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Options trading strategies
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Options strategies

  1. 1. - Pavan Makhija
  2. 2. Options are derivative products which, if you buy, give you certain rights Investors use options for two primary reasons -- to speculate and to hedge their risk Call Options give you a right to buy a share (at a certain specific price) Put Options give you a right to sell (again at a predefined price) The cost you pay for obtaining such rights is the premium (also called price or option value) Options will (like Futures) expire on the last Thursday of every month
  3. 3. Option Buyer (Option Holder) Party that purchases and holds the options contract Option Seller Party that writes, or creates, the options contract. Strike Price The price at which the option seller agrees to buy or sell a certain stock in the future Expiration Month The month in which the option will expire Expiration Date This is always the third Friday of the month in which the option is scheduled to expire
  4. 4. Option Contract Each options contract represents an interest in 100 shares of a certain underlying stock Put Option This type of option gives the option holder the right, but not the obligation, to sell Call Option This type of option gives the option holder the right, but not the obligation, to purchase In the money Situation in which an option's strike price is below the current market price of the underlier (for a call option) or above the current market price of the underlier (for a put option)
  5. 5. Out of the money A call option whose strike price is higher than the market price of the underlying security, or a put option whose strike price is lower than the market price of the underlying security Naked Option Writing When an investor writes an option on a stock he/she does not own, it is referred to as writing a “naked” options contract
  6. 6. European option An option that may only be exercised on expiration American option An option that may be exercised on any trading day on or before expiration Bermudan option An option that may be exercised only on specified dates on or before expiration Barrier option Any option with the general characteristic that the underlying security's price must reach some trigger level before the exercise can occur.
  7. 7. Strategy: Buy a Call Option Strategy View (Bullish) Investor thinks that the market will rise significantly in the short-term. . Strategy Implementation Call options are bought with a strike price of a. The more bullish the investor is, the higher the strike price should be. Upside Potential Profit potential is unlimited and rises as the market rises. Downside Risk Limited to the premium paid - incurred if the market at expiry is at, or below, the strike a. Comment If the market does little then the value of the position will decrease as the option time value falls.
  8. 8. (Payoff Table) Market Profit/ Price Premium Call Loss 100 -5 -5 a 110 -5 -5 120 -5 -5 125 -5 5 0 130 -5 10 5 140 -5 20 15 Strike Price (Call Option): 120 Premium: 5 Strike Price: Break-Even:
  9. 9. Strategy: Buy a Put Option Strategy View (Bearish) Investor thinks that the market will fall significantly in the short-term. . Strategy Implementation Put option is bought with a strike price of a. The more bearish the investor is, the lower the strike price should be. Upside Potential Profit potential is unlimited (well, not really unlimited of course as the market can not fall below zero). Downside Risk Limited to the premium paid - incurred if at expiry the market is at or above the strike a. Comment If the market does little then the value of the position will decrease as the option time value falls.
  10. 10. (Payoff Table) Market Profit/ Price Premium Put Loss 100 -5 30 25 a 110 -5 20 15 120 -5 10 5 125 -5 5 0 130 -5 -5 140 -5 -5 Strike Price (Put Option): 130 Premium: 5 Strike Price: Break-Even:
  11. 11. Strategy: Hold the stock and buy call options. Strategy View (Bearish) An investor holds stock but does not think the stock will rise in the short term, or that the stock will be neutral, income can be gained by selling call options against the stock holding. Strategy Implementation Call options are sold. The number of call options sold will be determined by the investor's market view and the size of the stock holding. Upside Potential Limited - by selling calls, the investor is writing off the potential prfit of the stock position. Maximum profit is the strike minus the market price plus the premium received. Downside Risk Large: Similar to that incurred with ordinary stock ownership, only off-set partially by the (fixed) option premium received. Main loss could be the opportunity loss if the market rises strongly.
  12. 12. (Payoff Table) Market Short Profit/ Price Premium Call Stock Loss 100 30 -20 10 110 30 -10 20 120 30 0 30 a 125 30 -5 5 30 130 30 -10 10 30 140 30 -20 20 30 Strike Price (Short Call): 120 Stock Price: 120 Premium: 30 Strike Price: Break-Even:
  13. 13. Strategy: Buy and sell Call Options with different strike prices. Strategy View (Bullish) Investor thinks that the market will not fall, but wants to cap the risk. Conservative strategy for one who thinks that the market is more likely to rise than fall. Strategy Implementation Call option is bought with a strike price of a and another call option sold with a strike of b, producing a net initial debit, Upside Potential Calls: difference between strikes minus initial debit Maximum profit if market at expiry is above the higher strike. Downside Risk Calls: net initial debit Maximum loss if at expiry market is below the lower strike. Comment Time value erosion not too significant due to the balanced position. .
