LN6 Trading Strategies Involving Options Bull Spread Using Call – Positive outlook, but content with limited

sing Call – Positive outlook, but content with limited upside and downside Butterfly Spread Using Calls Other Payoff Patterns
Objectives
Profit When the strike prices are close together a
 To create portfolios with calls, puts and the underlying asset to obtain Profit
butterfly spread provides a payoff consisting of a
interesting and useful payoff patterns Short 2 calls (𝐾 )
small “spike”
 To consider the conditions under which the above strategies are Short call (𝐾 )
If options with all strike prices were available any
appropriate ST K1 K2 K3 ST
Strategies Long call (𝐾3)
payoff pattern could (at least approximately) be
 Bond plus option - to create principal protected note K1 K2 created by combining the spikes obtained from
Long call (𝐾 )
 Stock plus option different butterfly spreads
 Two or more options of the same type - (a spread) A trader buys a call and sells a put with the same
 Two or more options of different types - (a combination) Long Call (𝐾 ) Butterfly Spread Using Puts strike price and maturity date. What is the
Principal Protected position equivalent to?
 Allows investor to take a risky position without risking any principal  Long call:
Profit a. A long forward
 Viability depends on  Premium (a.k.a. call price): 𝒄𝟏 = $𝟑 Short 2 puts (𝐾 )
Consider a four-month forward on an asset that is
 Level of dividends  Strike: 𝑲𝟏 = $𝟏𝟎𝟎
K1 K2 K3 ST expected to provide income equal to 2% of the
 Level of interest rates  Short call:
Long put (𝐾 ) asset price once during a four-month period. The
 Volatility of the portfolio  Premium (a.k.a. call price): 𝒄𝟐 = $2 Long put (𝐾3) risk-free rate of interest with continuous
 Example:  Strike: 𝑲𝟐 = $𝟏𝟐𝟎
compounding is 3% per year. If the asset price is
 Original Portfolio A now valued at $1,000
$60, what is the forward price? This asset pays 2%
 re-invested in portfolio B, which consists of  Profit of long call: Calendar Spread Using Calls
of its value every four months. Annualized, the rate
 3-year zero-coupon bond with principal of −$𝟑 if 𝑺𝑻 ≤ 𝟏𝟎𝟎
$1,000 − $𝟑 + (𝑺𝑻 -100) if 𝑺𝑻 > 𝟏𝟎𝟎
Profit at < is 3× 2% = 6% per year. The equivalent
 3-year at-the-money call option on portfolio continuously compounding rate is 𝑞 = 3 ×
 Profit of short call: .06
A (strike K=$1,000) Short Call (maturity )
𝑛 (1 + ) = 5.94%. The forward price
+ $𝟐 if 𝑺𝑻 ≤ 𝟏𝟐𝟎 3
 If portfolio A value at maturity 𝑆𝑇 < $1,000
 Option has no value + $𝟐 − (𝑺𝑻 -120) if 𝑺𝑻 > 𝟏𝟐𝟎 is therefore: 𝐹0 = 60𝑒 (.03−.0594)×4/ =
 Bond principal guarantees portfolio B value = $1,000  Bull spread profit: ST $59.41.
 If portfolio A value >= $1,000 + $𝟐 − $𝟑 = −$𝟏 if 𝑺𝑻 ≤ 𝟏𝟎𝟎
K Interest rates are zero. A European call with
 Option value = 𝑆𝑇 − 𝐾 = 𝑆𝑇 − 1,000 +$𝟐 − $𝟑 + (𝑺𝑻 − 𝟏𝟎𝟎) = 𝑺𝑻 − 𝟏𝟎𝟏 if 𝟏𝟎𝟎 < 𝑺𝑻 ≤ 𝟏𝟐𝟎
−$𝟑 + (𝑺𝑻 − 𝟏𝟎𝟎)+$𝟐 − (𝑺𝑻 − 𝟏𝟐𝟎) = 𝟏𝟗 a strike price of $50 and a maturity of one
 Bond value = $1,000 if 𝟏𝟐𝟎 < 𝑺𝑻
 Portfolio B value = 𝑆𝑇 − 1,000 + $1,000 = 𝑆𝑇 Bull Spread Using Puts – Positive outlook, but content with limited upside and downside Long Call (maturity )
year is worth $6. A European put with a
strike price of $50 and a maturity of one
Portfolio B value year is worth $7. The current stock price is
Calendar Spread Using Puts
Profit $49. Which of the following is true?
