Trading Strategies Involving Options Chapter 10 1

Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull Types of Strategies Take a position in the option and the underlying Take a position in 2 or more options of the same type (A spread) Combination: Take a position in a mixture of calls & puts (A combination)

Positions in an Option & the Underlying a) Writing a covered call b) covered call c) Protective put d) Reverse of protective put Options, Futures, and Other Derivatives 7 th Edition, Copyright © John C. Hull Profit STST K STST K STST K STST K (a) (b) (c)(d)

4 Bull Spread Using Calls (Figure 10.2, page 221) K1K1 K2K2 Profit STST A bull call spread is constructed by buying a call option with a low exercise price (K), and selling another call option with a higher exercise price. Both have same expiring date.call option Bull Call Spread Construction Buy 1 ITM Call Sell 1 OTM Call

5 Bull Spread Using Puts Figure 10.3, page 222 K1K1 K2K2 Profit STST A bull put spread is constructed by selling higher striking in-the- money put options and buying the same number of lower striking in- the-money put options on the same underlying security with the same expiration date. Bull Put Spread Construction Buy 1 ITM Put Sell 1 ITM Put

Bear Spread 6 A bear call spread is a limited profit, limited risk options trading strategy that can be used when the options trader is moderately bearish on the underlying security. It is entered by buying call options of a certain strike price and selling the same number of call options of lower strike price (in the money) on the same underlying security with the same expiration month. A bear put spread is a limited profit, limited risk options trading strategy that can be used when the options trader is moderately bearish on the underlying security. It is entered by buying higher striking in-the-money put options and selling the same number of lower striking out-of-the-money put options on the same underlying security and the same expiration month. options trading strategy

7 Bear Spread Using Calls Figure 10.5, page 225 K1K1 K2K2 Profit STST Bear Call Spread Construction Buy 1 OTM Call Sell 1 ITM Call

K1K1 K2K2 Profit STST 8 Bear Spread Using Puts Figure 10.4, page 223 Bear Put Spread Construction Buy 1 OTM Put Sell 1 ITM Put

Butterfly Spread Long butterfly spreads are entered when the investor thinks that the underlying stock will not rise or fall much by expiration. Butterfly spreads use four option contracts with the same expiration but three different strike prices to create a range of prices the strategy can profit from. The trader sells two option contracts at the middle strike price and buys one option contract at a lower strike price and one option contract at a higher strike price. Both puts and calls can be used for a butterfly spread. Butterfly spreads have limited risk, meaning you can only lose your initial investment. Your maximum return is when the price of the underlying asset remains around the middle strike price. 9

10 Butterfly Spread Using Calls Figure 10.6, page 227 K1K1 K3K3 Profit STST K2K2 Butterfly Spread Construction Buy 1 ITM Call Sell 2 ATM Calls Buy 1 OTM Call

11 Butterfly Spread Using Puts Figure 10.7, page 228 K1K1 K3K3 Profit STST K2K2 Long Put Butterfly Construction Buy 1 OTM Put Sell 2 ATM Puts Buy 1 ITM Put

12 Calendar Spread Using Calls Figure 10.8, page 228 Profit STST K A calendar spread (also called a time spread or horizontal spread) is a spread trade involving the simultaneous purchase of futures or options expiring at particular date and the sale of the same instrument expiring another date. Calendar Straddle Construction Sell Near-Term Straddle Buy Long-Term Straddle

13 Calendar Spread Using Puts Figure 10.9, page 229 Profit STST K

Combinations A combination is an option trading strategy that involves taking a position in both calls & puts on the same stock ◦ Straddles-market is volatile don’t know the directions ◦ Strangles-market is uncertain ◦ Strip-decrease is more than increase in stock price ◦ Strap-increase is more than decrease in stock price 14

15 A Straddle Combination Figure 10.10, page 230 Profit STST K Buy a call, strike price A Buy a put, strike price A Generally, the stock price will be at strike A Long Straddle Construction Buy 1 ATM Call Buy 1 ATM Put

16 Strip & Strap Figure 10.11, page 231 Profit KSTST KSTST Strip Strap Strip Construction Buy 1 ATM Call Buy 2 ATM Puts Strap Construction Buy 2 ATM Calls Buy 1 ATM Put

17 A Strangle Combination Figure 10.12, page 232 K1K1 K2K2 Profit STST Investor buys a put & a call with the same expiration date & different strike prices. Stock price has to move farther in a strangle to make a profit Long Strangle Construction Buy 1 OTM Call Buy 1 OTM Put