Financial Derivatives

FI6051
Finbarr Murphy
Dept. Accounting & Finance
University of Limerick
Autumn 2009

Week 5.1 – Trading Strategies

Options Trading Strategies
 The following discussion considers the combining
of positions in two or more options contracts
 Where the contracts are written on the same underlying
asset

 The primary effect of such options trading

strategies is the creation of varied payoff profiles

 For each of the options trading strategy

considered the profit and loss profile will be
illustrated
Spreads
 A spread trading strategy involves taking a
position in two or more options of the same type
 That is, calls or puts

 The next sections detail the four main spread

strategies, i.e.
 Bull spreads
 Bear spreads
 Butterfly spreads
 Calender spreads
Bull Spreads
 A bull spread is created by going long a call with
a given strike and short a call with a higher strike
 Both options have the same expiration date

 Note that the price of the low strike option will be

greater than the price of the high strike option

 As a result the bull spread strategy requires an

initial investment by the investor

 A bull spread attempts to cost effectively exploit

an expected rise in the underlying asset price
Bull Spreads
 The following graph illustrates the profit & loss
profile of the bull spread
Profit

K2- K1-(c1- c2)

c2

K1 K2
Stock Price
-(c1- c2)
-c1
Bull Spreads
 Let c1 be the call price associated with the low
strike option
 And let K1 be the strike price

 Let c2 be the call price associated with the high

strike option
 And let K2 be the strike price

 As noted before c1 > c2, and by definition K1 < K2

 Therefore, the cost of setting up the bull spread

is c - c
 Bull Spreads
 Now consider the payoff from each of the
options positions, and hence the payoff from the
bull spread

 The following table illustrates

Stock Price Range Payoff from Long Payoff from Short Payoff from Bull
Call Call Spread

ST ≥ K 2 ST − K1 K 2 − ST K 2 − K1
K1 < S T < K 2 ST − K1 0 ST − K1
ST ≤ K1 0 0 0
Bear Spreads
 A bear spread is created by going long a call with
a given strike and short a call with a lower strike
 Both options have the same expiration date

 Note that the price of the low strike option will be

greater than the price of the high strike option

 As a result the bear spread strategy involves an

initial cashflow to the investor

 A bear spread attempts to cost effectively exploit

an expected decline in the underlying asset price
Bear Spreads
 The following graph illustrates the profit & loss
profile of the bear spread

(c1- c2)

K1 K2

-(K2 - K1)+(c1 - c2)

Bear Spreads
 As before, let c1 be the call price associated with
the low strike option
 And let K1 be the strike price

 Let c2 be the call price associated with the high

strike option
 And let K2 be the strike price

 As noted before c1 > c2, and by definition K1 < K2

 Therefore, the initial cash inflow from the bear

spread is c - c
 Bear Spreads
 Now consider the payoff from each of the options
positions, and hence the payoff from the bear
spread

 The following table illustrates

Stock Price Range Payoff from Long Payoff from Short Payoff from Bear
Call Call Spread

ST ≥ K 2 ST − K 2 K1 − ST − ( K 2 − K1 )
K1 < S T < K 2 0 K1 − ST − (S T − K1 )
ST ≤ K1 0 0 0
Butterfly Spreads
 A butterfly spread involves taking positions in
three options with differing strikes

 The butterfly spread can be created by doing the

following
 Going long one call with a relatively low strike
 Going long one call with a relatively high strike
 Going short two calls with strikes halfway between the
strikes on the two long call options

 Note again that the term to maturity on the four

options is the same
 Butterfly Spreads
 The following graph illustrates the profit & loss
profile of the butterfly spread
Profit
c3

K2 - K1 - (c1+ c2 - 2c3)

K1 K3 K2 Stock Price
-(c1+ c2 - 2c3)
-c2

-c1
 Butterfly Spreads
 The following graph illustrates the profit & loss
profile of the butterfly spread

K2 - K1 - (c1+ c2 - 2c3)

K1 K3 K2
-(c1+ c2 - 2c3)
Butterfly Spreads
 Let c1 be the call price associated with the low
strike option
 And let K1 be the strike price

 Let c2 be the call price associated with the high

strike option
 And let K2 be the strike price

 Let c3 be the call price associated with each of the

intermediate strike options
 And let K3 be the strike price on each
Butterfly Spreads
 As noted before c1 > c3 > c2, and by definition K1
< K3 < K2

 Therefore, the cost of setting up the bull spread

is c1 + c2 – 2c3

 Now consider the payoff from each of the options

positions, and hence the payoff from the butterfly
spread
 Butterfly Spreads
 The following table illustrates
Stock Price Payoff from Payoff from Payoff from Payoff from
Range Long Call Long Call Short Calls Butterfly
(Low Strike) (High Strike) (Inter Strikes) Spread

ST < K1 0 0 0 0
K1 < S T < K 3 ST − K1 0 0 ST − K1
K 3 < ST < K 2 ST − K1 0 − 2( ST − K 3 ) K 2 − ST
ST > K 2 ST − K1 ST − K 2 − 2( ST − K 3 ) 0