$1000 a. The call price is high relative to the
RF Bond cost + Call Option Cost= ? Profit put price
(ideally, $1000) Short Put, (maturity )
K1 K2 ST b. The put price is high relative to the
call price
$1000 𝑃 𝑒 ST c. Both the call and put must be
 IF K mispriced
 3-year interest rate =6% (continuous compounding) d. None of the above
 Dividend yield on portfolio A = 1.5% per annum Check put-call parity: 𝑐 + 𝐾𝑒 −𝑟𝑇 = 6 +
 volatility of portfolio A is 15% per year Long Put (maturity ) 50𝑒 0× = 56 𝑝 + 𝑆0 = 7 + 49 = 56
 THEN Bear Spread Using Puts – Negative outlook, but content with limited upside and Which of the following can be used to
 3-year at-the-money European call option on the portfolio Straddle Combination
downside create a long position in a European put
costs $164.73 (will see later how this is determined)
 Cost of risk-free bond is : option on a stock?
𝑃𝑉(1,000) = 1,000 × 𝑒 −0.06×3 = $𝟖𝟑𝟓. 𝟐𝟕
Profit
Buy a call option on the stock and buy the
 Total value (today) of portfolio B = value of portfolio A Profit
stock
$164.73 + $835.27 = $1,000
Positions in an option Buy a call on the stock and short the stock
a) Long stock + short call Sell a call option on the stock and buy the
b) Short stock + long call K ST stock
c) Long stock + long put K1 K2 ST Long call (K)
d) Short stock + short put
Sell a call option on the stock and sell the
Long put (K) stock
 Long stock profit:
𝑆𝑇 − 𝑆0 The answer must be either (a) or (b)
 Short call profit: Strip & Strap
because of the long position in the put.
𝑐 if 𝑆𝑇 ≤ 𝐾 Profit Profit
𝑐 − (𝑆𝑇 − 𝐾) if 𝑆𝑇 > 𝐾 The payoff of the short stock position is
Bear Spread Using Calls – Negative outlook, but content with limited upside and
 Long stock + short call profit: downside always −𝑆𝑇 + 𝑆0 , where 𝑆0 is the initial
𝑆𝑇 − 𝑆0 + 𝑐 if 𝑆𝑇 ≤ 𝐾 stock price.
𝑆𝑇 − 𝑆0 + 𝑐 − (𝑆𝑇 − 𝐾) = 𝑐 + 𝐾 − 𝑆0 if 𝑆𝑇 > 𝐾 o If 𝑆𝑇 > 𝐾, the call option is exercised
K ST K ST
and its payoff is 𝑆𝑇 − 𝐾. Thus
Profit Profit Strap
Strip
(2 calls + 1 put)
combining with the short position,
K1 K2 ST (1 call + 2 puts)
the payoff of the entire combination
K Strangle Combination
(call+short stock) is: (−𝑆𝑇 + 𝑆0) +
ST K ST
(𝑆𝑇 − 𝐾) = 𝑆0 − 𝐾
(a) Profit o If 𝑆𝑇 < 𝐾, the call option is not
(b) exercised and the payoff of the
Profit Profit
K1 K2 position is −𝑆𝑇 + 𝑆0
Box Spread Therefore, if the strike is set at par (𝐾 =
K ST
 A combination of a bull call spread and a bear put spread with same Long call (𝐾 ) 𝑆0 ), we get that we can create a long put
Long put (𝐾 )
K ST strikes prices by buying a call and shorting a stock.
