4 - Trading Strategies Slope and Convexity Restrictions

Lecture 4:
Trading Strategies and Slope/Convexity

Restrictions
This lecture studies elementary options trading

strategies. In the process, we derive no-arbitrage
restrictions for options that are identical except for their
strike price. We restrict how quickly the option price
can change with the strike price (slope restrictions) and
how quickly this slope can change with the strike price
(convexity restrictions).
I. Motivation
II. Definitions and Notation
III. Trading Strategies
A. Hedges
B. European Spreads
C. American Spreads
D. European Butterflys
E. American Butterflys
F. Other Combinations
Trading Strategies and Slope/Convexity Restrictions
I. Motivation
Suppose a stock is trading at $100.
You see four month European calls priced

– at $8 for K D $100, and
– at $19 for K D $90.
The simple 4 month risk-free is 5.26%.
– I.e., B(t, t C 1=3) D $95, and
Questions:
Does the $8 price of the K D $100 call satisfy the
no-arbitrage bounds from Lecture 3?
Does the $19 price of the K D $90 call satisfy the
no-arbitrage bounds from Lecture 3?
Does this mean that we cannot have arbitrage?
– How do recognize that there is an arbitrage
opportunity?
Pricing “restrictions”
– How can we exploit it?
I.e., with what trading strategy?
Bus 35100 Page 2 Robert Novy-Marx

II. Definitions and Notation
Traders have names for common options portfolios.
These portfolios are typically specific “bets” on

what will happen to the prices and/or volatilities of
the underlying securities.
We use portfolios of options to illustrate further no-
arbitrage restrictions and to generate profits when
these restrictions are violated.
We describe a portfolio of options by the equation for

the current price of the portfolio. However, we drop
subscripts which are common to all securities.
Examples:
c(K1) c(K2) is a portfolio of a bought call with
exercise price K1 and a written call with exercise
price K2 and with the same maturity date.
p(T1 ) p(T2 ) is a portfolio of a bought put with

maturity T1 and a written put with maturity T2
and with the same exercise price.

III. Trading Strategies

A. Hedges: Combine options + underlying; protects
the underlying against a loss, or vice-versa.
Example: A covered call
– long stock / short a call on the stock
Profit
Covered Call
K S(T)
Payoff is always positive, so no-arbitrage H)

price of the covered call is positive, i.e.,
S (t ) c(K) 0 or c(K) S (t )

Another Example: A protective put

– long stock / long a put on the stock
* the put provides insurance
* so you must pay an “insurance premium”
Profit
Protected Put
K S(T)

B. Spreads
Combine options of the same type, with
– different strikes (a “vertical spread”), or
– different maturities (a “horizontal spread”)
1. Example: A bear spread
– Buy an ITM put (strike K2)
– Sell an OTM put (strike K1 < K2 )
Profit
K1 K2 S(T)
Bear Spread
Payoff always positive ) p(K2 ) p(K1 ) 0

2. Another Example: A “bull spread” made with puts

– Buy an OTM put (strike K1)
– Sell an ITM put (strike K2 > K1)
* Technically a “short bear spread”
* We’ll do a real bull spread in a second
Profit
Short Bear Spread
K1 K2 S(T)

3. Another Example: Bullish spread with puts, plus

bonds
– Buy an OTM put (strike K1)
– Sell an ITM put (strike K2 > K1)
– Buy K2 K1 face-value bonds
Payoff
pK1(T) – pK2(T) + (K2 – K1)
K1 K2 S(T)
Portfolio value at time t T
pK1 (t, T ) pK2 (t, T ) C (K2 K1) B(t, T )

Slope Restriction for Puts:

Can we say anything about the sensitivity of puts
to the strike?
Payoff to this last spread is always positive, so
pK1 (t, T ) pK2 (t, T ) C (K2 K1)B(t, T ) 0.
So
pK2 (t, T ) pK1 (t, T )
0 B(t, T ).
K2 K1
(LHS follows from pK1 (t, T ) pK2 (t, T ) 0)
True for arbitrary K1 and K2 > K1, so
@p
0 B(t, T )
@K
A $1 dollar increase in the strike causes the put

price to increase by no more than the PV of $1
– Simple intuition?

