Chapter 2

Options Strategies
By
Surya B. Rana
 Introduction to Option Strategies
Options strategies allows investors to combine their

wealth in underlying stocks, and options as such to

reduce the investment risks.
This section deals with several types of option strategies

that investors can assume.

a. The Protective Put Position
The protective put position is one way to obtain
protection against a bear market and still be able to
participate in a bull market. In other words, in the case
of stock price increase, this strategy benefits the
investors with increased stock price and when stock
price drops, it ensures the investors with the exercise
price at minimum against any decline in stock price.
This position can be established by buying stock and
buying a put on the stock simultaneously.
The pay-off position of the protective put is as follows:
 Position If ST > X If ST < X
Buy Stock ST ST
Buy Put 0 X - ST
Pay-off ST X

Thus protective put position offers the stock price if it increases at expiration
and ensures the exercise price at minimum if it declines. Hence, the value of
the portfolio does not decline below the exercise price in any case.

The cost of protective put position is the total of current stock price (S0) paid
to buy the stock and put premium (p) paid to buy the premium:
Cost of protective put = S0 – p

Profit or loss under protective put is given by:

Profit/Loss = Payoff of the protective put – cost of protective put
The protective put works like an insurance policy. When
you buy insurance for an asset such as a house, you pay a
premium that assures you that in the event of a loss, the
insurance policy will cover at least some of the loss. If the
loss does not occur during the policy’s life, you simply lose
the premium. Similarly, the protective put is insurance for
a stock. In a bear market, a loss on the stock is somewhat
offset by the put’s exercise. This is like filing a claim on the
insurance policy. In a bull market, the insurance is not
needed and the gain on the upside is reduced by the
premium paid.
It is to be noted that profit in the bull market varies
directly with the stock price at expiration. The higher ST
is, the higher is the profit. In a bear market, profit is not
affected by the stock price at expiration.
The breakeven stock price is attained when it is equal to
the cost of protective put.
Assignment 1
Suppose you buy a share of common stock of Mega bank
limited at Rs 120 per share. The put option in this stock is
trading at Rs 20 with exercise price of Rs 120. You buy a
share of common stock and a put option on this stock
simultaneously to establish a protective put position.
 What is the cost of protective put?
 What is the payoff of your position if stock prices at
expiration is Rs 100, Rs 110, Rs 120, Rs 140, Rs 160, Rs 200?
 Graph your protective put position and locate the
breakeven point? At what stock price it breakevens?
b. The Covered Call Position
The covered call position is established by buying a share of
common stock and simultaneously writing a call option on the
stock. An investor executing this strategy is said to be writing a
covered call.
Think of the uncovered call in which the investor writes a call
on a stock not owned. In such case the risk is unlimited which
might result because of significant increase in stock price in
the market after call has been sold.
However, with covered call, in which the option writer also
owns the stock, there is no risk of buying it in the market at a
potentially high price. If the call is exercised, the investor
simply delivers the stock.
The long stock position covers or protects the
investors from the payoff on the short call that
becomes necessary if there is a sharp rise in the stock
price.
The payoff position under covered call position is as
follows
Position If ST > X If ST < X

Buy Stock ST ST

Write Call -(ST – X) 0

Pay-off X ST
From another point of view, the holder of the stock
with no options written thereon is exposed to
substantial risk of the stock price moving down. By
writing a call against that stock, the investor reduces
the downside risk. If the stock price falls substantially,
the loss will be cushioned by the premium received for
writing the call.
The cost of covered call is given by:
Cost of covered call = S0 – c
Assignment 2
Assume you buy 100 shares of IBM stock at Rs 125 per
share and simultaneously write 100 call options on
them at a call price of Rs 15 each and exercise price of
Rs 125.
What is the cost of your position?
What is the payoff position if alternative stock price at
expiration is Rs 105, Rs 110, Rs 120, Rs 125, Rs 130, Rs 140?
Show the payoff position graph and determine the
breakeven point.
c. Spreads
A spread trading strategy involves taking a position in
two or more options of the same type (that is, two or
more calls or two or more puts).
Bull spreads
One of the most popular types of spread is a bull
spread. This can be created by buying a call option on a
stock with a certain strike price and selling a call option
on the same stock with a higher strike price.
Buy call with XL and sell call with XH on the same stock.
Both options have the same expiration date.
 Since the call options bought and sold have different strike prices,
three types of bull spread can be distinguished:
 Both calls are initially out of money.
 One call is initially in the money; the other call is initially out of the money.
 Both calls are initially in the money
 Accordingly, the pay-off position for bull spread can be represented as
follows:
 A bull spread strategy limits the investor’s upside as well as downside
risk
Position If ST < XL If XL< ST < XH If ST > XH
Buy call with XL 0 ST - XL ST - XL