ST
 Payoff is always the difference b/w strikes
 If all options are European a box spread is worth the present value of the
(d) (c) difference between the strike prices
 If they are American this is not necessarily so (see Business Snapshot 11.1)
Lecture 5- Mechanics of Options Markets
A contract giving its holder the right to either buy or sell a related asset (underlying) such
as a stock before a certain date (maturity)
Call option: holder has right to buy
Put option: holder has right to sell
A European option can be exercised only at maturity
An American option can be exercised at any time up to maturity
-Assets underlying Exchange Traded options: stocks, forex, indices, futures
-Sepcifications of exchange traded options: Expiration date, Third Friday of expiration
month, Strike price, European or American, Call or Put (option class)
Terminology
-Moneyness
At-the-money option: Current price = strike
In-the-money option = Current price > strike (call) ,, Current price < strike (put)
Out-of-the-money option= Current price < strike (call),, Current price > strike (put)
Terminology (cont.)
Option class = Set of all call/put options for a particular underlying (stock, index, currency, etc.) e.g.: All AAPL put Intrinsic and time values
options, with different maturities and strikes  Strike =$165 (from ticker symbol) Spot price = $158.63 Option premium: $11.65
Option series: Example: All AAPL puts expiring in a specific month (e.g., December 2014)
 Intrinsic value = $165 - $158.63 = $6.37 Time value = $11.65 - $6.37 = $5.28
Intrinsic value-Payoff value if option were to be exercised immediately
Time value= Option premium – Intrinsic value Dividends and stock splits
Suppose you own options with a strike price of K to buy (or sell) N shares:
1. An investor has exchange-traded put options to sell 100 shares for $20 each. There is 25%  No adjustments are made to the option terms for cash dividends
 When there is an n-for-m stock split, the strike price is changed to mK/n, the no. of
stock dividend. Which of the following is the position of the investor after the stock dividend? shares that can be bought (or sold) is increased to nN/m, Stock dividends are handled
(prices are per share) in a manner similar to stock splits
Consider a call option to buy 100 shares for $20 per share. How should terms be adjusted:for
0
A. Put options to sell 100 shares for $20 B. Put options to sell 75 shares for $25 C. Put options a 2-for-1 stock split? for a 5% stock dividend? 2 for 1 stock split: Strike reduced to 1 × =
00
to sell 125 shares for $15 D. Put options to sell 125 shares for $16 The investor receives an $10. No. of shares that can be bought is increased to 2 × = 200
additional 25 shares for every 100 held. This is a 125 for 100 stock split. 5% stock dividend:
 Receive 1 share for every 20 shares owned. Same as stock 21 for 20 stock split
2. Which of the following describes a short position in an option? a. A position in an option  Strike reduced to 20 ×
0
= $19.0476 No. of shares that can be bought is increased
lasting less than one month b. A position in an option lasting less than three months c. A to 21 ×
00
= 105
0
position in an option lasting less than six months d. A position where an option has been sold
Market makers
Most exchanges use market makers to facilitate options trading. A market maker quotes both
3. A stock price (which pays no dividends) is $50 and the strike price of a two year European bid and ask prices when requested. The market maker does not know whether the individual
put option is $54. The risk-free rate is 3% (continuously compounded). Which of the following requesting the quotes wants to buy or sell.
is a lower bound for the option price? a. $4.00 b. $3.86 c. $2.86 d. $0.86 = max (54𝑒^-.03(2) − is required when options are sold
50,0) For example, when a naked call option is written in the US, the margin is the greater of:
1 A total of 100% of the proceeds of the sale plus 20% of the underlying share price less
4. Which of the following creates a bull spread? A. Buy a low strike price call and sell a high the amount (if any) by which the option is out of the money: 𝑐 + .20 × 𝑆0 − max(𝐾 −
strike price call (slide 10 of LN6) B. Buy a high strike price call and sell a low strike price call 𝑆0 , 0)
2 A total of 100% of the proceeds of the sale plus 10% of the underlying share price
C. Buy a low strike price call and sell a high strike price put D. Buy a low strike price put and 𝑐 + .10 × 𝑆0