  14. 14. (Payoff Table) Market Call Call Profit/ Price Premium (120) (150) Loss 100 -11 -11 110 -11 -11 a 120 -11 -11 b 125 -11 5 -6 131 -11 11 0 140 -11 20 9 150 -11 30 19 Strike Price (Long)-a: 120 160 -11 40 -10 19 Strike Price (Short)-b: 150 Premium long call: 16 Strike Price: Break-Even: Premium short call: 5
  15. 15. Strategy: Buy a call option and a put option with the same strike prices. Strategy View (Neutral) Investor thinks that the market will be very volatile in the short-term. Strategy Implementation Call option and put option are bought with the same strike price a - usually at-the-money. Upside Potential Unlimited Breakeven Point at Expiry Lower point is the strike minus the two premiums paid, and the upper is the strike plus the two premiums. Downside Risk Limited to the two premiums paid. [If the investor would like to decrease the premium paid, a buy strangle might be interesting] Comment Position loses value with passage of time as time value decreases on options.
  16. 16. (Payoff Table) Market Profit/ Price Premium Call Put Loss 100 -11 30 19 a 110 -11 20 9 119 -11 11 0 130 -11 0 -11 141 -11 11 0 150 -11 20 9 160 -11 30 19 Strike Price (Long Call): 130 Strike Price (Long Put): 130 Premium long call: 5 Strike Price: Break-Even: Premium short call: 6
  17. 17. Strategy: Buy a call option and a put option with the different strike prices. Strategy View (Neutral) Investor thinks that the market will be very volatile in the short-term [this is similar to the buy straddle but the premium paid here is less] Strategy Implementation Put option is bought with a strike a and a call option is bought with a strike b. Upside Potential Unlimited - should the market fall or rise greatly. Downside Risk Limited to the two premiums paid. [If the investor would like to reduce the premiums paid still further, a short butterfly might be interesting]. Comment Position loses value with passage of time as time value decreases on options.
  18. 18. (Payoff Table) Market Profit/ Price Premium Call Put Loss 100 -11 20 9 109 -11 11 0 a b 120 -11 -11 130 -11 -11 140 -11 -11 151 -11 11 0 160 -11 20 9 Strike Price (Long Call): 140 Strike Price (Long Put): 120 Premium long call: 5 Strike Price: Break-Even: Premium long put: 6
  19. 19. Strategy: Buy a call option with lower strike price and a higher strike price. Also sell a call and a put option with a medium (same) strike price. Strategy View (Neutral) Investor thinks that the market will not be volatile, but wants to cap the downside risk. . Strategy Implementation Put option with low strike b bought and a straddle with medium strike a is sold and call option with high strike c bought. Upside Potential Limited Downside Risk Limited. Comment Can be difficult to execute such strategies quickly.
  20. 20. (Payoff Table) Market Short Long Long Short Profit Price Premium Call Call Put Put /Loss 100 13 10 -30 -7 b c 110 13 -20 -7 a 117 13 -13 0 130 13 0 0 0 0 13 143 13 -13 0 150 13 -20 -7 Strike Price (Short Call): 130 160 13 -30 10 -7 Strike Price (Short Put): 130 Strike Price (Long Call): 150 Premium short put: 13 Strike Price (Long Put): 110 Strike Price: Break-Even: Premium long put: 5 Premium long call: 6 Premium short call: 11
  21. 21. Strategy: Buy a call option and two put options with the same strike prices and expiration date Strategy View Investor mildly thinks that the market will be volatile but price is likely to decline. Strategy Implementation Call option and two put options with strike price „a‟ are bought Upside Potential Unlimited. Downside Risk Limited. Comment May be difficult to execute this strategy quickly.
  22. 22. (Payoff Table) Market Profit Price Premium Call Puts /Loss 120 -50 180 130 a 160 -50 100 50 190 -50 40 -10 210 -50 0 0 -50 230 -50 20 -30 260 -50 50 0 300 -50 90 40 Strike Price (Long Call): 210 Strike Price (Long Puts): 210 Premium long call: 10 Strike Price: Break-Even: Premium long put: 20
  23. 23. Strategy: Buy two call options and a put option with the same strike prices and expiration date Strategy View Investor mildly thinks that the market will be volatile but price is likely to decline. Strategy Implementation Call options and a put option with strike price „a‟ are bought Upside Potential Unlimited. Downside Risk Limited. Comment May be difficult to execute this strategy quickly.