4. Another Example: A true bull spread

– Buy an ITM call (strike K1)
– Sell an OTM call (strike K2 > K1)
Profit
K1 K2 S(T)
Bull Spread
What’s the difference between:

i. a bull spread, and
ii. a bullish spread made with puts?
i.e., a short bear spread

5. Slope Restriction for Calls:

A bull spread with a short position in bonds
– Buy an ITM call (strike K1)
– Sell an OTM call (strike K2 > K1)
– Sell K2 K1 face-value bonds
Payoff
K1 K2 S(T)
cK1(T) – cK2(T) – (K2– K1 )
Portfolio value at time t T is
cK1 (t, T ) cK2 (t, T ) (K2 K1) B(t, T )

Slope Restriction for Calls:

Can we say anything about the sensitivity of calls
to the strike?
Payoff to the last spread is always negative, so
cK1 (t, T ) cK2 (t, T ) (K2 K1)B(t, T ) 0.
So
cK2 (t, T ) cK1 (t, T )
B(t, T ) 0.
K2 K1
(LHS follows from cK1 (t, T ) cK2 (t, T ) 0)
Again, true for arbitrary K1 and K2 > K1, so
@c
B(t, T ) 0
@K
A $1 dollar increase in the strike causes the call

price to decrease by no more than the PV of $1
– Simple intuition?

If the restriction is violated ) Arbitrage

Example: European calls with 4 months to maturity
S (t ) D $100.
Calls priced
– at $8 for K D $100, and
– at $19 for K D $90.
The simple 4 month risk-free is 5.26%.
– I.e., B(t, t C 1=3) D $95, and
Is there an arbitrage opportunity?

How can it be exploited?
Payoff Payoff at T
Transaction at t S(T ) < 90 90 < S(T ) < 100 S(T ) > 100
What is the payoff diagram for this position?

Profit diagram for the arbitrage portfolio:
Payoff
$10
$90 $110 S(T)
-$10

Suppose one year European puts are priced:

– at $2 12 for K D $100, and
– at $12 14 for K D $110.
The yield-to-maturity on a one-year risk-free

zero coupon bond is 5%.
Can we exploit this with an arbitrage?
Payoff Payoff at T
Transaction at t S(T ) < 100 100 < S(T ) < 110 S(T ) > 110

Payoff Diagram:
Payoff
$10
$90 $110 S(T)
-$10
Question: is it still an arbitrage if the prices were

for American puts?

C. Slope Restrictions on American Option
The argument is basically the same: construct

spreads and see what NA implies for prices.
One big difference: written options can be

exercised against you at any time. If this happens:
you’ll have to close out the whole position, and
you may not gain the interest on the exercise
price.
So no-arbitrage implies that if the strike price

changes from K1 to K2 the price of the option
changes by no more than jK2 K1j. (Why?)

The slope restriction for American calls is therefore
(K2 K1) C (K2) C (K1) 0,
or
@C
1 0.
@K
The slope restriction for American puts is:
0 P (K2 ) P (K1 ) (K2 K1),
or
@P
0 1.
@K

D. Convexity Restrictions
A butterfly spread combines three options of the

same type but with different strike prices.
1. An Example: BS w/ European calls

Long an ITM call (strike K1 )
Long an OTM call (strike K3 > K1)
Short two ATM calls (strikes K2 D K1CK
2
3
)
It’s a combination of bullish and bearish vertical

call spreads at different exercise prices:
[c(K3) c(K2)] [c(K2) c(K1)]
It’s neither bullish or bearish.

What is it a bet on?
It’s easier to see in the payoff diagram.

Butterfly Spread Payoff Diagram
Payoff
Butterfly
Spread
K1 K2 K3 S(T)
It’s a “bet” on volatility.
Why?
– And in which direction?

Convexity Restriction for Calls:
The payoff to this butterfly spread is always

positive. NA ) its price is positive.
c(K1) 2c(K2) C c(K3) D
[c(K3) c(K2)] [c(K2) c(K1)] 0.
Since K3 K2 D K2 K1 > 0 we have
c(K3) c(K2) c(K2) c(K1)

0.
K3 K2 K2 K1
This implies that the call option price c(S , K, t, T )

is a convex function of the strike price K:
2

@ c(S , K, t, T ) @ @c(S , K, t, T )
D 0
@K 2 @K @K
The sensitivity of the call price to the strike

@c
decreases with the strike. (Remember, @K 0!)

Graphically, the call price looks like this, as a

function of the strike
Here S t D 100, r D 0.05, D 0.4, and T t = 1 year.
Call Price
50
40
30
20
10
Strike HKL
60 80 120 140
Question:
Is there a more intuitive way to think about this
convexity?