sell a high strike price call Margin for Naked Call
𝑐 = $3.50; 𝐾 = $60; 𝑆0 = $57
5. A stock price is currently $23. A reverse (i.e short) butterfly spread is created from options
1. 𝑐 + .20 × 𝑆0 − max(𝐾 − 𝑆0 , 0) = 3.5 + .2 × 57 − max(60 − 57,0) = 3.5 + .2 ×
with strike prices of $20, $25, and $30. Which of the following is true? a. The gain when the
57 − 3 = $𝟏𝟏. 𝟗
stock price is greater than $30 is less than the gain when the stock price is less than $20 b. The
2. 𝑐 + .10 × 𝑆0 = 3.5 + .10 × 57 = $𝟗. 𝟐
gain when the stock price is greater than $30 is greater than the gain when the stock price is less
3. The greater of the two quantities above is max(11.9,9.2) = $11.9
than $20 c. The gain when the stock price is greater than $30 is the same as the gain when This margin is per share. Each contract is on 100 shares. There are 5 contracts. The margin for
the stock price is less than $20 d. It is incorrect to assume that there is always a gain when the the 5 contracts is 500 × 11.9 = $5,950
stock price is greater than $30 or less than $20 When a naked put option is written in the US, the margin is the greater of:
1 A total of 100% of the proceeds of the sale plus 20% of the underlying share
7. Which of the following is true of a bear spread? A. It is a package consisting of call option price less the amount (if any) by which the option is out of the money:
and a put option with different strikes B. It involves two call options and two put options with 𝑝 + .20 × 𝑆0 − max(𝑆0 − 𝐾, 0)
two different strikes C. It has a known value at maturity D. All of the above E. None of the 2 A total of 100% of the proceeds of the sale plus 10% of the underlying share
above price 𝑝 + .10 × 𝐾
𝑝 = $10; 𝐾 = $64; 𝑆0 = $58
8. A trader creates a long butterfly spread from options with strike prices $60, $65, and $70. 1. 𝑝 + .20 × 𝑆0 − max(𝑆0 − 𝐾, 0)
The option prices are $11, $14, and $18, respectively. What is the maximum net loss (after the
= 10 + .2 × 58 − max(58 − 64,0) = 10 + .2 × 58 − 0 = $𝟐𝟏. 𝟔
cost of the options is taken into account)? A. $0.25 B. $0.50 C. $0.75 D. $1.00 Butterfly
1. 𝑝 + .10 × 𝐾 = 10 + .10 × 64 = $𝟏𝟔. 𝟒
spreads can be created with puts only or calls only (cf. slides 17 and 18, LN6.) The final answer
2. The greater of the two quantities above is
to this question will be the same, irrespective of whether it is based on puts or calls. Given that
max(21.6,16.4) = $21.6
put prices are higher with higher strikes, the word “respectively” above should help you
 This margin is per share
argue for a “first-principle” solution approach based on puts only. However, a more
 Each contract is on 100 shares. There are 5 contracts.
“direct” solution approach would simply note that, irrespective of whether puts or calls
 The margin for the 5 contracts is 500 × $21.6 = $10,800
are used, the largest net loss is captured by the horizontal segments of the red plots on
For both Calls and Puts
slides 17 and 18 of LN6. Those are the net cost of the strategy: the cost of the two options
 Replace . 𝟐𝟎 by . 𝟏𝟓 (in Green)
with lowest and highest strikes (strikes 𝐾ଵ = 60 and 𝐾ଵ = 70 ) reduced by the income
For call, quantity #1 becomes
provided by the sale of the 2 options with middle strike 𝐾ଵ = 65. That is: 2 × 14 − 11 − 18
= $1/share, which makes D the correct answer. 𝑐 + .15 × 𝑆0 − max(𝐾 − 𝑆0 , 0)
For put, quantity #1 becomes
𝑝 + .15 × 𝑆0 − max(𝑆0 − 𝐾, 0)
Warrants are options that are issued by a corporation or a financial institution. The number of warrants outstanding
is determined by the size of the original issue and changes only when they are exercised or when they expire. The
issuer settles with the holder when a warrant is exercised. When call warrants are issued by a corporation on its own
stock, exercise will usually lead to new stock being issued. Employee stock options are a form of remuneration issued
by a company to its executives (increasingly, also to rank-and-file employees). They are usually at the money when
issued. When options are exercised the company issues more stock and sells it to the option holder for the strike
price
Expensed on the income statement. Convertible bonds are regular bonds that can be exchanged for equity at certain
times in the future according to a predetermined exchange ratio. Usually a convertible is callable. The call provision is
a way in which the issuer can force conversion at a time earlier than the holder might otherwise choose