  24. 24. (Payoff Table) Market Profit Price Premium Call Puts /Loss 150 -30 60 30 a 180 -30 30 0 190 -30 20 -10 210 -30 0 0 -30 230 -30 40 10 250 -30 80 50 280 -30 140 110 Strike Price (Long Calls): 210 Strike Price (Long Put): 210 Premium long call: 5 Strike Price: Break-Even: Premium long put: 20
  25. 25. Strategy: Sell a Call Option. Strategy View (Bearish) Investor is certain that the market will not rise and and is unsure/unconcerned whether it will fall. Strategy Implementation Call option is sold with a strike price of a. If the investor is very certain of his view then at- the-money options should be sold, if less certain, then out-of-the-money ones should be sold. Upside Potential Limited to the premium received - received if the market at expiry is at, or below, the option strike. Downside Risk Unlimited. Losses on the position will worsen as the market rises. [If the investor likes the idea of the strategy, but not the downside risk, they might be interested in a bear spread]. Comment If the market does little, and time passes, this helps as the short position gains when the time value erodes
  26. 26. (Payoff Table) Market Profit/ Price Premium Call Loss 100 5 5 110 5 5 120 5 5 a 125 5 0 130 5 -10 -5 140 5 -20 -15 150 5 -30 -25 Strike Price (Call Option): 120 Premium: 5 Strike Price: Break-Even:
  27. 27. Strategy: Sell a Put Option Strategy View (Bullish) Investor is certain that the market will not go down, but unsure about whether it will rise. Strategy Implementation Put options are sold with a strike price a. If an investor is very bullish, then in-the-money puts would be sold. Upside Potential Profit potential is limited to the premium received. The more the option is in-the-money, the greater the premium received. Downside Risk Loss is almost unlimited ("almost"!). High risk strategy. Potential huge losses incurred if the market crashes. Comment If the market does little, and time passes, this helps as the short position gains when the time value erodes.
  28. 28. (Payoff Table) Market Profit/ Price Premium Call Put Loss 100 5 -30 -25 110 5 -20 -15 a 120 5 -10 -5 125 5 -5 0 130 5 5 140 5 5 Strike Price (Put Option)-a: 130 Premium: 5 Strike Price: Break-Even:
  29. 29. Strategy: Hold Stock and buy put options. Strategy View (Bearish) Investor holds stock and is worried about a market fall. Put options can be bought to protect the value of the stock position, while not preventing the position to benefit in the event of a market rise. Strategy Implementation Put options are bought with a strike price of a.The number of put options bought will depend on the bearishness of the investor and the size of the stock holding. Upside Potential Profit potential is unlimited, being the ordinary return on the stock minus the fixed premium paid for the put option. Downside Risk Potentially limited, (depending on the hedge ratio initially applied). The gains on the put options - as the market falls - will off-set the stock losses. Comment Strategy characteristics are similar to a buy call.
  30. 30. (Payoff Table) Market Long Profit Price Premium Put Stock /Loss 100 -5 20 -20 15 110 -5 10 -10 5 a 120 -5 0 0 -5 125 -5 5 0 130 -5 10 5 140 -5 20 15 Strike Price (Long Put): 120 Stock Price: 120 Strike Price: Break-Even: Premium: 5
  31. 31. Strategy: Buy and sell Put Options with different strike prices. Strategy View (Bearish) Investor thinks that the market will not rise, but wants to cap the risk. Conservative strategy for one who thinks that the market is more likely to fall than rise. Strategy Implementation Put option is sold with a stike of a and another put bought with a strike of b, producing a net initial debit. Upside Potential Puts: difference between strikes minus initial debit Maximum profit if market at expiry is below the lower strike. Downside Risk Puts: net initial debit Maximum loss if at expiry market is above the higher strike. Comment Time value erosion not too significant due to the balanced position. .