Sell call with XH -0 -0 -(ST – XH)

Pay-off 0 ST - XL XH – XL
Assignment 3
An investor buys for $3 a call with a strike price of $30
and sells for $1 a call with a strike price of $35. Assume
that both call options have three months to expiration
and any one of the following stock prices are expected
to prevail in three months: $28, $30, $32, $35, $40, $45.
What is the cost of your position?
Compute the payoff and profit at each alternative stock
prices.
What is the breakeven stock price?
Show the position graph based on your computed figures.
Note that bull spreads can also be created by buying a put
with a low strike price and selling a put with high strike
price. Unlike, the bull spread created from calls, bull spreads
created from puts involve a positive upfront cash flow to the
investors and a payoff that is either negative or zero.

Assignment 4
Suppose that put options on a stock with strike prices of $30
and $35 cost $4 and $5 respectively. How can the options be
used to create a bull spread? Construct a table that shows
the profit and payoff of the bull spread.
Bear Spreads
 An investor who enters into a bull spread is hoping that the stock price
will increase. By contrast, an investor who enters into a bear spread is
hoping that the stock price will decline.
 Bear spreads can be created by buying a put with one strike price and
selling a put with lower strike price.
 The payoff position of this strategy is shown in the following table.

Position If ST < XL If XL< ST < XH If ST > XH

Buy Put with XH XH – ST XH - S T 0
Sell Put with XL - (XL – ST) -0 0
Pay-off XH - XL XH - S T 0
A bear spread created from puts involves an initial cash
outflow because the price of the put sold is less than the
price of the put purchased.
In essence, the investor has bought a put with a certain
strike price and chosen to give up some of the profit
potential by selling a put with a lower strike price. In return
for the profit given up, the investor gets the price of the
option sold.
Assignment 5
An investor buys for $3 a put with a strike price of $35 and
sells for $1 a put with a strike price of $30. Demonstrate the
payoff and profit position of investors for stock price within
the range of below $30 to above $35.
Like bull spreads, bear spreads limit both the upside
profit potential and the downside risk. Bear spreads
can be created using calls instead of puts. The
investors buys a call with high strike price and sells a
call with low strike price. Bear spread created with
calls involve an initial cash inflow.
Assignment 6
Suppose that put options on a stock with strike prices
of $30 and $35 cost $4 and $7, respectively. How can
the options be used to create a bear spread? Construct
a table that shows the profit and payoff for the bear
spread.
Box Spread
A box spread is a combination of a bull call spread and
bear put spread.
It involves buying a call and selling a put with lower
strike price (XL) and selling a call and buying a put
with higher strike price (XH).
The payoff from the box spread is always XH – XL. The
value of box spread is therefore always the present
value of this payoff:
 Value of Box Spread = (XH- XL) e-rT
If it has different value there is an arbitrage
opportunity
The payoff position of the box spread is as follows:
Position If ST < XL If XL< ST < XH If ST > XH
Buy call with XL 0 ST - XL ST - XL
Sell Put with XL - (XL – ST) -0 -0
Sell call with XH -0 -0 -(ST – XH)

Buy Put with XH XH - ST XH – ST 0

Pay-off XH - XL XH - XL XH - XL

If the market price of the box spread is too low, it is

profitable to buy the box. And if the market price is
too high, it is profitable to sell the box
Assignment 7
Assume the following call and put prices with given
strike prices: Call $5, strike price $50; Call $2, strike
price $60; Put $5, strike price $60; Put $2, strike price
$50. How do you create a box spread involving the
given calls and puts? Determine the payoff of the box
if stock price at expiration is below $50; between $50
and $60; and Above $60. Also assume that both calls
and puts have 3 months to expiration. What is the
present value of the box spread if risk-free interest rate
is 10 percent per annum? What would you do if market
value of the box spread is $12? What would you do with
the position you decided?
Butterfly Spread
A butterfly spread involves positions in options with
three different strike prices.
It can be created by buying a call option with a
relatively low strike price (XL), buying a call option
with relatively high strike price (XH), and selling two
calls with a medium strike price (XM), half way
between XL and XH.
Generally, XM is closer to the current stock price.
Thus, in a butterfly spread, there are four possible
relation between stock price at expiration and strike
prices.
 Position ST < XL XL < ST < XM XM < ST < XH ST > XH
Buy call with 0 ST - XL ST – XL ST – XL
XL
Buy call with 0 0 0 ST – XH
XH
Sell two calls - 2 (0) -2(0) -2(ST – XM) -2(ST – XM)
with XM
Pay-off 0 ST - XL 2XM – XL - ST 2XM – XH - XL

