6800 02 Option Trading

Option Trading Strategies
Topics
1. A single Option and a Stock

2. Spreads
3. Combinations
Dr. Melanie Cao, SSB, FINE6800 1

1. Strategies Involving a Single Option and a Stock
1.1 A Covered Call: long a stock and short a call
Cost = S-c
Payoffs at maturity
ST  K ST < K
A covered call: -call -(ST - K) 0

+ stock
Profit (ignore the time ST ST
value of money: I.T.V.M)
ST
K
ST - (S – c)
K – (S-c)

1.1 A Covered Call: long a stock and short a call
Payoff: _______ Profit: ---------

1.2 A Protective Put: long a stock and long a put
Cost = S + p
Payoffs at maturity
ST  K ST < K
A protective put: +put 0 K -ST

+ stock
Profit (I.T.V.M) ST ST
K
ST
K - (S +p)
ST - (S+p)

…continued
1.2 A Protective Put: long a stock and long a put
Payoff: _______ Profit: ---------

2. Spreads: strategies Involving puts or calls
2.1 Bull Spread: long a call with K1 and short a call with K2
Cost = c(K1) – c(K2) with K2 > K1

…continued
Payoff: _______ Profit: ---------

…continued
• Use when expect market to go up.
• Different from a single call, because it is less expensive;
• Different from selling a put, because loss is limited to a small

amount.
Homework: Use two put options to create a bull spread.

2.2 Bear Spread: short a call with K1 and long a call with K2
Cash inflow = c(K1) – c(K2)

(This is the reverse of bull spread with K2 > K1 )

…continued
Payoff: _______ Profit: ---------

…continued
• Use when expect market to go down.
• Both gain and loss are limited, just like bull spread.
Homework: Use two put options to create a bear spread.

Embedded Bull Spread in Investment Products
Scotia Stock-Indexed GIC
• Scotia has offered a Stock-Indexed 1-year GIC whose rate of return is

tied to the performance of the TSX/SP60 Stock Index over a 1-year
period, excluding dividends;
• If the TSX/SP60 decreases over the one-year period, the holder of the
Stock-Indexed GIC receives the original deposit with no interest earned.
• If the TSX/SP60 increases by less than 5% over the one-year period, the
holder earns the same return as that of TSX/SP60.
• If the TSX/SP60 increases by more than 5% over the one-year period,

the holder earns 5% return.

3. Embedded Bull Spread in Investment Products
B. Payoff of Scotia Stock-Indexed GIC

3. Embedded Options in Investment Products
B. Payoff of CIBC Stock-Indexed GIC

2.3 Butterfly spread: long a call with K1 and long a call with K3, short 2 calls with K2
where K1 + K3 = 2K2
Cost = c(K1) + c(K3) – 2c(K2)

…continued
2.3 Butterfly spread: long a call with K1 and long a call with K3, short 2 calls with K2
where K1 + K3 = 2K2
Payoff: _______ Profit: ---------

…continued
2.3 Butterfly spread: long a call with K1 and long a call with K3,
short 2 calls with K2 where K1 + K3 = 2K2
• Require a small initial investment;
• Use it when market is stable;
• Both gain and loss are limited.
Homework: Use three put options to create a butterfly spread.

3. Combinations: strategies Involving put and call
3.1 Straddle: long a call with K and long a put with K
Cost = c(K) + p(K)

…continued
Payoff: _______ Profit: ---------

…continued
• Up front costs;
• Expect market to move either way (Bre-X, 1997).

3.2 Strips: long a call with K and long 2 puts with K
Cost = c(K) + 2p(K)

…continued
3.2 Strip: long a call with K and long 2 puts with K
Payoff: _______ Profit: ---------

…continued
3.2 Strip: long a call with K and long 2 puts with K
• Up front costs of 3 options;
• Expect market to move either way, but more likely to go down.