  32. 32. (Payoff Table) Market Put Put Profit/ Price Premium (120) (150) Loss 100 -11 -20 50 19 110 -11 -10 40 19 b 120 -11 30 19 a 125 -11 25 14 139 -11 11 0 145 -11 5 -6 150 -11 -11 Strike Price (Short)-a: 120 160 -11 -11 Strike Price (Long)-b: 150 Premium long put: 16 Strike Price: Break-Even: Premium short put: 5
  33. 33. Strategy: Sell a call option and put option with the same strike price. Strategy View (Neutral) Investor is certain that the market will not be very volatile (will neither go up nor down very much). Strategy Implementation A call option and a put option are sold with the same strike price a. Upside Potential Limited to the two premiums received - will be realized if market at expiry is exactly at the strike price level. Downside Risk Unlimited - should the market fall or rise greatly. Comment If the market does little then the value of the position will benefit as the short positions gain when the option time value falls.
  34. 34. (Payoff Table) Market Profit/ Price Premium Call Put Loss 100 11 - 110 11 130 -110 - a 119 11 130 -119 130 11 0 0 11 - 141 11 130 - 150 11 130 Strike Price (Short Call): 130 160 11 Strike Price (Short Put): 130 Premium long call: 5 Strike Price: Break-Even: Premium short call: 6
  35. 35. Strategy: Sell a put option at a given strike price and a call option with higher strike price. Strategy View (Bearish) The investor thinks that the market will not be volatile within a broad band. Strategy Implementation Put option is sold with a strike price of a and a call option is sold with the higher strike price b Upside Potential Limited to the two premiums received. Downside Risk Unlimited - should the market fall or rise greatly. [If the investor likes the strategy, but not the downside risk, a long butterfly might be interesting]. Comment If the market does little then the value of the position will benefit as the short positions gain when the option time value falls.
  36. 36. (Payoff Table) Market Profit Price Premium Call Put /Loss 100 11 -20 -9 109 11 -11 0 a b 120 11 11 130 11 11 140 11 11 151 11 -11 0 160 11 -20 -9 Strike Price (Short Call): 140 Strike Price (Short Put): 120 Premium long call: 5 Strike Price: Break-Even: Premium short call: 6
  37. 37. Strategy: Buy a call option and a put option with the different strike prices. Strategy View Investor mildly thinks that the market will be volatile. Strategy Implementation Put option is sold with strike b, a straddle is bought with strike a and a call option is sold with strike c Upside Potential Limited. Downside Risk Limited. Comment May be difficult to execute this strategy quickly.
  38. 38. (Payoff Table) Market Short Long Long Short Profit Price Premium Call Call Put Put /Loss 100 -13 30 -10 7 a 110 -13 20 7 b c 117 -13 13 0 130 -13 0 0 0 0 -13 143 -13 13 0 150 -13 20 -7 160 -13 -10 30 7 Premium short put: 5 Strike Price: Break-Even: Premium long put: 13
  39. 39. Strategy: Sell a call option and put options with the same strike price and expiration date. Strategy View Investor is certain that the market will not be very volatile but price is likely to rise Strategy Implementation A call option and put options are sold with the same strike price „a‟. Upside Potential Limited to the three premiums received - will be realized if market at expiry is exactly at the strike price level. Downside Risk Unlimited - should the market fall or rise greatly. Comment If the market does little then the value of the position will benefit as the short positions gain when the option time value falls.
  40. 40. (Payoff Table) Market Profit Price Premium Call Put /Loss 120 50 -180 -130 160 50 -100 -50 190 50 -40 10 a 210 50 0 0 50 230 50 -20 30 260 50 -50 0 300 50 -90 -40 Strike Price (Short Call): 210 Strike Price (Short Puts): 210 Premium long call: 10 Strike Price: Break-Even: Premium short call: 20
  41. 41. Strategy: Sell two call options and put option with the same strike price and expiration date. Strategy View Investor is certain that the market will not be very volatile but price is likely to decline Strategy Implementation A call option and put options are sold with the same strike price „a‟. Upside Potential Limited to the three premiums received - will be realized if market at expiry is exactly at the strike price level. Downside Risk Unlimited - should the market fall or rise greatly. Comment If the market does little then the value of the position will benefit as the short positions gain when the option time value falls.
  42. 42. (Payoff Table) Market Profit Price Premium Call Put /Loss 150 30 -60 -30 180 30 -30 0 190 30 -20 10 a 210 30 0 0 30 230 30 -20 10 250 30 -40 -10 280 30 -70 -40 Strike Price (Short Calls): 210 Strike Price (Short Put): 210 Premium long call: 5 Strike Price: Break-Even: Premium short call: 20

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