Note that if XM is just half way between XL and XH, then XM = (XL + XH)/2

A butterfly spread leads to profit if the stock price stays close to X M, but
gives rise to small loss if there is a significant stock price move in either
direction. It is therefore an appropriate strategy for an investor who feels
that large stock price moves are unlikely. This strategy requires small
investment initially
Assignments
Q. Suppose that a certain stock is currently worth $61. Consider an
investor who feels that a significant price move in the next 6 months
is unlikely. Suppose that the market prices of 6-month calls are as
follows: Strike price: $55, $60, $65 with call price of $10, $7 and $ 6
respectively.
 How could an investor create a butterfly spread?
 What is the cost of butterfly spread?
 Show the payoff and profit if the stock price in 6 month is less than $55 or
greater than $65 or in between $55 and $65.

Q. Call options on a stock are available with strike prices of $15,

$17.5 and $20, and expiration dates is 3 months. Their prices are
$4, $2, and $0.5 respectively. Explain how the options can be
used to create butterfly spread. Construct a table showing how
profit varies with stock price for the butterfly spread.
Possible Questions
What is meant by a protective put? How protective put works
as an insurance on stock investment? Explain.
Explain the ways in which bull spreads and bear spreads can
be created?
What do you mean by covered call strategy? How it is safer
than uncovered call? Explain.
What do you mean by box spread? Explain the payoff position
of an investor establishing box position?
When is it appropriate for an investor to purchase butterfly
spread? Explain.
Construct a table showing the payoff from a bull spread when
puts with strike prices XL and XH, with XH > XL, are used.
d. Combinations
A combination is an option trading strategy that involves
taking a position in both calls and puts on the same stock. We
consider following types of combinations:
Straddle
One popular combination is a straddle, which involves buying
a call and put with the same strike price and expiration date.
If stock price is closer to strike price at expiration, the
straddle leads to a loss.
However, if there is a sufficiently large move in either
direction, a significant profit will result.
Thus, a straddle is appropriate when an investor is
expecting a large move in a stock price but does not
know in which direction the move will be.
Example:
Consider an investor who feels that the price of a certain
stock, currently value at $69 by the market will move
significantly in the next 3 months. Both call and put has
strike price of $70, the cost of call is $4 and put is $3.
What would be the pay-off position of the investors who
buy these call and put and the stock price in 3-months
declined to $50? If it increased to $95? If the stock price
stays at $69? {Please workout yourself for pay-
off/profit-loss and the graph of the profit loss}
Assignment
A call option with a strike price of Rs 90 costs Rs 14. A
put option with the same strike price and expiration
date costs Rs 10. Construct a table that shows the profit
from a straddle. For what range of stock prices would
the straddle leads to a loss?
Strips and Straps
A strip consists of a long position in one call and two
puts with the same strike price and expiration date.
A strap consists of a long position in two calls and one
put with the same strike price and expiration date.
In a strip the investor is betting that there will be a big
stock price move and considers a decrease in stock price to
be more likely than an increase.
In a strap the investor is also betting that there will be a big
stock price move. However, in this case, an increase in the
stock price is considered to be more likely than a decrease.
Assignment
Assume that call option and put option both have 6
m0nths to expiration and both have strike price of Rs 200.
The call price is Rs 10 and the put price is Rs 12. How would
you establish the strip and strap positions from these calls
and puts? What are the pay-off and profit loss from strip
and strap for the stock price at expiration below or above
Rs 200? Construct a table and explain your answer.
Strangles
In a strangle, an investor buys a put and a call with the
same expiration date and different strike prices.
A strangle is similar strategy to a straddle. The investor
is betting that there will be a large price move, but is
uncertain whether it will be an increase or decrease.
However, the call strike price is higher than the put
strike price in the case of a strangle.
In the case of strangle, the stock price has to move
farther than in a straddle for the investors to make a
profit. However, the downside risk if the stock price
ends up at a central value is less with a strangle.
 The profit pattern obtained with a strangle depends on how close
together the strike prices are. The farther they are apart, the less
the downside risk and the farther the stock price has to move for a
profit to be realized.
Assignment:
 How would you establish the strangle position from the following
call and put: Call with strike $50 and call price $5 and Put with
strike $45 and put price $3. Calculate pay-off and profit/loss at
different stock price at expiration.
Possible Questions
 An investor believes that there will be a big jump in a stock price,
but is uncertain as to the direction. Identify the different
strategies the investor can follows and explain the differences
among them.
 What is a Strip and a Strap? What are the investors’ expectations
while creating a strip and a strap? Explain.