Let’s find another way to think about the

convexity restriction
Butterfly Spread Profit Diagram
Profit
Butterfly
Spread
K1 K2 K3 S(T)
How do we know that we must loose money for

big moves in the underlying?

For big enough moves in the underlying, we

must loose money on the butterfly spread
but the payoff at maturity is then zero )
c(K3) C c(K1) 2c(K2),

so
c(K3) C c(K1)
c(K2) .
2
Call Price
50
40
30
20
10
Strike HKL
60 80 120 140
Otherwise, there’s an arbitrage. (Why?)

One more way to think about the restriction
Remember: the butterfly is long one bull

spread and short another
c(K1) 2c(K2) C c(K3) D

[c(K1) c(K2)] [c(K2) c(K3)]
Each bull spread is like a “bond you only get

some of the time”
– Pays off when the underlying is high
Above the strikes
So the bull spread with low strikes is worth

more
– Pays off more of the time

2. Another Example: BS w/ European puts

Long an OTM put (strike K1)
Long an ITM put (strike K3 > K1)
K1 CK3
Short two ATM puts (strikes K2 D 2
)
It’s a combination of bullish and bearish vertical

put spreads at different exercise prices:
p(K1 ) 2p(K2 ) C p(K3 )

D [p(K3 ) p(K2 )] [p(K2 ) p(K1 )]

Butterfly Spread Payoff Diagram
Payoff
Butterfly
Spread
K1 K2 K3 S(T)
The payoff is exactly the same as a BS made

with calls
Why?
Is there any difference?
– Think p-c parity.

Convexity Restriction for Puts:
Again, the payoff to the butterfly spread is always

positive. NA ) its price is positive.
p(K1 ) 2p(K2 ) C p(K3 ) D
[p(K3 ) p(K2 )] [p(K2 ) p(K1 )] 0
Since K3 K2 D K2 K1 > 0 we have
p(K3 ) p(K2 ) p(K2 ) p(K1 )

0
K3 K2 K2 K1
This implies the put price p(S , K, t, T ) is a

convex function of the strike price K:
@2p(S , K, t, T )

@ @p(S , K, t, T )
D 2
0
@K @K @K
I.e., the sensitivity of the put price to the strike

increases with the strike.

Graphically:
Put Price
40
30
20
10
Strike HKL
60 80 120 140
Again, the convexity restriction just says that for big

enough moves in the underlying, we must loose
money on the butterfly spread:
p(K3 ) C p(K1 ) 2p(K2 ),

or
p(K3 ) C p(K1 )
p(K2 ) .
2

Note:
No-arbitrage implies that European put and call
butterfly spreads have the exact same price.
Why?
So
p(K1 ) 2p(K2 ) C p(K3 )

D c(K3) 2c(K2) C c(K1),
which implies
@2p(S , K, t, T ) @2c(S , K, t, T )
D .
@K 2 @K 2
Question: Do these convexity restrictions apply to

options on dividend paying stocks?
Absolutely!
– The relations were NA, based on payoffs at
expiration.

Arbitrage example:
Stock ABC is trading at $48 18 . 4-month European
put options are priced
– at $11 for K D 55,
– at $15 34 for K D 60,
– and at $20 for K D 65.
The risk-free rate over the next 4 months is 3.25%.
Is there an arbitrage opportunity?

– How can you tell?
– How can it be exploited?
Payoff Payoff at T
Transaction at t ST < 55 55 < ST < 60 60 < ST < 65 ST > 65

More general convexity restriction

In all our examples K2 D K1CK
2
3
.
This wasn’t necessary; it was just convienient.
More generally,

K3 K2 K2 K1
p(K2) K3 K1 p(K 1 )C K3 K1 p(K3).
If not, you get payed today to construct the portfolio

K3 K2 K2 K1
K3 K1
p(K1 ) C K3 K1
p(K3 ) p(K2 ).
Payoff Payoff at T
at t ST < K1 K1 < ST < K2 K2 < ST < K3
K3 K2 K3 K2
K3 K1
p(K1 ) K3 K1
(K1 ST ) 0 0
K2 K1 K2 K1 K2 K1 K2 K1
K3 K1
p(K3 ) K3 K1
(K3 ST ) K3 K1
(K3 ST ) K3 K1
(K3 ST )
p(K2 ) (K2 ST ) (K2 ST ) 0
0 0 0 0
If ST > K3, then all the options are OTM and the
payoff is zero.