 Note that the total payoffs in the final column

follow from noting that K 3 = 0.5( K1 + K 2 )
Calendar Spreads
 A calendar spread involves taking positions in
options with differing maturities
 The options however have the same strike price

 The calendar spread is created by going short a

call with a given maturity and long a call with a
longer maturity

 Note that the longer-maturity option will have the

higher call price
 The calendar spread therefore requires an initial
investment by the investor
Calendar Spreads
 The payoff profile of a calendar spread is usually
considered at the maturity of the shorter-
maturity option

 The following graph illustrates the profit & loss

profile of a calendar spread

K
Calendar Spreads
 Let c1 be the call price associated with the
shorter-maturity option

 Let c2 be the call price associated with the longer-

maturity option

 Let K be the strike price associated with both call

options

 As noted before c1 < c2

 Therefore, the initial cash investment into the

Calendar Spreads
 The profit & loss profile of the calendar spread is
very similar to that of the butterfly spread

 The calendar spread is used when an investor

believes the asset price will be close to the strike
price K
 As observed at the expiration of the shorter-maturity
option

 A neutral calendar spread – the strike price of the

options is chosen be or close to the current stock
price
Calendar Spreads
 A bullish calendar spread – the strike price of the
options is chosen to be higher than the current
stock price

 A bearish calendar spread – the strike price of the

options is chosen to be lower than the current
stock price
Combinations
 A combination trading strategy involves taking a
position in both call and put options

 The next sections detail the three main

combination strategies, i.e.
 Straddles
 Strips and Straps
 Strangles
Straddles
 A straddle involves buying a call and a put at the
same strike price and expiration date

 Let c1 be the price of the call option and let p1 be

the price of the put option

 Let K be the strike price associated with the call

and put options

 The initial cost of the straddle trading strategy is

c1 + p1
 Straddles
 Now consider the payoff from each of the options
positions, and hence the payoff from the straddle

 The following table illustrates

Stock Price Range Payoff from Long Payoff from Long Payoff from
Call Put Straddle Spread

ST ≤ K 0 K − ST K − ST
ST > K ST − K 0 ST − K
Straddles
 The following graph illustrates the profit & loss
profile of a straddle

-(c1 + p1)
Straddles
 A straddle is used when a trader expects a large
move in the underlying asset price
 But is unsure of the direction of the move

 In this way the straddle is often referred to as a

volatility trade

 Straddles however are quite expensive given the

need for the long position in two options
Strips
 A strip involves going long one call and two puts
with the same strike price and expiration date

 Let c1 be the price of the call option and let p1 be

the price of each of the put options

 Let K be the strike price associated with the call

and put options

 The initial cost of the strip trading strategy is

c1 + 2p1
 Strips
 Now consider the payoff from each of the options
positions, and hence the payoff from the strip

 The following table illustrates

Stock Price Range Payoff from Long Payoff from Long Payoff from Strip
Call Puts

ST ≤ K 0 2( K − S T ) 2( K − S T )
ST > K ST − K 0 ST − K
Strips
 The following graph illustrates the profit & loss
profile of a strip

-(c1 + 2p1)
Strips
 A strip is used when a trader expects a large
move in the underlying asset price
 But considers it more likely that movement in the asset
price will be downward
Straps
 A strap involves going long two calls and one put
with the same strike price and expiration date

 Let c1 be the price of each of the call options and

let p1 be the price of the put option

 Let K be the strike price associated with the call

and put options

 The initial cost of the strap trading strategy is

2c1 + p1
 Straps
 Now consider the payoff from each of the options
positions, and hence the payoff from the strap

 The following table illustrates

Stock Price Range Payoff from Long Payoff from Long Payoff from Strap
Call Puts

ST ≤ K 0 K − ST K − ST
ST > K 2( S T − K ) 0 2( S T − K )
Straps
 The following graph illustrates the profit & loss
profile of a strap

-(2c1 + p1)
Straps
 A strap is used when a trader expects a large
move in the underlying asset price
 But considers it more likely that movement in the asset
price will be upward
Strangle
 A strangle involves going long a call and put
option with the same expiration and different
strike prices

 The strike price on the call option is higher than

the strike price on the put option

 Let c1 be the call price and let K1 be the

associated strike price

 Let p2 be the put price and let K2 be the

associated strike price
 Strangle
 The cost of setting up a strangle trading strategy
is c1 + p2

 Now consider the payoff from each of the options

positions, and hence the payoff from the strangle

 The following table illustrates

Stock Price Range Payoff from Long Payoff from Long Payoff from
Call Puts strangle

ST ≤ K1 0 K1 − S T K1 − S T
K1 < S T < K 2 0 0 0
ST ≥ K 2 ST − K 2 0 ST − K 2
Strangle
 The following graph illustrates the profit & loss
profile of a strangle

K1 K2

-(c1 + p2)
 Further reading
 Hull, J.C, “Options, Futures & Other Derivatives”,
2009, 7th Ed.
 Chapter 10