell 3 Max Profit = 1 (50-49) + 3 (6) = 19 Upside BE = / (3-1) = 59.5 Downside BE = /1 = 31

Long stock, s1 < P < s2 short in money call (s1), short out of money call (s2) Max Profit = c1 + c2 + s1 - P Downside BE = s1 - MP Upside BE = s2 + MP Example Price = 65 Oct60C = 8 Oct70C = 3

Don’t do - because

Long s1s1 < s2 Short X s2 Example 2:1 Price = 44 Apr40C = 5buy 1 Apr45C = 3sell 2 BE = 51 MP = 6

Step 1

Step 2

3:1 example increase profit lower BE 2:1

3:1 example increase profit lower BE 3:1

Short Put Short Call Example Price = 45 Jan45C = 4 Jan45P =3

Same Example - But, sell 4 of each Price = 45 Jan45C = 4 Jan45P =3

Long Stock Short Call Short Put example Price = 51buy 100 shares Jan50C = 5sell 1 call Jan50P = 4sell 1 put Max Profit = Premium + S - P = = 8 BE = (P+S-Prem)/2 = 46

Short put (out of money) Short call (out of money) example price = 65 Jan70C = 4 Jan60P = 3 Downside BE = Sp - put - call = = 53 Upside BE = Sc + put + call = = 77 Max Profit = put + call = 3+4 = 7

same example price = 65 (price rises to 70) Jan70C = 4 Jan60P = 3Put falls to 1 Jan70P = 4 action: buy back the 60 put & sell the 70 put

Short out of money put Long out of money call example (Bullish Strike Split) price = 53 Jan50P = 2 Jan60C = 1 BE = 48

Short near term option Long distant term option example (Bull Calendar Spread) Price = 50 TodayApr50C = 5 short = +5 (Jan) July50C = 8 long = -8 Net Debit = -3 Price = 50 AprilApr50C = 0 July50C = 5

Price Apr50C/PLJuly50C/PLNet Profit 400/+500.5/ / / /+5004/ /+5005/ /+3006/ /08/ / /

Same as call short near term & long distant term ex - price = 50, Jan50P = 2, Apr50P = 3

Opposite of all other common positions Example (Reverse ratio - backspread) 2:1 Short s1 s1<s2 Long x s2 Price = 43 July40C = 4 July45C = 1

 Step 1

diff strikes & diff exp example (Diagonal Bull Spread) Price = 32 Apr30C = 3 Apr35C = 1 July30C = 4Long July30C July35C = 1.5Short Apr35C Normal Bull Spread -Long Apr30C Short Apr35C