Trading Strategies Involving Options

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull and Sankarshan Basu 2010

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)

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull and Sankarshan Basu 2010

Positions in an Option & the Underlying (Figure 10.1, page 240)

Profit
Profit

K K
(a) Profit Profit

ST
(b)

ST

K ST
(c)

K
(d)

ST

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull and Sankarshan Basu 2010

Bullish strategies
Long call Short put Bull spread Ratio spread Whether to use calls or puts for constructing a spread?

Depends upon which option has more liquidity (high open interest, narrow bid-ask spread) Also which option is over or under priced

Bull Spread Using Calls

(Figure 10.2, page 241)

Profit ST K1 K2

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull and Sankarshan Basu 2010

Bull Spread Using Puts

(Figure 10.3, page 242)

Profit K1 K2 ST

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull and Sankarshan Basu 2010

Bearish strategies
Long put Covered call Bear spread

Bear Spread Using Calls

(Figure 10.5, page 245)

Profi t K1 K2 ST

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull and Sankarshan Basu 2010

Bear Spread Using Puts

(Figure 10.4, page 243)

Profit

K1

K2

ST

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull and Sankarshan Basu 2010

Neutral strategies
Short straddle Short strangle Long butterfly Calendar spread

Butterfly Spread Using Calls

(Figure 10.6, page 247)

Profit K1 K2 K3 ST

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull and Sankarshan Basu 2010

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Butterfly Spread Using Puts

(Figure 10.7, page 248)

Profit K1 K2 K3 ST

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull and Sankarshan Basu 2010

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Calendar Spread Using Calls

(Figure 10.8, page 248)

Profit

ST
K

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull and Sankarshan Basu 2010

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Calendar Spread Using Puts

(Figure 10.9, page 249)

Profit

ST
K

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull and Sankarshan Basu 2010

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Volatility-based strategies
Long straddle Long strangle

A Straddle Combination
(Figure 10.10, page 250)

Profit

ST

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull and Sankarshan Basu 2010

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A Strangle Combination
(Figure 10.12, page 252)

Profit K1 K2 ST

Options, Futures, and Other Derivatives, 7th Edition, Copyright John C. Hull and Sankarshan Basu 2010

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Synthetic strategies
A synthetic strategy produces same riskreward profile as another strategy but is constructed with different instruments May provide cheaper entry into a position Can help to identify under- or over-priced options Generally used by professional traders, market makers etc

Synthetic strategies
A synthetic strategy produces same riskreward profile as another strategy but is constructed with different instruments May provide cheaper entry into a position Can help to identify under- or over-priced options Generally used by professional traders, market makers etc

Examples of synthetics
Strategy Long call Replicating strategy Long stock/ stock future and long put Payoff of both strategies Unlimited gain if underlying rises and limited loss if underlying falls Limited gain if underlying rises and unlimited loss if underlying falls Limited gain if underlying falls and unlimited loss if underlying rises Unlimited gain if underlying rises and unlimited loss if underlying falls

Short put

Long stock/future and short call (covered call)

Short call Short stock/future and short put

Long stock

Short put + long call

Examples of Synthetics (contd)

Strategy Long put Replicating strategy Long call and short stock/ future Payoff of both strategies Unlimited gain if underlying falls and limited loss if underlying rises

Short stock

Long put and short call Unlimited gain if underlying falls and unlimited loss if underlying rises