D. Convexity Restrictions on American Options
The convexity restrictions for American options

are exactly the same as they are for European
options.
The arbitrage arguments are also the same,

except...
... a written American option may be exercised
against you.
– This will force you to liquidate the rest of the
position.
Since the payoff at liquidation must always be

positive (why?), the spread must have a positive
value.
In any event, we still have
@2 P @2 C
2
D 2
0.
@K @K

E. Other Combinations
1. Straddles
Buy a put and a call with the same strike
py g ( ) y
Straddle:
C=f(S,t) ATM CALL + ATM PUT
S = 100 Profit
K = 100 (BUY ATM CALL @ $18.84)
(BUY ATM PUT @ $5.80)
t =1
r = 1.15
25
d = 1.00
V = . 3
50 75 125 150
Future Asset Price
-25 Strategy:
Strategy: Believe
Believevolatility
volatilityof
of
Straddle Value = $18.84 + $5.80 = $24.64 asset
assetprice
pricewill
willbe
behigh,
high,but
buthave
have
no
noclue
clueabout
aboutdirection.
direction.
Loss
Another bet on volatility

– a (long) straddle is a bet on high volatility
if you think volatility is higher than the market
consensus, buy a straddle - they’re cheap

2. Strangles
A close cousin to the straddle.
Buy a put stuck at K1 and a call at K2 > K1.
– E.g., buy both options OTM
162
Derivatives: A PowerPlus Picture Book I
Copyright©1999(Dec) by Mark Rubinstein
Strangle:
C=f(S,t) OTM CALL + OTM PUT
S = 100 Profit
K1 = 90 (BUY OTM PUT @ $3.07)
K2 = 110 (BUY OTM CALL @ $13.97)
t =1
25
r = 1.15
d = 1.00
V = . 3 50 75 125 150
Future Asset Price
-25
Strategy:
Strategy: Similar
Similarto
toaastraddle.
straddle.
Strangle Value = $13.97 + $3.07 = $17.04
Loss
A more extreme bet than a straddle

– Requires bigger moves (i.e., higher volatility)
to produce gains,
– but you don’t have to risk as much capital

3. Condor
A close cousin to the Butterfly Spread.
Buy deep in and out of the money calls (or
puts)
Sell near in and out of the money calls (or puts)
168
Condor:
C=f(S,t) DITM CALL - ITM CALL - OTM CALL + DOTM CALL
S = 100
Profit
K1 = 90 (BUY DITM CALL @ $24.81)
K2 = 95 (SELL ITM CALL @ $21.69)
K3 = 105 (SELL OTM CALL @ $16.27)
K4 = 110 (BUY DOTM CALL @ $13.97)
25
t =1
r = 1.15
d = 1.00
V = . 3 50 75 125 150
Future Asset Price

Condor Value = $0.82 =
$24.81 - $21.69 - $16.27 + $13.97
-25 Strategy:
Strategy: Similar
Similarto
to
aabutterfly
butterflyspread.
spread.
Loss
A less “confident” bet than a butterfly

– You gain over a bigger price range,
– but if you gain, you gain less.

4. Bull Cylinder
Like a “synthetic future”, only less optimistic
Buy an out of-the-money call
Sell an out of-the-money put
– Instead of the in-the-money in a future
160
Bull Cylinder:
C=f(S,t) OTM CALL - OTM PUT
S = 100 Profit
K1 = 90 (SELL OTM PUT @ $3.07)
K2 = 110 (BUY OTM CALL @ $13.97)
t =1
25
r = 1.15
d = 1.00
V = . 3 50 75 125 150
Future Asset Price
-25
Bull Cylinder Value = $13.97 - $3.07 = $10.90

Loss
Takes on less downside risk than a future

– You’re less likely to pay on the put
– So you have to pay something today

Possible strategies are more or less endless.

Some other common strategies go by names like
Straps
– 2 ATM calls + ATM put
– A bet on high vol., with a bullish tilt
Collars
– Underlying + OTM put - OTM call
– Caps the underlying’s up- and down-sides
Range Forwards (or “Fences”)
– Forward + ITM put - OTM call
– Essentially a forward bull spread
Back Spreads
– 2 OTM calls - ATM call
– A bear spread, plus a bet on upside
Seagulls
– ATM call - OTM calls - OTM Put
– A bull spread with a dropping tail
Try drawing the profit diagrams for these.