3.3 Straps: long 2 calls with K and long a put with K
Cost = 2c(K) + p(K)

…continued
3.3 Strap: long 2 calls with K and long a put with K
Payoff: _______ Profit: ---------

…continued
3.3 Strap: long 2 calls with K and long a put with K
• Up front costs of 3 options;
• Expect market to move either way, but more likely to go up.

3.4 Strangle: long a call and long a put with different strikes
Cost = c(K2) + p(K1) with K2 > K1

…continued
Payoff: _______ Profit: ---------

…continued
• Up front costs of 2 options, cheaper than straddle;
• Similar to straddle, but expect market to move a lot.

6800 02 Option Trading

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Option Trading Strategies

1. A single Option and a Stock

Dr. Melanie Cao, SSB, FINE6800 1

1.1 A Covered Call: long a stock and short a call

A covered call: -call -(ST - K) 0

Dr. Melanie Cao, SSB, FINE6800 2

1.1 A Covered Call: long a stock and short a call

Payoff: _______ Profit: ---------

Dr. Melanie Cao, SSB, FINE6800 3

1.2 A Protective Put: long a stock and long a put

A protective put: +put 0 K -ST

Dr. Melanie Cao, SSB, FINE6800 4

1.2 A Protective Put: long a stock and long a put

Payoff: _______ Profit: ---------

Dr. Melanie Cao, SSB, FINE6800 5

Cost = c(K1) – c(K2) with K2 > K1

Dr. Melanie Cao, SSB, FINE6800 6

Payoff: _______ Profit: ---------

Dr. Melanie Cao, SSB, FINE6800 7

• Use when expect market to go up.

• Different from a single call, because it is less expensive;

• Different from selling a put, because loss is limited to a small

Homework: Use two put options to create a bull spread.

Dr. Melanie Cao, SSB, FINE6800 8

Cash inflow = c(K1) – c(K2)

Dr. Melanie Cao, SSB, FINE6800 9

Payoff: _______ Profit: ---------

Dr. Melanie Cao, SSB, FINE6800 10

• Use when expect market to go down.

Homework: Use two put options to create a bear spread.

Dr. Melanie Cao, SSB, FINE6800 11

• Scotia has offered a Stock-Indexed 1-year GIC whose rate of return is

• If the TSX/SP60 increases by more than 5% over the one-year period,

Dr. Melanie Cao, SSB, FINE6800 12

B. Payoff of Scotia Stock-Indexed GIC

Dr. Melanie Cao, SSB, FINE6800 13

B. Payoff of CIBC Stock-Indexed GIC

Dr. Melanie Cao, SSB, FINE6800 14

Cost = c(K1) + c(K3) – 2c(K2)

Dr. Melanie Cao, SSB, FINE6800 15

Payoff: _______ Profit: ---------

Dr. Melanie Cao, SSB, FINE6800 16

• Require a small initial investment;

• Use it when market is stable;

• Both gain and loss are limited.

Homework: Use three put options to create a butterfly spread.

Dr. Melanie Cao, SSB, FINE6800 17

3.1 Straddle: long a call with K and long a put with K

Cost = c(K) + p(K)

Dr. Melanie Cao, SSB, FINE6800 18

3.1 Straddle: long a call with K and long a put with K

Payoff: _______ Profit: ---------

Dr. Melanie Cao, SSB, FINE6800 19

3.1 Straddle: long a call with K and long a put with K

• Expect market to move either way (Bre-X, 1997).

Dr. Melanie Cao, SSB, FINE6800 20

3.2 Strips: long a call with K and long 2 puts with K

Cost = c(K) + 2p(K)

Dr. Melanie Cao, SSB, FINE6800 21

3.2 Strip: long a call with K and long 2 puts with K

Payoff: _______ Profit: ---------

Dr. Melanie Cao, SSB, FINE6800 22

3.2 Strip: long a call with K and long 2 puts with K

• Up front costs of 3 options;