5. European box spread: borrowing or lending in

the options market
An Example: lending
– Buy ITM call and put (strikes K1 and K2 > K1)
– Sell OTM call and put (strikes K2 and K1)
c(K1) c(K2) C p(K2 ) p(K1 )
It’s a portfolio that’s

– long a synthetic future with delivery K1, and
– short a synthetic future with delivery K2.
– At delivery you’ll buy at K1 and sell at K2 ,
So it must be priced at (K2 K1) B today.
It’s also a portfolio that’s

– long a bull spread, and
– long a bear spread with the same strikes
i.e. short a bullish put spread.
– The difference: CF timing.
The positions transfer cash through time.

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4 - Trading Strategies Slope and Convexity Restrictions

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Lecture 4:

Trading Strategies and Slope/Convexity

This lecture studies elementary options trading

Suppose a stock is trading at $100.

 You see four month European calls priced

Bus 35100 Page 2 Robert Novy-Marx

II. Definitions and Notation

Traders have names for common options portfolios.

 These portfolios are typically specific “bets” on

We describe a portfolio of options by the equation for

 p(T1 ) p(T2 ) is a portfolio of a bought put with

Bus 35100 Page 3 Robert Novy-Marx

III. Trading Strategies

Payoff is always positive, so no-arbitrage H)

Bus 35100 Page 4 Robert Novy-Marx

Another Example: A protective put

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Payoff always positive ) p(K2 ) p(K1 )  0

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2. Another Example: A “bull spread” made with puts

Short Bear Spread

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3. Another Example: Bullish spread with puts, plus

pK1(T) – pK2(T) + (K2 – K1)

Portfolio value at time t  T

pK1 (t, T ) pK2 (t, T ) C (K2 K1) B(t, T )

Bus 35100 Page 8 Robert Novy-Marx

Slope Restriction for Puts:

pK1 (t, T ) pK2 (t, T ) C (K2 K1)B(t, T )  0.

(LHS follows from pK1 (t, T ) pK2 (t, T )  0)

True for arbitrary K1 and K2 > K1, so

 A $1 dollar increase in the strike causes the put

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4. Another Example: A true bull spread

What’s the difference between:

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5. Slope Restriction for Calls:

cK1(T) – cK2(T) – (K2– K1 )

Portfolio value at time t  T is

cK1 (t, T ) cK2 (t, T ) (K2 K1) B(t, T )

Bus 35100 Page 11 Robert Novy-Marx

Slope Restriction for Calls:

cK1 (t, T ) cK2 (t, T ) (K2 K1)B(t, T )  0.

(LHS follows from cK1 (t, T ) cK2 (t, T )  0)

Again, true for arbitrary K1 and K2 > K1, so

 A $1 dollar increase in the strike causes the call

Bus 35100 Page 12 Robert Novy-Marx

If the restriction is violated ) Arbitrage

Is there an arbitrage opportunity?

What is the payoff diagram for this position?

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Profit diagram for the arbitrage portfolio:

$90 $110 S(T)

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 Suppose one year European puts are priced:

 The yield-to-maturity on a one-year risk-free

Can we exploit this with an arbitrage?

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$90 $110 S(T)

Question: is it still an arbitrage if the prices were

Bus 35100 Page 16 Robert Novy-Marx

C. Slope Restrictions on American Option

You see four month European calls priced

These portfolios are typically specific “bets” on

p(T1 ) p(T2 ) is a portfolio of a bought put with

Payoff always positive ) p(K2 ) p(K1 ) 0

Portfolio value at time t T

pK1 (t, T ) pK2 (t, T ) C (K2 K1)B(t, T ) 0.

(LHS follows from pK1 (t, T ) pK2 (t, T ) 0)

A $1 dollar increase in the strike causes the put

Portfolio value at time t T is

cK1 (t, T ) cK2 (t, T ) (K2 K1)B(t, T ) 0.

(LHS follows from cK1 (t, T ) cK2 (t, T ) 0)

A $1 dollar increase in the strike causes the call

Suppose one year European puts are priced:

The yield-to-maturity on a one-year risk-free

(K2 K1) C (K2) C (K1) 0,

0 P (K2 ) P (K1 ) (K2 K1),

It’s neither bullish or bearish.

[c(K3) c(K2)] [c(K2) c(K1)] 0.

c(K3) C c(K1) 2c(K2),

Remember: the butterfly is long one bull

Each bull spread is like a “bond you only get

So the bull spread with low strikes is worth

[p(K3 ) p(K2 )] [p(K2 ) p(K1 )] 0

p(K3 ) C p(K1 ) 2p(K2 ),

Is there an arbitrage opportunity?